Question

Steinberg Corporation and Dietrich Corporation are identical firms except that Dietrich is more levered. Both companies will remain in business for one more year. The companies' economists agree that the probability of the continuation of the current expansion is 80 percent for the next year and the probability of a recession is 20 percent. If the expansion continues, each firm will generate earnings before interest and taxes (EBIT) of $3.1 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $1.5 million. Steinberg's debt obligation requires the firm to pay $940,000 at the end of the year. Dietrich's debt obligation requires the firm to pay $1.6 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 15 percent. a-1. What is the value today of Steinberg's debt and equity? (Do not round intermediate calculations and enter your answers in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.) a. What is the value today of Dietrich's debt and equity? (Do not round intermediate 2. calculations and enter your answers in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.) b. Steinberg's CEO recently stated that Steinberg's value should be higher than Dietrich's because the firm has less debt and therefore less bankruptcy risk. Do you agree or disagree with this statement? a-1. a-2. Steinberg equity value Steinberg debt value Dietrich equity value Dietrich debt value Risk of bankruptcy affect a firm's value b.

Answer 1

Ans1 Steinberg Particulars EBIT Less: Earnings to Bondholders Earnings available to equity holders Expansion Recession $3100000 $1500000 $940000 $940000 $2160000 $560000 • Market value of debt = [ $940000 x 0.80 + $940000 x 0.20 1(1 + 0.15) = $817391.30 • Market value of equity = { $2160000 x 0.80 + $560000 x 0.20 ]/(1 + 0.15) = $1600000

a-2) Particulars EBIT Dietrich Expansion Recession $3100000 $1500000 $16000001 $1500000 (cannot pay more than earnings) Less: Earnings to Bondholders Earnings available to equity holders $1500000 $0 • Market value of debt = [ $1600000 x 0.80 + $1500000 x 0.20]/(1 + 0.15) = $1373913.04 • Market value of equity = [ $1500000 x 0.80 + $0 x 0.20 ]/(1 + 0.15) = $1043478.26 c) Total value of Steinberg = $817391.30 + $1600000 = $2417391.30

• Market value of debt = [ $1600000 x 0.80+ $1500000 x 0.20]/(1 + 0.15) = $1373913.04 • Market value of equity = [ $1500000 x 0.80 + $0 x 0.20 J/(1 +0.15) = $1043478.26 c)Total value of Steinberg = $817391.30 + $1600000 = $2417391.30 • Total value of Dietrich = $1373913.04 + $1043478.26 = $2417391.30 We market values are same for both the companies. therefore, we disagree with the statement.