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 70 percent for the next year, and the probability of a recession is 30 percent. If the expansion continues, each firm will generate earnings before interest and taxes (EBIT) of 532 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $16 million. Steinberg's debt obligation requires the firm to pay $950,000 at the end of the year. Dietrich's debt obligation requires the firm to pay $17 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 12 percent .1. What are the current market values of Steinberg's equity and debt? (Enter your answers in dollars, not millions of dollars. Do not round Intermediate calculations and round your answers to the nearest whole dollar, e.g., 1.234,567.) Steinberg Equity value Debt value a-2. What are the current market values of Dietrich's equity and debt? (Enter your answers in dollars, not millions of dollars. Do not round Intermediate calculations and round your answers to the nearest whole dollar, e.g., 1,234,567.) Dietrich Equity value Debt value

Answer 1

Compute the estimated earnings before interest and taxes (EBTI), using the equation as shown below:

Estimated EBIT = (EBIT for expansion*Probability) + (EBIT for recession*Probability)

                           = ($3,200,000*70%) + ($1,600,000*30%)

                           = $2,240,000 + $480,000

                           = $2,720,000

Hence, the estimated EBIT is $2,720,000.

Compute the value of both the companies, using the equation as shown below:

Value of firm = Estimated EBIT/ (1 + Discount rate)

                       = $2,720,000/ (1 + 0.12)

                       = $2,428,571.42857

Hence, the value of both companies are $2,428,571.42857.

a-1

Compute the current market value of Steinberg’s debts, using the equation as shown below:

Debt value = Debt obligation/ (1 + Discount rate)

                   = $950,000/ (1 + 0.12)   

                   = $848,214.2857

Hence, the current market value of debt is $848,214

Compute the current market value of equity, using the equation as shown below:

Equity value = Value of firm – Value of debt

                     = $2,428,571.42857 - $848,214.2857

                     = $1,580,357.14287

Hence, the market value of equity is $1,580,357.

a-2

Compute the current market value of Dietrich’s debts, using the equation as shown below:

Debt value = Debt obligation/ (1 + Discount rate)

                   = $1,700,000/ (1 + 0.12)   

                   = $1,517,857.14285

Hence, the current market value of debt is $1,517,857.

Compute the current market value of equity, using the equation as shown below:

Equity value = Value of firm – Value of debt

                     = $2,428,571.42857 - $1,517,857.14285

                     = $910,714.28572

Hence, the market value of equity is $910,714.