Question

Steinberg Corporation and Dietrich Corporation are apparently identical firms except that Dietrich has more leverage. Both companies will remain in business for one year. The companies’ economists agree that the probability of continuation of the current expansion is 80 percent for the next year, and the probability of recession is 20 percent. If the expansion continues, each firm expects to generate earnings before interest and taxes (EBIT) of $2.7 million. If the recession occurs, each firm expects to generate EBIT of $1.1 million. Steinberg's debt obligation requires the firm to pay $900,000 at the end of the year. Dietrich’s debt obligation requires the firm pay $1.2 million at the end of the year. Neither firm pays taxes. Assume the required return on Steinberg's debt is 10 percent, and that for Dietrich is 10.5 percent. Assume Steinberg's equity cost of capital is 13 percent and Dietrich's equity cost of capital is 13.2 percent. Assume that you conclude from your analysis that the enterprise values of Steinberg Corporation and Deitrich Corporation are essentially identical, even though they have different capital structures. Which of the following financial arguments provides the best explanation for your finding? It is possible that a lower expected costs of financial distress for Steinberg is offset by a lower debt interest tax shield or lower flotation costs. Apparently, the capital structures are not sufficiently different to result in different risks of of financial distress It is possible that a higher expected cost of financial distress for Dietritch is offset by some signaling advantage associated with their higher level of debt. It is possible that a lower expected cost of financial distress for Steinberg is offset by higher agency costs associated with excessive risk taking.

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projects (Autosaved) (Autosaved) (Autosaved) Microsoft Excel Home nert Page Layout Formulas Data Review View dd-Ins Cut Σ AutoSum ー E " ゴWrap Text aCopy B า 프 . Ej-., Δ. : r_一 逻锂函Merge & Center. $, % , 弼,8 conditional Format . Cell Insert Delete Format Sort &Find & 2 ClearFe Select Edting Format Painter Formatting, as Table w styles. ▼ ㆆ ▼ Clipboard Alignment Number Cells EX18 EW EX EY EZ FA FB FC FD FE EXPANSION (80%) RECESSION (2096) 1100000 STEINBERG EBIT PAYOFF TO BOND HOLDERS PAYOFF TO STOCK HOLDERS 2700000 4 900000 AS BOND HOLDERS ARE PAID FIRST, 200000 THE AMOUNT LEFT WILL BE PAID TO STOCK HOLDERS 1800000 6 VALUE OF EQUITY VALUE OF DEBT- [0.80 (1800000)+0.20 (200000)1/1.13 [0.80 (900000)0.20 (900000)1/1.1- 1309734.51 818181.82 9 10 DIETRICH EBIT PAYOFF TO BOND HOLDERS PAYOFF TO STOCK HOLDERS RECESSION (20%) 1100000 1100000 0 EXPANSION (80%) 12 13 14 15 16 17 18 2700000 1200000 1500000 VALUE OF EQUITY [0.80 (1500000)+0.20 (0)1/1.132- [0.80 (1200000)+0.20 (1100000)1/1.105- 1060070.67 VALUE OF DEBT- 1067873.30 RATIOS CASH BUDGET WaccBOND EPS EBIT REPLACEMENT bond Sheet Sheeti STats NPVBETA LEVERED 福 erences: CO36 130% 26-05-2018

projects (Autosaved) (Autosaved) (Autosaved) Microsoft Excel Home nert Page Layout Formulas Data Review View dd-Ins s Cut aCopy Σ AutoSum Wrap Text General в 1 프 . Ej-., Δ. : rーー 逻锂函Merge & Center. $, % , 弼,8 Conditional Format eCell Insert Delete Format Paste Sort &Find & Format Painter Formatting as Table Styles2 Clear Clipboard Font Alignment Number Styles Cells Edting EX36 EW EX EY EZ FA FB FC FD FE 18 19 20 (b) 21 VALUE OF FIRM (STEINBERG) VALUE OF EQUITY VALUE OF DEBT- VALUE OF FIRM (DIETRICH) 1309734.51818181.82 2127916.33 2127943.97 VALUE OF EQUITYVALUE OF DEBT- 1060070.67+1067873.3 23 24 25 26 27 28 29 30 31 32 The two firm's have the same value. The risk of bankruptcy per se does not affect a firm's value It is the actual costs of bankruptcy that decreases firm value It is possible that a higher expected cost of financial distress for Dietritch is offset by some signaling advantage associated with their higher level of debt. It is possible that a lower expected cost of financial distress for Steinberg is offset by higher agency costs associated with excessive risk taking. 34 35 36 /4 トト Sheet7 Sheet1 STats NPV BETA LEVERED 福 HPR GMAM EAC MACRS . LEASE RATIOS CASH BUDGET wacc (BOND EPS EBIT , REPLACEMENT . / bond erences: CO36 130% 26-05-2018