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 $3.9 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $1.3 million. Steinberg's debt obligation requires the firm to pay $930,000 at the end of the year. Dietrich's debt obligation requires the firm to pay $1.4 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 12 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 thiis statement? a-1. Steinberg equity value Steinberg debt value a-2. Dietrich equity value Dietrich debt value b. Risk of bankruptcy affect a firm's value

Answer 1

Answer a-1:

Steinberg:

There is no tax.

Net Income = EBIT - Debt obligation payment

In case of expansion (probability = 80%):

Net Income = $3,900,000 - 930,000 = $2,970,000

In case of recession (probability = 20%):

Net Income = $1,300,000 - 930,000 =$370,000

Therefore, at given discount rate of 12%, the market value of Steinberg’s equity will be

= (2970000 * 80% + 370000 * 20%) / (1 + 12%)

= $2,187,500.00

Steinberg’s creditors' will receive $930,000 irrespective whether there is expansion or recession.

Hence, the market value of Steinberg’s debt is = 930000 / (1 + 12%) = $830,357.14

Hence:

Steinberg’s equity value = $2,187,500.00

Steinberg’s debt value = $830,357.14

Answer a-2:

Dietrich:

In case of expansion (probability = 80%):

Net Income = $3,900,000 - 1,400,000 = $2,500,000

In case of recession (probability = 20%):

Since EBIT = $1,300,000, Dietrich's creditors will receive only $1,300,000 against debt obligation of $1,400,000 and Dietrich's shareholders will not receive any amount.

Hence:

Therefore, at given discount rate of 12%, the market value of Dietirch’s equity will be

= (2500000 * 80% + 0 * 20%) / (1 + 12%)

= $1,785,714.29

Dietrich’s creditors' will receive $1,400,000 if there is expansion and $1,300,000 in case of recession.

Hence, the market value of Dietrich’s debt is = (1400000 * 80% + 1300000 * 20%) / (1 + 12%) = $1,232,142.86

As such:

Dietirch’s equity value = $1,785,714.29

Dietirch’s debt value = $1,232,142.86

Answer a-3:

Enterprise value = Equity value + Debt value

Steinberg’s Enterprise value = $2,187,500.00 + $830,357.14 = $3,017,857.14

Dietirch’s Enterprise value = $1,785,714.29 + $1,232,142.86 = $3,017,857.14

The bankruptcy risk does not affect the value since values of both the firms are same. As such we do not agree with the statement.

$2,187,500.00 $830,357.14 $1,785,714.2 $1,232,142.86 Steinberg eqity value Steinberg debt value Dietirch equity value Dietirch debt value Risk of bankruptcy affect a firm's value a-1 a-2 b. NO