Question

Problem 15-6 Costs of Financial Distress

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 $4.0 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $1.4 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 $1.5 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 15 percent.

a-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	$

b. Steinberg’s CEO recently stated that Steinberg’s value should be higher than Dietrich’s since the firm has less debt, and, therefore, less bankruptcy risk. Do you agree or disagree with this statement?

Agree

Disagree

Answer 1

(a-1);

	Steinberg
Equity value	$1982609
Debt value	$817391

Explanation;

	Expansion (70%)	Recession (30%)
EBIT	$4000000	$1400000
Payoff to debtholders	$940000	$940000
Payoff to stockholders	$3060000	$460000

Equity value will be calculated as follow;

($3060000 * 0.7 + $460000 * 0.3) / 1.15

= $2142000 + $138000 / 1.15

= $1982608.69 or $1982609 (Approx.)

Debt value will be calculated as follow;

($940000 * 0.7 + $940000 * 0.3) / 1.15

= $658000 + $282000 / 1.15

= $817391.30 or $817391 (Approx.)

(a-2);

	Dietrich
Equity value	$1521739
Debt value	$1278261

Explanation;

	Expansion (70%)	Recession (30%)
EBIT	$4000000	$1400000
Payoff to debtholders	$1500000	$1400000
Payoff to stockholders	$2500000	$0

Equity value will be calculated as follow;

($2500000 * 0.7 + $0 * 0.3) / 1.15

= $1750000 + $0 / 1.15

= $1521739.13 or $1521739 (Approx.)

Debt value will be calculated as follow;

($1500000 * 0.7 + $1400000 * 0.3) / 1.15

= $1050000 + $420000 / 1.15

= $1278260.87 or $1278261 (Approx.)

(b). Disagree

Explanation;

Value of Steinberg ($1982609 + $817391) = $2800000

Value of Dietrich ($1521739 + $1278261) = $2800000

Thus, it is clear that Steinberg’s value is not higher than Dietrich’s value. So statement of CEO is not correct.