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 $4.7 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 $1,010,000 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 13 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-2. What is the value today of Dietrich'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.)

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?

Answer 1

Answers for A-1 and A-2:-

	Particulars	Steinberg	Dietrich
		a-1	a-2
	Earnings calculation
a	Expansion($4.7 million * 80%)	$37,60,000.00	$37,60,000.00
b	Recission($1.3 million * 20%)	$2,60,000.00	$2,60,000.00
c	Estimated EBIT (a + b)	$40,20,000.00	$40,20,000.00
d	Value of debt @ present value of 13%	$8,93,805.31	$12,38,938.05
e	Value of equity (c-d)	$31,26,194.69	$27,81,061.95

WN:1	Present Value of Debt = Amount to be paid / (1+interest rate)^n
	where n = number of years for payment

The value of firm may vary based upon the capitalisation rates and other information. Based on the information provided the value of firm will be as above assuming it as a new business existing for one year.

Answer for b:-

Even from above calculation it is appearing that stein berg is more valued, the value for the established firms will be more for only those firms which are having optimum levarage for the following reasons:-

1. In case of more levaraged firm the risk of dilution of owners capital is less.
2. from the payment of interest a firm can avail tax benefits
3. Cost of equity capital will always be more than the cost of debt capital.