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Steinberg Corporation and Dietrich Corporation are identical firms except that Dietrich is more levered. Both companies...

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 $4.6 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 $1,000,000 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 12 percent.

Steinburgs Equity Value?______

Steinburgs Debt Value?_______

Dietrichs Equity Value?_______

Dietrichs Debt Value?________

I can't seem to get the right answer even though the formula seems straight forward from other similar problems. I'm missing something, please help.

Solutions

Expert Solution

Market value of equity or debt is the present value of the return Stockholder or debtholder is getting after discounting on the discount rate hence calculation for Steinberg

Steinberg’s Equity Value & Debt Value

Step1:calculation of equity

CASE

EBIT ($ in millions)

Bondholder obligation($ in million)

Stockholders Receive ($ in million)

Expansion

4.6

1

4.6-1=3.6

Recession

1.4

1

1.4-1=0.4

Probability

A

Stockholders Receive ($ in million)

B

Value c=A*B ($ in million)

Expansion (0.70)

3.6

3.6*0.70= $2.52

Recession(0.30)

0.4

0.4*0.30= $0.12

Total

$2.64

Market value of Steinbergs Equity= Value /1+ discount rate

=2640000/1.12

=$2357143

Step2:value of debt

Probability

A

Bondholder obligation($ in million)

B

Value c=A*B ($ in million)

Expansion (0.70)

1

1*0.70= $0.7

Recession(0.30)

1

1*0.30= $0.3

Total

$1

Market value of Steinbergs Debt= Value /1+ discount rate

=1000000/1.12

=$892857.14

Calculation for DIETRICHS

Dietrichs Equity & Debt Value

Step3 :calculation of equity

CASE

EBIT ($ in millions)

Bondholder obligation($ in million)

Stockholders Receive ($ in million)

Expansion

4.6

1.5

4.6-1.5=3.1

Recession

1.4

1.5

$0 (as bondholder obligation is higher hence stockholder will get nothing)

Probability

A

Stockholders Receive ($ in million)

B

Value c=A*B ($ in million)

Expansion (0.70)

3.1

3.1*0.70= $2.17

Recession(0.30)

0.0

0.0*0.30= $0.0

Total

$2.17

Market value of Dietrichs Equity= Value /1+ discount rate

=2170000/1.12

=$1937500

Step4

Value of debt

Probability

A

Bondholder obligation($ in million)

B

Value c=A*B ($ in million)

Expansion (0.70)

1.5

1.5*0.70= $1.05

Recession(0.30)

1.4 (because firm has the maximum earning 1.4million during recession as per given data)

1.4*0.30= $0.42

Total

$1.47

Market value of Dietrichs Debt= Value /1+ discount rate

=1470000/1.12

=$1312500

I hope stepwise calculation is clear still if you have any doubt you may ask i will reply.Kindly upvote if my answer is helpful. Good luck


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