In: Finance
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 $1.5 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 12 percent.
Steinburgs Equity Value?______
Steinburgs Debt Value?_______
Dietrichs Equity Value?_______
Dietrichs Debt Value?________
I can't seem to get the right answer even though the formula seems straight forward from other similar problems. I'm missing something, please help.
Market value of equity or debt is the present value of the return Stockholder or debtholder is getting after discounting on the discount rate hence calculation for Steinberg
Steinberg’s Equity Value & Debt Value
Step1:calculation of equity
CASE |
EBIT ($ 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