Question

Costs of Various Imperfections: Steinberg Corporation and Dietrich Corporation are apparently identical firms except that Dietrich has more leverage. Both companies will remain in business for one year. The companies’ economists agree that the probability of continuation of the current expansion is 80 percent for the next year, and the probability of recession is 20 percent. If the expansion continues, each firm expects to generate earnings before interest and taxes (EBIT) of $2.7 million. If the recession occurs, each firm expects to generate EBIT of $1.1 million. Steinberg's debt obligation requires the firm to pay $900,000 at the end of the year. Dietrich’s debt obligation requires the firm pay $1.2 million at the end of the year. Neither firm pays taxes. Assume the required return on Steinberg's debt is 10 percent, and that for Dietrich is 10.5 percent. Assume Steinberg's equity cost of capital is 13 percent and Dietrich's equity cost of capital is 13.2 percent. What is the value of Steinberg’s debt and equity? None of these values are correct. debt = $796,460, equity = $1,309,735 debt = $818,182, equity = $1,309,735 debt = $900,000, equity = $1,480,000

Answer 1

Solution:-

a) Calculating the value of Steinberg's debt

Amount to be paid at year end at end of the year in the form of interest

                                                                        = $900,000

Required rate of return on debt= 10%

Value of debt =

Amount to be paid at year end in form of interest/ Required rate

                          =$900,000/10%

                          =$9,000,000

b) Calculating the value of Steinberg's equity

EBIT if the recession occurs continues=$2.7 million

EBIT if the recession occurs=$1.10 million

Hence, expected EBIT=

EBIT (exp)*Probability(exp)+EBIT(rec)*Probability*(rec)

Where stands exp= If the recession occurs

                                    rec=recession

EBIT expected=2.7 million*0.80+1.1 million*0.20

                                    =$2.38 million

EBT=EBIT-interest

        =$(2.38million-0.90)= $1.48 million

Since the firm does not pay tax hence EAT=EBT=$1.48 million

Value of equity

                          =Earning after interest and tax/cost of capital equity

                          =$1.48 million/13%

                          =$11.38461538 million

                          =$11,384,615.38

Hence for Steinberg's the value of debt is $9,000,000 and value of equity is $11,384,615.38.

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