Question

[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 80% for the next year, the probability of a recession is 20%. If the
expansion continues, each firm will generate EBIT of $ 2.4 million. If a recession occurs each
firm will generate EBIT of $900,000. Steinberg’s debt obligation requires the firm to pay
$800,000 at the end of the year. Dietrich’s debt obligation requires the firm to pay $1.1
million at the end of the year. Neither firm pays taxes. Assume a discount rate of 15%.
a. What is the value today of Steinberg’s debt and equity? What about that for Dietrich’s?
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

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