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 $3.5 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $1.9 million. Steinberg's debt obligation requires the firm to pay $980,000 at the end of the year. Dietrich's debt obligation requires the firm to pay $2.0 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 10 percent.

a-1. What are the current market values of Steinberg's equity and debt? (Enter your answers in dollars, not millions of dollars. Do not round intermediate calculations and round your answers to the nearest whole dollar, e.g., 1,234,567.)
  

	Steinberg
Equity value	$
Debt value	$

a-2. What are the current market values of Dietrich's equity and debt? (Enter your answers in dollars, not millions of dollars. Do not round intermediate calculations and round your answers to the nearest whole dollar, e.g., 1,234,567.)

	Dietrich
Equity value	$
Debt value	$

b. Steinberg’s CEO recently stated that Steinberg’s value should be higher than Dietrich’s since the firm has less debt, and, therefore, less bankruptcy risk. Do you agree or disagree with this statement?

Agree

Disagree

Answer 1

a) Steinberg

Particulars	Recession	Expansion
EBIT	$1,900,000	$3,500,000
Less: Interest payment to debt holders	$980,000	$980,000
Earnings available to equity stockholders	$920,000	$2,520,000

These earnings or cash flows will occur at end of year 1, so we need to computed their present values.

Value of debt = [ 0.20 x $980,000 + 0.80 x $980,000 ] / (1 + 0.10) = $890,909.0909 or $890,909

Value of equity = [ 0.20 x $920,000 + 0.80 x $2,520,000 ] / (1 + 0.10) = $2,000,000

b) Dietrich

Particulars	Recession	Expansion
EBIT	$1,900,000	$3,500,000
Less: Interest payment to debt holders	$1,900,000 (cannot pay more than you earn)	$2,000,000
Earnings available to equity stockholders	$0	$1,500,000

These earnings or cash flows will occur at end of year 1, so we need to computed their present values.

Value of Debt = [ 0.20 x $1,900,000 + 0.80 x $2,000,000 ] / (1.10) = $1,800,000

Value of Equity = [ 0.20 x $0 + 0.80 x $1,500,000 ] / (1.10) = $1,090,909.0909 or $1,090,909

c) Market value of Steinberg = Value of Debt + Value of Equity = $890,909 + $2,000,000 = $2,890,909

Market value of Dietrich = $1,800,000 + $1,090,909 = $2,890,909

Since, market value of both the companies is equal, we disagree with the statement of Steinberg's CEO.