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 $2.9 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $1,050,000. Steinberg’s debt obligation requires the firm to pay $900,000 at the end of the year. Dietrich’s debt obligation requires the firm to pay $1.3 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 14 percent. a) What are the current market values of Steinberg’s equity and debt? What about those of Dietrich? 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?

Answer 1

a). Current market value of debt = present value (PV) of debt payment to be made in one year

Market value of debt for Steinberg = Probability of expansion*PV of debt payment + Probability of recession*PV of debt payment

= (80%*900,000/(1+14%)) + (20%*900,000/(1+14%)) = 789,473.68

Equity value = PV of (EBIT - debt payment)

Market value of equity for Steinberg = Probability of expansion*PV of equity + Probability of recession*PV of equity

= (80%*(2,900,000-900,000)/1.14) + (20%*(1,050,000-900,000)/1.14) = 1,429,824.56

Market value of debt for Dietrich = [(80%*1,300,000)+(20%*1,050,000)]/1.14 = 1,096,491.23

Market value of equity for Dietrich = [(80%*(2,900,000-1,300,000)) + (20%*0)]/1.14 = 1,122,807.02

b). Firm value of Steinberg = debt value + equity value = 789,473.68 + 1,429,824.56 = 2,219,298.25

Firm value of Dietrich = debt value + equity value = 1,429,824.56 + 1,122,807.02 = 2,219,298.25

Both firms have same value as there are zero bankruptcy costs. Firm values would have been affected only if actual bankruptcy costs would be there.