Question

Steinberg Corporation and Dietrich Corporation are identical companies 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 90 percent for the next year, and the probability of a recession is 10 percent. If the expansion continues, each company will generate earnings before interest and taxes (EBIT) of $4.2 million. If a recession occurs, each company will generate earnings before interest and taxes (EBIT) of $1.6 million. Steinberg's debt obligation requires the company to pay $960,000 at the end of the year. Dietrich's debt obligation requires the company to pay $1.7 million at the end of the year. Neither company pays taxes. Assume a discount rate of 14 percent.

  

a-1.	What is the value today of Steinberg's debt and equity? (Enter your answers in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answers to the nearest whole number, e.g., 32.)

     

	Steinberg's
Equity value	$
Debt value	$

a-2.	What is the value today of Dietrich's debt and equity? (Enter your answers in dollars, not millions of dollars, e.g., 1,234,567. Do not round intermediate calculations and round your answers to the nearest whole number, e.g., 32.)

  

	Dietrich's
Equity value	$
Debt value	$

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

Answer 1

a )

Net income = EBIT - Debt obligation payment

Expansion probability = 90%

Net income = 4200000 - 960000

= $3240000

In Case of recession probablity = 10%

Net income = 1600000 - 960000

= $640000

Given discount rate = 14 %

Steinberg's Equity = ( $3240000 * 90% + $640000 * 10% ) / (1 + 14 % )

= ($2916000 + $64000 ) / 1.14

= 2614035.08

Steinberg's debt = Debt obligation to pay the company / ( 1 + discount rate )

= 960000 / (1.14 )

= $ 842105.26

a2 )

Expansion probability = 90%

Net income = EBIT -  Dietrich's debt

= 4200000 - 1700000

= $2500000

Dietrich's equity = ( $2500000 * 90% + 0 *10 %) / (1 +0.14)

= $1973684.21053

Dietrich's Debt value = ( 1700000 *90 % + 1600000 * 10% ) / (1.14)

= (1530000 +160000 ) / 1.14

= $1482456.14

b )

Steinberg Enterprise value = Equity value + Debt value

= 2614035.08 + 842105.26

=$3456140.35

Dietirch Enterprise value = 1973684.21 + 1482456.14

=$ 3456140.35

Disagree. Bankruptacy risk does not affect the value since values of two companies are same