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 $3.7 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $1.1 million. Steinberg's debt obligation requires the firm to pay $910,000 at the end of the year. Dietrich's debt obligation requires the firm to pay $1.2 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 12 percent.

  

a-1.	What is the value today of Steinberg's debt and equity? (Do not round intermediate calculations and enter your answers in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.)
a-2.	What is the value today of Dietrich's debt and equity? (Do not round intermediate calculations and enter your answers in dollars, not millions of dollars, rounded to 2 decimal places, e.g., 1,234,567.)
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

a 1)

We need to find the value today of Steinberg's debt and equity or the enterprise value which is the sum of market value of debt and equity

If the expansion continues, Steinberg's will generate EBIT of $3.7 million

If the recession continues, Steinberg's will generate EBIT of $1.1 million

Steinberg's debt obligation requires the firm to pay $910,000 at the end of the year

Probability of expansion = 0.8

Probability of recession = 0.2

discount rate = 12 percent.

Therefore,

Market value of Steinberg's equity = [ 0.8 (3700000 - 910,000) + 0.2 (1100000 - 910,000) ] /1.12

= $ 2026785.71

Market value of Steinberg's debt = [ 0.8 (910,000) + 0.2 (910,000) ] /1.12

=$ 812500

a 2)

If the expansion continues, Dietrich's   will generate EBIT of $3.7 million

If the recession continues, Dietrich's   will generate EBIT of $1.1 million

Dietrich's debt obligation requires the firm to pay $1200,000 at the end of the year

Probability of expansion = 0.8

Probability of recession = 0.2

discount rate = 12 percent.

Here EBIT of 1100000 is less than debt of 1200000, so shareholders receive nothing in case of recession

Also bondholders will receive only EBIT amount i.e 1100000 and take a loss of 100000 in case of recession

Market value of Dietrich's equity = [ 0.8 (3700000 - 1200,000) + 0.2 (0) ] /1.12

= $ 1785714.29

Market value of Dietrich's debt = [ 0.8 (1200,000) + 0.2 (1100,000) ] /1.12

= $ 1053571.43

b)

The Enterprise value of Steinberg's = Market value of debt + equity

= 812500 + 2026785.71

= 2839285.7

The Enterprise value of Dietrich's = Market value of debt + equity

= 1053571.43 + 1785714.29

= 2839285.7

So we disagree with the CEO

We can see both the firm have same value. The risk of bankruptcy is merely a risk which doesnt affect the value . However the actual cost if bankuptcy occurred would affect the value