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 $1.3 million. Steinberg's debt obligation requires the firm to pay $920,000 at the end of the year. Dietrich's debt obligation requires the firm to pay $1.4 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 15 percent.

  

a-1.	What are the current market values of Steinberg's equity and debt? (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 dollar amount (e.g., 32).)

     

	Steinberg's
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 (e.g. 1,234,567). Do not round intermediate calculations and round your answers to the nearest whole dollar amount (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 firm has less debt, and, therefore, less bankruptcy risk. Do you agree or disagree with this statement?
	Disagree Agree

Answer 1

Steinberg	Expansion	Recession
Probability	80%	20%
EBIT	2,900,000	1,300,000
Interest	920,000	920,000
Profits	1,980,000	380,000
Expected	1,660,000
Equity	$ 1,443,478
Debt	$    800,000
Dietrich	Expansion	Recession
Probability	80%	20%
EBIT	2,900,000	1,300,000
Interest	1,400,000	1,400,000
Profits	1,500,000	(100,000)
Expected	1,180,000
Equity	$ 1,026,087
Debt	$ 1,217,391

Profits = EBIT - Interest

Expected Value of equity = Weighted average of Profits = Sum of probability x Profits

Current Equity Value = Expected / (1 + 15%)

Current Value of Debt = Interest / (1 + 15%)

Agree.