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 $3.9 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 $930,000 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 12 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?

Answer 1

Answer a-1:

As such ,

Current market of equity = ($2,970,000 * 80% + $370,000 * 20%) / (1 + 12%) = $2,187,500

Current market values of Steinberg's debt = ($930,000 * 80$ + $930,000 *20%) / (1 +12%) = $830,357

Answer a-2:

As such ,

Current market of equity = ($2,500,000 * 80% + $0 * 20%) / (1 + 12%) = $1,785,714

Current market values of Steinberg's debt = ($1,400,000 * 80$ + $1,300,000 *20%) / (1 +12%) = $1,232,143

Answer b:

Steinberg’s value = Debt + Equity = $2,187,500 + $830,357 = $3,017,857

Dietrich's value = Debt + Equity = $1,232,143 + $1,785,714 = $3,017,857

Do not agree, as the value of the two firms are identical.

In this example the EBIT is same for both the firms; the composition of capital (between debt and equity) changes.