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 $4.1 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $1.5 million. Steinberg's debt obligation requires the firm to pay $950,000 at the end of the year. Dietrich's debt obligation requires the firm to pay $1.6 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 14 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.)

Answer 1

a1).

Steinberg	Expansion(80%)	Recession(20%)
EBIT	4,100,000	1,500,000
Payoff to bondholders	950,000	950,000
Payoff to stockholders	3,150,000	550,000

Steinberg Potential Payoffs:

Equity = [(0.8 x 3,150,000) + (0.2 x 550,000)]/1.14

= [2,520,000 + 110,000]/1.14 = 2,630,000/1.14 = $2,307,017.54, or $2,307,018

Debt = [(0.8 x 950,000) + (0.2 x 950,000)]/1.14

= [760,000 + 190,000]/1.14 = 950,000/1.14 = $833,333.33 or $833,333

a2).

Dietrich	Expansion(80%)	Recession(20%)
EBIT	4,100,000	1,500,000
Payoff to bondholders	1,600,000	1,500,000
Payoff to stockholders	2,500,000	0

Dietrich Potential Payoffs:

Equity = [(0.8 x 2,500,000) + (0.2 x 0)]/1.14

= [2,000,000 + 0]/1.14 = 2,000,000/1.14 = $1,754,385.97 or $1,754,386

Debt = [(0.8 x 1,600,000) + (0.2 x 1,500,000)]/1.14

= [1,280,000 + 300,000]/1.14 = 1,580,000/1.14 = $1,385,964.91, or $1,385,965