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 70 percent for the next year, and the probability of a recession is 30 percent. If the expansion continues, each company will generate earnings before interest and taxes (EBIT) of $3.6 million. If a recession occurs, each company will generate earnings before interest and taxes (EBIT) of $1.5 million. Steinberg's debt obligation requires the company to pay $900,000 at the end of the year. Dietrich's debt obligation requires the company to pay $1.6 million at the end of the year. Neither company pays taxes. Assume a discount rate of 12 percent.

a. What is the value today of Steinberg's debt and equity?

b, What is the value today of Dietrich's debt and equity?

c. 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?

Answer 1