Question

Kangaroo Corporation and Platypus Corporation are identical firms except that Platypus 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 million. If a recession occurs, each firm will generate an EBIT of $800,000. Kangaroo’s debt obligation requires the firm to pay $750,000 at the end of the year. Platypus’s debt obligation requires the firm to pay $1 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 13 percent and that there is no bankruptcy.

1. What are the potential payoffs in one year to Kangaroo’s stockholders and bondholders in present value terms?
2. What are the potential payoffs in one year to Platypus’s stockholders and bondholders in present value terms?
3. Kangaroo’s CEO recently stated that Kangaroo’s value should be higher than Platypus’s because the firm has less debt and therefore less bankruptcy risk. Do you agree or disagree with this statement. Explain why!

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Answer 1