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 80 percent for the next year, and the probability of a recession is 20 percent. If the expansion continues, each company will generate earnings before interest and taxes (EBIT) of $3.9 million. If a recession occurs, each company will generate earnings before interest and taxes (EBIT) of $1.3 million. Steinberg's debt obligation requires the company to pay $930,000 at the end of the year. Dietrich's debt obligation requires the company to pay $1.4 million at the end of the year. Neither company pays taxes. Assume a discount rate of 12 percent.

  

a-1.	What is the value today of Steinberg's debt and equity? (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 number, e.g., 32.)

     

	Steinberg's
Equity value	$
Debt value	$

a-2.	What is the value today of Dietrich's debt and equity? (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 number, 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 company has less debt and therefore less bankruptcy risk. Do you agree or disagree with this statement?

Answer 1

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

Whether the market performance is in recession or in expansion, debtholders will receive fixed interest.

Value of debt = [(20% of 930000) + (80% of 930000)]/(1+12%) = 930000/1.12 = $830,357.14

Even if the company is in expansion out of 3.9 million of EBIT it has to pay interest of $930000 to debtholdders, and the same goes for the recession as well.

During expansion = {80% of (3,900,000-930000)}

During recession = {20% of (1,300,000-930000)}

Value of Equity = [{80% of (3,900,000-930000)}+{20% of (1,300,000-930000)}]/1.12 (Discounted at the discount rate of 12%)

Value of Equity = (2,376,000+ 74000)/1.12 = 2450000/1.12 = $2,187,500

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

Debt obligation of Dietrich is 1.4 million, which has to be paid from EBIT.

In case of expansion the EBIT is 3.9 million deducting debt obligation of 1.4 million. EBT wil be 2,5 million * 80%

In case of recession the debt obligation is more than the EBIT, hence recession EBT would be in negative.

Value of Equity for Dietrich is (80% of 2500000)/1.12 = $1,785,714.26

In case of expansion interest payment would bee made on 80% of 1.4 million, but in case of recession the EBIT is lower than the debt obligation, hence it would be 20% of the 1300000

Value of Debt = [(80% of 1,400,000) + (20% of 1,300,000) ]/1.12=

Value of debt = (1120000 + 260000)/1.12 = $1,232,142.86

b. 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?

Value of Steinberg = Debt + Equity = $830,357.14+$2,187,500= $3,017,857

Value of Dietrich = Debt + Equity = $1,232,142.86 + $1,785,714.26 = $3,017,857

It is clear from the above calculations, that value of both the companies are same irrespective ofo the debt equity composition. Though the debt obligation of Steinberg is less, but the distribution of wealth between bondholders and equityholders has equated the value of both the firms. (MM theory)