Steinberg Corporation and Dietrich Corporation are identical firms except that D

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.

What are the current market values of Steinberg's equity and debt? (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 dollar amount (e.g., 32).)

What are the current market values of Dietrich's equity and debt? (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 dollar amount (e.g., 32).)

What are the current market values of Steinberg's equity and debt? (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 dollar amount (e.g., 32).)

Explanation / Answer

a1. The total value of a firm’s equity is the discounted expected cash flow to the firm’s shareholders. If the expansion [in the economy] continues, each firm will generate EBIT of $3,900,000 . If a recession occurs, Steinberg will have an EBIT of $1,300,000 but still have to pay $930,000 in interest to bondholders.

Therefore, assuming a discount rate of 12%, the market value of Steinberg’s equity will be:

ESteinberg = [(.80)($3,900,000 - $930,000) + (.2)($1,300,000 - $930,000)]/1.12

ESteinberg = $2,187,500

Steinberg’s bondholders will receive $930,000 whether there is a recession or expansion in the economy.

So, the market value of Steinberg’s debt is: DSteinberg = {(.80)[$930,000] + (.2)[$930,000]}/1.12 = $830,357.14

a2. Since Dietrich owes its bondholders $1,400,000 at the end of the year, its shareholders will receive $ million [i.e., $3.9 million - $1.4 million] in the event of expansion. If there is a recession, its shareholders receive nothing because the EBIT of $1,300,000 is less than the interest payment of $1,400,000.

Therefore, the market value of Dietrich’s equity will be:

EDeitrich = {(.80)[3,900,000-1,400,000} + (.2)[0]}/1.12 = $1,785,714.29

Dietrich’s bondholders will receive $1,400,000 if the expansion continues, but only $1,300,000 if there is a recession [i.e., they take a $100,000 loss].

DDeitrich = { (.80)[$1,400,000] + (.2)[$1,300,000]}/1.12 = $1,232,142.86

b.The value of Steinberg is:

VSteinberg = D + E = $830,357.14 +$2,187,500 = $3,017,857.14

The value of Deitrich is: VDeitrich = D + E = $1,232,142.86 + $1,785,714.29 = $3,017,857.15

There is cost of bankrupcy given, if we assume there is a bankrupcy cost and cost of dissolution, that will signifcantly lower the value of Dietrich and hence we agree with the statement

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