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 $3.3 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $1.7 million. Steinberg's debt obligation requires the firm to pay $960,000 at the end of the year. Dietrich's debt obligation requires the firm to pay $1.8 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 10 percent.

What is the value today of Steinberg's debt and equity? (Enter your answers in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your answers to the nearest whole dollar amount. (e.g., 32))

What is the value today of Dietrich's debt and equity? (Enter your answers in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations and round your answers to the nearest whole dollar amount. (e.g., 32))

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 $3.3 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $1.7 million. Steinberg's debt obligation requires the firm to pay $960,000 at the end of the year. Dietrich's debt obligation requires the firm to pay $1.8 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 10 percent.

Explanation / Answer

Steinberg Debt and equity Value

The total EBIT for considering 80% expnasion and 20% recession is 0.8*3.3 + 0.2*1.7 = 2.98 Million

Now the discount rate is 10%. hene the value of EBIT today is 2.709 million = $2,709,090.91

The debt value of Stienber is $960,000

Hence the value of equity is   $2,709,090.91 ( same as EBIT since the total equity, the current share price and number of shares are not given)and that of debt is $960,000

Dietrich debt and equity

The equity of portion of Dietrich will also be the same as Stiember which is the also $2,709,090.91 (same as EBIT since the total equity, the current share price and number of shares are not given) and that of dent is $1,800,000.

Part- B

Yes I agree that Steinbergs value should be higher than that of Dietrich because of loser debt.

Although the Modigilani and miller model suggest that levered firm have a tax advnatge and having higher debt results in higher value, this is true only upto a certain extent. When the debt increases beyond a certain level, the innsolvency cost incerases which reduces the value of the firm.

Since both firms pay no taxes, there is no tax advnatage for Dietrich and hence the firm value of Steinberg is higer than that of Dietrich

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