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 70 percent for the next year, and the probability of a recession is 30 percent. If the expansion continues, each firm will generate earnings before interest and taxes (EBIT) of $4.6 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $1.4 million. Steinberg's debt obligation requires the firm to pay $1,000,000 at the end of the year. Dietrich's debt obligation requires the firm to pay $1.5 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 12 percent. a-1. 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).) a-2. 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).) b. Steinberg’s CEO recently stated that Steinberg’s value should be higher than Dietrich’s because the firm has less debt, and, therefore, less bankruptcy risk. Do you agree or disagree with this statement?

Explanation / Answer

It can be expressed as follows -

a) The total value of a firm’s equity is the discounted expected cash flow to the firm’s shareholders.

Discount rate of 12%,

Market value of Steinberg’s equity will be:

E (S) = [(.70)($4,600,000 - $1,000,000) + (.3)($1,400,000 - $1,000,000)] / 1.12

E(S) = $ (2,520,000 + 120,000 ) / 1.12

= $ 2,357,142.85

Market value of Steinberg’s debt is:

D(S) = {(.70)[$1,000,000] + (.3)[$1,000,000]}/1.12 = $892,857.14

Dietrich owes its bondholders $1.5 million at the end of the year, If there is a recession, its shareholders receive nothing because the EBIT of $1,400,000 is less than the interest payment of $ 1,500,000. Therefore, the

Market value of Dietrich’s equity will be:

E(D) = {(.7)[$4,600,000 - 1,500,000} + (.3)[0]} / 1.12 = $1,937,500

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

D(D) = { (.7)[$1,500,000} + (.3)[$1,400,000]}/1.12 = $1,312,500

b) Value of Steinberg = Equity + Debt = $2,357,142.85 +892,857.14 = $3250000

Value of Dietrich = Equity + Debt = $1,937,500 + 1,312,500 = $3250000

The two firm’s have the same value. So i disagree with this statement.

(in $) Expansion(70%) Recession(30%) EBIT 4600000 1400000 Steinberg Debt 1000000 Dietrich Debt 1500000

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