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. What are the current market values of Steinberg's equity and debt? What are the current market values of Dietrich's equity and debt? 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?

Answer 1

Answer: kindly see Explanation.

Step-by-step explanation:

STEINBERG Expansion Recession

Probability 70% 30%

EBIT 4,600,000 1,400,000

Payoff (bond) 1,000,000 1,000,000

Payoff(stock) 3,600,000 400,000

DIETRICH Expansion Recession

Probability 70% 30%

EBIT 4,600,000 1,400,000

Payoff (bond) 1,500,000 1,500,000

Payoff(stock) 3,100,000 (100,000)

Discount rate = 12%

Steinberg potential payoffs:

Equity = (0.7 × 3,600,000 + 0.3 × 400,000)/1.12 = 2357142

Debt = (0.7 × 1,000,000 + 0.3 × 1,000,000)/1.12 = 892857.14

Dietrich potential payoffs:

Equity = (0.7 × 3,100,000 + 0.3 × - 100,000)/1.12 = 1910714

Debt = (0.7 × 1,500,000 + 0.3 × 1,500,000)/1.12 = 1339285

B.) STEINBERG

DEBT + Equity = 2357142+892857 = $3249999

DIETRICH

DEBT + Equity = 1910714+1339285 = $3249999

Due to the identical nature of the two EBITs, it shows a redistribution of wealth between the stock and bond holders.