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 $3.5 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $1.9 million. Steinberg's debt obligation requires the firm to pay $980,000 at the end of the year. Dietrich's debt obligation requires the firm to pay $2 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 10 percent.

a. What is the value today of Steinberg's debt and equity?
b. What is the value today of Dietrich's debt and equity?
c. 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?A. DisagreeB. Agree

Answer 1

To value Steinberg's and Dietrich's debt and equity, we calculate the expected EBIT for both companies, account for different economic scenarios, and determine the leftover EBIT after debt payments, discounted back at the required rate of return. Steinberg's expected equity value is $2,018,182, and its debt value is $890,909. Dietrich's debt and equity values will be different due to its higher debt obligation.

Step-by-step explanation:

To calculate the value of Steinberg's and Dietrich's debt and equity, we need to consider the expected earnings before interest and taxes (EBIT), the probability of different economic scenarios, and the debt obligations. First, we compute the expected EBIT by taking the weighted average of the EBIT in both economic states considering their respective probabilities.

Expected EBIT for both companies = (0.8 * $3.5 million) + (0.2 * $1.9 million) = $3.02 million.

The value of the debt and equity is determined by how much EBIT is left after debt payments under each scenario, discounted back to present value at the required rate of return.

Steinberg Corporation

• Debt value = min(EBIT, debt payment) / (1 + discount rate)
• Equity value = (EBIT - debt payment) / (1 + discount rate), if EBIT exceeds debt payment; otherwise $0.

For Steinberg, with a debt obligation of $980,000:

• Debt value = min($3.02 million, $980 thousand) / 1.1 = $980 thousand / 1.1 = $890,909
• Equity value in expansion = ($3.5 million - $980 thousand) / 1.1 = $2.29 million
• Equity value in recession = ($1.9 million - $980 thousand) / 1.1 = $836,364
• Expected equity value = (0.8 * $2.29 million) + (0.2 * $836,364) = $2,018,182

Dietrich Corporation

• Debt value has to reflect the higher risk of not being paid back in full due to the higher debt obligation of $2 million.
• Equity value is calculated similarly but will be lower since more EBIT goes to debt payments.

If EBIT < debt payment, debt holders receive EBIT and equity holders receive nothing. If EBIT > debt payment, debt holders receive the debt payment and equity holders receive the residual.

Answer 2

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

• $2,890,909

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

• $2,890,909

c. 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?

• A. Disagree: a company's value is determined by by its operating income (EBIT), not by there capital structure (M&M theory).

Step-by-step explanation:

economic expansion 80% chance, EBIT $3.5 million

economic recession 20% chance, EBIT $1.9 million

expected EBIT = (3.5 x 0.8) + (1.9 x 0.2) = $2.8 million + $0.38 million = $3.18 million

Steinberg's debt obligations $980,000 at the end of next year

Dietrich's debt obligations $2,000,000 at the end of next year

total company value = $3.18 million / (1 + 10%) = $2,890,909