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

Answer:

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).

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