Answer:
a-1.
Steinberg's debt:
Steinberg's equity:
a-2.
Dietrich's debt:
Dietrich's equity:
b. Disagree as the values of the two companies are the same ( please see below Explanation for further clarification)
Explanation:
It is clear to determine that the value of debt and equity of the two firms is the present value of cash flow received in 1 year, discounted at 12%.
a-1.
In one year:
- Debt holder of Steinberg will receive $910,000 regardless of its EBIT. -=> Thus, Steinberg's debt present value = 910,000 / 1.12 = $812,500
- Given the probability of expansion and recession, Steinberg's shareholder will receive the amount equal EBIT - amount paid to its debt holders: 0.8 x (3,700,000 - 910,000) + 0.2 x (1,100,000-910,000) = $2,270,000.
=> Thus, Steinberg's equity present value = $2,270,000/ 1.12 = $2,026,786
=> Value of Steinberg = D+E = 812,500 + 2,026,786 = $2,839,286 ( note: no tax applied)
a-2.
In one year:
- Debt holder of Dietrich will receive $1,200,000 when the business expands while only $1,100,000 when the business goes into recession (i.e business loss is 100,000): 0.8 x 1,200,000 + 0.2 x 1,100,000 = $1,180,000
=> Thus, Dietrich's debt present value = 1,180,000 / 1.12 = $1,053,571
- Given the probability of expansion and recession, Dietrich's shareholder will receive the amount equal EBIT - amount paid to its debt holders: 0.8 x (3,700,000 - 1,200,000) + 0.2 x (1,100,000-1,100,000) = $2,000,000.
=> Thus, Dietrich's equity present value = 2,000,000 / 1.12 = $1,785,714
=> Value of Steinberg = D+E =$1,053,571+$1,785,714 = $2,839,286( note: no tax applied)
a-3.
From the calculation, it is clear that the values of the two companies are the same.
