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Costs of Financial Distress

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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 a recession next year is 20 percent and the probability of a continuation of the current expansion is 80 percent. If the expansion continues, each firm will generate earnings before interest and taxes (EBIT) of $2 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $0.8 million. Steinberg's debt obligation requires the firm to pay $750,000 at the end of the year. Dietrich's debt obligation requires the firm to pay $1 million at the end of the year. Neither firm pays taxes. Assume a one-period model, risk neutrality, and an annual discount rate of 15 percent.

a. what are the potential payoffs in one year to Steinberg's stockholders and bondholders? What about those for Dietrich's?

b. Steinberg's CEO recently stated that Steinberg's value should be higher than Dietrich's because the firm has less debt and thus less chance of bankruptcy risk. Do you agree or disagree?

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Solution Summary

This solution takes into consideration the Steinberg Corporation and Dietrich Corpoation are identical firms.

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a)
Expansion Steinberg Dietrich
EBIT 2.00 2.00
Interest 0.75 1.00
EBT 1.25 1.00
tax 0 0
EAT 1.25 1.00

Recession Steinberg Dietrich
EBIT ...

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