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Steinberg Corporation and Dietrich Corporation

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.

1.Assuming there are no costs of bankruptcy, what is the market value of each firm's debt and equity?
2.What is the value of each firm?
3.Steinberg's CEO recently stated that Steinberg's value should be higher than Dietrich's since the firm has less debt, and, therefore, less bankruptcy risk. Do you agree or disagree with this statement?

Solution Preview

a. The total value of a firm's equity is the discounted expected cash flow to the firm's stockholders.

If the expansion continues, each firm will generate earnings before interest and taxes of $2 million. If there is a recession each firm will generate earnings before interest and taxes of only $800,000.

Since Steinberg owes its bondholders $750,000 at the end of the year, its stockholders will receive $1.25 million (= $2 million - $750,000) if the expansion continues. If there is a recession, its stockholders will only receive $50,000 (= $800,000 - $750,000).

The market value of ...

Solution Summary

The solution explains how to determine the value of each firm with formulas, calculations and answers.

$2.19