Costs of Various Imperfections: Steinberg Corporation and Dietrich Corporation a
ID: 2728817 • Letter: C
Question
Costs of Various Imperfections: Steinberg Corporation and Dietrich Corporation are apparently identical firms except that Dietrich has more leverage. Both companies will remain in business for one year. The companies’ economists agree that the probability of continuation of the current expansion is 80 percent for the next year, and the probability of recession is 20 percent. If the expansion continues, each firm expects to generate earnings before interest and taxes (EBIT) of $2.7 million. If the recession occurs, each firm expects to generate EBIT of $1.1 million. Steinberg's debt obligation requires the firm to pay $900,000 at the end of the year. Dietrich’s debt obligation requires the firm pay $1.2 million at the end of the year. Neither firm pays taxes. Assume the required return on Steinberg's debt is 10 percent, and that for Dietrich is 10.5 percent. Assume Steinberg's equity cost of capital is 13 percent and Dietrich's equity cost of capital is 13.2 percent.
What is the value of Steinberg’s debt and equity?
Explanation / Answer
allfigures are in Millions amount of debt to be paid in year end required rate of return on debt value of Steinberg’s debt amount of debt to be paid in year end/required rate of return on debt 0.9 10% 9 probability EBIT EBIT * probability expansionary 0.8 2.7 2.16 recessionary 0.2 1.1 0.22 expected EBIT 2.38 payment of debt 0.9 Earning after interest 1.48 cost of equity capita; 13% value of equity earning after interest and taxes/cost of equity capital 11.3846154 value of debt 10 total value of firm 21.3846154