Steinberg Corporation and Dietrich Corporation are identical firms except that D
ID: 2798434 • Letter: S
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 $2.7 million. If a recession occurs, each firm will generate earnings before interest and taxes (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 to pay $1.2 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 13 percent.
a. What is the value today of Steinberg's debt and equity? What about that 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 therefore less bankruptcy risk. Do you agree or disagree with this statement?
Explanation / Answer
.17.
Answer:
d. Active in a broad array of growth industries.
Higher profits are made in the growth phase. Hence higher profits can be made by companies who are active in a portfolio of investment in growth industries.
.18.
If the goes down, he will make profit by buying at lowers price and deliver at contracted sell price
Hence (a) is wrong
If the stock price goes up , he will loose because he has to settle by buying at higher price from the market
Hence (b) is wrong and (d) is also wrong
He needs to settle by delivering the stock. Hence he is expected to repurchase the share at a lower price
Answer:(c)
19. Answer:
(b) Realising greater gain via stock repurchase as opposed to receiving the same gain as dividends. This defers taxes till it is sold
.21.
P/E ratio=14
Required rate of return=12%
Dividend yield=3.5%
Expected earning =0.8*2,700,000+0.2*1,100,000= $ 2,380,000
Discount rate=13%
Present value of future cash flow=2380000/1.13= $ 2,106,195
Present value of Debt obligation of Steinberg=900000/1.13= $ 796,460
Value today of Debt=$796,460
Value today of Equity of Steinberg=(2106195-796460)= $ 1,309,735
Present value of Debt obligation of Dietrich =1200000/1.13= $ 1,061,947
Value today of Debt=$1,061,947
Value today of Equity of Dietrich=(2106195-1061947)= $ 1,044,248
b. If a company’s debt equity ratio or leverage is higher, there will be higher risk , hence cost of capital or discount rate should be higher.
This will decrease the value of the firm having higher debt
Debt/Equity of Steinberg=796460/1309735=0.608108
Debt/Equity of Dietrich=1061947/1044248=1.016949
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