16.2 VanSant Corporation and Matta, Inc., are identical firms except that Matta, Inc., is more levered than VanSant. 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 have EBIT of $2 million. If a recession occurs, each firm will have EBIT of $0.8 million. VanSant’s debt obligation requires the firm to make $750,000 in payments. Because Matta carries more debt, its debt payment obligations are $1 million.

Assume that the investors in these firms are risk-neutral and that they discount the firms’

cash flows at 15 percent. Assume a one-period example. Also assume there are no taxes.

a. Duane, the president of VanSant, commented to Matta’s president, Deb, that his firm has a higher value than Matta, Inc., because VanSant has less debt and, therefore, less bankruptcy risk. Is Duane correct?

b. Using the data of the two firms, prove your answer to (a).

c. What might cause the firms to be valued differently?