Problem $17-6$ Costs of Financial Distress

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 $$3\mathrm{.}1$ million. If a recession occurs, each firm will generate earnings before

interest and taxes $($EBIT$)$ of $$1\mathrm{.}5$ million. Steinberg's debt obligation requires the firm to

pay $$940,000$ at the end of the year. Dietrich's debt obligation requires the firm to pay

$$1\mathrm{.}6$ million at the end of the year. Neither firm pays taxes. Assume a discount rate of $15$

percent.

a$-1.$ What is the value today of Steinberg's debt and equity? $($Do not round intermediate

calculations and enter your answers in dollars, not millions of dollars, rounded to

the nearest whole number, e$.$g$.,1,234,567.)$

a$-2.$ What is the value today of Dietrich's debt and equity? $($Do not round intermediate

calculations and enter your answers in dollars, not millions of dollars, rounded to

the nearest whole number, e$.$g$.,1,234,567.)$

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?

Answer is complete but not entirely correct.