Question 1:

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. What is the value today of Steinberg’s debt and equity? What about that for
Dietrich’s?
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 $4.5 million.
If there is a recession each firm will generate earnings before interest and taxes of only $1.9 million .
Since Steinberg owes its bondholders $990,000 at the end of the year, its stockholders will receive
$3510000 (= $4 ,500,000 million – $990,000) if the expansion continues. If there is a recession, its
stockholders will only receive $910,000 (= $1900,000 – $990,000).
The market value of Steinberg’s equity is:
{(0.90)($3510000) + (0.10)($910000)} / 1.14 = 2850877.2
The value of Steinberg’s equity is $2850877.2.
Steinberg’s bondholders will receive $750,000 regardless of whether there is a recession or a
continuation of the expansion.
The market value of Steinberg’s debt is:
[(0.90)($990,000) + (0.10)($990,000)] / 1.15 = $868421.05
The value of Steinberg’s debt is $868421.05.

Steinberg’s

Equity value 2850877.2$

Debt value 868421.05$

owes its bondholders $2 million at the end of the year, its stockholders will receive $2.5 million
(= $4.5 million – $2 million) if the expansion continues. If there is a recession, its stockholders
will receive nothing since the firm’s bondholders have a more senior claim on all $1900,000 of
the firm’s earnings.
The market value of Dietrich’s equity is:
{(0.90)($2,500,000) + (0.10)($0)} / 1.14 = $1973684.2
The value of Dietrich’s equity is $1973684.2
Dietrich’s bondholders will receive $2 million if the expansion continues and $1900,000 if there
is a recession.
The market value of Dietrich’s debt is:
{(0.90)($2,000,000) + (0.10)($1900,000)} / 1.14 = $174561.4
The value of Dietrich’s debt is $174561.4
 Dietrich’s

Equity value 1973684.2$

Debt value 1745614$

Question 2:
Good Time Company is a regional chain department store. It will remain in business for one more
year. The probability of a boom year is 60 percent and the probability of a recession is 40 percent. It
is projected that the company will generate a total cash flow of $185 million in a boom year and $76
million in a recession. The company’s required debt payment at the end of the year is $110 million.
The market value of the company’s outstanding debt is $83 million. The company pays no taxes.
a. What payoff do bondholders expect to receive in the event of a recession?
If recession happens, the total cash flow that the company realizes is 76 million. As bondholders
have the first right on all cash flows, the payoff for bondholders in the case of a recession is the
entire 76 million
b. What is the promised return on the company’s debt?
Promised return on debt = (promised amount/current market value)-1
Promised amount = 110 million
Current market value = 83 million
So promised return % on debt = (promised amount/current market value)-1
= (110/83)-1 = 32.53%
c. What is the expected return on the company’s debt?
In case boom happens, the realized return = promised return = 32.53%
In case recession happens, the realized return = (realized payoff/current market value)-1 =
(76/83)-1 = -8.43%
So expected return%= probability of boom* realized return%+probability of recession*realized return
% = 0.6 *32.53%+0.4*(-8.43%) = 16.14%