Reference no: EM132071484

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. Assume that you conclude from your analysis that the enterprise values of Steinberg Corporation and Deitrich Corporation are essentially identical, even though they have different capital structures. Which of the following financial arguments provides the best explanation for your finding? It is possible that a lower expected costs of financial distress for Steinberg is offset by a lower debt interest tax shield or lower flotation costs. Apparently, the capital structures are not sufficiently different to result in different risks of of financial distress It is possible that a higher expected cost of financial distress for Dietritch is offset by some signaling advantage associated with their higher level of debt. It is possible that a lower expected cost of financial distress for Steinberg is offset by higher agency costs associated with excessive risk taking.