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ABC and DEF are identical firms except that DEF 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 70 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. ABC's debt obligation requires the firm to pay $0.9 million at the end of the year. DEF'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 ABC's debt and equity? What about that for DEF's?
b. DEF's CEO recently worried that its firm value should be lower than ABC's because the firm has more debt and therefore more bankruptcy risk. Do you agree or disagree with this statement?
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