Reference no: EM132368604
Corporate Finance Questions -
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 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 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.
a. What is the value today of Steinberg's debt and equity? What about that for Dietrich?
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?
Question 2 - Fountain Corporation's economists estimate that a good business environment and a bad business environment are equally likely for coming year. The managers of Fountain must choose between two mutually exclusive projects. Assume that the project Fountain chooses will be the firm's only activity and that the firm will close one year from today. Fountain is obligated to make a $3,500 payment to bondholders at the end of the year.
The projects have the same systematic risk but different volatilities. Consider the following information pertaining to the two projects:
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Economy
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Probability
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Low-Volatility project payoff
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High-volatility project payoff
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Bad
|
.50
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$3,500
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$2,900
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Good
|
.50
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3,700
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4,300
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a. What is the expected value of the firm if the low-volatility project is undertaken? What if the high-volatility project is undertaken? Which of the two strategies maximises the expected value of the firm?
b. What is the expected value of the firm's equity if the low-volatility project is undertaken? What is it if the high-volatility project is undertaken?
c. Which project would Fountain's stockholders prefer? Explain.
d. Suppose bondholders are fully aware that stockholders might choose to maximise equity value rather than total firm value and opt for the high-volatility project. To minimise this agency cost, the firm's bondholders decide to use a bond covenant to stipulate that the bondholders can demand a higher payment if Fountain chooses to take on the high- volatility project. What payment to bondholders would make stockholders indifferent between the two projects?
Question 3 - State necessary assumptions for MM (1963).