Costs of Financial Distress Steinberg plc and Dietrich plc 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 per cent for the next year, and the probability of a recession is 20 per cent. If the expansion continues, each firm will generate profit before interest and taxes of £2 million. If a recession occurs, each firm will generate profit before interest and taxes of £800,000.

Steinberg’s debt obligation requires the firm to pay £750,000 at the end of the year. Dietrich’s debt obligation requires the firm to pay £1 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 15 per cent.

(a) What are the potential pay-offs in one year to Steinberg’s shareholders and bondholders? What about those for Dietrich’s?

(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?’