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Question 1 ABC and DEF are identical firms except that DEF is more levered. Both...

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Finance

Question 1

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 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. ABCs debt obligation requires the firm to pay $0.9 million at the end of the year. DEFs 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 15 percent.

a. What is the value today of ABCs debt and equity? What about that for DEFs?

b. DEFs CEO recently worried that its firm value should be lower than ABCs because the firm has more debt and therefore more bankruptcy risk. Do you agree or disagree with this statement?

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