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MT Company and EM Company are identical firms except that EM is more levered. Both...

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Finance

MT Company and EM Company are identical firms except that EM 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 30 percent. If the expansion continues, each firm will generate earnings before interest and taxes (EBIT) of $2.8 million. If a recession occurs, each firm will generate earnings before interest and taxes (EBIT) of $1.2 million. MTs debt obligation requires the firm to pay $0.8 million at the end of the year. EMs debt obligation requires the firm to pay $1.3 million at the end of the year. Neither firm pays taxes. Assume a discount rate of 10 percent.

a. What is the value today of MTs debt and equity? What about that for EMs?

b. MTs CEO recently stated that its firm value should be higher than EMs value because the firm has less debt and therefore less bankruptcy risk. Do you agree with this statement? Explain.

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