Question

Edwards Construction currently has debt outstanding with a market value of $310,000 and a cost of 6 percent. The company has an EBIT of $18,600 that is expected to continue in perpetuity. Assume there are no taxes.

a. What is the value of the company’s equity and the debt-to-value ratio? (Do not round intermediate calculations. Leave no cells blank - be certain to enter "0" wherever required. Round your debt-to-value answer to 3 decimal places, e.g., 32.161.)
  

Equity value	$
Debt-to-value

b. What is the equity value and the debt-to-value ratio if the company's growth rate is 3 percent? (Do not round intermediate calculations. Round your equity value to 2 decimal places, e.g., 32.16, and round your debt-to-value answer to 3 decimal places, e.g., 32.161.)

Equity value	$
Debt-to-value

c. What is the equity value and the debt-to-value ratio if the company's growth rate is 5 percent? (Do not round intermediate calculations. Round your equity value to 2 decimal places, e.g., 32.16, and round your debt-to-value answer to 3 decimal places, e.g., 32.161.)

Equity value	$
Debt-to-value

Answer 1

a). Interest = Market Value of Debt * Interest Rate = $310,000 * 0.06 = $18,600

EBIT = $18,600

Cash Flow for shareholders = $0

Value of Equity = $0

Debt to value of firm = $310,000 / $310,000 = 1

b). Earnings next year = EBIT * (1 + g) = $18,600 * (1 + 0.03) = $19,158

Since there is no risk, the required return for shareholders is the same as the required return on the company’s debt. The payments to stockholders will increase at the growth rate of 3% (a growing perpetuity), so the value of these payments today is:

Value of Equity = [$19,158 / (0.06 - 0.03)] - [$18,600 / 0.06]

= $638,600 - $310,000 = $328,600

Debt/Value Ratio = $310,000/($310,000 + $328,600) = $310,000 / $638,600 = 0.485

c). Earnings next year = EBIT * (1 + g) = $18,600 * (1 + 0.05) = $19,530

Value of Equity = [$19,530 / (0.06 - 0.05)] - [$18,600 / 0.06]

= $1,953,000 - $310,000 = $1,643,000

Debt/Value Ratio = $310,000/($310,000 + $1,643,000) = $310,000 / $1,953,000 = 0.159