Question

Golden Gate Construction Associates, a real estate developer and building contractor in San Francisco, has two sources of long-term capital: debt and equity. The cost to Golden Gate of issuing debt is the after-tax cost of the interest payments on the debt, taking into account the fact that the interest payments are tax deductible. The cost of Golden Gate’s equity capital is the investment opportunity rate of Golden Gate’s investors, that is, the rate they could earn on investments of similar risk to that of investing in Golden Gate Construction Associates. The interest rate on Golden Gate’s $62 million of long-term debt is 8 percent, and the company’s tax rate is 30 percent. The cost of Golden Gate’s equity capital is 10 percent. Moreover, the market value (and book value) of Golden Gate’s equity is $90 million.

The company has two divisions: the real estate division and the construction division. The divisions’ total assets, current liabilities, and before-tax operating income for the most recent year are as follows:

Division		Total Assets				Current Liabilities				Before-Tax Operating Income
Real estate		$	95,000,000			$	5,200,000			$	20,200,000
Construction			68,900,000				3,700,000				18,500,000

Required:

Calculate the economic value added (EVA) for each of Golden Gate Construction Associates’ divisions. (Round your weighted-average cost of capital to 3 decimal places (i.e. .123). Enter your answers in millions rounded to 3 decimal places (i.e. 1,234,000 should be entered as 1.234).)

Answer 1

SOLUTION:

Calculation of Weighted Average Cost of capital

Market Value of Debt = $62 Million

Market Value of Equity = $90 Million

Total Market Value = $152 Million

Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of equity x Weight of Equity]

= [0.08(1 – 0.30) x (62/152)] + [0.10 x (90/152]

= [0.0560 x 0.4079] + [0.10 x 0.5921]

= 0.0228 + 0.0592

= 0.082 or

= 8.20%

Economic Value Added (EVA) = EBIT(1 – Tax Rate) – [(Total asset – Total Current liabilities) x WACC]

EVA - Real Estate Division:

Economic Value Added (EVA) = EBIT(1 – Tax Rate) – [(Total asset – Total Current liabilities) x WACC]

= [$20,200,000(1 – 0.30)] – [($95,000,000 - $5,200,000) x 0.082]

= $14,140,000 - $7,363,600

= $6,776,400 or

= $6.776 Million

EVA – Construction Division:

Economic Value Added (EVA) = EBIT(1 – Tax Rate) – [(Total asset – Total Current liabilities) x WACC]

= [$18,500,000(1 – 0.30)] – [($68,900,000 - $3,700,000) x 0.082]

= $12,950,000 - $5,346,400

= $7,603,600 or

= $7.604 Million

Hence,

Division	EVA (in Millions)
Real Estate	$ 6.776 Million
Construction	$ 7.604 Million