Question

Edwards Construction currently has debt outstanding with a market value of $95,000 and a cost of 9 percent. The company has EBIT of $8,550 that is expected to continue in perpetuity. Assume there are no taxes.

  

a-1.	What is the value of the company's equity? (Do not round intermediate calculations. Leave no cell blank - be certain to enter "0" wherever required.)

  

Value of equity _____________

  

a-2.	What is the debt-to-value ratio? (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)

  

Debt-to-value ratio ____________

  

b.	What are the equity value and debt-to-value ratio if the company's growth rate is 4.5 percent? (Do not round intermediate calculations and round your "Debt-to-value" answer to 3 decimal places, e.g., 32.161.)

  

Equity value	$ ______
Debt-to-value	_________

  

c.	What are the equity value and debt-to-value ratio if the company's growth rate is 6.5 percent? (Do not round intermediate calculations and round your "Debt-to-value" answer to 3 decimal places, e.g., 32.161.)

  

Equity value	$ ________
Debt-to-value	__________

Answer 1

a.1

The interest payments each year will be: .09($95,000) = $8550 which is exactly equal to the EBIT, so no cash is available to shareholders. Under this scenario, the value of equity will be zero, since stockholders will never receive a payment [i.e., shareholders want some type of return for their investment]. Since the market value of the company’s debt is $95,000, and there is no probability of default

a.2

the total value of the firm is the market value of debt and the debt to value ratio is 1.

b

Earnings next year = $8550 x (1.045) = $8934.75

So, there will be cash available to shareholders.

Payment to shareholders = $8934.75 - $8550 = $384.75

Value of Equity = $384.75/(.09-.045) = 8550

The Debt/Value Ratio = $95,000/[$95,000 + $8550] = .917

c

Earnings next year = $8550 x (1.065) = $9105.75

So, there will be cash available to shareholders.

Payment to shareholders = $9105.75 - $8550 = $555.75

Value of Equity = $555.75/(.09-.065) = 22230

The Debt/Value Ratio = $95,000/[$95,000 + $22230] = .810