Question

Edwards Construction currently has debt outstanding with a market value of $300,000 and a cost of 8 percent. The company has an EBIT of $24,000 that is expected to continue in perpetuity. Assume there are no taxes.

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 is NOT 194,400 and debt value is NOT .607

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 is NOT 540000 and debt value is NOT .357

Answer 1

a). If the growth rate is 3% then EBIT of next year = $24,000(1+0.03) = $24,720

Cash available for shareholders = ($24,720 - $24,000) = $720

Since there is no risk, cost of equity should be equal to the cost of debt. Cash available to shareholders has growth rate of 3%.

According to growing perpetuity,

Value of equity = $720 / (0.08 - 0.03) = $14,400

Value of the company = D + E = ($300,000 + $14,400) = $314,400

Debt to value ratio = Debt/Value = $300,000 / $314,400 = 0.954

b). If the growth rate is 5% then EBIT of next year = $24,000(1+0.05) = $25,200

Cash available for shareholders = ($25,200 - $24,000) = $1,200

Since there is no risk, cost of equity should be equal to the cost of debt. Cash available to shareholders has growth rate of 5%.

According to growing perpetuity,

Value of equity = $1,200 / (0.08 - 0.05) = $40,000

Value of the company = D + E = ($300,000 + $40,000) = $340,000

Debt to value ratio = Debt/Value = $300,000 / $3440,000 = 0.882