Edwards Construction currently has debt outstanding with a market value of $420,

Question

Edwards Construction currently has debt outstanding with a market value of $420,000 and a cost of 5 percent. The company has an EBIT of $21,000 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. 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 b. Assume that the company's growth rate is 3 percent. What is the value of the company's equity and the debt-to-value ratio now? (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. Assume that the company's growth rate is 4 percent. What is the value of the company's equity and the debt-to-value ratio now? (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

Explanation / Answer

The interest payments each year will be: .5($420,000) = $21,000

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 $420,000, and there is no probability of default, the total value of the firm is the market value of debt and the debt to value ratio is 1.

Earnings next year = $21,000 x (1.03) = $21,630

So, there will be cash available to shareholders.

Payment to shareholders = $21,630 - $21,000 = $630

Value of Equity = $630/(.05-.03) = $31,500

The Debt/Value Ratio = $420,000/[420,000 + $31500] = .93

Earnings next year = $21000 x (1.07) = $22,470

Payment to shareholders = $22,470- $21000 = $1470

Value of Equity = $1,470/[.07 - .05] = $73,500.

Debt-to-Value Ratio: $420,000/[$420,000 + $73,500] = .85

As the fortunes of a company improves with growing earnings, the amount of leverage will decrease all other things being equal.

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