Edwards Construction currently has debt outstanding with a market value of $390,

Question

Edwards Construction currently has debt outstanding with a market value of $390,000 and a cost of 7 percent. The company has an EBIT of $27,300 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?

b. What is the equity value and the debt-to-value ratio if the company's growth rate is 3 percent?

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

Explanation / Answer

(a).

Value of the company’s equity = $0

Debt-to-value ratio = 1

Explanation;

Interest payment ($390000 * .07) = $27300

EBIT = $27300

As interest payment is equal to EBIT that is why value of equity will be = $0

Debt-to-value ratio ($390000 / $390000) = 1

(b).

Value of the company’s equity = $312975

Debt-to-value ratio = 0.555

Explanation;

Earnings for next year ($27300 * 1.03) = $28119

Value of equity will be calculated as follow;

Value of equity = $28119 / (.07 - .03) – $390000

Value of equity = $702975 – $390000

Value of equity = $312975

Now, let’s calculate Debt-to-value ratio;

$390000 / ($390000 + $312975)

$390000 / $702975

= 0.555

(C).

Value of the company’s equity = $1043250

Debt-to-value ratio = 0.272

Explanation;

Earnings for next year ($27300 * 1.05) = $28665

Value of equity will be calculated as follow;

Value of equity = $28665 / (.07 - .05) – $390000

Value of equity = $1433250 – $390000

Value of equity = $1043250

Now, let’s calculate Debt-to-value ratio;

$390000 / ($390000 + $1043250)

$390000 / $1433250

= 0.272

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