Edwards Construction currently has debt outstanding with a market value of $72,5

Question

Edwards Construction currently has debt outstanding with a market value of $72,500 and a cost of 7 percent. The company has EBIT of $5,075 that is expected to continue in perpetuity. Assume there are no taxes.

What are the equity value and debt-to-value ratio if the company's growth rate is 3 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   

What are the equity value and debt-to-value ratio if the company's growth rate is 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

Explanation / Answer

a) We first need to calculate the interest payments that need to be made.

Interest expense = 72,500 * 7% = $5,075

EBIT this year = $5,075.

EBIT next year = $5,075 * (1 + 3%) = $5,227.25

Cash flow to shareholders = 5,227.25 - $5,075 = $152.25

Value of Equity = 152.25/(0.07 - 0.03) = $3,806.250

The Debt/Value Ratio = 72,500/(72,500 + 3,806.25) = 95.012%

b) EBIT next year = $5,075 * (1 + 5%) = $5,328.75

Cash flow to shareholders = 5,328.75 - $5,075 = $253.75

Value of Equity = 253.75/(0.07 - 0.05) = $12,687.500

The Debt/Value Ratio = 72,500/(72,500 + 12,687.50) = 85.106%

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