Problem 15-3 Capital Structure and Growth Edwards Construction currently has deb
ID: 2740778 • Letter: P
Question
Problem 15-3 Capital Structure and Growth Edwards Construction currently has debt outstanding with a market value of $450,000 and a cost of 8 percent. The company has an EBIT of $36,000 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 0.00 100.000 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 4580 95.420e c. Assume that the company's growth rate is 5 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 (o.g., 32.16), and round your debt-to-value answer to 3 decimal places (e.g., 32.161).) Equity value Debt-to-value S 11.76 8 88.235Explanation / Answer
A. EBIT - INTEREST = 36000 - 36000(450000 × 8%)
= 0
Equity value = 0
Debt value = Debt / Total value( Equity + Debt)
= 450000/ 450000
= 1
B. Growth rate = 3%
Earnings next year =36000 ( 1+.03) = $37080
Equity value = earnings / (ke - growth rate) , ke = cost of equity
Where , in this case ke =kd , as there is no risk
Value of Equity =37080 / (8% - 3%)
= $741600
Debt ratio = 741600 / (741600 + 450000)
=.622
C.
Growth rate = 5%
Earnings next year =36000 ( 1+.05) = $37800
Equity value = earnings / (ke - growth rate) , ke = cost of equity
Where , in this case ke =kd , as there is no risk
Value of Equity =37800/ (8% - 5%)
= $1260000
Debt ratio = 1260000 / (1260000 + 450000)
=.736