Question

3. [Capital Structure and Growth] Edwards Construction currently has debt outstanding with
a market value of $70,000 and a cost of 8%. The company has EBIT of $5,600 that is
expected to continue in perpetuity. Assume there are no taxes.
a. What is the value of the company’s equity? What is the Debt-to-value ratio?
b. What are the equity value and debt-to-value ratio if the company’s growth rate is 3%?
c. What are the equity value and debt-to-value ratio if the company’s growth rate is 7%?

Answer 1

a.

Value of equity = EBIT - Interest

= 5600 - (70000*0.08) = $0

As the earnings to equity shareholders is 0, the debt to equity ratio is 100% or 1.

b.

EBIT for next year = 5600*1.03 = $5768

Interest = 5768 - 5600 = $168

Value of equity = 168/(0.08-0.03) = $3360

Total value of firm = 70000 + 3360 = $73360

Debt/Value = 70000/73360 = 0.9542

c.

EBIT for next year = 5600*1.07 = 5992

Interest = 5992 - 5600 = 392

Value of equity = 392/(0.08-0.07) = $3920

Total value of firm = 70000 + 3920 = $73920

Debt/Value = 70000/73920 = 0.6410