Question

Capital Structure and Growth Edwards Construction currently has debt outstanding with a market
value of $310,000 and a cost of 6 percent. The company has an EBIT of $18,600 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 is the equity value and debt-to-value ratio if the company’s growth rate is 2 percent?
c. What is the equity value and debt-to-value ratio if the company’s growth rate is 4 percent?

Answer 1

(a) Market Value of debt = D = $310000

Interest Rate = r = 6% or 0.06

EBIT/year in perpetuity = $18600

Hence, Equity Value = E = EBIT/r = 18600/0.06 = $310000

Debt to Value = D/E = 310000/310000 = 1

(b) Market Value of debt = D = $310000

Interest Rate = r = 2% or 0.02

EBIT/year in perpetuity = $18600

Hence, Equity Value = E = EBIT/r = 18600/0.02 = $930000

Debt to Value = D/E = 310000/930000 = 0.333

(c) Market Value of debt = D = $310000

Interest Rate = r = 4% or 0.04

EBIT/year in perpetuity = $18600

Hence, Equity Value = E = EBIT/r = 18600/0.04 = $465000

Debt to Value = D/E = 310000/465000 = 0.667