Edwards Construction currently has debt outstandind 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.
What is the value of the company's equity? What is the debt-to-value ratio?
To find the value of the company's equity, we can use the formula for the enterprise value:
Enterprise Value = Equity Value + Debt Value
We are given the debt value as $70,000, so we can calculate the equity value by subtracting the debt value from the enterprise value:
Equity Value = Enterprise Value - Debt Value
Since the company has no taxes and a perpetual EBIT of $5,600, we can use the formula for enterprise value:
Enterprise Value = EBIT / Discount Rate
First, we need to calculate the discount rate. The cost of debt is given as 8%. Since there are no taxes, the cost of debt is equal to the required rate of return on equity (ROE). Therefore, the discount rate is 8%.
Next, we can substitute the values into the formula:
Enterprise Value = $5,600 / 0.08 = $70,000
Now we can calculate the equity value:
Equity Value = $70,000 - $70,000 = $0
The value of the company's equity is $0.
To find the debt-to-value ratio, we can divide the debt value by the enterprise value:
Debt-to-Value Ratio = Debt Value / Enterprise Value
Substituting the values:
Debt-to-Value Ratio = $70,000 / $70,000 = 1
The debt-to-value ratio is 1, indicating that the company's debt is equal to its value.
To find the value of the company's equity, we need to calculate the total value of the company first. The value of the company can be determined using the concept of the perpetuity formula, which is commonly used in valuation. The perpetuity formula can be expressed as:
Value = EBIT / Cost of Debt
In this case, the EBIT is $5,600, and the cost of debt is 8%, or 0.08. Plugging in these values, we can solve for the value of the company:
Value = $5,600 / 0.08 = $70,000
Given that the market value of debt is $70,000, the value of the company is equal to the value of debt. Therefore, the equity value would be zero. This implies that the entire company value is accounted for by the debt.
To calculate the debt-to-value ratio, we divide the market value of the debt by the total value of the company:
Debt-to-value ratio = (Market value of debt) / (Total value of the company)
Debt-to-value ratio = $70,000 / $70,000 = 1
So, the debt-to-value ratio is 1, indicating that the company is fully financed by debt and has no equity value.