Question

Golden Gate Construction Associates, a real estate developer and building contractor in San Francisco, has two sources of long-term capital: debt and equity. The cost to Golden Gate of issuing debt is the after-tax cost of the interest payments on the debt, taking into account the fact that the interest payments are tax deductible. The cost of Golden Gate's equity capital is the investment opportunity rate of Golden Gate's investors, that is, the rate they could earn on investments of similar risk to that of investing in Golden Gate Construction Associates. The interest rate on Golden Gate's $64 million of long-term debt is 5 percent, and the company's tax rate is 30 percent. The cost of Golden Gate's equity capital is 10 percent. Moreover, the market value (and book value) of Golden Gate's equity is $86 million. The company has two divisions: the real estate division and the construction division. The divisions' total assets, current liabilities, and before-tax operating income for the most recent year are as follows: Division Real estate Construction Total Assets $93,000,000 64,000,000 Current Liabilities $5,200,000 3,400,000 Before-Tax Operating Income $21,600,000 18,600,000 Required: Calculate the economic value added (EVA) for each of Golden Gate Construction Associates' divisions. (Round your weighted- average cost of capital to 3 decimal places (i.e. 123). Enter your answers in millions rounded to 3 decimal places (i.e. 1,234,000 should be entered as 1.234).)

Answer 1

Division	Economic value added (in millions)
Real estate	$8.798 Million
Construction	$8.657 Million

Explanation:-

Calculation of weighted average cost of capital:

Market value of Debt = $64 million

Market value of equity = $86 million

Total market value = $150 million

Weighted average cost of capital = [After tax cost of debt × weight of debt] + [cost of equity × weight of equity)

Weighted average cost of capital = [0.05(1- 0.3) × (64/150)] + [0.10 × (86/150)]

Weighted average cost of capital = [0.035 × (64/150)] + [0.10 × (86/150)]

Weighted average cost of capital = 0.015 + 0.057

Weighted average cost of capital = 0.072 or

Weighted average cost of capital = 7.2%

EVA = Net operating income before tax (1 - tax rate) - [(Total assets - current Liabilities)] × weighted average cost of capital

EVA- Real estate

EVA = $21,600,000 (1 - 0.3) - [($93,000,000 - $5,200,000)] × 7.2%

EVA = $15,120,000 - ($87,800,000 ×7.2%)

EVA = $15,120,000 - $6,321,600

EVA = $8,798,400 or

EVA = 8.798 million

EVA- construction

EVA = $18,600,000 (1- 0.3) - [($64,000,000 - $3,400,000)] × 7.2%

EVA = $13,020,000 - ($60,600,000 ×7.2%)

EVA = $13,020,000 - $4,363,200

EVA = $8,656,800 or

EVA = 8.657 million