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 $60 million of long-term debt is 6 percent, and the company's tax rate is 40 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 $80 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: Before-Tax Operating Income Current Division Real estate $9e,e0e,000 $5,3e0, e00 $21,900,e0e Construction 65,680,000 3,800,e0e Total Assets Liabilities 18,1e8,e00 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 is complete but not entirely correct. Economic value added (in millions) Division Real Estate 6.993 Construction 6.375

Answer 1

DIVISION	EVA (in Millions)
Real Estate	$6.957 Million
Construction	$6.349 Million

Workings

Weighted Average Cost of capital

Market Value of Debt = $60 Million

Market Value of Equity = $80 Million

Total Market Value = $140 Million

Weighted Average Cost of Capital (WACC) = [After Tax Cost of Debt x Weight of Debt] + [Cost of equity x Weight of Equity]

= [0.06(1 – 0.40) x (60/140)] + [0.10 x (80140]

= [0.0360 x 0.4286] + [0.10 x 0.5714]

= 0.016 + 0.057

= 0.073 or

= 7.30%

Economic Value Added (EVA) is calculated by using the following formula

Economic Value Added (EVA) = EBIT(1 – Tax Rate) – [(Total asset – Total Current liabilities) x WACC]

EVA - Real Estate Division

Economic Value Added (EVA) = EBIT(1 – Tax Rate) – [(Total asset – Total Current liabilities) x WACC]

= [$21,900,000(1 – 0.40)] – [($90,000,000 - $5,300,000) x 0.073]

= $13,140,000 - $6,183,100

= $6,956,900 or

= $6.957 Million

EVA – Construction Division

Economic Value Added (EVA) = EBIT(1 – Tax Rate) – [(Total asset – Total Current liabilities) x WACC]

= [$18,100,000(1 – 0.40)] – [($65,600,000 - $3,800,000) x 0.073]

= $10,860,000 - $4,511,400

= $6,348,600 or

= $6.349 Million