Golden Gate Construction Associates, a real estate developer and building contra

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 $69 million of long-term debt is 5 percent, and the company’s tax rate is 20 percent. The cost of Golden Gate’s equity capital is 15 percent. Moreover, the market value (and book value) of Golden Gate’s equity is $81 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:

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).)

Division Total Assets Current Liabilities Before-Tax Operating Income Real estate $ 98,000,000 $ 5,600,000 $ 20,700,000 Construction 63,700,000 3,500,000 18,500,000

Explanation / Answer

Weighted Average cost of Capital (WACC) = ((After tax cost of debt)(Market value of debt)+(Cost of equity capital)(Market value of equity))/ (Market value of debt + Market value of equity)
After tax cost of debt = 5%-20% = 4%

WACC = ((0.04*$69,000,000) + (0.15*$81,000,000))/ (69,000,000+81,000,000)
= 14,910,000/150,000,000 = 9.94%

EVA = Investment center's after-tax operating income - ((Investment center's total asset - Investment center's current liabilities)*WACC)

Real Estate = After tax operating income = 20,700,000 - 20% = 16,560,000
Construction = After tax operating income = 18,500,000 - 20% = 14,800,000

EVA = Real Estate = 16560000 - ((98,000,000-5,600,000)*9.94%) = 7,375,440 or 7.375 million
EVA = Construction = 14,800,000 - ((63,700,000-3,500,000)*9.94%) = 8,816,120 or 8.816 million

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