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Question 1
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 10 percent, and the company’s tax rate is 40
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 $90 million.
Required: Calculate Golden Gate Construction Associates’
weighted-average cost of capital.
Question 2
Refer to the data in the preceding exercise for Golden Gate
Construction Associates. 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 Total Assets Current Before-Tax Operating Income Liabilities
Real estate
.......................................................................
$100,000,000 $6,000,000 $20,000,000 Construction
.................................................................... 60,000,000
4,000,000 18,000,000 Required: Calculate the economic value added (EVA) for
each of Golden Gate Construction Associates’ divisions. (You will need to use
the weighted-average cost of capital, which was computed in the preceding
exercise.)
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