ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2635683 • Letter: A
Question
ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $800,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $400,000 and the interest rate on its debt is 10 percent. Both firms expect EBIT to be $97,000. Ignore taxes.
Rico owns $80,000 worth of XYZ
ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $800,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $400,000 and the interest rate on its debt is 10 percent. Both firms expect EBIT to be $97,000. Ignore taxes.
Explanation / Answer
Answer:
(A) EBIT of XYZ company is $ 97,000
So,Earning after interest but before tax will be 97,000 - 40,000 (interest on 400,000)
= $ 57,000
So the rate of return for XYZ will be 57,000/400,000 * 100 = 14.25 %
Hence, Rico will expect 14.25 % rate of return or 80,000 * 14.25/100 = $ 11,400
b)
Rate of return of ABC is $ 97,000/ $ 800,000 * 100 = 12.13 %
So, Rico will get a return of 12.13 % or $ 80,000 * 12.13/100 = $ 9,704
c)
Cost of Equity for ABC = $ 97,000/$ 800,000 * 100 = 12.13 %
Cost of equity for XYZ = $ 57,000/$ 400,000 * 100 = 14.25 %
d)
Since, ABC used only one type of finance hence it's WACC will be simple cost to capital
i.e. $ 97,000/$ 800,000 * 100 = 12.13 %
WACC for XYZ :
Weight of equity = 400,000/800,000 = 50 %
Weight of debt = 400,000/800,000 = 50 %
Cost of equity = 57,000/400,000 = 14.25 %
Cost of debt = 10 %
WACC = (Weight of equity * cost of equity) + ( weight of debt * cost of debt)
Putting the values, we get
(50 * 14.25)/100 + (50 * 10)/100
=12.13
Thanks