ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2644824 • 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 $700,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $350,000 and the interest rate on its debt is 8.5 percent. Both firms expect EBIT to be $73,000. Ignore taxes.
Rico owns $52,500 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 $700,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $350,000 and the interest rate on its debt is 8.5 percent. Both firms expect EBIT to be $73,000. Ignore taxes.
Explanation / Answer
a) Rate of Return of XYZ stock-
EBIT- 43250 ( 73000 - 350000*8.5%)
Equity Stock - 350000
So rate of return on $ 52500= (43250/350000)* 52500
= 6488
=6488/52500= 12.36%
b)RATE OF RETURN = 10.43%
Suppose the person borrows the invested amount i.e $ 52500 in XYZ @ 8.5%
So interest expense- 4462 (52500*8.5%)
Dividend Income by investing in ABC- 5475 (73000/700000)*52500
So cash inflow- 1013 (5475-4462)
c) Ke of ABC - 10.43% (73000/700000)
Ke of XYZ =
EBIT 73000
- Interest 29750 (350000*8.5%)
EBT 43250
Ke = 12.36 % (43250/350000)
d) WACC - ABC = 10.43%
WACC - XYZ =
Debt 350000 50% 8.5%
Equity 350000 50% 12.36%
=8.5*.5 + 12.36*.5
= 10.43 %