ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2654470 • 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 $475,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $237,500 and the interest rate on its debt is 10 percent. Both firms expect EBIT to be $53,000. Ignore taxes.
Rico owns $23,750 worth of XYZ’s stock. What rate of return is he expecting? (Round your answer to 2 decimal places. (e.g., 32.16))
Suppose Rico invests in ABC Co and uses homemade leverage. Calculate his total cash flow and rate of return. (Round your percentage answer to 2 decimal places. (e.g., 32.16))
What is the cost of equity for ABC and XYZ? (Round your answers to 2 decimal places. (e.g., 32.16))
What is the WACC for ABC and XYZ? (Round your answers to 2 decimal places. (e.g., 32.16))
a.
Rico owns $23,750 worth of XYZ’s stock. What rate of return is he expecting? (Round your answer to 2 decimal places. (e.g., 32.16))
Explanation / Answer
1.
Calculate the expected rate of return.
The company has a debt rate of 10%.
EBIT = $53,000
Interest = 0.10 * 237500 = 23,750
Net Income = 29,250.
Expected return = 29250 / 237,500 = 0.1232 or 12.32%.
2.
Calculate the expected rate of return.
The company has a debt of 0%.
EBIT = $53,000
Interest = 0
Net Income = 53,000.
Expected return = 53000 / 475,000 = 0.01115 or 11.15%.
3.
Cost of equity of ABC company = EDIT / stock value = $53,000 / $475,000 = 11.15%
Cost of Equity of XYZ company = 29250 / 237,500 = 0.1232 or 12.32%.