ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2657785 • 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 $775,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $387,500 and the interest rate on its debt is 8 percent. Both firms expect EBIT to be $77,000. Ignore taxes a. Richard owns $58,125 worth of XYZ's stock. What rate of return is he expecting? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.) Rate of return b Suppose Richard invests in ABC Co. and uses homemade leverage to match his cash flow in part a. Calculate his total cash flow and rate of return. (Do not round intermediate calculations. Enter your return answer as a percent rounded to 2 decimal places, e.g., 32.16.) Total cash flow Rate of retum c. What is the cost of equity for ABC and XYZ? (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) Cost of equity ABC xYZ d. What is the WACC for ABC and XYZ? (Do not round intermediate calculations and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) WACC ABC XYZExplanation / Answer
ABC Co. and XYZ Co. both are identical in all respects except for their capital structure. ABC Co. is an unlevered company while XYZ Co. is a levered company. Total capital employed of both the companies is same. Capital of ABC Co. is $775,000 and hence capital of XYZ Co. is also $775,000, consisting of $387,500 in equity and remaining in debt of $387,500 i.e 775,000 - 387,500, interest on which is payable @8%.
Income statement of XYZ Co.
(a) Richard owns $58,125 worth of stock of XYZ Co.
Hence, Richard owns = [(58,125/387,500) x 100 ] of stock of XYZ Co.
= 15% of stock of XYZ Co.
Since, there are no taxes, hence earnings after interest of $46,000 of XYZ Co. are returns to the stockholders.
Since Richard owns 15% of stock of XYZ Co., he is entitled to 15% of $46,000
Hence, earnings of Richard = 46,000 x 15%
= $6,900
Hence, rate of return of Richard = 6,900/58,125
= 11.87%
(b) Richard sells his equity in XYZ Co. and gets $58,125. Richard holds 15% of equity of XYZ Co. To buy 15% equity of ABC Co., Richard needs = 775,000 x 15% = $116,250.
Richard would borrow $58,125 @8% (116,250 - 58,125) so that he can buy 15% of equity of ABC Co.
Now, Richard's position will be as under:
Dividend from ABC Co. = 77,000 x 15%
= $11,550
Less: Interest on borrowings = 58,125 x 8%
= $4,650
Net earnings of Richard = 11,550 - 4,650
= $6,900
Rate of return = 6,900/58,125
= 11.87%
(c) Cost of equity of ABC Co. = EBIT/Equity
= 77,000/775,000
= 9.94%
Cost of equity of XYZ Co. = Earnings after interest/Equity
= 46,000/387,500
= 11.87%
(d) Since ABC Co. is an all equity firm, its WACC would be same as its cost of equity.
Hence, WACC of ABC Co. = Cost of equity = 9.94%
WACC of XYZ Co. = (Cost of debt x Weight of debt) + (Cost of equity x Weight of equity)
= (8% x 0.50) + (11.87% x 0.50)
= 4% + 5.94%
= 9.94%
EBIT 77,000 Less: Interest (3,87,500 x 8%) - 31,000 Earnings after interest 46,000