ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2711458 • 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 $600,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $300,000 and the interest rate on its debt is 4.5 percent. Both firms expect EBIT to be $67,000. Ignore taxes.
a. Richard owns $36,000 worth of XYZ’s stock. What rate of return is he expecting?
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.
c. What is the cost of equity for ABC and XYZ?
d. What is the WACC for ABC and XYZ?
ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $600,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $300,000 and the interest rate on its debt is 4.5 percent. Both firms expect EBIT to be $67,000. Ignore taxes.
a. Richard owns $36,000 worth of XYZ’s stock. What rate of return is he expecting?
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.
c. What is the cost of equity for ABC and XYZ?
d. What is the WACC for ABC and XYZ?
Explanation / Answer
a) Richard's stake = 36000/300000 = 12%
Profit = EBIT - Interest = 67000 - 4.5% * 300000 = 67000 - 13500 = $53,500
Cash Flow to Richard = 53500 * 12% = $6,420
Rate of return expected = 6420/36000 = 17.83%
b) Richard's cash flow = 53500 * 12% = $6420
To match the cash in the above part by investing company ABC, Richard will have to match the capital strucure of ABC. For this, he will have to sell all his shares in XYZ worth $36,000. He should then borrow $36,000 which will create an interest liability of 4.5% * 36000 = $1620
He should use both these proceeds to buy stocks in ABC.
Cash flow that will be recevied by Richard = 67000 * (72000/600000) = $8,040
Interest cash flow = -1,620
Total cash flow = 8,040 - 1620 = $6,420
RIchard's Return = 6420/ 36000 = 17.83%
c) ABC is an all equity company
Cost of equity for ABC = RA = 67000/600000 = 11.166%
XYZ is financed equally with equiy and debt
Cost of equity for XYZ = RA + (RA - RD) * (D/E) * (1 - Tax Rate)
D/E = 1
Tax Rate = 0
Cost of Equity for XYZ = 11.166 + (11.166 - 4.5) = 17.832%
d) WACC = Cost of Equity * Weight of Equity + Cost of Debt * Weight of Dent * (1 - Tax Rate)
For ABC,
WACC = 11.166% * 1 + 0 = 11.166%
For XYZ,
WACC = 17.832 * 0.5 + 4.5 * 0.5 * 1 = 11.166%