ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2716262 • 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 5.2 percent. Both firms expect EBIT to be $79,000. Ignore taxes.
A) Suppose Rico invests in ABC Co. and uses homemade leverage. Calculate his total cash flow and rate of return. (Do not round intermediate calculations. Enter your rate of return answer as a percent rounded to 2 decimal places, e.g., 32.16.)
What is the cost of equity for ABC and XYZ? (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
A) Suppose Rico invests in ABC Co. and uses homemade leverage. Calculate his total cash flow and rate of return. (Do not round intermediate calculations. Enter your rate of return answer as a percent rounded to 2 decimal places, e.g., 32.16.)
Explanation / Answer
Given data,
EBIT = $79000
ABC Co. is equity financed, Equity = $800000
XYZ Co. is leveraged firm, Equity = $400000, debt = $800000 - $400000 = $400000
Interest rate on debt = 5.2%
Answer to Part A:
Investment in ABC Co.:
Total cash flow = EBIT (as non cash transaction details are not given)
Therefore, Total Cash Flow = $79000
Rate of Return
= EBIT / Equity
=$79000 / $800000
=0.09875
=9.875%
Total cash flow = $79000
Rate of Return = 9.875%
*For the purpose of answering part B, information is not provided.