ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2722863 • 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 $875,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $437,500 and the interest rate on its debt is 8 percent. Both firms expect EBIT to be $91,000. Ignore taxes.
Rico owns $87,500 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))
ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $875,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $437,500 and the interest rate on its debt is 8 percent. Both firms expect EBIT to be $91,000. Ignore taxes.
Explanation / Answer
a. The rate of return earned will be the dividend yield. The company has debt, so it must make an interest payment. The net income for the company is:
Value of ABC Co. = Value of XYZ Co. = Value of equity + Debt
$875,000 = $437,500 + Debt
Debt = $875,000 - $437,500 = $437,500
Net Income = EBIT – Interest on debt = $91,000 – ($437,500 * 8%) = $56,000
The investor will receive dividends in proportion to the percentage of the company’s share they own. The total dividends received by the shareholder will be:
Dividends received = $56,000 * ($87,500/$437,500) =$56,000 * 0.20 = $11,200
So the return the shareholder expects is:
R = $11,200/$87,500 = 0.128 or 12.80%
b.
The shareholder should sell all shares in XYZ. This will net $87,500. The shareholder should then borrow $87,500. This will create an interest cash flow of:
Interest cash flow = $87,500 * 8% = -$7,000
The investor should then use the proceeds of the stock sale and the loan to buy shares in ABC. The investor will receive dividends in proportion to the percentage of the company’s share they own. The total dividends received by the shareholder will be:
Dividends received = $91,000($175,000/$875,000) = $18,200
The total cash flow for the shareholder will be:
Total cash flow = $18,200 - $7,000 = $11,200
The shareholders return in this case will be:
R = $11,200/$87,500 = 0.128 = 12.80%
c. ABC is an all equity company, so:
RE = RA = $91,000/$875,000 = 0.104 = 10.4%
To find the cost of equity for XYZ we need to use M&M Proposition II, so:
RE = RA + (RA – RD)(D/E)(1 – tC)
RE = 0.104 + (0.104 – 0.08)*1 = 0.128 = 12.80%
d. To find the WACC for each company we need to use the WACC equation:
WACC = (E/V)RE + (D/V)RD(1 – tC)
So, for ABC, the WACC is:
WACC = (1)(0.104) + (0)(0.08) = 0.104 = 10.4%
And for XYZ, the WACC is:
WACC = (1/2)(0.128) + (1/2)(0.08) = 0.104 = 10.4%
When there are no corporate taxes, the cost of capital for the firm is unaffected by the capital structure; this is M&M Proposition I without taxes.