ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2725473 • 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 $700,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $350,000 and the interest rate on its debt is 8.5 percent. Both firms expect EBIT to be $73,000. Ignore taxes. a. Rico owns $52,500 worth of XYZ’s stock. What rate of return is he expecting? (Round your answer to 2 decimal places. (e.g., 32.16)) Rate of return % b. 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)) Total cash flow $ Rate of return % c. What is the cost of equity for ABC and XYZ? (Round your answers to 2 decimal places. (e.g., 32.16)) Cost of equity ABC % XYZ % d. What is the WACC for ABC and XYZ? (Round your answers to 2 decimal places. (e.g., 32.16)) WACC ABC % XYZ %
Explanation / Answer
a. The rate of return earned will be the dividend yield
The net income of the Company for the Company is = $73,000 - (8.5%*$350,000) = $43,250
The total dividend received by Rico will be in proportion to the percentage of the Company's shares they own:
Dividend Received = $43,250*($52,500/$350,000) = $6,487.50
Return to Rico = $6,487.50/ $52,500 = 12.36%
b. To generate the same cash flows , Rico needs to match the capital structure of ABC. He should sell shares in XYZ. This will net $52,500, he should then borrow $52,500, creating an interest cash flow of:
Interest Cash Flow = 8.5% * (-$52,500) = -$4,462.50
now Rico will use the stock sale proceeds and loan to buy shares in ABC. now total dividends received will be:
Dividends Received = $73,000*($105,000/$700,000) = $10,950
Total Cash flow for Rico = $10,950 - $4,462.50 = $6,487.50
Rico's return = $6,487.50 / $52,500 = 12.36%
c. ABC is an all equity Company, so:
Return on Equity = $73,000 / $700,000 = 10.43%
XYZ cost of equity will be determined as:
Return on equity = .1043 + (.1043-.085)(1) { M & M Proposition 2: Re = Ra + (Ra - Rd) * (D/E)
= 12.36%
d. WACC = {Rd *D/V * (1 - t)} + {Re * E/V}
For ABC,
WACC = 0 * 0.085 + 10.43 * 1 = 10.43%
For XYZ,
WACC = (1/2)*(.1236) + (1/2)*(0.085) = 10.43%