ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2733666 • 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 $725,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $362,500 and the interest rate on its debt is 8.2 percent. Both firms expect EBIT to be $74,000. Ignore taxes.
Rico owns $54,375 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 $725,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $362,500 and the interest rate on its debt is 8.2 percent. Both firms expect EBIT to be $74,000. Ignore taxes.
Explanation / Answer
a.Calculation of Rate of Return for Rico
EBIT of XYZ = $74000,Kd =8.2%
Net Income = EBIT - Interest =$74000-($362500*8.2%) =$44275
Net icome is available for distribution as dividend to each shareholder in proportion of their sharecapital.
Rico held Stock worth $54375 in XYZ stock of $362500
Dividend available to Rico = $44275 *54375/362500 =$6641.25
Rate of return = Dividend from XYZ/Investment in XYZ =$6641.25/$54375 =12.214%
b.Total cashflow of Rico from ABC
It is assumed that same amount of investment i.e $54375 is invested in ABC like XYZ.
Dividend available to Rico =($74000/$725000)*$54375=$5550
Total cashflow = Dividend received - Interest on Investment(Oppurtunity cost)
=5550-(54375*8.2%) =$1091.25
Rate of Return = Total cash flow/Investment =1091.25/54375 =2.007%
c.Cost of Equity(Ke)
ABC
Cost of Equity (Ke) = Net income / Equity of ABC =$74000/$725000=10.21%
XYZ
Cost of Equity (Ke) = 10.21%+(10.21%-8.2%)(362500/362500) =12.22%
d.WACC
ABC
For ABC,WACC is the cost of capital of equity as there is no other capital.
WACC = Ke=10.21%
XYZ
It contains both debt and equity.
WACC = (Equity/Total value)Ke+(Debt/Total value)Kd(1-Tax) =0.5*12.22%+0.5*8.2% =10.21%