ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2734477 • 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. a. Rico owns $87,500 worth of XYZ's stock. What rate of return is he expecting? b. Suppose Rico invests in ABC Co and uses homemade leverage. 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) EBIT 91000 interest -35000 EBT 56000 Rate of return = 56000/437500*100 = 12.8% b) Total cashflow =91000/87500*875000 = 9100 Rate of return = 91000/875000*100 = 10.4% c) Cost of Equity for ABC = 10.4% Cost of Equity for XYZ = 12.8% d) WACC of ABC = 10.4% WACC of XYZ = (10.4%*1/2)+(8%*1/2) = 9.2%