ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2737971 • 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 $600, 000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $300, 000 and the interest rate on its debt is 4.5 percent. Both firms expect EBIT to be $67,000. Ignore taxes. Rico owns $36,000 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))Explanation / Answer
Answer:
XYZ is leveraged firm, so we need to find out earning available to shareholders.
Earning available to share holders of XYZ = EBIT - (Debt x debt interest %)
Earning available to share holders of XYZ = $67,000 - (300,000 x 4.5%)
Earning available to share holders of XYZ = $ 67,000 - $ 13,500
Earning available to share holders of XYZ = $ 53,500
Expected earning by share holders of XYZ in % terms = Earning available to share holders/amount invested by share holders
Expected earning by share holders of XYZ in % terms = 53,500/300,000
Expected earning by share holders of XYZ in % terms = 0.17833 = 17.83%
Answer a:
Rate of return expected by Rico will be equal to earning % expected by all share holders of XYZ = 17.83%
Answer b:
Suppose Rico invests in ABC, due to non availability of information in the question, I assume that RIco is investing same amount of $ 36,000 in ABC stocks
than cash flow will be $ 36,000 if answer is required for cash outflow
cash flow will be dividend income if required for cash inflow = 36,000 x 11.67%(as computed below) = $ 4020
Earning available to share holders of ABC = $ 67,000
Expected earning by share holders of ABC in % terms = Earning available to share holders/amount invested by share holders
Expected earning by share holders of ABC in % terms = 67,000/600,000
Expected earning by share holders of XYZ in % terms = 0.111667 = 11.17%
Answer C:
Cost of equity = expectation of return by share holders, which we have already computed above
ABC = 11.17%
XYZ = 17.83%
Answer D
WACC of ABC will be = cost of equity because no debt is taken. so, answer = 11.17%
WACC of XYZ = cost of equity(0.50) + cost of debt (0.50)
WACC of XYZ = 17.83(0.50) + 4.5(0.50)
WACC of XYZ = 8.915 + 2.25
WACC of XYZ = 11.165%