ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2738704 • 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 $625,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $312,500 and the interest rate on its debt is 5.5 percent. Both firms expect EBIT to be $68,000. Ignore taxes. a. Rico owns $37,500 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?
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:
NI = $68000 – 0.055 ($312500)
NI = $50812.50
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 = $50812.50 ($37500/$312500)
Dividends received = $6097.50
So the return the shareholder expects is:
R = $6097.50 /$37500
R = 0.1626 or 16.26%
b. To generate exactly the same cash flows in the other company, the shareholder needs to match the capital structure of ABC. The shareholder should sell all shares in XYZ. This will net $37500. The shareholder should then borrow $37500. This will create an interest cash flow of:
Interest cash flow = .055($37500)
Interest cash flow = –$2062.50
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 = $68000($75000/$625000)
Dividends received = $8160
The total cash flow for the shareholder will be:
Total cash flow = $8160 – 2062.50
Total cash flow = $6097.50
The shareholders return in this case will be:
R = $6097.50 / $37500
R = 0.1626 or 16.26%
c. ABC is an all equity company, so:
RE = RA = $68000 / $625,000
RE = 0.1088 or 10.88%
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 = 0.1088 + (0.1088 – 0.055)(1)(1)
RE = .1626 or 16.26%
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)(0.1088) + (0)(0.055)
WACC = 0.1088 or 10.88%
And for XYZ, the WACC is:
WACC = (1/2)(.1426) + (1/2)(0.055)
WACC = 0.1088 or 10.88%
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.