ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2741093 • 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 $800,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $400,000 and the interest rate on its debt is 10 percent. Both firms expect EBIT to be $97,000. Ignore taxes.
Rico owns $80,000 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))
ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $800,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $400,000 and the interest rate on its debt is 10 percent. Both firms expect EBIT to be $97,000. Ignore taxes.
Explanation / Answer
a.Net Income = EBIT - 0.1($400000) = $97000 - $40000 = $37000
Rate of return to shareholder = Dividend received / Stock owned
Dividend received = 37000(80000/400000) = $7400
Rate of return to shareholder = $7400 / $80000 = 9.25%
b.Investing using Home made leverage by Rico
Rico should borrow $80000 at interest rate of 10%
Interest cash flow = 0.10($80000) = ($8000)
Dividends received = $97000($160000/$800000) = $19400
Total cash flow = $19400 - $8000 =$11400
Shareholders return = Total cash flow / Investment = $11400/$80000 = 14.25%
c.Cost of equity
ABC is an all equity company,so RE = RA
RE = EBIT / Stock = 97000 / 800000 = 12.125%
For XYZ,(using M&M Approach)
RE = RA+(RA-RD)(D/E)(1-Tax)
=12.125%+(0.12125-0.10)(1/1)(1-0) = 14.25%
d.WACC = (E/V)RE+(D/V)RD(1-Tax)
For ABC,WACC = (1)(.12125) =12.125%
For XYZ,WACC = (1/2)(0.1425)+(1/2)(0.1) =12.125%