ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2759316 • 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
Answer:
XYZ Co.debt finance = Total Funds - equity finance = 800,000 - 400,000 = $400,000
Answer a:
Rico owns shares worth $80,000. He should expect a return of 14.25%(as calculated in above table) on its investment.
Answer b:
Let us suppose Rico invests in ABC Co $ 100,000 uses homemade leverages with same amount.
Below it the total cash flow and rate of return for Rico-
Answer c:
Answer d:
ABC Co. XYZ Co. EBIT 97,000 97,000 Less: Interest (10% of 400,000) - 40,000 EBT 97,000 57,000 Less: Tax - - Earning after tax(for shareholders) 97,000 57,000 Equity 800,000 400,000 Debt - 400,000 Return on equity(Earning after tax/Equity) 12.13% 14.25%