ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2761593 • 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.
b. Suppose Rico invests in ABC Co. and uses homemade leverage. Calculate his total cash flow and rate of return. (Do not round intermediate calculations. Enter your rate of return answer as a percent rounded to 2 decimal places, e.g., 32.16.) Total cash flow $ Rate of return %
Explanation / Answer
Answer:
•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 $87500. The shareholder should then borrow $87500. This will create an interest cash flow of:
•Interest cash flow = .08($)87500
•Interest cash flow = –$7000
•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 = $91000($175000/$875000)
•Dividends received = $18200
•The total cash flow for the shareholder will be:
•Total cash flow = $18200 – 7000
•Total cash flow = $11200
•The shareholders return in this case will be:
•R = $11200/$87,500
•R = 12.8%