ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2763735 • 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 $750,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $375,000 and the interest rate on its debt is 6.4 percent. Both firms expect EBIT to be $73,000. Ignore taxes.
Rico owns $56,250 worth of XYZ’s stock. What rate of return is he expecting? (Do not round intermediate calculations. Enter your answer as a percent rounded 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. (Do not round intermediate calculations. Enter your rate of return answer as a percent rounded to 2 decimal places, e.g., 32.16.)
What is the cost of equity for ABC and XYZ? (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.)
What is the WACC for ABC and XYZ? (Do not round intermediate calculations. Enter your answers as a percent rounded 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 $750,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $375,000 and the interest rate on its debt is 6.4 percent. Both firms expect EBIT to be $73,000. Ignore taxes.
Explanation / Answer
Part A)
The rate of return (which in this case would be same as dividend yield) can be calculated as follows:
Net Income after Interest = 73,000 - 6.4%*375,000 = $49,000
Proportion of Dividend Received by the Investor = 49,000*56,250/375,000= $7,350
Rate of Return = Dividend Yield = Dividend/Value of Stock*100 = 7,350/56,250*100 = 13.07%
__________
Part B)
The value of cash flow is calculated as follows:
Cash Flow = Dividend Received - Interest Cash Flow
Interest Cash Flow = Value Realized from Sale of Stock*Interest Rate = 56,250*6.4% = $3,600
Rico will have to borrow $56,250 to match the capital structure of XYZ. The value of dividend received is calculated as follows:
Dividend Received = EBIT*(Value from Stock Sale + Amount Borrowed)/Value of Equity = 73,000*(56,250 + 56,250)/750,000 = $10,950 (or simply stated 73,000*15%)
Now, we can calculated total cash flow and rate of return as follows:
Total Cash Flow = 10,950 - 3,600 = $7,350
The rate of return is calculated as follows:
Rate of Return = 7,350/56,250*100 = 13.07%
__________
Part C)
The cost of equity for ABC and XYZ is calculated as follows:
ABC = EBIT/Value of Equity*100 = 73,000/750,000*100 = 9.73%
XYZ (MM Proposition II) = Cost of Equity Unlevered Firm + ( Cost of Equity Unlevered Firm - Cost of Debt)*(Debt/Equity)*(1-Tax Rate) = 9.73% + (9.73% - 6.4%)*(1)*(1-0) = 13.07%
__________
Part D)
The WACC is calculated as follows:
ABC = Cost of Equity calculated in Part C (as there is no debt) = 9.73%
XYZ = Weight of Debt*Cost of Debt + Weight of Equity*Cost of Equity = 50%*6.4% + 50%*13.07% = 9.73%
The WACC will be same under both the methods in the absence of taxes.