ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2784063 • 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 $500,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $250,000 and the interest rate on its debt is 8 percent. Both firms expect EBIT to be $51,000. Ignore taxes a. Rico owns $25,000 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.) Rate of return 0 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 0 c. 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.) Cost of equity ABC XYZ d. 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.) WACC ABC XYZExplanation / Answer
a. Given, total equity value for XYZ= $250,000
As XYZ is similar to ABC,it will have the same amount of total capital of $500,000 and the rest amount of $250,000 will be sponsored by debt.
Interest rate on debt= 8%
So, Interest cost= 0.08*$250,000= $20,000
Given, EBIT= $51,000
So, net earnings for XYZ shareholders= $51,000-$20,000= $31,000
Therefore, rate of return of Rico on XYZ's stock= Net earnings/ Value of equity
=$31,000/$250,000 = 0.124 or 12.40%
b. If Rico uses homemade leverage and maintains a debt-equity ratio of 1:1 similar to XYZ firm, he would have the same rate of return as XYZ even if he buys the stock of ABC which is an unlevered firm.
Let us assume that Rico invests $25,000 in ABC, out of which $12,500 is his own money and the rest is sponsored by debt.
We will also assume that Rico can borrow money at the same rate as XYZ i.e. 8 percent.
Now as ABC has no debt, its net earnings will be equal to its EBIT i.e. $51,000.
So, returns for Rico from ABC before interest payments= ($25,000/$500,000)*(51,000) = $2,550
Interest costs for Rico= 0.08*$12,500= $1,000
Earnings for Rico after interest payments= $2,550-$1,000 = $1,550
So, the total cash flow for Rico = $1,550
Therefore, rate of return of Rico on ABC's stock= Net earnings/ Value of equity = $1,550/$12500 = 0.124 or 12.40%
c. Cost of equity for ABC= Net earnings/ Value of equity = $51,000/$500,000= 0.102 or 10.20%
Cost of equity for XYZ= Net earnings/ Value of equity = $31,000/$250,000= 0.124 or 12.40%
d. As ABC has no debt, so its WACC will be equal to its cost of equity i.e. 10.20%
For XYZ, WACC is given by = Weight of debt* Cost of debt + Weight of equity* Cost of equity (Ignoring taxes as per question)
=0.5*8% + 0.5*12.4% = 10.20%