ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2784402 • 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 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 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 XYZ 0Explanation / Answer
1. Since XYZ uses debt, it will pay interest on debts as well.
EBIT = 51,000, Interest(@8%) = 0.08 x 250,000 = 20,000
Net Income = 51,000 - 20,000 = 31,000
Rico receive dividends in proportion to the percentage of the company’s shares he owns.
Dividends received = 31,000x(25,000/250,000)
Dividends received = 3,100
So the return the shareholder expects is:rS= 3,100/25,000
rS= 0.124 or 12.4%
2. 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 $25,000.
The shareholder should then borrow $30,000. This will create an interest cash flow of:
Interest cash flow = 0.08(–$25,000)
Interest cash flow = –$2,000
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 = 51,000(50,000/500,000)
Dividends received = 5,100
The total cash flow for the shareholder will be:Total cash flow = 5100 – 2,000
Total cash flow = 3,100
The shareholders return in this case will be:
rS= 3,100/25,000
rS= 0.124 or 12.4%
3. ABC is an all equity company, so:
RE = RA = 51,000/500,000
RE = 0.102 or 10.2%
To find the cost of equity for XYZ we need to use M&M Proposition II, so:
RE = RA + (RA – RD)(D/E)(1 – tC)
RE = .102 + (.102 – .08)(1)(1)
RE = ..124 or 12.4%
4. To find the WACC for each company we need to use the WACC equation:
WACC = (E/V)RE + (D/V)RD(1 – tC)
So, for ABC, the WACC is:
WACC = (1)(.1217) + (0)(.08)
WACC = .102 or 10.2%
And for XYZ, the WACC is:
WACC = (1/2)(.124) + (1/2)(.08)
WACC = .102 or 10.2%
When there are no corporate taxes, the cost of capital for the firm is unaffected by the capital structure; this is M&M Proposition I without taxes.