ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2794486 • Letter: A
Question
ABC Co. and XYZ Co. are identical firms in all respects except for their capital structures. ABC is all-equity financed with $450,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $225,000 and the interest rate on its debt is 6 percent. Both firms expect EBIT to be $51,000. Ignore taxes.
a. Richard owns $22,500 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 Richard invests in ABC Co. and uses homemade leverage to match his cash flow in part a. Calculate his total cash flow and rate of return. (Enter your return answer as a percent. Do not round intermediate calculations and round your answers to 2 decimal places, e.g., 32.16.)
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.)
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.)
Total cash flow $ Rate of return %
Explanation / Answer
a)
The rate of return earned will be the dividend yield=annual dividend per share/ price per share.
The company has debt, so it must make an interest payment.
The net income for the company is:
Value (L)=Value (U)
D+E=800D=800-400=400
D/E=1
NI = EBIT - (rate on debt)*(Stock worth) = 51000-0.06*225000 = $37,500
The investor will receive dividends in proportion to the percentage of the company’s shares they own.
The total dividends received by the shareholder willbe:
Dividends received = $37,500($22,500/$225,000) = $3,750
So the return the shareholder expects is:rS= $3750/22500 = 0.1667 or 16.67%
b)
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 $22,500
The shareholder should then borrow $22,500.
This will create an interest cash flow of:
Interest cash flow = 0.06 * (–$22500) = –$1,350
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 thepercentage of the company’s share they own.
The total dividends received by the shareholder will be:
Dividends received = $95,000($45,000/$450,000) = $9,500
The total cash flow for the shareholder will be:
Total cash flow = $9,500 – 1350 = $8150
The shareholders return in this case will be:rS= $8150/$22,500 = 0.3622 or 36.22%