ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2795015 • 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 $525,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $262,500 and the interest rate on its debt is 6 percent. Both firms expect EBIT to be $57,000. Ignore taxes.
a. Richard owns $26,250 worth of XYZ’s stock. What rate of return is he expecting? (Do not round intermediate calculations and 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. (Do not round intermediate calculations. Enter your 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 and 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 and enter your answers as a percent rounded to 2 decimal places, e.g., 32.16.) WACC ABC % XYZ %
Explanation / Answer
a) FIRM XYZ: EBIT $ 57,000 Interest = 262500*6% = $ 15,750 NI $ 41,250 Return for Richard = 41250*26250/262500 = $ 4,125 Rate of return for Richard = 4125/26250 = 15.71% b) FIRM ABC: EBIT=NI = $ 57,000 Rate of return on equity = 57000/525000 = 10.86% Amount to be invested in ABC to get $4125 = 4125/10.86% = 37983 To create home made leverage, Richard should borrow 50% of the above amount = 37983*50% = 18992 Equity = 50% = 18992 Rate of return for Richard: Share of net income of ABC 4125 Interest on debt = 18992*6% = 1140 Net $ returns 2985 Rate of return of investment = 2985/18992 = 15.72% c) Cost of equity for ABC = 57000/525000 = 10.86% Cost of equity for XYZ = 41250/262500 = 15.71% d) WACC for ABC = 10.86*1 = 10.86% WACC for XYZ = 15.71*0.5+6*0.5 = 10.86%