ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2795200 • 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.
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.)
Cost of equity ABC % XYZ %
Explanation / Answer
Value of ABC=EBIT*(1-tax rate)/cost of equity
=>cost of equity of ABC=51000*(1-0)/450000=11.335%
WACC for ABC=cost of equity=11.335%
value of XYZ=value of ABC in absence of taxes=Debt+Equity=225000+Debt
Hence, 225000+Debt=450000
=>Debt=225000
cost of equity=unlevered cost of equity+D/E*(unlevered cost of equity-cost of debt)=11.335%+0.5*(11.335%-6%)=14.0025%
WACC for XYZ=D/(D+E)*cost of debt+E/(D+E)*cost of debt=225000/450000*11.335%+225000/450000*6%=8.6675%