ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2801130 • 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.
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.)
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.)
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.)
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.)
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.
Explanation / Answer
Step 1:
Calculate rate of return
Rate of return earned = Annual dividend per share/ price per share
Value of levered firm(ABC) = value of unlevered firm (XYZ)
Netincome for XYZ
EBIT 51000
Less; Interest on debt 20,000
Net income 31000
1.Rico owns $25,000 worth of XYZ’s stock. What rate of return is he expecting?
Total value of XYZ company = 5, 00,000 in which 250000 as equity and 250000 as Debt
Rico worth on XYZ stock (X) = Investment/ value of Debt = 25000/250000 = 0.1
Dividend received = X*Net income = 0.01*31000 = 3100
The total return Rico expects from the investment is 3100/25000 = 12.4%
2. Suppose Rico invests in ABC Co. and uses homemade leverage. Calculate his total cash flow and rate of return
Using the MM approach, in order to generate the same cash flow from ABC company, the shareholder should match the capital structure of ABC by selling all the shares in XYZ and borrowing loan for 25000 at 8 percent debt.
Total amount of investment is 25000 from shares +25000 loan at 8% interest rate = 50000
The investor receives dividend based on the proportionate amount of money invested in ABC .
50,000/5,00,000 = 0.1 in percentage = 10% in ABC
Rico stock worth of investment = 50,000/5, 00,000 = 0.1 in percentage = 10% in ABC
Net Income of ABC
EBIT 51000
Less; Interest on debt ------
Net income 51000
Dividend Received from ABC for 50000 investment = 51000*10% = 5100
Rico should pay back the loan amount with the interest 2000 = 5100- 2000 = 3100
3100 is the cash flows from ABC limited..
= 3100/25000 = 12.4%
3. Cost of equity for ABC and XYZ limited
Ke = Net income available to equity shareholders / Value of equity
For ABC, there is no debt amount, it is all equity firm . Therefore the netincome available for equity shareholders are the whole EBIT amount.
ABC = 51,000/500000 = 10.2%
To find the cost of equity for XYZ we should use MM proposition II
Ke of xyz= ke +(Ke- int.rate)(B/S)(1-t) ke = cost of equity, int.rate = interest rate. B= value of debt, s = value of equity t = tax rate
Ke of XYZ = .102 + (.102 – .08)(1)(1)
= 12.4
All three parts are answered.. kindly rate if the answers are correct..