ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2801150 • 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
ABC XYZ Equity 5,00,000 2,50,000 8% Debt 2,50,000 Debt/Equity - 1 a EBIT 51,000 51,000 Interest - 20,000 EBT 51,000 31,000 R.O.R 51000/500000 31000/250000 10.20% 12.40% So total dividend received=12.4%*25000=3100 b % of share holding in XYZ =25000/250000=10% to Hold same % of holding money require 500000*10%=50000 Ricoh 25000 worth share balance 25000 they have to arrange loan Interest to pay 8%*25000=2000 So total dividend received =50000*10.2%=5100 minus interest cost 2000=3100 So ROR will 3100/25000= 12.40% c As per M&M Proposition II debt equity ratio =rE = r0 +D/E*(r0-rd) Where r0 is the cost of equity of the firm without debt r0=10.2% D/E=1 rd=cost of debt re=10.2%+1*(10.2%-8%) 10.20% d WACC of the ABC=0*0%+1*10.2% 10.20% WACC of the XYZ=.5*8%+.5*12.4% 10.20%