ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2816316 • 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 $800,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $400,000 and the interest rate on its debt is 5.2 percent. Both firms expect EBIT to be $79,000. Ignore taxes a. Rico owns $60,000 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.) Rate of return b. 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.) Total cash flow Rate of return c. What is the cost of equity for ABC and XYZ? (Do not round intermediate calculations. Enter your Cost of ABC 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.) WACC ABC 9.88 %Explanation / Answer
a. Rico's Rate of return
Rate of Return = XYZ Income * Rico's Investment / XYZ Equity * 1 / Rico's Invetement
Rate of Return = ($79000 - $400000 * 5.2%) * 60000 / 400000 * 1 / 60000
Rate of Return = ($79000 - $20800) * 60000 / 400000 * 1 / 60000
Rate of Return = 14.55%
b. Total Cash Flow and Rate of Return
Cash Flow from XYZ Co. = Net Income * Rico's Investment / XYZ Equity
Cash Flow from XYZ Co. = 58200 * 60000 / 400000
Cash Flow from XYZ Co. = $8730
To receive $8730 cash flow from ABC Co. Rico has to sell his investment in XYZ Co. and need to borrow and borrow another $60000 from the market at 5.2% to match the capital structure of ABC Co.
Thus by borrowing from market @5.2%
Rico's Total Cash Flow = Net Income of ABC Co. * Rico's Investment / ABC Co. Equity - Interest
Rico's Total Cash Flow = 79000 * 120000 / 800000 - 60000 * 5.2%
Rico's Total Cash Flow = $8730
Rico's Rate of Return = Total Cash Flow / Investment = $8730 / $60000 = 14.55%
c.
Cost of Equity of A = Net Income / Equity = $79000 / $800000 = 9.88%
Cost of Equity of B = Cost of All Equity + (Cost of All Equity - Cost of Debt)
Cost of Equity of B = 9.88% + (9.88% - 5.2%)
Cost of Equity of B = 14.56%
d. WACC
WACC OF ABC Co. = Weight of Equity * Cost of Equity = 9.88%
WACC OF XYZ Co. = Weight of Equity * Cost of Equity + Weight of Debt * Cost of Debt
WACC OF XYZ Co. = 0.50 * 0.1456 + 0.50 * 0.052
WACC OF XYZ Co. = 9.88%