Homemade Leverage and WACC [LO1] ABC Co. and XYZ Co. are identical firms in all

Question

Homemade Leverage and WACC [LO1] 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. 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.) 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.)

Explanation / Answer

Answer (C)

Cost of equity = Profit available to equityshareholders / Equity share capital

For ABC company

Cost equity = $79,000 / $800,000 *100 = 9.88%

For XYZ company

EBIT = $79,000

Interest on Debt = $400,000 *5.2%= $20,800

Profit after charging interest = $79,000 - $20,800 = $58,200

Cost of equity = $58,200 / $400,000 * 100 = 14.55%

(Note - It is assumed that the total equity in XYZ company is also $800,000 which is divided equally between equity and debt)

Related Questions

Navigate

• Browse (All)
• Browse H
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.