14- ABC Co. and XYZ Co. are identical firms in all respects except for their cap

Question

14-

ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $425,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $212,500 and the interest rate on its debt is 6 percent. Both firms expect EBIT to be $48,000. Ignore taxes.

Rico owns $21,250 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 $425,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $212,500 and the interest rate on its debt is 6 percent. Both firms expect EBIT to be $48,000. Ignore taxes.

Explanation / Answer

(a) EBIT of XYZ company is $ 48,000

So,Earning after interest but before tax will be 48,000 - 12,750 ($212,500*6%)

                                                                 = $35,250

So the rate of return for XYZ will be 35,000/212,500 * 100 = 16.59 %

Hence, Rico will expect 16.59 % rate of return or 21,250 * 16.59/100 = $3,525.38

b) Rate of return of ABC is $ 48,000/ $ 425,000 * 100 = 11.29 %

So, Rico will get a return of 11.29 % or $ 21,250 * 11.29/100 = $ 2399.13

c)

Cost of Equity for ABC = $48,000/$ 425,000 * 100 = 11.29 %

Cost of equity for XYZ = $ 35,000/212,500 * 100 = 16.59 %

d)

Since, ABC used only one type of finance hence it's WACC will be simple cost to capital

i.e. $ $48,000/$ 425,000 * 100 = 11.29 %

WACC for XYZ :

Weight of equity = 212,500/425,000 = 50 %

Weight of debt   = 212,500/425,000 = 50 %

Cost of equity = $35,250/212500 = 16.59 %

Cost of debt = 6%

WACC = (Weight of equity * cost of equity) + ( weight of debt * cost of debt)

Putting the values, we get

(50 * 16.59)/100 + (50 * 6)/100 = 11.30%

Thanks

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