ABC Co. and XYZ Co. are identical firms in all respects except for their capital

Question

ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $625,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $312,500 and the interest rate on its debt is 6 percent. Both firms expect EBIT to be $68,000. Ignore taxes.

Richard owns $37,500 worth of XYZ’s stock. What rate of return is he expecting? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)

Suppose Richard invests in ABC Co. and uses homemade leverage to match his cash flow in part a. Calculate his total cash flow and rate of return. (Do not round intermediate calculations. Enter your 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 and 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 and 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 $625,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $312,500 and the interest rate on its debt is 6 percent. Both firms expect EBIT to be $68,000. Ignore taxes.

Explanation / Answer

a) Net Income = EBIT - Interest = 68,000 - 6% x (312,500) = 49,250

Rate of return = Net Income / Equity = 49,250 / 312,500 = 15.76%

Cash flows to Richard = 15.76% x 37,500 = 5,910

b) In order to create homemade leverage, Richard should borrow $37,500 at 6% and invest a total of $75,000 in ABC.

Cash flows from ABC = 68,000 / 625,000 x 75,000 = 8,160

Interest paid = 37,500 x 6% = -2,250

=> Net Cash Flows = 8160 - 2250 = $5,910

Rate of return = 5,910 / 37,500 = 15.76%

c) Cost of equity for ABC = 68,000 / 625,000 = 10.88%

Cost of equity for XYZ = 49,250 / 312,500 = 15.76%

d) WACC = wd x kd + we x ke, w - weight, k - cost, e - equity, d - debt

For ABC, WACC = 100% x 10.88% = 10.88%

For XYZ, WACC = 50% x 15.76% + 50% x 6% = 10.88%

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