ABC Co. and XYZ Co. are identical firms in all respects except for their capital
ID: 2796075 • 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 $450,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $225,000 and the interest rate on its debt is 6 percent. Both firms expect EBIT to be $51,000. Ignore taxes.
Richard owns $22,500 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 $450,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $225,000 and the interest rate on its debt is 6 percent. Both firms expect EBIT to be $51,000. Ignore taxes.
Explanation / Answer
(a)
Net Income = EBIT - EBIT*Debt Interest Rate = 51,000 - 51,000*0.06 = 47,940
Return on Equity on XYZ = Net Income/Avg. Outstanding Equity = 47,940/225,000 = 0.213 = 21.30%
Richard will earn 21.3% on his worth 22,500 = $4,792.50
(b)
Return on Equity for ABC = 51,000/450,000 = 0.1133 = 11.33%
In order to earn same cash flow from $4,792.50 he needs to invest 4792.50/0.1133 = $42299.22
The total cash flow for Richard will be
Investment = 22,500 + 42,299.22 = 64,799.5 and Earnings = 4792.5*2=9,585
Equivalent Return from overall investment = 0.1479 = 14.79%
Total = Investments and Earnings = $74,384.5
(c)
Cost of Equity for ABC = 21.3% from solution (a) and (b)
Cost of Equity for XYZ = 11.33%
(d)
For ABC cost of equity is WACC since it is purely equity funded
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