ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $480,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $240,000 and the interest rate on its debt is 9 percent. Both firms expect EBIT to be $58,400. Ignore taxes. The cost of equity for ABC is percent, and for XYZ it is percent.

The cost of equity for ABC is 12.17 percent, and for XYZ it is 15.33 percent.

Explanation:

Since we are to ignore tax for the two companies, ABC will pay no interest since it is all equity financed. Therefore, we have.

ABC Co. cost of equity = $58,400 ÷ $480,000 = 0.1217, or 12.17%

XYZ has $240,000 equity and $240,000 debt, it has to pay interest on debt. We can therefore calculate its cost of equity as follows:

XYZ interest on loan = $240,000 × 9% = $21,600

XYZ Profit after interest = $58,400 - $21,600 = $36,800

XYZ cost of equity = $36,000 ÷ 240,000 = 0.1533, or 15.33%

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