ABC Co. and XYZ Co. are identical firms in all respects except for their capital structures. ABC is all-equity financed with $475,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $237,500 and the interest rate on its debt is 10 percent. Both firms expect EBIT to be $53,000. Ignore taxes. Requried:

a. Rico owns $23,750 worth of XYZ’s stock. What rate of return is he expecting?

b. Suppose Rico invests in ABC Co and uses homemade leverage. Calculate his total cash flow and rate of return.

c. What is the cost of equity for ABC and XYZ?

d. What is the WACC for ABC and XYZ?

ABC Co. and XYZ Co.

a. Rico owns $23,750 worth of XYZ’s stock. What rate of return is he expecting?

Expected Rate of Return = 12.32%

b. Suppose Rico invests in ABC Co and uses homemade leverage. Calculate his total cash flow and rate of return.

Cash flow from ABC Co. = 11.16% of $23,750 = $2,650.50

Cash outflow from homemade leverage = 10% of $11,875 = $1,187.50

Total cash flows = $1,463 ($2,650.50 - $1,187.50)

Rate of return = $1,463/$11,875 x 100 = 12.32%

c. What is the cost of equity for ABC and XYZ?

Cost of Equity for ABC Co. = Expected Return on Equity

= $53,000/$475,000 x 100

= 11.16%

Cost of Equity for XYZ Co. = Expected Return on Equity

= $29,250/$237,500 x 100

= 12.32%

d. What is the WACC for ABC and XYZ?

WACC for ABC = Cost of Equity = 11.16%

WACC for XYZ = Weighted Cost of Equity + Weighted Cost of Debt

= 11.16% x 50% + 10% x 50%

= 0.0558 + 0.05

= 0.1058

= 10.58%

Explanation:

ABC:

Equity = $475,000

Expected EBIT = $53,000

Returns on Equity = $53,000/$475,000 x 100 = 11.16%

XYZ:

Equity = $237,500

Debt = $237,500

Interest on Debt = 10% = $23,750

EBIT = $53,000

Return for Equity = $29,250 ($53,000 - 23,750)

Return on Equity = $29,250/$237,500 x 100 = 12.32%

RICO is assumed to leverage debt for his shares in ABC Co. to the tune of 50% just as the debt leverage in XYZ Co.

ABC's and XYZ's costs of equity are equal to the expected returns on the equities expressed percentages of the equities.

ABC's and XYZ's WACC or Weighted Average Costs of Capital are the weighted cost of equity plus the weighted cost of debt respectively.

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