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 5.5 percent. Both firms expect EBIT to be $68,000. Ignore taxes.

  

a.	Rico 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.)
b.	Suppose Rico invests in ABC Co. and uses homemade leverage. Calculate his total cash flow and rate of return. (Do not round intermediate calculations and enter your rate of return answer as a percent rounded to 2 decimal places, e.g., 32.16.)
c.	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.)
d.	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.)

	a. Rate of return 16.26 % b. Cash flow ? $ Rate of return 16.26 % c. ABC cost of equity 10.88 % XYZ cost of equity 16.26 % d. ABC WACC 10.88 % XYZ WACC 10.88 %

Answer 1

The computation is shown below:

a) The expected rate of rerturn is

= Net income / Equity

where,

Net Income

= EBIT - Interest expense

= $68,000 - (5.5% * $312,500)

= $50,812.50

And, the equity is $312,500

So, the expected rate of return is

= $50,812.50 / $312,500

= 16.26%

b) Now the total cash flow and the rate of return is

Before computing this, first we have to determine the stake percentage which is

= Stock owned / stock worth

= $30,000 / $312,500

= 12%

Now the total cash flow is

= EBIT - interest

= ($68,000 * 12%) - ($37,500 * 5.5%)

= $8,160 - $2,062.50

= $6,097.50

Now the rate of return is

= Total cash flow / owning stock

= $6,097.50 / $37,500

= 16.26%

c) Now

The Cost of equity for ABC is

= EBIT / Equity financed

= $68,000 / $625,000

= 10.88%

And, the Cost of equity for XYZ is

= EBIT / Worth of stock

= {$68,000 - ($625,000 - $312,500) * 5.5%} / $312,500

= 16.26%

d) Now

As we know that

WACC = weight of debt * cost of debt + weight of equity * cost of equity

So,

For ABC

The WACC = 100% * 10.88%

= 10.88%

And, For XYZ,

The WACC = 50% x 16.26% + 50% x 5.5%

= 10.88%