Question

ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $650,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $325,000 and the interest rate on its debt is 6.5 percent. Both firms expect EBIT to be $71,000. Ignore taxes.

ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $650,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $325,000 and the interest rate on its debt is 6.5 percent. Both firms expect EBIT to be $71,000. Ignore taxes.

  

a.	Richard owns $39,000 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 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.)
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.)

Answer 1

(Part a)

	ABC Company	XYZ Company
Equity	650,000	325,000	A
6.5% Debt	-	325,000	B
Total Capital	650,000	650,000	A+B
EBIT	$              71,000	$         71,000	C	As per Question
Less: Interest	$                     -	$         21,125	D	6.5% of Debt
EBT	$              71,000	$         49,875	E	C-D
EAT(Earnings after taxes)	$              71,000	$         49,875	F	E
Return on Equity		15.35%	G	F/A
Richard's Stock		$39,000	H
Return to Richard		$5,985.00	I	G*H
(Part b)
	ABC Company	XYZ Company
Equity	650,000	325,000	A
6.5% Debt	-	325,000	B
Total Capital	650,000	650,000	A+B
EBIT	$              71,000	$         71,000	C	As per Question
Less: Interest	$                     -	$         21,125	D	6.5% of Debt
EBT	$              71,000	$         49,875	E	C-D
EAT (Earnings after taxes)	$              71,000	$         49,875	F	E
Return on Equity	10.92%	15.35%	G	F/A
Richard's Stock	$39,000	$39,000	H	Given in question
Return to Richard	$4,260.00	$5,985.00	I	G*H
Cash Required to match cash flows	$1,725.00	J
(This is return (in I above) for XYZ- return (in I above) for ABC)
Now, Richard will take leverage in such a way that his net cash flows should be 1,725
Total Net Cash Required:	$1,725.00	K
Interest Rate	6.50%	L
Total Leverage Required	$                 1,844.92	M	K/(1-L)

Total Cash Flow and Return
Inflow from Stock with ABC	$4,260.00	I
(+) Cash from Homemade Leverage	$1,844.92	M
(-) Interest	$(119.92)	N	L*M
Net Cash	$5,985.00	O	I+M+N
Total Return for Richard	15.35%	P	H*O
Note: Return for Richard is now same as that in ABC Company.

(c) Cost of Equity	10.92%	15.35%	Q
Note: This is the same as returns on equity since there are no taxes.
(d) Weighted Average Cost of Capital
Cost of Debt	-	6.50%	R	As per Question
Cost of Equity	10.92%	15.35%	Q	As above in (c)
Weight of Debt	0%	50%	T	B/(B+A)
Weight of Equity	100%	50%	U	1-T
WACC	10.92%	10.92%	R*T+Q*U

Note: WACC is same in both cases on account of no taxes, which could magnify returns to the stock holder by leveraging.