Question

1. ABC and XYZ are two industry competitors, operating under MM perfect capital markets environment. ABC’s market-value-based Debt/Equity ratio is 3/7. Its market-value-based cost of debt, rD, is 7.5% and cost of equity, rE, is 15%. XYZ’s Debt/Equity ratio is 2/3. XYZ’s cost of debt, rD, is 7.875% A. What is the required rate of return on ABC’s assets, rA? B. What is ABC’s weighted average cost of capital (WACC)? Explain. C. What is the required rate of return on XYZ’s assets, rA? Explain. D. What is XYZ’s weighted average cost of capital (WACC)? Explain. E. What is the required rate of return on XYZ’s unlevered equity? Explain. F. What is the required rate of return on XYZ’s levered equity, rE?

Answer 1

Answer:

Explanation:

Given

For ABC

rE = 15%

rD = 7.5%

D/E = 3/7

rE = rA + (rA-rD)*(D/E)

15 = rA + (rA-7.5)*(3/7)

105 = 7rA + 3rA - 22.5

10rA = 127.5

Hence,

rA = 12.75%

Now,

Weighted average cost of capital is the rate of return required from the firm. Irrespective of its capital structure.

WACC = (D/V)* rD + (E/V)*rE

Since, D/E = 2/7

So, D/V = D/(D+E) = 3/10

SImilary, E/V = 7/10

Hence,

WACC = (3/10)*7.5 + (7/10)*15

= 12.75%

c

Since this is perfect capital market and firms are competitors with different capital structure.

According to MM proposition the Asset return and WACC of two identical firms with different capital structure are same

Hence

rA of XYZ = 12.75%

d

similarly as question c

WACC of XYZ = 12.75%

E  AND F is solved in the attached below