Question

ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $550,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $275,000 and the interest rate on its debt is 10 percent. Both firms expect EBIT to be $59,000. Ignore taxes. a. Rico owns $33,000 worth of XYZ’s stock. What rate of return is he expecting? (Round your answer to 2 decimal places. (e.g., 32.16)) Rate of return % b. Suppose Rico invests in ABC Co and uses homemade leverage. Calculate his total cash flow and rate of return. (Round your percentage answer to 2 decimal places. (e.g., 32.16)) Total cash flow $ Rate of return %c. What is the cost of equity for ABC and XYZ? (Round your answers to 2 decimal places. (e.g., 32.16)) Cost of equity ABC % XYZ % d. What is the WACC for ABC and XYZ? (Round your answers to 2 decimal places. (e.g., 32.16)) WACC ABC % XYZ %

Answer 1

Answer:

ABC return on equity 10.27%

XYZ return on equity   11.45%

WACC ABC same as has no debt: 10.27

WACC XYZ 10.72500%

Explanation:

550,000 - 275,000= 275,000 debt

275,000 x 10% = 27,500 interest expense

EBIT 59,000 - 27,500 interest expense= 31,500

XYZ return on equity: 31,500 / 275,000 = 0.11454545 = 11.45%

ABC return on equity: 59,000 / 550,000 = 0.102727 = 10.27%

XYZ WACC:

$WACC = K_e(\frac{E}{E+D}) + K_d(1-t)(\frac{D}{E+D})$  

Ke 0.1145

Equity weight 0.5

Kd 0.1

Debt Weight 0.5

t 0  (we are told to ignore taxes)

$WACC = 0.1145(0.5) + 0.1(1-0)(0.5)$  

WACC 10.72500%