Question

1. ABC and XYZ are identical firms in all respects except for their capital structure. ABC is all equity financed with $800,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $400,000 and the interest rate on its debt is 10%. Both firms expect EBIT to be $95,000 and all income will be distributed as dividends. Ignore taxes.

a. Richard owns $30,000 worth of XYZ stock. What rate of return is he expecting?

b. Show how Richard could generate exactly the same cash flows and rate of return by investing in ABC and using homemade leverage.

c. Now assume ABC and XYZ each pay a 20% marginal corporate tax, but Richard pays no taxes. Repeat a) and b). Is the outcome different than in a) and b)? Explain. Which firm would Richard prefer to invest in? Why?

d. Now assume ABC and XYZ each pay a 20% marginal corporate tax, and Richard pays a 15% tax on dividends. Repeat a) and b). Is the outcome different than in a), b), and c)? Explain. Which firm would Richard prefer to invest in? Why?

2. Shadow Corp. has no debt but can borrow at 7%. The firm’s WACC is currently 11%, and the tax rate is 35%.

a. What is Shadow’s cost of equity?

b. If the firm converts to a 25% debt-to-equity ratio, what will its cost of equity be?

c. What is Shadow’s WACC after it converts to the 25% debt-to-equity ratio?

d. Assume that converting to the 25% debt-to-equity ratio does not significantly increase Shadow Corp.’s probability of bankruptcy. Should Shadow Corp. convert to the new capital structure? Explain.

Answer 1

answer a) The rate of return earned will be the dividend yield=annual dividend per share/ price per share.

for XYZ company , Dividend= EAIT = EBIT- Interest -Tax

Interest = Amount of debt * 10% = 400,000 * 10% = $ 40,000

Dividend = 95000 -40000 = 55000

Return on equity = dividend / equity = 55,000 / 400,000 = 13.75 %

so. investment in stock of XYZ will give return = 13.75%

Net cash flow for Richard owns $30,000 worth of XYZ stock = $30,000 * 0.1375 = $ 4125

Answer b) To create the same cash flows in the ABC,Richard has to match the capital structure of XYZ.

Richard sell share of XYZ and borrow equivalent amount at rate of 10% ,

Net cash outflow in Interest = 10% * 30,000 = $3,000

Invest $ 60,000( $ 30,000 + $ 30,000) in shares of company ABC

For ABC company , Dividend= EAIT = EBIT- Interest -Tax , here all equity finance

Dividend = EBIT = 95,000

Return on equity = dividend / equity = 95,000 / 800,000 = 11.875 %

Dividend Received by investment of $ 60,000 = 95,000 * ( 60,000/8,00,000) = $ 7125.

Net Cash flow for investor = 7125 - 3000 = $ 4125

Shareholders return = 4125/30,000 = 13.75%

Answer C )

	XYZ	ABC
Equity	400000	800000
Debt	400000	0
Capital	800000	800000
EBIT	$95,000	$95,000
Interest	-40000	0
EBT	$55,000	$95,000
Tax	($11,000)	($19,000)
EAT	$44,000	$76,000
Dividend	$44,000	$76,000
Return on Equity	11.00%	9.50%

Outcome is different from the previous one , I would prefer to invest in Company XYZ.

Answer d)

	XYZ	ABC
Equity	400000	800000
Debt	400000	0
Capital	800000	800000
EBIT	$95,000	$95,000
Inetrest	-40000	0
EBT	$55,000	$95,000
Tax	($11,000)	($19,000)
EAT	$44,000	$76,000
Dividend	$44,000	$76,000
Return on Equity	11.00%	9.50%
Dividend Tax 20%	20.00%	20.00%
Net return after Dividend tax	8.80%	7.60%

I would prefer to invest in Company XYZ. due to higher rate of return.

Kindly re-post remaining questions