Question

ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $750,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $375,000 and the interest rate on its debt is 10 percent. Both firms expect EBIT to be $73,000. Ignore taxes.

A) You own $56,250 worth of XYZ’s stock. What rate of return are you expecting?

B) Calculate the cash flows and rate of return by investing in ABC and using homemade leverage, how could you generate exactly the same returns?

C) What is the cost of equity for ABC? What is it for XYZ?

D) What is the WACC for ABC? For XYZ? What do you conclude?

Answer 1

A)

XYZ:

Return on Equity = $73K / $750K = 9.73333%

Cost of Debt : 10% ignored tax

Proportion of debt and equity : equal

Therefore return expected = 0.5(9.73333+10) = 9.86666666%

B)

Cashflows wil be initial purchase of stock at a certai price, yearly inflow of dividend as a percent of amount attributable to equity shareholders and a redemption/ sell price or buyback amount at a later date.

Rate of return by investing in ABC:

Return on Equity = $73K / $750K = 9.73333%

To earn a return of 9.866666% ABC can use homemade leverage ie personal loan and adjust its capital structure. This can be done by eqactly making the sam epropotion of 50% each debt and equity and borrowing at the rate of 10%.

C) Cost of equity will be same for both ABC and XYZ at

= $73K / $750K = 9.73333%

D) WACC for ABC =

= $73K / $750K = 9.73333%

WACC for XYZ =

0.5(9.73333+10) = 9.86666666%

We can conclude that that wacc shall reduce on addition of debt in our portfolio when return on investment > cost of debt which is not the case in XYZ and hence WACC increases as 9.733 <10.