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9. Homemade Leverage and WACC ABC Co. and XYZ Co. are identical firms in all respects...

9. Homemade Leverage and WACC 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 8 percent. Both firms expect EBIT to be $86,000. Ignore taxes. a. Richard owns $30,000 worth of XYZ’s 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. What is the cost of equity for ABC? What is it for XYZ? d. What is the WACC for ABC? For XYZ? What principle have you illustrated? ros34779_ch16_494-525.indd 521 24/08/12 2:00 PM www.mhhe.com/rwj 522 Part IV Capital Structure and Dividend Policy 10. MM Nina Corp. uses no debt. The weighted average cost of capital is 9 percent. If the current market value of the equity is $37 million and there are no taxes, what is EBIT?

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ABC XYZ
Debt - $ 0              375,000
Equity - $                 750,000              375,000
Total capital                 750,000              750,000
Debt - % of capital 0 50.00%
Equity - % of capital 100.00% 50.00%
Cost of debt - % 0 8%
Cost of equity - %
EBIT 86000 86000
Interest payable 0                30,000
= cost of debt* amount of debt
EBT 86000 56000
=EBIT-Interest
Tax 0 0
PAT 86000 56000
Return on equity capital (ROCE)- % 11.47% 14.93%
=PAT/ Equity capital
Richards capital 30000
Returns to Richard 3440
=capital invested* ROCE

Hence, Richard should invest $23,041 in XYZ to achieve the same cash flow as ABC

Cost of equity
=expected ROCE 11.47% 14.93%
Cost of debt 0.00% 8.00%
WACC =0*0+11.47%*100% =50%*8%+50%*14.93%
=cost of debt*% of debt capital + cost of equity* % of equity capital 11.47% 11.47%

As the firm increases leverage, the expected cost of equity increases

Nina Corp
Debt - % of capital 0
Equity - % of capital 100.00%
Cost of debt - % 0
Cost of equity - % 9%
WACC =0*0+9%*100%
=cost of debt*% of debt capital + cost of equity* % of equity capital 9.00%
EBIT =9%*37,000,000
=ROCE*equity capital              3,330,000

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