Question

ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $875,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $437,500 and the interest rate on its debt is 8 percent. Both firms expect EBIT to be $91,000. Ignore taxes. NOT EXCEL

  

a.	Richard owns $87,500 worth of XYZ’s stock. What rate of return is he expecting?

b.	Suppose Richard invests in ABC Co. and uses homemade leverage to match his cash flow in part a. Calculate his total cash flow and rate of return.

c.	What is the cost of equity for ABC and XYZ?

  

   

d.	What is the WACC for ABC and XYZ?

Answer 1

Solution: (a)

The net income for XYZ company is given below

EBIT	91,000
Debt	437,500 = (875,000 - 437,500)
Interest	35,000 (437,500 * 0.08)
Net income	56,000

As we know Richard will receive dividends in proportion to the percentage of the company's shares he owns. So his dividend will be

• 56,000 (87,500 / 437,500) = $11,200

So the rate of return will be

• 11,200 / 87,500 = 0.128 = 12.8%

b)

To generate same cash flow and get a rate of return equal to XYZ company, Richard needs to buy the shares of ABC company and borrow to develop capital structure like XYZ company. XYZ company has 50% debt and 50% equity. So Richard will take a loan equal to $87,500 and add his equity equal to 87,500 to buy the shares of ABC company.

Dividend receive = x 91,000 = $18,200

Interest expense = 87,500 x 0.08 = $7,000

total cash flow = 18,200 - 7000 = $ 11,200

So the rate of return = 11,200 / 87,500 = 12.8%

c)

Cost of equity for all equity firm ABC will be

= EBIT / Equity = 91,000/ 875,000 = 10.40%

Cost of equity for levered firm XYZ will be

= = (91,000 - 35000) / 437,500 = 12.8%

d)

The formula for WACC is:

WACC = (S/V)Rs+(B/V)Rb

where,

• S = Value of stock
• B = Value of debt
• V = Value of total capital
• Rs = Cost of equity
• Rb = Cost of debt

WACC for ABC = (875,000/875,000) x 0.104 + 0 = 0.104 = 10.4

WACC for XYZ = (437,500 / 875,000) x 0.128 + (437,500 / 875,000) x 0.104 = 10.4