0078034760 1. ABC co. and XYZ Co. are identical firms in all respect except for

Question

0078034760

1.  ABC co. and XYZ Co. are identical firms in all respect except for their capitalstructure. ABC is all equity financed with $780,000 in stock. XYZ uses bothstock and perpetual debt; its stock is worth $390,000 and the interest rate onits debt is 8 percent. Both firms expect EBIT to be $87,000. Ignore taxes.

a)  Allison  own  $48,750  worth  of  XYZ’s  stock.  What  rate  of  return  is  sheexpecting?b)  Show how Allison could generate exactly the same cash flows and rate ofreturn by investing in ABC and using homemade leveragec)  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?

Explanation / Answer

a) Rate of return on stock = (EBIT - Interest) / equity

Since, both the firm are identical in respect of capital amount , but different in structure,

XYZ's capital = debt + equity

$780000 = Debt + $390000

Debt = $390000   

Therefore interest on debt = 8% * $390000

= $31200

Rate of return = ($87000 - $31200) / $390000

= $55800 / $390000

= 14.31%

Related Questions

Navigate

• Browse (All)
• Browse
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.