# ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC...

## Question:

ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $700,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $350,000 and the interest rate on its debt is 8.5%. Both firms expect EBIT to be $73,000. Ignore taxes.

a. Rico owns $52,500 worth of XYZ's stock. What rate of return is he expecting? (Round your answer to 2 decimal places. (e.g., 32.16))

b. Suppose Rico invests in ABC Co and uses homemade leverage. Calculate his total cash flow and rate of return. (Round your percentage answer to 2 decimal places. (e.g., 32.16))

c. What is the cost of equity for ABC and XYZ? (Round your answers to 2 decimal places. (e.g., 32.16))

d. What is the WACC for ABC and XYZ? (Round your answers to 2 decimal places. (e.g., 32.16))

## Cost of Capital:

Capital refers to the total amount that the owner invests in the business. Capital could be generated by issuing bonds or equity. There is some cost that the owner needs to pay on the capital. The combined cost of capital is the total cost that is paid to the lenders.

## Answer and Explanation:

**Details:**

- Equity financed = $700,000
- Stock and perpetual debt worth = $350,000
- Interest rate = 8.5%
- EBIT = $73,000
- Rico's stock = $52,500

**a. Rate of return**

EBT = EBIT - (Stock and perpetual debt worth * Interest rate)

EBT = 73,000 - (350,000 * 8.5%)

EBT = 73,000 - (350,000 * 0.085)

EBT = 73,000 - 29,750

EBT = $43,250

{eq}Return \ on \ Rico \ stock \ = \ \left ( \dfrac{EBT}{Stock \ and \ perpetual \ debt \ worth} \right ) \ \times \ Rico's \ stock \\ Return \ on \ Rico \ stock \ = \ \left ( \dfrac{43,250}{350,000} \right ) \ \times \ 52,500 \\ Return \ on \ Rico \ stock \ = \ \$6,488 {/eq}

{eq}Rate \ of \ return \ = \ \dfrac{Return \ on \ Rico \ stock}{Rico's \ stock} \ \times \ 100 \\ Rate \ of \ return \ = \ \dfrac{6,488}{52,500} \ \times \ 100 \\ Rate \ of \ return \ = \ 12.36\% {/eq}

**b. Total cash flow and rate of return**

{eq}Return \ on \ Rico \ stock \ = \ \left ( \dfrac{EBIT}{Equity \ financed} \right ) \ \times \ Rico's \ stock \\ Return \ on \ Rico \ stock \ = \ \left ( \dfrac{73,000}{700,000} \right ) \ \times \ 52,500 \\ Return \ on \ Rico \ stock \ = \ \$5,475 {/eq}

{eq}Rate \ of \ return \ = \ \dfrac{Return \ on \ Rico \ stock}{Rico's \ stock} \ \times \ 100 \\ Rate \ of \ return \ = \ \dfrac{5,475}{52,500} \ \times \ 100 \\ Rate \ of \ return \ = \ 10.43\% {/eq}

**c. Cost of equity**

{eq}Cost \ of \ equity \ of \ ABC \ = \ \dfrac{Return \ on \ Rico \ stock}{Rico's \ stock} \ \times \ 100 \\ Cost \ of \ equity \ of \ ABC \ = \ \dfrac{5,475}{52,500} \ \times \ 100 \\ Cost \ of \ equity \ of \ ABC \ = \ 10.43\% {/eq}

{eq}Cost \ of \ equity \ of \ XYZ \ = \ \dfrac{Return \ on \ Rico \ stock}{Rico's \ stock} \ \times \ 100 \\ Cost \ of \ equity \ of \ XYZ \ = \ \dfrac{6,488}{52,500} \ \times \ 100 \\ Cost \ of \ equity \ of \ XYZ \ = \ 12.36\% {/eq}

**d. WACC**

WACC for ABC = 10.43%

WACC of XYZ = (0.5 * Cost of equity of XYZ) + (0.5 * Interest rate)

WACC of XYZ = (0.5 * 12.36%) + (0.5 * 8.5%)

WACC of XYZ = 6.18% + 4.25%

WACC of XYZ = 10.43%

#### Learn more about this topic:

from Corporate Finance: Help & Review

Chapter 3 / Lesson 18