Question

ABC and XYZ are identical firms in all respects except for their capital structures. ABC is all-equity financed with $530,000 in stock. XYZ has the same total value but uses both stock and perpetual debt; its stock is worth $310,000 and the interest rate on its debt is 7.9 percent. Both firms expect EBIT to be $62,222. Ignore taxes. The cost of equity for ABC is _____ percent and for XYZ it is ______ percent.

Select one:

11.74; 9.82

11.74; 12.48

11.74; 14.47

12.09; 9.82

12.09; 12.48

Answer 1

ABC Firm:

ABC is all equity financed company = $530,000

As in ABC there is no debt, and there is no taxes as well. Thus, EBIT is the Net Income = $62,222

Cost of Equity for ABC = Net Income/Total Equity

= $62,222/$530,000

= 11.74%

XYZ Firm:

XYZ uses both Equity as well as perpetual Debt, Its Equity portion = $310,000

Perpetual Debt portion = $ 530,000 - $ 310,000 = $ 220,000

Interest on Perpetual Debt = $220,000*7.9% = $17,380

Net Income = EBIT- Interest

= $62,222 - $ 17,380

= $ 44,842

Cost of Equity for ABC = Net Income/Total Equity

= $44,842/$310,000

= 14.47%

Hence, Option C. 11.74% , 14.47%

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