Question

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

financed with $600,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $300,000 and

the interest rate on its debt is 10 percent. Both firms expect EBIT to be $73,000. Ignore taxes.

a.SupposeRico owns $30,000 worth of XYZ’s stock. What rate of return is she expecting?

b. What is the cost of equity for ABC? What is it for XYZ?

c. What is the WACC for ABC? For XYZ? What principle have you illustrated?

Answer 1

a. XYZ company EBIT= 73000, Interest= 10% * 300,000= 30,000 (debt=300,000)

so Profit before tax = 73000-30000= 43,000

rico ows 30000$ worth of xyz's stock so share is 30000/300000= 10%

so ROE of company= NET INCOME/ AVERAGE EQUITY

= 43000/ 300000= 14.33%

However, rico owns 10% of total company shares so his return on equity is 10% of company ROE= 1.433%

B. COST OF EQUITY FOR ABC=

EBIT= 73000, Interest= 0 AS THERE IS NO DEBT

so Profit before tax = 73000

so ROE of company= NET INCOME/ AVERAGE EQUITY

= 73000/ 600000= 12.1667% I.E. COST OF EQUITY IS THIS.

COST OF EQUITY FOR XYZ=14.33%

C. ABC-

WACC = weight of equity* cost of equity + weight of debt * cost of debt

= 1* 0.121667= 12.1667%

XYZ-

WACC = weight of equity* cost of equity + weight of debt * cost of debt

= 0.5*0.1433 + 0.5*0.10= 0.0717+ 0.05= 12.17%