Question

ABC Corporation and XYZ Corporation are identical firms in all aspects except for their capital structure....

ABC Corporation and XYZ Corporation are identical firms in all aspects except for their capital structure. ABC is financed by 100% equity. XYZ is financed by 80% equity and 20% debt. ABC's current cost of equity is 12%. XYZ's current cost of debt is 8%. The corporate tax rate is 30%.

What are XYZ's (i) cost of equity (3 pt); (ii) WACC? (3 pt)
(iii) Discuss why XYZ’s cost of equity is higher than that of ABC. (2 pt)

(iv) What’s ABC’s WACC? (2 pt)

(v) Discuss why XYZ’s WACC is less than that of ABC despite a higher cost of equity. (2 pt)

1)

Cost of equity of XYZ, re = cost of unlevered equity + (Cost of unlevered equity - cost of debt)( 1 - tax rate) debt / equity

re = 0.12 + (0.12 - 0.08)(1 - 0.3) 20 / 80

re = 0.127 or 12.7%

Cost of capital for XYZ, WACC = (80 / 100) * 0.127 + (20 / 100) * 0.08(1 - 0.3)

WACC = 0.1016 + 0.0112

WACC = 0.1128 or 11.28%

2)

XYZ's oct of equity is higher because XYZ is has a debt component of 20%. The risk to to the shareholder increase when a company takes debt. Therefore, shareholders demand more return for extra risk. Since ABC's capital structure has no debt and XYZ's capital structure has 20% debt, XYZ's cost fo equity will be higher.

3)

ABC's WACC will be equal to ABC's cost of equity i.e, 12%

4)

XYZ's WACC is less than ABC because of 20% debt component. Because interest paid on debt is tax deductable, the use of debt provides a tax shield that transalates into savings.