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 $650,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $325,000 and the interest rate on its debt is 8 percent. Both firms expect EBIT to be $68,000. Ignore taxes.

a. Rico owns $48,750 worth of XYZ’s stock. What rate of return is he expecting?

b. Show how Rico could generate exactly the same cash flows and rate of return by investing in ABC and using homemade leverage.

c. 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?

Cost Of Equity
The cost of equity is the return a company requires to decide if an investment meets capital return requirements. Firms often use it as a capital budgeting threshold for the required rate of return. A firm's cost of equity represents the...