9. 9.

Homemade leverage and WACC [LO 16.1] ABC Co. and XYZ Co.

are identical firms in all respects except for their capital structure ABC is all-equity financed with $720 000 in shares. XYZ uses both shares and perpetual debt; its shares are worth $360 000 and the interest rate on its debt is 7 per cent. Both firms expect EBIT to be $73 000. Ignore taxes.

1. Rico owns $43 500 worth of XYZ’s shares. What rate of return is he expecting?

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

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

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