Question
ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $750,000 in stock.
ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $750,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $375,000 and the interest rate on its debt is 8 percent. Both firms expect EBIT to be $86,000. Ignore taxes. Richard owns $30,000 worth of XYZs stock. What rate of return is he expecting? ________________% Show how Richard could generate exactly the same cash flows and rate of return by investing in ABC and using homemade leverage. Assume Richard sells all his shares in XYZ. He then uses the $30,000 proceeds and borrows additional $30,000 to buy share in ABC. His ABC dividends will be _______________minus the interest charge of ___________________ for the total cash flow of __________. His return on a $30,000 investment is ___________________%. What is the cost of equity for ABC? __________% For XYZ? __________% What is the WACC for ABC? __________% For XYZ? __________% What principle have you illustrated? ____________________
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