ABC Limited and XYZ Inc are identical firms in all respects except for their capital structure.

ABC is an all equity firm with a market value of $10,000,000. XYZ which also has a market value of $10,000,000 uses both stock and perpetual debt. XYZ has a debt/equity ratio of 3/5. Its cost of debt is 8%. Both firms expect EBIT to be $1,500,000 per year forever. Ignore taxes.

a. Justine owns $200,000 worth of XYZ Inc. stock. What rate of return is she expecting?

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

c. What is the cost of equity for ABC? For XYZ?

d. What is the rWACC for ABC? For XYZ? What is your conclusion?