St. Louis Co. and St. Romuald Co. are identical firms in all respects except for their capital structure. St. Louis is all-equity financed with $780,000 in stock. St. Romuald uses both stock and perpetual debt; its stock is worth $390,000 and the interest rate on its debt is 8%. Both firms expect EBIT to be $87,000. Ignore taxes.

a. Clifford owns $48,750 worth of St. Romualds stock. What rate of return is he expecting? (assume Clifford is not selling the stock)

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

c. What is the cost of equity for St. Louis? What is it for St. Romuald? (Assume the D/E for St. Romuald = 1)

d. What is the WACC for St. Louis? For St. Romuald? What principle have you illustrated?