ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $600,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $300,000 and the interest rate on its debt is 4.5 percent. Both firms expect EBIT to be $67,000. Ignore taxes.
a. Richard owns $36,000 worth of XYZ’s stock. What rate of return is he expecting?
b. Suppose Richard invests in ABC Co. and uses homemade leverage to match his cash flow in part a. Calculate his total cash flow and rate of return.
c. What is the cost of equity for ABC and XYZ?
d. What is the WACC for ABC and XYZ?