Homemade Leverage and WACC [LO1] ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $780,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $390,000 and the interest rate on its debt is 8 percent. Both firms expect EBIT to be $87,000. Ignore taxes.
a. Rico owns $48,750 worth of XYZ’s stock. What
b. Show how Rico could generate exactly the same cash flows and rate of return by investing in ABC and using homemade leverage.
c. What is the
d. What is the WACC for ABC? For XYZ? What principle have you illustrated?
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- Q No 4 FFC is trying to establish its optimal capital structure. Its current capital structure consists of 25% debt and 75% equity; however, the CEO believes that the firm should use more debt. The risk-free rate, rRF, is 4%; the market risk premium, RPM, is 5%; and the firm’s tax rate is 40%. Currently, FFC has beta of 1.5. What would be FFC’s estimated cost of equity if it changed its capital structure to 40% debt and 60% equity? Should the company opt new capital structure, decide based on the cost of equity computations?arrow_forwardQ No. 1 Lucky Cement is trying to establish its optimal capital structure. Its current capital structure consists of 20% debt and 80% equity; however, the CEO believes that the firm should use more debt. The risk-free rate, rRF, is 5%; the market risk premium, RPM, is 6%; and the firm’s tax rate is 40%. Currently, Lucky Cement has beta of 1.5. What would be Lucky Cement’s estimated cost of equity if it changed its capital structure to 40% debt and 60% equity? Should the company opt new capital structure? (Decide based on the cost of equity computations)?arrow_forwardA5 6b DEF Company is comparing three different capital structures. Plan A is an all-equity plan and would result in 1000 shares of stock. Plan B would result in 700 shares of stock and $13,500 in debt. Plan C would result in 800 shares of stock and $9000 in debt. The firm’s EBIT will be $10,000 per year until infinity. The interest rate on the debt is 12%. b. Compute the break-even EBIT that will cause the EPS on Plan B to be equal to the all-equity EPS (Plan A).arrow_forward
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