ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $800,000 in stock. XYZ uses both stock and perpetual debt. Its stock is worth $400,000 and the interest rate on its debt is 10%. Both firms expect EBIT to be $90,000. Ignore Taxes.
Rico owns $30,000 worth of XYZ stock. What rate of return is he expecting?
Show how Rico could generate exactly the same cash flows and rate of return by investing in ABC and using homemade leverage.
What is the cost of equity for ABC? What is it for XYZ?
What is the WACC for ABC? For XYZ? What principle have you demonstrated?
In the absence of taxes, the value of a leveraged firm is same as that of an unlevered firm. Thus value of XYX=Value of ABC=800,000
rLevered = runlevered +(runleverd -rdebt)*Debt/Equity
Value of XYZ= Value of equity + ...
This solution provides calculations for rate of return, cost of equity, and WACC.