Homemade Leverage and WACC\u2003ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $540,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $270,000 and the interest rate on its debt is 8 percent. Both firms expect EBIT to be $61,000. Ignore taxes.<\/p>\n\n\n\n
a. Richard owns $30,000 worth of XYZ\u2019s stock. What rate of return is he expecting?<\/p>\n\n\n\n
b. Show how Richard could generate exactly the same cash flows and rate of return by investing in ABC and using homemade leverage.<\/p>\n\n\n\n
c. What is the cost of equity for ABC? What is it for XYZ?<\/p>\n\n\n\n
d. What is the WACC for ABC? For XYZ? What principle have you illustrated?<\/p>\n\n\n\n
The correct answer and explanation is :<\/strong><\/mark><\/p>\n\n\n\n The expected return on equity (RsR_s) for XYZ can be calculated as: Rs=EBIT\u2212InterestEquity ValueR_s = \\frac{\\text{EBIT} – \\text{Interest}}{\\text{Equity Value}}<\/p>\n\n\n\n Interest Expense for XYZ: Debt=Total Value\u2212Equity=540,000\u2212270,000=270,000\\text{Debt} = \\text{Total Value} – \\text{Equity} = 540,000 – 270,000 = 270,000 Interest Expense=270,000\u00d70.08=21,600\\text{Interest Expense} = 270,000 \\times 0.08 = 21,600 Rs=61,000\u221221,600270,000=39,400270,000=0.1459 or 14.59%R_s = \\frac{61,000 – 21,600}{270,000} = \\frac{39,400}{270,000} = 0.1459 \\text{ or } 14.59\\%<\/p>\n\n\n\n Since Richard owns $30,000 of XYZ stock, his expected return is also 14.59%<\/strong>.<\/p>\n\n\n\n To replicate XYZ\u2019s returns, Richard should borrow funds to create the same debt-equity ratio. Since XYZ has 50% debt, he borrows 50% of his investment ($15,000 at 8%) and invests $30,000 in ABC stock.<\/p>\n\n\n\n Thus, Richard replicates XYZ\u2019s cash flow and return using ABC and personal borrowing.<\/p>\n\n\n\n Thus, WACC remains the same<\/strong> for both firms, illustrating Modigliani-Miller Proposition I<\/strong>: In a no-tax world, capital structure does not affect firm value or WACC.<\/p>\n","protected":false},"excerpt":{"rendered":" Homemade Leverage and WACC\u2003ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $540,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $270,000 and the interest rate on its debt is 8 percent. Both firms expect EBIT to […]<\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"site-sidebar-layout":"default","site-content-layout":"","ast-site-content-layout":"default","site-content-style":"default","site-sidebar-style":"default","ast-global-header-display":"","ast-banner-title-visibility":"","ast-main-header-display":"","ast-hfb-above-header-display":"","ast-hfb-below-header-display":"","ast-hfb-mobile-header-display":"","site-post-title":"","ast-breadcrumbs-content":"","ast-featured-img":"","footer-sml-layout":"","ast-disable-related-posts":"","theme-transparent-header-meta":"","adv-header-id-meta":"","stick-header-meta":"","header-above-stick-meta":"","header-main-stick-meta":"","header-below-stick-meta":"","astra-migrate-meta-layouts":"default","ast-page-background-enabled":"default","ast-page-background-meta":{"desktop":{"background-color":"","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""},"tablet":{"background-color":"","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""},"mobile":{"background-color":"","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""}},"ast-content-background-meta":{"desktop":{"background-color":"var(--ast-global-color-5)","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""},"tablet":{"background-color":"var(--ast-global-color-5)","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""},"mobile":{"background-color":"var(--ast-global-color-5)","background-image":"","background-repeat":"repeat","background-position":"center center","background-size":"auto","background-attachment":"scroll","background-type":"","background-media":"","overlay-type":"","overlay-color":"","overlay-opacity":"","overlay-gradient":""}},"footnotes":""},"categories":[25],"tags":[],"class_list":["post-204822","post","type-post","status-publish","format-standard","hentry","category-exams-certification"],"_links":{"self":[{"href":"https:\/\/www.learnexams.com\/blog\/wp-json\/wp\/v2\/posts\/204822","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.learnexams.com\/blog\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.learnexams.com\/blog\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.learnexams.com\/blog\/wp-json\/wp\/v2\/users\/1"}],"replies":[{"embeddable":true,"href":"https:\/\/www.learnexams.com\/blog\/wp-json\/wp\/v2\/comments?post=204822"}],"version-history":[{"count":0,"href":"https:\/\/www.learnexams.com\/blog\/wp-json\/wp\/v2\/posts\/204822\/revisions"}],"wp:attachment":[{"href":"https:\/\/www.learnexams.com\/blog\/wp-json\/wp\/v2\/media?parent=204822"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.learnexams.com\/blog\/wp-json\/wp\/v2\/categories?post=204822"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.learnexams.com\/blog\/wp-json\/wp\/v2\/tags?post=204822"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}Solution:<\/h3>\n\n\n\n
(a) Richard\u2019s Expected Rate of Return on XYZ Stock<\/strong><\/h4>\n\n\n\n
\n\n\n\n(b) Homemade Leverage using ABC<\/strong><\/h4>\n\n\n\n
\n
\n\n\n\n(c) Cost of Equity for ABC and XYZ<\/strong><\/h4>\n\n\n\n
\n
\n\n\n\n(d) WACC for ABC and XYZ<\/strong><\/h4>\n\n\n\n
\n