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ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $480,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $240,000 and the interest rate on its debt is 9 percent. Both firms expect EBIT to be $58,400. Ignore taxes. The cost of equity for ABC is _____ percent, and for XYZ it is ______ percent.

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Answer:

The cost of equity for ABC is 12.17 percent, and for XYZ it is 15.33 percent.

Explanation:

Since we are to ignore tax for the two companies, ABC will pay no interest since it is all equity financed. Therefore, we have.

ABC Co. cost of equity = $58,400 ÷ $480,000 = 0.1217, or 12.17%

XYZ has $240,000 equity and $240,000 debt, it has to pay interest on debt. We can therefore calculate its cost of equity as follows:

XYZ interest on loan = $240,000 × 9% = $21,600

XYZ Profit after interest = $58,400 - $21,600 = $36,800

XYZ cost of equity = $36,000 ÷ 240,000 = 0.1533, or 15.33%

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