Solution of 16 &17
Solution of 16 &17
Solution of 16 &17
9. 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
percent. Both firms expect EBIT to be $95,000. Ignore taxes.
The investor should then use the proceeds of the stock sale
and the loan to buy shares in ABC. The investor will receive
dividends in proportion to the percentage of the company‘s
share they own. The total dividends received by the
shareholder will be:
Dividends received = 95,000(60,000/800,000) = 7,125
4. What is the WACC for ABC? For XYZ? What principle have
you illustrated?
To find the WACC for each company, we need to use the
WACC equation:
WACC = (E/V)RE + (D/V)RD(1 – TC)
So, for ABC, the WACC is:
WACC = (1)(.1188) + (0)(.10) WACC = .1188 or 11.88%
And for XYZ, the WACC is:
WACC = (1/2)(.1375) + (1/2)(.10) WACC = .1188 or
11.88%
EL = 3,400,000(100) = 340,000,000
22. The Veblen Company and the Knight Company are identical
in every respect except that Veblen is not levered. The
market value of Knight Company’s 6 percent bonds is $1.2
million. Financial information for the two firms appears here.
All earnings streams are perpetuities. Neither firm pays taxes.
Both firms distribute all earnings available to common
stockholders immediately.
1. An investor who can borrow at 6 percent per year wishes
to purchase 5 percent of Knight’s equity. Can he increase his
dollar return by purchasing 5 percent of Veblen’s equity if he
borrows so that the initial net costs of the two strategies are
the same?
To purchase 5 percent of Knight‘s equity, the investor
would need = .05($2,532,000) = $126,600
And to purchase 5 percent of Veblen without borrowing
would require: = .05($3,600,000) = $180,000
In order to compare dollar returns, the initial net cost of
both positions should be the same. Therefore, the investor
will need to borrow the difference between the two
amounts, i.e. Amount to borrow = $180,000 – 126,600 =
$53,400
Since Dietrich owes its bondholders 1.1 million at the end of the
year, its stockholders will receive 1.3 million (= 2.4 million –
1.1 million) if the expansion continues. If there is a recession,
its stockholders will receive nothing since the firm‘s
bondholders have a more senior claim on all 800,000 of the
firm‘s earnings. So, the market value of Dietrich‘s equity is:
S Dietrich = [.80(1,300,000) + .20(0)] / 1.15 = 904,348
Dietrich‘s bondholders will receive 1.1 million if the expansion
continues and 900,000 if there is a recession. So, the market
value of Dietrich‘s debt is:
B Dietrich = [.80(1,100,000) + .20(900,000)] / 1.15 = 921,739