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Calculate the cost of equity for banana

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Except for their capital structure, Banana Company and Pear Company are identical firms in all respect. Banana is wholly equity financed with $740,000 in stock. Pear uses both stock and perpetual debt; its stock is worth $370,000 and its debt is worth $370,000. The interest rate on its debt is 6.8 percent. Both firms expect earnings before interest and tax (EBIT) to be $102,000. Ignore taxes.

(i) Calculate the cost of equity for Banana and for Pear respectively.

(ii) Estimate the weighted average cost of capital (WACC) for Banana and for Pear. What capital structure principle does the results indicate?

(iii) Suppose Samuel owns $45,000 worth of Pear's stock. Calculate his expected rate of return.

(iv) Explain how Samuel could generate exactly the same cash flows and rate of return by investing in Banana and using homemade leverage.

Reference no: EM132742169

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