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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 $725,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $362,500 and the interest rate on its debt is 8.2 percent. Both firms expect EBIT to be $74,000. Ignore taxes.
a. Richard owns $54,375 worth of XYZ's stock. What rate of return is he expecting? (Do not round intermediate calculations and enter your answer as a percent rounded to 2 decimal places, e.g., 32.16.)
b. Suppose Richard invests in ABC Co. and uses homemade leverage to match his cash flow in part (a). Calculate his total cash flow and rate of return. (Do not round intermediate calculations. Enter your return answer as a percent rounded to 2 decimal places, e.g., 32.16.)
When getting into a project of this type you generally consider a 5-year holding period and look for a 12% rate of return.
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