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ABC and XYZ are identical firms in all respects except for their capital structures. ABC is all-equity financed with $530,000 in stock. XYZ has the same total value but uses both stock and perpetual debt; its stock is worth $310,000 and the interest rate on its debt is 7.9 percent. Both firms expect EBIT to be $62,222. 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 11.74 percent and for XYZ it is 14.47 percent.

Explanation:

a. For ABC

ABC cost of equity = Earning before interest and tax (EBIT) / Equity = $62,222 / $530,000 = 0.1174, or 11.74%

b. For XYZ

Perpetual debt = $530,000 - $310,000 = $220,000

Interest on debt = $220,000 * 7.9% = $17,380

Earning after interest = $62,222 - $17,380 = $44,842

XYZ cost of equity = $44,842 / $310,000 = 0.1447, or 14.47%

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