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.
A) 11.74; 9.82
B) 11.74; 12.48
C) 11.74; 14.47
D) 12.09; 9.82
E) 12.09; 12.48

Question

Quizplus · Accepted Answer

The cost of equity for ABC is calculated as EBIT/Equity = $62,222 / $530,000 = 11.74%. For XYZ, the cost of equity is calculated using the formula: Cost of Equity = (EBIT - Interest) / Equity = ($62,222 - ($530,000 - $310,000) * 7.9%) / $310,000 = 14.47%.

ABC and XYZ Are Identical Firms in All Respects Except