1. ABC and XYZ are identical firms in all respects except for their capital structure. ABC...

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1. ABC and XYZ are identical firms in all respects except fortheir capital structure. ABC is all equity financed with $800,000in stock. XYZ uses both stock and perpetual debt; its stock isworth $400,000 and the interest rate on its debt is 10%. Both firmsexpect EBIT to be $95,000 and all income will be distributed asdividends. Ignore taxes.
a. Richard owns $30,000 worth of XYZ stock. What rate of returnis he expecting?
b. Show how Richard could generate exactly the same cash flowsand rate of return by investing in ABC and using homemadeleverage.
c. Now assume ABC and XYZ each pay a 20% marginal corporate tax,but Richard pays no taxes. Repeat a) and b). Is the outcomedifferent than in a) and b)? Explain. Which firm would Richardprefer to invest in? Why?
d. Now assume ABC and XYZ each pay a 20% marginal corporate tax,and Richard pays a 15% tax on dividends. Repeat a) and b). Is theoutcome different than in a), b), and c)? Explain. Which firm wouldRichard prefer to invest in? Why?
2. Shadow Corp. has no debt but can borrow at 7%. The firm’sWACC is currently 11%, and the tax rate is 35%.
a. What is Shadow’s cost of equity?
b. If the firm converts to a 25% debt-to-equity ratio, what willits cost of equity be?
c. What is Shadow’s WACC after it converts to the 25%debt-to-equity ratio?
d. Assume that converting to the 25% debt-to-equity ratio doesnot significantly increase Shadow Corp.’s probability ofbankruptcy. Should Shadow Corp. convert to the new capitalstructure? Explain.

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answer a The rate of return earned will be the dividend yieldannual dividend per share price per share for XYZ company Dividend EAIT EBIT Interest Tax Interest Amount of debt 10 400000 10 40000 Dividend 95000 40000 55000 Return on equity dividend equity 55000 400000 1375 so investment in stock of XYZ will give return See Answer

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1. ABC and XYZ are identical firms in all respects except fortheir capital structure. ABC is all equity financed with $800,000in stock. XYZ uses both stock and perpetual debt; its stock isworth $400,000 and the interest rate on its debt is 10%. Both firmsexpect EBIT to be $95,000 and all income will be distributed asdividends. Ignore taxes.a. Richard owns $30,000 worth of XYZ stock. What rate of returnis he expecting?b. Show how Richard could generate exactly the same cash flowsand rate of return by investing in ABC and using homemadeleverage.c. Now assume ABC and XYZ each pay a 20% marginal corporate tax,but Richard pays no taxes. Repeat a) and b). Is the outcomedifferent than in a) and b)? Explain. Which firm would Richardprefer to invest in? Why?d. Now assume ABC and XYZ each pay a 20% marginal corporate tax,and Richard pays a 15% tax on dividends. Repeat a) and b). Is theoutcome different than in a), b), and c)? Explain. Which firm wouldRichard prefer to invest in? Why?2. Shadow Corp. has no debt but can borrow at 7%. The firm’sWACC is currently 11%, and the tax rate is 35%.a. What is Shadow’s cost of equity?b. If the firm converts to a 25% debt-to-equity ratio, what willits cost of equity be?c. What is Shadow’s WACC after it converts to the 25%debt-to-equity ratio?d. Assume that converting to the 25% debt-to-equity ratio doesnot significantly increase Shadow Corp.’s probability ofbankruptcy. Should Shadow Corp. convert to the new capitalstructure? Explain.