Abc co and xyz co are identical firms

Problem 16-1 EBIT and Leverage [LO1]

Pendergast, Inc., has no debt outstanding and a total market value of $153,000. Earnings before interest and taxes, EBIT, are projected to be $9,500 if economic conditions are normal. If there is strong expansion in the economy, then EBIT will be 20 percent higher. If there is a recession, then EBIT will be 35 percent lower. Pendergast is considering a $45,300 debt issue with an interest rate of 5 percent. The proceeds will be used to repurchase shares of stock. There are currently 5,100 shares outstanding. Ignore taxes for this problem.

Requirement 1:

(a)

Calculate earnings per share, EPS, under each of the three economic scenarios before any debt is issued. (Do not round intermediate calculations. Round your answers to 2 decimal places (e.g., 32.16).)

EPS

Recession

$

Normal

$

Expansion

$

(b)

Calculate the percentage changes in EPS when the economy expands or enters a recession. (Do not round intermediate calculations. Negative amounts should be indicated by a minus sign.Round your answers to 2 decimal places (e.g., 32.16).)

%ΔEPS

Recession

%

Expansion

%

Requirement 2:

Assume Pendergast goes through with recapitalization.

(a)

Calculate earnings per share, EPS, under each of the three economic scenarios after the recapitalization. (Do not round intermediate calculations. Round your answers to 2 decimal places (e.g., 32.16).)

EPS

Recession

$

Normal

$

Expansion

$

(b)

Calculate the percentage changes in EPS when the economy expands or enters a recession.(Negative amounts should be indicated by a minus sign. Round your answers to 2 decimal places (e.g., 32.16).)

%ΔEPS

Recession

%

Expansion

%

Problem 16-4 Break-Even EBIT [LO1]

Rise Against Corporation is comparing two different capital structures: an all-equity plan (Plan I) and a levered plan (Plan II). Under Plan I, the company would have 195,000 shares of stock outstanding. Under Plan II, there would be 145,000 shares of stock outstanding and $2.10 million in debt outstanding. The interest rate on the debt is 8 percent, and there are no taxes.

a.

If EBIT is $550,000, what is the EPS for each plan? (Round your answers to 2 decimal places.(e.g., 32.16))

EPS

Plan I

$

Plan II

$

b.

If EBIT is $800,000, what is the EPS for each plan? (Round your answers to 2 decimal places.(e.g., 32.16))

EPS

Plan I

$

Plan II

$

c.

What is the break-even EBIT? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, i.e. 1,234,567.)

Break-even EBIT

$

Problem 16-9 Homemade Leverage and WACC [LO1]

ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $650,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $325,000 and the interest rate on its debt is 6.5 percent. Both firms expect EBIT to be $71,000. Ignore taxes.

a.

Rico owns $39,000 worth of XYZ’s stock. What rate of return is he expecting? (Round your answer to 2 decimal places. (e.g., 32.16))

Rate of return

%

b.

Suppose Rico invests in ABC Co and uses homemade leverage. Calculate his total cash flow and rate of return. (Round your percentage answer to 2 decimal places. (e.g., 32.16))

Total cash flow

$

Rate of return

%

c.

What is the cost of equity for ABC and XYZ? (Round your answers to 2 decimal places. (e.g., 32.16))

Cost of equity

ABC

%

XYZ

%

d.

What is the WACC for ABC and XYZ? (Round your answers to 2 decimal places. (e.g., 32.16))

WACC

ABC

%

XYZ

%

Problem 16-12 Calculating WACC [LO1]

Skillet Industries has a debt–equity ratio of 1.3. Its WACC is 7.1 percent, and its cost of debt is 6.6 percent. The corporate tax rate is 35 percent.

a.

What is the company’s cost of equity capital? (Round your answer to 2 decimal places. (e.g., 32.16))

Cost of equity capital

%

b.

What is the company’s unlevered cost of equity capital? (Round your answer to 2 decimal places. (e.g., 32.16))

Unlevered cost of equity capital

%

c-1

What would the cost of equity be if the debt–equity ratio were 2? (Round your answer to 2 decimal places. (e.g., 32.16))

Cost of equity

%

c-2

What would the cost of equity be if the debt–equity ratio were 1.0? (Round your answer to 2 decimal places. (e.g., 32.16))

Cost of equity

%

c-3

What would the cost of equity be if the debt–equity ratio were zero? (Round your answer to 2 decimal places. (e.g., 32.16))

Cost of equity

%

Problem 16-14 MM and Taxes

O’Connell & Co. expects its EBIT to be $61,000 every year forever. The firm can borrow at 7 percent. O’Connell currently has no debt, and its cost of equity is 14 percent.

If the tax rate is 35 percent, what is the value of the firm? (Round your answer to 2 decimal places. (e.g., 32.16))

Value of the firm

$

What will the value be if the company borrows $148,000 and uses the proceeds to repurchase shares?(Round your answer to 2 decimal places. (e.g., 32.16))

Value of the firm

$

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