ABC Co. and XYZ Co. are identical firms in all respects except for their capital structures. ABC is all-equity financed with $550,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $275,000 and the interest rate on its debt is 8 percent. Both firms expect EBIT to be $60,000. Ignore taxes.

a. Richard owns $20,000 worth of XYZ’s stock. What rate of return is he expecting?

b. Show how Richard could generate exactly the same cash flows and rate of return by investing in ABC and using homemade leverage.

c. What is the cost of equity for ABC? What is it for XYZ?

d. What is the WACC for ABC? For XYZ? What principle have you illustrated?