ABC AG and XYZ AG are identical firms in all respects except for their capital structure. ABC is all equity financed with NKr600,000 in equity shares. XYZ uses both shares and perpetual debt; its equity is worth NKr300,000 and the interest rate on its debt is 10 per cent. Both firms expect EBIT to be NKr73,000. Ignore taxes.

(a) Knut owns NKr30,000 worth of XYZ’s shares. What rate of return is he expecting?

(b) Show how Knut 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?