Question

1. ABC and XYZ are two industry competitors, operating under MM perfect capital markets environment. ABC’s market-value-based Debt/Equity ratio is 3/7. Its market-value-based cost of debt, rD, is 7.5% and cost of equity, rE, is 15%. XYZ’s Debt/Equity ratio is 2/3. XYZ’s cost of debt, rD, is 7.875%

E. What is the required rate of return on XYZ’s unlevered equity? Explain.

F. What is the required rate of return on XYZ’s levered equity, rE?

Answer 1

		ABC	XYZ	Formula
	Debt / Equity	3/7	2/3	MV of Debt/ MV of Equity
	Rd	7.50%	7.88%
	Re	15.00%	?
	Re Unlevered	X	X
	Debt / MV	3/10	2/5
	Equity / MV	7/10	3/5
WACC =	Unlevered Cost of Equity * Equity / (Enterprise Value) + Cost of Debt * Debt / (Enterprise Value)
For ABC
Re Unlevered =	X
WACC =	15.00%	(Levered Cost of Capital)
15% =	x* 7/10 + Rd * 3/10
15% =	x* 7/10 + 7.5% * 3/10
12.7500%	7x/10
18.21%	x
Re unlevered for comparable companies will be the same.
Hence Re for XYZ and ABC =		18.21%
Levered Re for XYZ
Levered Re	Rd * Debt/ MV + Re * Equity / MV
Levered Re	=7.88%*2/5+18.21%*3/5
Levered Re for XYZ	14.08%
E) Unlevered COC for XYZ	18.21%
F) Levered COC for XYZ	14.08%