6885-15-9P AID: 63238 | 21/05/2020

Capital Structure refers to the amount of debt and equity of a certain company. The
Debt-Equity Ratio is an important factor as it affects the payoffs to the shareholders.
Financial Leverage may not affect the cost of capital but it has dramatic impact on the
investors confidence.

(a) The shareholder holds $ 30,000 worth of stocks in XYZ Co. The rate of return
earned by the shareholder will be in the form of dividend paid by the company with
respect to the amount of shares possessed by the shareholder

Net Income of XYZ

Dividend Received = ´ Amount of Shares held by Shareholder
Total Equity of XYZ
43,000
=$ ´ 30,000
3,00,000
= $ 4,300

The Rate of Return the shareholder expects is

4,300
Rate of Return = ´ 100
30,000
=14.33%

Rate of Return =14.33%

(b) To replicate the structure in the other company, the shareholder should sell
$ 30,000 worth shares at 10% and borrow $ 30,000 .

The shareholder will generate an interest cash flow to be paid by the shareholder

Interest Cash Flow = Amount borrowed ´ Interest Rate

= - 30,000 ´ 0.10
= $ - 3,000
The shareholder will receive dividend payment on the $ 60,000 worth shares it has
purchased in the first company which is:

Net Income of ABC

Dividend Received = ´ Amount of Shares held by Shareholder
Total Equity of ABC
73,000
=$ ´ 60,000
6,00,000
= $ 7,300

Cash Flow of the shareholder =Dividends Received - Interest Cash Flow

= $ 7,300 - 3,000
= $ 4,300

The Rate of Return the shareholder expects is

4,300
Rate of Return = ´ 100
30,000
=14.33%

The rate of return is 14.33%

(c)
1. Calculate Cost of Equity of ABC
ABC is all-equity company. The cost of equity is given by RE
Net Income
Re =
Value of the Firm
73,000
=
600,000
=12.17%

Cost of Equity of ABC Co. is Re = 12.17%

The Required Rate of Unlevered Firm is equal to the Required Rate of Equity
i.e. Ru =Re

2. Calculate the Cost of Equity of XYZ

D
=1
XYZ comprises of both Debt and Equity in equal proportion i.e. E
According to M&M Proposition II
D
Re =Ru + ´ (Ru - Rd )
E
Here,
Ru =12.17%
Rd =10%
D
=1
E

Putting these values in the above equation to find ke

D
Re =Ru + ´ (Ru - Rd )
E
=12.17% +1´ (12.17% - 10%)
=14.34%
Cost of Equity of XYZ Co. is ke = 14.34%

(d)
1. Calculate the WACC of ABC
WACC ABC =Re =12.17%
Since ABC is a All-Equity company

2. Calculate the WACC of XYZ

XYZ and ABC have identical capital structure. Based on M&M II the Cost of
Unlevered firm is equal to Cost of Levered Firm. So,
WACC XYZ =WACC ABC =12.17%