problem: Homemade leverage and WACC. ABC Co. & XYZ Co. is identical firms in all respects except for their capital structure. ABC is all equity financed with $800,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth USD 400,000 and the interest rate on its debt is ten percent. Both firms expect EBIT to be USD 90,000. Ignore all kind of taxes.

[A]   Show how Rico could generate exactly the same cash flows and rate of return by investing in ABC and using homemade leverage [i.e., by borrowing at the risk free rate of 10 percent.]

[B]   What is the WACC for ABC? For XYZ? What principle have you illustrated?

[C]   Rico owns $30,000 worth of XYZ's stock. What rate of return is he expecting?

[D]   Find the cost of equity for ABC? What is it for XYZ?