Problem:

ABC Co. and XYZ Co. are identical firms in all respects except for their capital structure. ABC is all equity financed with $575,000 in stock. XYZ uses both stock and perpetual debt; its stock is worth $287,500 and the interest rate on its debt is 8.5 percent. Both firms expect EBIT to be $64,000. Ignore taxes.

Required:

Suppose Rico invests in ABC Co and uses homemade leverage. Calculate his total cash flow and rate of return.

Question 1: What is the cost of equity for ABC and XYZ?

Question 2: What is the WACC for ABC and XYZ?

Illustrate out all the calculation.