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    Rate of Return 14.33%

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    Smriti Mehta
    This document discusses capital structure and its impact on return for shareholders. It provides an example of a shareholder's return from holding shares in Company XYZ. The shareholder's return is calculated as 14.33% based on the dividend received. The document then shows how replicating the capital structure in another company, ABC, would provide the same 14.33% return through interest payments and dividends. It concludes by calculating the cost of equity and weighted average cost of capital for both companies.

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    Rate of Return 14.33%

    Uploaded by

    Smriti Mehta
    34 views3 pages
    This document discusses capital structure and its impact on return for shareholders. It provides an example of a shareholder's return from holding shares in Company XYZ. The shareholder's return is calculated as 14.33% based on the dividend received. The document then shows how replicating the capital structure in another company, ABC, would provide the same 14.33% return through interest payments and dividends. It concludes by calculating the cost of equity and weighted average cost of capital for both companies.

    Original Title

    6885-15-9P

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    This document discusses capital structure and its impact on return for shareholders. It provides an example of a shareholder's return from holding shares in Company XYZ. The shareholder's return is calculated as 14.33% based on the dividend received. The document then shows how replicating the capital structure in another company, ABC, would provide the same 14.33% return through interest payments and dividends. It concludes by calculating the cost of equity and weighted average cost of capital for both companies.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    34 views3 pages

    Rate of Return 14.33%

    Uploaded by

    Smriti Mehta
    This document discusses capital structure and its impact on return for shareholders. It provides an example of a shareholder's return from holding shares in Company XYZ. The shareholder's return is calculated as 14.33% based on the dividend received. The document then shows how replicating the capital structure in another company, ABC, would provide the same 14.33% return through interest payments and dividends. It concludes by calculating the cost of equity and weighted average cost of capital for both companies.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    of 3

    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%

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