Abacus Calculation Company and Zoom Calculators Inc. are identical except for capital structures. Abacus has 50% debt and 50% equity, whereas Zoom has 30% debt and 70% percent equity. The borrowings rate for both companies is 8% in a no tax world, and capital markets are assumed to be perfect. i. If you own 4 percent of the stock of Abacus, what is dollar return if the company has net operating income of $3,60000 and the overall capitalization rate of the company is 18%? ii. What is the implied required rate of return on equity? Zoom has the same net operating income as Abacus. What is the implied required equity return of Zoom? Why does it differ from that of Abacus?
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
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