2. 18.

Homemade leverage [LO 16.1] The Day Company and the Knight Company are identical in every respect except that Day is not levered.

Financial information for the two firms appears in the following table.

All earnings streams are perpetuities, and neither firm pays taxes. Both firms distribute all earnings available to ordinary shareholders immediately

1. 1. An investor who can borrow at 6 per cent per year wishes to purchase 5 per cent of Knight’s equity. Can he increase his dollar return by purchasing 5 per cent of Day’s equity if he borrows so that the initial net costs of the strategies are the same?
2. Given the two investment strategies in (a), which will investors choose? When will this process cease?

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Day Knight Projected operating profit $ 375 000 $ 375 000 Year-end interest on debt $ 54.000 Market value of shares $2 300 000 $1 650 000 Market value of debt - $ 900 000