15.5 The Veblen Company and the Knight Company are identical in every respect except that Veblen Company is not levered. The market value of Knight Company’s 6-percent bonds is

$1 million. The financial statistics for the two firms appear below. Neither firm pays taxes.

a. An investor who is also able to borrow at 6 percent owns $10,000 worth of Knight stock. Can he increase his net return by borrowing money to buy Veblen stock? If so, show the strategy.

b. According to Modigliani and Miller, what kind of investors will attempt this strategy?
When will the process cease?

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Net operating income Interest on debt Earnings available to common stock Required return on equity Veblen $ 300,000 0 $ 300,000 Knight $ 300,000 60,000 $ 240,000 0.125 0.140 Market value of stock $2,400,000 $1,714,000 Market value of debt 0 $1,000,000 Market value of the firm $2,400,000 $2,714,000 Overall required return 0.125 0.110 Debt-equity ratio 0 0.584