Problem 16-22 Homemade Leverage

The Veblen Company and the Knight Company are identical in every respect except that Veblen is not levered. The market value of Knight Companys 5 percent bonds is $1.70 million. Financial information for the two firms appears here. All earnings streams are perpetuities. Neither firm pays taxes. Both firms distribute all earnings available to common stockholders immediately.

		Veblen			Knight
Projected operating income	$	900,000		$	900,000
Year-end interest on debt					85,000
Market value of stock		3,900,000			2,450,000
Market value of debt					1,700,000

a-1. What will the annual cash flow be to an investor who purchases 5 percent of Knight's equity? (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations.)

Cash flow $

a-2. What is the annual net cash flow to the investor if 5 percent of Veblen's equity is purchased instead? Assume that borrowing occurs so that the net initial investment in each company is equal. The interest rate on debt is 5 percent per year. (Enter your answer in dollars, not millions of dollars, i.e. 1,234,567. Do not round intermediate calculations.)

Net cash flow $

b. Given the two investment strategies in (a), which will investors choose?

Veblen or Knight