Question
The Veblen Company and the Knight Company are identical in every respect except that Veblen is not levered. The Knight Companys 4 percent bonds sell
The Veblen Company and the Knight Company are identical in every respect except that Veblen is not levered. The Knight Companys 4 percent bonds sell at par value. Financial information for the two firms appears below. All earnings streams are perpetuities. Neither firm pays taxes. Both firms distribute all earnings available to common stockholders immediately.
1a. What will the annual cash flow be to an investor who purchases 10 percent of Knight's equity?
1b. What is the annual net cash flow to the investor if 10 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 4 percent per year.
1c. Given the two investment strategies in (a), which will investors choose?
| Veblen | Knight | |||||
| Projected operating income | $ | 850,000 | $ | 850,000 | ||
| Year-end interest on debt | 66,000 | |||||
| Market value of stock | 3,800,000 | 2,400,000 | ||||
| Market value of debt | 1,650,000 |
|
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