The Veblen Company and the Knight Company are identical in every respect except

Question

The Veblen Company and the Knight Company are identical in every respect except that Veblen is not levered. The Knight Company’s 6 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.
  

a-1. What will the annual cash flow be to an investor who purchases 10 percent of Knight's equity? (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, e.g., 1,234,567.)

Cash flow           $

a-2. 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 6 percent per year. (Do not round intermediate calculations. Enter your answer in dollars, not millions of dollars, e.g., 1,234,567.)

Net cash flow           $

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

Knight

Veblen

Veblen Knight Projected operating income $ 1,250,000 $ 1,250,000 Year-end interest on debt ? 123,000 Market value of stock 4,600,000 2,800,000 Market value of debt ? 2,050,000

Explanation / Answer

a1)

Cash flow = 10%×(Operating income - Interest expense)

= 10%×($1,250,000 – $123,000)

= $112,700

a2)

Amount to borrow = 10%×(Market value of Veblen - Market value of knight)

= 10%×($4,600,000 - $2,800,000)

= $180,000

Net cash flow = 10%×Operating income - (Amount borrowed×Interest rate)

= 10%×$1,250,000 - ($180,000×10%)

= $107,000

b)

since cash flow from Veblen is greater than Knight, we should choose Veblen.

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