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. 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 common stockholders immediately.

What will the annual cash flow be to an investor who purchases 5 percent of Knight's equity?

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.

The Veblen Company and the Knight Company are identical in every respect except that Veblen 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 common stockholders immediately.

Explanation / Answer

a1)

cash flow = 5% * (operating income - interest expense)

= 5% * (900000 - 85000)

= $40,750

a2)

amount to borrow = 5% * (market value of Veblen - market value of knight)

= 5% * (3900000 - 2450000)

= 72500

net cash flow = 5% * operating income - (amount borrowed * interest rate)

= 5% * 900000 - (72500 * 0.05)

=41,375

b)

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

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