Problem: The Veblen Company and the Knight Company are identical in every respect except that Veblen is not levered. The market value of Knight Company's 6-percent bonds is $1 million. Financial information for the two firms appears below. All earnings streams are perpetuities. Neither firm pays taxes. Both firms distribute all earnings available to common stockholders immediately.
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Veblen
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Knight
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Projected operating income
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$ 300,000
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$ 300,000
|
|
Year-end interest on debt
|
-
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60,000
|
|
Projected earnings available to common stock
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$ 300,000
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$ 240,000
|
|
Required return on equity (rS)
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0.125
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0.140
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|
Market value of stock
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$2,400,000
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$1,714,000
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Market value of debt
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-
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1,000,000
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|
Value of the firm
|
$2,400,000
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$2,714,000
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|
Weighted average cost of capital(rWACC)
|
0.125
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0.110
|
|
Debt-equity ratio
|
0
|
0.584
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a. An investor who is able to borrow at 6 percent per annum wishes to purchase 5 percent of Knight's equity. Can he increase his dollar return by purchasing 5 percent of Veblen's equity if he borrows so that the initial net cost of the two options are the same?
b. Given the two investment strategies in (a), which will investors choose? When will this process cease?