Problem 16-22 Homemade Leverage The Veblen Company and the Knight Company are id
ID: 2731300 • Letter: P
Question
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 Company’s 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.
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
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 1,700,000Explanation / Answer
a-1
Cash flow = (Projected Operating Income- Interest Expenses)*Percentage of Holding
Cash flow = (900000-85000)*5%
Cash flow = $ 40750
a-2)
Cash flow = (Projected Operating Income- Interest Expenses)*Percentage of Holding - Interest Expenses on Borrowing
Cash flow = (900000-0)*5% - 5%*(3900000*5%- 2450000*5%)
Cash flow = $ 41,375
b)
Investor Should Choose
Veblen