The Veblen Company and the Knight Company are identical in everyrespect except that Veblen is unlevered. The market value of KnightCompany’s 4 percent bonds is $2.1 million. Financial informationfor the two firms appears here. All earnings streams areperpetuities. Neither firm pays taxes. Both firms distribute allearnings available to common stockholders immediately. |
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| | Veblen | | | Knight |
| Â Â Projected operating income | $ | 1,300,000 | | $ | 1,300,000 |
|   Year-end interest on debt | | − | | | 84,000 |
| Â Â Market value of stock | | 4,700,000 | | | 2,850,000 |
|   Market value of debt | | − | | | 2,100,000 |
|
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| a-1. | What will the annual cash flow be to an investor who purchases 5percent of Knight's equity? (Do not round intermediatecalculations and enter your answer in dollars, not millions ofdollars, rounded to the nearest whole number, e.g.,1,234,567.) |
| a-2. | What is the annual net cash flow to the investor if 5 percentof Veblen's equity is purchased instead? Assume that borrowingoccurs so that the net initial investment in each company is equal.The interest rate on debt is 4 percent per year. (Do notround intermediate calculations and enter your answer in dollars,not millions of dollars, rounded to the nearest whole number, e.g.,1,234,567.) |
a-1. Cash flow = ________________
a-2. Net cash flow = _____________
b. Given the two investment strategies in (a), which willinvestors choose?
a: Veblen
b: Knight
