Question

The Veblen Company and the Knight Company are identical in every respect except that Veblen is unlevered. The market value of Knight Company’s 4 percent bonds is $1.5 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.

  

		Veblen			Knight
Projected operating income	$	700,000		$	700,000
Year-end interest on debt		−			60,000
Market value of stock		3,500,000			2,250,000
Market value of debt		−			1,500,000

  

a-1.	What will the annual cash flow be to an investor who purchases 5 percent of Knight's equity? (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, 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 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 4 percent per year. (Do not round intermediate calculations and enter your answer in dollars, not millions of dollars, rounded to the nearest whole number, e.g., 1,234,567.)

Answer 1

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- 2x m Find & Insert Delete Format Σ AutoSum : A Fill 2 Sort & 2 Clear Filter Editing Select Cells PV, FV, ANNUITY (Autosaved) - Microsoft Excel (Product Activation Failed) File Home Insert Page Layout Formulas Data Review View Add-Ins % Cut Calibri -11AA = = = Dr Wrap Text General Ea Copy Paste B I U. B. A Format Painter Merge & Center - Merge & Center - $ $ -% % ; 48. Conditional Format Cell Formatting as Table Styles Clipboard Font Alignment Number Styles CV417 Box CK CL C M CN CO CP CQ CR CS CT 407 VEBLEN KNIGHT 408 UNLEVERED LEVERED 409 OPERATING INCOME 700000 700000 410 INTEREST 60000 411 MV (S) 3500000 2250000 412 MV (D) 1500000 413 MV (F) 3500000 3750000 Formula Bar CV CW cx 414 415 (a-1) KNIGHT HAS NET INCOME OF (700000 - 60000)= 640000 IF INVESTOR HOLDS 5% EQUITY OF KNIGHT HIS ANNUAL CASHFLOW WILL BE 5% OF NET INCOME ANNUAL CASH FLOW = 5% of 640000 = 32000 416 417 418 419 420 421 422 423 424 (a-2) MARKET VALUE OF STOCK OF VEBLEN = 3500000 MARKET VALUE OF STOCK OF KNIGHT = 2250000 5% INVESTMENT COSTS IN VEBLEN = 175000 5% INVESTMENT COSTS IN KNIGHT = 112500 TO COMPARE DOLLAR RETURNS, INITIAL NET COST OF BOTH POSITIONS SHOULD BE THE SAME SO INVESTOR SHOULD BORROW = 175000-112500 = 62500 425 426 427 H N CAP STRU VALUE profit margin loan with points LOCK BOX DILUTION DOLLAR COST AVG EXPONPER APR CPI ear FVA C O LOAN OPTIONSpv, fv, annuity ferences pva 52 BO 53 120% Rea 1 - ... B 9 . * ENG 23-11-2019

PV, FV, ANNUITY (Autosaved) - Microsoft Excel (Product Activation Failed) Review View Add-Ins File Home Insert Page Layout Formulas Data - 2x % Cut Calibri Dr General -11AA = = = D- DA E = 5 Wrap Text Fat Merge Merge & Center - Center m Find & E Copy Paste Format Painter Clipboard BI U st $ $ .0 .00 :.: Insert Delete Format % % , , Number Conditional Format Formatting as Table Styles Cell Styles Σ AutoSum : A Fill 2 Sort & 2 Clear Filter Editing Select Font Alignment Cells for I CT446 c - a CM CN co CP Q R S T cu v w x 5 427 428 VEBLEN 700000 OPERATING INCOME INTEREST NET INCOME 700000 429 430 431 432 433 434 435 436 35000 [5% X 700000] DIVIDEND LESS : INTEREST PAID ON BORROWING [62500 X 4%] annual net cash flow 2500 32500 437 438 (b) ANNUAL CASH FLOW FOR VEBLEN FOR KNIGHT 32500 32000 439 440 441 442 443 444 445 446 447 GO FOR VEBLEN FIRM, BORROW AS ANNUAL CASH FLOW IS HIGHER H N CAP STRU VALUE profit margin loan with points LOCK BOX DILUTION DOLLAR COST AVG EXPONPER APR CPI ear FVA 52 C O LOAN OPTIONSpv, fv, annuity ferences pva 0 53 120% Rea 1 0 + D F B * * OENG 23-11-2019