The Veblen Company and the Knight Company are identical in every respect except
ID: 2382672 • Letter: T
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.
The Veblen Company and the Knight Company are identic al 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 Veblen Knight Projected operating income 650,000 650,000 -$87,000 $ 3,400,000 $2,200,000 -$1,450,000 Year-end interest on debt Market value of stock Market value of debt a-1 What will the annual cash flow be to an investor who purchases 10 percent of Knight's equity? Cash flow a-2 What is the annual net cash flow to the investor if 10 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 6 percent per year Net cash flow b. Given the two investment strategies in (a), which will investors choose? Veblen O KnightExplanation / Answer
Answer for a-1:
If a person is holding 10% of kinght's equity, annual cash inflows would be 10% of $563,000 =$56,300.
Answer for subpoint a-2:
Market value of Knight =$2,200,000. Amount spent to purchase 10% of stock =$2,200,000*10%
=$220,000.
Market value of veblen =$3,400,000
10% of value =$3,400,000 *10%
=$340,000
It is given that net initial investment is equal in both companies therefore own funds out of $340,000 is therefore $220,000. Rest is debt borrowed at 6%. i.e., $340,000 -$220,000 =$120,000.
Interest on debt i.e., $120,000 *6% =$7,200.
Net cash flow =Cash in flow - Interest on debt taken
Cash inflow is as computed in the table at the top of the answer.
=$650,000 *10% -$7,200
=$65,000 -$7,200
=$57,800.
Answer to subpoint b:
Earnings in the strategy mentioned in a-1 =$56,300
Earnings in the strategy mentioned in a-2 =$57,800
As the earnings is more in the second strategy the investor will choose Veblen.
Particulars Veblen Knight Operating income $650,000.00 $650,000.00 Minus: interest on debt $0.00 $87,000.00 Earnings after debt $650,000.00 $563,000.00Related Questions
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