The Day Company and the Knight Company are identical in every respect except tha

Question

The Day Company and the Knight Company are identical in every respect except that Day is not levered Financial information for the two firms appears in the following table. All earnings streams are perpetuities and neither immediately firm pays taxes. Both firms distribute a earnings available to common stockholders Knight Day 850,000 Projected operating income Year-end interest on debt Market value of stock Market value of debt $ $ 850,000 -$ 66,000 $3,800,000 2,400,000 -1,650,000 a-1 What will the annual cash flow be to an investor who purchases 10 percent of Knight's equity? (Do not round intermediate calculations. Round your answer to the nearest whole number, e.g., 32.) Cash flow a-2 What is the annual net cash flow to the investor if 10 percent of Day'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. Round your answer to the nearest whole number, e.g., 32.) Net cash flow b. Given the two investment strategies in (a), which will investors choose? Day O Knight

Explanation / Answer

a-1: net cash flow from knight equity= 78400

a-2: Net cash flow from Day equity= 79400

b. Day equity will be chosen by investors

Day Knight Income        8,50,000        8,50,000 Less: Interest            66,000 Net income        8,50,000        7,84,000 10% share            85,000            78,400 Less: Interest on borrowed funds              5,600 Net cash flow            79,400            78,400 Investment: 10% equity value        3,80,000        2,40,000 Own funds        2,40,000        2,40,000 Borrowed funds        1,40,000 Interest              5,600

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