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 6 percent bonds is $1.2 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 operation income |
$400,000 |
$400,000 |
|
Year-end interest on debt |
– |
72,000 |
|
Market value of stock |
3,600,000 |
2,532,000 |
|
Market value of debt |
– |
1,200,000 |
1. An investor who can borrow at 6 percent per year wishes to purchase 5 percent of Knight’s equity. Can he increase his dollar return by purchasing 5 percent of Veblen’s equity if he borrows so that the initial net costs of the two strategies are the same?
2. Given the two investment strategies in (a), which will investors choose? When will this process cease?