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 firm pays taxes. Both firms distribute all earnings available to common stockholders immediately.

  

		Day			Knight
Projected operating income	$	600,000		$	600,000
Year-end interest on debt		?		$	70,000
Market value of stock	$	3,300,000		$	2,150,000
Market value of debt		?		$	1,400,000

  

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. 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 5 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 5 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?

	Knight
	Day

Answer 1

a-1. The annual cash flow be to an investor who purchases 5 percent of Knight's equity

Projected operating income = $ 600,000

Less : Interest on Debt = - $ 70,000  

Income available to Investors $ 530,000

Since it is given that firms pays no tax and all the earnings distributed immediately all the $ 530,000 will be distributed.

Annual cash flow to the Investor who purchased 5% stake = $ 530,000 X 5%

= $ 26,500

a-2 Projected operating income = $ 600,000 X 5 %

= $ 30,000   

b) Day Knight   

Annual Cash Flow $ 30,000 $ 26,500

Market Value $ 3,000,000 $ 3,550,000

Earning rate 1 % 0.74 %

Investor will choose Day