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	$	650,000		$	650,000
Year-end interest on debt		−		$	87,000
Market value of stock	$	3,400,000		$	2,200,000
Market value of debt		−		$	1,450,000

  

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 and round your answer to the nearest whole number, e.g., 32.)
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 6 percent per year. (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)

     

b.	Given the two investment strategies in (a), which will investors choose?
	Day Knight

Answer 1

a1. annual cash flow from Knight's equity purchase = (Projected operating income - Year-end interest on debt)*% equity purchased

annual cash flow from Knight's equity purchase = ($650,000 - $87,000)*10% = $563,000‬*10% = $56,300‬

a2. annual cash flow from Day's equity purchase = Projected operating income*% equity purchased

annual cash flow from Day's equity purchase = $650,000*10% = $65,000

b. Investors will choose Day because it has higher annual cash flow than Knight. Day doesn't have any debt. so, cash flow available for investors is higher than Knight.