18. Homemade Leverage 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 perpe- tuities, and neither firm pays taxes. Both firms distribute all earnings available to common stockholders immediately. Veblen Knight Projected operating income $ 500,000 $ 500,000 Year-end interest on debt — $ 78,000 Market value of stock $3,100,000 $2,050,000 Market value of debt — $1,300,000 a. 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 strategies are the same? b. Given the two investment strategies in (a), which will investors choose? When will this process cease?
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