Homemade Leverage
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1. 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 million. Financial information for the two firms appears below. All earnings streams are perpetuities. Neither firm pays taxes. Both firms distribute all earnings available to common stockholders immediately.
Veblen Knight
Projected operating income $ 300,000 $ 300,000
Year-end interest on debt ? 60,000
Projected earnings available to common stock $ 300,000 $ 240,000
Required return on equity (rS) 0.125 0.140
Market value of stock $2,400,000 $1,714,000
Market value of debt ? 1,000,000
Value of the firm $2,400,000 $2,714,000
Weighted average cost of capital(rWACC) 0.125 0.110
Debt-equity ratio 0 0.584
a. An investor who is able to borrow at 6 percent per annum 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 cost of the two options are the same?
b.Given the two investment strategies in (a), which will investors choose? When will this process cease?
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Solution Summary
The solution explains the use of homemade leverage to increase the return.
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a. Since the market value of Knight's equity is $1,714,000, 5% of the firm's equity costs $85,700 (= 0.05 * $1,714,000).
Since the market value of Veblen's equity is $2,400,000, 5% of the firm's equity costs $120,000 (= 0.05 * $2,400,000). In order to compare dollar returns, the initial net cost of both positions should be the same. Therefore, the investor will borrow $34,300 (= $120,000 - $87,500) at 6% per annum when purchasing $120,000 of Veblen's equity for a net cost of $85,700 (= $120,000 - $34,300).
An investor who owns 5% of Knight's equity will be entitled to 5% of the firm's earnings available to common stock holders at the ...
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