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 $750,000 $ 750,000 income Year-end interest on debt $ 77,500 Market value of stock $3,600,000 $2,300,000 Market value of debt - $1,550,000

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 5 percent per year. (Do not round intermediate calculations and round your answer to the nearest whole number, e.g., 32.)
X Answer is not complete.
a-1. Cash flow $ 67,250
a-2. Cash flow
b. Given the two investment strategies in (a), which will investors choose?

Answer 1

a) $67,250

b) $68,500

c) Investment in Day Company results in a higher return, so I guess investors would probably go for it.

Step-by-step explanation:

Knight Company's net income = $750,000 - $77,500 = $672,500

total investment in Knight Company = $2,300,000 / 10% = $230,000

earnings per 1$ invested = $672,500 / $2,300,000 = $0.292391

total cash flow = $230,000 x $0.292391304 = $67,250

Day Company's net income = $750,000

earnings per 1$ invested = $750,000 / $3,600,000 = $0.208333333

total investment in Day Company = $360,000, but I borrowed $130,000 to make this investment. The $130,000 will result in $6,500 annual interest payments

total cash flow = ($360,000 x $0.208333333) - $6,500 = $75,000 - $6,500 = $68,500