Chapter 16, Problem 18QP

Homemade Leverage [LO1] 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	$ 400,000	$ 400,000
Year-end interest on debt	–	$ 72,000
Market value of stock	$2,900,000	$1,850,000
Market value of debt	–	$1,200,000

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 Day’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?