The Montmagny Company and the Shawinigan Company are identical in every respect except that Montmagny 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 shareholders immediately.

a. An investor who can borrow at 6% per year wishes to purchase 5% of Shawinigan’s equity. Can he increase his dollar return by purchasing 5% of Montmagny’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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Projected operating income Year-end interest on debt Market value of stock Market value of debt Montmagny $ 400,000 $2,900,000 Shawinigan $ 400,000 72,000 $1,850,000 $1,200,000