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 per cent bonds is SKr1 million. Financial information for the two firms appears here. All earnings streams are perpetuities. Neither firm pays taxes. Both firms distribute all earnings available to ordinary shareholders immediately.

(a) An investor who can borrow at 6 per cent per year wishes to purchase 5 per cent of Knight’s equity. Can he increase his Krona return by purchasing 5 per cent of Veblen’s equity if he borrows so that the initial net costs of the two 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 Veblen(Skr) 300,000 - 2,400,000 Knight(Skr) 300,000 60,000 1,714,000 1,000,000