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Sun Company and Moon Company are identical in every respect except that Sun is not levered. The market value of Moon Company's 6 percent bonds is $1.2 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 common stockholders immediately.
Sun
Moon
Projected operating income
$400,000
Year-end interest on debt
0
72,000
Market value of debt
1,200,000
Market value of stock
3,600,000
2,532,000
Questions:
1. An investor who can borrow at 6 percent per year wishes to purchase 5 percent of Moon's equity. Can he increase his dollar return by purchasing 5 percent of Sun's equity if he borrows so that the initial net costs of the two strategies are the same?
2. Given the two investment strategies in (a), which will investors choose? When will this process cease?
3. Justify your answer in details
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