The Pennsylvania Railroad (PRR) currently has a levered capital structure, but it is considering a proposal to issue new equity (@$30/share) and use the proceeds to retire its debt. Selected financial information for PRR is provided in the table below. Assume that PRR generates perpetual annual EBIT at a constant level. Assume that all cash flows occur at the end of the year and we are currently at the beginning of a year. Assume that taxes are zero. Assume that all of net income is paid out as a dividend. Assume that the debt is perpetual with an annual coupon rate of 5% (and yield of 5%). Assume that individual investors can borrow and lend at the same interest rate (and with the same terms) as corporations.
Charlie Jones, an engineer for the railway, owns 100 shares of PRR. Charlie receives annual dividend income of $75 under the current capital structure. Charlie likes the lower risk and the return on investment that he could earn under the proposed all-equity capital structure. If PRR chooses not to change its capital structure, then what can Charlie do to achieve the investment cash flows (and return on investment) that he would have received under the all equity capital structure?
| | Capital Structure | Capital Structure |
| | All Equity | Levered |
| EBIT | $150,000 | $150,000 |
| Debt, D | $0 | $1,500,000 |
| Cost of Debt, kd | N/A | 5% |
| Shares Outstanding | 150,000 | 100,000 |
| Stock Price | $30.00 | $30.00 |
| Earnings per share | | $0.75 |
| Dividend per share | | $0.75 |
◦ Sell $1,500 worth of shares and lend the proceeds.
◦ Invest an additional $1,500 and buy more shares.
◦ Sell 50 shares and loan the proceeds.
◦ Invest an additional $1,000 and buy 33.33 more shares.
◦ Sell 33.33 shares and lend the proceeds.
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