The Atchison, Topeka &Santa Fe Railway (ATSFR) is currently all equity financed, but it is considering a leveraged capital structure. Selected financial information for ATSFR is provided in the table below. Assume that ATSFR 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 3% (and yield of 3%). Assume that individual investors can borrow and lend at the same interest rate (and with the same terms) as corporations.
Under the proposed levered capital structure, ATSFR will use all of the new debt to repurchase (and cancel) shares.
Bill Strong, a brakeman for the railway, owns 100 shares of ATSFR. Bill receives annual dividend income of $150. Bill likes the return on investment that he could earn under the proposed levered capital structure. If ATSFR chooses not to change its capital structure, then what can Bill do to achieve the investment cash flows (and return on investment) that he would have received under the levered capital structure? (Assume that Bill would not sell shares during the repurchase.)
| | Capital Structure | Capital Structure |
| | All Equity | Levered |
| EBIT | $150,000 | $150,000 |
| Debt, D | 0 | $1,500,000 |
| Cost of Debt, kd | N/A | 3% |
| Shares Outstanding | 100,000 | 50,000 |
| Stock Price | $30.00 | $30.00 |
| Earnings per share | $1.50 | |
| Dividend per share | $1.50 | |
◦ Borrow $1,500 and buy more shares.
◦ Invest an additional $1,500 and buy more shares.
◦ Borrow $3,000 and use it to buy more shares.
◦ Invest an additional $3,000 and buy 100 more shares.
◦ Sell 33.33 shares and lend the proceeds.
J. M. W. Turner, Rain, Steam, and Speed—The Great Western Railway.
J. M. W. Turner, Rain, Steam, and Speed—The Great Western Railway.
Efficiency vs. Equity
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