The Cripple Creek Railway is currently all equity financed, but it is considering a leveraged capital structure. Selected financial information for Cripple Creek is provided in the table below. Assume that Cripple Creek 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 4% (and yield of 4%). 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, Cripple Creek will use all of the new debt to repurchase (and cancel)shares.
Bill Strong, a brakeman for the railway, bought 100 shares of Cripple Creek at $60. Bill receives annual dividend income of $300. Bill likes the return on investment that he could earn under the proposed levered capital structure, but Cripple Creek has announced that it will not go forward with the change in capital structure. If Bill borrows $2,000 and buys shares, then what is his return on investment?
$$\begin{array} { | c | c | c | }
\hline & \begin{array} { c }
\text { Capital } \
\text { Structure }
\end{array} & \begin{array} { c }
\text { Capital } \
\text { Structure }
\end{array} \
\hline & \text { All Equity } & \text { Levered } \
\hline \text { EBIT } & \$ 300,000 & \$ 300,000 \
\hline \text { Debt, D } & 0 & \$ 1,500,000 \
\hline \begin{array} { c }
\text { Cost of Debt, } \
\mathrm { k } _ { \mathrm { d } }
\end{array} & \text { N/A } & 4 \% \
\hline \begin{array} { c }
\text { Shares } \
\text { Outstanding }
\end{array} & 100,000 & 75,000 \
\hline \text { Stock Price } & \$ 60.00 & \$ 60.00 \
\hline \begin{array} { c }
\text { Earnings per } \
\text { share }
\end{array} & \$ 3.00 & \
\hline \begin{array} { c }
\text { Dividend per } \
\text { share }
\end{array} & \$ 3.00 & \
\hline
\end{array}$$
A)5.00%
B)5.15%
C)5.33%
D)5.50%
E)5.67%

Question

The Cripple Creek Railway is currently all equity financed, but it is considering a leveraged capital structure. Selected financial information for Cripple Creek is provided in the table below. Assume that Cripple Creek 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 4% (and yield of 4%). 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, Cripple Creek will use all of the new debt to repurchase (and cancel)shares.
Bill Strong, a brakeman for the railway, bought 100 shares of Cripple Creek at $60. Bill receives annual dividend income of $300. Bill likes the return on investment that he could earn under the proposed levered capital structure, but Cripple Creek has announced that it will not go forward with the change in capital structure. If Bill borrows $2,000 and buys shares, then what is his return on investment?
$$\begin{array} { | c | c | c | } 
\hline & \begin{array} { c } 
\text { Capital } \
\text { Structure }
\end{array} & \begin{array} { c } 
\text { Capital } \
\text { Structure }
\end{array} \
\hline & \text { All Equity } & \text { Levered } \
\hline \text { EBIT } & \$ 300,000 & \$ 300,000 \
\hline \text { Debt, D } & 0 & \$ 1,500,000 \
\hline \begin{array} { c } 
\text { Cost of Debt, } \
\mathrm { k } _ { \mathrm { d } }
\end{array} & \text { N/A } & 4 \% \
\hline \begin{array} { c } 
\text { Shares } \
\text { Outstanding }
\end{array} & 100,000 & 75,000 \
\hline \text { Stock Price } & \$ 60.00 & \$ 60.00 \
\hline \begin{array} { c } 
\text { Earnings per } \
\text { share }
\end{array} & \$ 3.00 & \
\hline \begin{array} { c } 
\text { Dividend per } \
\text { share }
\end{array} & \$ 3.00 & \
\hline
\end{array}$$
A)5.00%
B)5.15%
C)5.33%
D)5.50%
E)5.67%

Quizplus · Accepted Answer

Bill's return on investment is calculated as follows: He initially owns 100 shares, receiving $300 in dividends. By borrowing $2,000, he can buy 33.33 more shares ($2,000 / $60 per share). His total shares become 133.33, and his total dividend income becomes $400 (133.33 shares * $3 per share). His return on investment is ($400 - $80 interest on $2,000 at 4%) / $4,000 (initial investment + borrowed amount) = 5.33%.

The Cripple Creek Railway Is Currently All Equity Financed, but It