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?

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?

A) 5.00% 
B) 5.15% 
C) 5.33% 
D) 5.50% 
E) 5.67%

Quizplus · Accepted Answer

If Bill borrows $2,000, then he can buy 33.333 new shares. He will receive total dividends of 133.33 × $3 = $400. However, he will have an annual interest expense of $80 (=0.04 × $2,000) on his loan, so his net cash flows is $320 (= $400 - $80).
His return is $320/($60 × 100) = 320/6,000 = 0.05333.

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