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?

Question

Quizplus · Accepted Answer

Under the proposed capital structure:
Total dividends = Net income Net Income = EBIT Interest = $0
Total Dividends = EBIT = $150,000
To retire the debt, the company will issue shares at $30 per share
New share issued = $1,500,000/$30 = 50,000 shares
Shares outstanding after = 100,000 + 50,000 = 150,000
After the new issue dividends per share are:
Dividends = $150,000/150,000 = $1.00
If PRR goes ahead with the change in capital structure and if Charlie holds on to his 100 shares during the new issue and debt retirement, then he would be entitled to $100 (100 × $1) of dividend income annually.
If PRR stays with the levered capital structure, and if Charlie sells 33.33 shares and lends the proceeds, then he will receive total dividends of 66.666 × $0.75 = $50. However, he will also receive interest income of $50 (= 0.05 × 33.33 × $30) on his loan, so his net cash flows is $100 (= $50 + $50).

The Pennsylvania Railroad (PRR)currently Has a Levered Capital Structure,but It