The Kansas City Southern Railroad (KCSR)currently has a levered capital structure,but it is considering a proposal to issue new equity (@$15/share)and use the proceeds to retire its debt.Selected financial information for KCSR is provided in the table below.Assume that KCSR 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.
Charlie Jones,an engineer for the railway,owns 100 shares of KCSR.Charlie receives annual dividend income of $260 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,but Kansas City Southern has announced that it will not go forward with the change in capital structure.If Charlie sells 40 shares and lends the proceeds,then what is his return on investment?

Question

Quizplus · Accepted Answer

If KCSR stays with the levered capital structure, and if Charlie sells 40 shares and lends the proceeds, then he will receive total dividends of (100 - 40) × $2.60 = $156. However, he will also receive interest income of $24 (=0.04 × 40 × $15) on his loan, so his net cash flows is $180 (= $156 + $24).
His return is $180/($15 × 100) = 180/1,500 = 0.12.

The Kansas City Southern Railroad (KCSR)currently Has a Levered Capital