The Naugatuck Railway is currently all equity financed, but it is considering a leveraged capital structure. Selected financial information for Naugatuck is provided in the table below

Question

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, Naugatuck will use all of the new debt to repurchase (and cancel) shares.
Bill Strong, a brakeman for the railway, bought 100 shares of Naugatuck at $40. Bill receives annual dividend income of $200 under the current capital structure. Bill likes the return on investment that he could earn under the proposed levered capital structure, but Naugatuck has announced that it will not go forward with the change in capital structure. If Bill borrows $2,400 and buys shares, then what are his annual investment cash flows?

Capital Structure Capital Structure
All Equity Levered
EBIT $200,000 $200,000
Debt, D 0 $1,500,000
Cost of Debt, kd N/A 4%
Shares Outstanding 100,000 62,500
Stock Price $40.00 $40.00
Earnings per share $2.00
Dividend per share $2.00

A) $200
B) $224
C) $245
D) $267
E) $320

Answer 1

B