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The Mohawk & Hudson Railway (M&H)currently Has a Levered Capital

question 107

Multiple Choice

The Mohawk & Hudson Railway (M&H) currently has a levered capital structure, but it is considering a proposal to issue new equity (@$60/share) and use the proceeds to retire its debt. Selected financial information for M&H is provided in the table below. 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 M&H. Charlie receives annual dividend income of $360 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 Mohawk & Hudson has announced that it will not go forward with the change in capital structure. If Charlie sells 14.29 shares and lends the proceeds, then what are his annual investment cash flows?
$\begin{array} { | c | c | c | } \hline & \begin{array} { c } \text { Capital } \\\text { Structure }\end{array} & \begin{array} { c } \text { Capital } \\\text { Structure }\end{array} \\\hline & \text { Levered } & \text { All Equity } \\\hline \text { EBIT } & \$ 400,000 & \$ 400,000 \\\hline \text { Debt, D } & \$ 1,000,000 & \$ 0 \\\hline \begin{array} { c } \text { Cost of Debt, } \\\mathrm { k } _ { \mathrm { d } }\end{array} & 4 \% & \text { N/A } \\\hline \begin{array} { c } \text { Shares } \\\text { Outstanding }\end{array} & 100,000 & 116,667 \\\hline \text { Stock Price } & \$ 60.00 & \$ 60.00 \\\hline \begin{array} { c } \text { Earnings per } \\\text { share }\end{array} & \$ 3.60 & 0 \\\hline \begin{array} { c } \text { Dividend per } \\\text { share }\end{array} & \$ 3.60 & 0 \\\hline\end{array}$

Definitions:

Debris

Scattered fragments, typically of something wrecked or destroyed.

Statute Of Frauds

State-level legislation that addresses the enforceability of contracts that fail to meet the requirements set forth in the statute; serves to protect promisors from poorly considered oral contracts by requiring certain contracts to be in writing.

Parol Evidence Rule

A principle in contract law that prevents the parties from presenting external evidence that contradicts or adds to the written terms of a contract.

Merger Clause

A contract provision stating that the written contract represents the complete and final agreement between the parties.