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Schulich Incorporated is all-equity financed with $10 million in stock with 1 million shares outstanding. Schulich generates expected annual EBIT (earnings before interest and tax) of $1 million without growth (i.e., perpetual cashflow). Note that no growth implies 100% dividend payout ratio (dividend / net Income). Assume that there are no taxes. Sarah has $100,000 to invest.
a) If Sarah invests in Schulich Incorporated, what are the cashflow and return on investment that she can expect?
b) Schulich Incorporated decides to repurchase half of its equity through share repurchase program by issuing risk-free perpetual debt of $5 million. Interest on perpetual debt is 5%. Sarah is not happy about capital structure decision by Schulich Incorporated. She prefers investing in a company with no debt. How could Sarah generate exactly the same cash flows and rate of return when she would invest in a company with no leverage (i.e., Schulich Incorporated before capital restructuring) by investing in newly recapitalized Schulich Incorporated and using homemade leverage?
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