Government Loan Guarantees and the Failure of the Canadian Northern Railway

Abstract

The failure of the Canadian Northern Railway is analyzed with a model of optimal capital structure drawn from finance theory. Ex ante bankruptcy probabilities, which are computed on the basis of different assumptions about investors' expectations, range from 40 to 90 percent; and our best estimate is about 70 percent. These high probabilities were a consequence of loan guarantees provided to the Canadian Northern by the federal and provincial governments. The guarantees induced the railway's promoters to undertake an ex ante unprofitable project and to finance that project almost exclusively with debt.

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