Continent Cont inental al Carr Carrier iers, s, Inc Inc..
Situation analysis Continental Carrier (CCI) is a regulated motor carrier with routes alon the Pacific Coast from Oregon and Califonia to the industria Midwest and from Chicagi to several points in Texas. The company was founded in 1952 and has grown organically over the years through a combination of intensive marketing efforts, extensive computerization and improvement in terminal facilities.
The company wishes to expand aggressively to other parts of the United States through acquisition strategies. The first of its acquisitions is Midland Freight Inc (MDI). CCI is acquiring MDI through a cash payment of USD 50m to existing owners of MDI.
The company has to decide how to fund this acquisition.
Problem and Decision options
Criteria Criteria
Bond
Equity
Preference shares
Preferred option
Flexibility
Bond offers the flexibility
The equity once issued is
Moderate flexibility if the
Bond
for the company to amend
not easily redeemed like
company issues
its capital structure.
the debt or preferred shares
redeemable preference
The debt can be repaid by
The company also may not
debts
the company if they do not
be successful with the
wish to restructure
equity issue
The bond options result in a
The past disappointing
We do not have enough
higher degree of risk for the
stock performance of the
information to access the
company especially during
company on the stock
preference stock
times of poor financial
market heightens the risk
performance. The table and
that the offer may not be
graph in exhibit 3 shows
successful, this is apart
that during a recession,
from the fact that the stock
when EBIT falls to $12.5m
is underpriced at $17.75
the company would only be
per unit compared to the
Risk
barely able to return EPS of book equity per share value $1 however when the
Continental Carriers, Inc. | [Your Name]
of $44.94 per share. The
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Equity
company performs well,
shareholders have a lot to
the bond option maximizes
loose if new shareholders
the return of equity holders
come in at such a low
to $3.87 per share rather
price.
that $2.72 per share if the equity option is selected.
Besides there is no
The company already has a
guarantee that the stock
potential investor-
would be fully subscribed.
California Insurance company
CCI is obligated to pay the annual interest cost irrespective of the company’s cashflow situation. EG with an EBIT of below %4m the company may not be able to survive Income
Cost of Debt: 10-10*.4=6% (on an after tax basis)
Cost of Equity: 1.5/16.75= 8.96%
Cost of Preference shares: 10.5/100= 10.5%
High transaction cost of $1 per share i.e $3million Continental Carriers, Inc. | [Your Name]
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Debt
The debt provides an interest tax shield of $2m, which is the benefit the company gains from choosing debt financing over other options
Control
The shareholders continue
The issue of equity would
The shareholders continue
to retain control
dilute the stock value. EPS
to retain control
Debt/preferred stock
would be diluted by $2.72 Timing
CCI would be able to
This would take
This would take
complete the bond
considerable time and
considerable time and
transaction faster as it is
efforts to conclude
efforts to conclude
High admin costs
Medium admin costs
Debt
just one investor Others
The bond reduces the administrative costs of having to deal with many investore
Table 1 Interest tax shield
EBIT
B on ds
Sto ck s
Preferre d stock
Bonds
Stocks
Preferre d stock
$ 12,500
$ 12,500
$ 12,500
$34,00 0
$ 34,000
$ 34,000
Continental Carriers, Inc. | [Your Name]
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Debt
Tax at 40% Available cashflows for investors
3,000
5,000
5,000
11,600
13,600
13,600
9,500
7,500
7,500
22,400
20,400
20,400
To bond holders
5,000
0
0
5,000
0
5,250.00
To preferred stock holders To stock holders
4,500
Interest tax shield
2,000
7,500
2,250
0 5,250.00
17,400
20,400
15,150
2,000
Recommendation and justification The bond option is recommended for the following reasons: 1. The company has significant assets funded by equity. Before now, it was 100% equity funded hence the debt ratio will only grow to 0.40 with the additional $50m debt. 2. The benefit of the $2m tax shield be able to generate $12.7M a year to its stockholders and investors, instead of $8.9M for equity only. 3. The stock price and earnings per share will increase to $3.87 per share with debt financing compared to EPS as equity issue of $2.72 per share.
Action plan In implementing the debt, the company should perform a critical sensitivity analysis to assess the degree of sensitivity to changes in operational and financial leverage There should be a mechanism for managing the sinking fund so as to manage the company’s cashflows. Continental Carriers, Inc. | [Your Name]
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Continental Carriers, Inc. | [Your Name]
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Appendices 1. Evaluate the financial conditions of the company? The company has been performing relatively well since 1982. Average year on year Operating revenue witnessed a growth of 9%, profit after tax of 14% and Return on equity of 6%. See exhibit 1. The company had a strong liquidity ratios. In 1987, it had a current ratio at 1.5:1, acid test ratio at 1.3:1, receivable turnover of 27 times and debtor days of 14 days. CCI had consistentlymaintained a policy of avoidinglong term debt and had rather met its financing needs through retained earnings and infrequent short term loans. The company does not have any debt. Average dividend yield was 7%.
2. How much debt can this company support? The company should support debt at the breakeven point where the EBIT is indifferent to the capital structure in place i.e the break even EPS. Break even EBIT EBIT/7500 4500EBIT= 4500EBIT7500EBIT -3000EBIT EBIT
EBIT with additional equity = EBIT with debt (EBIT-5000)/4500 7500 EBIT
-37500000
= = =
-37500000 -37500000 12500
Continental Carriers, Inc. | [Your Name]
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EBIT must be at $12.5 million to be able to support the debt of the company. In addition one can also look at the level of debt to be the point when the company’s free cashflow equals the after tax interest expense. Using the graph in exhibit 3, Secnario 1- Bond plan during a possible Recession- At this point the EPS is zero and the EBIT is $ 5million and there is no requirement to set aside a sinking fund. If the bond plan requires a sinking fund, then the company must generate free cashflows of 9.2m to service interest and sinking fund. 3. How does the cost of the proposed bond (Kd) compare with the cost of equity (Ke)? What might be accounting for the differences? Cost of Equity: 1.5/16.75= 8.96% Cost of Debt: 10-10*.4=6% (on an after tax basis The reason for the difference is the interest tax shield which would be gained from the tax savings on the debt. 4. What type / level of risk(s) should be the business be considering in taking this decision? The company should consider its degree of operating leverage i.e the extent to which changes in sales affect the changes in EBIT. The degree of financial leverage i.e changes to EPS affect EBIT and the degree of leverage i.e the extent to which changes in sales affect EPS.
Continental Carriers, Inc. | [Your Name]
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5. How do the charts of EBIT (Bond Plan and Equity Plan) assist with evaluating this decision? The chart looks at the impact of different financial performance on the capital structure of the company. It help us determine the break even EBIT and also the scenarios under which it is no more b eneficial to hold debt or equity. 6. What decision do you recommend and why? I
% change in EBIT 1982 1983 1984 1985 1986 1987 1988
% change in EPS
% change in sales
15% 15% 16% 12% 15% -11% recommend the debt option for the following reasons:
10% 6% 16% 8% 11% 5%
15% 15% 16% 12% 26% -2%
Operating leverage
Financial leverage
Degree of leverage
100% 100% 100% 100% 169% 21%
147% 241% 100% 152% 232% -46%
147% 241% 100% 152% 137% -222%
1. The company has significant assets the debt ratio will only grow to 0.40 with the additional $50m debt. 2. The benefit of the $2m tax shield be able to generate $12.7M a year to its stockholders and investors, instead of $8.9M for equity only. The stock price and earnings per share will increase to $3.87 with debt financing compared to EPS under equity financing of $2.72 per share.
ContinentaCarriers. xlsx
Continental Carriers, Inc. | [Your Name]
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