Continental Case Study

Continental Carriers, Inc.

natalie

2

Continental Carriers, Inc. FactsElizabeth Thorp, 1988 Treasurer

Mr. Evans: President: Wants to expand revenues on existing routes through an intensive marketing effort and renewed emphasis on improving service

CCI: a regulated general commodities motor carrier founded in 1952 by 3 brothers

1982: Reduced operating costs through a combination of extensive computerization of operations and improvement in terminal facilities.

1988: no debt, and avoids LT debt.

Meets needs through retained earnings and proceeds from 1982 stock offering and infrequent ST bank loans.

Most Common stock held by management, shares traded infrequently over the OTC Market

If the market declines CCI’s net proceeds per share to public is $16.75 a share.

Want to reconsider LT stock, due to stability in future earnings.

3

Midland Freight, Inc. Facts

Common Carrier serving Michigan and Indiana from Chicago

Sold for $50 million cash

To expand CCI’s route system

Well suited for CCI’s marketing and cost reductions program

Closing date : October 1, 1988

Will add $8.4 million in EBIT on an annual basis

Need external financing to acquire

4

OptionsIssue Common Stock: 3 million new shares, $16.75 per share and a dividend of $1.50

Cost nearly 9%

Issue Preferred Stock: 500,000 shares with a dividend of $10.50, par value of $100

Issue Debt (bonds): $50 million in bonds; i= 10%, n= 15 years, annual sinking fund = $2.5 million, and $12.5 million outstanding due at maturity

Creates a sizeable need for cash.

Current Marginal Tax rate 40%, (34% federal corporate income tax, 9% deductible state and local corporate income taxes), 10% equal to 6% on after tax basis.

Arguments from Directors1. Cost of the debt issue figures did not include annual payment to sinking fund

This only represents 8% of average size of bond issue over 15 year life, felt stock issue had a smaller cost than bonds

Cash outlay required by bond alternative and $12.5 million maturity added considerable risk, and will make stock more speculative and cause greater variation in market price.

2. Issuance of C/S would net 10% , or $5 mil. Per year after taxes from the acquisition.

• If 3 mil. Shares of C/S were sold, dividend requirements at rate of $1.50 would only be $4.5 million

• Believes bond issue should be denied due to the cash demands it would require

3. Thinks stock is a steal at $17.75, book value of firm to $45.00 per shares as of Dec. 1987, Value of firm understated

o Worried that dilution of managements voting control, thinks sale of CS would be a gift .

4. Sell of stock will dilute stocks value, measured in terms of EPS

Post acquisitions would equal $34 million EBIT

If C/S sold, EPS would be diluted $2.72

Sole use of debt would increase EPA to $3.87

Not important that sinking fund equaled $.56 per share each year.

5. Issuance of Preferred stock

CCI was one of few major carriers, price earnings ratio was among the lowest

Suggested to sell 500,000 shares bearing a dividend rate of $10.50 and a par value of $100.

6

Problem: What to issue?

What is the best method of financing the acquisition of Midland Freight, Inc.?

Issue Common Stock: 3 million new shares, $17.75 per share and a dividend rate of $1.50

Issue Preferred Stock: 500,000 shares with a dividend of $10.50, par value of $100

Issue Debt (bonds): $50 million in bonds; i= 10%, n= 15 years, sinking fund = $2.5 million, and $12.5 million outstanding at maturity to a California Insurance Company

7

Advantages and DisadvantagesOptions Pros Cons

Debt • Less taxes• Higher EPS• Lower cost of financing

Higher Potential Return• No payment of dividends

• Greater Level of risk• Must pay interest• 2.5 million a year, and 12.5

million at end of 15 years

Common Stock • No principal to be paid• No interest to be paid

• High Cost of issuance• Taxes• Offering price could be to low?• Dilution of owernship

Preferred Stock • Only pay dividends• No principal to be paid• No interest to be paid

• High cost of issuance• Taxes• Market Value of company will

stay the same

8

Financial Analysis

Cost of Preferred Capital: 10.5/100= 10.5%

Cost of Equity: 1.5/16.75= 8.96%

Cost of Debt: 10-10*.4=6%

Issuing Debt has the lowest cost of capital

Use of debt= $3.87-$.56= $3.31 EPS after sinking fund payments when stock is $2.72 at the expected level of earnings after the acquisition

9

Bonds Interest Payment Model

To prove we can pay off debtInflation included

What I conclude from this model:• If their anticipated post acquisition earnings is correct they will have a

positive net cash flow, even if they are off by $12 million.• They will be able to pay off debt.

EBIT 34000Inflation 2%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15EBIT 34000 34680 35374 36081 36803 37539 38290 39055 39836 40633 41446 42275 43120 43983 44862Interest 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000Taxable Earnings 29000 29680 30374 31081 31803 32539 33290 34055 34836 35633 36446 37275 38120 38983 39862Tax (40%) 11600 11872 12149 12432 12721 13015 13316 13622 13935 14253 14578 14910 15248 15593 15945After-Tax Earnings 17400 17808 18224 18649 19082 19523 19974 20433 20902 21380 21867 22365 22872 23390 23917Annual Sinking Fund 2500 2500 2500 2500 2500 2500 2500 2500 2500 2500 2500 2500 2500 2500 2500Principal @ Maturity 12500Net Cash Flow 14900 15308 15724 16149 16582 17023 17474 17933 18402 18880 19367 19865 20372 20890 8917

EBIT 22736Inflation 2%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15EBIT 22736 23191 23655 24128 24610 25102 25604 26117 26639 27172 27715 28269 28835 29411 30000Interest 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000 5000Taxable Earnings 17736 18190.72 18655 19128 19610 20102 20604 21117 21639 22172 22715 23269 23835 24411 25000Tax (40%) 7094.4 7276.288 7462 7651 7844 8041 8242 8447 8656 8869 9086 9308 9534 9765 10000After-Tax Earnings 10641.6 10914.432 11193 11477 11766 12061 12363 12670 12983 13303 13629 13962 14301 14647 15000Annual Sinking Fund 2500 2500 2500 2500 2500 2500 2500 2500 2500 2500 2500 2500 2500 2500 2500Principal @ Maturity 12500Net Cash Flow 8142 8414 8693 8977 9266 9561 9863 10170 10483 10803 11129 11462 11801 12147 0

10

Bonds Interest Payment Model

To prove we can pay off debt

What I conclude from this model:• If their anticipated post acquisition earnings is correct they will have a

positive net cash flow, even if they are off by $4 million• They will be able to pay off debt.

11

My Suggestion

We want to choose the most effective and cost advantage option available:

Issue Long Term Debt ( Bonds)

Lower cost of financing (Capital) as compared to the issuance of stock by about 3-4%

Bond issue interest expenses are tax deductible

Sinking fund= annual payments to debt holders (California Insurance Company)

Have a higher EBIT, due to high degree of financial leverage