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Continental Carriers, Inc.

[Your Name]

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

The decision problem facing Ms. Thorp, the treasurer of CCI is how to address the board
of directors concerns about the financing options she had presented to them. These
options were as follows:
1. Bond financing- A long term bond that would mature in 15 years. Interest rate on the
bond is 10% and an annual sinking fund of 12.5 million would be required.
2. Equity option To issue three million new common shares at &17.75 per share. After
transaction costs would be $16.75 per share.
3. A third option suggested by one of the directors is 50,000 preference stock with a
$100 par value. Dividend on the preference stock is $10.5 per share.

Continental Carriers, Inc. | [Your Name]

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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

Risk

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


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
companys 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% Cost of Equity: 1.5/16.75=


8.96%
(on an after tax basis)

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

Bonds

Stocks

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

To preferred stock holders

5,000

5,250.00

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 companys 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 consistently maintained a policy of avoiding long 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.
EBIT with additional equity = EBIT with
Break even EBIT debt
EBIT/7500
4500EBIT=
4500EBIT7500EBIT
-3000EBIT
EBIT

(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 companys 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 beneficial to hold debt or equity.
6. What decision do you recommend and why?
I

% change in
EBIT

% change in
sales

1982
15%
10%
1983
15%
6%
1984
16%
16%
1985
12%
8%
1986
15%
11%
1987
-11%
5%
1988
recommend the debt option for the following reasons:

%
change
in EPS

15%
15%
16%
12%
26%
-2%

Operating
leverage

Financial
leverage Degree of leverage

147%
241%
100%
152%
137%
-222%

100%
100%
100%
100%
169%
21%

147%
241%
100%
152%
232%
-46%

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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