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[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 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.
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Criteria
Criteria
Bond
Equity
Preference shares
Preferred option
Flexibility
Bond
company issues
redeemable preference
debts
wish to restructure
equity issue
Risk
preference stock
is underpriced at $17.75
Equity
price.
Besides there is no
potential investor-
California Insurance
company
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Debt
Control
to retain control
to retain control
Debt/preferred stock
transaction faster as it is
efforts to conclude
efforts to conclude
Debt
EBIT
Bonds
Stocks
Preferre
d stock
Bonds
Stocks
Preferre
d stock
$
12,500
$
12,500
$
12,500
$34,00
0
$
34,000
$
34,000
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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
5,000
5,250.00
To stock holders
4,500
2,000
7,500
2,250
0
5,250.00
17,400
20,400
15,150
2,000
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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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%.
(EBIT-5000)/4500
7500 EBIT
-37500000
=
=
=
-37500000
-37500000
12500
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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.
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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
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