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    Continental Case Study

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    Natalie E Wilson
    Continental Carriers is considering options to finance the acquisition of Midland Freight. The options are: issuing common stock, preferred stock, or long-term debt. Long-term debt has the lowest cost of capital at 6% and allows for tax deductibility of interest payments. Models show that even with earnings $4-12 million lower than expected, Continental Carriers could still pay off the debt over 15 years through the annual sinking fund payments. Therefore, the document recommends issuing long-term debt in the form of $50 million bonds to finance the Midland Freight acquisition.

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    Continental Case Study

    Uploaded by

    Natalie E Wilson
    5K views11 pages
    Continental Carriers is considering options to finance the acquisition of Midland Freight. The options are: issuing common stock, preferred stock, or long-term debt. Long-term debt has the lowest cost of capital at 6% and allows for tax deductibility of interest payments. Models show that even with earnings $4-12 million lower than expected, Continental Carriers could still pay off the debt over 15 years through the annual sinking fund payments. Therefore, the document recommends issuing long-term debt in the form of $50 million bonds to finance the Midland Freight acquisition.

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    Continental Carriers is considering options to finance the acquisition of Midland Freight. The options are: issuing common stock, preferred stock, or long-term debt. Long-term debt has the lowest cost of capital at 6% and allows for tax deductibility of interest payments. Models show that even with earnings $4-12 million lower than expected, Continental Carriers could still pay off the debt over 15 years through the annual sinking fund payments. Therefore, the document recommends issuing long-term debt in the form of $50 million bonds to finance the Midland Freight acquisition.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    5K views11 pages

    Continental Case Study

    Uploaded by

    Natalie E Wilson
    Continental Carriers is considering options to finance the acquisition of Midland Freight. The options are: issuing common stock, preferred stock, or long-term debt. Long-term debt has the lowest cost of capital at 6% and allows for tax deductibility of interest payments. Models show that even with earnings $4-12 million lower than expected, Continental Carriers could still pay off the debt over 15 years through the annual sinking fund payments. Therefore, the document recommends issuing long-term debt in the form of $50 million bonds to finance the Midland Freight acquisition.

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    The key carrier Continental Carriers Inc. is considering acquiring Midland Freight Inc. for $50 million and is evaluating different financing options such as issuing common stock, preferred stock or long term debt.

    The options being considered are: issuing 3 million shares of common stock at $17.75 per share, issuing 500,000 shares of preferred stock with a dividend of $10.50 per share, or issuing $50 million in bonds with an interest rate of 10% over 15 years.

    The pros and cons of each option discussed are: for common stock - no principal/interest but dilution of ownership; for preferred stock - only pay dividends but high costs; for debt - lower costs but must pay principal/interest

    2

    Continental Carriers, Inc. Facts


    Elizabeth 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 CCIs net proceeds per share to public is $16.75 a share. Want to reconsider LT stock, due to stability in future earnings.

    Midland Freight, Inc. Facts


    Common Carrier serving Michigan and Indiana from Chicago
    Sold for $50 million cash
    To expand CCIs route system Well suited for CCIs 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

    Options
    Issue 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.

    1.

    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. 3. o 4.

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

    5.

    Sole use of debt would increase EPA to $3.87


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

    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

    Advantages and Disadvantages


    Options Pros Cons

    Debt

    Less taxes Higher EPS Lower cost of financing Higher Potential Return No payment of dividends No principal to be paid No interest to be paid

    Greater Level of risk Must pay interest 2.5 million a year, and 12.5 million at end of 15 years

    Common Stock

    High Cost of issuance Taxes Offering price could be to low? Dilution of owernship High cost of issuance Taxes Market Value of company will stay the same

    Preferred Stock

    Only pay dividends No principal to be paid No interest to be paid

    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

    Bonds Interest Payment Model


    EBIT Inflation EBIT Interest Taxable Earnings Tax (40%) After-Tax Earnings Annual Sinking Fund Principal @ Maturity Net Cash Flow EBIT Inflation EBIT Interest Taxable Earnings Tax (40%) After-Tax Earnings Annual Sinking Fund Principal @ Maturity Net Cash Flow 34000 2% 1 34000 5000 29000 11600 17400 2500 14900 22736 2% 1 22736 5000 17736 7094.4 10641.6 2500 8142 2 34680 5000 29680 11872 17808 2500 15308 3 35374 5000 30374 12149 18224 2500 15724 4 36081 5000 31081 12432 18649 2500 16149 5 36803 5000 31803 12721 19082 2500 16582 6 37539 5000 32539 13015 19523 2500 17023 7 38290 5000 33290 13316 19974 2500 17474 8 39055 5000 34055 13622 20433 2500 17933 9 39836 5000 34836 13935 20902 2500 18402 10 40633 5000 35633 14253 21380 2500 18880 11 41446 5000 36446 14578 21867 2500 19367 12 42275 5000 37275 14910 22365 2500 19865 13 43120 5000 38120 15248 22872 2500 20372 14 43983 5000 38983 15593 23390 2500 20890 15 44862 5000 39862 15945 23917 2500 12500 8917

    To prove we can pay off debt Inflation included

    2 23191 5000 18190.72 7276.288 10914.432 2500 8414

    3 23655 5000 18655 7462 11193 2500 8693

    4 24128 5000 19128 7651 11477 2500 8977

    5 24610 5000 19610 7844 11766 2500 9266

    6 25102 5000 20102 8041 12061 2500 9561

    7 25604 5000 20604 8242 12363 2500 9863

    8 26117 5000 21117 8447 12670 2500 10170

    9 26639 5000 21639 8656 12983 2500 10483

    10 27172 5000 22172 8869 13303 2500 10803

    11 27715 5000 22715 9086 13629 2500 11129

    12 28269 5000 23269 9308 13962 2500 11462

    13 28835 5000 23835 9534 14301 2500 11801

    14 29411 5000 24411 9765 14647 2500 12147

    15 30000 5000 25000 10000 15000 2500 12500 0

    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.

    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
    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

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