Continental Carriers Inc.

Case Analysis
Continental Carriers, Inc Continental Carriers, Inc is a regulated general commodities motor carrier who had shipping routes up and down the Pacific Coast and to parts of the Midwest. They sought to acquire Midland Freight, Inc to expand its operations and were deliberating about which method to finance the acquisition. The purchase of Midland Freight, Inc would cost $50 million in cash. CCI would gain $8.4 million to its earnings before interest and tax. There were three options that the board of directors debated over: issuing new common stock, issuing preferred stock or selling bonds. As Ms. Thorp, evaluate the impact of the bond issue and of the stock issue on the EPS. What are the risks in each alternative? The bond alternative arranges to sell $50 million in bonds to a California insurance company with an interest rate of 10 percent at maturity of 15 years. There is $2.5 million sinking fund required which leaves $12.5 million outstanding at maturity. The issues with this method are as follows: Long-term-debt can be burdensome and can stunt or slow growth of the company. The company has to payback what was borrowed plus the interest on the debt. It also puts stockholders and management who are primary holders of stock at risk, because if the company earnings are substantially lower than what was forecasted then the bondholders can virtually gain control of company. The second alternative would be the possibility of issuing new common stock of 3 million shares offered at $17.75 per share. This would bring the total common stock to 4.5 million shares outstanding. There would be many concerns if CCI decided to issue new common stock. The introduction of new shares would hurt present shareholders because it would dilute the stock and bring the value down in terms of EPS. If there is more shareholders then whatever increased earnings, if any, are reaped then it has to be shared with old and new shareholders. This creates more dependency on shareholders resulting in less flexibility for the company. There can also be a loss of control because stockholders

are effectively owners of the company. The volatility of the stock price can be greatly affected if there is one large equity holder. Also taxes would be greater because tax shield would not be applicable with this option. Should the firm use preferred stock? Preferred stock has a par value of $100, which arranges to sell 500,000 shares at a dividend rate of $10.50 per share. However, this option will not be a good idea because it has preference over common stock in the payment of dividend. One positive element is preferred shareholders would not have any voting rights. It is also could be callable by the issuer which may be unattractive to investors. There is no guarantee that investors would even want to purchase preferred stock because of the high premium to obtain it and the subpar performance by the common stock. Although this is an easy way to raise capital it would upset and agitate current stockholders and the outcome may not be good as there are not many other reasons to issue the preferred stock. How would you fund the acquisition, considering all qualitative and quantitative issues? In order to procure Midland Freight, Inc the optimal way to finance would be through the sale of bonds to the insurance company. According to Exhibit 3 the EBIT for the stock or bond will be $34 million and the EPS of stock at $2.72 and the bond at $3.87. Even after factoring in the cash set aside for the annual sinking fund, the bond EPS is at $3.31 which is still a higher EPS compared to the stock. By choosing the alternative the tax shield is used and saves on a lower taxable earning due to the interest paid back every year. Although there is a $3 million difference between after tax earnings of the stock and after tax earnings of the bond, CCI still nets $17.4 million and would have actually increased the EPS from $1 to $3.87. The value of the stock was also underpriced falling from $45.00 in December 1987 to its present price of $17.87. Issuance of new stock would only further lower the price and may force the termination of dividends. This could cause non-management shareholders to become nervous about the value of the stock and may choose to liquidate. Opting for the sale of bonds leaves more flexibility for CCI because of the types of bonds they can issue such as convertible bonds, which can be converted into common stock; a

callable bond, which allows CCI to call the bond back to redeem before maturity date; and put bonds, which gives the bondholder the right to redeem the bond before the maturity date. Issuance of the bond will keep shareholders happy by increasing its earnings before interests and taxes, increasing EPS while avoiding a decrease in the stock value.