Continental Carriers

I. Case Context Continental Carriers, Inc., (CCI) is known as a regular commodities motor carrier. Since its inception, it has experienced continuous growth in revenues and mastered the strategic reduction of operating costs. It soon became known in the trucking industry as a widely profitable key player. In order to sustain continuous growth in revenues and income, management has decided that key acquisitions need to be made. The top contender, Midland Freight, Inc., a common carrier company would expand CCIs route system. The prospect company also demonstrated congruence with the type of marketing and cost reduction programs that ushered CCIs growth. The owners of Midland agreed to sell it for $50 million in cash. Since the stipulation was for cash, the funds would have to be acquired externally so as to prevent cash flow problems that would disrupt operations for CCI. One of the primary considerations was that the pending merger would provide additional $8.4 million annually in Earnings before interest and taxes (EBIT) making it easy for management to seek external funds. Another serious consideration was that CCI has always had a consistent policy of having no long-term debt in its capital structure. In 1988, the current year, the companys capital structure was purely composed of common stock and surplus. In addition, most of the common stock was being held by management. Furthermore, there is no dominant interest except that of management. Ms. Thorp, the CCI treasurer proposed 2 options. The first proposal included an issuance of 3 million shares of new common stock, in line with the no long-term debt policy of the company. However, Ms. Thorp and president, Mr. Evans had not been satisfied with the performance of the common stock of the company in the market in recent years. Thus they decided to reconsider taking on a long-term debt in the form of a $50 million bond issue, with 15 years to maturity at an interest rate of 10% with a yearly $2.5 million sinking fund. During the meeting, some directors had reservations regarding bond issue, in particular, the sizable need for cash in sustaining the bond until maturity, especially sinking fund requirement. This relative degree of indebtedness, naturally would add sizable risk to the company leading to greater speculation and thus variation in the market price of CCI stock. They also argued that the new issue of common stock will not hurt existing stockholders. However, the bond issue would increase EPS to $3.87. Although CCI was

one of the few in the trucking industry that did not make use of long term debt, their price earnings ratio was also one of the lowest. Other directors also had their own reservations regarding the issue of new common stock. They argued that CCI stock was currently undervalued giving new stockholders a lucky strike whilst diluting the voting control of existing management. Also, issuing new stock would decrease EPS to $2.72. Other directors also suggested the option of issuing preferred stock. II. Problem Definition Faced with the approved acquisition plan of Midland Freight, Continental Carriers must determine its best financing source. Under the leadership of Elizabeth Thorp, the best alternative must be presented to the board of directors given the numerous concerns brought up during the past meeting. III. Decision Framework The options available for long term financing are the sale of $50 million in bonds to a California insurance company with a provision of an annual payment of $2.5 million to a sinking fund, issuance of 3 million shares of common stock at $17.75 per share at net $16.75 with dividend payments of $1.5 per share, or issuance of 500,000 shares of preferred stock at par $100 with dividend payments of $10.5 per share. Given these options, the company must first assess its current operating and financial position by obtaining income and dividend data for 1988, before the effects of the acquisition can be reflected. The next step is to input the effects of the acquisition on earnings before interest and taxes, interest expense, tax expense, dividends and key financial indicators such as the degree of financial leverage, the debt ratio, earnings per share, and the resulting effective interest rate under each of the alternatives. This will allow the company to see which alternative will provide the company with the most benefits compared to the current situation and to other alternatives. After this has been done, it will be useful for the company to graphically represent the relationship between the EPS and EBIT for each financing plan. This graph should also indicate the desired level of dividends, the potential additional earnings brought about by the acquisition, as well as earnings should a recession occur. Following this step, the company should determine all cash inflows and outflows for the fifteen years associated with each alternative form of financing. Doing so will expose the feasibility of pursuing any one strategy, given the companys anticipated revenues and costs. Only differential costs and revenues tied to each strategy should be used in the

analysis. Lastly, the company must take into consideration any qualitative factors that could influence the decision such as company policy and market performance. The companys choice of financing will be based on the option that maximizes the wealth of existing stockholders, allows the company to exploit future earnings, and will reduce the risk faced by the company, its creditors and stockholders. IV. Analysis Income and dividend data before the acquisition and under each financing plan are listed in the table below. Figure 1 (in $000) [pic] The company currently does not pay any interest expense because it does not use any long-term debt. The earnings per share is $3.41, and the company has a relatively low debt ratio of about 20%. This indicates that the company is very heavy on its assets that are not financed through long-term liabilities. Because the acquisition will add $8.4 million dollars to earnings before interest and taxes, each of the EBITs under each alternative will increase to $34 million. Under the bond issue, interest of $5 million will be paid out on the first year. Taxes will amount to $11.6 million, compared to $13.6 million under the other types of issues. This means that there is a $2 million tax shield associated with the bond issue. The deduction of these taxes will result in after-tax earnings of $17.4 million. This level of earnings is higher than the current level, although less than the after-tax earnings associated with either the common stock or preferred stock issue. The bond and preferred stock issues impose restrictions on the amount of income available to common stock holders. Under the bond issue, $2.5 million must first go into a sinking fund which will be used to retire the bonds on an annual basis. Dividends to preferred stock holders must also be paid before dividends to common stock holders can be paid. If the company continues to pay dividends to its stockholders at a level of $1.5 per share, there will be more than enough from earnings in year one to do so under all three arrangements. Under the common stock and preferred stock issue, after-tax income will rise to $20.4 million. Despite the higher level of income, just about the same amount is left after payments of dividends because of the increase of shares issued and in the case of preferred stock, the higher dividend rate of $10.5 per share.

In the aspect of earnings per share, only the bond issue will increase EPS to $3.87 from its current level of $3.41. The common stock issue will reduce the EPS to $2.72, owing to the increased number of shares issued. The preferred stock issue will reduce EPS to $3.37 because of the decreased amount of income available to common stock holders after accounting for dividends paid to common stock holders. In this aspect, it is the bond issue that will maximize the wealth of the existing stock holders. In terms of the degree of financial leverage, which shows the effects of a change in EBIT on EPS, only the bond issue has a positive DFL. This means that a change in the level of EBIT will positively affect the EPS. Both stock issues result in negative DFLs. The relatively small DFL under the preferred stock issue indicates that although only a small decrease in EPS will occur for a given increase in EBIT, the company will not be able to take advantage of this increase. It will not be magnified with the use of preferred stock. In the case of common stock, the losses suffered for every increase in EBIT is even greater. The debt ratio will increase to 33% after the acquisition of Midland. This is still an acceptable level given the nature of the companys operations. The debt ratio under the stock issues will decrease because the assets were acquired without using any debt. Lastly, the cost of capital for the bond issue is only 6% after taxes. The sinking fund payment need not be taken into account in the calculation of this rate. The common stock issue results in an effective interest rate of about 9%, while the preferred stock issue results in a rate of 11%. Clearly, the bond issue is the least costly form of financing. Figure 2 [pic] The graph of the financing plan above shows the EPS associated with each specific EBIT value for the stock and bond financing alternatives. Employing the EBIT EPS approach to capital structure underlines the maximization of owners returns, represented by EPS, over a given expected range of earnings. The maximization of EPS is stressed as it signifies the maximization of the stock price (i.e., owners wealth), which is the primary goal of the financial manager. At an EBIT level of $12,500,000, the stock plan and the bond plan both yield an EPS of $1.00. At the $20,000,000 EBIT level, representing a possible recession level of earnings, the bond plan gives a higher EPS of $2.00 as opposed to the stock plan EPS of approximately $1.75. At the $34,000,000 EBIT mark, which is the expected EBIT after the Midland Freight acquisition, the EPS associated with the bond plan is $1.15 higher than the EPS associated with the stock plan. The bond plans EPS is $3.87, while the stock plans EPS is only $2.72. It is also clearly illustrated that over the range of $20 million to $35 million in earnings, the bond plan consistently presents a higher EPS than the stock plan. The preferred stock line (not shown) will be

located between the stock plan and bond plan lines. The bond plan line will still provide the highest EPS for a given EBIT. The data on the EBIT EPS axes can also be used to assess the relative risk of the two alternatives. The first measure is the financial breakeven point, which is the xintercept of each capital structure line. The financial breakeven point is the level of EBIT needed to cover all fixed financial costs; therefore a lower breakeven point indicates a lower level of financial risk. The financial breakeven point of the stock plan is $0, while the breakeven of the bond plan is $5 million. Another measure of financial risk is the degree of financial leverage, which is shown by the slope or steepness of the capital structure line. The line of the bond plan is steeper than the line of the stock plan, which again implies that the bond plan has a greater level of financial risk. The higher risk of the bond plan makes sense because it is the alternative that gives the higher return to owners (EPS). Figure 3 [pic] The above table shows the incremental cash flows of Continental Carriers, Inc. for the succeeding 15 years. The companys acquisition of Midland Freight, Inc. is believed to result in an $8.4 million increase in earnings before interest and taxes yearly. Annual outflows consist of a 6% interest applied to the remaining balance, and a fixed sinking fund of $2.5 million. At the end of 15 years, the total sinking fund paid would amount to $37.5 million. Should the company choose to issue bonds, it will be able to generate $50 million, leaving it with $12.5 million to pay back the balance. Inflows associated with the common stock and preferred stock are also an additional $8.4 million, but outflows only consist of dividend payments. No principal has to be repaid in the future. And every year, all dividend payments can be made with the company. Although CCIs management had consistently followed the company policy of avoiding long-term debt as a financing source, it is in the best interest for the firm to reconsider the advantages of this option. Short-term bank loans and retained earnings had previously been relied on for financing, but due to the long-term nature of the acquisition, it is necessary to pursue a more appropriate alternative. Currently, the declining market performance and the uncertainty of the offering price for new common stock provide reasons for raising the required funds through debt. Given that the acquisition will bring about additional inflows to the firm, using debt to raise funds will be viewed positively by existing shareholders, as they will fully capture the total increased value of their stocks. Although obligations to creditors will be prioritized over

dividend payments, current stockholders should not see this as a cause for concern as the firm intends to sustain its annual dividend payments. Moreover, without having to issue new shares of common stock, management can continue to maintain its voting control. The option for issuing preferred stock will bring about no additional benefit to the company as the market value of the firm will remain the same whether additional common stock or preferred stock are issued. Rather than increasing annual dividend payments by $5.25 million, selling bonds is a better alternative in terms of maximizing shareholder wealth. Therefore, Thorp was right in not considering preferred stock as a possibility for financing. V. Decision The most practical financing source for CCI would be to acquire long term debt through the sale of bonds worth $50 million to a California insurance company. During the directors meeting in June, Elizabeth Thorp will present to the board the numerous advantages of this option that greatly outweigh the high costs of issuing shares of either common or preferred stock. In conclusion, the sale of bonds to acquire the required funds would attain the set objectives for the company. Wealth of the existing stockholders would be maximized while reducing the risk faced by CCI, its creditors and its current shareholders. VI. Justification Although the use of bonds will not increase after-tax earnings as much as the use of stock, it is still justified because the bond issue results in interest expenses which are taxdeductible, and a $2 million tax shield is realized. This means the company will save $2 million dollars in taxes by using the bond scheme. Also, even after accounting for annual payments into a sinking fund, the company will have more than enough left to pay common stock holders dividends of $1.5 per share. This move will continue to improve the market perception of the companys stock. The bond issue is also the option that will maximize shareholder wealth by increasing the EPS to $3.87. Under this option, the company will be able to take advantage of the increases in EBIT using the bond issue, as evidenced by the highest DFL associated with this plan. Even though the debt ratio will increase, 33% is still very acceptable given that the companys operations rely heavily on assets. Not only does the bond issue provide the most number of benefits, but it also has the least costs, as given by the after-tax cost of capital of 6%.

Utilizing the EBIT-EPS approach via graphical analysis shows that the bond plan yields a higher return than the stock plan, which is reflected by the higher EPS provided by the bond alternative over the range of possible EBIT levels given by CCI. At the possible recession of level of earnings, the EPS associated with the bond plan is $0.25 higher than that of the stock plan. In the expected post-acquisition EBIT level of $34 million, the EPS of the bond plan is $1.15 higher than the stock plans. The EPS of the bond plan is considerably higher over the range of $20 million to $34 million EBIT levels, showing that the bond financing alternative is more effective in maximizing returns, thus making it the more desirable option. As emphasized by the cash flow table (figure 3), annual debt repayments throughout the 15 years are completely feasible. Deducting the decreasing yearly interest payments and $2.5 million sinking fund each year from the expected annual expected earnings of $8.4 million, it is exhibited that the $12.5 million outstanding at maturity can easily be repaid from the total net cash inflow of $29.75 million (check this number). As emphasized by the cash flow table (figure 3), annual debt repayments throughout the 15 years are completely feasible. Deducting the decreasing yearly interest payments and $2.5 million sinking fund each year from the expected annual expected earnings of $8.4 million, it is exhibited that the $12.5 million outstanding at maturity can easily be repaid from the total net cash inflow of $59.25 million. The low PE ratio of the company as compared to the industry average is an indicator of the perception of the market on the performance of the company. In spite of the high potential of the acquisition, it would not be beneficial for the firm to issue new shares. First and foremost, it would be difficult to sell these common stocks as the market exhibits low confidence in the CCIs ability to generate revenues from its pipeline of projects. Also, with the use of debt, no further problems of company ownership and management will surface because no new additional stocks will be issued. VII. Implementing Steps To issue $50 million in bonds, CCI must first approach a California insurance company to set the contract. In this indenture, terms of payments must be defined, including the 10% interest rate applied on these bonds with a 15-year maturity, and the requirement of an annual sinking fund of $2.5 million. After the bonds have been issued, the funds acquired will be used for CCIs acquisition of Midland freight, Inc. The terms of the merger must be settled after the acquisition. The expansion of the route system and implementation of marketing and cost reduction programs must also be decided upon.

Throughout the duration of the bond financing plan, CCI must strictly adhere to the terms of payments of the bond issue. It must meet its interest payments, and comply with the annual sinking fund of $2.5 million and the $12.5 million payment at maturity. The existing shareholders of CCI must be satisfied through the declaration and payment of annual dividends at $1.50 per share from the companys retained earnings. Finally, CCI must ensure that all operational agreements with Midland Freight are closely monitored to sustain company growth and to maximize owners wealth.