Question

Have anyone worked with case study
Continental Carriers, Inc

Problem info: In may 1988 Elizabeth thorp treasurer of CCI was considering advantages and disadvantages of several alternative methods of financing CCI’s acquisition of Midland Freight Inc. At a recent meeting of the board of directors there had been substantial disagreement as to the best method of financing the acquisition. After the meeting Ms. Thorp was asked by John Evans president of CCI to assess the arguments presented by the various directors and to outline a position to be taken by management at the June directors meeting. Owners of midland agree to sell for $50 mil in cash. Midland would add $8.4 mil EBIT to CCI annually. One idea to raise funds, barring major market decline, new common stock could be sold at $17.75 per share and after fees net proceeds would be $16.75. If common stock was used, it would require issuance of 3 million new shares. CCI also sell $50 million in bonds to insurance company at 10% maturing in 15 years. An annual sinking fund of $2.5 mil would be required, leaving $12.5 million outstanding at maturity. Given tax deductibility of bond interest and CCI current marginal tax rate of 40% (34% federal corp income tax, 9% deductible state and local corp income tax) the 10% rate was equivalent to 6% on after tax basis. In contrast she felt 16.75 share and a dividend of $1.50 a share would cost CCI nearly 9%. Director 1 pointed out that this doesn’t include annual payment to sinking fund and argued that it represented 8% of average size of bond issue over 15 year life and felt the stock issue had a smaller cost than the bonds. Director 2 argue for issuance of common stock because CCI would net 10% or $5 million a year after tax from acquisition. Yet if an additional 3 million shares of common stock were issued the additional dividend requirement at $1.50 a share would be only $4.5 million a year. Director 3 argues stock was a steal at $17.75 a share. CCI policy of retained earnings had built book value of firm to $45 a share as of Dec 1987. Felt book value of assets was also understated because current value of CCI assets was below replacement cost. Dilution in of stocks value measured in terms of EPS not book or replacement value. Post acquisition earnings would be $34 mil before tax and interest. If common stock sold, EPS diluted to $2.72. Sole use of debt would increase earnings to $3.87. Sinking fund equaled $0.56 share each year. Director 4 said could also sell preferred stock. 50,000 shares bearing dividend of $10.50 per share and a par value of $100 per share.

Thank you.

Could help with this answer.

Assume CCI already had $80 million of debt outstanding at the time of the case situation. How would the interest expense and sinking fund on the $20 million of outstanding debt be incorporated into the EBIT analysis, if at all?

Answer 1

FUND REQUIREMENT = $50M= $50000000

IF $50M IS RAISED BY EQUITY ONLY (16.75 PER SHARE X 3M SHARES = $50.75M)               

post acquisition earnings = EBIT=    $34m

less interest   (105 0n existing $80m debt)= $8m

EBT=                        =                                   $26m

less tax @40%                                               $10.4m

Earnings for equity share holders                  $15.6

If common stock is sold EPS=$2.72 is given.

EPS= equity earnigs/ number of equity shares

2.72= 15.6m/number of eq shares

So number of eq shares= 5.73m shares , out of which $3m shares are out of current issue and 2.73m shares are existing

IF $50M IS RAISED BY DEBT(INTEREST OF $5M +8M EXISTING = $13M + SINKING FUND OF $2.5M IS PAYABLE

EBIT    =                                                 $34m

less int= 8+5                                         $13m

EBT                                                      $21m

less taxes @40%                                 $ 8.4

EAT                                                      $12.6m

less sinking fund                                 $2.5m

equity earnings                                    $10.1

EPS= $10.1/2.73 m shares= $3.70 per share

IF $50M IS RAISED BY PREFERENCE SHARES

ebit                                                      $34m

less int                                                $8m

EBT                                                      $26m

less taxes 40%                                   $10.4

EAT                                                      $15.6

less pref dividend$10.5x 500000)       $5.25

equity earnings                                  $10.35

EPS= $10.35/2.73m shares= $3.79 per share

WE WOULD SELECT OPTION 3 (ISSUE OF PREFERENCE SHARES) SINCE THAT GIVES THE HIGHEST EPS OF $3.79 PER SHARE