Question

The Howland Carpet Company has grown rapidly during the past 5 years. Recently, its commercial bank urged the company to consider increasing its permanent financing. Its bank loan under a line of credit has risen to $200,000, carrying a 8% interest rate. Howland has been 30 to 60 days late in paying trade creditors.

Discussions with an investment banker have resulted in the decision to raise $400,000 at this time. Investment bankers have assured the firm that the following alternatives are feasible (flotation costs will be ignored).

• Alternative 1: Sell common stock at $8.
• Alternative 2: Sell convertible bonds at a 8% coupon, convertible into 100 shares of common stock for each $1,000 bond (i.e., the conversion price is $10 per share).
• Alternative 3: Sell debentures at a 8% coupon, each $1,000 bond carrying 100 warrants to buy common stock at $10.

John L. Howland, the president, owns 80% of the common stock and wishes to maintain control of the company. There are 100,000 shares outstanding. The following are extracts of Howland's latest financial statements:

Balance Sheet
			Current liabilities	$400,000
			Common stock, par $1	100,000
			Retained earnings	50,000
Total assets	$550,000		Total claims	$550,000

Income Statement
Sales	$1,100,000
All costs except interest	990,000
EBIT	$   110,000
Interest	16,000
EBT	$     94,000
Taxes (40%)	37,600
Net income	$     56,400
Shares outstanding	100,000
Earnings per share	$         0.56
Price/earnings ratio	15.16
Market price of stock	$         8.55

1. Show the new balance sheet under each alternative. For Alternatives 2 and 3, show the balance sheet after conversion of the bonds or exercise of the warrants. Assume that half of the funds raised will be used to pay off the bank loan and half to increase total assets.
2. Show Mr. Howland's control position under each alternative, assuming that he does not purchase additional shares. Round your answers to the nearest whole number, if necessary.
3. What is the effect on earnings per share of each alternative, assuming that profits before interest and taxes will be 20% of total assets? Round your answers to the nearest cent.
4. What will be the debt ratio (TL/TA) under each alternative? Round your answers to the nearest whole number, if necessary.

Answer 1

(a) Alternative 1:

Total Assets	950,000
Current liabilities	400,000
Common Stock	500,000
Retained Earnings	50,000
Total Equity And Liabilities	950,000

Alternative 2:

Total Assets	750,000
Current liabilities	200,000
Convertible bonds @8%	400,000
Common Stock	100,000
Retained Earnings	50,000
Total Equity And Liabilities	750,000

Alternative 3:

Total Assets	750,000
Current liabilities	200,000
8% Debentures	400,000
Common Stock	100,000
Retained Earnings	50,000
Total Equity And Liabilities	750,000

(b) Alternative 1:

Shares = 100,000

New shares (400,000/8) = 50,000

Total outstanding shares = 150,000

Shares held by Mr. Howland = 80,000

Thus, controlling power = 80,000 / 150,000 *100

= 53.33%

Alternative 2:

Controlling power = 80%

Alternative 3:

Controlling power = 80%

(c)

	Alternative 1	Alternative 2	Alternative 3
Total assets	950,000	750,000	750,000
Profit (20%)	190,000	150,000	150,000
Less: Interest on Loan	(200,000 * 8%) = 16,000	(400,000 * 8%) = 32,000	(400,000 * 8%) = 32,000
EBT	174,000	118,000	118,000
Less: Tax @40%	69,600	47,200	47,200
Net income	104,400	70,800	70,800
Divide by Total outstanding shares	150,000	100,000	100,000
EPS	0.696	0.708	0.708

(d) Debt ratio = Total debt/Total assets

	Total debt	Total assets	Debt ratio
Alternative 1	400,000	950,000	0.42
Alternative 2	600,000	750,000	0.80
Alternative 3	600,000	750,000	0.80