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Continental Carriers Inc Case Solution
In 1952, three brothers created CCI, a regulated general commodities motor carrier with Pacific Coast and Midwest routes. CCI didn't grow until the 1970s. By 1988, CCI's president, Mr. Evans, had concluded that acquisitions were the key to development, so the board decided to buy Midland Freight, Inc. (MFI) for $50 million. Mr. Evans decided to fund the transaction externally since the business lacked cash. Until the transaction, CCI's management avoided long-term Debt. CCI must find $50 million to buy MFI. CCI can sell the preferred stock first. This option reduces the risk for the firm. Preferred stock dilutes earnings per share but not voting rights. Company preferred stock costs 10.5%. (Exhibit 1). Sell more common stock. This option avoids risk and the $12.5 million bond maturity payment. Adding common stockholders would diminish voting rights and earnings per share, which would irritate present investors (as shown in the save). Company equity financing costs 21.96%. The third option is to sell bonds to take on Debt, which is tax-deductible and does not dilute investor interest. This option would increase the company's risk and require it to repay $12.5 million in principle at bond maturity. Company debt costs 6%.
Following questions are answered in this case study solution
Considering Continental Carriers, Inc.'s capital structure, and given the nature of the business, how much debt can it support? Evaluate the question from the interest coverage ratio perspective,
Consider the EBIT chart. What information can you extract from it?
Which Financing alternative is best for shareholders? Consider the impact of each, in turn, on the following:
i. EPS level
ii. EPS growth
iii. EPS Volatility
iv. Capacity to pay dividends
Why not assume a lot of debt?
Does the sale of new shares pose any risks or potential problems? In what sense, if any, will the sale of new shares “dilute” the stock of existing shareholders?
What do you recommend Continental Carriers, Inc. to do?
Case Analysis for Continental Carriers Inc
1. Considering Continental Carriers, Inc.'s capital structure and given the nature of the business, how much Debt can it support? Evaluate the question from the interest coverage ratio perspective.
Considering the nature of its business, Continental Carriers, Inc. has a strong financial position and can easily afford to borrow $50 million to acquire the Midland firm, which would raise the company's earnings before interest and taxes (EBIT) by $8.4 million. In addition, the firm gets the finance it requires with the help of Continental Carriers, despite the fact that it has never taken on any long-term debt.
The interest coverage ratio can be used to evaluate its capacity to support Debt. This ratio is calculated by taking the Earnings Before Interest and Taxes (EBIT) and dividing it by the Interest Expense as indicated below:
Interest Coverage ratio = EBIT / Interest Expense
This ratio shows how much earnings a company has to pay for its interest expense. Ideally, this ratio should be above 1.5 to have a sufficient cushion. In the case of CCI, the interest coverage ratio is 6.8. As per the ratio of 1.5, the company can easily support $200 million in debt, but it's only seeking $50 million, which is way less than it can support. So, the company has enough earnings to cover its interest payments.
We can also calculate the debt ratio to evaluate its financial position to sponsor Debt.
Debt Ratio = Total Debt / Total Assets
Debt Ratio = 50,600 / 253,100
Debt Ratio = 0.20
Above, we see that the debt ratio for Continental Carriers, Inc. is ideal, indicating that the firm is taking reasonable precautions with its short-term borrowing and will be able to make timely and appropriate payments in the future.
Debt-to-Equity Ratio = Total Liabilities / Total shareholders' Equity
Debt-to-Equity Ratio = 50,600 / 202,100
Debt-to-Equity Ratio = 0.25 = 25%
The debt-to-equity ratio of 0.25 indicates that all Debt is covered by equity, limiting the exposure to risk for investors. Because of this, Continental Carriers, Inc. can take on an additional $50,000,000 in long-term Debt.
2. Consider the EBIT chart. What information can you extract from it?
The Earnings Before Interest and Taxes (EBIT) chart displays the earnings per share values for the company under various scenarios that Continental Carriers, Inc. can use to finance the acquisition of Midland. These scenarios include all stocks, bonds, and one that reflects the EPS level after the sinking fund payment. The figure leads us to the conclusion that if the firm has an EBIT that is larger than $12.5 million, the bond plan is the one that will result in the highest earnings per share for the company. If the annual operating income of the firm is less than $12.5 million, the stock plan will result in higher earnings per share value. In addition, the figure shows that the bond plan offers the highest value to the company since it results in the highest profits per share of $3.87 based on the predicted levels of earnings (EBIT) following the acquisition.
On the other hand, the stock plan results in an earnings-per-share value of $2.72, which is the lowest of the three options. Even after accounting for the contribution to the sinking fund, the profits per share value is still higher than the EPS calculated for the stock plan. In a similar vein, the bond plan is one that continues to deliver a bigger amount of earnings per share even in the event that a recession is conceivable and earnings remain at a low level. However, when the economy is in a downturn, the earnings from the stock plan are higher than the earnings per share that are left over after the payment to the fund. This indicates that when the economy is in a downturn, Continental Carriers, Inc. would be more protected and have a better financial performance if the company finances the acquisition only with equity.
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