Continental Carriers Inc. Case Study

Continental Carriers, Inc.

(This is not an essay. Continental Carriers, Inc. responds to each of

the comments raised by the five members of the board.)

Continental Carriers, Inc. (CCI) should take on the long-term debt to

finance the acquisition of Midland Freight, Inc. for a few reasons.

The company is heavy on assets, the debt ratio will only grow to 0.40

with the added $50M in debt. Also, the firm will benefit from an

added $2M in a tax shield and be able to return $12.7M a year to its

stockholders and investors, instead of $8.9M if equity is raised to

finance the acquisition. Lastly, the stock price and earnings per

share will increase to $3.87 in comparison to an equity-financed

acquisition of $2.72 per share. CCI would be taking a somewhat high

risk by issuing additional stock due to the uncertainty about the

offering price. Having a low P/E ratio with respect to the rest of

the market, and the replacement cost of the firm being greater than

its book value (argument 3), there is a good chance that the current

stock price and the proposed offering prices are too low.

Although long-term debt is a better financing choice a few of the

drawbacks are pointed out. Debt holders claim profit before equity

holders, so the chance that profits may be lower than expected,

increases risk to equity may reduce or impede stock value. However,

in extreme financial situations such as a recession period, CCI would

still be able to increase its cash during a recession period with all

debt capital structure. Also, there is a remaining 12.5 million that

would have to be paid at the expiration of the bonds, but that could

be paid off by issuing new bonds or additional equity at that

time.

Five members of the board raised comments that have been addressed as

follows:

1. The argument of the debt financing being a risky venture since the

proposition was to pay out to a sinking fund does not make sense.

Over the course of the next seven years, CCI had a historical growth

in revenue of 9%. This growth along with the $2M tax shelter would

easily pay for the sinking fund. In addition, by buying back bonds

annually, the interest expense is further decreased, thus creating

less of a burden on the cash flow. In contrast, an equity-financed

acquisition would spread the net income out over 3 million more

shares, thereby reducing the dividend pay-out to shareholders.

2. Another director argued that with equity financing, the

shareholders will yield a 10% EBIT of $5M. Furthermore, this director

posited that 3 million shares at $1.50 in dividends would only yield

$4.5 million dollars in a cash outflow, thereby increasing the

company’s equity by the difference each year. This argument does not

account for the $2M tax shelter that is gain in the debt financing.

The expected pay-out per share when using debt financing would be $1.7

per share compared to $1.2 per share of equity financing. The total

dividend pay out is also 1.3 M less for debt financing. Since 71% of

the assets are fixed assets, Debt ratio of .4 and current ratio of

1.34 does not seem to be a bad number.

3. Another director