Continental Carriers free essay sample

Continental Carriers is a general commodity motor carrier and has been since 1952, and they recently experienced successful growth since Mr. Evans focused on improving service, as well as an extensive marketing effort to boost their revenues in their already existing routes. He also implemented a way to reduce costs through computerization of operations as well as an improvement in terminal facilities to improve the company’s structure. This has since made CCI become a much larger company and has become extremely profitable by posting an income after taxes of $15. 36 million dollars alone in the year of 1988 of and is now looking to expand. Ms. Thorp, the treasure of CCIs now proposed an acquisition of Midland Freight Inc. to expand their business by 50% and increase their EBIT by 8. 4 million dollars per year. They have ran into the problem whether to finance solely on debt or by issuing common stock to obtain the 50 million dollars in cash they need to acquire Midland Freight Inc. The directors of the company have selected Midland Freight, Inc which they believe would fit seamlessly with their current operations, the agreed acquisition price is $50 million in cash which would have to be financed externally. The purpose of this analysis is to analyze financing strategies for CCIs acquisition of Midland Freight and decide which would be in the best interest of Continental Carriers, Inc and its stakeholders. Analysis Ms. Thorp has proposed two financing options that she has found suitable for their current situation, both of which she finds plausible for the company to be able to execute in a timely manner. Ms. Thorp believes that if they choose to issue common stock and issue it at $16. 75 with a dividend of 1.50 it could possibly dilute the stock and cost CCI by more than 9% but has proposed this as one of the potential strategies. She has also proposed that they could sell 50 million dollars in bonds and finance through long-term debt, which would be a first for CCI because they have never had to raise this much capital prior and therefore have never financed in debt before We have evaluated their two ways to finance their current acquisition of Midland Freight Inc and have come up with the following appraisal costs. Bond Issue During the two decades that Continental Carriers, Inc has been in business they have always maintained a standing policy of avoiding long term debt; and is currently one of the few companies in this industry that have no long-term debt in their capital structure, their current debt ratio lies at about . 2 (Kester, 1991). In addition to foregoing a long standing point of pride, issuing debt is another concern to the company because of the large cash requirements that are included with this option, namely the $12. 5 million due at maturity for the sinking fund. An advantage of debt financing was that the earnings per share was projected to increase to $3. 86 with $. 56 of that amount would be contributed to the sinking fund (Kester, 1991). The net EPS would be roughly $3. 20 which is $0. 21 less than the EPS in 1988, however this is still a favorable situation for the company as they have no other substantial debt. Another positive aspect of this option is the tax advantage derived from debt financing, the interest paid on bonds is deductible from the company’s tax return; this $2 million annual tax shelter can offset the sinking fund of $2.5 million per year for 10 years. There is also the option of buying back bonds to reduce the interest price. Long term Debt: N=15 years Periods= 30 (based on the assumption that a bond makes semi-annual payments) Interest=10% Paid annually Present Value of Principle=$2,865,427. 67 Present Value of Annuity=$45,454,545. 45 Total Cost of Bond Financing = $48,319,973. 12 *Plus an additional 2. 5 million dollars per year in sinking fund costs. Over 15 years that additional cost will be 37. 5 million dollars Total Cost of Long Term Debt Financing: Plus an additional $12. 5 million dollar still due at maturity. Stock Issue Based on their current business, the estimated additional after-tax revenue post-acquisition of Midland Freight, Inc would be $5 million. If the company issues an additional 3 million shares, dividend payments would amount to at least $4. 5 million. In addition to this with respect to book value and retained earnings the current stock is currently undervalued by approximately 61%. If the 3 million shares are sold the already undervalued stock will not only be further diluted to $2.72 earnings per share, but it would also dilute managements controlling vote within the company. However an advantage of issuing new common stock is that a principal does not need to be repaid and neither do interest payments when compared to financing through debt. Common Stock: Cost of Common Stock issue: Ordinary stock issuance: 4,500,000 shares $1 par value $17. 75 a share; proceeds of $16. 75 a share ($1 disparity) Dividend: $1. 50 a share New issuance: 3,000,000 shares Diluted EPS: $2. 72 $2. 72 x 7,500,000 shares = $20,400,000 Transaction Cost of Issuance= $3,000,000 x $1 $23,400,000 Total Cost of Common Stock=$20,400,000 +$23,400,000= 43,800,000 Preferred Stock Issue An option for preferred stock is to issue 500,000 shares at a $10. 50 DPS with a par value of $100 (Kester, 1991). Being preferred stock, CCI would have to pay $5. 25 million in dividends each year to preferred stockholders only, this would decrease the dividend that is currently paid out to those who own common stock, to less than a $1. 00 per share. A decrease that would likely lead to a decrease in overall stock price as well. This action would have a negative impact on the EPS dropping it to $3. 36 (Kester, 1991). This action would be unlikely for management for two main reasons. First, the stock is owned primarily by the management itself. Second, it is the managements’ duty to act in the best interest of its shareholders; a move like this would act in opposition of this fundamental duty. Recommendation Effective and aggressive yet responsible management has been essential to the success of Continental Carriers, Inc along with a sound business and healthy financials. They have relied on the revenue from their IPO in 1982 and infrequent short-term bank loans to finance their operations until now, and are only in need of considerable external financing because they want to further expand their business by acquisition. The acquisition of Midland Freight, Inc would increase CCI’s earnings by a projected $8. 4 million a year before interest and tax, which would be a little more than $5 million after taxes and interest. Although CCI is a profitable business under excellent management their stock has not performed well in the market, undervalued as mentioned before by about 61%, with respect to their book value, and traded infrequently. CCI prides itself being one of the few businesses in its industry that have been able to steer clear of accumulating substantial long term debt, however in our estimation this tradition has to end in order for the company to achieve its expansion goals. Debt financing for this acquisition is the best option for Continental Carriers, Inc for a multitude of reasons. Firstly, the $1. 15 difference in earnings per share between debt and equity financing, favors the debt option. Their debt and current ratios are only . 2 and 67 respectively and after debt financing will only increase to . 4 and 1. 34, which are still healthy ratios. The company’s annual after tax income has been steadily growing at an approximate 10% rate for the past 5 years, ranging between $7. 2 15. 7 million, accompanied with the $2 million tax shelter and the additional $8. 4 million cash flow after the acquisition; CCI should pursue issuing debt to finance its acquisition.