2
Continental Carriers, Inc. Facts Elizabeth Thorp, 1988 Treasurer Mr. Evans: President: Wants to expand revenues on existing routes through an intensive marketing effort and renewed emphasis on improving service CCI: a regulated general commodities motor carrier founded in 1952 by 3 brothers 1982: Reduced operating costs through a combination of extensive computerization of operations and improvement in terminal facilities. 1988: no debt, and avoids LT debt. Meets needs through retained earnings and proceeds from 1982 stock offering and infrequent ST bank loans. Most Common stock held by management, shares traded infrequently over the OTC Market If the market declines CCI’s net proceeds per share to public is $16.75 a share. Want to reconsider LT stock, due to stability in future earnings.
3
Midland Freight, Inc. Facts Common Carrier serving Michigan and Indiana from Chicago Sold for $50 million cash To expand CCI’s route system Well suited for CCI’s marketing and cost reductions program Closing date : October 1, 1988 Will add $8.4 million in EBIT on an annual basis Need external financing to acquire
4
Options Issue Common Stock: 3 million new shares, $16.75 per share and a dividend of $1.50 Cost nearly 9%
Issue Preferred Stock: 500,000 shares with a dividend of $10.50, par value of $100 Issue Debt (bonds): $50 million in bonds; i= 10%, n= 15 years, annual sinking fund = $2.5 million, and $12.5 million outstanding due at maturity Creates a sizeable need for cash. Current Marginal Tax rate 40%, (34% federal corporate income tax, 9% deductible state and local corporate income taxes), 10% equal to 6% on after tax basis.
5
1.
Cost of the debt issue figures did not include annual payment to sinking fund This only represents 8% of average size of bond issue over 15 year life, felt stock issue had a smaller cost than bonds Cash outlay required by bond alternative and $12.5 million maturity added considerable risk, and will make stock more speculative and cause greater variation in market price.
2.
Issuance of C/S would net 10% , or $5 mil. Per year after taxes from the acquisition. •
If 3 mil. Shares of C/S were sold, dividend requirements at rate of $1.50 would only be $4.5 million
•
Believes bond issue should be denied due to the cash demands it would require
3.
Thinks stock is a steal at $17.75, book value of firm to $45.00 per shares as of Dec. 1987, Value of firm understated o
4.
Worried that dilution of managements voting control, thinks sale of CS would be a gift . Sell of stock will dilute stocks value, measured in terms of EPS
Post acquisitions would equal $34 million EBIT
If C/S sold, EPS would be diluted $2.72
Sole use of debt would increase EPA to $3.87
Not important that sinking fund equaled $.56 per share each year.
5.
Issuance of Preferred stock
CCI was one of few major carriers, price earnings ratio was among the lowest
Suggested to sell 500,000 shares bearing a dividend rate of $10.50 and a par value of $100.
6
Problem: What to issue? What is the best method of financing the acquisition of Midland Freight, Inc.? Issue Common Stock: 3 million new shares, $17.75 per share and a dividend rate of $1.50 Issue Preferred Stock: 500,000 shares with a dividend of $10.50, par value of $100 Issue Debt (bonds): $50 million in bonds; i= 10%, n= 15 years, sinking fund = $2.5 million, and $12.5 million outstanding at maturity to a California Insurance Company
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Advantages and Disadvantages Options
Pros
Cons
Debt
• • •
• • •
Greater Level of risk Must pay interest 2.5 million a year, and 12.5 million at end of 15 years
•
Less taxes Higher EPS Lower cost of financing Higher Potential Return No payment of dividends
Common Stock
• •
No principal to be paid No interest to be paid
• • • •
High Cost of issuance Taxes Offering price could be to low? Dilution of owernship
Preferred Stock
• • •
Only pay dividends No principal to be paid No interest to be paid
• • •
High cost of issuance Taxes Market Value of company will stay the
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Financial Analysis Cost of Preferred Capital: 10.5/100= 10.5% Cost of Equity: 1.5/16.75= 8.96% Cost of Debt: 10-10*.4=6% Issuing Debt has the lowest cost of capital Use of debt= $3.87-$.56= $3.31 EPS after sinking fund payments when stock is $2.72 at the expected level of earnings after the acquisition
9
Bonds Interest Payment Model
To prove we can pay off debt Inflation included
EBIT Inflation
34000 2% 1 34000 5000
2 34680 5000
3 35374 5000
4 36081 5000
5 36803 5000
6 37539 5000
7 38290 5000
8 39055 5000
9 39836 5000
10 40633 5000
11 41446 5000
12 42275 5000
13 43120 5000
14 43983 5000
15 44862 5000
Taxable Earnings Tax (40%) After-Tax Earnings Annual Sinking Fund Principal @ Maturity Net Cash Flow
29000 11600 17400 2500
29680 11872 17808 2500
30374 12149 18224 2500
31081 12432 18649 2500
31803 12721 19082 2500
32539 13015 19523 2500
33290 13316 19974 2500
34055 13622 20433 2500
34836 13935 20902 2500
35633 14253 21380 2500
36446 14578 21867 2500
37275 14910 22365 2500
38120 15248 22872 2500
38983 15593 23390 2500
14900
15308
15724
16149
16582
17023
17474
17933
18402
18880
19367
19865
20372
20890
39862 15945 23917 2500 12500 8917
EBIT
22736
Inflation
2% 1 22736 5000 17736 7094.4
2 23191 5000 18190.72 7276.288
3 23655 5000 18655 7462
4 24128 5000 19128 7651
5 24610 5000 19610 7844
6 25102 5000 20102 8041
7 25604 5000 20604 8242
8 26117 5000 21117 8447
9 26639 5000 21639 8656
10 27172 5000 22172 8869
11 27715 5000 22715 9086
12 28269 5000 23269 9308
13 28835 5000 23835 9534
14 29411 5000 24411 9765
15 30000 5000 25000 10000
10641.6 2500
10914.432 2500
11193 2500
11477 2500
11766 2500
12061 2500
12363 2500
12670 2500
12983 2500
13303 2500
13629 2500
13962 2500
14301 2500
14647 2500
8142
8414
8693
8977
9266
9561
9863
10170
10483
10803
11129
11462
11801
12147
15000 2500 12500 0
EBIT Interest
EBIT Interest Taxable Earnings Tax (40%) After-Tax Earnings Annual Sinking Fund Principal @ Maturity Net Cash Flow
What I conclude from this model: • If their anticipated post acquisition earnings is correct they will have a positive net cash flow, even if they are off by $12 million. • They will be able to pay off debt.
10
Bonds Interest Payment Model
To prove we can pay off debt
What I conclude from this model: • If their anticipated post acquisition earnings is correct they will have a positive net cash flow, even if they are off by $4 million • They will be able to pay off debt.
11
My Suggestion Issue Long Term Debt ( Bonds) Lower cost of financing (Capital) as compared to the issuance of stock by about 3-4% Bond issue interest expenses are tax deductible Sinking fund= annual payments to debt holders (California Insurance Company) Have a higher EBIT, due to high degree of financial leverage
