Should Continental Carriers, Inc. use debt or equity to finance the acquisition of Midland Freight in 1988, either by selling $50 million in bonds at a 10% interest rate to a California insurance company with a maturity of 15 years, or by issuing 3 million in common stock at $17.75 per share with a dividend rate of $1.50 per share?
The outcomes of various financial alternatives can be examined through an EPS-EBIT analysis, where EPS is calculated for each alternative form of financing. Earnings per share represent the amount of income common stockholders are entitled to receive per share of stock owned. This income can be paid out in the form of dividends, retained earnings, or a combination of both. Earnings before interest and taxes (EBIT) is the amount of income after subtracting operating expenses from gross sales, also called net operating income. The EPS-EBIT approach determines the best capital structure by considering various funding sources to maximize earnings per share (EPS) over the firm’s expected range of earnings before taxes and interest (EBIT).
III.Application of Financial Framework
A measure of EPS against EBIT, showing how change in the capital structure affects EPS, can be seen in Exhibit C. Given a possible recession, financial investors perceive that the firm’s EBIT will be $20 million. If the firm has no leverage with only outstanding shares of 7.5 million the EPS is $1.60. However, with a leveraged situation with an interest of $5 million of shares of 4.5 million the EPS is $2. The EPS of $1.60 and $2 during the proposed recession represents the number of dollars earned during the period on behalf of each outstanding share of common stock. However, the proposition for the issue of bonds, excluding the account for the sinking fund is more attractive, as shareholders earn $0.40 more than in the case of no leverage.
Exhibit A presents the 1988 estimates when the firm still has not acquired Midland Freight and doesn’t choose a method of financing. Given the income before tax of $25.6 million and the proposed additional $8.4 million EBIT with the acquisition, Continental Carriers projected EBIT is $34 million. With this increase in EBIT, the EPS for each capital structure changes. When the acquisition is financed through the bond issue, the EPS is $3.87. When the proceeds from the issue of additional stock are used the finance the acquisition the EPS is $2.72.
IV.Assumptions and Special Circumstances
Continental Carriers assumes an increase in EBIT of $8.4 million with the acquisition of Midland Freight, for a total projected EBIT of $34 million in 1988; given a possible recession, the EBIT will be $20 million.
V.Conclusions and Recommendations
It is suggested that the acquisition of Midland Freight be financed through long term debt via the sale of $50 million in bonds to the California insurance company. By choosing the debt alternative Continental Carriers will benefits from higher earnings per share. As seen in Exhibit 3, once the company has earnings before interest and tax of $12.5 million and above, they are in a position to allow long term debt since the EPS would be greater than $1.00. If the firm had issued common stock instead, EPS would be lower at $2.72 as compared to $3.87. As suggested by Ms Thorpe, the stock at $16.75 per share and a dividend of $1.50 per share would cost CCI nearly 9% whereas the bond’s after tax rate of interest was only 6%. Issuing stock is therefore more expensive than the bond alternative and there is also the risk of management’s voting control being diluted by the issuing of the common stock.
With $12.5 million outstanding at expiration date, Continental Carriers can either settle this by a short term loan or by issuing common stock. Issuing common stock may be a viable option as much less shares will be needed as compared to 3 million as before. Assuming that the market price remains the same, only 704,226 shares would have to be issued.