ContinentalCarriersInc.

CaseAnalysis
ContinentalCarriers,Inc.
ContinentalCarriers,Inc.isaregulatedgeneralcommoditiesmotorcarrierwhohadshipping
routesupanddownthePacificCoastandtopartsoftheMidwest.Theysoughttoacquire
MidlandFreight,Inc.toexpanditsoperationsandweredeliberatingaboutwhichmethodto
financetheacquisition.ThepurchaseofMidlandFreight,Inc.wouldcost$50millionincash.
CCIwouldgain$8.4milliontoitsearningsbeforeinterestandtax.Therewerethreeoptions
thattheboardofdirectorsdebatedover:issuingnewcommonstock,issuingpreferredstock
orsellingbonds.

AsMsThorp,evaluatetheimpactofthebondissueandofthestockissueonthe
EPS.Whataretherisksineachalternative?
Thebondalternativearrangestosell$50millioninbondstoaCaliforniainsurancecompany
withaninterestrateof10percentatmaturityof15years.Thereis$2.5millionsinkingfund
requiredwhichleaves$12.5millionoutstandingatmaturity.Theissueswiththismethodare
asfollows:Longtermdebtcanbeburdensomeandcanstuntorslowgrowthofthecompany.
Thecompanyhastopaybackwhatwasborrowedplustheinterestonthedebt.Italsoputs
stockholdersandmanagementwhoareprimaryholdersofstockatrisk,becauseifthe
companyearningsaresubstantiallylowerthanwhatwasforecastedthenthebondholderscan
virtuallygaincontrolofcompany.
Thesecondalternativewouldbethepossibilityofissuingnewcommonstockof3million
sharesofferedat$17.75pershare.Thiswouldbringthetotalcommonstockto4.5million
sharesoutstanding.TherewouldbemanyconcernsifCCIdecidedtoissuenewcommon
stock.Theintroductionofnewshareswouldhurtpresentshareholdersbecauseitwoulddilute
thestockandbringthevaluedownintermsofEPS.Ifthereismoreshareholdersthen
whateverincreasedearnings,ifany,arereapedthenithastobesharedwitholdandnew
shareholders.Thiscreatesmoredependencyonshareholdersresultinginlessflexibilityfor
thecompany.Therecanalsobealossofcontrolbecausestockholdersareeffectivelyowners
ofthecompany.Thevolatilityofthestockpricecanbegreatlyaffectedifthereisonelarge
equityholder.Alsotaxeswouldbegreaterbecausetaxshieldwouldnotbeapplicablewith
thisoption.

Shouldthefirmusepreferredstock?
Preferredstockhasaparvalueof$100,whicharrangestosell500,000sharesatadividend
rateof$10.50pershare.However,thisoptionwillnotbeagoodideabecauseithas
preferenceovercommonstockinthepaymentofdividend.Onepositiveelementispreferred
shareholderswouldnothaveanyvotingrights.Itisalsocouldbecallablebytheissuerwhich
maybeunattractivetoinvestors.Thereisnoguaranteethatinvestorswouldevenwantto
purchasepreferredstockbecauseofthehighpremiumtoobtainitandthesubparperformance
bythecommonstock.Althoughthisisaneasywaytoraisecapitalitwouldupsetandagitate
currentstockholdersandtheoutcomemaynotbegoodastherearenotmanyotherreasonsto
issuethepreferredstock.

Howwouldyoufundtheacquisition,consideringallqualitativeandquantitative
issues?
InordertoprocureMidlandFreight,Inc.theoptimalwaytofinancewouldbethroughthe
saleofbondstotheinsurancecompany.AccordingtoExhibit3theEBITforthestockor
bondwillbe$34millionandtheEPSofstockat$2.72andthebondat$3.87.Evenafter
factoringinthecashsetasidefortheannualsinkingfund,thebondEPSisat$3.31whichis
stillahigherEPScomparedtothestock.Bychoosingthealternativethetaxshieldisused
andsavesonalowertaxableearningduetotheinterestpaidbackeveryyear.Althoughthere
isa$3milliondifferencebetweenaftertaxearningsofthestockandaftertaxearningsofthe
bond,CCIstillnets$17.4millionandwouldhaveactuallyincreasedtheEPSfrom$1to
$3.87.Thevalueofthestockwasalsounderpricedfallingfrom$45.00inDecember1987to
itspresentpriceof$17.87.Issuanceofnewstockwouldonlyfurtherlowerthepriceandmay
forcetheterminationofdividends.Thiscouldcausenonmanagementshareholderstobecome
nervousaboutthevalueofthestockandmaychoosetoliquidate.Optingforthesaleofbonds
leavesmoreflexibilityforCCIbecauseofthetypesofbondstheycanissuesuchas
convertiblebonds,whichcanbeconvertedintocommonstock;acallablebond,whichallows
CCItocallthebondbacktoredeembeforematuritydate;andputbonds,whichgivesthe
bondholdertherighttoredeemthebondbeforethematuritydate.Issuanceofthebondwill
keepshareholdershappybyincreasingitsearningsbeforeinterestsandtaxes,increasingEPS
whileavoidingadecreaseinthestockvalue.