Continental Carriers Inc.

Case Analysis
Continental Carriers, Inc
Continental Carriers, Inc is a regulated general commodities motor carrier who had shipping routes up and down the
Pacific Coast and to parts of the Midwest. They sought to acquire Midland Freight, Inc to expand its operations and
were deliberating about which method to finance the acquisition. The purchase of Midland Freight, Inc would cost
$50 million in cash. CCI would gain $8.4 million to its earnings before interest and tax. There were three options
that the board of directors debated over: issuing new common stock, issuing preferred stock or selling bonds.
As Ms. Thorp, evaluate the impact of the bond issue and of the stock issue on the EPS. What are the risks in each
alternative?
The bond alternative arranges to sell $50 million in bonds to a California insurance company with an interest rate of
10 percent at maturity of 15 years. There is $2.5 million sinking fund required which leaves $12.5 million outstanding
at maturity. The issues with this method are as follows: Long-term-debt can be burdensome and can stunt or slow
growth of the company. The company has to payback what was borrowed plus the interest on the debt. It also puts
stockholders and management who are primary holders of stock at risk, because if the company earnings are
substantially lower than what was forecasted then the bondholders can virtually gain control of company.
The second alternative would be the possibility of issuing new common stock of 3 million shares offered at $17.75 per
share. This would bring the total common stock to 4.5 million shares outstanding. There would be many concerns if
CCI decided to issue new common stock. The introduction of new shares would hurt present shareholders because
it would dilute the stock and bring the value down in terms of EPS. If there is more shareholders then whatever
increased earnings, if any, are reaped then it has to be shared with old and new shareholders. This creates more
dependency.

Introduction
Continental Carriers, Inc. Advanced Financial Management Professor Clayton June 16, 2005
Tim Boyd Dave Chen Ian Hoffman Chirayu Patel 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. ...read more.

Middle
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. ...read
more.

Conclusion
5. The last director argued for a preferred stock in lieu of a bond issue. This alternative
would yield a preferred stock pay-out of $5.25M. The bond alternative would yield a total
stockholder pay-out of $7.04M. Furthermore, an equity financed project will likely lower the
overall stock price, which would offset the benefits of a preferred stock with a dividend of
$10.50. Preferred stock issuance is not good for existing board members and especially
common stock holders. It provides a fixed dividend pay out of 5.25 M to the preferred stock
holder and leaves the common stock holder with only 3.7 M, which equals a dividend level of
only $.83 per share. The common stock holder would be left with only $.22 per share if EBIT
grew to only 23.7M. Given that CCI is currently light on debt, the tax-shield resulting from
debt, and that a greater return would be realized by stockholders under the issue new debt
alternative, it is recommended that CGI pursue their opportunity to sell 50 million in bonds
to the California insurance company. Continental Carriers, Inc. 3 June 16, 2005 ...read more.

Continental Carriers, Inc.

(This is not an essay. This paper 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
companys 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 argued that the share price was a steal at
$17.75/share and according to his calculations he yielded a book value
share price of $45/share. In addition, the equity value ($202,500)
was currently less than the replacement cost of the firm ($253,100).
Our calculations are in agreement with this argument, which supports
the debt financing option. One reason for such a low stock price could
be the fact the CCI is all equity financed, which may signal to the
market that the firm is having trouble with its cash-flows and
therefore does not have faith in its future.
4. Our calculations are also in agreement with the fourth director,
assuming that EBIT does increase to $34M it would yield an earnings
per share of $2.72 and the use of debt would increase the earnings per
share to $3.87 with the cost of the sinking fund at only $0.56 per
share. However, pre-acquisition numbers range between $7.2M and
$15.3M. The Midland deal only promised an added cash flow of $8.4M.
CCI could only expect to see their EBIT grow to $23.7M. Using a more
modest growth, the EPS would result in $2.49 and $1.90 (debt and
equity) respectively. This possibility still favors debt financing.
5. The last director argued for a preferred stock in lieu of a bond
issue. This alternative would yield a preferred stock pay-out of
$5.25M. The bond alternative would yield a total stockholder pay-out
of $7.04M. Furthermore, an equity financed project will likely lower
the overall stock price, which would offset the benefits of a
preferred stock with a dividend of $10.50. Preferred stock issuance
is not good for existing board members and especially common stock
holders. It provides a fixed dividend pay out of 5.25 M to the
preferred stock holder and leaves the common stock holder with only
3.7 M, which equals a dividend level of only $.83 per share. The
common stock holder would be left with only $.22 per share if EBIT
grew to only 23.7M.
Given that CCI is currently light on debt, the tax-shield resulting
from debt, and that a greater return would be realized by stockholders
under the issue new debt alternative, it is recommended that CGI

pursue their opportunity to sell 50 million in bonds to the California

insurance company.
Continental Carriers, Inc.
Advanced Financial Management
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
f ...

Continental Carriers
Introduction
Continental Carriers Inc is a trucking company which specialises in transporting
general commodities. Since its establishment in 1952 the company operates within the
district of the Pacific Coast and from Chicago to various points in Texas. It was noted
that the company maintains an overall low debt policy, whereby they obtain infrequent
short term loans and avoid long term debt. Furthermore with the appointment of Mr.
Evans as president, the company became more profitable and experienced internal
growth through intensive marketing and computerisation of operations.

In order for the company to continue expanding its revenues the president Mr.
Evans advocated the acquisition of Midland Freight. External financing of $50 million
would be required to accomplish this goal. However, the directors have a difficult
challenge with regard to the appropriate method of financing. Through extensive
discussion and evaluation the directors identified three distinct options, namely, selling
$50 million in bonds at a 10% interest rate to a California Insurance Company or issuing
3 million in common stocks at $17.75 per share with a dividend rate of $1.50 per share
or issuing 500 000 preference shares at a par of $100 per share and with a dividend rate
of $10.50 per share (See appendix A for case assumptions).
Discussion
1. Given the nature of CCIs business how much debt can it support?
Continental Carriers Inc. must possess certain organizational and structural
characteristics if it has to finance its future acquisitions by long term debt. The nature of
an incorporated business allows it to enjoy the benefits of liability protection, tax
savings, business credibility, ease of raising capital, prestige for the corporate officers,
perpetual duration and its centralized management. Consequently, businesses such as
this one would be typically expected to be able to support large amounts of debt.
In the first instance, the culture and quality of management must be cooperative of
a merger. In this case, the company is "widely respected in the industry for its aggressive
management. Management is predominantly in control of its resources especially due
to its large stock ownership in the company. Hence, with Continentals funds in direct
management control, it is more likely definite that its debt would be repaid.
Additionally, according to Singhs two studies (1971 and 1975) of mergers, most
potential acquirers/bidders are on average bigger, more profitable, faster growing, more
liquid, more highly geared than those acquired, and typically show greater recent
improvement in profits and retained earnings. Although Continental is not heavily
geared, being a well-established company for the past 36 years has contributed to its
accumulation of substantial capital capable of supporting its debt. Having a reputable
standing would also persuade financial institutions to grant it long-term debt.
Another defining characteristic of this organization is that it is highly computerized
and has been undergoing a process of mechanization and advancement in its operations
for the past few years. Such a firm would usually benefit from lower average costs and
thereby be in a better position to meet the accompanying interest payments from bond
financing.
2. How is the companys financial performance? Examine appropriate financial ratios.
For the period 1987 (See Appendix1for table of ratios)

Liquidity Ratios: It can be seen that the company has more than sufficient liquid assets to cover its
current liabilities of 1.47 and is generally considered to have good short-term financial
strength. However, given the industry average of 1.8, the company is under averaged
with its current ratio.
The quick ratio of 1.31 indicates that liquid assets are sufficient to cover current
debt. To the contrary, the industry average of 1.7 shows that the company is less able to
liquidate assets to cover debts.
Profitability Ratios: The ROA is a critical indicator of profitability. Unfortunately the company is not
using its assets efficiently in generating profits as the industry average of 25.4% is
higher. An EPS of $3.49 represents the amount earned during the period on behalf of
each outstanding share of common stock. This is closely watched by the investing public
and is considered an important indicator of corporate success. Since, the industry
average is considerably lower at $0.09 the company is viewed as successful. The ROE of
7.78% shows the company can reinvest earnings to generate additional earnings. It is
used as a general