Continental Carriers Inc

Group A:
Karishma Gupta | Kunal Sharma | Prateek Kumar | Puja B
Saikiran | Shivom | Vishal Wasson
Financing the acquisition using Debt

• To finance the $50 million acquisition, the company has an opportunity to sell bonds to an
insurance company.

• Interest rate at 10% and will mature in 15 years.

• To cover the repayments, an annual sinking fund of $2.5 million would be maintained.

• Apart from the Sinking fund, $12.5 million will be outstanding at maturity.
Pro’s of financing the acquisition using Debt

• Since debt can be obtained faster, the acquisition can go smooth as it needs to be
completed within 4 months(October 1988).

• The company management will not be losing out the control of the company by getting
more debt. (Share value propositions)

• The tax benefits of getting debt will bring down the interest payment of the bond to 6%
from 10%.

• Even after factoring in the annual payments to the sinking fund, the cost of debt came
up to only 8%.

• Post-Acquisition earnings would increase the earnings per share to $3.87

Con’s of financing the acquisition using Debt

• The Risk of the company will increase due to the addition of Debt.

• The requirement of real earnings in cash will increase due to the debt repayments.

• The company would lose out its name as one of the few companies that has no long-
term debt.
Financing the acquisition using Equity

• Estimates by an Investment banker state that new common stock can be sold to the
public at $17.75 a share.

• After deducting underwriting expenses, the net proceeds to the company would be
$16.75 per share.

• A total of 3 million new shares will be issued to source $50 million required for the
acquisition.

• Dividends per share will remain at $1.50 .

• Earnings per share will be diluted to $2.72 .

Pro’s of financing the acquisition using Equity

• Since there are no debt commitments, there is no increase in requirement of real

earnings (cash).

• There is no negative effect on the risk of the company due to the issuance of new equity.

• The company will hold on to its name as a debt-free company.

Con’s of financing the acquisition using Equity

• The increase in the number of shareholders dilutes the earnings per share to $2.72
which may make the current shareholders unhappy.

• As the number of shareholders has increased , the company may struggle to pay the
annual dividends ($1.50 per share) in the future.

• The stock of the company is already undervalued even though the book value per share
was $45. With this low price-to-book ratio, it would be an economic loss for the
company to release shares at this time.

• The voting control of the management would be diluted due to the additional share
offering.
 Cost of Debt and Cost of Equity

Debt 50000000 Equity Sourcing 50000000

Interest paid 5000000 # new shareholders 3000000
Tax benefit of debt 2000000 Dividend rate (per share) 2
Actual additional cost due to debt 3000000 Increase in annual dividends 4500000
Cost of Debt 6.0% Cost of Equity 9.0%

No New Equity With New Equity

Market Price(Average) 21.75 17.75
Shareholder's Equity 202500000 252750000
# shareholders 4500000 7500000
Book value per share 45 34
P/B ratio 0.48 0.53
 Effect on Earnings per share

Using Debt Using Equity

EBIT 34000000 34000000
Less: Interest 1st year 5000000 0
Taxable earnings 29000000 34000000
Less: Tax @ 40% 11600000 13600000.00
After-tax earnings 17400000 20400000
Less: Payment to Sinking fund 2500000 0
Earnings 14900000 20400000
# of shareholders 4500000 7500000
Per share contribution to sinking fund 0.56 0
EPS 3.31 2.72
Conclusion

• Issuing new shares at a time when price to book ratio is less than 1 is a loss to the
company.

• The book value per share will further reduce if new shares are released.

• In the long-run, The company would not be able to maintain the same dividend
rate due to the increase in shareholders.

• Even though the risk increases if debt is obtained, the interest of shareholders is
better protected if debt is obtained rather than more equity as EPS increases.

• The liability from debt can be closed in 15 years whereas the liability from Equity
will be continuing in the long term.