Carriers

Continental Carriers, Inc.

I. Statement of Financial Problem

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?

II. Financial Framework

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...