Continental Carriers

Continental Carriers Case

I. Statement of Financial Problem

In May 1988, Continental Carriers, Inc. (CCI) was acquiring Midland Freight, Inc. (Midland) for $50 million in cash. CCI would have to raise the funds for the acquisition from outside sources. How should CCI finance the proposed acquisition of Midland? Should they use 100% debt, 100% equity, or a blend of debt and equity?

II. Financial Framework

The weighted average cost of capital (WACC) is the framework used to determine the target proportions of debt and common equity. Exhibit 1 shows the WACC calculation. In more general terms, and in equation format, WACC = wdrd(1-T) + wcrs.

The weight represents the ratio of debt to equity. For example, if CCI were to fund it with 80% debt, then the weight for debt would be 0.8 and the weight for equity would be 0.2.

The after-tax cost of debt, rd(1-T) is the interest rate on new debt, rd, less the tax savings that result because interest is tax deductible.

The cost of retained earnings, rs, is the rate of return stockholders require on the company’s common stock. The discounted cash flow (DCF) model can be used to calculate the rs. Exhibit 1 shows the DCF model calculation. Given the current dividend and stock price, and the expected growth, I will be able to calculate the rs.

III. Application of Framework

For application of WACC, I will run three different variables to determine the best use of debt to equity in financing the merger. The first will be 100% debt, then 25% debt to 75% equity, and finally 100% equity. Exhibit 2 shows the calculations used in determining the WACC for these levels.

In applying the framework described, it is necessary to first calculate the expected future growth rate of earnings and dividends. I can then calculate the cost of equity that will enable us to calculate the WACC for the different financing scenarios. The scenario with the lowest WACC should then be chosen as the financing method for the acquisition....