Cec

CENTRAL EXPRESS CORPORATION

Central Express Corporation recently experienced high levels of growth as a result of aggressive management which uses the proceeds from the initial public offering of its shares. To continue revenue expansion, CEC adopted a policy of selected acquisitions. The board chose Midland Freight, Inc. for the acquisition. CEC is now considering whether to use long term bonds, common stock, or preferred stock as method of financing for the $10M acquisition project.

Computation of costs of capital shows that long term bonds have the lowest cost at 5.39%; furthermore, it also results to relatively higher earnings per share which most likely results to higher market price per share as supported by statistical analyses. Financial leverage is also favorable starting at EBIT of $2.6M вЂ" lower than the projected level of recession of earnings вЂ" and higher. Additional risk and cash demand of the bonds is addressed by additional earnings from the acquisition, predicted stability of future earnings, factoring of high levels of receivables, and increasing prices. Dilution of earnings per share is also avoided through the use of debt over equity; therefore, reduction of market price per share is also avoided.

Hence, the group recommends the use of long term debt as means of financing the acquisition.

Central Express Corporation (CEC) is a carrier of commodities serving areas across the entire United States. It has been in the industry for more than 40 years, but has only experienced remarkable growth since the past decade, when efforts have been exerted on intensive marketing and improving service. Initial Public Offering of CEC common stocks in 1967 has raised funds used in computerizing operations that led to reduction of operating costs and an increase in income.

In 1973, with the desire to continue expansion and company profitability, CEC opted for making selected acquisitions of other common carriers. After a study of potential candidates, Midland Freight, Inc. has been unanimously chosen by the board. Its acquisition would expand Central’s route system; and, it adheres to the company’s marketing and cost reduction programs that have fostered Central’s growth.

Which method of financing must CEC use to finance the $10M-acquisition of Midland Freight, Inc.?

The group’s framework for analysis starts with the assessment of CEC’s strategy through the BCG Matrix. This will situate the company in its proper economic context, and verify whether company actions match the appropriate strategy suggested by the matrix.

After assessment, various statistical analyses will be performed on given figures which will aid in decision making. Choosing among the different methods of financing the acquisition of Midland Freight, Inc. вЂ" through long term-debt, common stock, or preferred stock вЂ" will be evaluated based on their rationality and potential. Options anchored on improper treatment of data will be disregarded.

Then, the cost of capital of long term debt, common stock, and preferred stock will be computed. After computation, the benefits and setbacks of the alternatives shall be weighed, considering other case facts, such as the company’s historical experience and expansionary programs, in order to arrive at a decision of which method of financing to use. Information on performance and company goals may be useful in predicting effects of the acquisition.

The BCG Matrix Analysis shows that CEC is in the вЂ?star’ quadrant (see Exhibit 6). This quadrant’s main characteristic is growth вЂ" a trend apparent to CEC in the past years and seems to continue in the future. The best strategy for firms in this quadrant is to generate brand loyalty, maintain market share, and expansion. This, precisely, supports the strategy of CEC of selective acquisitions.

Statistical analysis on selected income and dividend data show that dividends per share (DPS) have a very high correlation with earnings per share (EPS), at 0.90. The same goes for market price per share (MPS) вЂ" high & low вЂ" with earnings per share, at 0.85 and 0.98 respectively. However, the same does not hold for the growth rates. The correlation of DPS growth rate with EPS growth is only 0.14, while MPS growth rate вЂ" high & low вЂ" is only 0.45 and 0.66 correspondingly (see Exhibit 1). This means that at high levels of EPS, we can expect that DPS and MPS are also high; however, high growth rates on EPS do not necessarily mean high growth rates on DPS and MPS.

Computation on costs of capital show that bonds has an after-tax cost of 5.39% - the lowest among the three sources. This cost already accounted for the yearly sinking fund payments. On the other hand, preferred stock has a cost of 8.38%, while common stock has a cost of 22.44% which already accounted for the historical average on dividend growth (see Exhibits 1, 4, & 5). The historical average of 14.44% was used as a constant growth rate to dividends because statistical analysis on growth rates show that correlation between growth rates of EPS and DPS is only 0.14. This means that after acquisition, whether EPS growth is positive or negative, DPS growth is changed only very slightly. Accounting for the growth rate is crucial as correlation between EPS and DPS is very high at 0.90 (see Exhibit 1). Both stocks’ cash proceeds were reduced by underwriting fees and expenses.

Exhibit 3 shows that financial leverage is achieved starting at $2.6M. This level of earnings is already below the predicted possible earnings recession. This exhibit also shows that EPS from bonds becomes higher, relative to EPS from stocks, as EBIT rises from $2.6M; and, as shown by exhibit 1, higher EPS results to higher MPS; consequently, opting for stocks results to dilution or lower EPS, therefore lower MPS.

Exhibit 2 shows that CEC has high levels of account receivables accounting for 15% of total assets. Additional cash demands resulting from bond payments may be addressed by