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 CCI's 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 Continental's funds in direct management control, it is more likely definite that its debt would be repaid.

Additionally, according to Singh's 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 company's 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 indication of the company's efficiency; in other words, how much profit it is able to generate given the resources provided by its stockholders. The industry average of 21.6% indicates the firm's inability to generate additional earnings. Investors usually look for companies with returns on equity that are high and growing.

Leverage Ratios: -

The company currently relies on 19.99% debt to finance assets. The industry average is 28.1% showing the company's lower reliance on debt for asset formation. The company is less risky since excessive debt can lead to a very heavy interest and principal repayment burden. However, when a company chooses to forgo debt and rely largely on equity, they are also giving up the tax reduction effect of interest payments. Thus, a company will have to consider both risk and tax issues when deciding on an optimal debt ratio.

Market Ratios: -

When the market price was $25, investors were willing to pay $7.16 for each dollar of the firm's earnings compared to $5.33 when the market was low. Since the industry's average was 16.1, it shows that investors are not confident in the firm's future performance. As a result this influences the falling stock price in the company's shares.

For the period 1988 without acquisition and financing (See Appendix 1.1for ratio table): -

There was a decrease in the earnings per share from $3.49 to $3.41 indicating the company is making less profit or incurring an increase in expenses. Prospect investors would think that the performance of the firm is falling and project a decline in the marketability of the shares. With respect to the industry average of $0.09 the decrease would still rank the shares above average.

The ROE decreased from 7.78% to 7.27% as a result of a fall in earning available for common