Continental Carriers Case Analysis

When looking at the EBIT chart we can see many things that the chart helps plot out and show. The main point of the chart is to show the effect that a change in the capital structure has on EPS by plotting EPS against the EBIT. Through this chart we can infer multiple things about each scenario. In the stock plan scenario, where CCI has no debt or interest payment, when EBIT is zero the EPS is also zero, meaning that the EPS begins at the origin. With the bond plan scenario however you must assume that the EPS extends past the line and into the negatives because when EBIT is zero CCI has a negative EPS since they have to pay interest of $5 million. So when the EPS is zero the EBIT is actually equal to $5 million. Also on the chart we can see that there is a line extending vertically at $20 million for EBIT. This is where investors believe the EBIT will be if there is a possible recession. In the stock plan scenario we figured out with calculations that the EPS will be $1.60 at the possible recession and $2.00 for the bond plan scenario. So in the bond plan scenario where there is no leverage the shareholders earn $0.40 more during the possible recession. Also on the chart there is another vertical line that represents what the EPS will be after the acquisition of Midland. Through calculations we figured out that the EBIT at this point is $34 million for CCI. On the chart it shows that the EPS for the stock plan scenario at this line is $2.72 and for the bond plan scenario is $3.87. So in the situation after the acquisition the shareholders earn $1.50 more with the bond plan. The chart also shows that the EPS is the same for both scenarios at $1.00 when the EBIT is at $12.5 million.

3. Which alternative is best for shareholders? Consider the impact of each, in turn, on the following:

a. EPS level

The bond alternative is the best alternative for shareholders in respect to EPS level. This is because the $50 bond debt would give them a $2 million dollar tax shield, a lower weighted cost of capital and an addition they would see an increase in their return on equity ratio. Once the EBIT is above $12.5 million the shareholders would see greater increases in EPS. The stock alternative would give shareholders a smaller EPS after $12.5 million but in the instance that the EBIT is below $12.5 the stock issues would give a greater EPS. Also in a recession because the bond has a sinking fund it makes the stock alternative preferable during the recession.

b. EPS growth

The bond alternative again would be the better choice for shareholders because it has a greater rate of growth than the stock option. Again because of the interest on the $50 million bond issue they need to reach an EBIT of $5 million before any increase of EPS. Once the initial $5 million is reached the growth rate is larger than the stock issue and passes it once EBIT is $12.5 million. The stock issue has a lower growth rate for EPS but is a better alternative in times of a recession because of the initial $5 million the company has to make to begin to have any EPS with the issue of bonds.

c. EPS volatility

In a very volatile marker the issue of stock may be the best option for stock holders. This is because as stated previously with the issue of bonds the company must surpass $5 million of EBIT before the shareholders would even begin to see any EPS above zero. For the issue of stock they would start to see gains in EPS as soon as EBIT was above zero. Although the returns in a good to great market would see better returns for the issue of bond, in a volatile market the issue of stock would be the best bet.

d. Capacity to pay dividends

The bond issue would be what shareholders would want CCI to choose because it would give the company a ability to pay the dividends. In either case they said that the rate of dividends would not change so that is not a factor. With the issue of bonds the EPS in a good market would be greater which would be better for the shareholders. If CCI did the stock alternative it would increase the amount of outstanding stocks by 3 million. This would dilute the power of the shares and would also decrease the EPS of the shareholders.

4. Why not issue a lot of debt? What are the potential risks and rewards?

A reason why Continental Carriers would not want to issue a lot of debt is because they have always had a consistent policy of having no long-term debt in its capital structure. They are one of few common carriers that have no long-term debt in their capital structures.

A potential reward to issuing debt would be an interest tax shied, as interest paid on debt is tax deductable. In addition, the company would have more voting power and control versus issuing common stock, where creditors would have more voting power and control. Another potential reward of issuing a lot debt is that it