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Capital Decisions: Equity, Convertible Bonds, Warrants

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The Howland Carpet Company has grown rapidly during the past 5 years. Recently, its commercial bank urged the company to consider increasing its permanent financing. Its bank loan under a line of credit has risen to $250,000, carrying an 8 percent interest rate. Howland has been 30 to 60 days late in paying trade creditors.

Discussions with an investment banker have resulted in the decision to raise $500,000 at this time. Investment bankers have assured the firm that the following alternatives are feasible (flotation costs will be ignored):
Alternative 1: Sell common stock at $8.
Alternative 2: Sell convertible bonds at an 8 percent coupon, convertible into 100 shares of common stock for each $1,000 bond (that is, the conversion price is $10 per share).
Alternative 3: Sell debentures at an 8 percent coupon, each $1,000 bond carrying 100 warrants to buy common stock at $10.

John L. Howland, the president, owns 80 percent of the common stock and wishes to maintain control of the company. One hundred thousand shares are outstanding. The following are extracts of Howland's latest financial statements:

> Balance Sheet

Total assets $550,000

Current Liabilities $400,000
Common stock par $1 $100,000
Retained earnings $50,000
Total claims $550,000

> Income Statement

Sales $1,100,000
All costs except interest $990,000
EBIT $110,000
Interest $20,000
EBT $90,000
Taxes $36,000
Net Income $54,000

Shares outstanding 100,000
Earnings per share $0.54
Price/earnings ratio 15.83x
Market price of stock $8.55

> Questions:

a. Show the new balance sheet under each alternative. For those Alternatives 2 and 3, show the balance sheet after conversion of the bonds or exercise of the warrants. Assume that half of the funds raised will be used to pay off the bank loan and half to increase total assets.
b. Show Mr. Holand's control position under each alternative, assuming that he does not purchase additional shares.
c. What is the effect on earnings per share of each alternative, if it is assumed that profits before interest and taxes will be 20 percent of total assets?
d. What will be the debt ratio under each alternative?
e. Which of the three alternatives would you recommend to Howland, and why?

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Solution Summary

This post sets up a capital structure decisions problem in Excel. The effect on control position, EPS and debt ratio is analyzed for the three capital raising alternatives.