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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?

#### 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.

\$2.19

## Lester Electronics Gap Analysis

Lester Electronics Gap Analysis
Using the Gap Analysis Template, prepare a 1,400-1,750-word paper in which you complete table 1, table 2, table 3, and perform a gap analysis for Lester Electronics. Be sure to incorporate appropriate citations from your readings.
NOTE: The word count does not include the tables.
Review the rubric for further assignment expectations.

To get you started in the right direction on this week's assignment, I wanted to post the following information for your help.

A brief outline/example of what needs to be covered follows.

Situation
The situation is that Lester has decided to pursue the merger. Do not write you paper stating that Lester is trying to decide what to do in that area. That decision has been made. You now need to decide on the financing for the merger. The choices could be any or a combination of the following:

(1) Long term debt bank financing
(2) Corporate debentures
(3) Secondary offering of common stock
(4) Offering of Preferred stock
(5) Convertible debt offering
(6) Debt offering with warrants
(7) Equity offering of convertible preferred shares
(8) Use of cash in the Retained Earnings account

An issue could be that if Lester uses all retained earnings for the merger, that would leave them with very or n excess funds in reserves. An opportunity could be that Lester could use alternative financing sources for the merger. Relating to readings: In an effort to not deplete all of capital in reserve or retained earnings, companies often use secondary offering of common stock "when no new capital is raised and all the shares on offer are being sold as a secondary offering by existing shareholders" (Brealey, p. 388.)

Stakeholder Perspectives and Ethical Dilemmas

X verses Y: Lester Electronics vs. Firms new board.
Interests, rights and values: Non-agreement on new boards direction or strategies, New board may outvote and dismiss Bernard Lester.
What is the ethical dilemma: Bernard Lester may not be in full control with a new board of directors for the new company. Bernard may inadvertently go through a hostel takeover.

A good problem statement would be: Lester can maximize shareholder wealth by selecting an appropriate finance alternative.

Example of End State Goals: Put yourself into the future and imagine what Lester Electronics will have become if the problem is solved/the opportunity is realized. Describe this end state, that is, the different things you would see happening considering the concepts and ideas from the course. Next, think about the specific metrics that will let you know that you have achieved this desired end state. These are your end-state goals. Example:
If an End State is:Provide the maximum wealth for shareholders by choosing a finance option that will yield a high return on investment.
Your End-State Goal is à Minimize your weighted average cost of capital
Your Measure is à The percentage of both debt and equity to yield a large return
Your Target is à 100% shareholder confidence in the Avral, Lester acquisition of Shangwa.
Your End-State Goal is à Appropriate debt-equity mix
Your Measure is à amount of risk and debt to yield a return on investment
Your Target is à 100% shareholder confidence in the Avral, Lester acquisition of Shangwa.
Identify several end states and then list the associated end state goals.