Question

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% 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% coupon, convertible into 100 shares of common stock for each $1,000 bond (i.e., the conversion price is $10 per share).
* Alternative 3: Sell debentures at an 8% coupon, each $1,000 bond carrying 100 warrants to buy common stock at $10.
John L. Howland, the president, owns 80% of the common stock and wishes to maintain control of the company. There are 100,000 shares outstanding. The following are extracts of Howland

Answer 1

Alternative 3 ( Sell debentures at an 8% coupon, each $1,000 bond carrying 100 warrants to buy common stock at $10) is the best alternative if Mr. John is to maintain control of the company

Step-by-step explanation:

Given data :

Bank loan under a line of credit = $250,000

interest rate on bank loan = 8%

lateness = 30 to 60 days

Action : To raise $500,000

Question : Determine the best Alternative for John Howland if he wants to maintain control of the company

Considering alternative 1 ( sell common stock at $8 )

Current liabilities = $150,000

Common stock, par $1 = $600,000

retained earnings = $50,000

Total claims / Total assets = $800,000

next determine Mr. John Howland control here

no of shares issued = 62500 ( 500000/8)

Total shares outstanding = 100,000 + 62500 = 162500

shares owned by Howland = 80% * 100,000 = 80,000

percentage of Howland's share =( 80,000 / 162500 ) * 100 = 49.23%

Next show the effect of earnings per share ( EPS )

EBIT = 20% * 800,000 = $160,000

interest = $0

EBT = $160,000 - $0 = $160,000

Taxes = 40% * 160,000 = $64,000

net income = 160,000 - 64,000 = $96,000

outstanding shares = 162,500

EPS = $0.59

Next determine the debt ratio ( TL / TA )

= current liabilities / Total claims

= 150,000 / 800,000 = 18.75%

Note : After repeating the same processes for Alternative 2 and 3

Alternative 2 ( Sell convertible bonds at an 8% coupon, convertible into 100 shares of common stock for each $1,000 bond (i.e., the conversion price is $10 per share).

Total assets / Total claims = $800,000

Mr. Howland control in Alternative 2 = 53.33%

EPS = $0.64

Debt ratio ( TL/TA ) = 18.75%

Alternative 3 ( Sell debentures at an 8% coupon, each $1,000 bond carrying 100 warrants to buy common stock at $10.

Total assets / Total claims = $1300000

Mr. Howland control in Alternative 3 = 53.33 %

EPS = $0.88

Debit ratio ( TL / TA ) = 50.0%

For John L Howland to maintain control of the company we have to choose an alternative with the Highest EPS value and exerts the highest control in percentage for John Howland and that Alternative is Alternative 3