The Howe Computer 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 $150,000, carrying a 10% interest rate, and Howe has been 30 to 60 days late in paying trade creditors. Discussions with an investment banker
Discussions with an investment banker have resulted in the decision to raise $250,000 at this time. Investment bankers have assured Howe that the following alternatives are feasible (flotation costs will be ignored):
€¢ Alternative 1: Sell common stock at $10 per share.
€¢ Alternative 2: Sell convertible bonds at a 10% coupon, convertible into 80 shares of common stock for each $1,000 bond (i.e., the conversion price is $12.50 per share).
€¢ Alternative 3: Sell debentures with a 10% coupon; each $1,000 bond will have 80 warrants to buy 1 share of common stock at $12.50.
Keith Howe, the president, owns 80% of Howe€™s common stock and wants to maintain control of the company; 50,000 shares are outstanding. The following are summaries of Howe€™s latest financial statements:
All costs except interest€¦€¦€¦€¦€¦€¦€¦€¦..495,000
Net income€¦€¦€¦€¦€¦€¦€¦€¦€¦€¦€¦€¦... $ 24,000
Earnings per share€¦€¦€¦€¦€¦€¦€¦€¦€¦€¦€¦.$0.48
Market price of stock€¦€¦€¦€¦€¦€¦€¦€¦€¦€¦$8.64
a. Show the new balance sheet under each alternative. For Alternatives 2 and 3, show the balance sheet after conversion of the debentures or exercise of the warrants. Assume that $150,000 of the funds raised will be used to pay off the bank loan and the rest used to increase total assets.
b. Show Keith Howe€™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 earnings before interest and taxes will be 20% of total assets?
d. What will be the debt ratio under each alternative?
e. Which of the three alternatives would you recommend to Keith Howe? Why?
Debenture DefinitionDebentures are corporate loan instruments secured against the promise by the issuer to pay interest and principal. The holder of the debenture is promised to be paid a periodic interest and principal at the term. Companies who... Common Stock
Common stock is an equity component that represents the worth of stock owned by the shareholders of the company. The common stock represents the par value of the shares outstanding at a balance sheet date. Public companies can trade their stocks on... Line of Credit
A line of credit (LOC) is a preset borrowing limit that can be used at any time. The borrower can take money out as needed until the limit is reached, and as money is repaid, it can be borrowed again in the case of an open line of credit. A LOC is...
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Fundamentals of Financial Management
Authors: Eugene F. Brigham, Joel F. Houston