Accounting in Action: CM2

After a long day on the job at CM2, you are reflecting on how much you have learned about business decision making through this internship. A good example is CM2s current plan to raise money through a stock issue rather than a debt issue. You recall from your Intermediate Accounting class that issuing debt imposes a fixed financial obligation on the company, but does not convey ownership to the debt holders. However, if CM2 issues stock, it gives up some ownership and thus some control. You know how protective Conner and Martin are of the company, and you wonder why they chose to issue stock. You decide to ask them the next day.

The next day you ask the management team if you could get some information about the proposed stock issue. You explain that there are trade-offs between issuing stock and issuing debt, and you wonder why they are planning to issue stock. Martin has an immediate response: They do not want to take on any more debt; they would prefer relinquishing some control rather than assuming more obligations. They argue that companies are like people who have ready access to multiple credit cards and use them to live on, effectively taking on more debt than they can easily repay. Having friends in this situation, you understand CM2s position.

They then ask you to help them evaluate the three options they are considering for raising the necessary money for expansion. Amazingly enough, one of the options is to issue debtyou are glad to see they are at least considering it. The three options are:

1. Issue $10,000,000 of 10-year bonds with a coupon rate of 6%, interest payable semiannually. (CM2 has an A bond rating.) Although the current market rate is 6%, based on current economic forecasts, Conner and Martin recognize that market rates might increase to 8% by the time they issue the bonds. Although they do not like the option of added debt, they feel it is a reasonable alternative and should be considered.

2. A second possibility is to issue 2,600,000 shares of common stock ($2 par value) to current shareholders and a selected group of new investors (a private issue). The stock would be priced to sell at CM2s book value per share at the end of 2013.

3. The third option is to proceed with the initial public offering (IPO). Based on current and anticipated economic conditions, the resurgence of the IPO market, and interest in high-tech companies, Conner and Martin think they could get an IPO price of around $5 per share. At this price, they would need to issue approximately 2,000,000 shares.

The company does have some shares held in treasury but does not want to re-issue these shares at this time. Conner and Martin also plan to continue to pay dividends to current shareholders but at a lower amount, probably $0.05 per share.

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Instructions

(a) As a fourth alternative, you suggest that the company borrow the money from a financial institution instead of issuing either bonds or stock. Conner and Martin of course turn the question right back to you, and ask you to summarize the advantages of borrowing in this fashion compared to issuing bonds. Write a memo describing the advantages and disadvantages of each method of financing.

(b) Which alternative would you recommend to Conner and Martin? Be sure to justify your answer in comparing the merits of raising capital through bonds, loans, and common stock. Include any pros or cons of utilizing treasury stock in raising capital. Be specific in your answer, but remember you are writing to entrepreneurs, not accountants.