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(20-6) Warrant/Convertible Decisions

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 Howlands latest financial statements: "

a. Show the new balance sheet under each alternative. For 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. Howlands 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, assuming that profits before interest and taxes will be 20% of total assets?

d. What will be the debt ratio (TL/TA) under each alternative?

e. Which of the three alternatives would you recommend to Howland, and why?

Balance Sheet 250,000 $150,000 Line of credit Other current liabilities Long-term debt Common stock, par $1 Retained earnings Total claims 100,000 50,000 $550,000 Total assets $550,000 Income Statement Sales All costs except interest EBIT Interest Pre-tax earnings Taxes (40%) Net income Shares outstanding Earnings per share Pricelearnings ratio Market price of stock $1,100,000 990,000 $ 110,000 20,000 $ 90,000 36,000 $ 54,000 100,000 $ 0.54 15.83 $ 8.55 Balance Sheet 250,000 $150,000 Line of credit Other current liabilities Long-term debt Common stock, par $1 Retained earnings Total claims 100,000 50,000 $550,000 Total assets $550,000 Income Statement Sales All costs except interest EBIT Interest Pre-tax earnings Taxes (40%) Net income Shares outstanding Earnings per share Pricelearnings ratio Market price of stock $1,100,000 990,000 $ 110,000 20,000 $ 90,000 36,000 $ 54,000 100,000 $ 0.54 15.83 $ 8.55