Chapter 15 Accounting in Action

Chapter 15Accounting in Action: CM2After a long day on the job at CM2 , you are reflecting on how much you havelearned about business decision making through this internship. A good exampleis CM2s current plan to raise money through a stock issue rather than a debtissue. You recall from your Intermediate Accounting class that issuing debtimposes a fixed financial obligation on the company, but does not conveyownership to the debt holders. However, if CM2issues stock, it gives up someownership and thus some control. You know how protective Conner and Martinare of the company, and you wonder why they chose to issue stock. You decideto ask them the next day.The next day you ask the management team if you could get someinformation about the proposed stock issue. You explain that there are trade-offsbetween issuing stock and issuing debt, and you wonder why they are planningto issue stock. Martin has an immediate response: They do not want to take onany more debt; they would prefer relinquishing some control rather thanassuming more obligations. They argue that companies are like people who haveready access to multiple credit cards and use them to live on, effectively takingon more debt than they can easily repay. Having friends in this situation, youunderstand CM2s position.They then ask you to help them evaluate the three options they areconsidering for raising the necessary money for expansion. Amazingly enough, one of theoptions is to issue debtyou are glad to see they are at leastconsidering it. The three options are:1. Issue $10,000,000 of 10-year bonds with a coupon rate of 6%, interestpayable semiannually. (CM2 has an A bond rating.) Although the current marketrate is 6%, based on current economic forecasts, Conner and Martin recognizethat 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 reasonablealternative and should be considered.2. A second possibility is to issue 2,600,000 shares of common stock ($2 parvalue) to current shareholders and a selected group of new investors (a privateissue). The stock would be priced to sell at CM2s book value per share at theend of 2013.3. The third option is to proceed with the initial public offering (IPO). Basedon current and anticipated economic conditions, the resurgence of the IPOmarket, and interest in high-tech companies, Conner and Martin think they couldget an IPO price of around $5 per share. At this price, they would need to issueapproximately 2,000,000 shares.The company does have some shares held in treasury but does not wantto re-issue these shares at this time. Conner and Martin also plan to continue topay dividends to current shareholders but at a lower amount, probably $0.05 pershare.Instructions(a) As a fourth alternative, you suggest that the company borrow themoney from a financial institution instead of issuing either bonds or stock.Conner and Martin of course turn the question right back to you, and askyou to summarize the advantages of borrowing in this fashion comparedto issuing bonds. Write a memo describing the advantages anddisadvantages of each method of financing.(b) Which alternative would you recommend to Conner and Martin? Be sureto justify your answer in comparing the merits of raising capital throughbonds, loans, and common stock. Include any pros or cons of utilizingtreasury stock in raising capital. Be specific in your answer, but rememberyou are writing to entrepreneurs, not accountants.