Evaluate Mr. Johnsons arguments about the stock issue and dividend payment versus the debt issue argument of the CEO. Who is correct? What is the required rate of return on the new planes?

MINICASE In March 2015 the management team of Londonderry Air (LA) met you say flies in the face of common sense. Why should we want to discuss a proposal to purchase five shorthaul aircraft at a total to sell more equity when our stock has fallen over the past year cost of $25 million. There was general enthusiasm for the invest by nearly a fifth? Our stock is currently offering a dividend yield ment, and the new aircraft were expected to generate an annual of 65 cash flow of $4 million for 20 years. %, which makes equity an expensive source of capital. Increasing the dividend would simply make it more expensive. The focus of the meeting was on how to finance the purchase. What's more, I don't see the point of paying out more money to LA had $20 million in cash and marketable securities (see table), the stockholders at the same time that we are asking them for cash. but Ed Johnson, the chief financial officer, pointed out that the If we hike the dividend, we will need to increase the amount of the company needed at least S10 million in cash to meet normal out- stock issue; so we will just be paying the higher dividend out of flow and as a contingency reserve. This meant that there would be a the shareholders' own pockets. You're also ignoring the question of cash deficiency of $15 million, which the firm would need to cover dilution. Our equity currently has a book value of S12 a share: it's cither by the sale of common stock or by additional borrowing. not playing fair by our existing shareholders if we now issue stock While admitting that the arguments were finely balanced, Mr. John- for around S10 a share. son recommended an issue of stock. He pointed out that the airline Look at the alternative, we can bono today at 6%, we get industry was subject to wide swings in profits and the firm should a tax break on the interest, so the after-tax cost of borrowing is be careful to avoid the risk of excessive borrowing. He estimated 65 x 6-39%. That's about half the cost of equity. We expect to that in market value terms the long-term debt ratio was about 59% earn a return of 15% on these new aircraft. If we can raise money at and that a further debt issue would raise the ratio to 62% 3.9% and invest it at 15%, that's a good deal in my book. Mr. Johnson's only doubt about making a stock issue was that You finance guys are always talking about risk, but as long as investors might jump to the conclusion that management believed we don't go bankrupt, borrowing doesn't add any risk at all the stock was overpriced, in which case the announcement might "Ed. I don't want to push my views on this-after all. you're the prompt an unjustified selloff by investors. He stressed therefore that expert. We don't need to make a firm recommendation to the board the company needed to explain carefully the reasons for the issue. until next month. In the meantime, why don't you get one of your Also, he suggested that demand for the issue would be enhanced if at new business graduates to look at the whole issue of how we should the same time LA increased its dividend payment. This would pro- finance the deal and what return we nced to earn on these planes?" vide a tangible indication of management's confidence in the future. Evaluate Mr. Johnson's arguments about the stock issue and These arguments cut little ice with LA's chief executive. "Ed. dividend payment as well as the reply of LA's chief executive. Who she said, "I know that you're the expert on all this, but everything is correct? What is the required rate of return on the new planes? Summary financial statements for Londonderry Air, 2014 (Figures are book values, in millions of dollars.) Balance Sheet Bank debt Other current liabilities 10% bond, due 2032. Stockholders' equity 120 Total liabilities Other current assets Fixed assets 250 100 Total assets Income Statement S57.5 Gross profit Interest Pretax profit Tax 7 6.5 Dividend "The yield to maturity on LA debt currently is 6%. LA has 10 million shares outstanding, with a market price of $10 a share. LAs equity beta as s estimated at 1.25, the market risk premium is 8%, and te Treasury bil rate MINICASE In March 2015 the management team of Londonderry Air (LA) met you say flies in the face of common sense. Why should we want to discuss a proposal to purchase five shorthaul aircraft at a total to sell more equity when our stock has fallen over the past year cost of $25 million. There was general enthusiasm for the invest by nearly a fifth? Our stock is currently offering a dividend yield ment, and the new aircraft were expected to generate an annual of 65 cash flow of $4 million for 20 years. %, which makes equity an expensive source of capital. Increasing the dividend would simply make it more expensive. The focus of the meeting was on how to finance the purchase. What's more, I don't see the point of paying out more money to LA had $20 million in cash and marketable securities (see table), the stockholders at the same time that we are asking them for cash. but Ed Johnson, the chief financial officer, pointed out that the If we hike the dividend, we will need to increase the amount of the company needed at least S10 million in cash to meet normal out- stock issue; so we will just be paying the higher dividend out of flow and as a contingency reserve. This meant that there would be a the shareholders' own pockets. You're also ignoring the question of cash deficiency of $15 million, which the firm would need to cover dilution. Our equity currently has a book value of S12 a share: it's cither by the sale of common stock or by additional borrowing. not playing fair by our existing shareholders if we now issue stock While admitting that the arguments were finely balanced, Mr. John- for around S10 a share. son recommended an issue of stock. He pointed out that the airline Look at the alternative, we can bono today at 6%, we get industry was subject to wide swings in profits and the firm should a tax break on the interest, so the after-tax cost of borrowing is be careful to avoid the risk of excessive borrowing. He estimated 65 x 6-39%. That's about half the cost of equity. We expect to that in market value terms the long-term debt ratio was about 59% earn a return of 15% on these new aircraft. If we can raise money at and that a further debt issue would raise the ratio to 62% 3.9% and invest it at 15%, that's a good deal in my book. Mr. Johnson's only doubt about making a stock issue was that You finance guys are always talking about risk, but as long as investors might jump to the conclusion that management believed we don't go bankrupt, borrowing doesn't add any risk at all the stock was overpriced, in which case the announcement might "Ed. I don't want to push my views on this-after all. you're the prompt an unjustified selloff by investors. He stressed therefore that expert. We don't need to make a firm recommendation to the board the company needed to explain carefully the reasons for the issue. until next month. In the meantime, why don't you get one of your Also, he suggested that demand for the issue would be enhanced if at new business graduates to look at the whole issue of how we should the same time LA increased its dividend payment. This would pro- finance the deal and what return we nced to earn on these planes?" vide a tangible indication of management's confidence in the future. Evaluate Mr. Johnson's arguments about the stock issue and These arguments cut little ice with LA's chief executive. "Ed. dividend payment as well as the reply of LA's chief executive. Who she said, "I know that you're the expert on all this, but everything is correct? What is the required rate of return on the new planes? Summary financial statements for Londonderry Air, 2014 (Figures are book values, in millions of dollars.) Balance Sheet Bank debt Other current liabilities 10% bond, due 2032. Stockholders' equity 120 Total liabilities Other current assets Fixed assets 250 100 Total assets Income Statement S57.5 Gross profit Interest Pretax profit Tax 7 6.5 Dividend "The yield to maturity on LA debt currently is 6%. LA has 10 million shares outstanding, with a market price of $10 a share. LAs equity beta as s estimated at 1.25, the market risk premium is 8%, and te Treasury bil rate