You are trying to evaluate whether United Airlines
(UAL) has any excess debt capacity. In 1995, UAL had 12.2 million shares outstanding at $210 per share and debt outstanding of approximately $3 billion (book as well as market value). The debt had a rating of B, and carried a market interest rate of 10.12%. In addition, the firm had leases outstanding, with annual lease payments anticipated to by $150 million. The beta of the stock is 1.26, and the firm faces a tax rate of 35%. The Treasury bond rate is 6.12%.
a. Estimate the current debt ratio for UAL.
b. Estimate the current cost of capital.
c. On the basis of 1995 operating income, the optimal debt ratio is computed to be 30%, at which point the rating will be BBB, and the market interest rate is 8.12%.
d. Would the fact that 1995 operating income for airlines was depressed alter your analysis in any way? Explain why.