MINICASE

In March 2013 the management team of Londonderry Air (LA) met to discuss a
proposal to purchase five shorthaul aircraft at a total cost of $25 million. There was
general enthusiasm for the investment, and the new aircraft were expected to
generate an annual cash flow of $4 million for 20 years.

The focus of the meeting was on how to finance the purchase. LA had $20 million in
cash and marketable securities (see table), but Ed Johnson, the chief financial
officer, pointed out that the company needed at least $10 million in cash to meet
normal outflow and as a contingency reserve. This meant that there would be a cash
deficiency of $15 million, which the firm would need to cover either by the sale of
common stock or by additional borrowing. While admitting that the arguments were
finely balanced, Mr. Johnson recommended an issue of stock. He pointed out that the
airline industry was subject to wide swings in profits and the firm should be careful
to avoid the risk of excessive borrowing. He estimated that in market value terms the
long-term debt ratio was about 59% and that a further debt issue would raise the
ratio to 62%.

Mr. Johnson's only doubt about making a stock issue was that investors might jump
to the conclusion that management believed the stock was overpriced, in which case
the announcement might prompt an unjustified selloff by investors. He stressed
therefore that the company needed to explain carefully the reasons for the issue.
Also, he suggested that demand for the issue would be enhanced if at the same time
LA increased its dividend payment. This would provide a tangible indication of
management's confidence in the future.

Summary financial statements for Londonderry Air, 2012 (Figures are book values, in millions of dollars.)
Balance Sheet

Bank debt $50Cash $20

Other current liabilities 20Other current assets 20

10% bond, due 2032* 100Fixed assets 250

Stockholders' equity 120

Total liabilities $290Total assets $290

Income Statement

Gross profit $57.5

Depreciation 20.0

Interest 7.5
Pretax profit 30.0

Tax 10.5

Net profit 19.5

Dividend 6.5
Page 475

These arguments cut little ice with LA's chief executive. Ed, she said, I know that
you're the expert on all this, but everything you say flies in the face of common
sense. Why should we want to sell more equity when our stock has fallen over the
past year by nearly a fifth? Our stock is currently offering a dividend yield of 6.5%,
which makes equity an expensive source of capital. Increasing the dividend would
simply make it more expensive. What's more, I don't see the point of paying out more
money to the stockholders at the same time that we are asking them for cash. If we
hike the dividend, we will need to increase the amount of the stock issue; so we will
just be paying the higher dividend out of the shareholders' own pockets. You're also
ignoring the question of dilution. Our equity currently has a book value of $12 a
share; it's not playing fair by our existing shareholders if we now issue stock for
around $10 a share.

Look at the alternative. We can borrow today at 6%. We get a tax break on the
interest, so the after-tax cost of borrowing is .65 6 = 3.9%. That's about half the
cost of equity. We expect to earn a return of 15% on these new aircraft. If we can
raise money at 3.9% and invest it at 15%, that's a good deal in my book.

You finance guys are always talking about risk, but as long as we don't go bankrupt,
borrowing doesn't add any risk at all.

Ed, I don't want to push my views on thisafter all, you're the expert. We don't need
to make a firm recommendation to the board until next month. In the meantime, why
don't you get one of your new business graduates to look at the whole issue of how
we should finance the deal and what return we need to earn on these planes?

Evaluate Mr. Johnson's arguments about the stock issue and dividend payment as
well as the reply of LA's chief executive. Who is correct? What is the required rate of
return on the new planes?

Answer:

Johnsons arguments are based on the pecking order theory of capital structure. He is right
that investors may interpret it as issue of stock which is a signal shared by management
views as currently overpriced. If the stock price falls at the declaration of equity offer, it
would be very expensive source of finance. The suggestion of Johnsons increase in
dividends makes sense. If the management confirms higher dividend, it should expect that
firm will be able to generate sufficient cash flow to pay for the dividend. Therefore, an
increase in dividends indicates the firm is performing well and investors fear that issuing of
equity is not a good indication.

LAs chief executive discusses various false equity issues. The fall in the stock price
compared to recent levels makes equity a cheap source of financing. It is expensive when
the management believes that stock price has reduced too much and will recover soon.

According to the MM propositions, if the equity has high expected return of return compared to
debt, it is cheap source of financing. LAs chief executive did not recognize that debt has an
implicit cost: issuing higher debt make debt and equity riskier. Therefore, the observation that
yields on bonds of only 5% is irrelevant to the issue that which debt or equity is better
financing. Nor the chief executive is concerned about equity book value warranted. It is not
related to the value of the firm as continuous business. Till the equity is priced fairly, the firm
will issue equity. Change in the book value share of equity has no effect on the stockholders
wealth.

To calculate the required rate of return on the new planes, we use the weighted average cost of
capital. Market values of financing sources are as follows:

Debt: $50 million bank loan + $162 million bonds = $212 million

Equity: Value of shares = $10 10 million = $100 million

Therefore, debt (including short-term debt) comprises: 212/312 = 67.9% of total financing

Equity is 32.1% of total financing.

The expected return on debt is 5% and the expected return on equity is (using data from the
notes to the financial statements):

rf + b(rm rf) = 4% + 1.25 8% = 14%

Therefore:

WACC = [0.679 5% (1 0.35)] + (0.321 14%) = 6.70%

Using data from the notes to financial statements

LA has 10 million shares outstanding, with a market price of $10 a share. LAs equity beta is estimated
at 1.25, the market risk premium is 8 percent, and the Treasury bill rate is 4 percent.