Case Assignment 2 - Chapter 16 Mini Case

In March 2020, the management team of Londonderry Air (LA) Summary financial statements for Londonderry Air, 2019 met to discuss a proposal to purchase five shorthaul aircraft at a (Figures are book values, in millions of dollars) 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, "The yield to maturity on LA debt currently is 6%. that the company needed to explain carefully the reasons for the "LA has 10 million shares outstanding, with a market price of $10 a share. LA's enhanced if at the same time LA increased its dividend payment. This would provide a tangible indication of management's confi- "Look at the alternative. We can borrow today at 6%. We get a dence in the future. tax break on the interest, so with a 21% tax rate, the after-tax cost These arguments cut little ice with LA's chief executive. "Ed," of borrowing is (1.21)6%=4.74%. That's less than the cost of she said, "I know that you're the expert on all this, but everything equity. We expect to earn a return of 15% on these new aircraft. If you say flies in the face of common sense. Why should we want to we can raise money at 4.74% and invest it at 15%, that's a good deal sell more equity when our stock has fallen over the past year by in my book. nearly a fifth? Our stock is currently offering a dividend yield of "You finance guys are always talking about risk, but as long as 6.5%, which makes equity an expensive source of capital. we don't go bankrupt, borrowing doesn't add any risk at all. Increasing the dividend would simply make it more expensive. "Ed filindon't want to push my views on this-after all, you're the What's more, I don't see the point of paying out more money to the expert. We don't need to make a firm recommendation to the board stockholders at the same time that we are asking them for cash. If until next month. In the meantime, why don't you get one of your we hike the dividend, we will need to increase the amount of the new business graduates to look at the whole issue of how we should stock issue; so we will just be paying the higher dividend out of the finance the deal and what return we need to earn on these planes?" shareholders' own pockets. You're also ignoring the question of Use the most recently available financial data from 2019 to help dilution. Our equity currently has a book value of $12 a share; it's evaluate Mr. Johnson's arguments about the stock issue and divinot playing fair by our existing shareholders if we now issue stock dend payment as well as the reply of LA's chief executive. Who is for around $10 a share. correct? What is the required rate of return on the new planes