In March 2015 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.

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?

Summary financial statements for Londonderry Air, 2014 (Figures are

book values, in millions of dollars.

Balance Sheet

Bank debt $ 50 Cash $ 20

Other current liabilities 20 Other current assets 20

10% bond, due 2032* 100 Fixed assets 250

Stockholders' equity 120

Total liabilities $290 Total assets $290

Income Statement

Gross profi t $57.5

Depreciation 20.0

Interest 7.5

Pretax profi t 30.0

Tax 10.5

Net profi t 19.5

Dividend 6.5

* The yield to maturity on LA debt currently is 6%.

LA has 10 million shares outstanding, with a market price of $10 a share. LA's equity beta

is estimated at 1.25, the market risk premium is 8%, and the Treasury bill rate is 3%.