MINICASE 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 BALANCE SHEET annual cash flow of $4 million for 20 years. The focus of the meeting was on how to finance the purchase. Bank debt $ 50 Cash $ 20 LA had $20 million in cash and marketable securities (see table), Other current liabilities 20 Other current but Ed Johnson, the chief financial officer, pointed out that the assets 20 company needed at least $10 million in cash to meet normal out- 10% bond, due 2034* 100 Fixed assets 250 flow and as a contingency reserve. This meant that there would Stockholders' equity 120 be a cash deficiency of $15 million, which the firm would need to Total liabilities $290 Total assets $290 cover either by the sale of common stock or by additional borrow- ing. While admitting that the arguments were finely balanced, INCOME STATEMENT Mr. Johnson recommended an issue of stock. He pointed out that Gross profit $57.5 the airline industry was subject to wide swings in profits and the Depreciation 20.0 firm should be careful to avoid the risk of excessive borrowing. Interest 7.5 He estimated that in market value terms, the long-term debt ratio Pretax profit 30.0 was about 59% and that a further debt issue would raise the ratio Tax to 62%. 10.5 Mr. Johnson's only doubt about making a stock issue was that Net profit 19.5 investors might jump to the conclusion that management believed Dividend 6.5 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%. +LA has 10 million shares outstanding, with a market price of $10 a share. LA's that the company needed to explain carefully the reasons for the equity beta is estimated at 1.25, the market risk premium is 8%, and the Treasury issue. Also, he suggested that demand for the issue would be bill rate is 3%. 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) x 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, I don'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 divi- not 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