The management team of ABC airlines met to discuss how to fund an investment of 25 million. The company has 10 million internal cash for the investment but, has to raise 15 million in external funding either by the sale of common stock or by additional borrowing.

Anne, the Chief Financing Officer (CFO) recommended an issue of stock on the basis that in market value terms the current long-term debt ratio for the company was about 59%, which was close to the upper limits of the level of debt the company could sustain, and that a further debt issue would increase the ratio to 65%, which in her opinion is not possible. She also 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. Annes only doubt about the stock issue was that the investor might conclude that the management believed that the price was overvalued, in which case the announcement might prompt an unjustified sell off by the investors. She stressed therefore, that the company needed to explain carefully the reason for the issue. Also, she suggested the demand for the issue will be enhanced if at the same time ABC increased its dividend payment. This will provide a tangible evidence of managements confidence in the future. Jeffrey, Chief Executive (CEO) did not agree. He said, Everything you have said flies in the face of common sense. Our stock is currently offering a dividend yield of 6%, which makes equity an expensive cost of capital. If we increase 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. 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 3.9%. We expect to earn a return of about 15% on these new aircrafts. If we can raise money at 3.9% and invest it at 15%, thats a good deal in my book. In my opinion, as long as we dont go bankrupt, borrowing doesnt add any risks at all. Based on the above scenario and your knowledge about Capital Structure and Dividend theory, discuss the:

a) CFOs proposal about the stock issue and the dividend payment, with particular focus on:

The type of capital structure theories is she referring to.

The conclusion investors might derive from a stock issue and its implications in relation to share price and the cost of equity as a form of funding.

The dividend argument.

b) CEOs response to the CFOs proposal, with particular focus on:

The theory of capital structure he is referring to in relation to debt.

His statement as long as we dont go bankrupt, borrowing doesnt add any risks at all.

The dividend yield and cost of equity argument