Management of Leisure Air met to discuss possibly purchasing five aircraft at a total cost of $25
million. The new aircraft were expected to generate an annual cash flow of $4 million for 20
The focus was on how to finance the purchase. Leisure Air had $20 million in cash and
marketable securities (see table), but the Chief Financial Officer (CFO), Mr. Hobbs, said that
the company needed at least $10 million in cash to meet normal out flow 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. Mr. Hobbs
recommended issuing stock. He pointed out that the airline industry was subject to wide swings
in profits and the company 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. Hobbs had concerns that investors might jump to the conclusion that management believed
the stock was overpriced though, and that the announcement might prompt an unjustified selloff
by investors. Hobbs stressed, therefore, that the company needed to explain the reasons for the
issue. Also, he suggested that demand for the issue would be enhanced if at the same time
Leisure Air increased its dividend payment.
These arguments cut little ice with Leisure Air’s Chief Executive Mrs. Smith. “I know that
you’re the expert on all this”. She spoke. “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
with a 21% tax rate, the after-tax cost of borrowing is (1 − .21) × 6% = 4.74%. That’s less than
the cost of equity. We expect to earn a return of 15% on these new aircraft. If we can raise
money at 4.74% 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.
Mrs. Smith continued. “I don’t want to push my views on this—after 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?”
Use the most recently available financial data from 2019 to help evaluate CFO Mr. Hobbs’s
arguments about the stock issue and dividend payment as well as the reply of Leisure Air’s Chief
Executive Mrs. Smith. Who is correct? Use calculations. What is the required rate of return
on the new planes?