Question

King Fisher Aviation has a target capital structure of 72 percent common stock and 28 percent debt. Their cost of equity is 12 percent and the cost of debt is 5 percent. The tax rate is 40 percent

King Fisher Aviation issued a 25 year, 6.8 percent semiannual bond 8 years ago. The bond sells today for 110 percent of its face value. The tax rate is 40%.

Evaluate King Fisher's target capital structure. What are your recommendations? Consider the impact of taxes and explain your reasoning.

Answer 1

The following information are given in the question:

Common stock = 72%

Debt = 28%

Cost of equity = 12%

Cost of debt = 5%

Tax rate = 40%

Bond issued for 25 years at 6.8% semi annual coupon payment 8 years ago and currrently trading at 110%.

1. Evaluation of target capital structure:

Capital structure refers to the propotion of equity and debt in a company. The company is in aviation industry and hence the capital structure needs to be evaluated with specific to the aviation industry. Aviation is a capital intensive industry and have complex regulations to adhere to.

a. Leasing predominantly forms major part of balance sheet for a airline company. Taking aircrafts on leases improves the liquidity of the company and the principal amount of the leases (depending on the lease type) forms part of debt. With 72% equity and 28% debt, the given company is a low leveraged company implying majority of its financing are done through equity and its aircrafts have been procured instead of going for lease. Thus, the company may not be highly liquid.  

b. A higher debt, conversely, impacts the profitability of the company (inspite of tax shields) as the coupon payments are fixed and to be paid irrespective whether the company is profitable or not. While the return to shareholders (in the form of dividend) need not be given if the company makes loss. Also, aviation being a capital intensive industry, takes a longer time to break-even and have profits and hence during the initial years, being less leveraged is advantageous to the company if its not making profits. Hence, the given company can sustain even if its not profitable with the target capital structure.

c. Aviation is a heavily competitive industry and a a firm which is highly levered tends to lose market share to their less levered competitive firms.This is because low cost players (who predominantly do not use debt) have larger share of the market. Thus, the given company has the competitive advantage with the current target capital structure.

d. Aviation industry is seasonal. Travel happens more in the summer months or on holidays. Thus, this seasonality factor makes it difficult for the companies to fulfil the debt obligation throughout the year. The given company has the advantage here with the current target capital structure.

e. Debts come with tax benefits as the interest paid are tax deductible. The company is at 40% tax bracket. Thus, with the current target capital structure, the company may not fully take advantage of the tax benefits available.

Recommendations:

The required or optimum debt mix is dependant on various other parameters and differs company to company and hence the optimum capital structure cannot be defined. However, the recommendation for this question is provided basis the generic reasons given below.

First, lets find the weighted average cost of capital (WACC) of the company.

WACC = Cost of equity * (Equity/Total Capital) + Cost of debt * (Debt/Total Capital)

= 12%*72%+5%(1-40%)*28% = 8.64%+0.84% = 9.48%

The bond issued currently sells at 110% of its face value implying that the coupon rate offered is higher than the current prevailing rate. Even with this higher coupon rate, the cost of debt (and considering the tax benefit) is is significantly lesser than cost of equity of 12%.

It is recommended to increase the debt component of the company for the following reasons:

1. Aviation industry involves expansions at regular intervals and there is a need to purchase more air-crafts, pay for fuel, etc. Thus, these expansions comes at a huge cost and to recover these takes years during which the investors may not be given adequate returns in the form of dividend, etc. Thus, relying on common stock-holders to the maximum may not help in the long run and the investors may not further invest in the company if they do not get adequate returns. Thus, the financing from ordinary shareholders (equity) needs to be reduced.

2. Aircrafts taken under lease helps the company improve its liquidity. Further, aircrafts which are leased are comparatively less inactive implying more higher capacity utilisation resulting in higher revenue since the company would always be cognizant of the lease payments made periodically. The principal amount of these leases, depending on the lease type, forms of the debt Hence the company has to resort to more leasing implying more debt.

3. Debts have additional advantage of tax deductions. With the company at 40% tax bracket, the effective rate of these debts gets significantly reduced due to the tax benefit available.

Thus, the company is recommended to go for higher debt than the current debt structure of 28%. Also, any increase in debt mix for this company will only reduce the overall cost of capital. Thus, assuming debt mix is raised from 28% to 40%, WACC improves by over 1% to 8.4% (5%*(1-40%)*40%+(12%*60%)).

Hence from the perspective of having lower WACC and considering the generic reasons provided as above., company is recommended to review its target structure by increasing the debt component.