Question

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. Anne’s 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 management’s 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 shareholder’s 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%, that’s a good deal in my book. In my opinion, as long as we don’t go bankrupt, borrowing doesn’t add any risks at all”. Based on the above scenario and your knowledge about Capital Structure and Dividend theory, discuss the:

a) CFO’s 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) CEO’s response to the CFO’s proposal, with particular focus on:

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

 His statement “as long as we don’t go bankrupt, borrowing doesn’t add any risks at all”.

 The dividend yield and cost of equity argument

Answer 1

PART A: The CFOs proposal

There are four approaches to capital structure theories namely, net income approach, net operating income approach, traditional approach and Modigliani and Miller approach, popularly known as MM approach. Also, there are two types of risk, operating and financial. Operating risk arises due to a firm's day to day operations. This risk is inherent in the industry and most companies cannot reduce this type of risk. Then there is financial risk that arises due to taking on more debt by the firm. It increases its interest payments and thus reduces Profit after tax. This will be a great problem when EBIT is low or negative.

The capital structure theory referred to here is MM approach which says in a proposition that if amount of debt is increased, it would increase the financial risk. This financial risk is bore by the shareholders and hence, they demand a higher return for the same amount of investments. Hence, the CFO says that 65% debt in capital structure might not be possible.

Usually, companies issue new shares only when the market price is higher than the intrinsic value (Everyone wnts a higher price for their sale, even the companies). So, if share issue announcement is made, it will imply to the market that share is overvalued. This will prompt them to sell their existing holdings, reducing the market price and consequently, reducing even the price of new issue. Usually, companies have a fixed dividend policy, which in this case would mean higher cost of equity and thus increasing WACC.

The increase in dividend might actually have an opposite impact than desired. As per MM approach, a growing firm should not pay any divided, because if they don't pay it, the amount get reinvested in the company and will appreciate the capital gains for shareholders. If they pay the dividend, that means the company is implying that, "There are better investment destinations than us, take your money and invest in those, higher growth companies", which is not the signal that the company would like to give. Additionally, extra dividend payment would increase cost of equity, which is unfavourable.

PART B: The CEOs Response

The CEO is referring to the net income approach of capital structure theory. It implies that cost of debt is usually lower than cost of equity. Hence, addition of more and more debt would imply a decrease in Weighted Average Cost of Capital or WACC, in turn increasing the value of firm. But this approach is one of the in initial ones, which does not consider the impact of increased debt or increased financial risk on cost of equity. The shareholders demand a higher return for added risk, also known as financial risk premium, which increases the equity beta in CAPM formula, thus increasing cost of equity. Therefore, keeping the WACC practically at the same level as previous (in absence of taxes).