Friendly Skies Airlines, Inc. is a low cost airline that provides service to pas
ID: 2751225 • Letter: F
Question
Friendly Skies Airlines, Inc. is a low cost airline that provides service to passengers in select US cities. They operate primarily in highly populated urban markets utilizing gates at smaller airports. The company has been able to offer affordable airfares due to their operating costs through efficient utilization of their aircraft, operating only one type of aircraft, creating a productive workforce and lowering distribution costs (paperless ticketing).
Friendly Skies has been very successful in tapping into new customer bases and believe they could enjoy further success if they expand their markets by adding new routes and increasing the number of flights they offer to existing destinations. To accomplish this growth, additional aircraft would be required. The company anticipated they would need 200 additional aircraft at a cost of $6.8 billion. Their current fleet was financed either through secured debt or operating leases. The company believes they could achieve favorable operating leases for the new airplanes.
In addition to new aircraft, Friendly Skies required capital in order to expand their markets. Investments in new hangers, extra spare parts, additional personnel, training, airport gate fees and marketing would be needed. The company received two financing proposals from investment banks for this capital expansion. The first involved an equity offering of 2.6 million shares at an estimated $42.50 per share. The second proposal was to issue $150 million in convertible bonds with a stated 4.5% interest rate and convertible into shares at $63.75 per share.
Friendly Skies’ Chief Financial Officer favored conservative financing but was concerned about the dilution an equity offering would have on EPS. However, debt financing was riskier. The airline industry is vulnerable to fuel prices. She was concerned that, if fuel prices rose significantly, they may not be able to meet its debt service obligations.
Requirements:
Explanation / Answer
Under equity offering option total inflow of fund= 2.6*10^6*42.5
Inflow=$110500000 or $110.5 Million
There is no outflow under this option as equity stock does not pay any interest etc.
Under debt financing inflow is $150 Million
Outflow is $150*10^6*4.5% = $6750000 as an interest payment each year.
If debt is converted to equity shares,Number of equity shares =$150/63.75=2.35 Million shares
EPS = Net income/ Shares outstanding at the end of period
EPS in case 1=(22360)/(10+2.6)
EPS=-1774.60
EPS in case 2 if converted to equity=(22360)/(10+2.35)
=-1810.53
Net income due to increased interest expense in case would be -22200-400-6.75=22606.75
After tax net income=22606.75*(1-0.011)=22366.68
EPS =-22366.68/10=-2236.668
Debt to equity ratio in case 1= 234700/(164100+11600+110.5)
D/E case 1=1.33
Debt to equity ratio in case 2=(234700+150)/(164100+11600)
D/E in case 2=1.34
Original D/E ratio is 1.33
Interest expense on debt provide tax shield but if current trend of negative income continues, company will not be able to service its debt obligations. This problem wil not be there in equity offering.
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