Long Term Financing Pattern of British Airways - Case Study Example

Assessment of long Term financing pattern of British Airways Introduction: This paper seeks to consider the pattern of long term financials of a global airlines company, British Airways (BA), and delves into the various aspects that govern financial structuring decisions in this company. This paper also considers financial options available to BA specifically, in order to better understand how large corporations gain and utilise funds, especially in the critical areas of public accountability, financial disclosures and shareholders' interests. It is first of all necessary to understand the factors that determine long term financing and how this could impinge operations of BA. It is seen that, by and large, there are a number of determinants that constitute the pattern of financing that needs to be followed by BA and they are as follows: Business Risks: Business risks: It is seen that the higher the risks of the business, the lower should be the dependence on debt, or outside funds. In the context of British Airways, it is seen that gearing percentage has come down from 67.7% in 2004-05 to just 28.8% in 2007-08. In other words, it indicates that the dependence for debt capital has come down by nearly 58% in just 3 years, averaging nearly 20% drop each year. (Financial highlights). One of the main reasons for the drop in gearing to 28.8% in 2007-08 could be the better operating performance and the build-up of retained profits and reserves during the years, all this despite high rises in fuel, employee and other operating costs. (Financial Highlights). It is also seen that "Despite increases in the UK and US floating rates, our interest payable on bank and other loans reduced, mainly as a result of lower debt levels." (Chief financial officer's report continued p.4). Further, it is seen that due to growth in retained profits, the debt equity ratio was only 28.8% during 2008, which is lower than last year. Again, considering operating leases, debt/total capital ratio was 38.4%. (Chief financial officer's report continued p.5). Capital structure theories: Market value of a firm is determined by its earning power and the risk of its underlying assets, and it is related with how they have financed or how they have distributed their dividends.A firm can raise finance through twoways. They areissuing shares or borrowing from banks. Debt equity ratio: It is the ratio of debt to the equity. A company's financial leverage can be calculated by dividingits total liabilitiesbystockholders' equity. It indicates the proportion of equity and debt the company is using to finance its assets.It is also known as the Personal Debt/Equity Ratio, thiscan be applied to both personal financial statements and companies' financial statements. A high debt/equity ratio shows that the company has been aggressive in financing its growth or equity with debt. This can result in high earnings as a result of the additional expense. If a company is using lot ofdebtfinance in its operations (high debt to equity), it can generate more earningsthan it would have without thisoutside financing.If this were to increase earnings by a greater amount than the debt cost (interest), then the shareholders will get higher amount of earnings as dividend. However, the cost of this debt financing may outweigh the return thatthe companygenerates on the debt through investment and business activities and become too much for the company to handle. This can lead to bankruptcy, which would leave shareholders with nothing. The main advantage of debt financing is that it is a cheaper source of finance. It means that required rate of return on equity will always be higher than the interest rate on debt, there is a "hidden" cost involved in the cost of equity. And the cost of equity rises when we utilize more debt financing. This is one reason for using the average cost of capital in valuing a project or company which is more appropriate, even if we intend to borrow all the money to finance it. While we may use cheap debt to finance a project, the increased risk to shareholders from increasing our financial leverage results in an increase in the cost of equity. The debt/equity ratio depends upon the industryin which the company operates. For example, capital-intensive industries such as automanufacturing tend to have a debt/equity ratio above 2, while personal computer companies have a debt/equity of below 0.5. (Capital structure 2009). British Airways debt equity ratio: An examination of the trend of debt equity over the four year period denotes that the company relied heavily on debts during 2005 (68%) and 2006 (44%), but with increased profits and reserves during 2006 (304) and 2007(694), these debts were reduced and larger profits and reserves contributed to better equity. "Net debt at March 31, 2008 amounted to 1,310 million, an increase of 319 million compared with March 31, 2007. This is net of cash and cash equivalents and other interest-bearing deposits totalling 1,864 million. Despite our increase in net debt, the net debt/total capital ratio at March 31, 2008 was 28.8 per cent, a 0.3 point reduction on last year. This was mainly due to growth in retained profits. Including operating leases, our net debt/total capital ratio was 38.4 per cent, a 1.2 point reduction from last year." (Where we fly to, p.19). The management of BA believes that these figures would show the low dependence on debt over the years by the company. From the company's point of view it may be said that large scale debts could be incurred for purchase of aircrafts, capital expenditures on the construction of Terminal 5 in Heathrow airport, and the need to invest in new planes for future. "Although most of our debt is currently asset-related, there can be no assurance that aircraft will continue to provide attractive security for lenders in the future." (Business review continued principal risk and uncertainties). Debt Summary Debt Instrument CUSIP/ ISIN Original Issue Issue Date Amount Outstanding Maturity Date Issuer: British Airways plc 7.25% bonds due 2016 XS0133582147 250m 26/07/2001 250m 23/08/2016 NYC Indust Dev Agency due 2032 US$115m 03/12/1998 US$115m 01/12/2032 Spl Fac Rev Bonds due 2032 US$85m 02/07/2002 US$85m 01/12/2032 Issuer: British Airways Finance (Jersey)L.P 6.75% Guaranteed non-voting cum pfd secs series A GB0056794497 EUR300m 28/04/1999 EUR300m Perpetual (Debt summary). Requirements for long term funds: The main aspect regarding long term funds requirements for BA could be in terms of: 1. Need to modernize and add new aircrafts to its fleet 2. Upkeep and Maintenance of its exclusive Terminal 5 at Heathrow airport which is expected to assuage congestion and heavy traffic at this airport. New Terminal 5 at Heathrow at a total cost of 4.3 Billion is expected to become operational by 2008. The 'Fit for 5 ' has become a major issue in terms of total change of logistical activities to this new terminal which would pose challenging and facilitative, and once operational, is expected to resolve imbalances in London's air travel permanently. "The terminal, which will be capable of handling 30 million customers a year, will enable us to provide new levels of customer experience." (Third quarter results 2006-2007 (unaudited)). 3. The liabilities for Pension Funds and the main issue of Net Deficit of 2.1 Billion in the pension fund account have been addressed. However, it would be necessary to make a "net off payment of 800 million to the Pension Fund for the 33,500 people who hold a Company Pension. Its Annual Cost would be about 280 M for the next decade." (British airways agrees pension deal with main union, 2007). Thus, the main risks that would impinge BA in the coming decades could be seen in terms of heavy liabilities that could become real and enforceable. It is seen that the optimal capital structure that BA needs to pursue needs to consider the maximization of pricing of the company's stock which needs to have the best debt ratio in place. The main capital structure theories are as below: 1. The Modigliani-Miller Model. 2. The Hamada Model 3. The Miller Model 4. The Trade-off Model. 5. The Signaling Model. The Modigliani-Miller Model: This theory of cost of capital states that the overall cost of capital remains constant as the financial gearing of a firm increases. (Modigliani- miller theory of the cost of capital). The Modigliani Miller Theory propounds that it does not make much of a difference to the value of a company, if the company is financed by debt capital, or equity capital, provided there are no taxes, brokerage, uniform interest rates and no bankruptcy costs, and efficient markets are present. A valid illustration would be in place here. There are two Companies, A and B.While A is a highly leveraged company (high debts), B is comparatively lowly leveraged (high equity). It is possibly that Mr. C wishes to exercise a choice to buy either A or B. Would he prefer a highly leveraged or lowly leveraged company C on his part could buy Company B and also take a loan amount that could equate with A's debt burden. In effect, C has a highly leveraged company without having really invested in one. This principle is embodied in the Modigliani -Miller Model, in that in the ultimate analysis, does not really make much difference and leveraging simultaneously raises risk of equity just as much as it raises the risk of debt. "Indeed, in a world of sure returns, the distinction between debt and equity funds reduces largely to one of terminology." (Modigliani & Miller, 1958). In the case of BA, it is seen that there a long term bonds maturing in years 2016 for 250M and also during 2032 for $ 200M. Thus the debt equity would need to take account for these debts. Besides, perpetual securities for $ 300M are also present. The Hamada Equation Model: It is next proposed to consider the Hamada Equation Model, which is based on the premise that an increase in the debt ratio would also increase the risk faced by shareholders and this could affect cost of equity. The Hamada equation could be expressed as b= b[1+ (1-T) (D/E)] The increase in the debt/equity ratio could increase beta symbolized by b, which is the beta free of debt. Once values are assigned for b, its impact upon cost of equity could be measured. An illustration could prove the point. A leveraged company has both equity and bond capital. (6:6); while equity carries risks, bonds carry fixed interest rates. Some of the equity holders decide to opt for bond and the new structure is (3:9). However, the new bondholders cannot be kept at par with existing bondholders and therefore, they are treated separately with higher yearly interest payouts. While the risk for equity has reduced, the total risks for firm increases in proportion to the equity shareholders exercising option for bonds, with the changed leverage to bondholders. Thus while a narrower equity base may fetch higher returns for this genre of shareholders it would increase total risks for firm. The Miller Model: The Modigliani Miller Model propagated by Modigliani fails to take into account the aspect of personal and corporate tax in capital structuring. The impact of corporate and individual tax elements have, however, been considered by Miller, in his theory in which he argued that all firms would issue a judicious mix of debt and equity such that the pre-tax yield on security and personal tax rate of investors would, in the long run, adjust against the equity. In other words, the MM model has been validated by Miller adding the dimension of tax impacts on the firm. This could be suitable in the case of BA also in that there are large doses of corporation taxes meted out by the company. "Our total tax charge arising on profits from continuing operations was 187 million (2006/07: 173 million) giving us an effective tax rate for the year in relation to our profits from continuing operations of 21 per cent (2006/07: 28 per cent)." (Where we fly to, p.18). Trade-Off Models: The Trade-Off Models consider the optimal capital structure as a substitution between benefit of debt (interest tax shelter) and cost of debt (economic destitution and third party costs). The provisos to trade-offs in essence, seeks to discuss as follows: 1. Firms with more business risks need to take up fewer debts, since risks could add up to risk of bankruptcy that could affect high risk companies more than low risks ones. 2. Again, this model advocates that firms having tangible assets, like aircrafts, hangars, etc should seek more debt than companies who do not possess such assets. This is because it would be in a better position to sell off such assets and gain funds for liquidation of debts as compared with firms that do not have tangible assets to liquidate. 3. The aspect of taxation is also important, since firms who pay higher doses of taxes now and in future, could reap the benefits of increased debt capital, with depreciation shields to protect them against high risks associated with high debt equity. British Airways operates in a highly volatile and high risk environment. Not only is an air travel innately high risk venture, but is also underpinned by Governmental regulations, flying rights and security aspects. Moreover, the recent recessionary trends in global economy in terms of economic meltdowns, lower employment and revenue generation levels and fall in air travel, especially in the premium classes, have not contributed positively to the fiscal well being of airlines industry as whole. Even large airline companies are feeling the heat of lack of growth stimulus in their operational areas and the encroachment of competitive forces on their market turfs. (Where we fly to, p.18). From the above it is seen that total capital expenditures during 2007/8 had risen by 93% over figures for 206/07. Moreover, there are also capital commitments for5189, including 5162 towards debts incurred for aircraft purchases, which would need to be met in near future. Signaling Model: The Signaling Model takes into consideration the fact that companies use internal funds before using external sources. Even dividend payments are made on the basis of future investment opportunities and future cash flows. Once a dividend payout ratio is set, (after considering expenses), the rates are kept intact, but they are not increased or reduced except under exceptional circumstances. If excess funds are available after providing for capital expenditures, they would be used in the order of investments in market securities, to wipe off debt, increase dividend rates or buy back its own shares. If more funds are needed, it would first use up its internal investments and then only would go to outside sources for funds. Applying Signalling model to BA, a view of Cash flow statement for fiscal 2008 (Appendix 1) reveals that the closing balance of cash at 683M has been arrived at after considering the following borrowings and liability clearances: Purchase of Property, Plant & Equipments (596M), Decrease in interest bearing deposits (458M), repayments of borrowings, (68M), payment of final lease liabilities (356M) and disbursements made to holders of perpetual Securities ((14M), (Where we fly to). Conclusions: In as far as the capital structure of British Airways is concerned, it is seen that it is a lowly geared company with debt capital forming just around 29% of its capital structure. This has occurred due to better overall performance over the last five years, operating margins at 10%, and better efficiencies and reductions being effected due to better operational competencies and marked improvements in all major and key areas of public accountability. A major area that had been harrying BA's operations had been high operating costs, employee costs and lack of fuel efficiencies, but this has been kept at around 6% of costs through various cost lowering schemes. Further it is also seen that revenue generation has been reasonably good and is showing upward trends over the years. It is apparent that considering the high risks involved in airlines business, especially with competition from other no frill and private airliners, BA needs to be constantly alert to new opportunities for growth and development, especially on a global level. BA strategic alliances in terms of 13.15 % stakes in Air Iberia, and negotiations for strategic mergers, more than just code sharing with American Airlines and Continental airlines are testimonials of wide-ranging co-operative efforts initiated with these two major airlines. For its part, BA is committed to offer unified global skies for all operators. Perhaps it would have been this fact that has encouraged it to seek a wide range of mergers and code sharing, agreements and strategic alliances. "Iberia and British Airways have already signed so-called code-sharing agreements on 57 routes which allow each airline to sell tickets to fill seats on the other airline's flights. But full-scale mergers are trickier to negotiate because of bilateral agreements made between individual governments and third countries which dictate where airlines can fly. "(BA may merge with Iberia 2003). Thus, it could be said that things have begun to look up for the beleaguered British Airways, which had a series of near problems including the opening of Terminal 5 at Heathrow airport and a series of other issues to grapple with. Writers' Note: If more analysis is required it is requested that scanned attachments may please be sent. Thank you. Appendix A Reference BA may merge with Iberia 2003, BBC News, viewed 4 April 2009, http://news.bbc.co.uk/1/hi/business/3165488.stm Business review continued principal risk and uncertainties: financial commitments, British Airways, viewed 4 April 2009, http://www.britishairways.com/cms/global/microsites/ba_reports/pdfs/12_BR_Risks.pdf British airways agrees pension deal with main union: British airways has reached a deal with its four main trade unions on a package of reforms to tackle its 2.1bn pension deficit 2007, Personnel Todays.com, viewed 4 April 2009, http://www.personneltoday.com/articles/2007/01/08/38800/british-airways-agrees-pension-deal-with-main-unions.html Chief financial officer's report continued, British Airways, viewed 4 April 2009, http://www.britishairways.com/cms/global/microsites/ba_reports/overview/cfo_p4.html Chief financial officer's report continued, British Airways viewed 4 April 2009, http://www.britishairways.com/cms/global/microsites/ba_reports/overview/cfo_p5.html Capital structure 2009, Investopedia, viewed 4 April 2009, http://www.investopedia.com/terms/c/capitalstructure.asp Debt summary, Badedebtholders.com-Invester Relation, viewed 7 April 2009, http://www.badebtholders.com/phoenix.zhtmlc=69499&p=irol-debtsummary Financial highlights, British Airways, viewed 4 April 2009, http://www.britishairways.com/cms/global/microsites/ba_reports/overview/highlights.html Financial Highlights: group revenue by area of original sale, British Airways.com, viewed 7 April 2009, http://www.britishairways.com/cms/global/microsites/ba_reports/overview/highlights.html Modigliani- miller theory of the cost of capital, Economy Professor, viewed 4 April 2009, http://www.economyprofessor.com/economictheories/modigliani-miller-theory-of-the-cost-of-capital.php Modigliani, Franco & Miller, Merton H 1958, The American economic Review: The Cost of Capital, Corporation Finance and the Theory of Investment, vol. XL VIII, no. 3 (provided by the students). Operating and financial statistics, British Airways, viewed 4 April 2009, http://www.britishairways.com/cms/global/microsites/ba_reports/fin_statements/fs_opfin_stats.html Third quarter results 2006-2007 (unaudited): terminal 5, British Airways, viewed 4 April 2009, http://library.corporate-ir.net/library/69/694/69499/items/229464/Q3_BA_Results.pdf Where we fly to, British Airways, viewed 4 April 2009, http://www.britishairways.com/cms/global/microsites/ba_reports/pdfs/BA_Report_2007_08.pdf Where we fly to: net debt /total capital ratio, British Airways, viewed 7 April 2009, http://www.britishairways.com/cms/global/microsites/ba_reports/pdfs/BA_Report_2007_08.pdf Where we fly to: Chief financial officers report continued: Taxation, British Airways, viewed 7 April 2009, http://www.britishairways.com/cms/global/microsites/ba_reports/pdfs/BA_Report_2007_08.pdf Where we fly to, British Airways, viewed 7 April 2009, http://www.britishairways.com/cms/global/microsites/ba_reports/pdfs/BA_Report_2007_08.pdf Read More