Analysis of Airline Finance - Research Paper Example

 Analysis of Airline Finance Abstract In this report, the trends and main issues in airline financing are discussed. The trends in airline financing show that the financing of airlines have been affected adversely by the global financial crisis. They show most airlines facing significant losses in 2008 except the low cost carriers. The full service airlines face downward competitive pressures from the low cost carriers as obtained from the analysis. Moreover the revenue generating capacities of most airlines have come down significantly and not enough to cope up with the rising costs. The case study of British Airways illustrate that all the key financial figures show huge losses for the company in 2009. The estimation of cost of capital based on the WACC approach has been illustrated with the example of British Airways in this report. This company uses several alternative assumptions like Market Capitalization ratio, estimates provided by other regulators, evidence from financial markets etc in addition to the CAPM for estimating WACC. 1. Introduction The importance of aviation industry in terms of economic and financial benefits has been quite established (Yilmaz, 2008). This industry brings new employment opportunities and helps in linking people in different parts of the world (Michalski, 1996). In addition to the economic and financial benefits, this industry is very important for the social progress of a nation too(Rochat,2007).It is also established as an environmentally responsible industry through using sustainable technologies for containing its environmental impact(Lazar,2003).The industry has undergone many changes in the recent years including the deregulation and privatization measures and the emergence of many low cost carriers creating high competition to the low cost carriers etc. Given the importance of aviation industry in an economy and the dynamic changes taking place in the industry, the financing of airlines has also become an issue of widespread interest. This report examines the global trends in airline financing and also some major issues in airline financing .This report is organized as follows. Section 2 discusses the review of literature on airline finance. Section 3 discusses the objective of the study and the research methodology. Section 4 discusses the findings and section 5 concludes the study. 2. Literature Review The main sources of finance identified for the airlines are cash, operating leases and sale/leasebacks, bank loans/finance leases, export credit guaranteed loans, tax leases, manufacturer support. EETC and Islamic finance (Air finance journal, 2010).The cash is identified as the cheapest source of finance among these. The main limitation with usage of cash is that during economic downturns, there are lots of problems associated with releasing cash. In the second case, there are operating lessors who either order aircraft from manufacturers or buy them from airlines and lease them back. In the third case, the aircraft guarantee loans and banks lend money with these guaranteed loans. The third financing type is very relevant during economic downturns when the banks stop lending. In the fourth case, the companies are encouraged to work more efficiently by the government through tax breaks. In the case of manufacturer support, either the manufacturer leases the aircraft on finance and gives them back at the end. The EETCs or enhanced equipment trust certificates are bond financing issued by aircrafts. In the case of Islamic leasing, interest rates are not charged based on the Islamic finance (Air finance Journal, 2010). In the study by Gibson and Morrel (2005), the measures used to evaluate investments in aircraft by the airlines are evaluated. The study finds the cash based measures rather than the accounting based techniques as more advanced method in this regard.249 Chief financial officers all over the world are interviewed in this study. The interview revealed huge differences in many techniques mainly cost of equity estimation and risk estimation. One main issue obtained in the study was the estimation of cost of capital especially based on Weighted Average Cost of Capital (WACC). The main problems identified with the estimation of WACC was the calculation of Net Present Value, which itself is subject to present variation. Studies have shown that the CAPM, which is used as the theoretical framework for calculating WACC, has failed to explain the relationship between the risk and return in many nations (Erb etal, 1996; Harvey 2001 etc). These studies have criticized the use of beta as an appropriate risk of measure due to the failure of underlying assumptions for beta like no home bias, constant expected returns and risk and integration of market into world markets, for many equity markets. In addition to the limitations of CAPM, one of the most debatable parts of estimating WACC is the estimation of cost of equity capital. In the debt market yields are available and hence the cost of debt is not a debatable issue. However, for equities this type of data is not available. Hence, the practitioners are forced to depend on indirect and abstract methods to estimate cost of equity capital (Bruner et al, 1998). The risk free rate used for calculating WACC is based on a single period model according to CAPM, while in reality it is not the case. Real data generally is multi period ones where risk free arte needs to be selected between different rates. The estimation of WACC is sensitive to this selection (Bruner et al, 1998). The estimation of beta is sensitive to the period over which the estimates are averaged, the type of average used and the type of market portfolio. Since WACC is sensitive to the beta measure, each of these can have an impact on WACC. Hence the study expresses doubts regarding the statistical validity of WACC obtained for many airways. The investment analysis and the project financing were obtained to be highly interactive in this study. Moreover the study clearly shows airlines not using more sophisticated techniques in the market. In the study by Loudon (2004), the exposure of Australian and New Zealand airlines to interest rate, currency and fuel price risks are estimated using both linear and non linear techniques. The results show strengthening trends of exposure with the lengthening of return horizon and remaining unchanged even with the terrorist attacks of September 2001. The review of literature thus shows the different forms of airline financing and their definitions. It also shows that the airlines use traditional techniques more for investment purposes rather than sophisticated methods. One main issue identified is the cost of capital estimation for airways. Moreover the airlines are exposed to many financial risks which remain unchanged. In this context, this report examines the global trends in airline financing and the methods to overcome the issues associated with cost of capital estimation as well as the impact of global financial crisis on airlines financing both illustrated with the case study of British Airways. 3. Aim of the Study and Methodology 1. To examine the worldwide trends in airline financing 2. To examine whether the airlines have shown poor financial performance after global financial crisis based on financial statement analysis 3. To examine how to overcome the problems associated with the cost of capital estimation based on CAPM For the first objective, the financial statistics of selected airlines in USA, Europe and Asia are examined based on the data from Centre for Asia Pacific Aviation. For the second and third objectives, the case study of British Airways is used as an illustration. The financial ratios and the cost of capital estimation for British Airways are examined in this regard. 4. Findings 4.1. International Trends in Airline Financing USA Legacy Carriers American Airlines US Airways 2006 2007 2008 2006 2007 2008 Revenue 22563 22935 23766 11692 11813 12244 Operating Costs 21503 21970 25655 11135 11289 14017 Operating Profits 1060 965 -1889 557 524 -1773 Passenger Revenue per Km 0.08 0.08 0.09 0.104 0.107 0.11 Source: Centre for Asia Pacific Aviation (2010) Low Cost Carriers Jetblue Airtran 2006 2007 2008 2006 2007 2008 Revenue 23310 25721 26069 18920 23099 25524 Operating Costs 21453 20987 20676 23456 23543 23124 Operating Profits 117039 166184 84588 40861 144160 -72010 Passenger Revenue per miles 2.33 2.5 2.6 1.3 1.7 1.8 Source: Centre for Asia Pacific Aviation (2010) Europe Legacy Carriers Air Lngus British Airways Lufthansa 2006 2007 2008 2006 2007 2008 2006 2007 2008 Revenue 1273 1284 1357 8492 8758 8992 1984 2242 2487 Operating Costs 1205326 1206239 1375006 7936 7880 9212 8384 9358 11069 Operating Profits 68832 78638 -17650 602 878 -220 1078 1586 1383 Passenger Revenue per Km 6.13 6.79 7.16 6.31 6.44 6.42 134786 135011 154155 Source: Centre for Asia Pacific Aviation (2010) Low Cost Carriers Easy Jet 2006 2007 2008 Revenue 1619.7 1797.2 2362.8 Operating Costs 38.34 35.88 43.39 Operating Profits 172 91 60.1 Passenger Revenue per miles 41.66 40.42 45.51 Source: Centre for Asia Pacific Aviation (2010) Asia Legacy Carriers Cathay Pacific Singapore Airlines 2006 2007 2008 2006 2007 2008 Revenue 45538 50727 38445 11344 12760 13050 Operating Costs -55565 -67619 -94039 10317 11116 12227 Operating Profits 5218 7739 -7461 1027 1644 823 Passenger Revenue per Km 7.2 8.2 9.1 90345 91485 90128 Source: Centre for Asia Pacific Aviation (2010) Low Cost Carriers Air Asia Jet Airways 2006 2007 2008 2006 2007 2008 Revenue 1071 1094 2635 74013 95510 117869 Operating Costs 997 858 2966 73499 98941 134216 Operating Profits 86.2 276.7 -869 280 -2531 -4023 Passenger Revenue per miles 6702 5930 13485 4.82 4.4 4.4 Passenger Numbers(thousand) 5719 5197 1180 5432 5234 5432 Passenger Load factor(%) 78 80 85 69.5 69.2 67.7 Source: Centre for Asia Pacific Aviation (2010) The above tables show that in all the case the revenues for legacy carriers face high competitive pressures from the low cost carriers. The operating expenses have been increasing significantly in the period of analysis for the legacy carriers while the revenue generating capacities have not been sufficient to cope up with them. In fact the revenues have declined significantly .Most legacy carriers face significant losses in 2008 while the low cost carriers operate profitably except those in Asia. 4.2. Global Financial Crisis and Financial Performance British Airways is one of the most famous and largest international airlines in UK with 148 destinations and 245 aircrafts in service, being its headquarters at Heathrow (British Airways, 2009a). In the context of the global economic crisis, it is very relevant to examine whether the investors can buy the stocks of the company. The analysis of the financial statements is done for the company in this regard. Four financial ratios are calculated based on the financial statements of British Airways for 2008 and 2009. They are working capital (current assets - current liabilities), current ratio (current assets/current liabilities), quick ratio (current assets minus inventory/current liabilities), debt to equity ratio (total liabilities/shareholder’s equity), gross profit margin (gross profit/revenue) and price /cash flow ratio (current share price/total cash flow from operations). The key financial ratios for 2008 and 2009 based on the financial statements for the British airways are given in table 1. Table 1: Financial Ratios Working capital Current ratio Quick ratio Debt to Equity Ratio Earnings per share Gross Profit Margin Price/cash Flow ratio 2008 -2521 45.76 43.4 3.49 61.9 10.03 57.8 2009 -4063 24.61 22.3 8.16 32.6 2.4 64.4 Source: British Airways (2009b) The ratios working capital, current ratio and quick ratio show the financial strength and liquidity of the company. It can be seen from table 1 that the working capital of the company is negative and the loss has been rising from 2008 to 2009. This means that it is not in a condition to meet its short-term liabilities. The current ratio again is over 1 for both the years but has shown a decline from 2008 to 2009. The quick ratio also has declined from 43.4 to 22.3 in the period of analysis. Thus, these ratios show poor financial strength and liquidity of the company. The leverage ratio, which is the debt equity ratio, has increased from 3.49 to 8.16 .This shows that the proportion of debt used to finance the assets of British Airways has been rising in the period of analysis. This ratio also has not been favourable to the company. Earnings per share, which is the profit in pence per share has shown a decline in 2009 compared to 208.Another profitability ratio ,gross profit margin has also shown a decline in 2009 compared to 2008. The price/ cash flow ratio has shown slight rise in 2009 compared to 2008, which shows that though the profitability has declined, British Airways is still in s secure industry. Thus, all the financial ratios like the financial strength and liquidity ratios, leverage ratio and the profitability ratios show poor financial performance for British Airways in 2009 which has been due to the global economic crisis(British Airways,2009b). 4.3.Estimating Cost of Capital One formula for estimating the post tax WACC according to Copenhagen Economics(2008) is given as WACC = g*(1-T) *(Rf+ DRP) +(1-g) (Rf+ βj ERP) …..(3), where T is the company tax rate; DRP is the Debt Risk Premium, and ERP is the Equity Risk Premium and g is defined as g = Sum of debt/ (Sum of debt +Sum of equity) = D/(D+E). Six parameters are thus involved in estimating WACC based on the CAPM model. These are risk free rate, taxes, equity risk premium, debt premium , financial gearing and beta(Copenhagen economics,2008). The estimation of each of these parameters and the WACC is illustrated below with the example of British Airways. The British Airways estimate WAAC based on the CAPM. CAPM is subject to many limitations like poor predictability for historic excess returns, high standard errors for parameter estimates and substantial uncertainty regarding the selection of values (CEPA, 2006). To overcome these limitations, British Airways makes use of many extra approaches and information to calculate WACC in addition to CAPM like market capitalization, dividend growth model, estimates by other regulators and evidence from financial markets (CEPA, 2006). Based on CAPM, the parameters needed to calculate the cost of equity capital are risk free rate, ERP and beta. The risk free rate for British Airways is seen as ranging between 2 to 2.25% .ERP is an indirect variable and is sensitive to factors like period of measurement, type of average used and the market portfolio. Hence, the company makes use of the Smithers (2003) estimate of ERP based on long run historic excess returns and the ERP values used by regulators since 2002 to estimate its ERP. Based on all these, ERP is taken as ranging between 3 to 5 %( CEPA, 2006). The beat factor is estimated by the company based on comparing the corporate average equity of beta over different periods and comparing the systematic risk of the company with the risk of equity market and a whole and the risks of other sectors. The beta estimates in this way ranges between 0.8 to 0.95 (CEPA, 2006).The additional approaches like Market capitalization ratio, dividend growth model and estimates by other regulators as alternative approaches to estimate the cost of equity capital for the company. The optimal gearing of the company is calculated by considering the business and regulatory risks and the projected pre finance post tax net cash flows of the regulated businesses. The taxation costs are adjusted in such a way that there are enough revenues to yield to the capital suppliers the estimated post tax WACC. Moreover, it is ensured that revenues can finance actual taxation costs after taking into account the risks and uncertainty (CEPA, 2006). To calculate the cost of debt, debt premium and risk free rate to be estimated first. The return on long dated Sterling index linked bonds is used to measure the real risk free rate. The assumptions that are made while calculating the debt premium of the company are the following (i) It needs to reflect the default risk of the company and (ii) it needs to reflect a solid investment grade credit rating .The debt premium thus calculated will be of the range 1 to 1.25%. Based on all these assumptions , the post tax WACC for the company is calculated as WACC = re (E/V)+ rd (D/V) , where re is the post-tax cost of equity, rd is the gross cost of debt, D is the value of the firm’s debt, E is the value of the firm’s equity and V = D+ E (CEPA,2006). The estimation of cost of capital based on the WACC approach has been illustrated with the example of British Airways in this report. This company uses several alternative assumptions like Market Capitalization ratio, estimates provided by other regulators, evidence from financial markets etc in addition to the CAPM for estimating WACC. Thus this illustrates how to estimate the WACC overcoming the traditional limitations of CAPM. 5. Conclusion In this report, the main issues in airline financing are discussed. The discussion shows different types of airlines financing and the issues associated with then usage of several techniques in the investment valuation .One main issue is the cost of capital estimation and risk estimation. Moreover, the financing of airlines have been affected adversely by the global financial crisis as shown by the discussion. The trends in the financial statistics of selected legacy and low cost carriers in USA, Europe and Asia are examined. They show most airlines facing significant losses in 2008 except the low cost carriers. The full service airlines face downward competitive pressures from the low cost carriers as obtained from the analysis. Moreover the revenue generating capacities of most airlines have come down significantly and not enough to cope up with the rising costs. The case study of British Airways illustrate that all the key financial figures show huge losses for the company in 2009. Key financial ratios for the company show that the financial strength and liquidity of the company has been deteriorating in 2009 in the aftermath of the crisis. The leverage ratio as well as the profitability ratios also shows a declining trend in 2009. The analysis in this report thus shows a deteriorating financial performance for the company in the aftermath of the global economic crisis. WACC has been the most popular approach to estimate the cost of capital for most firms in spite of its limitations. Moreover, WACC has been estimated based on the poplar CAPM model. This is mainly due to the great advantages associated with it that outweigh its disadvantages .Moreover, the unavailability of appropriate alternatives also makes WACC as the most appropriate approach for cost of capital estimation. The estimation of cost of capital based on the WACC approach has been illustrated with the example of British Airways in this report. This company uses several alternative assumptions like Market Capitalization ratio, estimates provided by other regulators, evidence from financial markets etc in addition to the CAPM for estimating WACC. References Airfiannace Journal(2010): “What is Air finance?”, www. Airfinance Journal – Air finance explained.mht, Accessed October 2 2010. British Airways (2009a): “Annual Report and Accounts ,Who we are”, https://www.britishairways.com/cms/global/microsites/ba_reports0809/pdfs/Who_we_are.pdf, Accessed February 2 2010. British Airways (2009b): “British Airways 2008-09 Annual Report and Accounts”, https://www.britishairways.com/cms/global/microsites/ba_reports0809/pdfs/BA_AR_2008_09.pdf, Accessed February 2 2010. Cambridge Economic Policy Associates Ltd (2006): “Setting the Weighted Average Cost of Capital for BAA in Q5”, http://www.caa.co.uk/docs/5/ergdocs/cepa_costofcapital.pdf, Accessed March 4 2010. Copenhagen Economics (2008): “Cost of Capital for Swedish Mobile Telecom Networks”, 18 March. Lazar, Fred. (2003), A vital industry in search of new policies: air transport in Canada. Behind the Headlines, (2003). http://goliath.ecnext.com/coms2/gi_0199-162100/A-vital-industry-insearch.html, (April 18, 2008). Loudon GF (2004): “Financial Risk Exposures in the Airline Industry: Evidence from Australia and New Zealand”, Australian Journal of Management, December 2004. Michalski, W(1996). The Future of International Air Transport, Special Edition of THE OECD OBSERVER for the WTO Ministerial Conference in Singapore, http://www1.oecd.org/publications/observer/singap/013-014a.pdf, April 21, 2008. Rochat, P(2007). “Air transport – a global approach to sustainability”, http://www.airportint.com/categories/environment/air-transport-a-global-approach-to-sustainability.asp. Yilmaz A K(2008): “The Corporate Sustainability Model for Air Business” .European Journal of Scientific Business, Volume 22,No.3,pp304-317. Read More