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- 1. University of Houston-Victoria School of Business Administration Individual Term Project Continental Airlines: Cost of Capital, Capital Structure, & Capital Budgeting Analysis Submitted by: Frank J. Paul May 10, 2008 Financial Management – FIN 6352 (Section 29308) University of Houston - Victoria Spring 2009 Instructor: Dr. Yixi Ning
- 2. Table of Contents Executive Summary……………………………………………………………………..3 Financial Ratio Analysis………………………………………………………………...4 Capital Structure Estimation…………………………………………………………...11 Weighted Average Cost of Capital Computation……………………………………...12 Cash flow Estimation………………………………………………………………….13 Capital Budgeting Analysis…………………………………………………………....14 Sensitivity Analysis…………………………………………………………………....14 Recommendation……………………………………………………………………....14 References……………………………………………………………………………..15 3/10/2010 Page 2 of 16
- 3. Executive Summary Founded in 1934, Continental Airlines, Inc. is the world’s fifth largest airline and is headquartered in Houston, Texas. As of December 31, 2008, the company owned or leased 350 mainline jets and 282 regional aircraft. Continental, together with Continental Express and Continental Connection, has more than 2,800 daily departures throughout the Americas, Europe and Asia, serving 135 domestic and 132 international destinations. More than 650 additional points are served via alliance partners. With more than 42,000 employees, Continental has hubs serving New York, Houston, Cleveland and Guam, and together with Continental Express, carries approximately 67 million passengers per year. Continental Airlines (CAL) major competitors are American Airlines (AMR), Untied Airlines (UAUA), Delta Airlines (DAL), and a few other “legacy” carriers. Southwest Airlines was not taken into consideration for this analysis, due to the fact that it is not considered a “legacy” or “hub-and-spoke” carrier and has a completely different financial structure. Continental Airlines is currently considering a major new project. The project under consideration will require an initial investment of $180 million dollars for fixed assets, $12 million for shipping and installation fees, and have a life of eight years. This paper analyzes Continental Airlines current financial position and its ability to take on the project to add value to the shareholders and the company itself. Continental Airlines has determined that the net present value (NPV) of the project will be $$50,109,299and will pay for itself in 6.82 years using the discount payback calculation. The impact of $192 million dollars is too risky for Continental Airlines considering it had a net income of loss of $585,000 dollars for 2008. Therefore, it is recommended that Continental Airlines forego this project due to unfavorable effect it could have on itself and its shareholders. 3/10/2010 Page 3 of 16
- 4. Financial Ratio Analysis EXHIBIT 1. Continental Airline’s Financial Ratios & Comparison Continental America United Delta Airlines n Airlines Airlines Airlines Comparison (For 2008 Period) (CAL) (AMR) (UAUA) (DAL) Comments Liquidity Ratios Current Ratio 0.97 0.63 0.67 0.81 Good Quick Ratio 0.92 0.58 0.64 0.77 Good Asset Management Ratios Inventory Turnover Ratio 64.86 45.27 85.21 58.5 OK Days Sales Outstanding 16.02 12.46 17.66 29.65 OK Fixed Assets Turnover Ratio 2.08 1.51 1.96 1.10 OK Total Assets Turnover Ratio 1.20 0.94 1.04 0.50 Favorable Debt Management Ratios Debt Ratio 0.99 1.12 1.13 0.98 OK Times-Interest-Earned (TIE) Ratio -1.06 -1.86 -9.28 -11.82 Good Profitability Ratios Profit Margin on Sales -0.04% -0.09% -0.26% -0.39% Good Basic Earning Power (BEP) Ratio -0.03% -0.05% -0.27% -0.20% Good Return on Total Assets (ROA) -0.05% -0.08% -0.27% -0.20% Good Return on Common Equity (ROE) -5.57% -0.71% -2.17% -10.21% OK Market Measures Price/Earnings (P/E) Ratio -3.27 -1.27 -0.25 -0.51 Poor Price/Cash Flow Ratio -5.72 -1.93 -1.09 -2.96 Poor Market /Book Ratio 20.53 -0.99 -0.60 8.56 Favorable 3/10/2010 Page 4 of 16
- 5. At the onset of summer 2008, the prospect of U.S. airlines losing more than $10 billion was very real. Fuel, already the industry’s top cost, became its most volatile one, eliminating any chance of extending the industry’s two-year “streak” of mediocre profitability. Over the past year, bankruptcy for some and the threat of liquidation for others pushed carriers to act swiftly and boldly to tap new sources of revenue, identify new opportunities for fuel conservation, streamline operations and expand global market presence. With the fuel crisis temporarily in check, the airlines find themselves one year into a U.S. recession, with daily warnings of further deterioration. As the industry continues its quest for sustained profitability, it is important to consider the value of airlines not only posting accounting profits but also achieving a return on invested capital that exceeds the cost of that capital. Upon analysis of Continental Airlines’ (CAL) financial ratios, Continental is found to perform quite well in comparison to its major competitors in an industry whose main focus is survival. Liquidity ratios which generally determine a company's ability to pay off its short-terms debts obligations show CAL with 25% advantage over its competitors. Figure 1 below shows the liquidity ratios for CAL, AMR, UAUA, and DAL. 3/10/2010 Page 5 of 16
- 6. Figure 1 Industry Liquidity Ratios 1.2 0.97 0.92 1 0.81 0.77 0.8 CAL 0.63 0.67 0.64 0.58 AMR 0.6 UAUA 0.4 DAL 0.2 0 Current Ratio Quick Ratio CAL’s asset management ratios have remained steadfast over the past three years. The one exceptional improvement has been in the reduction of days sales outstanding (DSO). CAL has dramatically reduced the number of days it takes its customers to pay their bills. Figure 2 below shows a three years comparison of DSO for Continental Airlines. Figure 2 CAL's DSO Ratio 30 22.18 20.77 20 16.02 10 0 2006 2007 2008 In comparison with the rest of the industry, CAL is very competitive in managing how effectively it utilizes its assets. In fact, CAL has established an industry standard with 3/10/2010 Page 6 of 16
- 7. its fixed and total asset turnover ratios of 2.08 and 1.20 in comparison to the average 1.52 and 0.83. While performing the trend analysis, one must keep in mind the overall poor general health of the airline industry. This fact directly translates to extremely high debt ratio and negative TIE ratios. In 2008 CAL had an incredible high debt ratio of 99%, but in comparison to DAL at 98%, AMR at 112%, and UAUA at 113%, CAL was doing considerable better than most of its competition. In addition to the extremely high debt ratios, figure 3 below also shows that CAL had the lowest TIE ratio of its major competitors. Figure 3 Debt Management Ratios 4 0.99 1.12 1.13 0.98 0 -1.06 CAL -4 -1.87 AMR -8 UAUA DAL -9.28 -12 -11.82 -16 Debt Ratio TIE Ratio Further analysis of the profitability ratios and market measures will reveal the magnitude of financial devastation suffered by CAL and its competitors in 2008. Please refer to the accompanying excel worksheet tab labeled “Industry Financial Ratios” for further analysis of CAL and its major competitors. 3/10/2010 Page 7 of 16
- 8. EXHIBIT 2. TREND ANALYSIS OF LIQUIDITY RATIOS CAL Liquidity Ratios 1.06 1.04 1.04 1.03 1.02 1 0.99 0.98 0.97 Current Ratio 0.96 0.96 Quick Ratio 0.94 0.92 0.92 0.9 0.88 0.86 2006 2007 2008 EXHIBIT 3. TREND ANALYSIS OF ASSET MANAGEMENT RATIOS CAL Asset Management Ratios 70 65 64.86 60 60.5 Inventory Turnover 55 52.52 Ratio 50 45 Days Sales 40 Outstanding 35 30 Fixed Assets Turnover 25 Ratio 20 20.77 22.18 15 16.02 Total Assets Turnover 10 5 0 2.1 1.16 2.17 1.18 2.08 1.2 2006 2007 2008 3/10/2010 Page 8 of 16
- 9. EXHIBIT 4. TREND ANALYSIS OF DEBT RATIO CAL Debt Rato 125 96.9 99.2 100 87.2 75 Debt Rato 50 25 0 2006 2007 2008 EXHIBIT 5. TREND ANALYSIS OF TIME-INTEREST-EARNED RATIO CAL (TIE) Ratio 3 2.59 2.5 1.96 2 1.5 1 Times-interest-Earned 0.5 (TIE) Ratio 0 -0.5 -1 -1.5 -1.06 2006 2007 2008 3/10/2010 Page 9 of 16
- 10. EXHIBIT 6. TEND ANALYSIS OF PROFITABILTIY RATIOS CAL Profitability Ratios 1.06 2006 0.03 0.07 0.03 ROE 0.3 ROA 2007 0.04 0.08 BEP Ratio 0.03 Profit Margin on Sales -5.57 2008 -0.05 -0.03 -0.04 -6 -5 -4 -3 -2 -1 0 1 2 EXHIBIT 7. TREND ANALYSIS OF MARKET VALUE RATIOS CAL Market Values 25 20.53 20 15 10.86 10.91 (P/E) Ratio 10 4.63 Price/Cash Flow Ratio 3.47 5 1.87 1.38 Market/Book Value 0 -5 -3.27 -5.72 -10 2006 2007 2008 3/10/2010 Page 10 of 16
- 11. Capital Structure Estimation EXHIBIT 8. ESTIMATIONS OF WEIGHTS OF CAPITAL COMPONENTS Estimating Capital Structure: Weights Book Values Weights Market Values Weights Debt $5,890.00 98% $5,890.00 78.15% Preferred Stock 0 0 Common Stock 105 2% 1,647.15 21.85% Total $5,995.00 100% $7,535.15 100% As of 4/09/2009 CAL had 123.66 million shares outstanding. Market value of common stocks was found by obtaining the closing CAL stock price on April 9, 2009 from Yahoo Finance in the amount of $13.32 per share. Continental Airlines does not issue preferred stocks, nor does it have any outstanding shares. Weighted Average Cost of Capital Computation Chapter 10, page 343 in our text states that if a company has issued debt in the past and the bonds are publicly trade, “the financial staff could use the market price of the bonds to find their yield to maturity. This yield is the rate of return the existing bondholders expect to receive, and it is also a good estimate of rd, the rate of return that new bondholders will require.” According to Yahoo Finance, Continental Airlines’ publicly trade bonds have yield to maturity rate of 28.22% and subsequently establishes Continental Airlines’ before-tax component cost of debt, (rd). The after-tax component cost of debt is calculated in the following manner: After-Tax Cost of Debt = rd(1-Tax Rate) 22.28%(1 – 3.6%) 0.2228(0.964) = 21.48% Note: Please refer to excel worksheet “CAL WACC” for detail explanation of Continental Airline’s Tax Rate. 3/10/2010 Page 11 of 16
- 12. CAPM Approach The risk-free rate, (rRF), was found by looking up a 10-year T-bond on Yahoo Finance which is currently at 3.12% as of close of market on May 1st, 2009. Yahoo Finance also reports the beat for Continental Airlines to be 0.91. The market risk premium of 4.07% will be used. The market risk premium was calculated using the forward-looking data method of (rM – rRF) = (7.19-3.12). According to page 350 of Chapter 10, RPM of 4.07% is within the standard range of 3.5% to 6.5%. The calculation for the cost of common equity using the CAPM Approach is as follows: rs = rRF + (RPM)bi rs = 3.12% + 4.07%(0.91) rs = 3.12 + 3.70 rs = 6.82% DCF Approach According to Continental Airline’s Investment Section of its website, Continental Airlines does not pay dividends. The Discounted Cash Flow (DCF) Approach is non- applicable in this situation since two of the three inputs: current dividend and expected growth of dividends do not exist. Bond-Yield-Plus-Risk-Premium Approach The cost of debt is 22.28% and the estimated bond risk premium is determined to be 4.54%. As a result, the cost of common equity is 26.82 %. It has been determined that the Bond-Yield-Plus-Premium does not yield a reliable cost of common equity, therefore the CAPM Approach is used which results in rs = 6.82%. 3/10/2010 Page 12 of 16
- 13. The WACC is found to be 18.28% from the calculation below using the after-tax cost of debt of 22.28% and the CAPM Approach of cost of equity of 6.82% and their respective weights. WACC = 78.15 %( 22.28%) (1-3.6%) +21.85 %( 6.82%) WACC = 18.28% Cash Flow Estimation Continental Airlines is currently considering a major new project. The project under consideration will require an initial investment of $180 million dollars for fixed assets, $12 million for shipping and installation fees, and have a life of eight years. Continental Airlines’ Senior Management would like to know whether the project would be financially beneficial for itself and its shareholders. Below please find the data for the project under consideration. EXHIBIT 9. NEW PROJECT DATA UNDER CONSIDERATION Fixed Assets $180,000,000 Salvage Value $25,000,000 Shipping & Installation fee $12,000,000 Total Initial Investment $192,000,000 Expected Growth First Year Sales (in units) 870,000 Rate 10% Sales Price per Unit $250 Inflation Rate 2.50% First Year Variable Cost per Unit $175 Company Tax Project Economic Life 8 years Bracket 33% Fixed Asset Life 7 years NOWC of Sales 18% WACC 18.28% Note: for details on calculations and data please see Excel file under the CAL Cash Flow Estimation and & CAL Capital Budgeting Analysis. 3/10/2010 Page 13 of 16
- 14. Capital Budgeting Analysis EXHIBIT 10. CAPITAL BUDGETING ANALYSIS NPV $50,109,299 IRR 24.68% MIRR 21.70% PI 1.26 Payback Period 4.00 Discounted Payback 6.84 Sensitivity Analysis EXHIBIT 11. SENSITIVITY ANALYSIS FOR EFFECTS FOR KEY VARIABLES NPV $400 Millions $300 $200 Sales Price $100 Fixed Costs Growh Rate $0 Year 1 Units Sold ($100) WACC ($200) ($300) -30 -15 0 15 30 Deviation from Base Case Value (%) Based on the analysis of the new project Continental Airlines is considering, the NPV of the proposed project is $50,109,299. At the end of 2008, Continental Airlines had 123.26 million shares of common stock. Therefore, it is estimated that each shareholder will receive approximately $0.41 cents per share that they own. This analysis also revealed that the IRR and MIR are greater than the WACC of 18.28%, at 24.68% and 21.70% respectively. According to the discount payback calculation method, the project will pay for itself in 6.84 years. Upon examination of sensitivity analysis, this project is considered to be quite risky. This particular project is particularly sensitive to 3/10/2010 Page 14 of 16
- 15. fluctuations in sales price and fixed cost, potentially resulting in a negative NPV. It is also worth noting that this project under consideration is for the most part not sensitive to the changes in sales growth rate and units sold. Based on this information, the current state of the economy, and the fact that it will take this project over 6.84 year to pay for itself, Continental Airlines should not take on this project. I would recommend that Continental Airlines consider another project that has a lower initial investment and a shorter payback period due to the current state of the economy, which causes passenger demand to be unpredictable and the volatility of fuel costs. 3/10/2010 Page 15 of 16
- 16. References ▪ Data with respect to Continental Airlines’ annual dividends retrieved on 05/03/2009 from: http://www.continental.com/web/en- US/content/company/investor/faq.aspx?Mobile=1 ▪ Data with respect to Continental Airlines’ preferred stocks retrieved on 05/03/2009 from: http://www.reuters.com/finance/stocks/incomeStatement? stmtType=BAL&perType=ANN&symbol=CAL.N ▪ Data with respect to Continental Airlines’ beta retrieved on 05/06/2009 from: http://finance.yahoo.com/q/ks?s=CAL ▪ Data with respect to Continental Airlines’ risk-free rate retrieved on 05/01/2009 from: http://finance.yahoo.com/bonds ▪ Data with respect to Continental Airlines’ 2008 10-K retrieved on 05/01/2009 from: www.sec.gov ▪ Data with respect to Continental Airlines’ Historical Stock Prices retrieved on 05/04/2009 from: http://finance.aol.com/quotes/continental-airlines- inc/cal/nys/historical-prices?tf=y%2C3&gran=d ▪ Data with respect to Continental Airlines, American Airlines, United Airlines, and Delta Airlines Outstanding Shares of common stock retrieved on 05/06/2009 from: www.moneycentral.msn.com ▪ Data with respect to Continental Airlines, American Airlines, United Airlines, and Delta Airlines Balance Sheet retrieved on 04/26/2009 from: http://finance.yahoo.com/ ▪ Data with respect to Continental Airlines, American Airlines, United Airlines, and Delta Airlines Income Statement retrieved on 04/26/2009 from: http://finance.yahoo.com/ ▪ Data with respect to 2008 S & P Earnings retrieved on 05/05/2009 from: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/spearn.htm 3/10/2010 Page 16 of 16

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