This document provides a financial analysis of Continental Airlines' capital structure, weighted average cost of capital, and potential capital budgeting project. It analyzes Continental's financial ratios, capital structure, cost of debt, cost of equity, and weighted average cost of capital. The document recommends that Continental forego a $192 million project due to its potential unfavorable impact, as the airline had a net loss in 2008.

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
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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.
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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
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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.
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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
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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.
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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
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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
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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
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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.
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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%.
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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.
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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
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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.
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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
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