Hong Kong Dragon Airlines Limited: The Cost of Capital1 In early January 2006, a taskforce at Hong Kong Dragon Airlines (Dragonair) led by engineering manager John Walters and finance manager Bevis Ho was formed to evaluate ways to replace a

spare engine that had been determined to be beyond economic repair (BER)2. Whilst the airline

could support itself with three spare engines until 2006, the expected number of engine

maintenance events from early 2007 onwards would call for a replacement spare engine by early

2007. Two potential options were on the table: either to purchase the engine outright or to lease the

engine. In order to assess and compare the attractiveness of each option, the taskforce first had to

determine the appropriate discount rate for Dragonairs cash flows. Dragonairs board of directors had agreed to the requirement in principle, subject to detailed analysis of the options by the

taskforce.

To recommend the appropriate discount rate, the taskforce needed to determine the cost of debt and

cost of equity, and then the weighted-average cost of capital. Ho suggested that Cathay Pacific be

used as a proxy because Dragonair was not a listed company but Cathay Pacific was, and the two

were in the same industry. Ho further argues that Dragonairs risk profile and the type and maturity of debt were very similar to those of Cathay Pacific.

1. In late January 2006, Walters and Ho were reviewing the data they had collected, which include

the 2004 and 2005 balance sheet information for Cathay Pacific (see Exhibit 1) and Hong Kong

capital market information (see Exhibit 2). The corporate tax rate was 17.5 percent. Based on Hos suggestion, estimate the cost of debt and cost of equity for Dragonair, and then determine its

weighted average cost of capital. Explain how you arrive at those estimates.

2. After having reviewed the result from part (a), Dragonairs CEO Stanley Hui mentioned the possibility that Dragonair could significantly increase its financial leverage in the near future under

a recapitalization plan. As a result, Dragonairs financial risk would increase although its business risk would remain the same as that of Cathay Pacific. Determine Dragonairs weighted average cost of capital for the new target leverage of 45 percent.

1 Company background: Hong Kong-based Dragonair was founded in May 1985 as a wholly owned subsidiary of Hong Kong Macau International Investment Co by local industrialist K.P. Chao. The airline started operations in July 1985 with a Boeing

737 and service between Hong Kong and Kota Kinabalu in Malaysia. With a fleet of only one aircraft, Dragonair was known

in its early days as the when-its-in-the-air-theres-nothing-on-the-ground airline. After much effort by Chao to rally support from both the Chinese central government and the British government, Dragonair began service to Phuket and six cities in

mainland China in 1986.

In 1990, Cathay Pacific Airways (Cathay Pacific), CITIC Pacific, and the Swire Group (which was also the largest shareholder of Cathay) and acquired an 89% stake in Dragonair. After the acquisition, Cathay Pacific transferred its Beijing

and Shanghai services to Dragonair, along with its Lockheed L1011-1 TriStar aircraft. But soon Dragonair embarked on an

aggressive fleet-renewal program. In 1991, Dragonair chose the Airbus A320 aircraft with International Aero Engines AGs V2500 engines for its narrow-body fleet. With the delivery of six A320s in 1993, Dragonair phased out all its five 737s. Two

years later, the airline replaced its aging TriStar fleet with three Airbus A330 wide-body aircraft.

The new millennium marked a watershed in Dragonairs development when it moved into its purpose-built headquarters at the Hong Kong International Airport in Cheklapkok in June 2000 and began its all-cargo service with a Boeing 747-200 in July.

Dragonairs fleet expansion continued through 2005. In 2002, its fleet of freighters included three Boeing 747-300s. On the passenger side, it operated eight A320s, four A321s and nine A330s. Between 2003 and 2005, Dragonair increased its total

fleet size by more than 40%, adding one 747-200 freighter, three A320s, two A321s and four A330s. 2 In the aviation industry, a piece of equipment was usually deemed BER when the cost of repair exceeded 7080% of the new equipment cost. A spare V2500 engine, the type used for Dragonairs A320-family aircraft, was purchased as part of the expansion plan for Dragonairs A320-family fleet between 2003 and 2005, and was delivered in late 2003. This additional spare engine would have increased Dragonairs number of spare V2500 engines to four. However, another engine on the fleet was deemed BER during a heavy maintenance event in late 2002. Whilst the airline could support itself with three spares until

2006, the expected number of engine maintenance events from early 2007 onwards would call for a replacement spare V2500

engine by early 2007.

Solution

Hong Kong Dragon Airlines (Dragonair) in this mini case is not a listed company, as there are

no historical market data available, we are unable to use the conventional approach by a

linear regression for estimating the Beta of the company. With this reasoning the best

approach to estimate the Beta of the company is to use Bottom-Up Betas.

Beta

To develop the Bottom-Up Betas approach, we need to find other publicly traded firm in the

same business. In this case, the finance manager Bevis Ho states that both Cathay Pacific

and Dragonair have very similar risk profile and maturity debt, thus based on this fact, we

can assume that Dragonairs Beta is the same as Cathay Pacifics Beta of 0.85.

Risk Free Rate

To be consistence with the time horizon of the investment, we used the long-term

government bond rate as a Risk Free Rate. In this analysis we take the most recent return on

10-Year Hong Kong Notes at that time which was the figure of Dec-05 (4.18%).

Market Risk Premium (MRP)

We consider the average historical return of Hang Seng Index during 1976-2005 (12.58%) as

Market Risk and the average historical of 10-Year Hong Kong Notes (5.98%) as a Risk Free

Rate to compute the MRP.

The Market Risk Premium can be calculated as follows:

= 12.58% 5.98% = 6.60%.

Cost of Equity

We use the CAPM to estimate the cost of equity and the MRP figure that we obtained in prior

calculation.

= 4.18% + 0.85(6.60%) = 9.79%

After-Tax Cost of Debt

The After-tax Cost of Debt is estimated by using the best lending rate (7.42%) of the recent

rates of return on Dec-05 as Pre-tax Cost of Debt. The reason of this is because we assume

that the rate describes the loan pricing at the market and it has taken the Default Spread of

Firm into consideration which is between 120 bps and 186 bps.

Since interest expenses are tax deductible, therefore we need to consider the tax effect in

the computation by using the same Corporate Tax Rate for both companies (17.50%).

We can estimate an After-tax Cost of Debt for Dragonair:

= 7.42% (1 17.5%) = 6.12%

Weighted Average Cost of Capital

Having estimated the Equity percentage and Debt percentage, we can put them together to

calculate the Weighted Average Cost of Capital as follows:

= 9.79%,

= 6.12%

/( + ) = 22,631/(32,989 + 22,631) = 41%

/( + ) = 32,989/(32,989 + 22,631) = 59%

Finally the Weighted Average Cost of Capital is estimated as follows:

= 9.79% 59% + 6.12% 41% = 8.30%

Estimated WACC for The New Target Leverage of 45%

If Dragonair increase its financial leverage with new target leverage of 45%, its financial risk

would increase although its business risk would remain the same as Cathay Pacific. The

increasing of financial risk causing the Weighted Average Cost of Capital goes up from 5.71%

to 5.79%.

Risk Free Rate

We use Risk Free Rate of December 2005 (4.18%) as it was the most recent return on 10-Year

Hong Kong Notes at that time of analysis.

Market Risk Premium (MRP)

We use the same Market Risk Premium that we obtained in previous question.

= 12.58% 5.98% = 6.60%.

Levered Beta for Dragonair

An increase in financial leverage will increase the beta of equity in the firm, as a result of this

we need to adjust the levered Beta in the firm which can be estimated by Bottom-Up Betas

approach in several steps:

i)

=

22,631

32,898= 0.69

ii) = 0.85/(1 + (1 17.5%) 0.69) = 0.54

iii)

=

45%

55%= 0.82

iv) = 0.54 (1 + (1 1.75%) 0.82) = 0.91

Cost of Equity

So, the new Cost of Equity can be estimated using the CAPM model with new target levered

Beta.

= 4.18% + 0.91(6.60%) = 10.18%

After-Tax Cost of Debt

In this analysis, After-tax Cost of Debt is not affected by the new leverage Beta of Dragonair,

thus we again use the same Corporate Tax Rate (17.50%) and After Tax Cost of Debt is:

= 7.42% (1 17.5%) = 6.12%

Weighted Average Cost of Capital

Finally the Weighted Average Cost of Capital can be computed using the new target leverage

45%.

= 55% 10.18% + 45% 6.12% = 8.35%