Project Report

20th March, 2012IIM Lucknow

Group 3

Anup Abkari (PGP27009)Arathi Sundarram (PGP27010)

Deeksha Khanna (PGP27017)Priyanka Chowdhary (PGP27038)

Submitted to Dr. Madhumita Chakraborty

Financial Management Project Report –

Aviation SectorA comparison and analysis of capital structure

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4Financial Management Project – Aviation Section (A comparison and analysis of Capital Structure)

Table of ContentsIntroduction...................................................................................................................................2

Major Players..........................................................................................................................................................2

Choice of Sector......................................................................................................................................................3

Capital Structure and Interest Coverage Ratios...............................................................................4

Basic Definitions and Interpretations.....................................................................................................................4

Financial Data.........................................................................................................................................................4

Analysis...................................................................................................................................................................5

Degree of Financial Leverage..........................................................................................................7


Financial Data.........................................................................................................................................................7

Analysis...................................................................................................................................................................8

Cash Balance Management.............................................................................................................9


Financial Data ........................................................................................................................................................9

Analysis...................................................................................................................................................................9

Tax Shields...................................................................................................................................10

Basic Definitions and Interpretations...................................................................................................................10

Financial Data.......................................................................................................................................................10

Analysis.................................................................................................................................................................10

References...................................................................................................................................10

Appendix – A (Union Budget’s Impact on Aviation Sector for 2011-12)..........................................11

Group 3 Section A PGP-I (FM)

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IntroductionThe aviation industry in India is one of the sectors that has witnessed a constant pace of growth over the past several years. The open sky policy of the government has facilitated the entry of overseas players in the aviation sector in India following which there has been steady growth both in terms of number of players and aircraft. This is reflected in a CAGR of 16%.

According to the Investment Commission of India, potential investment requirements in new aircrafts till the year 2020 could touch US$80 billion At present, private airlines account for over two-thirds of the domestic aviation market.

The growth of the aviation sector and capacity expansion by carriers h given rise to the following challenges:

1. Shortage of trained pilots and other technical personnel2. Inadequacy of infrastructure, despite the recent investments this regard and3. Declining returns due to stiff competition and rising fuel costs.

In this report, we have narrowed the aviation sector down as follows and analysed the capital structures and financial ratios from the perspective of Indian passenger air transport services.

Major Players1. GoAir: Established in June 2005 and started operations in November 2005. The airline is

owned by the Wadia Group. It has a strategic tie-up with Singapore Airlines Engineering Company for meeting aircraft maintenance and engineering requirements. It has 10 aircraft as on January 2011.


Aviation Industry

Civil Aviation

Scheduled Air Transport

Passenger Air

Transport Services

Cargo Air Transpor

t

General Aviation

Privately

Owned

Companies

Owned

Military Aviation

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2. Air India: Air India was established by JRD Tata in 1932 as Tata Airlines, a division of Tata Sons Limited. Tata Airlines became a public limited company on July 29, 1946, under the name Air India.Currently, Air India has code-sharing agreements with global carriers like Lufthansa, Singapore airlines, Ethiopian Airlines, Russian Airlines and Gulf Air etc. The airline operates a fleet of Airbus and Boeing aircraft serving Asia, Australia, Europe and North America.

3. Spice Jet: Spice Jet was earlier known as Modiluft. Kalanithi Maran, owner of the Sun Group picked up a 57.7 per cent stake in the airline in November 2010. It has 25 aircrafts as on January 2011.

4. Kingfisher: Kingfisher Airlines, part of the United Breweries Group, began operations in May 2005. In 2008-09, Kingfisher merged low-cost carrier Air Deccan with itself and renamed it as Kingfisher Red. The carrier operates the Airbus A330-200 on all long-haul routes. In 2010, Kingfisher signed an agreement with the Oneworld Alliance, a global airline alliance, for membership, which helped the airline to expand its network through interlining.

In 2011, as part of a debt-restructuring program, a consortium of 13 lenders acquired a 23.4 per cent stake in the airline. State Bank of India and ICICI Bank together has close to 11 per cent stake in the company. Other companies in the consortium include IDBI Bank, Bank of Baroda and Punjab National Bank, etc.

5. Jet Airways: Jet Airways was incorporated as an air taxi operator in 1993. It began commercial airline operations in May that year. The airline covers 66 domestic and international destinations with around 400 daily flights. Jet has 8 code-sharing agreements with international players such as American Airlines, Etihad Airways, Qantas Airways, Air Canada and Brussels Airlines. Jet Airways started its low-fare carrier, Jet Konnect in mid 2009-10 to compete with others in the segment such as Kingfisher Red, Indigo, etc. Jet converted 66 per cent of its total capacity to the LFC model.

Choice of Sector

Quote: “How do you become a millionaire? Start as a billionaire, and then invest in the airline industry.”

- Pat Dorsey, Director of Equity Research, Sanibel Captiva Trust.

The reason we have zeroed in on this project does not limit itself to personal curiosity. We feel as a group that being students of management, it is dangerously easy to cocoon ourselves in the comfort of sectors that are easier to analyse, for which there is plenty of readily available data. Through the pursuit of this project, we wish to delve into the capital structures and debt ratios that each of these companies follow in an industry that does not have the same guiding principles and structures that most others do. Through this, we hope to gain a better understanding of the roles that financial leverage and these ratios play in the face of such severe financial crises, thus bettering our idea of the way the financial world works.


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Although the financial data for a lot of players in this industry is difficult to obtain, which has curtailed the width of our analysis in a lot of cases to three or four of the companies in this sector, we believe that the depth of learning to be obtained from this sector was worth the effort.


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Capital Structure and Interest Coverage Ratios

Basic Definitions and Interpretations

Capital Structure Ratio: The capital structure ratio shows the percent of long term financing represented by long term debt. A capital structure ratio over 50% usually indicates that a company may be near their borrowing limit (which is pegged at approximately 65%).

Interest Coverage Ratio: Times interest earned (TIE) or interest coverage ratio is a measure of a company's ability to honor its debt payments. It may be calculated as either EBIT or EBITDA divided by the total interest payable.

Interest Coverage Ratio= EBIT∨EBITDAR

Times Interest Earned or Interest Coverage is an excellent tool when measuring a company's ability to meet its debt obligations. When the interest coverage ratio is smaller than 1, the company is not generating enough cash from its operations EBIT to meet its interest obligations. The company would then have to either use cash on hand to make up the difference or borrow funds. Typically, it is a warning sign when interest coverage falls below 2.5.

Financial DataCapital Structure Mar '11 Mar '10 Mar '09 Mar '08 Mar '07

Kingfisher

Shareholders Funds -2,951.19 -3,898.45 -2,125.34 198.88 384.7Total Debt 7,057.08 7,922.60 5,665.56 934.38 916.71 D/E 0.00 0.00 0.00 3.29 2.32Interest Coverage Ratio -0.16 -0.87 -1.77 -7.76 -10.29 ROE 0.00 0.00 0.00 0.00 0.00

Jet Airways

Shareholders Funds 2,604.34 2,641.98 3,156.95 4,551.65 2,237.25Total Debt 13,480.39 13,896.98 16,323.53 12,015.04 6,056.30 D/E 16.46 14.24 9.01 4.57 2.58Interest Coverage Ratio 0.88 0.46 -1.46 -0.63 0.30 ROE -9.00 0.00 0.00 -32.42 -8.19

SpiceJet

Shareholders Funds 321.11 -342.18 -429.45 27.98 184.58Total Debt 85.76 438.29 488.81 540.12 432.15 D/E 0.00 0.00 0.00 4.53 4.96Interest Coverage Ratio 12.24 6.96 -20.80 -11.67 -25.81 ROE 13.3 251.64 0 0 0

GoAir

Shareholders Funds -513.21 -423.33 -400.77 -226.01Total Debt 709.39 596.04 288.5 107.1 D/E 0.00 0.00 0.00 0.00Interest Coverage Ratio 0 0 0 0


http://en.wikipedia.org/wiki/Interest

http://en.wikipedia.org/wiki/EBITDA

http://en.wikipedia.org/wiki/Earnings_before_interest_and_taxes

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ROE 19.2 5.47 55.76 105.07

Capital Structure Mar '11 Mar '10 Mar '09 Mar '08 Mar '07Mar '06

Mar

Air India

Shareholders FundsData unavailable for

these years

208.35 5813.13 -108.13 339.8 324.96

Total Debt 31,116.37 24,226.53 7,556.973,961.7

11,586.6

D/E 214.60 167.08 48.72 7.35 4.80

AnalysisFinancial Performance

Amongst the 3 listed airlines in India (SpiceJet, JetAirways and Kingfisher), SpiceJet was the only company to report a positive Net Income in FY ’10. It reported a Net Income of INR 63 crore in FY ’10. The table given below compares the financial performance of SpiceJet with the other listed airlines.

Category Ratio SpiceJet JetAirways Kingfisher

Profitability Ratios

Net Profit Margin 2.82% -4.51% -32.50%

Operating Margin 11.86% 7.45% -18.00%

Return on Invested Capital 74.67% 3.18% -22.37%

Leverage Ratios

Debt-Equity Ratio -1.28% 5.26% -2.03%

Interest Coverage Ratio 6.96 0.53 -1.01

Liquidity Ratios Current ratio 0.67 1.02 1.34

Valuation Ratios

EPS 2.54 -54.19 -61.95

PE ratio 29.87 - -

Payout Ratio 0.00 0.00 0.00

Debt Equity Ratio

Both Kingfisher and SpiceJet have a negative debt equity ratio owing to the negative value of equity. The value of equity for both these airlines is negative because of the accumulated losses they have suffered over the years. Only Jet Airways has a positive value of equity but it is substantially leveraged with a DE ratio of 5.26. This is on account of the capacity addition that Jet did before the financial downturn of 2008.

Interest Coverage Ratio


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SpiceJet has the best Interest coverage ratio of the 3 listed airlines. This is because of the lower interest cost of SpiceJet due to the Operating lease model. The operating lease model has already been described in the Return on Invested Capital part. This model basically allows SpiceJet to operate with lower levels on Debt as compared to others and thus it has the lowest interest expense. This low interest expense results in a high Interest Cover Ratio.

Current Ratio

Kingfisher Airlines has the best current ratio; its current ratio value is nearly twice of the current ratio value for SpiceJet. Kingfisher funds a major part of its working capital requirements from its Currents Assets, giving it a high Current Ratio.


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Degree of Financial Leverage

Basic Definitions and InterpretationsThe degree of financial leverage (DFL) is defined as the percentage change in the earnings per share or EPS due to a given percentage change in operating income or EBIT:

In this report, we have given a subjective analysis on the capital structure of each company and stated whether it is optimal (using the industry bench-mark). An analysis has also been done of the leverage of each firm and whether they are under or over leverage.

Financial Data DFL for each company

Name of Company

Mar '11 Mar '10 Mar '09 Mar '08 Mar '07

Jet Airways 3.097957 4.418396 -2.5799

4.140049359 3.05336

Spice Jet 4.20747 6.055528 -0.13663 -1.22787352 -0.78172GoAir 1.00000 1.00000 1.00000 1.00000 1.00000Kingfisher Airline -0.78012 0.005707 -0.02304 0.32749226 -0.20629


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500

1,000

1,500

2,000

2,500

3,000

-3-2-1012345

Jet Airways

EBIT (in cr.) R (in cr.) DFL


100200300400500600700

-2-101234567

Spice Jet


Mar '11 Mar '10 Mar '09 Mar '08 Mar '07-500

0

500

1,000

1,500

2,000

2,500

-1-0.8-0.6-0.4-0.200.20.4

Kingfisher



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AnalysisWhen the DFL of the company approaches 1, the effect of debt on the relation between EPS and EBIT is almost zero. Hence, for these companies, the amount of debt in the capital structure is low. In the case of Jet Airways and for Spice Jet from ’10 onwards, the DFL has been consistently high, meaning that the EPS for these companies is more volatile, making them risky to invest in.

Now, as seen from the table, both Kingfisher and Spice Jet (prior to ’10) have negative DFL. The reason for this was because of the high amount of interest that they incurred from the huge amount of debt in the capital structure in addition to the low earnings. These companies could not raise ticket prices as much as fuel cost due to stiff completion from FCC players, who were reducing prices to increase load factors and gain market share.

However, subsequently, Spice Jet was driven by strong capacity additions and passenger growth, which increased by 28.0% YOY. Thus, they were able to garner more revenue, thereby increasing the DFL.

As seen from the table, GoAir has a DFL=1 throughout. This is because the interest paid reported by the company has been zero for all these years, making DFL=EBIT/(EBIT-0)=1


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Cash Balance Management

Basic Definitions and InterpretationsThe cash balance is an account balance that represents cash alone, as distinct from an account balance that includes money owed but as yet unpaid.

Financial Data .The following table shows the cash balances of the five peer group companies analysed in this report.

Cash Balance (Rs. in Crs)

Mar 11 Mar 10 Mar 09 Mar 08 Mar 07

Kingfisher 252.36 206.47 171.87 280.12 817.05Jet 587.71 772.83 1,394.50 855.14 1,096.64SpiceJet 192.23 450.69 308 599.51 352.72GoAir N/A 2.39 7.34 4.63 41.71Air India N/A N/A 1,139.64 1,001.89 305.36

AnalysisIn the case of Kingfisher, as seen from the table, there is significant liquidity improvement over prior year due to the younger fleet, from ’09 onwards. Due to the increased cash balance, it is recommended to retire some amount of debt in order to reduce the interest charges incurred, so as to improve the subsequent years’ DFL.

GoAir’s cash balance is quite low compared to the other players due to its high investment in new airbuses, maintenance and more recently, Pratt & Whitney engines worth $1 billion. Therefore, although the inventory and fixed assets are considerable, the amount of liquid cash in the company is low.

SpiceJet has a fluctuating balance over the years, indicating inefficient management of their cash flows and a weak cash position due to high unit costs ex fuel and labor, weak market cap and weak advance bookings. Due to the declining position of DFL over the years, it is recommended to retire some debt in order to lower the interest charges incurred, thereby moving DFL from being negative to marginally positive.


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Tax Shields

Basic Definitions and InterpretationsSince interest on debt is a tax-deductible expense, a tax shield is essentially the reduction in income taxes that results from taking this debt. Since a tax shield is a way to save cash flows, it increases the value of the business, and it is an important aspect of business valuation.

Financial Data

Tax Shield Mar 11 Mar 10 Mar 09 Mar 08 Mar 07

Kingfisher Total Debt 7,057.08 7,922.60 5,665.56 934.38 916.71

Tax Shield 2,399.41 2,693.68 1,926.29 317.6892 311.6814

Jet Airways Total Debt 13,480.39 13,896.98 16,323.53 12,015.04 6,056.30

Tax Shield 4,583.33 4,724.97 5,550.00 4085.1136 2059.142

SpiceJet Total Debt 85.76 438.29 488.81 531.61 432.15

Tax Shield 29.16 149.02 166.20 180.7474 146.931

Go Airlines Total Debt 709.39 596.04 288.5 107.1

Tax Shield 241.19 202.65 98.09 36.414

Air India Total Debt 31,116.37 24,226.53 7,556.97

Tax Shield 10,579.57 8237.0202 2569.3698

AnalysisA higher tax shield means higher reported earnings for the firm and consequently, a higher value of the company. However, in pursuit of a higher value and earnings, the company should not fail to take into account that the larger the amount of debt in the structure, the higher the interest payment per year. This higher interest can have a negative impact on the financial leverage, as seen in the cases of Kingfisher and Spice Jet.


http://en.wikipedia.org/wiki/Business_valuation

http://en.wikipedia.org/wiki/Cash_flows

http://en.wikipedia.org/wiki/Income_tax

http://en.wikipedia.org/wiki/Income_tax

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References

http://www.moneycontrol.com/

http://www.capitaline.com/

Brealey, R., S. Myers, “Principles of Corporate Finance”


http://www.capitaline.com/

http://www.moneycontrol.com/

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Appendix – A (Union Budget’s Impact on Aviation Sector for 2011-12)

Direct tax proposalsThere are no Direct Tax proposals specifically affecting the Travel and Aviation sectors. However, the following key changes applicable to all companies in general will affect this sector as well. The tax authorities have been given additional powers to seek information regarding use of Double Taxation Avoidance Agreements. These powers could be used by the tax authorities to well to examine tax efficient structuring of aircraft leases, among other transactions.

• Increase in MAT rate from 18% to 18.5%. Since most airline companies are reeling under huge accumulated losses, there should not be any immediate additional cash outflow on account of this change.

• Reduction in surcharge from 7.5% to 5%. The reduction in effective corporate tax rate will not have an immediate impact on account of accumulated losses.

Indirect tax proposalsThe aviation industry has faced the brunt of the economic down turn and most players in the industry have incurred significant losses. However, rather than easing the burden on the industry, most of the indirect tax proposals seek to increase the tax incidence.

The following changes have been proposed in the Finance Bill 2011:

Customs: A basic customs duty of 2.5% is being imposed on imports of aircrafts for non-scheduled

operations. The exemption from additional duty of customs (CVD) and special additional duty of customs (SAD) would continue.

Exemption from education cess and secondary and higher education cess presently available to aircrafts isbeing withdrawn.

Service Tax: It is proposed to exempt services for specified purposes provided within a port or an airport

which are classified under the ‘Works contract’ category. The rate of service tax on travel by air are being increased as follows:

S. No Travel Type Present Rate Proposed Rate

1 Domestic Travel(Economy Class)

Rs. 100 Rs. 150

2 International Travel(Economy Class)

Rs. 500 Rs. 750

3Domestic Travel

(other thanEconomy Class)

Rs. 100 10%


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It is proposed that transport of goods by air would be considered as exports as long as the recipient of the service is located outside India. The existing requirement is that the whole or part of the services should have been performed outside India.


Documents

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