Financial Management Project Report

A comparison and analysis of capital structure

Aviation Sector

Group 3 Anup Abkari (PGP27009) Arathi Sundarram (PGP27010) Deeksha Khanna (PGP27017) Priyanka Chowdhary (PGP27038)

Submitted to Dr. Madhumita Chakraborty

20th March, 2012 IIM Lucknow

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

Table of Contents
Introduction ................................................................................................................................ 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 Basic Definitions and Interpretations ....................................................................................................................... 7 Financial Data ........................................................................................................................................................... 7 Analysis ..................................................................................................................................................................... 8 Cash Balance Management .......................................................................................................... 9 Basic Definitions and Interpretations ....................................................................................................................... 9 Financial Data . ......................................................................................................................................................... 9 Analysis ..................................................................................................................................................................... 9 Tax Shields ................................................................................................................................ 10 Basic Definitions and Interpretations .....................................................................................................................10 Financial Data .........................................................................................................................................................10 Analysis ...................................................................................................................................................................10 References ................................................................................................................................ 10 Appendix A (Union Budgets Impact on Aviation Sector for 2011-12) ........................................ 11

Group 3 Section A PGP-I (FM)

March 20, 2012

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

Introduction
The 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 personnel 2. Inadequacy of infrastructure, despite the recent investments this regard and 3. 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. Aviation Industry

Civil Aviation

Military Aviation

Scheduled Air Transport

General Aviation

Passenger Air Transport Services

Cargo Air Transport

Privately Owned

Companies Owned

Major Players
March 20, 2012 1. 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. 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. Group 3 Section A PGP-I (FM)

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

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. 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. March 20, 2012 Group 3 Section A PGP-I (FM)

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

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.

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 Data
Capital Structure Shareholders Funds Total Debt Kingfisher D/E Interest Coverage Ratio ROE Shareholders Funds Total Debt Jet Airways D/E Interest Coverage Ratio ROE Shareholders Funds Total Debt SpiceJet D/E Interest Coverage Ratio ROE Shareholders Funds Total Debt GoAir D/E Interest Coverage Ratio ROE Mar '11 -2,951.19 7,057.08 0.00 -0.16 0.00 2,604.34 13,480.39 16.46 0.88 -9.00 321.11 85.76 0.00 12.24 13.3 Mar '10 -3,898.45 7,922.60 0.00 -0.87 0.00 2,641.98 13,896.98 14.24 0.46 0.00 -342.18 438.29 0.00 6.96 251.64 -513.21 709.39 0.00 0 19.2 Mar '09 -2,125.34 5,665.56 0.00 -1.77 0.00 3,156.95 16,323.53 9.01 -1.46 0.00 -429.45 488.81 0.00 -20.80 0 -423.33 596.04 0.00 0 5.47 Mar '08 198.88 934.38 3.29 -7.76 0.00 4,551.65 12,015.04 4.57 -0.63 -32.42 27.98 540.12 4.53 -11.67 0 -400.77 288.5 0.00 0 55.76 Mar '07 384.7 916.71 2.32 -10.29 0.00 2,237.25 6,056.30 2.58 0.30 -8.19 184.58 432.15 4.96 -25.81 0 -226.01 107.1 0.00 0 105.07

Group 3 Section A PGP-I (FM)

March 20, 2012

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

5
Mar '06 339.8 3,961.71 7.35 Mar '05 324.96 1,586.65 4.80

Capital Structure Shareholders Funds Total Debt Air India D/E

Mar '11

Mar '10

Data unavailable for these years

Mar '09 208.35 31,116.37 214.60

Mar '08 5813.13 24,226.53 167.08

Mar '07 -108.13 7,556.97 48.72

Analysis
Financial 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 Net Profit Margin Profitability Operating Margin Ratios Return on Invested Capital Leverage Ratios Liquidity Ratios Debt-Equity Ratio Interest Coverage Ratio SpiceJet 2.82% 11.86% 74.67% -1.28% 6.96 JetAirways Kingfisher -4.51% 7.45% 3.18% 5.26% 0.53 -32.50% -18.00% -22.37% -2.03% -1.01

Current ratio EPS

0.67 2.54 29.87 0.00

1.02 -54.19 0.00

1.34 -61.95 0.00

Valuation Ratios

PE ratio Payout Ratio

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 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

Group 3 Section A PGP-I (FM)

March 20, 2012

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

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.

Group 3 Section A PGP-I (FM)

March 20, 2012

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

Degree of Financial Leverage

Basic Definitions and Interpretations
The 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 Jet Airways Spice Jet GoAir Kingfisher Airline Mar '11 Mar '10 Mar '09 Mar '08 Mar '07

3.097957 4.418396 -2.5799 4.20747 6.055528 -0.13663 1.00000 1.00000 1.00000 -0.78012 0.005707 -0.02304

4.140049359 3.05336 -1.22787352 -0.78172 1.00000 1.00000 0.32749226 -0.20629

Jet Airways
3,000 2,500 2,000 1,500 1,000 500 0 Mar '11 Mar '10 Mar '09 Mar '08 Mar '07 EBIT (in cr.) R (in cr.) DFL 6 4 2 0 -2 -4 800 600 400 200 0

Spice Jet
8 6 4 2 0 -2 Mar '11 Mar '10 Mar '09 Mar '08 Mar '07 EBIT (in cr.) R (in cr.) DFL

Kingfisher
3,000 2,000 1,000 0 Mar '11 -1,000 EBIT (in cr.) R (in cr.) DFL Mar '10 Mar '09 Mar '08 Mar '07 -1 -0.5 0.5 0

Group 3 Section A PGP-I (FM)

March 20, 2012

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

Analysis
When 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

Group 3 Section A PGP-I (FM)

March 20, 2012

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

Cash Balance Management

Basic Definitions and Interpretations
The 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) Kingfisher Jet SpiceJet GoAir Air India Mar 11 252.36 587.71 192.23 N/A N/A Mar 10 206.47 772.83 450.69 2.39 N/A Mar 09 171.87 1,394.50 308 7.34 1,139.64 Mar 08 280.12 855.14 599.51 4.63 1,001.89 Mar 07 817.05 1,096.64 352.72 41.71 305.36

Analysis
In 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. GoAirs 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.

Group 3 Section A PGP-I (FM)

March 20, 2012

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

10

Tax Shields
Basic Definitions and Interpretations
Since 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 Kingfisher Total Debt Tax Shield Jet Airways Total Debt Tax Shield SpiceJet Total Debt Tax Shield Go Airlines Total Debt Tax Shield Air India Total Debt Tax Shield Mar 11 7,057.08 2,399.41 13,480.39 4,583.33 85.76 29.16 Mar 10 7,922.60 2,693.68 13,896.98 4,724.97 438.29 149.02 709.39 241.19 Mar 09 5,665.56 1,926.29 16,323.53 5,550.00 488.81 166.20 596.04 202.65 31,116.37 10,579.57 Mar 08 934.38 317.6892 12,015.04 4085.1136 531.61 180.7474 288.5 98.09 24,226.53 8237.0202 Mar 07 916.71 311.6814 6,056.30 2059.142 432.15 146.931 107.1 36.414 7,556.97 2569.3698

Analysis
A 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.

References
http://www.moneycontrol.com/ http://www.capitaline.com/ Brealey, R., S. Myers, Principles of Corporate Finance Group 3 Section A PGP-I (FM)

March 20, 2012

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

11

Appendix A (Union Budgets Impact on Aviation Sector for 2011-12)

Direct tax proposals There 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 proposals The 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 is being 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 Domestic Travel 1 Rs. 100 Rs. 150 (Economy Class) International Travel 2 Rs. 500 Rs. 750 (Economy Class) Domestic Travel 3 (other than Rs. 100 10% Economy Class)

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.

Group 3 Section A PGP-I (FM)

March 20, 2012