EAS431

Aviation Finance
Seminar 1

Understanding Financing Requirements

-- Prediction
Prediction of
ofAir
Air Traffic
Traffic Growth
Growth
Depends
Dependson
onGDP
GDPGrowth
Growth(2:1)
(2:1)and
andReal
Realcost
costof
ofAir
AirTravel
Travel

-- Capacity
Capacity Growth
Growth
(Number
(Numberof
ofSeats,
Seats,Efficient
Efficientuse,
use,airborne
airborneTime,
Time,Flying
Flying
Speed)
Speed)

-- Numbers
Numbers of
ofAircraft
Aircraft
Size
Sizeof
ofAircraft
Aircraft

-- Retirements
Retirements (30
(30 years
years life
life span)
span)

Understanding Financing Requirements

Understanding Financing Requirements

Understanding Financing Requirements

Cyclicality
Financing needs to be fairly conservative

Aviation Revenue & Expenditure

Aviation Revenue & Expenditure

Financing Methods
Market Demand Fluctuations, Tax Funding

Residual Value Risk

Residual Value Risk

External Shock factors & Profitability

GDP
GDPgrowth
growth
War
War&
& terrorism
terrorism (e.g.
(e.g. Iraq,
Iraq, Sept
Sept 11)
11)
Environmental
Environmental Volcanic
Volcanic Eruption
Eruption
Uncertain
Uncertain Fuel
Fuel Prices
Prices
-- hedging
hedging
-- Fuel
FuelTanking
Tanking
-- Fuel
Fuel Surcharges
Surcharges to
to Passengers
Passengers

External Shock factors & Profitability

Asian
Asian currency
currency crisis
crisis
Epidemic
Epidemic (Sars,
(Sars, Bird
Bird Flu)
Flu)
Capital
Capital Intensive
Intensive Large
Large Fixed
Fixed Assets
Assets
Low
LowCost
Cost Carriers
Carriers

Govt
Govt vs
vs Private
Private
National
National Strategic
Strategic Economic
Economic Key
KeyAssets
Assets
Air
Airtransport
transportAccess
Access

The Balance Sheet

Balance Sheet

Income Statement

Balance Sheet
Numbers in millions
2003

2002

2003

2002

Cash

696

58 A/P

307

303

A/R

956

992 N/P

26

119

Inventory

301

361 Other CL

1,662

1,353

Other CA

303

264 Total CL

1,995

1,775

Total CA

2,256

1,675 LT Debt

843

1,091

Net FA

3,138

3,358 C/S

2,556

2,167

Total
Assets

5,394

5,033 Total Liab.

& Equity

5,394

5,033

Income Statement
Numbers in millions, except EPS & DPS
Revenues

5,000

Cost of Goods Sold

2,006

Expenses

1,740

Depreciation

116

EBIT

1,138

Interest Expense

Taxable Income
Taxes

1,131
442

Net Income

689

EPS

3.61

Dividends per share

1.08

Sources and Uses

Sources
Cash inflow occurs when we sell something
Decrease in asset account (Sample B/S)
Accounts receivable, inventory, and net fixed assets

Increase in liability or equity account

Accounts payable, other current liabilities, and common stock

Uses
Cash outflow occurs when we buy something
Increase in asset account
Cash and other current assets

Decrease in liability or equity account

Notes payable and long-term debt

Statement of Cash Flows

Statement that summarizes the sources and uses
of cash
Changes divided into three major categories
Operating Activity includes net income and
changes in most current accounts
Investment Activity includes changes in fixed
assets
Financing Activity includes changes in notes
payable, long-term debt and equity accounts as well
as dividends

Statement of Cash Flows

Numbers in millions
Cash, beginning of year

58

Operating Activity

Financing Activity
Decrease in Notes Payable

Net Income

689

Decrease in LT Debt

Plus: Depreciation

116

Decrease in C/S (minus RE)

Decrease in A/R

36

Decrease in Inventory

60

Increase in A/P
Increase in Other CL
Less: Increase in CA
Net Cash from Operations

4
309
-39
1,175

Investment Activity
Sale of Fixed Assets
Net Cash from Investments

104
104

Dividends Paid
Net Cash from Financing

-93
-248
-94
-206
-641

Net Increase in Cash

638

Cash End of Year

696

What is business risk?

Uncertainty about future operating income (EBIT),
i.e., how well can we predict operating income?
Probability

Low risk

High risk
0
E(EBIT)
EBIT
Note that business risk
does not include financing
effects.

What determines business risk?

Uncertainty about demand (sales)
Uncertainty about output prices
Uncertainty about costs
Operating leverage

What is operating leverage, and how does it affect

a firms business risk?
Operating leverage is the use of fixed costs
rather than variable costs.
If most costs are fixed, hence do not decline
when demand falls, then the firm has high
operating leverage.

Effect of Operating Leverage

More operating leverage leads to more
business risk, for then a small sales decline
causes a big profit decline.
Rev.
Rev.

TC

} Profit
TC
FC

FC
QBE

Sales

QBE

Sales

Using Operating Leverage

Typical situation: Can use operating leverage to get higher
E(EBIT), but risk also increases.
Low operating leverage

Probability

High operating leverage

EBITL

EBITH

What is financial leverage?

Financial risk?
Financial leverage is the use of debt and
preferred stock.
Financial risk is the additional risk
concentrated on common stockholders as a
result of financial leverage.

Business Risk vs. Financial Risk

Business risk depends on business factors
such as competition, product liability, and
operating leverage.
Financial risk depends only on the types of
securities issued.
More debt, more financial risk.
Concentrates business risk on stockholders.

An Example:
Illustrating Effects of Financial Leverage
Two firms with the same operating leverage, business risk, and
probability distribution of EBIT.
Only differ with respect to their use of debt (capital structure).

Firm U: Unleveraged

Probability
EBIT
Interest
EBT
Taxes (40%)
NI

Bad
0.25

Economy
Average
0.50

Good
0.25

$2,000
0
$2,000
800
$1,200

$3,000
0
$3,000
1,200
$1,800

$4,000
0
$4,000
1,600
$2,400

Firm L: Leveraged

Ratio Comparison Between Leveraged and

Unleveraged Firms
Firm U
BEP
ROE
TIE

Bad
10.0%
6.0

Average
15.0%
9.0

Good
20.0%
12.0

Firm L
BEP
ROE
TIE

Bad
10.0%
4.8
1.67

Average
15.0%
10.8
2.50x

Good
20.0%
16.8
3.30x

Risk and Return for Leveraged and

Unleveraged Firms