StudentShare
Contact Us
Sign In / Sign Up for FREE
Search
Go to advanced search...
Free

Financing the JetBlue Airways Expansions - Research Paper Example

Cite this document
Summary
The goal of the following research is to analyze the long-term as well as short-test financing of business expansions of JetBlue Airways. Observations made suggest that JetBlue Airways should go in for mixed sources for financing its expansion programs…
Download full paper File format: .doc, available for editing
GRAB THE BEST PAPER93.5% of users find it useful
Financing the JetBlue Airways Expansions
Read Text Preview

Extract of sample "Financing the JetBlue Airways Expansions"

 Financing the JetBlue Airways Expansions Introduction JetBlue Airways Corporation was formed basically as a low fare low cost but high service passenger airline in 1998. The airline witnessed resounding success over the period. Even after the terrorist attacks on September 11, 2001, when major airlines struggled and some even filed bankruptcy, JetBlue survived and earned profits. Sensing growth JetBlue Airways decided to add further markets of operations and new destinations beyond large metropolitan that were earlier served by the JetBlue Airways only through its A320 aircrafts. In order to pursue its expansion plans the company has entered into agreements to acquire more Airbus A 320 aircrafts as well as for first time the Embraer E190 aircrafts. The reason to purchase Embraer E 190 is to enter smaller markets by lowering the operating costs. Also the Embraer aircrafts being smaller jets would allow the company to increase flight frequency on existing routes where operating larger Airbus 320 could not be justified. Besides adding to the aircraft fleet, the company needs capital to make investments for enlarging its infrastructure facilities for the operation of expansion plans. Moreover the company also requires capital to smoothen working capital to meet short term obligations with ease. For all these expansions and working capital requirements, the company has two options as suggested by its investment bankers to raise additional capital. First option is raising $110.5 million by offering an issue of 2.6 million shares at an estimated cost of $42.50 per share. The second option is to raise $150 million through private placement of 3.5%, 30 year convertible bonds convertible at rate of $63.75 per share. In this report an analysis of two alternative sources of funding is undertaken in order to enable the company to take a decision about financing the expansion programs out of two available options of raising equity or debt capital Long Term Financing The expansion program of JetBlue Airways Corporation is a financing matter connected mainly with long term assets financing and also to a lesser extent improvement of the working capital position. That is the reason the company has decided to seek long term financing either from issuance of equity capital or raising funds from issuance of convertible bonds. In either case the company has decided to resort to long term financing sources. A corporation is held by its common shareholders. Some of the common shares are held by individual investors and others are held by individual institutional investors. This means that existing ownership gets all cash flows and makes all investment and operating decisions. As soon as fresh issues are made the existing ownership gets diluted. On dilution of ownership the power to take decision on behalf of firm also changes. Similarly when funds are raised through debts these rights to cash flows get split and reallocated between owners and lenders. When companies borrow money, they promise to make regular interest payments and to repay the principal. However, the liability is limited. Stockholders have right to default on the debt if they are willing to handover the corporation’s assets to the lenders. Clearly they will chose to do this only if the value of assets is less than the amount of debts. Moreover shareholders are residual owners of the company and thus when debts are issued they become entitled to what is leftover after paying interest on the debts. In that way the shareholders’ rights as owners also get diluted when debt capital issued. So one of the main factors required to be considered is dilution or leverage of capital structure. Another important factor to be considered in long term financing is the cost of capital. Cost of capital is important for evaluating the company’s investment projects, for determining the capital structure, for assessing leasing proposals, for setting the rates that regulated organizations can charge to their customers. Accordingly important factors to be considered in case JetBlue Airways Corporation for taking decision between equity and debt capital are cost of capital and leverages of capital structure Costs of Capital ‘Cost of capital is the expected rate of return that market requires in order to attract funds to a particular investment. In economic terms, cost of capital for a particular investment is an opportunity cost- the cost of foregoing the next best alternative investment.’(Shannon P Pratt, page 3)1 Company’s cost of invested capital is the weighted average cost of various sources of finance used. In the case of JetBlue Airways Corporation either equity capital or debt capital or may be combinations of both will be used. Thus its weighted average cost of capital (WACC) will be calculated as under: WACC = (proportion of equity) (cost of equity) + (Proportion of debt) (Cost of debt) ‘The cost of capital is the rate of return that a firm must earn on the projects in which it invest to maintain the market value of its stock. It can also be thought of as the rate of return required by the market suppliers of capital to attract their funds to the firm. If risk is held constant, project with rate of return above cost of capital will increase the value of the firm, and projects with a rate of return below the cost of capital will decrease the value of the firm.’ (Lawrence J. Gitman, page 498)2 The rationale for using WACC as the hurdle rate in capital budgeting is straight forward. If a firm’s rate of return on its investment exceeds its cost of capital, equity shareholders benefit. To illustrate this point consider a firm which employs equity and debt in equal proportion and whose cost of equity and debt are 14 percent and 6 percent respectively. The cost of capital, which is weighted average cost of capital, works out to 10 percent (0.5 *14 +0.5 * 6). If the firm invests say $100 million on a project which earns a rate of return of 12 percent, the return on equity funds employed in the project will be Total return on the project – Interest on debt 100(0.12) – 50 (0.06) ---------------------------------------------------- = ---------------------------- = 18 percent Equity funds 50 Since 18 % exceeds the cost of equity (14 %), equity shareholders benefit. Let us make these calculations for the project of JetBlue Airways Corporation under consideration: Cost of equity: It is not possible to use Dividend Growth Model Approach (i.e. Gordon Model) to calculate the cost of capital by using following formula: P­­­0 = D1 / (rE – g ), where P­­­0 = Current price of stock D1= dividend expected to be expected to be paid at end of the year rE = Equity shareholders required rate of return g = dividend growth rate The reason is that JetBlue Airways has not declared dividend so far. Accordingly it is not possible to calculate dividend growth rate (g) and expected shareholders required rate of return (rE). Under the circumstances the present rate of return on equity is assumed to be cost of capital, and that is calculated here under: Accordingly return on equity of 13.24% in 2002 is assumed to be the cost of equity for calculation of hurdle rate. Cost of Long term Debt: Conceptually, the cost of a debt instrument is the yield to maturity of that instrument. The cost of debentures (rD) in our case is calculated using following equation: I + (F – P0)/ n rD =---------------------- 0.6 P0 + 0.4 F Where P0 = Current market price of debentures, I = Annual Interest payment, n = Number of years left to maturity, and F = maturity value of debentures Again it is not possible to compute the cost of debentures because of non- availability of market price of debentures. Under such eventuality, the interest rate of 4.70% of the 30 year Treasury bond is taken as the cost of capital. After computing the cost of capital and cost of debt we have following three options to compute hurdle rate: 1. Assuming only equities are issued to meet the need of expansions, then the WACC (hurdle rate) would be 13.24% 2. Assuming only 30 years debentures are issued , then WACC (hurdle rate) would be 4.7% 3. Assuming the financing are raised equally from both sources, then WACC (hurdle rate) would be as under = 0.5 * 13.24 + 0.5*4.7 = 9.97% If third option is employed then benefit to shareholders is calculated as under on the assumption that rate of return on fresh investment (assuming $150 million) would be the existing rate of return on assets: Benefit to shareholders under third alternative= (100(0.3.98)- 50(0.4.7)/ 50) – 13.24 = 2.06% Therefore from the point of view of cost of capital, subject to assumptions made in its calculations, it is suggestible if investment is financed equally through raising equity capital as well as by issuance of 30 year 3.5% Debentures. Leverages of Capital Structure “Leverage results from the use of fixed cost assets or funds to magnify returns to the firm’s owners. Generally increase in leverage result in increased return and risk, whereas decrease in leverage result in decreased return and risk. The amount of leverage in the firm’s capital structure – the mix of long term debts and equity maintained by the firm – can significantly affect its value by affecting return and risk.” (Lawrence J. Gitman, page 538)3 It is useful to classify leverage as operating and financial leverage. Operating leverage arises from fixed operating costs (fixed costs other than financing costs), such as depreciation, salaries, advertisement expenditure and property taxes. Financial leverage stems from the presence of fixed financing cost such as interest. Financial Leverage It is important here to take the decision of financing on the basis of financial leverage because financing for expansion project of JetBlue Airways will affects its capital structure in an effective way. Financial leverage is connected with earnings before interest and taxes and earning per share of ordinary or common stock. This is because when a firm has fixed cost financing (like debentures in case of JetBlue), a change in one percent in EBIT (Earnings before interest and taxes) results in change of more than one percent in earning per share. This is because “financial leverage is the potential use of fixed financial costs to magnify the effects of changes in earnings before interest and taxes on the firm’s earning per share.” (Lawrence J. Gitman, page 546)4 Financial leverage can be numerically measured through the degree of financial leverage (DFL). Accordingly let us first calculate the degree of financial leverage of JetBlue for the year 2002 and 2003. The required figures of 2003 for calculations of DFL are taken from the annual report of 2003 available at website of JetBlue Airways. It may be noted that DFL differs at each level of EBIT. So, one has to indicate the level of output at which DFL is measured. For the purpose of estimating DFL at different level, debt ratios are calculated hereunder when financing is assumed either through equities, or debt capita, or an equal mixture of equity and debts. In the year 2003 the company is highly geared as more than 50% of total assets have financed through debts. In 2003 DFL calculated earlier is 76.6% at debt ratio of 69.3%. For debt ratios of the three assumed alternatives the effects on DFL with EBIT at 2003 level are calculated as under: The above figure suggests that when changes are made in capital structure keeping EBIT at same level of 2003, degree of financial leverage changes more when financing is through convertible debentures. This reflects that theory of leverage is concerned and based on fixed cost. ‘Using return on shareholders equity as the criterion, the higher the proportion of debt – and its fixed interest charges – in the capital structure, the greater will be the leverage contribution to the return on shareholders’ equity, for a given positive return achieved on the investments. Conversely, as achieved return drops below the rate of interest (tax adjusted), the fixed nature of interest charges will begin to magnify the return the reduction in return on equity.’(Erich A Helfert, page 222)5 Accordingly judging from the point of financial leverage, financing of expansion program of JetBlue Airways the preference should be given to debt financing as the equity holders get the advantage of trading in equity on rising profitability. Operating Leverage Another financial tool that will help JetBlue Airways in decision making is the Degree of operating leverage. It is a sensitivity analysis method that helps in deciding between alternative scenarios. DOL is a technique that effectively evaluates the operating results of alternative finance raising suggestions made by investment bankers to JetBlue Airways. Selection of alternatives of financing is in fact a matter of risk assessment. As per V. Padmanand and V.G.Patel (page 132)6, ‘risk is estimated in terms of possible variability in profits. The variability in profits arises primarily because variability in sales (volumes or margins or both). This risk includes the degree of operating leverage (DOL) arising from structure of operating cost (variable cost that vary with output and fixed costs that do not) of the enterprise and the degree of financial leverage (DFL) arising from the financial structure of the firm.” We have studied the impact financial leverage of each of the alternatives in preceding paragraphs. Let us analyze the impact on profitability using the tool of degree of operating leverage. DOL is function of cost structure. It is defined as a relationship between fixed costs and total cost of the cost structure of the firm. If the fixed costs constitute relatively high proportion in total cost of the firm, the firm is said to have higher operating leverage. “A firm with high operating leverage will also have higher variability in operating income than a firm producing a similar product with low operating leverage.” (Aswath Damodarn, page193)7 It is normally difficult to gather data from income statements to measure operating leverage. It is observed that the income statement presentations (also in case of JetBlue airways) do not distinguish between fixed and variable costs. Only aggregate costs are shown in the income statement. However, judging by the nature of costs from the income statement of JetBlue Airways, an effort is made to compute the degree of operating leverage. The formula for measuring degree of operating leverage is as under: DOL = Percentage change in operating profits (EBIT) / Percentage change in sales. In case of JetBlue Airways DOL is calculated by comparing the figures 2003 to that of 2002. The income statement figures for 2003 are taken from annual report 20038 available on website of the company: The presence of operating leverage can be judged when percentage change in operating profits from a given percentage of sales is greater than percentage change in sales. That means the operating leverage exists only when degree of operating leverage is more than one. From above calculations it is clear that operating leverage existed in 2003 as per information from the financial statements of JetBlue Airways. As indicated above operating leverage is the effect of changes in fixed operating costs. That means when the project under consideration will result in changes in fixed operating costs more than changes in variable costs, the presence of degree of operating leverage will bring higher income on changes in percentage of sales. For JetBlue Airways there are two options to finance the expansion project. One is to raise the funds through debt capital of $150 million through private placement of convertible debentures. As the coupon rate on debentures is 3.5% it will require JetBlue Airways every year to meet an extra expenditure on interest of $5.25 million till those debentures get converted into equity shares. This interest being finance expense is deductible only after calculating operating profits. That is to say it will not be considered for calculations of EBIT. The point to consider here is that whether the presence of DOL will enable JetBlue Airways to earn so much extra operating profit with increase in its revenue to meet at least this fixed interest on convertible debentures. For meeting extra interest cost of debenture capital $5.25 million Jet Blue Airways requires at least $27.79 million of extra revenue calculated as under: In other words JetBlue requires additional turnover of $27.79m to breakeven with cost (interest at coupon rate of debentures) of raising funds debt capital, when DOL is 1.06% at level of 2003 revenue. Now take the other alternative of financing the expansion project that is equity funding at a premium. Equity financing does not affect the fixed operational costs and thus degree of operational leverage will not have a role to play. In other words equity holders will get the advantage when there is increase in fixed operational expenses. But this will stand good only under conditions when earnings are rising. As JetBlue Airways is quite optimistic for its expansion programs, the equity holders will also get the benefit of leverages only when there is effect on charges of fixed nature, and that can happen only when debt capital is raised. Accordingly, when considered from the point of view of the effects of financial leverage or the effects of operational leverage, the financing through debt capital is always preferred. Total Leverage Total leverage effect is the combined effect of financial leverage and operating leverage. “Total leverage indicates a firm’s ability to use both operating and financial fixed costs to magnify the effect of changes in sales on a firm earning per share. Whenever the percentage change in earning per share resulting from a given percent change in sales exceeds the percentage increase in sales, the total average is positive. The total or combined leverage for a company equals the product of operating and financial leverages (DTL = DOL * DFL).” (Charles J Woelfel, page 104)9 Based on this formula the degree of total leverage (DTL) is calculated hereunder taking the figures of DOL and DFT calculations earlier in this write up. When the project is financed through debt capital, i.e., issuance of debentures, the total effect on earning per share of changes in sales would be through the effect of total leverage of 81.62%. This is because of presence of fixed nature of interest expenses on debenture financing. However, the effect of equity financing of project can not be studied as equity financing does not affect the fixed cost of financing or operations. It only dilutes the existing equity and thus reduces the earning per share. Accordingly observations made from the point of leverages, the debt capital is preferred for financing the expansion project of JetBlue Airways. Equity Financing The biggest drawback of equity financing for expansion is that it dilutes the control of existing equity holders. The cost of raising equity capital is generally higher than cost of funding the expansion through debt capital. Accordingly the rate of return required by equity holders has to be greater than the rate of return required by debenture holders. In fact firm’s liability is fixed at coupon rates for debenture holders. Also equity dividend payouts are treated as sharing of profits, whereas the debenture interests are allowed as expenditure for calculating earnings available to equity shareholders. This factor also increases the relative cost of equity. On the other hand there is no compulsion to pay dividends to equity holders. If the firm has insufficiency of cash, it can skip equity dividends without suffering any legal consequences. Equity capital has no maturity date and hence the JetBlue Airways will be required to redeem the equity. As a matter of fact equity capital provides a cushion to lenders; it enhances the creditworthiness of the company. In general, other things being equal, the larger the equity base, the greater the ability of the firm to raise debt finance on favorable terms. Equity holders, as owner of the firm, exercise an indirect control over the operations of the firm. But that is more of a theoretical control. Often such indirect control is weak and ineffective because of apathy and indifference of most of the shareholders who rarely bother to use their powers as shareholders. Debenture financing The most important feature of debt financing is that it does not result in dilution of control because debenture holders are not entitled to vote. But debenture holders cannot partake in the value created by the company as payments to them are limited to interest and principal. If there is a precipitous decline in the value of the firm, the shareholders have the option of defaulting on the debt obligations and turning the firm to debt holders. The burden of servicing debentures is generally fixed in nominal terms. Hence debts provide protection against high unanticipated inflation. Interest on debts is a deductible expense for tax purposes, whereas equity dividends are paid out of profits after tax. As debt financing entails fixed interest and principal repayment obligations, failure to meet these commitments can cause great deal of financial embarrassment and even lead to bankruptcy. As seen in earlier part of this write up debt financing increases financial leverage, which according to CAPM, raises the cost of equity to the firm. Moreover debt contracts, many a times, impose restrictions that limit the borrowing firm’s financial and operating flexibility. These restrictions may impair the borrowing firm’s ability to resort to value- maximizing behavior. Above all, if the rate of inflation turns out to be unexpectedly low, the real cost of debenture financing will be greater than expected. Conclusion Observations made from the point of view of costs of capital of financing the expansion programs of JetBlue Airways suggest that JetBlue Airways should go in for mixed sources for financing its expansion programs. On the other hands leverages of capital structure, both financial leverage and operational leverage are in favor of financing through debentures. This is mainly because debentures issuance will involve the fixed liability of interest payment on JetBlue Airways and that is fixed nature of expense affecting the leverages. Equity funding does not impose any such fixed liability of expenditure on the firm. In the case of equity funding, cost structure for calculation of EBIT does not get affected. That is why leverages of financial structure will not be affected by funding from equities. At the same time high leverages of capital structure provide the equity holders an advantage of trading in equity particularly when profitability is rising. Looking at the entire scenario and the fact that JetBlue will have to redeem the debenture liability if conversion option is not exercised by debenture holders, it is recommended that JetBlue should finance it expansion program from both the debentures as well as equity issues. However, the decision between the debenture issues and equity issues should be based on benefits of leverages and trading of equity to its stakeholders. References: Read More
Tags
Cite this document
  • APA
  • MLA
  • CHICAGO
(Financing the JetBlue Airways Expansions Research Paper, n.d.)
Financing the JetBlue Airways Expansions Research Paper. Retrieved from https://studentshare.org/finance-accounting/1720457-finance
(Financing the JetBlue Airways Expansions Research Paper)
Financing the JetBlue Airways Expansions Research Paper. https://studentshare.org/finance-accounting/1720457-finance.
“Financing the JetBlue Airways Expansions Research Paper”, n.d. https://studentshare.org/finance-accounting/1720457-finance.
  • Cited: 0 times

CHECK THESE SAMPLES OF Financing the JetBlue Airways Expansions

A Tale of Two IS Projects. JetBlue and WestJet

This paper is on focus of two of the leading airline firms “jetblue” and “WestJet” in order to understand the significance of information technology in the firms' service operations.... Importance of Reservation System in WestJet and jetblue For airline companies like jetblue or WestJet, the importance of the reservation system is like a heart to organizations' operations giving stimulus to each of the organization sections.... Ability to book flights or dealing customers with time effectiveness comes directly from an effective reservation system and for that reason organizations like jetblue and WestJet emphasize on keeping their reservation systems upgraded....
7 Pages (1750 words) Essay

Jet Blue Airline

The planes from jetblue Airline Company connect over 80 destinations including; Bahamas, Las Vegas, West Palm Beach, San Juan, and Puerto Rico (James, 2012).... The executive vice president of jetblue's systems and technology, John Eng revealed the plans of the airline company to disclose its modern workstation in New York at the John F.... The Jet Blue Company also broke up its contract with the Navitaire Company; a move which Navitaire claims is as a result of jetblue's misperception about the ability of the company's functionality....
5 Pages (1250 words) Research Paper

Analysis of Case JetBlue Airline's Success Story

jetblue's survival and success gained immense popularity by virtue of being a firm that was operating in an industry that was losing money rapidly.... The only way jetblue could succeed was by discovering and developing a business model that would promote cost efficiency and effectiveness.... The few core areas that jetblue targeted were cost, operations, technology, marketing and human resource.... jetblue knew that cutting costs is not always the best practice unless it is matched by higher quality as well....
5 Pages (1250 words) Essay

JetBlue the Next People Express

In the paper “jetblue the Next People Express” the author focuses on a low-cost airline, which has witnessed phenomenal growth over the last few years and is now ranked as the fifth largest airline in the US.... hellip; The author states that although jetblue executives sought to downplay the suspension of its operations as a one-off event, industry watchers feel otherwise.... Parallels are already being drawn to People Airline Express, another low-cost carrier that sank without a trace in 1997 under similar constraints as are being faced by jetblue today....
2 Pages (500 words) Case Study

A Cadre of New Managers and its Control

jetblue airways Corporation.... jetblue airways.... LUE airways: A CADRE OF NEW MANAGERSTakes Control1.... The reporter gives answers to important questions, one of which is what the key functional strategies that have enabled the CEO and jetblue's management to implement and execute its chosen strategy are.... hellip; jetblue's main vision is to make their customers satisfied by making sure that they receive exemplary customer service....
1 Pages (250 words) Case Study

JetBlue Crucial Concepts

Hence, they are usually shaped by society jetblue jetblue Questions Question The three concepts are crucial in any business organization such as jetblue.... uestion 3The production concept best applies to jetblue.... Needs are classified as necessities in human survival....
1 Pages (250 words) Assignment

Improving the Effectiveness of JetBlue

The success of this company has been through… e cooperation of Systems Operation Center (SOC) and Organization Development (OD) team that has developed a JetBlue University to foster a healthy organization culture with deep understanding of behavioral science to bring in the much needed JetBlue experience for crew members JetBlue jetblue airways is an American low-cost airline and it was founded in August 1998 and its operating base is John F.... jetblue airways has always experienced large turnout of passengers during peak period....
10 Pages (2500 words) Essay

The Power of Airline

The paper entitled 'The Power of Airline' presents Airline that carriers have a key role in the development of tourism worldwide; their contribution to the development of destinations is related primarily to the increase of profits of local businesses.... hellip; The development of a place as a cultural destination could be also achieved through the airline carriers – without which the visiting of the above place would be extremely difficult....
5 Pages (1250 words) Term Paper
sponsored ads
We use cookies to create the best experience for you. Keep on browsing if you are OK with that, or find out how to manage cookies.
Contact Us