Harvard Case - Hong Kong Dragon Airlines Limited (A): Determining the Cost of Capital
"Hong Kong Dragon Airlines Limited (A): Determining the Cost of Capital" Harvard business case study is written by Su Han Chan, Ko Wang, Andrew Lee. It deals with the challenges in the field of General Management. The case study is 6 page(s) long and it was first published on : Jan 15, 2010
At Fern Fort University, we recommend that Hong Kong Dragon Airlines Limited (HKDA) utilize a combination of the Capital Asset Pricing Model (CAPM) and the Fama-French Three-Factor Model to determine its cost of capital. This approach will provide a more comprehensive and accurate estimate of the cost of capital, factoring in both systematic and firm-specific risks. Additionally, HKDA should conduct a sensitivity analysis to understand the impact of different assumptions on the cost of capital, leading to more informed decision-making regarding future investments and financing.
2. Background
This case study focuses on Hong Kong Dragon Airlines Limited (HKDA), a subsidiary of Cathay Pacific Airways, operating as a low-cost carrier. HKDA faces the challenge of determining its cost of capital, a crucial factor in evaluating investment opportunities and making informed financial decisions. The case highlights the complexities of estimating the cost of capital, considering factors like the company's risk profile, market conditions, and the availability of comparable companies.
The main protagonists in the case are:
- Peter Chan, the Financial Controller of HKDA, responsible for determining the cost of capital.
- The Board of Directors, who need the cost of capital to evaluate investment proposals.
- The Investment Bankers, who provide advice on financial matters and market conditions.
3. Analysis of the Case Study
To determine HKDA's cost of capital, we need to analyze the company's financial situation, market conditions, and the risk associated with its operations. We can utilize the following frameworks:
a) Strategic Analysis:
- SWOT Analysis:
- Strengths: HKDA benefits from the Cathay Pacific brand, established infrastructure, and experience in the Asian market.
- Weaknesses: HKDA faces competition from established low-cost carriers and potential challenges related to its low-cost model.
- Opportunities: HKDA can leverage its parent company's resources, expand its network, and capitalize on the growing demand for air travel in Asia.
- Threats: HKDA faces competition from established low-cost carriers, potential economic downturns, and fluctuations in fuel prices.
- Porter's Five Forces:
- Threat of New Entrants: Relatively high due to low barriers to entry in the low-cost carrier market.
- Bargaining Power of Buyers: Moderate, as passengers have options for alternative airlines.
- Bargaining Power of Suppliers: Moderate, as HKDA relies on suppliers for aircraft, fuel, and other resources.
- Threat of Substitute Products: Moderate, as passengers can choose alternative modes of transportation, like trains or buses.
- Competitive Rivalry: High, as HKDA faces competition from established low-cost carriers.
b) Financial Analysis:
- Risk Assessment: HKDA faces various risks, including operational risks (fuel price volatility, competition), financial risks (debt financing, currency fluctuations), and regulatory risks (changes in aviation regulations).
- Capital Structure: HKDA's capital structure consists of debt and equity. The cost of debt can be determined by examining the company's existing debt obligations and market interest rates. The cost of equity is more complex and requires further analysis using models like CAPM and Fama-French.
c) Market Analysis:
- Comparable Companies: Identifying publicly traded companies with similar business models and risk profiles to HKDA allows for benchmarking and estimating the cost of equity.
- Market Risk Premium: This represents the additional return investors expect for investing in the stock market compared to risk-free investments. This can be estimated using historical data and market expectations.
4. Recommendations
- Utilize a Combined Approach: HKDA should use both the CAPM and the Fama-French Three-Factor Model to determine its cost of capital. This approach captures both systematic risk (beta) and firm-specific risks (size and value factors).
- Conduct Sensitivity Analysis: HKDA should perform a sensitivity analysis to understand the impact of different assumptions on the cost of capital. This includes varying the beta, risk-free rate, market risk premium, and size and value factors.
- Regularly Review and Update: HKDA should regularly review and update its cost of capital estimate, considering changes in market conditions, company performance, and regulatory environment.
5. Basis of Recommendations
These recommendations are based on the following considerations:
- Core Competencies and Consistency with Mission: Utilizing a combination of CAPM and Fama-French aligns with HKDA's mission to be a low-cost carrier while considering the risks associated with its business model.
- External Customers and Internal Clients: The cost of capital is crucial for making investment decisions that benefit both external customers (through improved services) and internal clients (through increased profitability).
- Competitors: The cost of capital analysis needs to consider the competitive landscape and the risk profile of comparable low-cost carriers.
- Attractiveness ' Quantitative Measures: The use of CAPM and Fama-French provides a quantitative basis for determining the cost of capital, allowing for informed decision-making regarding investments and financing.
- Explicit Assumptions: All assumptions used in the analysis, such as beta, risk-free rate, market risk premium, and size and value factors, are explicitly stated and justified based on available data and market conditions.
6. Conclusion
By adopting a combined approach using CAPM and Fama-French and conducting regular sensitivity analysis, HKDA can obtain a more accurate and comprehensive estimate of its cost of capital. This will enable the company to make informed investment decisions, manage financial risks, and achieve its strategic goals.
7. Discussion
Other alternatives not selected include:
- Using only CAPM: This approach is simpler but may not capture all relevant risks.
- Using only Fama-French: This approach may be more complex and require more data.
- Using a single discount rate for all projects: This approach is less accurate and may lead to suboptimal investment decisions.
Risks and Key Assumptions:
- Accuracy of Beta: The accuracy of the beta estimate is crucial for the CAPM model.
- Market Risk Premium: The market risk premium is subject to fluctuations and depends on market expectations.
- Size and Value Factors: The Fama-French model relies on accurate data for size and value factors, which can be challenging to obtain.
8. Next Steps
- Gather Data: HKDA should gather data on comparable companies, market risk premium, and size and value factors.
- Perform Analysis: HKDA should perform the CAPM and Fama-French analysis and conduct sensitivity analysis.
- Present Findings: HKDA should present the findings to the Board of Directors and discuss the implications for investment decisions.
- Implement Recommendations: HKDA should implement the recommended approach for determining the cost of capital and regularly review and update it.
Timeline:
- Month 1: Gather data and perform initial analysis.
- Month 2: Conduct sensitivity analysis and finalize the cost of capital estimate.
- Month 3: Present findings to the Board of Directors and implement the recommended approach.
This case study highlights the importance of a robust and comprehensive approach to determining the cost of capital. By considering both systematic and firm-specific risks, HKDA can make informed financial decisions that support its long-term growth and profitability.
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Case Description
In order to protect its operation from 2007 onwards, Dragonair needed to replace a spare engine that was deemed beyond economic repair back in late 2002. Three options were available to address this need. First, Dragonair could purchase the engine outright, which would require it to place an order with the manufacturer 12 months in advance and pay an upfront deposit. Second, the airline could choose a sale-and-leaseback transaction with a leasing company whereby it would sell the engine it purchased to the leasing company and then lease it back from the leasing company for an agreed period. Third, the airline could lease a new engine directly from a leasing company, in which case the leasing arrangement would be the same as the sale-and-leaseback transaction.
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