Capital Structure Analysis: British Airways Case Study Common App Essay Help

Introduction

Capital structure is one of the most fundamental business concepts, as this structure defines a company's market position, as well as its appeal to partners and investors, to a large extent (Grossman, 2009, p. 129). The topic of this study is the airline or aviation industry, as exemplified by British Airways, one of the world's leading airlines. This company's annual reports provide rather disputed data in the areas of equity, debt, and WACC (British Airways, 2007; 2008; 2009), which is the primary basis for the following examination of British Airways' capital structure. Specifically, the capital structure dynamics of a corporation are investigated with the aid of debt and equity and gearing ratios and main capital structures theories now available.

Basic Theories of Capital Structure

Overall, capital structure theory rests on four major pillars, i.e. the four most prominent hypotheses that researchers have developed throughout the course of their work in this field of study. In 1958, Modigliani and Miller developed the seminal theory of capital structure (Brigham, 2007, p. 442). According to this theory, if market circumstances are ideal, the capital structure has no effect on the company's overall value, as both phenomena are viewed as distinct and independent business concepts. Many scholars, including Brigham (2007) and Grossman (2009), criticize this theory for being impossible in practice, as Modigliani and Miller consider capital structure irrelevant under the conditions of no taxes and agency costs, firms not using debt to fund operations, and investors possessing the same information as the management of the firm regarding the latter's growth potential (Brigham, 2007, p. 442).

Obviously, such conditions are impossible in the real world. Nevertheless, scholars have used the ideas of Modigliani and Miller to develop opposing theories, based on the assumption that if the capital structure has no value in an ideal market, it has a significant impact in the real business world. Brigham (2007) and Grossman (2009) believe, based on this concept, that three key theories dominate capital structure research today: the trade-off, the pecking order, and the agency costs theories. Kraus and Litzenberger's trade-off theory defends the relevance of bankruptcy costs and debt financing of a firm (Grossman, 2009, p. 151), whereas Myers and Majluf's pecking order theory sees the least effort principle as the basis for capital structure development, where equity is preferred during internal funding and debt is used during external funding processes (Grossman, 2009, p. 152).

Lastly, the agency costs theory is the position that acknowledges the significance of other factors Modigliani and Miller neglected in the construction of a firm's capital structure. In particular, the agency costs theory emphasizes the significance of debt and equity ratios, underinvestment difficulties, and free cash flows for the construction of an appropriate capital structure (Brigham, 2007, p. 16).

History of the Airline Industry

Therefore, British Airways is a prominent player in the international aviation business. The recent history of this business allows for the formation of substantial hypotheses regarding the capital structure of firms in this industry in general and British Airways in particular. Thus, Zinnov (2007) argues about the predicted 5.6% expansion of the global aviation industry since 2004 and observes that European airlines were expected to account for more than 60% of the global market under these conditions.

However, Brogden (2009) notes that the recession is affecting the sector and cites a 5.7% decline in passenger counts on a global scale in 2009, while airline operators lost an astonishing $4.7 billion in the same year. All of these circumstances are compared with the long-term industry advancements that have enabled airline service providers, for instance, to raise productivity by 61% and fuel economy by over 20%. In light of this reality, airline sector investments increased by 49% between 1980 and 2007. (Zinnov, 2007; Brogden, 2009). The aforementioned statistics demonstrate that the aviation business is exposed to several forces, which cannot help but affect the capital structure of any of its participants.

British Aviation

General Concepts

British Airways is a global leader in the provision of aviation services. The organization was created in 1919 under the name Aircraft Transport and Travel Limited (AT&T). Since then, the company has changed its name several times and added several other services, including hotel reservations, worldwide cargo delivery, electronic ticketing, and other investor relations-related endeavors (British Airways, 2010). British Airways today holds one of the most significant positions in the global aviation business due to these factors.

British Airways's Position in the Industry

British Airways holds one of the most prominent positions within the airline sector. According to the company's 2009 annual report, British Airways is projected to hold a 35% share of the EU airline market and a 21% share of the US market (British Airways, 2009). British Airways earned £8.992 billion at the end of the 2009 fiscal year, compared to £8.753 billion at the end of the 2008 fiscal year, despite the fact that the global economic recession reduced demand for airline services by almost 6% over the same period (British Airways, 2008; 2009). Therefore, British Airways' position in the business is quite strong, yet the recent modifications in its capital structure provide information for airline investors to examine.

Capital Structure

Cost of Equity from 2007 through 2009

Therefore, the first part of British Airways' capital structure is the cost of equity. British Airways's cost of equity has nearly doubled between 2007 and 2009, if only the dividend model is considered. In such a circumstance, the formula for estimating the cost of equity is:

Ko = Do / Po,

where Do represents the dividend per share and Po represents the current market value of British Airways stock. Accordingly, the cost of equity under the dividend model for the years 2007 to 2009 is as follows:

2007: Ko = 20.995/615 = 3.4% 2008: Ko = 29.387/526 = 5.6% 2009: Ko = 36.417/600 = 6.1%

However, if the growth rate g is included to the formula, the growth rate will be substantially slower.

g = √ (36.417/20.995)-1=31.7%

Consequently, the formula for calculating the actual rise of the cost of equity, with the growth rate g included, and the yearly cost of equity calculations will look as follows:

Ko = D1 / Po + g 2007: Ko = 29.387/615+0.317 = 3.6% 2008: Ko = 36.417/526+0.317 = 3.9% 2009: Ko = [36.417*(1+0.317)]/600+0.317 = 4.0%

The preceding equations demonstrate that the growth rate has a significant impact on the cost of equity, which, according to Grossman (2009, p. 184), indicates that the company's stock is highly leveraged, as demonstrated by the cost of debt.

Debt Cost from 2007 to 2009

In particular, between 2007 and 2009, the cost of debt for British Airways has been steadily declining. It is crucial to note that in 2008, the cost of debt declined by only 0.38 percent, whereas in 2009, the figure decreased by over double that amount. Using the formula (10), it is possible to follow the cost dynamics of debt:

Kd = I * (1-t) / Pd Kd = 1,393*(1-0.33)/15,651 = 5.96% Kd = 1,547*(1-0.37)/17,464 = 5.58% Kd = 1,110*(1-0.33)/25,518 = 2.91%

Accordingly, two key assumptions may be made based on the estimated statistics presented above. First, the drop in British Airways' cost of debt may have been contingent on the growth of revenue and the cost of equity. Grossman argues that the latter two elements provided the corporation with all necessary internal finance, resulting in a decrease in the cost of debt for British Airways (2009, p. 152). Second, British Airways may have artificially lowered the cost of debt to avoid underinvestment, as stated by Brigham (2007, p. 142) in light of the global economic slowdown and the debt-to-equity ratio that continued to rise from 2007 to 2009.

WACC in 2007 – 2009

On the basis of the cost of equity and cost of debt for British Airways in 2007, 2008, and 2009, it is now feasible to examine the evolution of the WACC (weighted average cost of capital) during the same time period. Specifically, this can be accomplished using the following formula:

WACC = [RS*(S/V)+[RB*(B/V)]

,

Where R represents the return on capital, V represents the whole company's capital, B represents the company's total debt, and S represents British Airways' equity for the relevant time. Consequently, the dynamics of the three-year WACC can be depicted as follows:

2007: WACC = [0.036*(93,690/109,341)+0.0596*(15,651/109,341)] = 3.94% 2008: WACC = [0.039*(91,303/108,767)+0.0558*(17,464/108,767)] = 4.17% 2009: WACC = [0.04*(101,613/127,131)+0.0291*(25,518/127,131)] = 3.78%

Thus, it can be seen that British Airways' WACC increased only in 2008 compared to 2007, while the 2009 WACC statistic reflected a decline of this element in the company's operations.

Capital Structure Dynamics

All of these specifics, i.e., the calculations of cost of equity, cost of debt, and WACC from 2007 to 2009, make it possible to trace the evolution of British Airways' whole capital structure during the same time period. Using the following formula (18), it is feasible to determine that the company's total capital has increased substantially over the specified time period:

V = B + S,

Where V represents the total capital, B represents the total debt, and S represents the company's equity. Consequently, the total capital for the years 2007 to 2009 increased as follows (British Airways, 2007; 2008; 2009):

Year Calculation Total capital

2007 £15,651 + £93,690 £109,341

2008 £17,464 + £91,303 £108,767

2009 £25,518 + £101,613 £127,131

British Airways' capital structure evolved as the cost of equity increased and the cost of debt declined dramatically (British Airways, 2007; 2008; 2009):

Cost of Equity by Year Price of Debt

2007 3.6% 5.96%

2008 3.9% 5.58%

2009 4.0% 2.91%

Intriguingly, the dynamics of the company's WACC correspond to the dynamics of its tax payment percentages from 2007 to 2009 (British Airways, 2007; 2008; 2009):

Annual WACC Taxes

2007 3.94% 33%

2008 4.17% 37%

2009 3.78% 33%

Thus, it can be seen that the capital structure of British Airways evolved in accordance with the agent costs theory from 2007 to 2009, insofar as the WACC levels were directly affected by the company's tax payment, while its cost of equity rose as the cost of debt fell in the context of the global economic recession and sufficient funds were available for internal financing.

Conclusions

Thus, the preceding discussion permits the conclusion that the capital structure of any business enterprise is a crucial aspect of its functionality and appeal to investors and business partners. The capital structure of a corporation largely dictates its market performance, whereas market success can alter the capital structure of a company. British Airways is used to illustrate these concepts since the capital structure of this corporation changed in tandem with the evolution of the market and the global economy.

Bibliography

Brigham, Edward (2007). Cengage Learning's Financial management fundamentals

British Airways Annual Report and Accounts for 2006/2007

Web.

British Airways Annual Report and Accounts for 2007/2008 Web.

British Airways Annual Report and Accounts for 2008/2009 Web.

British Airways is an airline (2010). Official Business Website. Web.

Brogden, L. (2009). Trends in the Airline Industry's Development Web.

T. Grossman (2009). MBA in Finance and Accounting on the Go. John Wiley & Sons, Inc.

Zinnov, L. (2007). Global Aviation Markets – Internet Analysis.

[supanova question]

× How can I help you?