WeightedAverage Cost of Capital of JetBlue Airways

WeightedAverage Cost of Capital of JetBlue Airways

Theweighted average cost of capital is a calculation done to deduce acompany`s expenditure of capital where each category of assets getsweighted. All capital sources including bonds, preferred stock, andany other long-term are part of this calculation. A company`s WACCincreases as the rate of return and beta on equity increases. Anincrease in the weighted average cost of capital indicates that thereis a decrease in a company`s valuation as a result of a rise in risk.The most common method of calculating WACC involves themultiplication of each of the capital components by theirproportional weights and then summing the results. The formula forcalculating WACC is represented by the following equation(Brigham& Houston, 2012). 

Inthe illustrated model in the Excel spreadsheet, we use the formula tocalculate JetBlue Airways’ weighted cost of capital. I begin bycollecting crucial information for the 2015 financial year from theincome statement and balance sheet. Using mathematical tools, Icompute the total liabilities, overall equity, sum debt and equity,net income after tax, and net income before tax that form the core ofderiving the necessary ratios used in the formula (Panchey, 2015).

Usingthe ratios I derive the WACC= (E/(D+E)*re) + (D/(D+E)*(1+T)rd) -(1-L)re+ (L(1-T)rd)

Summarizedit becomes WACC=(1-L) re + L(1-T) rd

Thisequals (1-0.6147)0.2107+0.6147(1-0.3791)0.1321=0.1311*100%=13.11% asthe weighted cost of capital.

WACCis often used by investors to indicate if a certain investment provesworthy to pursue. WACC represents the minimum acceptable limit rateof return that a company can yield to stakeholders (Westerfield etal., 2012). In our case, for the 2016 financial year, JetBlue Airwayshad a 23.9% rate of return on invested capital, which means that thecompany was creating value for shareholders. The value can becalculated by simply subtracting 23.9%-13.11%=10.79%. It means thatevery dollar that the company is investing is generating ten cents ofvalue. This indicates that investing in JetBlue Airways will be aneffective measure.

Accordingto Damodaran 2016, the airline industry has an average cost of equityof about 9.88% which is lower than the obtained JetBlue`s cost ofcapital that stands at 13.11%. A major competitor to JetBlue isSouthwest Airlines whose weighted average cost of capital is 9.01%.The company`s return on invested capital is 38.99%. All this arecalculated from the company`s TTM income statements and data(Damodaran 2016). The company generates higher returns on theinvestments made than it costs them to raise further capital neededfor investments. Southwest airlines cost of equity is earning excessreturns as compared to JetBlue airlines when value metrics areobtained. The value can be obtained as 38.99%-9.01%=29.98%. Thatmeans for every dollar invested by the company creates thirty centsof value. The company expects to continue generating excess returnsfor its shareholders especially on the new investments in foreseeablefuture that will see the company`s value increase as the companyfurther grows.

Equitycapital unlike debt holders do not demand an explicit return on theircapital. However, the equity shareholders face an opportunity cost oninvesting in a certain company due to the risks involved hence, theopportunity cost of equity capital must be considered. The capitalasset pricing model suggests that the equity shareholders demand aminimum rate of return that is equal to the returns for bearing extrarisks in addition to the returns from risk-free investment. The extrathreat is called the equivalent to the risk premium times the betamultiplier that measures the dangers of security relative to thetotal market.

TheCapital Asset Pricing Model (CAPM) is a standard model that isadopted to calculate the value of business by determining discountrates. It is viewed by many as a simpler alternative to investedcapital methods. The proponents of CAPM suggest that one weakness ofthe invested capital approach is that appraisers cannot determine thedebt-to-equity ratio that is used to calculate the weighted averagecost of capital (Wasterfield et al., 2012). They also indicate thatthere are wide swings in WACC caused by changes in the assumeddebt/equity that can drastically affect the calculation of FairMarket Value (FMV).

CAPMhas several assumptions such as that investors hold diversifiedportfolios hence will only require returns for systematic risks intheir portfolios. It also assumes that the capital market is perfectand that all securities are correctly valued. However, there istaxation and no perfect information to investors in real capitalmarkets (Brigham & Houston, 2012).

IterativeValuation Approach

Thecost of equity capital=Risk-free rate + (Beta times Market riskpremium) Market risk premium is the additional return that ashareholder requires above risk-free rate.

Thefirst step in the calculation of JetBlue`s cost of capital is toconsult the annual balance sheet for 2015 that indicates a total debtvalue of 1746. The total debt has two components: Regular debt andcapital leases. Since there are two kinds of debt, we have to weighthe different interest rates that have been associate with every kindof debt. This brings us to the risk-free rate (Damodaran, 2016).

Risk-freerate.The suggested resource for this is the rates of return on thelong-term US government treasury bonds. From the United StatesTreasury website, the CMT risk-free rates stand at 2.11%. Yields onthe 20 year US Treasury.

TheBeta coefficient.Damodaran (2016) indicates that the beta coefficient for the airlineindustry stands at 1.27. There are a number of sources available forobtaining the beta of a specific company. One good source is yahoofinance 2016 which I have used to obtain market return figures.

MarketModel Regression

Returnsfor the firm=alpha+beta(returns for the market index)

Thebeta is a little risky than average in industry. Jetblue Airways doesnot fluctuate as the average firm would hence the beta makes sense.Historical data from yahoo finance (2016) suggests that a beta can becalculated from the data collected from 2011 to 2015. The use of fiveyears is crucial since it offers a bank of prices in the markets thatcan be used to accurately calculate the market risk figures.

Toobtain beta in excel spreadsheet attached =Slope(JBLUret,Mktret) withJBLUret and Mktret representing the renamed columns in excelspreadsheet attached.

Beta=0.088595

Themarket risk premium

Inthis paper, I consider a value of 4.5 for my market risk premiumvalue, which represents the geometric mean of the United Statestreasury bonds.

Withabove parameters, we can calculate the cost of equity capital, whichderives a figure of 2%. Finally, we weigh the capital componentsbased on their contribution to the entire enterprise. In our case,total capital is at 5390 for 2015 while equity and debt stand at 3210and 1746 respectively. This gives a value of 3210/5390 and 1746/5390=0.5955 and 0.3239.

Theafter-tax cost of debt stands at 12.1% while the cost of equity is2%. The debt value is 1746 and equity value is 3210. With the valueswe can obtain JetBlue airlines WACC as(12.1*0.5955)+(0.3299*2)=13.11%

Usingthe CAPM approach, the expected return on the stock since theinvestor is long-term would be =0.064+0.0561(0.95)=0.1173=11.73%. Ifwe use 4.5% as an estimate of the expected returns, it would be0.064+0.95(0.055) =11.63%. The cost of equity would be long-termsince JetBlue operates on that basis.

Theformula gives the levered beta for the JetBlue Airlines:

Solvingfor Bunlevered= 0.95/(1+(1-0.36)(1.7/1.5))=0.55. The business riskportion of the company`s equity is given by 0.55/0.95=58% while theremaining 42% is due to financial leverage risk. In this framework,the cost of equity equals 0.064+1.70(0.055) =15.75%. All risks arebusiness related (Damodaran, 2016).

References

Brigham,E. F., & Houston, J. F. (2012). *Fundamentalsof financial management*.Cengage Learning.

Damodaran,A. (2016). Damodaran Online: Financial analysis. Accessed 02/10/2016from http://pages.stern.nyu.edu/~adamodar/

Pandey,M. (2015). Financial Management: 11 Edition. New York: VikasPublishing House.

Treasury.(2016). Daily Treasury Long Term Rate Data.https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=longtermrate

Westerfield,R., Ross, M and Jordan, B. (2012). Fundamentals of Corporate FinanceAlternate Edition. Chicago: McGraw-Hill Higher Education.

YahooFinance. (2016).http://finance.yahoo.com/quote/%5EGSPC/history?p=%5EGSPC