The estimation of cost of capital for JetBlue proved to be a difficult process.
Considering the company has an unfavorable capital structure, due to the fact that they are acquiring a large number of aircrafts, simply taking the weights of debt and equity are not acceptable. In order to accurately judge the discount rate the multiples method is necessary. The comparison was to a leading low-fare airline company, Southwest. Another critical point is that taking the book values as compared to the market values is not an accurate depiction of what the market is willing to pay.
There are several components that came into play with calculating the WACC. Necessary components included: weights of debt and equity, cost of debt and equity, and the tax rate. Cost of Debt Determining the cost of debt is generally an easy process. Since JetBlue is not a public company at the moment that this case is taking place, their issuance of debt is not readily available.
A fair judgment would be Southwest’s cost of debt in this case. To calculate that, we simply took the average yield-to-maturity for Southwest’s outstanding bonds (see Exhibit 6).Cost of debt was 6. 91% Cost of Equity In order to calculate the cost of equity in this particular situation the CAPM model was the best choice. The risk-free rate and the market risk premium were given in the case. Both numbers were five percent.
Beta can be somewhat difficult to calculate, especially for a firm that is not publicly held. For estimating this value we can once again use the multiples method to come to a fair estimation. Since using the multiples with JetBlue proves to be more challenging than necessary, an industry average can be applied.Professor Damoradan has a great set of data to choose from based on industry, and that is where we found the value of 0. 82.
All of these values put together into the formula of the risk-free rate plus beta multiplied by the market risk premium gave a cost of equity of xxx. Tax Rate The tax rate was given in the case information. A marginal tax rate of 34% was used. The average tax rate is not applicable here.
Weight of Debt When calculating weights it may seem ideal to simply calculate the book values, but we must use market values.JetBlue had a strange capital structure with debt being over 100% of debt and stockholders’ equity. Using a multiples method seemed to be the best way to calculate the market values, but it proved to be more of problem than simply using an industry average. Using a comparable company’s capital structure is the most accurate and fair judgment to calculate weights. The information at hand points toward using Southwest’s capital structure, but they much larger and more established than JetBlue.
JetBlue has seen considerable growth and could eventually reach Southwest’s level, but it is important to take note that these companies are different. Weight of Equity Once the issue of weight of debt is handled we can simply subtract that value from one since that is the total amount of capital. Either debt or equity can be calculated first, but they both can be just as difficult to calculate. Some information is more readily available than other information, so the order of which to process first could depend on what you have available.
Since we have weight of debt already we can just subtract that value from one, and the remainder is the weight of equity. In this case we get xxx. DCF Valuation There are several different approaches to get a fair valuation of a company. All these approaches have their strengths and weaknesses, but the discounted cash flows method was the optimal choice for JetBlue. The process of calculating WACC gives us the appropriate discount rate for discounting our free cash flows.
