Last Updated 01 Sep 2020

# British Airways Management of Company Finance

Category Airways, Company, Finance
Words 1704 (7 pages)
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British airways is one of the most valuable company in the world that is why I choose her. With the aim to evaluate the proportion of debt in British airways, we will study his financial gearing: income gearing and capital gearing. In order to calculate the company’s capital gearing according to the book value, we need especially the value of the long-term and short-term borrowings and the value of shareholders’ funds.

But, there is several different formulas which arises some issues: the fact that the book value is lower than the market value (the first formula) and provisions can be considered either as liabilities or assets (the second formula), depending on firm. Then I will calculate the Weighted Average Cost of Capital. In 2004, the way of doing the balance sheets changed that’s why there are some differences between two reports.

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• Part 1 Measure of the gearing and income ratio
• Part 2 Measure of the debt and equity based upon the market value
• Part 3 Estimation of the WACC.

## Measure of gearing and income ratios

We will take those expressions:

1. Debt to equity ratio=Long term Liabilities/Shareholders’funds
2. Debt to debt plus equity ratio=LTL/(LTL+ Shareholders’funds)
3. Long Term Borrowings/Shareholders’ funds

### Gearing Ratio

Capital Gearing = LTL / Shareholders' Funds

|2006 |2005 |2004 | |Capital Gearing |259. 75% |437. 6% |590. 7% |

To set an upper ratio; we can incorporate the LTL at the shareholder value. Capital Gearing = LTL / (LTL + Shareholders' Funds)

|2006 |2005 |2004 | |Capital Gearing |72. 2% |81. 4% |85. 5% |

The provision are incorporates in those 2 formulas.

We can consider that the provision can be take as liabilities (highly certain) or as equity (ultra-prudence). Capital Gearing = Long Term Borrowing (LTL - provisions) / Shareholders' Funds

|2006 |2005 |2004 | |Capital Gearing |193. 5% |341. 4 % |475,40% |

Net Debt: Net debt = (Finance debt – cash and liquid resources)/ Equity For British Airways, Net debt = (loans, finance leases and hire purchase arrangements + Convertible Capital Bonds, net of other current interest bearing deposits and cash and cash equivalents – overdrafts) British Airways' definition from the annual report 2006)

|? million |2006 |2005 |2004 | |Capital Gearing |1641 |2922 |4158 |

The figures of long term liabilities are higher than the net debt that explain the fact that the ratios are different; The company health seem less vital, because of the cash and those equivalent, and deposits. Overdrafts are not representing a big amount, we include them. Since 2004 a policy of high liquidity is developed in order to reduce the debt, they tried to repay the debt earlier.

The debt are reduced by the conversion of the 112 millions of convertible bonds. "The ? 320 million 9 3/4 per cent Convertible Capital Bonds 2005 issued in 1989 matured on June 15, 2005. On that date 47,979,486 ordinary shares were issued in exchange for 112,317,274 Convertible Capital Bonds on the basis of one ordinary share for every 2. 34 Bonds held" (British Airways Report 2006). The capital gearing of the company is around 65% in almost all gearing indicators and more in som of them, as a conclusion we can say that the financial statement of the company is risky and more the company is weak due to the payment on the debt.

We can also highlight the fact that British Airways is finance by debt. Its has a important amount of lease and purchase arrangement, which exceeds the bank loans.

### Income Gearing

This ratios show us the security of creditor’s fund and the debt exposure. While using Income Ration we highlight the relation of the company’s income and its interest commitments.

Income Ratio = Interest payable / Profit Before Interest and Tax |% |2006 |2005 |2004 | |Income Gearing |0,17 |0,26 |0,87 |

Interest are taking a lower place in the profit (strategy reduction of debt). In fact, we use the Interest cover to see if the company can meet its interest.

Interest cover = Profit before interest and tax / Interest charges |Times |2006 |2005 |2004 | |Interest Cover |5,79 |3,80 |1,15 |

The company can afford her interest.

1. Because of the decrease of the amount of debt,
2. The profit before tax and interest increased by 269%, the risk is less important.

We can also use another formula, which gives a better image of the finance. It based on the fact that cash has not been received. As a conclusion we can says that: :British Airways reduced its long term debt by 28. 5%, and keep their interest payment low and increase the PBIT strongly. From the shareholder point of view, the company takes high risks so they have a good return on investment although reduction of the debt of the company makes the rate of return lower and lower.

## Measure of the debt and equity based on the market value

### Value of Equity

Share Price*:Number of Shares*: 2004: ? 2,181 083 845 000 2005: ? ,941 082 903 000 2006: ? 2,791 130 882 000 *I took those which were in the report. *The difference in the number of shares between 2005 and 2006 is the conversion of the 112 millions of Convertible Bonds into 47,979,486 shares. The value of equity is now:

|? |2006 |2005 |2004 | |Value of Equity |3 155 160 780 |2 100 831 820 |2 362 782 100 |

### Rating: Value of Debt

The rating shows that the company take risks for financing because she invest in high return share in the junk bond or high yield market those are really unstable.

This means that the company is highly financing by debt, investor need an important rate of return regards to the risk of non payment. In spite of that, British Airways’s main source of external funding is less sensitive to credit rating than the unsecured bond. The impact of the credit ration is not important for some parts of the debt. We will use the faire value of the debt to calculate the market value of debt. Because of the “"fair values of the Euro-Sterling notes and Euro-Sterling Bond 2016 are based on the quoted market values at March 31, 2006.

The fair values of floating rate borrowings are deemed to be equal to their carrying values. " British Airways Report Example in March, 31st 2006: Market value of the debt is:

|? million |2006 |2005 |2004 | |Market Value of Debt |4 130 |4 682 |5 954 | |Book Value of Debt |4 081 |4 492 |5 716 |

The problem is: Those market values are blending the current liabilities.

In the purpose to respect the ratios made before, I will deduct with percentage the current liabilities. The new market value of debt is: |? million |2006 |2005 |2004 | |Market Value of Debt |3645 |4216 |5244 | |Book Value of Debt |3 602 |4 045 |5 034 |

There is the a market where Debt are trade daily, that explain the difference between years.

## Measure of gearing based on market values

We use here the gearing ratio to compare the book value and the market value of the company: Capital Gearing = LTL / Shareholders' Funds |% |2006 |2005 |2004 | |Capital Gearing |115,5 |200,7 |221,9 | We can make a second ratio in order to set an upper limit: Capital Gearing = LTL / (LTL + Shareholders' Funds) % |2006 |2005 |2004 | |Capital Gearing |53,6 |66,7 |68,9 | Figures are lower than the one we made with the book value. The equity are valued in the book value at 25p whereas in the market value at an average price of the three years at 230p This divergence makes the ratios lower, thus with the book values the company seems to be less indebted and also less risky to investors.

## Estimation of the Weighted Average Cost of Capital (WACC)

### Cost of Equity

To estimate the cost of equity, we can use two ways:

1. The dividend valuation model
2. The Capital Asset Price Model (CAPM).

In this case, we can not use the dividend valuation model because the company did not distribute dividends since 2001, so the cost of equity will be 0 that would lead to irrelevant results. British Airways has not distributed dividends because: -They wants to strengthen the balance sheet by making new investment, then it invests into the company Quantas and also into the 5th Terminal in Heathrow.

British Airways is the 13th highest performing company out of the 93 FTSE 100 companies remaining for the performance period April,1st 2003 to March, 31st 2006. The board of director indicated that the payment of dividends will be resumed at an appropriate time. To calculate the cost of equity, the CAPM is the only model available: Ke = Rf + ? (Rm – Rf) Rf ( the risk-free return; Rm ( the market risk; ? ( quantitative measure of the volatility of a given stock, mutual fund, or portfolio, relative to the overall market.

A beta above 1 is more volatile than the overall market, while a beta below 1 is less volatile. For British Airways, the Beta is, for the three years, 0,91. The risk-free return can be found in the website of the Bank of England for each years and the market risk is the caps of the FTSE 100 of year N less years N-1 divided by the caps year N-1: (Caps N – caps N-1) / caps N-1 The risk-free return rate is: 2004: 4,75% 2005: 5,1% 2006: 4,2%

The market risk is: |  |31. 03. 2006 |31. 03. 2005 |31. 03. 004 | |Caps FTSE 100 |5964,6 |4894,4 |4385,7 | |year N - year N-1 |1070,2 |508,7 |772,4 | |Market Risk (%) |21,87 |11,60 |21,38 | The Cost of Equity using the CAPM is: |% |2006 |2005 |2004 | |Cost of Equity |20,1 |10,9 |19,7 | )

### Cost of debt

In order to obtain the cost of debt, the best ratio is to divide the interest payable by the debt: |% |2006 |2005 |2004 | |Cost Of Debt |2,62 |3,01 |3,50 | They leads to the same conclusion decrease in Debt and interest. We can add that no debt has been taken in 2006. All the purchase have been made by internal cash flow. c) The WACC The Weighted Average Cost of Capital is used to measure the cost of capital.

The formula is: Ko = Ke (Ve/Vo) + Kd (Vd/Vo) Where: Ke (the cost of equity Ve (the value of equity Kd (the cost of debt Vd (the value of debt Vo (the total value of the firm: |? million |2006 |2005 |2004 | |Vo |7 236 |6 593 |8 079 | The WACC is: |% |2006 |2005 |2004 | |WACC |10,08 |5,41 |8,04 |

The amount of Debt decreased but the WACC stay in the average, that because of the high level of the cost of equity. 2005 is discernible by a share price lower than the two other years. This leads to a lower shareholders' funds and also an higher influence of the debt’s drop, therefore the lower WACC. However, the CAPM have some limitations.

He is based on several assumptions:

• The investors are rational and risk-adverse who set a level of risk.
• The investors have the same single-period planning horizon.
• The investors have homogeneous expectations on the future yield. The investors can borrow and lend unlimited amounts at a risk-free rate.
• There is neither taxes nor cost of transactions
• The investors have all an efficient portfolio which maximize the yield, for a level of risk given.

Whole of efficient portfolio form a curve called the efficiency frontier.

To conclude, from the point of view of market value, we can say that British airways succeeded to face its commitments in term of debt and equity. Indeed, they took advantage of an increase in share price. The repayment of share allowing to reduce the gearing in debt capital.

This essay was written by a fellow student. You can use it as an example when writing your own essay or use it as a source, but you need cite it.

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