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When William Paul arrived for work on January 11, 2000,

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When William Paul arrived for work on January 11, 2000, he was called into a meeting in;his supervisors office. The topic of the meeting was the possible merger of small, regional, and;privately held New England Airlines, into his companys client, larger, international, and publicly;traded Goliath Airlines.;Goliath Airlines, based in Chicago, Illinois, controlled a significant share of the air travel;market along the Pacific Rim and throughout the Western United States. New England, in contrast;was a well-run regional airline, providing service in the Eastern United States. Its desirable routes;modern fleet, efficient and motivated employees, strong growth, and potential to feed Goliaths;highly profitable international flights made it an excellent candidate for acquisition by Goliath;which wished to establish an instant and significant presence along the East Coast. Since New;England Airlines was privately held, its value of equity was unknown, and Paul was assigned the;task of determining this value. With merger negotiations between New England and Goliath;beginning in one week, Pauls valuation of New Englands equity would be a critical piece of;information for Goliaths management.;History;New England Airlines was founded in Providence, Rhode Island, in 1989. Following the;example of established and successful Southwest Airlines, its business strategy was to provide low;cost, high quality, point-to-point service, with an emphasis on timely operations and quick turn;arounds. New Englands home base was small, less-expensive, and less-congested T.E. Green;Airport in Providence, Rhode Island which served the Boston metropolitan area while avoiding;congested and often-delayed Logan Airport. New England began operations in 1990, providing;service to and between Providence, Newark, Philadelphia, Pittsburgh, and Washington, D.C.;New Englands operating strategy was non-traditional and unknown in the Eastern United;States, and for some months consumers were reluctant to try New Englands service. Consumers;who did fly with New England, however, were very satisfied with the experience. New Englands;low fares and excellent on-time performance gave it a competitive advantage over traditional hub;and spoke carriers in the region, causing New Englands passenger loads to grow steadily over time;and the airline quickly generated positive operating profits, as well as positive operating cash flows.;During its ten year life New England expanded its operations in a careful and well thought out;manner, and by January of 2000 the airline provided service to four of the original five cities, as;well as Baltimore, Columbus, Indianapolis, Chicago, Nashville, Norfolk, Raleigh-Durham;Orlando, Tampa, and Ft. Lauderdale. This expansion had been successful, and during the last five;years, New England had experienced revenue growth of 12.6% per year, well above the industry;average of 8.25%.;Financial statements for 1998 and 1999 for New England Airlines are presented in Exhibit 1.;Operations;New Englands management believed the two key factors in its success and growth were its;low fares and its superior on-time performance. New England was able to operate profitably, in;spite of fares consistently among the lowest in the industry, due to its highly efficient operations.;New Englands aircraft were typically turned around (arrival at gate, disembarking of passengers;unloading of luggage, boarding of passengers, loading of luggage, re-fueling, departure from gate);in forty minutes, far quicker than a traditional trunk airline running a hub and spoke system. By;New England Airlines;137-C00;Fall 2014-A;keeping its planes in the air more often, and on the ground less often, New England was able to;generate additional revenue per seat.;New Englands commitment to low fares was also facilitated by its choice of aircraft. From;inception New England had operated single-aisle aircraft from the Airbus 320 family only. Airbus;technological improvements and commonality of design, maintenance, and flight operations gave;New England a competitive advantage in cost, allowing it to operate profitably in spite of its low;fare structure. This strategic operating choice made New Englands fleet among the youngest and;most efficient in the industry.;Superior on-time performance was maintained through its fast aircraft turn around and by;avoiding airports known for delays whenever possible. Persistent weather and congestion delays in;Newark, for example, had led New England to discontinue service at that airport, as delays in;Newark occasionally caused delays and cancellations throughout New Englands entire system.;The Future;Management at New England Airlines planned to continue its successful strategy of well;thought out expansion. In 2000 and 2001, the airline would expand into Manchester, New;Hampshire, and St. Louis, Missouri, respectively. Future expansion would continue in the Eastern;United States, consistent with New Englands operating strategy. Management expected New;England Airlines to continue to grow faster than the industry until 2004, at which time growth in;revenue, income, and free cash flow was expected to slow to an 8.25% per year constant and;perpetual rate for years 2005 and beyond.;Valuation;William Paul remembered from his college coursework and professional development work;in valuation that two different methods were available to estimate the value of an entire enterprise;and the companys owners equity;1. Valuation by multiples, and;2. Discounted cash flow valuation;To determine the value of owners equity through multiples valuation, Paul needed;information on both New England Airlines and its industry peers. Paul quickly obtained this;information from recent annual reports and information intermediaries. This information is;presented in Exhibit 2.;The second valuation method, discounted cash flow, required Paul to determine the free cash;flows to all capital providers of New England Airlines, discount these cash flows at the appropriate;risk-adjusted cost of capital, and apportion total enterprise value to debt and equity holders. Paul;had access to New Englands forecasted income statements and partial balance sheets from 2000 to;2004, as presented in Exhibit 3, and he estimated the cost of capital (also called the discount rate, or;the required rate of return) for New England was 10.5%.;Assignment;William Paul was assigned the critical task of determining the value of equity of New;England Airlines. He was given two days to present this value to his supervisor, as well as justify;his choice of valuation method and the inputs to the chosen valuation methodology.

 

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