Fair rate of return on investment for Canadian transcontinental air carriers
Creators: name: O’Hara, Liisa Anneli
Publisher: name: University of British Columbia
Year: 2010

description: Like other industries the air transport industry must be permitted to earn an adequate rate of return on its invested capital to remain a viable operation. The topic for this thesis was inspired by the obvious lack of action by all parties concerned regarding the above adequate return. The objective of this thesis is to determine the level of a fair rate of return on investment (FROI) applicable to Canadian transcontinental air carriers, and to analyse some of the conceptual issues regarding both theoretically sound and operationally workable approaches to the above. A system of a sanctioned rate of return, based on the FROI, has been in use by the Civil Aeronautics Board (CAB) in the U.S. for years. Within the context of this study the FROI is defined as follows: Fair rate of return on investment is that percentage value which, when multiplied by the investment rate base, will result in sufficient current dollars to cover the fixed charges of debt and provide fair and reasonable compensation for the common equity holders of the regulated enterprise. Under ideal conditions, regulation forces the industry to operate at competitive levels of investment, price, output, and profit. Because of the inherent difficulties in the practical application, it is assumed that regulation is primarily aimed at eliminating monopoly profits and maintaining a balanced industry. The problem, therefore, is to set a FROI that would be obtained in a competitive market. To achieve this goal, regulation should assure that the average expected rate of return on desired new investment is equal to the regulated firm's market cost of capital. Consequently, the FROI for Canadian transcontinental air carriers should equal their market cost of capital. The above approach, most consistent with the theory of finance, can not be directly applied due to the unique characteristics of the two air carriers. Both Air Canada and CP Air have an excessive amount of debt in their capital structures, feasible only through their close relationships with the Federal Government and Canadian Pacific Ltd. If the calculation of the cost of capital was based on the actual capital structures, the FROI determined would reflect an utterly unrealistic condition as compared with the current capital market. Based on the above, this thesis is an attempt to determine an FROI for a hypothetical, independent transcontinental air carrier. This will make it possible to determine the return that investors at large would anticipate. To estimate the market cost of capital for the hypothetical air carrier, the weighted average cost of capital method is used. This method requires the determination of the appropriate cost of debt and equity, and their application to the selected capital structure. For transcontinental air carriers a capital structure with a debt/ equity ratio of 45/55 was considered reasonable. This choice was based on considerations such as fixed charge coverage ratio, actual debt/equity ratios of various Canadian industries, Canadian regional air carriers, and U.S. trunk carriers. The estimate for the market cost of debt of 10.5-11.5% was based on corporate bond yields during the second half of 1975, and the interest rate trend forecast for 1976. There is no unique method for determining the market cost of equity. Therefore, evidence was obtained from such diversified sources as a review of interest rates, ex post rates of return to investors, an application of the discounted cash flow technique, capital asset pricing model and comparable earnings approach. The combined findings indicate that current market cost of equity for air carriers is in the range of 16-18%. Based on the foregone, the weighted average cost of capital after tax for Canadian transcontinental air carriers is 11.2 to 12.5%. Canadian air carriers follow the CAB method of calculating the actual return on investment. This method involves adding the interest on long term debt before tax, back to the net income after tax, to obtain the return base. Therefore, to be consistent the FROI has to be based on the cost of capital that reflects the before tax cost of debt. On this basis the weighted average cost of capital is in the range of 13.5 to 15.1%. Based on the above, the following ultimate recommendations are made: The FROI of a regulated firm shall be equal to its market cost of capital. For Canadian transcontinental air carriers in 1976, the FROI should be within the range of 13.5% to 15.1% The Federal Government, through its agency, the CTC, should sanction the method of determination of the FROI outlined above and the proposed FROI level.