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UBC Theses and Dissertations

Fair rate of return on investment for Canadian transcontinental air carriers O’Hara, Liisa Anneli 1976

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FAIR RATE OF RETURN ON INVESTMENT FOR CANADIAN TRANSCONTINENTAL AIR CARRIERS by LIISA ANNELI O'HARA M.B.A., University of Tampere, Finland, 1971 A THESIS SUBMITTED IN PARTIAL FULFILMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF SCIENCE I N BUSINESS ADMINISTRATION in the Faculty of COMMERCE AND BUSINESS ADMINISTRATION, FINANCE DIVISION We accept t h i s t h e s i s as conforming to the required standard THE UNIVERSITY OF BRITISH COLUMBIA Ap r i l 1976 In p r e s e n t i n g t h i s t h e s i s in p a r t i a l f u l f i l m e n t o f the r e q u i r e m e n t s f o r an advanced degree at the U n i v e r s i t y o f B r i t i s h Co lumb i a , I a g ree that the L i b r a r y s h a l l make i t f r e e l y a v a i l a b l e f o r r e f e r e n c e and s tudy . I f u r t h e r agree t h a t p e r m i s s i o n f o r e x t e n s i v e c o p y i n g o f t h i s t h e s i s f o r s c h o l a r l y purposes may be g r a n t e d by the Head o f my Department o r by h i s r e p r e s e n t a t i v e s . It i s u n d e r s t o o d that c o p y i n g o r p u b l i c a t i o n o f t h i s t h e s i s f o r f i n a n c i a l g a i n s h a l l not be a l l o w e d w i thou t my w r i t t e n p e r m i s s i o n . Department o f Commerce a n d B u s i n e s s A d m i n i s t r a t i o n The U n i v e r s i t y o f B r i t i s h Co lumbia 2075 Wesbrook Place Vancouver, Canada V6T 1W5 Date APhik <LU,&\ - i -A B S T R A C T Like other industries the a i r transport industry must be permitted to earn an adequate rate of return on i t s invested c a p i t a l to remain a v i a b l e operation. The topic f o r t h i s thesis was i n s p i r e d by the obvious lack of action by a l l parties concerned regarding the above adequate return. The o b j e c t i v e of t h i s thesis i s to determine the lev e l of a f a i r rate of return on investment (FROI) applicable to Canadian trans-continental a i r c a r r i e r s , and to analyse some of the conceptual issues regarding both t h e o r e t i c a l l y 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 C i v i l Aeronautics Board (CAB) in the U.S. f o r years. Within the context of t h i s study the FROI i s defined as follows: F a i r rate of return on investment i s that percentage value which, when m u l t i p l i e d by the investment rate base, w i l l r e s u l t in s u f f i c i e n t current d o l l a r s to cover the f i x e d charges of debt and provide f a i r and reasonable compensation f o r the common equity holders of the regulated enterprise. Under ideal conditions, regulation forces the industry to operate at competitive l e v e l s of investment, p r i c e , output, and p r o f i t . Because of the inherent d i f f i c u l t i e s i n the p r a c t i c a l a p p l i c a t i o n , i t i s assumed that regulation i s p r i m a r i l y aimed at eliminating monopoly p r o f i t s and maintaining a balanced industry. - i i -The problem, therefore, i s to set a FROI that would be obtained in a competitive market. To achieve t h i s goal, regulation should assure that the average expected rate of return on desired new investment i s equal to the regulated firm's market cost of c a p i t a l . Consequently, the FROI f o r Canadian transcontinental a i r c a r r i e r s should equal t h e i r market cost of c a p i t a l . The above approach, most consistent with the theory of finance, can not be d i r e c t l y applied due to the unique c h a r a c t e r i s t i c s of the two a i r c a r r i e r s . Both A i r Canada and CP A i r have an excessive amount of debt in t h e i r c a p i t a l s t r u c t u r e s , f e a s i b l e only through t h e i r close r e l a t i o n s h i p s with the Federal Government and Canadian P a c i f i c Ltd. I f the c a l c u l a t i o n of the cost of c a p i t a l was based on the actual c a p i t a l s t r u c t u r e s , the FROI determined would r e f l e c t an u t t e r l y u n r e a l i s t i c condition as compared with the current c a p i t a l market. Based on the above, t h i s thesis i s an attempt to determine an FROI fo r a hypothetical, independent transcontinental a i r c a r r i e r . This w i l l make i t possible to determine the return that investors at large would a n t i c i p a t e . To estimate the market cost of c a p i t a l f o r the hypothetical a i r c a r r i e r , the weighted average cost of c a p i t a l method i s used. This method requires the determination of the appropriate cost of debt and equity, and t h e i r a p p l i c a t i o n to the selected c a p i t a l structure. For transcontinental a i r c a r r i e r s a c a p i t a l structure with a debt/ equity r a t i o of 45/55 was considered reasonable. This choice was based on considerations such as fixed charge coverage r a t i o , actual debt/equity r a t i o s of various Canadian i n d u s t r i e s , Canadian regional a i r c a r r i e r s , and U.S. trunk c a r r i e r s . The estimate f o r the market cost of debt of 10.5-11.5% was based on corporate bond y i e l d s during the second h a l f of 1975, and the i n t e r e s t rate trend forecast f o r 1976. There i s no unique method f o r determining the market cost of equity. Therefore, evidence was obtained from such d i v e r s i f i e d sources as a review of i n t e r e s t r a t e s , ex post rates of return to i n v e s t o r s , an a p p l i c a t i o n of the discounted cash flow technique, c a p i t a l asset p r i c i n g model and comparable earnings approach. The combined findings in d i c a t e that current market cost of equity for a i r c a r r i e r s i s in the range of 16-18%. Based on the foregone, the weighted average cost of c a p i t a l a f t e r tax f o r Canadian transcontinental a i r c a r r i e r s i s 11.2 to 12.5%. Canadian a i r c a r r i e r s follow the CAB method of c a l c u l a t i n g the actual return on investment. This method involves adding the i n t e r e s t on long term debt before tax, back to the net income a f t e r tax, to obtain the return base. Therefore, to be consistent the FROI has to be based on the cost of c a p i t a l that r e f l e c t s the before tax cost of debt. On t h i s basis the weighted average cost of c a p i t a l i s i n the range of 13.5 to 15.1%. Based on the above, the following ultimate recommendations are made: The FROI of a regulated firm s h a l l be equal to i t s market cost of c a p i t a l . For Canadian transcontinental a i r c a r r i e r s i n 1976, the FROI should be within the range of 13.5% to 15.1% The Federal Government, through i t s agency, the CTC, should sanction the method of determination of the FROI outlined above and the proposed FROI l e v e l . - V -TABLE OF CONTENTS PAGE I INTRODUCTION 1 II CANADIAN TRANSCONTINENTAL AIR CARRIERS 6 1.0. A i r Canada 6 2.0. CP A i r 8 III RATE OF RETURN IN REGULATED INDUSTRIES 11 1.0.0. Theoretical Considerations 11 1.1.0. The Theory of Economic Regulation 11 1.2.0. Regulatory Constraints 14 1.3.0. Fai r Rate of Return Regulation 17 1.3.1.0. Regulatory Models 17 1.3.1.1. F a i r Rate of Return 17 Exogenously Given 1.3.1.2. F a i r Rate of Return 22 Endogenous Variable 1.3.2.0. F a i r Rate of Return Concept 24 1.3.2.1. A l t e r n a t i v e Rate of Return 24 De f i n i t i o n s 1.3.2.2. Discussion on the F a i r Rate 29 of Return and the Appropriate Rate Base 1.3.3.0. Fai r Rate of Return and Risk 31 1.3.3.1. Market Risk Measures 33 1.3.3.2. Book Risk Measures 35 2.0.0. Approaches Taken in Rate Hearings f o r 38 Regulatory Decisions 2.1.0. Weighted Average Cost of Capital 41 2.2.0. Capital Structure 44 - v i -TABLE OF CONTENTS (Cont'd) PAGE 2.2.1. Actual Capital Structure 47 2.2.2. Hypothetical Capital Structure 47 2.2.3. Optimal Capital Structure 48 2.3.0. Cost of Debt 49 2.4.0. Cost of Preferred Stock 50 2.5.0. Cost of Common Stock Equity, 51 2.5.1.0. Market Value Approach 52 2.5.1.1. Earnings - Price Ratio Method 52 2.5.1.2. Discounted Cash Flow Method 53 2.5.2.0. Comparable Earnings Approach 54 2.5.3.0. Debt Coverage P r i n c i p l e 55 3.0.0. Regulatory Approaches i n the A i r l i n e 57 Industry 3.1.0. F a i r Rate of Return on Investment 57 3.2.0. Actual Rate of Return on 59 Investment 3.3.0. Leased F l i g h t Equipment in the 67 Investment Base 4.0.0. Summary 71 IV THE FAIR.RATE OF RETURN'ON-INVESTMENT FOR CANADIAN 73 TRANSCONTINENTAL AIR CARRIERS 1.0.0. Review 73 1.1.0. FROI and Comparable Earnings Standard 73 1.2.0. FROI and the Competitive Market 75 1.3.0. I n f l a t i o n 77 1.4.0. Capital Structure 82 1.4.1. Actual vs. Optimal 82 1.4.2. Determination of Optimal Capital 86 Structure - v i i -TABLE OF CONTENTS (Cont'd) PAGE 1.5.0. Estimation of Cost of Equity Capital 89 1.5.1. DCF - Method 89 1.5.2. Capital Asset P r i c i n g Model 92 1.5.3. Comparable Earnings Approach 97 1.5.4. Conclusion 1°° 2.0.0. The Approach Most Consistent with the Theory 1°1 of Finance 2.1.0. A l t e r n a t i v e Sources of Finance 101 2.2.0. Capital Structure 104 2.2.1. Actual Capital Structure 104 '2.2.2. Optimal Capital Structure 1 0 4 2.3.0. Cost of Debt m 2.4.0. Cost of Equity m 3.0.0. P r a c t i c a l Limitations due to the Unique H4 C h a r a c t e r i s t i c s of the Canadian Transcon-t i n e n t a l A i r C a r r i e r s 3.1.0. A i r Canada - H 4 3.2.0. CP A i r 115 4.0.0. The Approach Selected to Determine the FROI H 9 f o r Canadian Transcontinental A i r Ca r r i e r s 4.1.0. Hypothetical C a r r i e r - Canadian Continental H9 4.2.0. Basic Assumptions 122 4.3.0. Sources of Evidence f o r Cost of Equity 124 Estimation 4.3.1. DCF-Formula a'nd Beta Factors 124 4.3.2. Comparable Earnings Study, 129 Relationship between Risks and Returns 5.0.0. Summary 136 - v i i i -TABLE OF CONTENTS (Cont'd) PAGE V EMPIRICAL FINDINGS REGARDING THE COST OF EQUITY 1 3 7 ESTIMATES 1.0.0. Interest Rates 137 1.1.0. Trends 137 1.2.0. Nominal versus Real Yields 138 2.0.0. Ex Post Rates of Return to Investors 141 3.0.0. Application of DCF-Formula 145 3.1.0. H i s t o r i c a l Financial Performance of U.S. 145 A i r l i n e s 3.2.0. Future Prospects of the A i r Transport Industry 147 3.2.1. I n f l a t i o n versus Pr o d u c t i v i t y 147 3.2.2. Markets in 1975-1980 151 3.2.3. A i r l i n e Technology 154 3.2.4. Equipment and Equipment Financing 155 3.2.5. Summary 156 3.3.0. Future-Oriented DCF-Formula 159 4.0.01 Application of CAPM-Model 164 5.0.0. Application of Comparable Earnings Approach 167 5.1.0. Empirical Findings 167 5.2.0. Cost of Equity Capital f o r Reference Groups 171 6.0.0. Additional C r i t e r i a 173 6.1.0. Cost of Equity Capital f o r U.S. Carri e r s as 173 decided by the C.A.B. 6.2.0. Cost of Equity Capital Estimates by the C.T.C. 173 7.0.0. Summary 175 - ix -TABLE OF CONTENTS (Cont'd) PAGE VI SUMMARY 179 1.0. Fa i r Rate of Return Versus Weighted Average 179 Cost of Capital 2.0. Considerations f o r the FROI Application 181 2.1. Investment Rate Base 181 2.2 System Operations Versus Routes 183 3.0. Topics f o r Further Research 184 VII EXHIBITS 7 186 VIII BIBLIOGRAPHY 201 IX ATTACHMENTS 207 ATTACHMENT A: 207 The Model Used to Estimate Western A i r l i n e s ' Cost of Capital ATTACHMENT B: 215 Capital Asset Price Model Application ATTACHMENT C: 221 Comparable Earnings Approach Application - X -LIST OF TABLES PAGE I CANADIAN TRANSCONTINENTAL AMD 5 REGIONAL AIR CARRIERS - RATES OF RETURN ON INVESTMENT ELEMENTS OF VARIOUS METHODS OF CALCULATING ROI: IA INVESTMENT BASE 62 IB RETURN BASE 63 II RETURN ON INVESTMENT FOR CP AIR 64 IN 1973 -COMPARISON OF VARIOUS METHODS III COMPARISON OF ROI IM 1969-1973 65 CAB-FORMULA VS. CP AIR-FORMULA IV CONSTRUCTIVE OWNERSHIP REPORTING 66 VS. DIRECT EXPENSE REPORTING V REQUIRED NET INCOME TO OBTAIN 70 12* RETURN ON INVESTMENT VI AIRLINE COST INFLATION COMPARED 148 WITH PRODUCTIVITY AMD YIELD CHANGE 1967-1973 VII SENSITIVITY ANALYSIS OF WEIGHTED 178 AVERAGE COST OF CAPITAL - xi -LIST OF EXHIBITS EXHIBIT NUMBER PAGE 1 CALCULATION OF EMBEDDED COST OF 186 CAPITAL 2 GROUP I AMD GROUP II 187 ACTUAL EMBEDDED COST OF DEBT 3 FIXED CHARGE COVERAGE BY CANADIAN 188 AIR CARRIERS 4 DEBT CAPACITY OF CANADIAN 189 AIR CARRIERS 5 SEAT-MILE COST COMPARISON 190 CANADIAN VS. U.S. CARRIERS 5A TOTAL OPERATING EXPENSE PLUS NON- 191 OPERATING EXPENSE COMPARISON CANADIAN VS. U.S. CARRIERS 6 AVERAGE STAGE LENGTHS 192 CANADIAN VS. U.S. CARRIERS 7 BREAKEVEN LOAD FACTORS 193 CANADIAN VS. U.S. CARRIERS 8A REAL GNP VERSUS REVENUE PASSENGER 194 MILES FLOWN IN CANADA 8B REAL GNP VERSUS NUMBER OF NORTH 195 AMERICAN CARS SOLD IN CANADA 8C REAL GNP VERSUS MANUFACTURERS' SALES 196 OF MADE-IN-CANADA APPLIANCES 9 COMPARATIVE EARNING POWER FOR CANADIAN 197 STOCKS AND BONDS IN 1973-1974 9A COMPARATIVE EARNING POWER FOR CANADIAN 198 STOCKS AND BONDS IN 1974-1975 10 TREND OF CANADIAN PRIME BANK RATE 1973-1975' 199 10A ESTIMATED REAL SECURITY YIELDS TO MATURITY 200 - xi i -ACKNOWLEDGEMENTS I wish to express my appreciation and thanks to a l l who provided assistance and encouragement during the preparation of t h i s t h e s i s . In p a r t i c u l a r , to the following: Mr. R. Sherer Director of Bureau of Economics C.A.B. Mr. W.F. Lutz C.A.B. Mr. J.R. Foster Foster Associates Inc. for providing material related to the U.S. a i r transport industry. CP A i r Management fo r providing information regarding the problems of Canadian trans-continental a i r c a r r i e r s . Messrs. P. L u s z t i g , Ph.D. Professor, Chairman, Finance D i v i s i o n B. Schwab, Ph.D. Associate Professor, Finance D i v i s i o n W. Waters I I , Ph.D., Transportation D i v i s i o n from the Faculty of Commerce and Business Administration, U.B.C, - xi i i -f o r t h e i r guidance and comments concerning the th e o r e t i c a l aspects of the subject. Further, my special personal gratitude i s directed to Mr. VI.D. Wiedemann Di r e c t o r , Financial Evaluations CP A i r f o r providing the i n i t i a l idea f o r the subject and his continuous moral support, and Prof. B. Schwab, PH.D. as committee chairman f o r his continuous personal encouragement and professional advice. Last, but not l e a s t , to my husband Michael f o r his patience and understanding. - 1 -I INTRODUCTION During the past two years (1974-1976), Canadian a i r l i n e passengers have been subjected to four fare increases on domestic routes. ^ These increases were j u s t i f i e d mainly by i n f l a t i o n a r y cost increases and extraordinary fuel cost e s c a l a t i o n . In the past, cost increases were absorbed by the a i r transport industry through improved avia t i o n e f f i c i e n c y . These e f f i c i e n c y improvements were passed on to the customers i n the form of reduced or steady state f a r e s . However, the e f f e c t of the recent cost increases could not be mitigated by further technical improvements, and must by necessity be paid by the customers. The r e s u l t i s d i s -content by the public at large with l i m i t e d understanding of the necessity of fare increases. Like other industries the a i r transport industry must be permitted to earn an adequate rate of return on i t s invested c a p i t a l to remain as a v i a b l e operation. As a consequence, in A p r i l 1975, the A i r Transport Association (ATA) of Canada petitioned the Federal Government to e s t a b l i s h a sanctioned 2} rate of return on investment f o r Canadian a i r c a r r i e r s . ' This rate was then to be used as a guide f o r future fare increases. This system of a sanctioned rate of return has been i n use by the C i v i l Aeronautics Board (C.A.B.) in the U.S. as a means of regulating 1) February 1974, J u l y 1975, May 1975, and A p r i l 1976 2) See Globe and M a i l , A p r i l 1975 the a i r transport industry f o r years. ' In Canada, t h i s philosophy has not been accepted yet. The evidence submitted, when f i l i n g with the Canadian Transport Commission (C.T.C.) f o r new t a r i f f s implementing various fare increases, normally includes the rate of return c a l c u l a t i o n f o r the respective a i r c a r r i e r s . Again, during the l a t e s t fare hearing in May 1975, the C.T.C. commented on the return on investment of a i r c a r r i e r s as stated below, without taking further a c t i o n . ' "We have examined the rates of return shown in Table II of Appendix A, and, i n the l i g h t of the cost of c a p i t a l to the a i r l i n e industry i n today's markets, we believe i t to be eminently c l e a r that none of them 5) i s unreasonable." ' The operation of an e f f i c i e n t a i r transport industry requires large monetary investments. Neither public nor private i n t e r e s t s w i l l under-take t h i s type of investment unless adequate return incentives are provided. This emphasizes the need of a government sanctioned rate of return f o r the Canadian a i r transport industry. The topic for t h i s thesis was i n s p i r e d by the obvious lack of a govern-ment sanctioned rate of return, the i n a c t i v i t y of the C.T.C, the actions of the ATA representing the Canadian a i r transport industry, 3) A 12 percent l e v e l was deemed to be adequate f o r U.S. trunk c a r r i e r s in 1971 4) See reasons f o r decision No. 4163 by A i r Transport Committee of the C.T.C in the matter of a proposed passenger t o l l increase f i l e d as C.T.C T a r i f f No. CTC No. 132 ( A i r Canada, CP A i r , Eastern Provincial Airways Ltd., and P a c i f i c Western A i r l i n e s Ltd., Nordair Ltd., Quebecair and Transair Ltd.) and T a r i f f No. CTC No. 53 (CP A i r ) 5) A copy of t h i s table shown at the end of the introductory chapter. - 3 -/rand the writer's professional i n t e r e s t in the above. The objective of th i s thesis i s to determine the level of a f a i r rate of return on investment as applicable to Canadian t r a n s c o n t i -nental a i r c a r r i e r s , providing a basis f o r the recommended govern-ment sanctioned rate of return on investment, and to analyse some of the conceptual issues regarding both t h e o r e t i c a l l y sound and operationally workable approaches to the above. In Chapter I I , the Canadian transcontinental a i r c a r r i e r s , A i r Canada and CP A i r , and t h e i r relevant background are introduced. In Chapter I I I , the theory of economic regulation in general, and the rate of return regulation s p e c i f i c a l l y are discussed. Following, some of the approaches taken in past rate hearings, as related to the rate of return regulation exercised by regulatory bodies, are reviewed. Special emphasis i s given to some of the unique problems encountered i n the regulation of the a i r transport industry. In Chapter IV, the determination of the f a i r rate of return on investment f o r Canadian transcontinental a i r c a r r i e r s i s discussed. A c r i t i c a l evaluation of the appraoches discussed i n Chapter III determines the selected approach most consistent with the modern theory of finance. However, the unique c h a r a c t e r i s t i c s of the transcontinental a i r c a r r i e r s cause p r a c t i c a l l i m i t a t i o n s to the appli c a t i o n of th i s approach. These l i m i t a t i o n s are reviewed, and the f i n a l approach formulated. In Chapter V, the cost of equity f o r transcontinental a i r c a r r i e r s i s determined by applying d i f f e r e n t techniques, related to the theory of finance, to c o l l e c t e d empirical data. _ 4 -In Chapter VI, the conclusions derived concerning c a p i t a l s t r u c t u r e , cost of debt, and cost of equity are summarized and applied to compute the weighted average cost of c a p i t a l equal to the f a i r rate of return on investment. - 5 -CANADIAN TRANSCONTINENTAL AND REGIONAL AIR CARRIERS RATES OF RETURN ON INVESTMENT TOTAL SYSTEM OPERATIONS ACTUAL 1974 ESTIMATE NO FARE INCREASES IN 1975 ESTIMATE WITH FARE INCREASES IN 1975 AIR CANADA % 5.0 % 5.5 % 6.5 CP AIR 7.3 6.5 8.1 P.W.A. 8.2 6.1 7.8 E.P.A. 7.8 3.5 7.0 NORDAIR 7.8 7.5 8.8 QUEBECAIR x ^ 6.0 6.2 9.3 TRANSAIR 7.5 4.6 7.7 EXCLUDING CAPITAL, REVENUE AND EXPENSES RELATED TO CHARTER OPERATIONS SOURCE: DECISION NO. 4163 BY AIR TRANSPORT COMMITTEE OF THE C.T.C. (TABLE I I , APPENDIX A) TABLE I II CANADIAN TRANSCONTINENTAL AIR CARRIERS 1.0. A i r Canada A i r Canada i s a Federal Crown Corporation providing comprehensive national a t r services f o r Canada. I t i s one of the world's l a r g e s t a i r c a r r i e r s f l y i n g , i n addition to the above, to many major c i t i e s i n Europe and United States. The majority of A i r Canada's shares i s held by Canadian National Railways, owned by the Federal Government. A i r Canada's major source of revenue i s the scheduled passenger s e r v i c e , which i n 1974 produced 83% of the t o t a l operating revenue. Cargo and mail operations provided 12%, charter operations 3%, and incidental services the remaining 2% of the t o t a l operating revenue. In 1974, s a l a r i e s represented 40.1%, fuel and o i l 17.0%, and depreciation 11.5% of the tota l operating expenses. At the end of 1974, A i r Canada had a 95/5 debt/equity r a t i o . Considering the business r i s k of the a i r transport industry, t h i s i s a very u n r e a l i s t i c r a t i o . Only a Government owned and subsidized a i r l i n e can e x i s t with such a c a p i t a l s tructure. Most of the financing i s arranged through Government loans under the Federal Financing and Guarantee Act. However, during 1974-1975, A i r Canada has made an e f f o r t to obtain more of i t s c a p i t a l require-ments through private Canadian sources. In 1974, in excess of $38 m i l l i o n in leasing funds was raised from Canadian finance and ^ A i r Canada Annual Report 1974 t r u s t funds - 7 -companies. Further exploration was undertaken in 1975. for other private Canadian During the 1965-1973 period, with the exception of 1970, A i r Canada always made a p r o f i t even i f i t was not s a t i s f a c t o r y . However, during 1974, a record net loss of $9.2 m i l l i o n was reported. Estimated losses f o r 1975 are an awesome $12.0 m i l l i o n a f t e r tax. A i r Canada's return on investment, calculated i n compliance with the CAB method declined from 5.8% i n 1973 to 5% in 1974. The losses indicated f o r 1975 w i l l mean a further d e t e r i o r a t i o n i n the return on investment, since no major investment base or ca p i t a l structure changes have occurred. This obvious d e t e r i o r a t i o n of the performance combined with the previously unsatisfactory p r o f i t l e v e l s are i n d i c a t i v e of the f a r reaching changes required. According to a plan approved by the Federal cabinet in early January 1976, A i r Canada w i l l be e n t i r e l y re-organized, and possibly w i l l s e l l some of i t s shares to the pub!ic. 3^ Further, A i r Canada would have to complete f o r routes on an equal basis with other a i r c a r r i e r s . Routes would then be awarded to the c a r r i e r which could perform most economically. Under the terms of t h i s proposal, A i r Canada's operations would be divided into two parts. The f i r s t would concern normal p r o f i t a b l e routes. The second would be composed of unprofitable routes which the 2) 1 See discussion i n III.3.2.0. 3) ' Montreal Gazette, January 1976 - 8 -Government wants served in the national i n t e r e s t s . These routes would be subsidized, but only a f t e r A i r Canada has received the route r i g h t s in competition with other a i r c a r r i e r s . A i r Canada would also be allowed to p a r t i c i p a t e in t r a v e l - r e l a t e d a c t i v i t i e s , by buying h o t e l s , food caterers and travel agencies. With these proposed changes, which would also require a d i f f e r e n t and more independent management struc t u r e , A i r Canada can be expected to be operating more l i k e a conventional independent a i r c a r r i e r s 2.0. CP A i r CP A i r i s a private company, a wholly owned subsidiary of Canadian P a c i f i c Ltd. CP A i r ' s route system covers f i v e continents. This includes among other c i t i e s Tokyo, Hong Kong, Sydney, Honolulu, Mexico C i t y , Buenos A i r e s , Amsterdam, Rome and Tel Aviv. Domestically, CP A i r i s permitted by the Federal Government to compete with A i r Canada by providing up to 25% of the seat capacity of the trans-continental route. CP A i r derives most of i t s operating revenue from scheduled passenger s e r v i c e . In 1974, i t provided 85% of the t o t a l operating revenue. Cargo and mail operations provided 11%, charter operations 1%, and incidental services the r e m a i n i n g ^ of the t o t a l operating 4) revenue. ' CP A i r Annual Report 1974 - 9 -In 1974, s a l a r i e s represented 37%, fuel and o i l 21%, and deprecia-t i o n 8% o f t o t a l operating expenses. The major portion of CP A i r ' s f l i g h t equipment i s leased from CP S e c u r i t i e s Ltd., which i s another a f f i l i a t e company of CP equipment i s treated as though i t was owned. Lease ob l i g a t i o n s payable during the coming year have been included with current l i a b i l i t i e s , and the remaining part shown as long term debt. As a r e s u l t of t h i s procedure, the debt/equity r a t i o of the company on December 31, 1975, was 90/10, as compared to a r a t i o of 85/15 on December 31, 1974. Had the leases not been c a p i t a l i z e d , t h i s r a t i o would have been 45/55 in 1975 and 50/50 in 1974. A f t e r 13 continuous years of p r o f i t s , i n 1975 CP A i r recorded a net loss of $6.4 m i l l i o n a f t e r tax. This contrasts with the 1974 net income of $2.4 m i l l i o n . Consequently, the return on invest-ment declined from 7.3% in 1974 to 4.4% i n 1975. CP A i r i s negotiating with the M i n i s t r y of Transport to relax e x i s t i n g seat capacity r e s t r i c t i o n s in an e f f o r t to obtain a larger share of the domestic market, and better equipment u t i l i z a t i o n . The desired r u l i n g i s a y e a r l y increase of 2% of the seat capacity from the present 25% to an ultimate 45% by Ltd. For f i n a n c i a l statement purposes t h i s leased f l i g h t 1985. 6) 5) See discussion i n IV.3.2.0. f o r more d e t a i l . 6) Globe and M a i l , March 1976 - 1 0 -Recent changes in top management company philosophy and p o l i c i e s , changes expected i n A i r Canada's a considerable s h i f t i n CP A i r ' s positions may herald a d i f f e r e n t In combination with the probable organization t h i s could r e s u l t i n operations. - n -in RATE OF RETURN IN REGULATED INDUSTRIES 1.0.0 T h e o r e t i c a l c o n s i d e r a t i o n s 1.1.0 The Theory of Economic Regulation The Government i s a p o t e n t i a l resource or t h r e a t to every i n d u s t r y i n s o c i e t y . With i t s c o n t r o l l i n g power the Government can choose s e l e c t i v e l y to a s s i s t or hurt a vast number o f i n d u s t r i e s . The Government e x e r c i s e s i t s power among other things by means o f economic r e g u l a t i o n . The theory of economic r e g u l a t i o n i s an attempt to e x p l a i n , who w i l l r e c e i v e the b e n e f i t s or burdens o f r e g u l a t i o n , what form r e g u l a t -ion w i l l take, and the e f f e c t s o f r e g u l a t i o n upon the a l l o c a t i o n o f resources. ^ Economic r e g u l a t i o n i s accepted by i n d u s t r i e s e i t h e r by choice o r n e c e s s i t y . I t i s assumed i n the f o l l o w i n g t h a t r e g u l a t i o n i s developed and operated p r i m a r i l y f o r the i n d u s t r i e s ' b e n e f i t . The f o l l o w i n g p o l i c i e s are the most f r e q u e n t l y a p p l i e d means, which a government may use to f o r c e economic r e g u l a t i o n : ^ 1) D i r e c t Monetary Subsidies T h i s i s the most obvious c o n t r i b u t i o n t h a t any i n d u s t r y group may seek from the government. 1) See (28) pp. 3-4 2) I b i d pp. 5-21 - 12 -R e s t r i c t i o n o f competition by c o n t r o l over  entry o f new a r r i v a l s This p u b l i c resource has been e f f i c i e n t l y used f . ex. by the C i v i l Aeronautics Board (CAB). The CAB has not allowed a s i n g l e new trunk l i n e t o be launched s i n c e i t was created i n 1938. Su b s t i t u t e s and complements The i n d u s t r i e s are attempting to i n f l u e n c e t h i s government p o l i c y f o r their own b e n e f i t . F. ex. the a i r l i n e i n d u s t r y a c t i v e l y supports f e d e r a l s u b s i d i e s f o r a i r p o r t s , which complement t h e i r own e f f o r t s . P r i c e - c o n t r o l P r i c e c o n t r o l s imposed by the government may be wanted even by an i n d u s t r y t h a t has achieved entry c o n t r o l f o r the f o l l o w i n g reason: Where there are economies of l a r g e s c a l e f o r the i n d i v i d u a l f i r m (e.g. a motor t r u c k i n g f i r m can add trucks under a given l i c e n c e as common c a r r i e r ) , p r i c e c o n t r o l i s e s s e n t i a l t o achieve more than competitive r a t e s o f r e t u r n . In a d d i t i o n to the above, two economic reasons f o r f o r r e g u l a t i o n , s p e c i f i c a l l y r e l a t e d to the a i r -t r a n s p o r t i n d u s t r y should be mentioned: Entry - E x i t Control Route a l l o c a t i o n by r e g u l a t i o n i s an i n d i r e c t means of t a x a t i o n o f the a i r t r a n s p o r t i n d u s t r y to s u b s i d i z e unremunerative but s o c i a l l y d e s i r a b l e s e r v i c e s . Regulation f o r c e s s e r v i c e s to a much l a r g e r number of c i t i e s than unregulated s e r v i c e would provide. By doing so i t reduces the need to s u b s i d i z e small-town s e r v i c e with d i r e c t tax revenues. - 13 -6) Safety c o n t r o l A second reason given f o r a i r l i n e r e g u l a t i o n i s s a f e t y . I t i s assumed that s a f e t y standards are best enforced i n a regulated i n d u s t r y . ^ To complete the d i s c u s s i o n the f o l l o w i n g major l i m i t a t i o n s upon b e n e f i t s of the economic r e g u l a t i o n should a l s o be emphasized: 1) D i s t r i b u t i o n o f c o n t r o l w i t h i n the i n d u s t r y In an unregulated i n d u s t r y each firm's i n f l u e n c e upon p r i c e and t o t a l output i s p r o p o r t i o n a l to i t s market share. P o l i t i c a l d e c i s i o n s , however, take i n t o account a l s o the p o l i t i c a l strength of the various f i r m s . As a r e s u l t small firms may have a l a r g e r i n f l u e n c e than they would possess i n an unregulated i n d u s t r y . T h e r e f o r e , the d i s t r i b u t i o n o f c o n t r o l o f the i n d u s t r y among the firms i n the i n d u s t r y i s changed. 2) Length o f Procedures o f P u b l i c Process P u b l i c hearings to determine, f o r i n s t a n c e , a i r f a r e s or p u b l i c u t i l i t y r a t e s , can be long drawn out and thereby c o s t l y i n terms o f fees and revenue l o s t . 3) Outsiders i n i n d u s t r y ' s d e c i s i o n making The p o l i t i c a l process a l s o a u t o m a t i c a l l y admits powerful! o u t s i d e r s to the i n d u s t r y ' s c o u n c i l s . 3) See (19) - 14 -•° Regulatory C o n s t r a i n t s Regulation cannot c o n t r o l a l l o f the d e c i s i o n s and i n t e r n a l r e l a t i o n s h i p s o f a f i r m under r e g u l a t i o n , Regulatory bodies t h e r e f o r e must s e l e c t and l i m i t the scope of r e g u l a t i o n . But they encounter c o n s i d e r a b l e d i f f i c u l t y i n doing so, because the r e g u l a t e d d e c i s i o n s a f f e c t the unregulated ones and the u l t i m a t e r e s u l t may escape the intended c o n t r o l . P r i c e s t r u c t u r e , competitive p o l i c i e s , e f f i c i e n c y o f pro-d u c t i o n , purchasing p o l i c i e s and f i n a n c i a l management are o n l y examples o f the number of economic v a r i a b l e s t h a t a company must determine. Control over these v a r i a b l e s by the company management i s never complete, d e s p i t e f u l l access to i n t e r n a l information and complete i n t e r n a l c o n t r o l . An outside agency l i k e a u t i l i t y or t r a n s p o r t commission would face a f a r more d i f f i c u l t task - i f i t t r i e d to c o n t r o l a company completely. But a commission does not t r y to do so. I d e a l l y , i t attempts to make the e n t e r p r i s e comply with a few performance c r i t e r i a , l e a v i n g other 4) matters to the d i s c r e t i o n o f i t s management. '' The r e g u l a t o r s ' task would be simpler i f there was only an i s o l a t e d interchange between each o f the above p o l i c i e s and the performance aspect t h a t the r e g u l a t o r s wished to a f f e c t . However, the i n t e r a c t i o n between each o f the p o l i c i e s as a r e s u l t o f the i n i t i a l a c t i o n must a l s o be considered. P o s s i b l y the rate-of-return-on-investment i s the best a v a i l a b l e way o f demonstrating the r e s u l t i n g i n t e r a c t i o n between i n d i v i d u a l v a r i a b l e s . This i s the reason f o r i t s frequent a p p l i c a t i o n as a r e g u l a t o r y c o n s t r a i n t . See (22) Discussion c o n s i d e r i n g the problem o f boundaries, pp.6-26 - 15 -Under the f a i r r a t e o f r e t u r n r e g u l a t i o n the firm's earnings may not exceed a f i x e d percentage (p) o f i t s invested c a p i t a l r e g a r d l e s s o f how investment i s fin a n c e d . There are at l e a s t two views on t h i s " f a i r " r a t e . l ) T h e percentage (p) c o n s t i t u t e s as c l o s e an approximation to the company's co s t of c a p i t a l as l e g a l procedures and records can prove it.2)The r e g u l a t o r sets the r a t e (p) to exceed the proven c o s t o f c a p i t a l and thus allows the f i r m p r o f i t s over and above i t s c o s t of c a p i t a l . Although commonly used, the f a i r r a t e o f r e t u r n r e g u l a t i o n has some s e r i o u s disadvantages. Once the r a t e of r e t u r n as defined by the r e g u l a t o r s has reached i t s permitted maximum, managerial i n c e n t i v e s concerning c o s t c o n t r o l s are s e v e r e l y weakened. Excess expenditures on executive p e r q u i s i t e s and corporate image are l i k e l y to appear. This i s c a l l e d o r g a n i z a t i o n a l l a c k . 5^ The f o l l o w i n g are examples o f other p o s s i b l e r e g u l a t o r y c o n s t r a i n t s : 1) F a i r Mark-Up on Cost Many aspects o f Government c o n t r o l are based on some v a r i a n t o f t h i s r e g u l a t o r y c o n s t r a i n t . P r o f i t s under t h i s technique are l i m i t e d to a f i x e d percentage o f c o s t s . T h i s method has the advantage o f being r e l a t i v e l y s t r a i g h t - f o r w a r d to apply, s i n c e costs are measurable. However, i t has been proven by B a i l e y , t h a t f a i r mark-up on c o s t as a c o n s t r a i n t has the disadvantage o f d i s -couraging e f f i c i e n t o peration by the f i r m whenever demand i s i n e l a s t i c . 5) See (34) - 1 6 -2) F a i r P r o f i t per Un i t A f i x e d ( f a i r ) p r o f i t per u n i t production s t r a t e g y i s of more t h e o r e t i c a l than p r a c t i c a l i n t e r e s t . The exception i s the case where l a r g e q u a n t i t i e s o f i d e n t i c a l items are produced. The reason i s t h a t i t i s d i f f i c u l t to j u s t i f y s e l e c t i o n o f any p a r t i c u l a r f a i r u n i t p r o f i t and i t i s d i f f i c u l t to d e f i n e an approp r i a t e u n i t o f output. Despite the problems involved f a i r p r o f i t per u n i t - method could be a p p l i e d . F. ex. a power company might be allowed some f r a c t i o n o f a cent per k i l o w a t t hour, and an a i r l i n e some cents per a v a i l a b l e ton-mile. I t should be emphasized that u n l i k e the " f a i r markup on c o s t " c o n s t r a i n t the " f a i r p r o f i t per u n i t " c o n s t r a i n t does not provide any i n c e n t i v e s f o r the f i r m to maintain i d l e resources. On the c o n t r a r y , t h i s c o n s t r a i n t gives a strong i n c e n t i v e towards e f f i c i e n t o p e r a t i o n s . ^ 6) See (12) pp. 129-142 f o r a l t e r n a t i v e r e g u l a t o r y c o n s t r a i n t s - 17 -F a i r Rate o f Return Regulation  Regulatory Models Extensive l i t e r a t u r e i s a v a i l a b l e a n a l y z i n g the behavior o f the p r o f i t - maximizing f i r m under f a i r - r a t e - o f - r e t u r n r e g u l a t i o n . Foilowing,the two major models and the t h e o r e t i c a l r e s u l t s d e r i v e d from them w i l l be d i s c u s s e d . 1.3.1.1 F a i r Rate of Return Exogeneously Given  Averch-Johnson Model Averch and Johnson ^ were the f i r s t authors to extend the t r a d i t i o n a l economic theory of the f i r m to i n c l u d e a r e g u l a t o r y c o n s t r a i n t on the firm's behaviour. T h e i r model provides a simple and comprehensible depection of a r e g u l a t o r y process and i t s r e l a t i o n to the behaviour of the f i r m by using a f a i r r a t e o f r e t u r n on investment as r e g u l a t o r y c o n s t r a i n t . The model i s based on the f o l l o w i n g assumptions: i ) The company employs two i n p u t s , labor and c a p i t a l , each of which i s a v a i l a b l e to i t i n u n l i m i t e d q u a n t i t i e s a t a f i x e d p r i c e per u n i t to produce a s i n g l e homogeneous output. i i ) The company's d e c i s i o n s are a f f e c t e d by the r e g u l a t o r i n only one way: i t i s permitted to earn no more than the r e g u l a t o r y " f a i r r a t e o f r e t u r n " on i t s invested c a p i t a l . In a l l other respects management i s permitted to pursue i t s o b j e c t i v e , maximization of p r o f i t , e x a c t l y as i f i n the absence o f r e g u l a t i o n . 1.3.0.0 1.3.1.0 7) See (11) - 18 -i i i ) The rate of return permitted to the firm by regulation is less than the return it would obtain if it were able to maximize its profits, but at least as great as the cost of firm's capital. More-over, the fair rate of return is exogenously given in the model. These assumptions can be brought out more specifically as follows: z = physical quantity of the firm's output x-| = the quantity of capital in the firm's rate base x2 = the quantity of labor input r-| = the unit cost of capital = the opportunity cost of resources tied up in plant and equipment r 2 = the unit cost of labor s = r-. + v be the rate of return permitted by regulation, v - 0 z = z(x-j ,x2) = the production function p = p(z) = the inverse demand function Then the company is assumed to select the values of z, x-j and x2 that maximize total profit "Tr-" I f ' = pz - r 1x ] - r 2x 2 (1) subject to the regulatory constraint pz - r 2x 2 - r-j + v = s x l (2) - 19 -Averch and Johnson de r i v e d from t h e i r model two major c o n c l u s i o n s . I A - J THEOREM: The pro f i t - m a x i m i z i n g f i r m under r a t e - o f - r e t u r n r e g u l a t i o n w i l l tend to use a c a p i t a l - l a b o r r a t i o g r e a t e r than t h a t which minimizes c o s t f o r i t s output l e v e l . II A - J THEOREM: The profit-maximizing f i r m under r e g u l a t o r y c o n s t r a i n t w i l l use a c a p i t a l - l a b o r r a t i o and produce an output g r e a t e r than i t would i n the absence o f r e g u l a t i o n . While the second theorem, as a g e n e r a l i z a t i o n , was l a t e r proved i n v a l i d by Baumol and K l e v o r i c k 8^ the f i r s t one, which a l s o i s more s i g n i f i c a n t from the p o i n t o f view of e f f i c i e n c y o f resource u t i l i z a t i o n i s s t i l l g e n e r a l l y accepted. The l i t e r a t u r e c overing r a t e - o f - r e t u r n r e g u l a t i o n c o n t i n u o u s l y r e f e r s to o v e r c a p i t a l i z a t i o n as Averch-Johnson e f f e c t . Averch and Johnson emphasize t h a t t h e i r r e s u l t s depend on the major assumption t h a t the r e g u l a t o r y " f a i r r a t e o f r e t u r n " exceeds the c o s t o f c a p i t a l . T h i s a s s e r t i o n i s not easy to prove e m p i r i c a l l y , s i n c e the c o s t o f c a p i t a l v a r i e s from f i r m to f i r m , depending on the degree o f r i s k i n c u r r e d by anyone p r o v i d i n g c a p i t a l f o r i t . Although i t i s extremely d i f f i c u l t to measure a firm's c o s t o f c a p i t a l with any degree o f accuracy, the r e g u l a t o r o f t e n attempts to s e t the " f a i r r a t e o f r e t u r n " a t a l e v e l as c l o s e to the c o s t o f c a p i t a l as he can determine. 8) See (13) Supra, 176-179 - 20 -For t h i s reason i t i s of i n t e r e s t to examine what happens to the A-J theorem of o v e r c a p i t a l i z a t i o n as the regulated rate of return (s) approaches the cost of c a p i t a l ( r ^ ) , and what occurs when the two coincide. I n t u i t i o n might suggest that once c a p i t a l no longer receives a return that may be c a l l e d "excessive", the firm w i l l f i n d i t unprofitable to use an i n e f f i c i e n t l y large quantity of c a p i t a l and i t w i l l therefore be moti-vated to u t i l i z e the more e f f i c i e n t c a p i t a l - l a b o u r r a t i o . This i n t u i t i o n i s , however, mathematically proved f a l s e 9) by Baumol and Klevorick. ' When s = r-j the firm has, in f a c t , no motivation to s e l e c t the more e f f i c i e n t r a t i o . ANY c a p i t a l - l a b o u r r a t i o becomes as p r o f i t a b l e to the regulated firm as any other. Moreover, i t i s shown that the more c l o s e l y the regulator succeeds in pushing the regulatory c e i l i n g return (s) to the cost of c a p i t a l the more i n e f f i c i e n t becomes the firm's c a p i t a l - l a b o u r r a t i o . This r e s u l t was proven geometrically by Fred M. Westfield. ^ More generally, a t h i r d theorem from the basic A-J model can be derived: The c l o s e r the " f a i r rate of return" i s to the true cost of c a p i t a l , the greater the quantity of c a p i t a l the f i r m w i l l want to use. 9) Ibid pp. 164, 173 10) See (20) - 21 -Providing, however, that the firm simultaneously expands i t s use of labour, there i s no need f o r the r e s u l t i n g c a p i t a l -labour r a t i o to be i n e f f i c i e n t . In addition to the above basic Averch-Johnson theorems some rel a t e d t h e o r e t i c a l r e s u l t s have been developed from the model. One l i n e o f i n v e s t i g a t i o n has examined the e f f e c t s of the regulatory c o n s t r a i n t upon the firm that seeks to maximize t o t a l revenue or some other maximand instead of t o t a l p r o f i t s . Such models have been studied by Bailey and Malone ^ and Zajac 1 2 \ Zajac concludes that f o r a regulated f i r m maximizing i t s rate of return, the c a p i t a l - l a b o u r r a t i o becomes indeterminate. Bailey and Malone f i n d that under t o t a l revenue maximization the nature of the i n e f f i c i e n c y discussed by Averch and Johnson appears to reverse i t s e l f . They prove: The sales-maximizing firm under rate-of-return regulation i s motivated to use a labour-capital r a t i o greater than that which minimizes cost f o r the output l e v e l i t chooses to produce. As a contribution to the theory of regulation the work of Averch and Johnson represents a s i g n i f i c a n t benchmark. The model and i t s modifications by other authors provide a d e t a i l e d analysis of the absolute and r e l a t i v e input l e v e l s selected by a p r o f i t - or sales - maximizing regulated firm. See (12) See (29) - 22 -1.3.1.2 F a i r Rate o f Return Endogenous V a r i a b l e  K l e v o r i c k Model In c o n t r a s t to the Averch-Johnson model, which d i d not provide any guidance concerning the l e v e l of f a i r r a t e 13) of r e t u r n , the K l e v o r i c k ' model concentrates on t h i s very aspect. In h i s paper, the c e n t r a l question i s : Given the way i n which the Averch-Johnson re g u l a t e d f i r m w i l l respond to different values of the f a i r r a t e , a t what l e v e l should the r e g u l a t o r s s e t t h i s f a i r r a t e o f r e t u r n , to induce the regulated f i r m to a c t i n a way most conducive to the o v e r a l l w e l l - b e i n g o f s o c i e t y . Recognizing t h a t there are inherent d i f f i c u l t i e s i n any attemp to measure s o c i a l w e l f a r e , K l e v o r i c k adopts the p o s i t i o n t h a t the goal of the r e g u l a t o r s should be maximization o f a s o c i a l welfare f u n c t i o n . The approach taken i s a p a r t i a l - e q u i l i b r i u m one which ignores the e f f e c t s o f p r i c e and output changes i n the m o n o p o l i s t i c regulated i n d u s t r y on the p r i c e s and outputs o f other f i r m s , and v i c e v e r s a . Within t h i s s o c i a l - welfare framework, taking the A - J model o f the regulated f i r m as basis to the a n a l y s i s , the K l e v o r i c k model presents a very u n r e a l i s t i c approach to determining the "optimal" value o f the f a i r r a t e o f r e t u r n . I t i s shown t h a t i f the regulated f i r m i s a rate-base maximizer no matter a t what l e v e l the f a i r r a t e i s s e t , s o c i e t y w i l l g e n e r a l l y - n o t want to s e t the f a i r r a t e (s) equal to the market c o s t o f c a p i t a l ( r ) . ^ 13) See (21) 14) Rate base here defined as the regulated f i r m ' s property, net o f d e p r e c i a t i o n - 23 -I f i t would, the i n p u t - i n e f f i c i e n t f i rms faced with the s = r c o n s t r a i n t w i l l produce "too l i t t l e " . On the other hand, the i n p u t - e f f i c i e n t f i r m faced with a c o n s t r a i n t i n 15) which s = r w i l l produce "too much". ' Because of the s p e c i f i c assumptions made concerning the nature o f the s o c i a l welfare f u n c t i o n and the r a t h e r u n r e a l i s t i c assumptions made about the regu l a t e d f i r m ( f o r ex. i t i s a monopolist i n s e l l i n g output, a pure competitor when h i r i n g inputs) the s p e c i f i c r e s u l t s d e r i v e d must be regarded p r i m a r i l y as suggestive. The model b a s i c a l l y questions the conventional view t h a t the f a i r r a t e o f r e t u r n allowed to a regulated f i r m should always be equated to the market c o s t o f c a p i t a l . I n p u t - e f f i c i e n t , i n p u t - i n e f f i c i e n t r e f e r to the degree of e f f i c i e n c y a t which a f i r m i s using i t s basic resources, c a p i t a l and labour. - 24 -1.3.2.0 F a i r Rate of Return Concept 1.3.2.1 A l t e r n a t i v e Rate o f Return D e f i n i t i o n s The r a t e o f r e t u r n on invested c a p i t a l i s a c e n t r a l concept i n f i n a n c i a l a n a l y s i s . I t i s widely used as a basis f o r d e c i s i o n s i n both regulated and unregulated i n d u s t r i a l s e c t o r s . Basically the r a t e o f r e t u r n on investment (ROI) i s determined by the i n t e r r e l a t i o n s o f oper a t i n g revenues, net income, and investment as shown below. Operating Revenues „ C a p i t a l T u r n o v e r Investment Net Income - Return Margin Operating Revenues Operating Revenues i x Net Income = Return on Investment Operating Revenues Investment ROI assessments are used f o r two major purposes: i ) F i n a n c i a l performance measurements (Actual Rate o f Return) i i ) E v a l u a t i o n o f investment proposals (Target Rate of Return) To c l a r i f y the terminology used, the above two aspects o f the "rate o f r e t u r n " on investment are determined as fol1ows: a) ACTUAL RATE OF RETURN This i s the i n d i c a t o r o f the actual or p r o s p e c t i v e f i n a n c i a l performance of a company.lt i s a measure of the annual r a t e a t which each u n i t of c a p i t a l input generates net f i n a n c i a l b e n e f i t s . - 25 -b) TARGET RATE OF RETURN Th i s i s the " r e q u i r e d " annual r a t e . I t i s the f i n a n c i a l standard a g a i n s t which the performance o f p r o s p e c t i v e or already committed c a p i t a l inputs must be measured. The FAIR RATE o f RETURN, s e t by the r e g u l a t o r s , which i s the measure o f the r e q u i r e d r a t e of r e t u r n to maintain a company i n a competitive p o s i t i o n , i s such a f i n a n c i a l standard. I f the r a t e o f r e t u r n on investment could be expressed i n a s i n g l e , c l e a r concept, i t s a p p l i c a t i o n to determine the " A c t u a l " or "Target" Rate o f Return would be simple, r e q u i r i n g only the c o r r e c t e s t i m a t i o n o f the R.O.I. However, the concept i s r a t h e r ambiguous, f o r the f o l l o w i n g reasons. There are many a l t e r n a t i v e and commonly used r e t u r n and investment base elements, some examples o f which are s t a t e d as f o l l o w s : Return Base - Net Income a f t e r taxes or before taxes - Net Income a f t e r taxes plus I n t e r e s t on Long Term Debt before taxes - Net income a f t e r taxes plus i n t e r e s t on L.T.D. a f t e r taxes Investment Base - T o t a l Assets - Shareholders Equity - Shareholders Equity plus Net Long Term Debt - 26 -In a d d i t i o n to the above the r a t e o f r e t u r n i s c u r r e n t l y a l s o measured i n terms o f d i s t i n c t u n i t s : book r a t e u n i t s and discounted cash flow u n i t s . The d i f f e r e n c e s s t a t e d i n the a l t e r n a t i v e r e t u r n and investment bases are obvious and t h e r e f o r e do not lead to confusion. Choice o f an investment base and a compatible r e t u r n base element w i l l depend on the view p o i n t from which a c e r t a i n ROI f i g u r e i s r e q u i r e d . An outside a n a l y s t e v a l u a t i n g a company and/or i n d u s t r y f o r investment o p p o r t u n i t i e s i s p r i m a r i l y i n t e r e s t e d i n r e t u r n on shareholders' e q u i t y . A combination of Net Income as r e t u r n base and shareholders' e q u i t y as investment base should, t h e r e f o r e , produce the d e s i r e d ROI r a t e . An a n a l y s t w i t h i n a company or the i n d u s t r y i s i n t e r e s t e d i n r e t u r n on t o t a l c a p i t a l i n v e s t e d . Whether the funds are generated through debt or e q u i t y f i n a n c i n g i s o f secondary importance. In t h i s case, the i n t e r e s t expense on long term debt should be added back to the net income to obtain the c o r r e c t r e t u r n base. T h i s i s based on the premise t h a t i n t e r e s t expense i s a d i s t r i b u t i o n o f income to s u p p l i e r s o f c a p i t a l r a t h e r than c o s t of doing business. A compatible investment base would then be "Total A s s e t s " or "Shareholders Equity plus Net Long Term Debt" 0 - 27 -To evaluate the e f f e c t o f book r a t e u n i t s and discounted cash flow u n i t s the concept of each must be discussed i n more d e t a i l . BOOK RATE UNITS (B.R.U.) These are more c o r r e c t l y c a l l e d book-ratio u n i t s . The " r a t e " measured i s defined as the r a t i o o f income during a given p e r i o d o f time to the net book-value o f invested c a p i t a l outstanding during the same p e r i o d . These values are d i r e c t l y d e r i v e d from the f i n a n c i a l statements of a f i r m . DISCOUNTED CASH FLOW UNITS (D.C.F.) T h i s i s a measure o f the r e t u r n on c a p i t a l i n terms o f the annual r a t e a t which the " f u t u r e " cash flows from an investment have a discounted value equal to the value o f the investment o u t l a y s r e q u i r e d to b r i n g about these cash flows. ^ Hence the name "discounted cash flow u n i t s " , which r e f e r s to the d i s c o u n t i n g process r e q u i r e d to c a l c u l a t e t h i s v e r s i o n o f ra t e o f re t u r n on investment. The " F a i r " or "Target" r a t e o f re t u r n can be measured i n both of the above u n i t s . F. ex., the concept o f the embedded c o s t o f debt c a p i t a l which w i l l be di s c u s s e d l a t e r , i s a "Book Rate U n i t " measure. Likewise the "comparative earnings" approach to e s t a b l i s h a f a i r r a t e o f r e t u r n , using book r a t e i n f o r m a t i o n as i t s b a s i s , i s a l s o a book r a t e u n i t measure. 16) See (27) p. 66 - 28 -In c o n t r a s t , there are other methodologies f o r s e t t i n g f i n a n c i a l standards f o r c a p i t a l usage, which are c l e a r l y DCF type r a t e s . The most obvious example o f such a r a t e i s the y i e l d to maturity o f a c t u a l outstanding or comparably r i s k y bonds. Another i s the c u r r e n t d i v i d e n d y i e l d plus d i v i d e n d growth formula f o r c a l c u l a t i n g the c o s t o f e q u i t y funds. The r u l e s f o r the " c o r r e c t " usage o f the above concepts and measures appear to be l o g i c a l . I f the actual or p r o s p e c t i v e performance o f any investment i s measured i n DCF u n i t s , and i f t h i s r a t e i s compared ag a i n s t some t a r g e t standard, the r e l e v a n t standard must by n e c e s s i t y be c a l c u l a t e d i n DCF u n i t s . I f book r a t e u n i t s are used to measure actual or p r o s p e c t i v e performance, the proper standard o f comparison i s a g a i n s t a f a i r r a t e of r e t u r n measured i n book ra t e u n i t s . While the above appears to be l o g i c a l , arguments have been advanced to the c o n t r a r y . Following i s a d i s c u s s i o n on the argument t h a t the actual performance measured i n book r a t e u n i t s should be compared a g a i n s t the Target r a t e expressed i n DCF - u n i t s . In p a r t i c u l a r , although the F a i r Rate of Return Standard i s based on D.C.F. - u n i t s , i t should be a p p l i e d to the r a t e base th a t i s expressed i n book r a t e u n i t s to compute the revenue r e q u i r e d to produce the above F.R.O.I. - 29 -1.3.2.2 Discussion on the F a i r Rate o f Return and the  Appropriate Rate Base F a i r Rate o f re t u r n on investment (FROI) i s that percentage f i g u r e which, when m u l t i p l i e d by the invesitment r a t e base, w i l l r e s u l t i n enough c u r r e n t d o l l a r s to cover the f i x e d charges o f debt and p r e f e r r e d stock and w i l l provide f a i r and reasonable compensation to the common eq u i t y holders o f the regulated e n t e r p r i s e . I f i t i s assumed t h a t the FROI equals the fi r m ' s c o s t o f c a p i t a l , the appro p r i a t e r a t e base remains to be s e l e c t e d . There are b a s i c a l l y three d i f f e r e n t concepts o f r a t e base that could be employed: 1) BOOK VALUE, based on the usual accounting p r i n c i p l e s 2) STOCK MARKET VALUE, i . e . , number o f shares outstanding m u l t i p l i e d by the share p r i c e . 3) COMPETITIVE MARKET VALUE, i . e . , whatever the firm ' s assets would be worth a t long-run e q u i l i b r i u m i n a competitive market. Solomon i n s i s t s t h a t a r e g u l a t o r y a u t h o r i t y i s i n c o n s i s t e n t when i t measures c o s t o f c a p i t a l i n DCF u n i t s and then t r a n s l a t e s t h i s number i n t o "required revenues" by m u l t i p l y i n g i t a g a i n s t a net book value estimate f o r the r a t e base. Myers ', however, emphasizes t h a t c o n s i s t e n c y does not re q u i r e the a p p l i c a t i o n o f a market-based c o s t o f c a p i t a l to a market value r a t e base. Moreover, he argues t h a t the market value r a t e base(equivalent to the DCF)is not useful a t a l l f o r the f o l l o w i n g reasons: 17) See (27) 18) See (25A) - 30 -a) Market value o f the r a t e base depends on how i n v e s t o r s expect the r e g u l a t o r s to a c t . Market value should be the "end r e s u l t - not the s t a r t i n g p o i n t " . b) Adopting market value as a r a t e base amounts to a commitment t o confirm the i n v e s t o r s ' expectations r e g a r d l e s s of what they are based on. c) I f the market value o f the r a t e base i s maintained c o n s i s t e n t l y above the book value, the r e g u l a t e d f i r m w i l l be expected to earn a r a t e o f r e t u r n on i t s new investment, which i s g r e a t e r than the c o s t o f c a p i t a l . The f o l l o w i n g example i l l u s t r a t e s Myers' p o i n t : Assume an a l l - e q u i t y financed u t i l i t y with a r a t e base o f $100 per share. Earnings per share (EPS) are $16, a l l paid out as dividends (D) and expected to remain constant i n d e f i n i t e l y . Under the above c o n d i t i o n s the E / P - r a t i o w i l l measure shareholders opportunity c o s t ( u t i l i t y ' s c o s t o f c a p i t a l c o r r e c t l y . Suppose a c u r r e n t market p r i c e (PO) o f $200. Then Return Required = p^-1 - £l = ^ = .08 = k g Normally the r e g u l a t o r y body would allow the u t i l i t y earnings o f 8 percent on the book value r a t e base. The p r i c e o f the u t i l i t y ' s product w i l l be s e t a t the l e v e l s u f f i c i e n t to y i e l d p r o f i t s of .08 x $100 or $8.00 per share. I f i n v e s t o r s now consider the new earnings l e v e l permanent, the u t i l i t y ' s stock p r i c e w i l l f a l l to $100. P Q = EPS, = 8^00 = $100 k .08 e - 31 -In other words, t h i s approach w i l l d r i v e share p r i c e to book value per share. The stock s o l d a t $200 i n the f i r s t p l ace only because the f i r m was then earning and was expected to earn, twice the c o s t o f c a p i t a l . However, the expectations the i n v e s t o r s were holding before the r e g u l a t o r y d e c i s i o n , turned out to be wrong i n the end. As a t h i r d a l t e r n a t i v e f o r the r a t e base Myers suggests a concept of competitive market value (CMV). T h i s i s the value which the u t i l i t y ' s a ssets would be worth a t long-run e q u i l i b r i u m i n a competitive market. CMV can a l s o be defined as the o r i g i n a l c o s t o f the firm's assets l e s s economic d e p r e c i a t i o n . T h i s i s i n comparison with the book value r a t e base which equals o r i g i n a l c o s t l e s s accounting d e p r e c i a t i o n . The e s t i m a t i o n of CMV, however, i s d i f f i c u l t , which r e s t r i c t s the use o f CMV as r a t e base. 1.3.3.0 F a i r Rate o f Return and Risk At the highest l e v e l o f a b s t r a c t i o n , r i s k i s a summary measure o f the expected d i s p e r s i o n o f the asset's p o t e n t i a l stream o f returns over time. In c a p i t a l market theory the a p p r o p r i a t e measure o f r i s k i s the standard d e v i a t i o n of returns f o r an e f f i c i e n t p o r t f o l i o and that c o n t r i b u t i o n o f a s e c u r i t y to the r i s k 19) o f the p o r t f o l i o f o r i n d i v i d u a l s e c u r i t i e s . In corporate f i n a n c e , r i s k i s c l a s s i f i e d according to source as business or f i n a n c i a l r i s k as f o l l o w s : 1) Business Risk T h i s represents the u n c e r t a i n t y t h a t a company might experience a d e c l i n e i n i t s earning power. 19) See (5) - 32 -Business r i s k i s the o v e r a l l r i s k determined by the business enviroment, and i s independent o f the c a p i t a l s t r u c t u r e o f the company. For example, business i s s u b j e c t to the r i s k o f a r e c e s s i o n or depression, t e c h n o l o g i c a l obsolescence, s o c i a l or p o l i t i c a l change, l a b o r d i s p u t e s , or i n c r e a s i n g c o s t s . Regulated i n d u s t r i e s are su b j e c t to an a d d i t i o n a l unique r i s k which a r i s e s out o f exposure to r e g u l a t i o n . Regulation reduces the a b i l i t y o f management to promptly and adequately a d j u s t p o l i c i e s because o f changes i n p r i c e s , c o s t and consumer demand. F i n a n c i a l Risk T h i s represents the r i s k s i n c u r r e d by c r e d i t o r s and stock holders as the r e s u l t o f the d e c i s i o n by management to i s s u e d i f f e r e n t kinds o f s e c u r i t i e s to appeal to d i f f e r e n t c l a s s e s o f i n v e s t o r s with d i f f e r e n t r i s k preferences. The t o t a l c a p i t a l employed by the e n t e r p r i s e i s represented by common stock, debt and p r e f e r r e d stock. The c r e d i t o r r e q u i r e s p r o t e c t i o n a g a i n s t s u b s t a n t i a l p r o p o r t i o n o f the r i s k s o f business, so that the r i s k burden f a l l s d i s - p r o p o r t i o n a t e l y upon the owners, who have only a r e s i d u a l c l a i m on earnings and a s s e t s . F i n a n c i a l r i s k t h e r e f o r e concerns the unequal d i s t r i b u t i o n o f a company's business r i s k among i t s several c l a s s e s o f i n v e s t o r s . Assessing business and f i n a n c i a l r i s k i s a d i f f i c u l t task. There are several ways the problem o f r i s k assessment can be approached. - 33 -Both o f the above r i s k c a t e g o r i e s can be assessed by using "Market" or "Book" r i s k measurements as a base. In the f o l l o w i n g the two r i s k measurement approaches are o u t l i n e d . 1.3.3.1 Market Risk Measures The modern c a p i t a l market theory has introduced the p o r t f o l i o concept, which gives r i s k a new dimension as defined p r e v i o u s l y . ^ Since the i n v e s t o r i s i n t e r e s t e d i n the r i s k o f h i s p o r t -f o l i o , he does not judge the r i s k o f an i n d i v i d u a l stock i n i s o l a t i o n . Instead, he w i l l judge the r i s k of any s e c u r i t y by assessing i t s c o n t r i b u t i o n to p o r t f o l i o r i s k . T h i s c o n t r i b u t i o n depends on how d i v e r s i f i e d the p o r t f o l i o i s . Following are two extreme cases: 1 ) NO DIVERSIFICATION I.e. the i n v e s t o r holds only one stock. 2) MAXIMUM POSSIBLE DIVERSIFICATION In t h i s case, the i n v e s t o r ' s p o r t f o l i o i s so widely d i v e r s i f i e d t h a t i t s performance f o l l o w s the market very c l o s e l y . In the f i r s t case, the standard d e v i a t i o n o f the stock's r e t u r n i s a good measure o f i t s r i s k . In the second case, however, f l u c t u a t i o n s i n i t s r e t u r n w i l l tend to cancel out f l u c t u a t i o n s i n the returns on the other s e c u r i t i e s i n the p o r t f o l i o . A stock t h a t seems h i g h l y r i s k y to an u n d i v e r s i f i e d i n v e s t o r might c o n t r i b u t e very l i t t l e to the r i s k o f a broadly d i v e r s i f i e d p o r t f o l i o . 20) The b a s i c concepts i n t h i s chapter as defined by Myers, see (26) - 34 -The p o r t f o l i o theory d i s t i n g u i s h e s between two d i s t i n c t r i s k elements which are r e f l e c t e d i n the standard d e v i a t i o n o f a s e c u r i t y ' s r e t u r n . IFHE UNSYSTEMATIC ELEMENT i s that p a r t which can be el i m i n a t e d by d i v e r s i f i c a t i o n . THE SYSTEMATIC ELEMENT r e f l e c t s the stock's s e n s i t i v i t y to market f a c t o r s which a l s o a f f e c t most other s e c u r i t i e s . T h i s element i s c a l l e d market s e n s i t i v i t y . By d e f i n i t i o n a s e c u r i t y ' s systematic r i s k element cannot be d i v e r s i f i e d away. According to the " C a p i t a l Asset P r i c i n g Model" (CAPM) ~ a stock's systematic r i s k can be measured by the beta f a c t o r , the "market s e n s i t i v i t y index". The b a s i c idea o f the model developed by Sharpe, L i n t n e r and Mossin i s expressed i n the f o l l o w i n g equation: E(Rj) • < « « , ) - Rf)pj where R. = the expected r e t u r n on a s e c u r i t y J Rf = a r i s k - f r e e i n t e r e s t r a t e ~ t n e expected r e t u r n on a broad-based market index (a l a r g e p o r t f o l i o o f s e c u r i t i e s ) PJ = a measure o f v o l a t i l i t y o f the I n d i v i d u a l s e c u r i t y r e l a t i v e to market r e t u r n s . j}j i s measured by the r a t i o o f the co-variance o f the returns o f the i n d i v i d u a l s e c u r i t y with market returns d i v i d e d by the variance o f market returns o r P j • C O V < W VAR (RJ - 35 -The model's p r a c t i c a l use has been l i m i t e d to t e n t a t i v e s t u d i e s using i n d i v i d u a l f i r m s ' beta f a c t o r s to e s t a b l i s h the r e l a t i v e degree of r i s k o f a f i r m and thereby help to estimate i t s c o s t o f eq u i t y f o r the co s t o f c a p i t a l c a l c u l a t i o n . In 1971, S.C. Myers (26) s u c c e s s f u l l y a p p l i e d the C.A.P.M. model to determine the c o s t o f eq u i t y f o r A.T. & T. The d i f f i c u l t y o f using the CAPM i s due to the f a c t that the model i s expressed e n t i r e l y i n terms o f market rat e s o f r e t u r n . I f the company's shares are not traded i n any stock exchange, no b e t a - f a c t o r can be computed f o r t h i s company. Even i f the shares are traded on the market, the information acquired may not be r e l i a b l e . The expected r e t u r n on a s e c u r i t y c a l c u l a t e d by using the CAPM i s true o n l y , i f the shares are traded i n a p e r f e c t l y r a t i o n a l and e f f i c i e n t f i n a n c i a l market. 1.3.3.2 Book Risk Measures Since the " C a p i t a l Asset P r i c i n g Model" as discussed above provides useful information about a firm's r i s k i n e s s under r a t i o n a l market c o n d i t i o n s o n l y , other r i s k measures have to be a p p l i e d on many occasions. Recently, attempts have been made to e s t a b l i s h the r e a l 21) determinants o f the systematic r i s k . ' The purpose i s t o f i n d those r e a l v a r i a b l e s t h a t a f f e c t systematic market r i s k and t h a t the f i r m can estimate d i r e c t l y from the accounting. Following are the r e a l v a r i a b l e s or book r i s k measures th a t were found by Beaver, K e t t l e r and Scholes to determine the high market r i s k o f a f i r m : 21) See (25B) - 36 -1) Dividend payout 2) Growth of Net Book Assets 3) F i n a n c i a l Leverage 4) L i q u i d i t y 5) S i z e 6) Earnings V a r i a b i l i t y 7) Earnings Beta f a c t o r which i s the slope c o - e f f i c i e n t o f the r e g r e s s i o n o f the firm's net earnings on the 22) average earnings f o r the e n t i r e sample o f f i r m s . S i m i l a r book r i s k measures w i l l be a p p l i e d l a t e r i n t h i s paper to determine the r i s k i n e s s o f t r a n s c o n t i n e n t a l a i r c a r r i e r s i n r e l a t i o n to other s e l e c t e d i n d u s t r i e s . The f o l l o w i n g diagram demonstrates the source r e l a t i o n s h i p between the "book" and "market" r i s k measures. The book r i s k measures can be seen as a s h o r t c u t to express the market r i s k which cannot always be r e l i a b l y and/or d i r e c t l y c a l c u l a t e d . See (14) - 37 -RELATIONSHIP  BETWEEN BOOK AND MARKET RISK MEASURES PRODUCT AND FACTOR MARKETS THE FIRM BOOK RISK MEASURES REAL SECTOR FINANCIAL SECTOR REAL RETURN: CASH FLOW (-) ECONOMIC DEPRECIATION (+) CHANGE IN NPV OF FUTURE INVESTMENT MARKET RETURN: DIVIDENDS PLUS CAPITAL GAINS MARKET RISK MEASURES: BETA & OTHERS I JL MEASURED BUSINESS AND FINANCIAL RISK - 38 -2.0.0 APPROACHES TAKEN IN RATE HEARINGS FOR REGULATORY DECISIONS Most of the a v a i l a b l e l i t e r a t u r e on r e g u l a t o r y r a t e hearings o r i g i n a t e d i n the U.S.A. There the r e g u l a t o r y a u t h o r i t i e s had a choice of a number o f r e g u l a t o r y c o n s t r a i n t s which could be a p p l i e d . The three most f r e q u e n t l y used c o n s t r a i n t s are as f o l l o w s : 1) F a i r Rate of Return on Investment 2) F a i r Mark Up on Cost 3) F a i r P r o f i t Per Unit The d e t a i l s o f the above a l t e r n a t i v e c o n s t r a i n t s have been p r e v i o u s l y discussed i n chapter 11 L.I. Out o f the a l t e r n a t i v e s s t a t e d , F.R.O.I, i s the most f r e q u e n t l y a p p l i e d c o n s t r a i n t . During past r a t e hearings i n the U.S.A. concerning F.R.0.1. cases the f o l l o w i n g l e g a l case records have been r e f e r r e d to e x c l u s i v e l y as l e g a l precedents. Following are some excerpts of these l e g a l case records. i ) In the "Blue F i e l d Waterworks" case (1923) the Supreme Court o f the U.S.A. he l d : A p u b l i c u t i l i t y i s e n t i t l e d to such r a t e s as w i l l permit i t to earn a r e t u r n on the value o f the property which i t employs f o r the convenience o f the p u b l i c equal to t h a t g e n e r a l l y being made a t the same time and i n the same general p a r t of the country on investments i n other business undertakings which are attended by corresponding r i s k s and u n c e r t a i n t i e s , but i t has no c o n s t i t u t i o n a l r i g h t to p r o f i t such as r e a l i z e d or a n t i c i p a t e d i n h i g h l y p r o f i t a b l e enter-p r i s e s or s p e c u l a t i v e ventures. - 39 -Two decades l a t e r , i n i t s d e c i s i o n i n the "Hope Natural Gas" case (1944), the c o u r t repeated t h i s p o i n t of view. i i ) Hope Natural Gas case (1944) From the i n v e s t o r or company p o i n t of view i t i s important t h a t there be enough revenue not only f o r operating expenses but a l s o f o r c a p i t a l c osts o f the business. These inc l u d e s e r v i c e on the debt and dividends on the stock. By t h a t standard the r e t u r n to the e q u i t y owner should be commensurate with returns on investment on other e n t e r p r i s e s having corresponding r i s k s . The content o f the above c o u r t d e c i s i o n s , e s t a b l i s h e s a precedent and l e g a l b a s i s f o r economic c r i t e r i a which should be considered when s e t t i n g a f a i r r a t e o f r e t u r n oh investment as f o l l o w s : Economic C r i t e r i a i ) F.R.O.I, should be s u f f i c i e n t t o enable r e g u l a t e d i n d u s t r i e s to a t t r a c t the new c a p i t a l r e q u i r e d by a growing e n t e r p r i s e . i i ) F.R.O.I, should be s u f f i c i e n t to enable a r e g u l a t e d i n d u s t r y to maintain i t s c r e d i t standing and f i n a n c i a l i n t e g r i t y . i i i ) F.R.O.I, should be commensurate with returns on investment being earned by i n d u s t r i e s with corresponding r i s k s . - 40 -During most p u b l i c u t i l i t y and other r a t e hearings, the predominant method to determine f a i r r a t e of r e t u r n on investment i s based on the weighted average c o s t o f c a p i t a l c a l c u l a t i o n . The "Cost o f C a p i t a l " includes three key v a r i a b l e s each o f which can have a very d e c i s i v e i n f l u e n c e . These v a r i a b l e s are: a) C a p i t a l s t r u c t u r e b) Cost o f debt c) Cost of e q u i t y The f o l l o w i n g c o n s i d e r a t i o n s regarding the "Weighted average c o s t o f c a p i t a l " and comments concerning the three key v a r i a b l e s are based on t h e 0 Theory of Finance and the approaches taken during a c t u a l past r a t e hearings. - 41 -2.1.0 Weighted Average Cost o f C a p i t a l The c o s t o f c a p i t a l (ko) r e f l e c t s the degree o f r i s k a t which a firm operates. Moreover, c o s t o f c a p i t a l i s the i n d i c a t o r o f external return r e q u i r e d by i n v e s t o r s . As such i t s t i m u l a t e s investment i n t e r e s t i n an e n t e r p r i s e and r e f l e c t s the p o s s i b l e market o p p o r t u n i t i e s a v a i l a b l e to i n v e s t o r s . For r e g u l a t o r y purposes c o s t o f c a p i t a l i s c o r r e c t l y defined as the r a t e a t which i n v e s t o r s discount returns which they b e l i e v e to be i n prospect. Where there i s no u n c e r t a i n t y c o s t o f c a p i t a l (ko) i s equal to the pure i n t e r e s t r a t e (OL). Pure i n t e r e s t r a t e i s defined as the p r i c e charged f o r the use of c a p i t a l i n cases where the p r o b a b i l i t y o f d e f a u l t i s z e r o . T h i s c o n d i t i o n i s n e a r l y achieved by Government Bonds. Bond y i e l d s to maturity t h e r e f o r e , provide a basis f o r v a l i d estimates ofCX. An immediate consequence o f l i f t i n g the c e r t a i n t y assumption i s the requirement o f various sources o f c a p i t a l each p a r t i c i p a t i n g a t i t s own l e v e l i n the success and f a i l u r e s o f the f i r m . Investors perceive d i f f e r e n t c l a s s e s o f s e c u r i t i e s to have d i f f e r e n t degrees o f r i s k s . T h i s r e s u l t s i n v a r i a t i o n s i n the co s t o f d i f f e r e n t types o f s e c u r i t i e s . The i n d i v i d u a l component costs are combined i n the weighted c o s t o f c a p i t a l . Thus the weighted average c o s t o f c a p i t a l approach i n v o l v e s f i n d i n g the appropriate c o s t o f debt, p r e f e r r e d stock and common e q u i t y , and then applying them to the appropriate c a p i t a l s t r u c t u r e as i l l u s t r a t e d below: C a p i t a l Components % o f Total 30 10 60 Component Cost (%) 6.0 8.0 14.0 Factor P r e f e r r e d Stock Common Equity Debt (kd) x x x 1.8% .8% 8.4% 100% Weighted Average Cost o f C a p i t a l (ko) 11.0% The p r i n c i p l e o f the weighted average c o s t o f c a p i t a l i s simple. However, there i s some confusion about the weights to be a p p l i e d mainly, whether book or market value weights should be used. - 42 -The d e f i n i t i o n of cost of c a p i t a l (ko) in terms of investors opportunity cost implies that both the cost of equity and cost of debt are at the current market l e v e l . Therefore, t h i s d e f i n i -t i o n also implies that market value weights should be used to determine the c a p i t a l structure. The use of book value weights could d i s t o r t the firm's average cost of ca p i t a l quite s i g n i f i c a n t l y , p a r t i c u l a r l y where a com-pany might be viewed as a growth s i t u a t i o n by the market. The balance sheet values of common shares and retained earnings w i l l l i k e l y be well below the market value of shares and t h e i r 23) use as weights could understate the cost of c a p i t a l . ' There are numerous methods of estimating the market value weights. Following i s the method used by Myers f o r the A.T&T 24) case: ' The f i r s t step i n converting the book weights to market weights i s the c a l c u l a t i o n of the r a t i o s of the market values of debt and equity to t h e i r respective book values. In the case of equity, the r a t i o i s simply the stock price divided by the book value per share. (F.ex. =1.11). In order to obtain a reasonable approximation f o r the market value of debt, Myers calculated the t o t a l market value of outstanding debt of A,T&T only, (excluding the obligations of the s u b s i d i a r i e s ) and divided t h i s value by the book value of these bonds. (F.ex. = .87). Assuming a debt/equity r a t i o of 45/55 and the above market/book value r a t i o s , f o r every d o l l a r of book c a p i t a l i z a t i o n there i s debt outstanding with a market value of .45 x .87 = $.39. For every d o l l a r of book c a p i t a l i z a t i o n , there i s equity outstanding with a market value of .55 x 1.11 = $.61. 23) See (3) 24) See (26) f o r more d e t a i l - 43 -Thus, the weights are: .39 Debt: .39 + .61 = .39 E q u i t y : ^ = .61 .39 + .61 A r e g u l a t o r y s t r a t e g y based on c u r r e n t debt and e q u i t y costs and t h e i r a p p l i c a t i o n to the market weights corresponds to the p r i n c i p l e s o f the f i n a n c e theory. However, up to the present, r e g u l a t o r y commissions have avoided the c u r r e n t debt c o s t . This i s because the r e g u l a t o r s t r y to prevent stockholders from gaini n g i n s i t u a t i o n s where market c o s t of debt i s f a r above the actual embedded i n t e r e s t c o s t . This approach does not n e c e s s a r i l y have to be i l l o g i c a l or i n c o n t r a d i c t i o n with the theory o f f i n a n c e . With no r e g u l a t o r y l a g , the use o f embedded co s t s i s g e n e r a l l y c o n s i s t e n t with the p r i n c i p l e t hat the r e g u l a t e d f i r m should earn the c o s t o f c a p i t a l on new investment. I f regulated firms could change t h e i r f a r e s or r a t e s a u t o m a t i c a l l y any time t h e i r embedded debt c o s t changed, then the r a t e o f r e t u r n earned on new investment would always r e f l e c t the actual c u r r e n t c o s t of any debt f i n a n c i n g a s s o c i a t e d with the new investment. In the case described above, a r e g u l a t o r y s t r a t e g y based on embedded debt costs would r e q u i r e use o f book weights instead., o f market weights to determine the d e s i r e d r a t e o f r e t u r n allowance. The f i r m should be allowed to earn 1) I t s actual embedded i n t e r e s t c o s t , plus 2) Equity earnings equal to the c o s t o f e q u i t y c a p i t a l m u l t i p l i e d by the book value o f the e q u i t y . Under t h i s procedure the o v e r a l l r a t e o f r e t u r n w i l l be a weighted average o f embedded debt costs and the c o s t of e q u i t y c a p i t a l , using Book weights. - 44 -2.2.0 C a p i t a l S t r u c t u r e As p r e v i o u s l y d e f i n e d , f i n a n c i a l r i s k concerns the unequal d i s t r i b u t i o n o f a company's business r i s k among i t s several c l a s s e s o f i n v e s t o r s . I t i s the c a p i t a l s t r u c t u r e t h a t determines the d i s t r i b u t i o n o f business r i s k s among c l a s s e s o f i n v e s t o r s i n accordance with i n v e s t o r s preferences. Under c o n d i t i o n s o f p e r f e c t markets and c e r t a i n t y , there i s no d i f f e r e n c e whatever between any o f the p o s s i b l e forms o f f i n a n c i n g and t h e r e f o r e there i s e s s e n t i a l l y no f i n a n c i n g d e c i s i o n . In p a r t i c u l a r , there i s no d i f f e r e n c e between debt and equ i t y . Where u n c e r t a i n t y e x i s t s , e q u i t y investment i s u s u a l l y considered more r i s k y than investment i n the bonds of the same company. As the proportion o f borrowed funds to t o t a l c a p i t a l i z a t i o n i n c r e a s e s , not only may the i n t e r e s t r a t e i n c r e a s e but the added r i s k to eq u i t y holders may cause the cost o f e q u i t y c a p i t a l (ke) to incr e a s e as w e l l . Conversely, when the amount of debt i s r e l a t i v e l y low the r i s k s h i f t e d to the common eq u i t y holder i s s m aller per d o l l a r o f t o t a l c a p i t a l . Other f a c t o r s being equal, the co s t per d o l l a r o f common e q u i t y i s lower. In t h i s r e a l world s i t u a t i o n , the f i n a n c i n g mix d e c i s i o n i s o f great importance. The change i n debt-equity r a t i o could a f f e c t e i t h e r k . k., k or a l l o f them, e d o In the f o l l o w i n g , the opposite views c o n s i d e r i n g the importance of f i n a n c i a l leverage w i l l be b r i e f l y d i s c u s s e d . ' 25) See (23) f o r a more d e t a i l review - 45 -The s t a r t i n g p o i n t i n the a n a l y s i s o f changes i n the f i n a n c i n g mix i s M o d i g l i a n i and M i l l e r ' s (MM's) famous P r o p o s i t i o n I (23) which s t a t e s t h a t the value o f a f i r m (V) and i t s c o s t o f c a p i t a l ( k Q ) are independent of f i n a n c i a l leverage. The p r o p o s i t i o n depends on three assumptions: 1) The e x i s t e n c e o f p e r f e c t markets, 2) Changes i n f i n a n c i a l leverage do not a f f e c t the firm's a s s e t s , f u t u r e investments, or the s i z e and r i s k c h a r a c t e r i s t i c s o f i t s income stream, 3) The absence o f corporate income taxes. The f o l l o w i n g graph i l l u s t r a t e s the MM's propostion I. 4 i 1 1 \ « 1 1 < ( 1 — A l l Equity F i n a n c i a l Financing Leverage In o p p o s i t i o n to the M & M P r o p o s i t i o n I,the t r a d i t i o n a l view on the f i n a n c i n g mix has been t h a t the value of a f i r m and i t s c o s t o f c a p i t a l depend on f i n a n c i a l leverage. - 46 -As a company repla c e s e q u i t y with cheaper debt c a p i t a l , c o s t o f c a p i t a l ( k Q ) may decrease f o r "reasonable l e v e l s " o f debt, and then increase s h a r p l y when leverage becomes unreasonably high. The f o l l o w i n g graph summarizes the above p o s i t i o n s concerning a f i r m ' s c o s t o f c a p i t a l . Cost o f C a p i t a l "ko" M M Hypothesis T r a d i t i o n a l Hypothesis & 1 — D e b t fe>6 6 1 • E q u i t y /oo o MM p o s i t i o n implies t h a t there e x i s t s no optimal c a p i t a l s t r u c t u r e that minimizes the firm's c o s t o f c a p i t a l . A l l debt/equity combinations r e s u l t i n the same c o s t o f c a p i t a l . The t r a d i t i o n a l p o s i t i o n , however, implies that there does e x i s t a c l e a r l y d e f i n a b l e optimal c a p i t a l s t r u c t u r e where the c o s t o f c a p i t a l i s a t i t s minimum. I t i s the p o i n t a t which the marginal c o s t of more debt i s equal to or greater than a company's c o s t o f c a p i t a l . - 47 -In the foregoing the famous M & M P r o p o s i t i o n I, and the t r a d i t i o n a l p o s i t i o n concerning p o s s i b l e optimal c a p i t a l s t r u c t u r e s have been di s c u s s e d . There are other intermediary approaches which could be considered. However, to determine the co s t o f c a p i t a l f o r F.R.O.I. - c a l c u l a t i o n s the f o l l o w i n g three major approaches concerning the approp r i a t e c a p i t a l s t r u c t u r e s are used i n r a t e hearings. 2.2.1 Actual C a p i t a l S t r u c t u r e The f i r s t a l t e r n a t i v e i s to use the actu a l c a p i t a l s t r u c t u r e at some given p o i n t i n time, p r e f e r a b l y as c u r r e n t as p o s s i b l e . T h i s approach has two advantages. F i r s t , i t represents an o b j e c t i v e e x i s t i n g s t r u c t u r e . Secondly, i t bears some r e l a t i o n s h i p t o the data employed i n c o s t o f c a p i t a l c a l c u l a t i o n s , which are based upon h i s t o r i c a l a n a l y s i s . I t s major weakness i s t h a t i t does not n e c e s s a r i l y r e f l e c t the fu t u r e c a p i t a l s t r u c t u r e , should some s i g n i f i c a n t changes occur. 2.2.2 Hypothetical C a p i t a l S t r u c t u r e The second p o s s i b l e c a p i t a l s t r u c t u r e i s a hy p o t h e t i c a l c a p i t a l i z a t i o n based on what i s a n t i c i p a t e d a t a f u t u r e date. The strength o f t h i s a l t e r n a t i v e i s i t s e x p l i c i t attempt to recognize p o t e n t i a l f u t u r e s h i f t s i n the debt/equity r a t i o . However, t h i s strength i s a l s o i t s major weakness si n c e the fu t u r e c a p i t a l s t r u c t u r e must by n e c e s s i t y be estimated. A l l estimates o f f u t u r e f i n a n c i n g r e q u i r e the e x e r c i s e o f s u b j e c t i v e judgement. - 48 -2.2.3 Optimal Capital Structure The t h i r d a l t e r n a t i v e i s to determine an optimum c a p i t a l s t r u c t u r e , representing a debt/equity r a t i o that minimizes the cost of c a p i t a l while maintaining f i n a n c i a l soundness. T h e o r e t i c a l l y t h i s a l t e r n a t i v e has great merits. In p r a c t i c e , an optimal c a p i t a l structure i s very d i f f i c u l t to determine. The current theory on the optimal c a p i t a l structure holds that as f a r as leverage alone i s concerned, there e x i s t s a c l e a r l y definable optimum p o s i t i o n . This i s ignoring a l l other considerations that might influence the choice between debt and equity. The optimum p o s i t i o n i s the point at which the marginal cost of more debt i s equal to or greater than a company's average cost of c a p i t a l . Although t h e o r e t i c a l l y well defined, t h i s point i s not easy to f i n d i n p r a c t i c e , and therefore the conclusions derived are not too relevant i n a p r a c t i c a l s e t t i n g . - 49 -2.3.0 Cost o f Debt As a f i r s t approximation, the c o s t o f debt (k^) i s defined as the r a t e of r e t u r n r e q u i r e d by debt holders to supply that amount o f debt c a p i t a l to the f i r m . The above d e f i n i t i o n a p p l i e s to c o s t o f debt on a before tax b a s i s . This c o s t can then be modified to take account o f the d e d u c t a b i l i t y o f i n t e r e s t payments f o r income tax purposes. In past hearings, the actual embedded co s t o f debt has been the s t a r t i n g p o i n t f o r determining the a p p r o p r i a t e c o s t o f debt (7,8,25,26). The embedded c o s t o f debt i s the actual c o n t r a c t u a l c a r r y i n g c o s t to the company o f i t s outstanding long-term debt. T h i s i s computed by taking the company's net c u r r e n t i n t e r e s t expense and d i v i d i n g i t by the net debt outstanding. The second step i s to look at the f u t u r e embedded c o s t o f debt. T h i s i s necessary, because the r e g u l a t o r y bodies don't s e t new f a i r r a t e o f r e t u r n standards on a y e a r l y b a s i s . In the past, there have been no hearings to determine the f a i r r a t e o f r e t u r n f o r Canadian A i r C a r r i e r s . A l l previous Canadian Passenger Rate increases were based on the assumption o f equivalance with the U.S.A. " F a i r Rate o f Return" standard. These standards were s e t by the C.A.B. based on present c o n d i t i o n s t a k i n g i n t o account foreseeable trends i n the c o s t o f debt and e q u i t y . Some regu l a t e d i n d u s t r i e s , l i k e the A i r Transport Industry, have exceedingly l a r g e new c a p i t a l requirements, p r i m a r i l y to f i n a n c e the purchase o f new major equipment. The i n t e r e s t r a t e s paid f o r the new c a p i t a l are f a r above those r e f l e c t e d i n the a l r e a d y embedded c o s t of debt c a p i t a l . Obviously, the p r o s p e c t i v e l e v e l - 50 -o f i n t e r e s t r a t e s has a greater s i g n i f i c a n c e f o r r a p i d l y growing business, with l a r g e new c a p i t a l requirements, than f o r a r e l a t i v e l y s t a t i c company. The determination o f the f u t u r e embedded c o s t o f debt i n v o l v e s e s t i m a t i n g both the amount o f debt c a p i t a l to be acquired and i t s probable c o s t . However, the r e l i a b i l i t y o f estimates of f u t u r e c o s t of debt and the amount o f debt c a p i t a l r e q u i r e d i s questionable due to the l a r g e a d d i t i o n a l problem concerning the f u t u r e embedded c o s t o f debt. T h i s i s , whenever the estimates of f u t u r e embedded c o s t o f debt are above or below the c u r r e n t embedded c o s t , t h e i r e x c l u s i v e use f o r r a t e making purposes may r e s u l t i n w i n d f a l l p r o f i t s or l o s s e s to the shareholders. Another a l t e r n a t i v e i s to use a c u r r e n t average i n t e r e s t c o s t i n s t e a d o f a c t u a l or f u t u r e embedded co s t s o f d e b t . However, up to the present r e g u l a t o r y commissions have avoided the use of c a p i t a l market data. The embedded c o s t o f debt i s considered to be more r e l e v a n t than the c u r r e n t c o s t s , because the c u r r e n t r a t e s are "at h i s t o r i c a l peaks" and have to come .0 Cost of P r e f e r r e d Stock To the i n v e s t o r , p r e f e r r e d stock i s l e s s r i s k y than common stock e q u i t y , but more r i s k y than debt. The same t h e o r e t i c a l issues are involved i n the c a l c u l a t i o n o f the c o s t of p r e f e r r e d stock as f o r the c o s t of debt, s i n c e p r e f e r r e d dividends are u s u a l l y viewed as a f i x e d o b l i g a t i o n s i m i l a r to i n t e r e s t on long-term debt. However, the p r o p o r t i o n of p r e f e r r e d stock i n a normal c a p i t a l s t r u c t u r e i s so small t h a t i t s a f f e c t can o f t e n be neglected, when c a l c u l a t i n g the cost of c a p i t a l to determine a f a i r r a t e of r e t u r n . This argument may have been v a l i d i n the past. The same does not n e c e s s a r i l y apply i n the f u t u r e . - 51 -. 0 Cost o f Common Stock Equity The c o s t o f common stock e q u i t y c a p i t a l ( k g ) i s de f i n e d as the "opportunity c o s t " o f i n v e s t i n g i n a firm's a s s e t s . The "opportunity c o s t " i s a marginal concept, which i s u s u a l l y defined as the a n t i c i p a t e d r a t e o f re t u r n on an incremental investment i n the best a l t e r n a t i v e . In g e n e r a l , there i s a d i f f e r e n t c o s t a p p l i c a b l e to e q u i t y c a p i t a l r a i s e d by re t a i n e d earnings than to th a t r a i s e d by s e l l i n g new common stock. The c o s t o f new common stock (external e q u i t y c a p i t a l ) i s higher than the co s t o f r e t a i n e d earnings because o f the f l o a t i n g c o s t i n v o l v e d i n s e l l i n g new common stock. For r a t e making purposes, however, the c o s t o f r e t a i n e d earnings i s o f major importance. 27) T h i s f a c t i s emphasized by Foster i as s t a t e d i n the f o l l o w i n g : The major component o f the c o s t o f common e q u i t y to a i r l i n e s and p u b l i c u t i l i t i e s i s the prospect o f p r o f i t which i s reasonably s u f f i c i e n t to induce i n v e s t o r s to commit new s u p p l i e s o f eq u i t y c a p i t a l to the regulated businesses. A smaller component i s the costs which would be i n c u r r e d d i r e c t l y by the company i n o b t a i n i n g a supply o f new c a p i t a l , namely, c o s t o f f i n a n c i n g . The c o s t o f common e q u i t y i s much more d i f f i c u l t to determine than the c o s t o f debt. I t can not be expressed i n the terms o f c a p i t a l c o n t r a c t s . There i s a l s o no d i r e c t and p r e c i s e formula f o r measurement o f co s t o f common eq u i t y . Many elements o f judgement, based on a v a i l a b l e i n f o r m a t i o n , are involved i n a r r i v i n g a t a s p e c i f i c c o s t o f common e q u i t y . T h e r e f o r e , during p u b l i c u t i l i t y hearings the most contentious i s s u e has been the method of determination o f an appropriate r a t e o f r e t u r n on e q u i t y . The f o l l o w i n g approaches are most f r e q u e n t l y used: See (8) - 52 -2.5.1.0 Market Value Approach The market value approach determines the cost of common equity by r e f e r r i n g to market prices of common stock i n r e l a t i o n to earnings, dividends and growth rates, as evidence of investors' return requirements. .2.5.1.1 Earnings - Price Ratio Method Current Earnings Per Share x l f ) f ) Current Market Price Per Share In the past, the above r a t i o has been used to estimate investor return requirements. I t i s however, a v a l i d and useful measure of the c a p i t a l i z a t i o n rate only when stockholders expect that future earnings w i l l be the same as current earnings. When investors expect earnings to grow, the earnings-price r a t i o method i s neither t h e o r e t i c a l l y v a l i d nor useful for determining reasonable earnings, because i t ignores investor expectations of growth i n per-share earnings i n a dynamic economy under i n f l a t i o n . Yet, i n the hearings before the "Federal Power Commission" and before the "State Commission" in the United States the concept of basing the allowable rate of return on an adjusted average of the earnings-price r a t i o has been p e r s i s t e n t l y advanced. The motive, of course, i s to induce rate reductions or prevent rate increases. Its use i n recent years has often resulted in a recommended return of approximately 7% on the book equity. Such a return i s l i k e l y to have a serious adverse e f f e c t on the 28) earnings potential of the common stock.' 28) See (24) pp. 21-22 - 53 -2.5.1.2 Discounted Cash Flow Method (DCF) The DCF method takes growth into consideration. The premise of th i s method i s , that the market price "Po" of a stock equals the cash flow of expected future incomes both dividends, D-j-D,,-^ and sales price "Pn" discounted to the present value. This can be expressed by the following equation: Po = DI , D2 . D3 . P3 , n (1 + k) (1 + k)2 (1 + k)3 (1 + k)3 u ; n = 3 The discount rate "k" which s a t i s f i e s the equation i s equal to the cost common equity c a p i t a l . This i s the return required by investors. Assuming the dividend stream grows i n d e f i n i t e l y at some rate of "g", equation I can be s i m p l i f i e d to read as follows: K e = Do + n ~ P o — + 9 Ke = The cost of common equity c a p i t a l Do = The company's current dividend Po = The current market price of the company's stock g = The expected future growth rate (dividends and sale price) This means that the cost of equity c a p i t a l w i l l be equal to the dividend y i e l d plus the growth rate, assuming the stated assumption i s co r r e c t . The discounted cash flow (DCF) method has two s i g n i f i c a n t l i m i t a t i o n s . ( i ) When market price d i f f e r s from book value of the stock, there i s no single book value rate to which an unadjusted DCF f a i r rate of return may be applied to obtain an estimate of the amount of permissible earnings. - 54 -( i i ) The second l i m i t a t i o n i s caused by the s u b j e c t i v i t y r e q u i r e d to estimate the value o f "g" the r a t e a t which i n v e s t o r s expect dividends to grow i n the f u t u r e . Estimating i n v e s t o r expectations f o r "g" i n the a i r t r a n s p o r t i n d u s t r y i s p a r t i c u l a r l y d i f f i c u l t because the i n d u s t r y has a widely f l u c t u a t i n g growth h i s t o r y . G e n e r a l l y , the market approach to the determination o f allowable r a t e o f r e t u r n on common eq u i t y c a p i t a l , whether by reference to earnings p r i c e r a t i o , o r DCF method, f a i l s to give meaningful r e s u l t s i n two circumstances. ( i i i ) I f f u t u r e earnings are h i g h l y uncertain and th e r e f o r e cannot be subjected to estimations w i t h i n a reasonable range of p r o b a b i l i t y . In that case, a common stock i s i n h e r e n t l y s p e c u l a t i v e . i v ) I f p r i c e s o f s t o c k s , although not i n h e r e n t l y s p e c u l a t i v e , r e f l e c t s p e c u l a t i v e m o t i v a t i o n of buyers. This i s because i n v e s t o r r e t u r n requirements cannot be measured by reference to stock p r i c e s which merely r e f l e c t t r a d e r s hopes and expectations o f c a p i t a l g a i n s . 2.5;.2^0 Comparable Earnings Approach The comparable earnings approach assumes that the g r e a t e r the attendant investment r i s k , the g r e a t e r the expected r e t u r n must be i n order to a t t r a c t new eq u i t y c a p i t a l . I t a l s o assumes that s i n c e a l l companies must compete i n the same market place f o r c a p i t a l , r e g u l a t e d companies should earn a t l e a s t the same r e t u r n on book e q u i t y as unregulated 29) i n d u s t r i e s with comparable r i s k . ' 29) I b i d pp. 28-30 - 55 -The comparable earnings approach u t i l i z e s h i s t o r i c a l data to e s t a b l i s h a r e l a t i o n s h i p between r i s k and h i s t o r i c a l return on book equity for d i f f e r e n t regulated and unregulated i n d u s t r i e s . Analysis of these r e l a t i o n s h i p s provides an i n d i c a t i o n of the rate of return required to f l o a t new equity c a p i t a l i f future conditions were expected to remain s i m i l a r to those in the h i s t o r i c a l period analyzed. To take future conditions into account, a separate analysis of them must be made and compared to the h i s t o r i c a l period. I f future conditions are expected to d i f f e r s i g n i f i c a n t l y from the period analyzed, an adjustment i s required to the rate of return developed from h i s t o r i c a l data. This approach again, has two major l i m i t a t i o n s . ( i ) Extrapolation of the experienced earnings does not necessarily give an estimate of the future earnings needed to a t t r a c t c a p i t a l . ( i i ) The s e l e c t i o n of companies or i n d u s t r i e s for v a l i d r i s k comparison with' the regulated industry being investigated requires considerable judgement. 2.5.3.0 Debt Coverage P r i n c i p l e The debt coverage p r i n c i p l e i s another method of computing the cost of c a p i t a l and cost of equity r e s p e c t i v e l y . I t assumes that the overall cost of c a p i t a l i s one that w i l l cover fixed charges by some given m u l t i p l e . Once the cost of c a p i t a l and the cost of debt i s known, the cost o f equity can r e a d i l y be computed. Example Debt Coverage 3 Times Cost a) Debt 60% $60 5% $3.00 b) Total Capital 100% $100 9% $9.00 c) Equity 40% $40 15% $6,00 (=B-A) - 56 -This p r i n c i p l e usually r e l i e s upon the h i s t o r i c a l established debt/equity r a t i o s and i n t e r e s t covered. Thus, given the i n t e r e s t covered the overall rate of return w i l l change with the embedded cost of debt. If t h i s p r i n c i p l e were followed the cost of equity to u t i l i t i e s during a period of high i n t e r e s t rate would be f a r above the earnings of i n d u s t r i a l companies and therefore would v i o l a t e the opportunity cost p r i n c i p l e . U t i l i t y e q u i t i e s would a c t u a l l y benefit from higher debt 30) costs and s u f f e r from lower debt costs. ' See (24) and (30) - 57 -3.0.0 Regulatory Approaches i n the A i r l i n e Industry 3.1.0 F a i r Rate o f Return on Investment (E.R.O.I.) The amount o f information made p u b l i c by the Canadian Transport Commission (CTC) concerning r a t e hearings i s minimal. In c o n t r a s t , d e t a i l e d information i s made a v a i l a b l e by the C i v i l Aeronautics Board (CAB) i n the U.S.A. I t appears that i n the past most f a r e increases i n Canada were j u s t i f i e d simply by the i n f l a t i o n a r y operating c o s t increases faced by the a i r c a r r i e r s . The f a i r r a t e o f re t u r n t a r g e t s e t by the CAB merely served as the upper l i m i t f o r i n c r e a s e s . Recently, the Canadian A i r t r a n s p o r t A s s o c i a t i o n appointed a committee to i n v e s t i g a t e what could be considered to be a f a i r r a t e o f re t u r n on investment f o r Canadian A i r C a r r i e r s . American a i r c a r r i e r s , have been reg u l a t e d by the CAB on the basis o f t h e i r ROI f o r y e a r s . In A p r i l 1971, during the Domestic Passenger Fare I n v e s t i g a t i o n , the f a i r r a t e o f re t u r n on book investment f o r trunk c a r r i e r s was se t by 6.A.B. a t 12%. Th i s t a r g e t has not been changed. 31) S p e c i f i c a l l y , i t was found t h a t : ' 1) In view o f the unsoundness o f the actu a l i n d u s t r y average debt-equity r a t i o s , a h y p o t h e t i c a l r a t i o s h a l l be employed. 2) C o n s i s t e n t with the assumptions i m p l i c i t i n the hypo t h e t i c a l c a p i t a l s t r u c t u r e , c o s t o f debt s h a l l be based upon present embedded c o s t with no allowance f o r c o s t r e l a t e d to fu t u r e debt f i n a n c i n g . 31) See (6) - 58 -A s i n g l e r a t e o f r e t u r n should be e s t a b l i s h e d f o r the domestic t r u n k l i n e i n d u s t r y as a whole. The f a i r and reasonable r a t e o f r e t u r n on investment f o r domestic passenger f a r e s e r v i c e s o f the domestic t r u n k l i n e c a r r i e r s i s 12 percent. This i s based upon a 6.2 percent c o s t o f debt before tax, a 16.75 percent c o s t of e q u i t y and a 45/55 debt/equity r a t i o . The f a i r and reasonable r a t e o f r e t u r n on investment f o r l o c a l s e r v i c e c a r r i e r s f o r passenger-fare purposes i s 12.35 percent. This i s based upon a 7.25 percent c o s t of debt, 20 percent c o s t o f e q u i t y , and a 60/40 debt/equity r a t i o . - 59 -3.2.0 Actual Rate of Return on Investment The Canadian and American a i r c a r r i e r s a l s o have to face the p r e v i o u s l y discussed choice between various r e t u r n base and investment base a l t e r n a t i v e . In a d d i t i o n to the a l t e r n a t i v e s s t a t e d two s p e c i f i c i s sues have been debatable among the a i r l i n e s and the r e g u l a t o r y bodies. The f i r s t i s s u e concerns the accounting procedures o f leased f l i g h t equipment. The question i s , should the a i r c r a f t leases be c a p i t a l i z e d and included i n the investment base or not. Another issue concerns the treatment of equipment purchase deposits and progress payments and r e l a t e d c a p i t a l i z e d i n t e r e s t . The question i s , should equipment purchase deposits and r e l a t e d c a p i t a l i z e d i n t e r e s t , as st a t e d 32) i n the a s s e t s , be deducted from the investment base. ' Before d i s c u s s i n g the i m p l i c a t i o n s o f the treatment of leased f l i g h t equipment i n r e l a t i o n to the r a t e base, fo u r methods p r e s e n t l y used f o r ROI c a l c u l a t i o n i n Canada and the U.S. are b r i e f l y demonstrated. Method #1 "CORPORATE RATES OF RETURN" - (CAB) Th i s i s the c u r r e n t method used by the CAB. I t has been a p p l i e d s i n c e 1972 to a l l CAB reports and p u b l i c a t i o n s , except to e s t a b l i s h r a t e s t r u c t u r e s . Corporate r a t e s o f ret u r n are produced by the Bureau o f Accounts and S t a t i s t i c s , F i n a n c i a l and T r a f f i c Data S e c t i o n . These r a t e s are useful i n d i c a t o r s o f the general l e v e l and trend i n a i r l i n e e arnings. They do not r e f l e c t a l l adjustments normally made f o r rate-making purposes. - 60 -Method #2 AFAC/ATA RETURN ON INVESTMENT FORMULA This formula was proposed by the A i r l i n e Finance and Accounting Conference of the A i r Transport A s s o c i a t i o n (ATA). The formula p r e s e n t l y includes leased f l i g h t equipment i n the investment base on a discount value b a s i s . Method #3 RATE OF RETURN ON OPERATING INVESTMENT -(CAB) This formula has been used by the CAB f o r r a t e making purposes si n c e 1972. The CAB modified i t s method f o r r e c u r r e n t computation of r a t e s of r e t u r n on a i r c a r r i e r investment to conform more c l o s e l y to r e g u l a t o r y standards. The c a l c u l a t e d ROI a l s o measures more a c c u r a t e l y the f i n a n c i a l r e s u l t s of the c a r r i e r s ' t r a n s p o r t o p e r a t i o n s . System Operating Investment includes l i a b i l i t i e s and e q u i t i e s , which are recognized f o r rate-making purposes. They are adjusted to exclude any p o r t i o n a p p l i e d to assets that are not recognized f o r rate-making. The adjustment f o r o b t a i n i n g the recognized system operating investment i s computed as f o l l o w s : Recognized System = Recognized Assets ^ Recognized Operating Investment T o t a l Assets Sources Depreciation Adjustment f o r r e g u l a t o r y purposes i s a l s o a p p l i e d . System Operating Net Income r e f l e c t s reported operating revenues l e s s operating expenses (with d e p r e c i a t i o n adjusted f o r r e g u l a t o r y purposes) a f t e r deduction o f a p p l i c a b l e income taxes. ROI rates are produced by the S t a t i s t i c a l Planning and A n a l y s i s S e c t i o n , Bureau of Accounts and S t a t i s t i c s . Method #4 CP AIR RETURN ON INVESTMENT FORMULA The present CP A i r method f o r computing ROI i s based on the CAB formula ("Corporate Rates of Return") except f o r treatment of leased f l i g h t equipment. CP A i r f o l l o w s the idea o f c o n s t r u c t i v e ownership r e p o r t i n g , which includes leased f l i g h t equipment i n the investment base as i f the a i r l i n e had purchased the equipment, and adjusts the r e t u r n element by the amount t h a t a i r c r a f t r e n t a l payments exceed imputed d e p r e c i a t i o n expense. The Investment base i s c a l c u l a t e d by taking the a r i t h m e t i c mean over f i v e q u a r t e r l y account balances, which i s c o n s i s t a n t with CAB p r a c t i c e . Table I - A, B This i s a comparative p r e s e n t a t i o n o f the f o u r ROI methods. Table II This demonstrates ROI values c a l c u l a t e d i n accordance with three o f the fou r methods s t a t e d , based on actu a l CP A i r f i n a n c i a l r e s u l t s i n 1973. Table III This i s a comparison of actual ROI f i g u r e s o f CP A i r i n 1969-1973, which were computed by applying the CAB formula and the CP A i r formula. Table IV This demonstrates the changes i n f i n a n c i a l statements due to s h i f t from d i r e c t expense r e p o r t i n g to c o n s t r u c t i v e ownership r e p o r t i n g . ELEMENTS OF VARIOUS METHODS OF CALCULATING ROI CAB Corporate Rates of Return Net Long Term Debt Current P o r t i o n o f LTD Advances From A s s o c i a t e d Companies Advances From Non-Transport D i v i s i o n s Current Notes Payable ( i f used to finance c a p i t a l assets) Unamortized Discount and Expense on Debt + • Unamortized Premium On Debt Shareholders' E q u i t y •INVESTMENT BASE AFAC/ATM Formula Net Long Term Debt Current P o r t i o n o f LTD Leased F l i g h t Equipment (discounted value b a s i s ) Equipment Purchase Deposits and Related C a p i t a l i z e d I n t e r e s t Shareholders' E q u i t y CP A i r Formula CAB Rates of Return on Operating Investments* Recognized Sources = Net Long Term Debt Net Long Term Debt Current P o r t i o n o f LTD Current P o r t i o n o f LTD + + Leased F l i g h t Equipment Accumulated D e p r e c i a t i o n Adjustment f o r Regulatory Purposes ( c o n s t r u c t i v e ownership b a s i s ) + Advances From Associated Companies Advances From A s s o c i a t e d Companies-Non-Tr-a ^ S f f Elusions* Advances From Non-Transport D i v i s i o n s + + Current Notes Payable'" ( i f used to finance c a p i t a l assets) Current Notes Payable ( P o r t i o n Beyond 90 days) _ -Unamortized Discount ** and Expense on Debt Unamortized Discount and Expense on Debt + + Unamortized Premium ** on Debt Unamortized Premium On Debt + + Shareholders' Equity Shareholders' E q u i t y * System Operating Investment Recognized f o r ROI Purposes = ** N/A Recognized Assets T o t a l Assets X Recognized Sources TABLE I-A ELEMENTS OF THE VARIOUS METHODS OF CALCULATING ROI - RETURN BASE CAB Corporate Rates o f Return AFAC/ATM Formula CP A i r Formula CAB Rates o f Return on Operating- Investments Net Income A f t e r S p e c i a l Items Net Income Before S p e c i a l Items Net Income A f t e r S p e c i a l Items System Operating Net Income I n t e r e s t on . Longterm.Debt I n t e r e s t on LongtenrTDebt I n t e r e s t on Longterm Debt I n t e r e s t on Leased F l i g h t Equipment I n t e r e s t on Leased F l i g h t Equipment . I n t e r e s t on Advances From A s s o c i a t e d Companies I n t e r e s t on Advances From Ass o c i a t e d Companies C a p i t a l i z e d I n t e r e s t Related to Equipment Purchase Deposits NOTE: I n t e r e s t added back t o NET INCOME on the Before t a x " b a s i s . TABLE I-B RETURN ON INVESTMENT FOR CP AIR IN 197:3 ($000) CAB 'Corporate AFAC/ATA INVESTMENT BASE Debt Long Term Debt i n c l u d i n g c u r r e n t p o r t i o n L e a s e d F l i g h t Equipment Advances f r o m A s s o c i a t e d Companies C u r r e n t N o t e s P a y a b l e DEDUCT: Equipment P u r c h a s e D e p o s i t s and R e l a t e d C a p i t a l i z e d I n t e r e s t CP A i r E q u i t y S h a r e h o l d e r s ' E q u i t y TOTAL INVESTMENT BASE RE-1URN~BASE N e t Income I n t e r e s t on Long Term Debt ( b e f o r e t a x ) I n t e r e s t o n L e a s e d F l i g h t E q u i p m e n t ( b e f o r e t a x ) I n t e r e s t on Advances f r o m A s s o c i a t e d Companies DEDUCT: C a p i t a l i z e d I n t e r e s t TOTAL RETURN BASE RETURN ON INVESTMENT RETURN ON EQUITY *Note 1-Investment base i s computed b y t a k i n g t h e a r i t h m e t i c mean o v e r t h e f i v e q u a r t e r l y a c c o u n t b a l a n c e s . (Jan. 1, Ma r c h 3 1 , June 30, S e p t . 30, Dec. 31) *Note 2-CAB and CP A i r Formulas.'-apply : E i n a l . N e t "Income a f t e r S p e c i a l Items, as r e t u r n b a s e , w h i l e AFAC/ATA f o r m u l a a p p l i e s Net Income b e f o r e S p e c i a l Items. R a t e s o f R e t u r n " F o r m u l a F o r m u l a $ 7,546 N/A 18,000 $ 7,546 77,783 N/A N/A $ 7,546 77,783 18,000 N/A N/A N/A (6,814) ( 128) N/A N/A -25,546 78,387 103,329 34,871 $ 60,417 34,871 $ 113,258 34,871 $ 138,200 $ 4,19:9. $ 4,199 $ 4,199 "457 N/A. 1,496 457 5,007 N/A 457 5,007 1,496 N/A $ 6,152 (128) $ 9,535 N/A $ 11,159 10.18% 8.42% 8.07% 12.04% 12.04% 12.04% TABLE I I - 65 -Year CP AIR COMPARISON OF ROI D i r e c t Expense Reporting CAB Formula ROI C o n s t r u c t i v e Ownership Reporting CP A i r Formula ROI 1969 1970 1971 1972 1973 ,-.11.09 5.67 6.52 10.98 10.18 8.41 5.88 6.29 7.70 8.07 TABLE I I I - 66 -CONSTRUCTIVE OWNERSHIP REPORTING v s . DIRECT EXPENSE REPORTING CHANGES I N FINANCIAL STATEMENTS: BALANCE SHEET I n c r e a s e i n Long Term Debt $ 60,000 P l u s I n c r e a s e i n C u r r e n t P o r t i o n o f Long Term Debt 8,500 T o t a l I n c r e a s e i n L i a b i l i t i e s 68,500 (Funds needed t o b u y t h e l e a s e d a i r c r a f t equipment.) I n c r e a s e i n P r o p e r t i e s C o s t o f f l i g h t equipment 100,000 Minus A c c u m u l a t e d C o n t r u c t i v e D e p r e c i a t i o n 31,500 T o t a l I n c r e a s e i n A s s e t s 68,500 I n c r e a s e i n I n v e s t m e n t Base $ 68,500 .INCOME- STATEMENT De c r e a s e i n F l y i n g O p e r a t i o n s Expense ( a n n u a l r e n t a l payments) $ 10,500 T o t a l D e c r e a s e i n Expenses : 10,500 I n c r e a s e i n D e p r e c i a t i o n 6,800 ( C o n s t r u c t i v e d e p r e c i a t i o n o n l e a s e d a i r i c r i a f t ^ s u b s t i t x t t e j i ...for r e n t a l ..payments.) I n c r e a s e i n I n t e r e s t Expense 3,700 ( C o n s t r u c t i v e i n t e r e s t on l e a s e d a i r c r a f t = r e n t a l payments - im-p u t e d d e p r e c i a t i o n expense.) TOTAL INCREASE I N EXPENSES $ 10,500 INCREASE IN RETURN BASE $ 5,700 - 67 -3.3.0 Leased F l i g h t Equipment i n the Investment Base Several f a c t o r s have caused a i r c a r r i e r s to i n c r e a s i n g l y lease a d d i t i o n a l a i r c r a f t . F i r s t , the need of new c a p i t a l has been l a r g e r s i n c e the i n t r o d u c t i o n of the wide-bodied a i r c r a f t . Secondly, r e l a t i v e l y low earnings during the l a s t years have made i t ve^ry d i f f i c u l t to obtain a d d i t i o n a l funds from the more t r a d i t i o n a l sources of funds; i . e . the debt and e q u i t y markets. T h i r d the s i g n i f i c a n t tax b e n e f i t s , enjoyed by the l e s s o r s , r e s u l t i n r e l a t i v e l y low lease payments. There f o r e , not only are the c a r r i e r s able to o b t a i n a d d i t i o n a l f i n a n c i n g t h a t e s s e n t i a l l y i s not a v a i l a b l e from other sources, but a l s o they are able to obtain i t at a reasonable c o s t . For the purpose o f earnings r e g u l a t i o n the r e g u l a t o r y body must choose between 1) t r e a t i n g the c o s t of the leased f l i g h t equipment as an d i r e c t operating expense (DIRECT EXPENSE REPORTING) rec o g n i z i n g t h a t the c o n t r a c t u a l arrangements incr e a s e the r i s k and t h e r e f o r e cost of common stock investment and 2) c a p i t a l i z i n g the leased f l i g h t equipment. (CONSTRUCTIVE OWNERSHIP REPORTING) The f i r s t a l t e r n a t i v e avoids the need to estimate the d i r e c t c o s t o f the c a p i t a l represented by the leased equipment. For the second a l t e r n a t i v e t h i s cost has to be stated e x p l i c i t l y . I t cannot be assumed, without a d e t a i l a n a l y s i s t h a t the weighted average cost o f c a p i t a l i s reduced by the l e a s i n g o f a i r c r a f t - d e s p i t e the d i m i n i s h i n g p o r t i o n o f the expensive e q u i t y i n the c a p i t a l s t r u c t u r e . - 68 -In f a c t , the co s t of c a p i t a l could be the same under e i t h e r a l t e r n a t i v e . T h i s statement holds i f and only when the eq u i t y i n v e s t o r s a c t u a l l y perceive the higher r i s k r e l a t e d to the lease c o n t r a c t s , although they are not reported on a balance sheet. EXAMPLE: D i r e c t Expense Reporting DEBT Leased F l i g h t Equipment EQUITY k o % o f t o t a l c a p i t a l c o s t weight C o n s t r u c t i v e Ownership Reporting % o f t o t a l c a p i t a l c o s t 34.6% x 7% = 23.1% x!2% = 42.3% x!6% = weight 2.42 2.76 6.77 11.95 45% x 7% = 3.15 55% x 16% = 8.80 11.95 From the view p o i n t o f co s t o f c a p i t a l , i t would t h e r e f o r e be i r r e l e v a n t , whether o r not to i n c l u d e leased f l i g h t equipment i n the investment base. However, t h i s does not apply from the earnings p o i n t o f view. T h i s v»iew p o i n t i s discussed i n the f o l l o w i n g : In the U.S. the a i r c a r r i e r s are regulated by the CAB on the basis on t h e i r r e t u r n on investment. The CAB does not in c l u d e leased a i r c r a f t i n the investment base f o r purposes fo c a l c u l a t i n g the ROI. As l e a s i n g i n c r e a s e s , g r e a t e r proportions o f the c a r r i e r s ' operating assets are not included i n the investment base used f o r r e g u l a t o r y purposes. T h i s i s the reason the c a r r i e r s requested t h a t the CAB use the " c o n s t r u c t i v e ownership r e p o r t i n g p r i n c i p l e " f o r r e g u l a t o r y purposes to r e f l e c t the impact o f l e a s i n g on t h e i r ROI. - 69 -The c o n s t r u c t i v e ownership p r i n c i p l e provides f o r i n c l u s i o n o f the value o f leased a i r c r a f t i n the investment base and asso c i a t e d adjustments to the income statement t o r e f l e c t the c o n s t r u c t i v e treatment o f the leased a i r c r a f t . T h i s request was based on an extensive study by F.G. T r i p p 32) on a i r c r a f t l e a s i n g - . His major f i n d i n g s were as f o l l o w s : When the R.O.I, i s 5 percent or higher the c o n s t r u c t i v e ownership r e p o r t i n g r e s u l t s i n a lower R.O.I, than t h a t produced by d i r e c t expense r e p o r t i n g . When the R.O.I, i s below 5 percent or negative, c o n s t r u c t i v e ownership r e s u l t s i n an R.O.I, that i s higher than t h a t produced by d i r e c t expense r e p o r t i n g . Thus, higher revenues are requi r e d f o r c o n s t r u c t i v e ownership r e p o r t i n g to r e s u l t f . ex. i n a 12-percent R.O.I., when compared with d i r e c t expense r e p o r t i n g under the same s e t o f f i n a n c i a l o p e r a t i n g c o n d i t i o n s . (Assuming the R.O.I, l e v e l i s above 5%). In other words, the c o n s t r u c t i v e ownership method i n d i c a t e s the t o t a l a d d i t i o n a l revenues that must be generated to meet the increased f i n a n c i a l commitments by the c a r r i e r s . Table V i l l u s t a t e s t h i s controversy by using CP A i r , a c t u a l , 1973 Data. Based on the above, the leased f l i g h t equipment should be included i n the investment base f o r the c a r r i e r s ' b e n e f i t -and shown on the balance sheet. In Canada, CP A i r and A i r Canada f o l l o w the c o n s t r u c t i v e ownership p r i n c i p l e while the region a l c a r r i e r s s t i l l use d i r e c t expense r e p o r t i n g . See (4) - 70 -RETURN ON INVESTMENT ($000) CONSTRUCTIVE OWNERSHIP REPORTING DIRECT EXPENSE REPORTING Required Net Income Plus Interest (100%) Return Base Shareholders Equity January 1, 1973 Plus Net Income Minus Dividends Shareholders Equity December 31, 1973 Average Equity 1973 Average Long Term Debt 1973 Investment Base 10,359 6,960 x) 17,319 36,888 10,359 2,150 45,097 40,992 103,329 x) 144,321 5,755 1,953 7,708 36,888 5,755 2,150 40,493 38,690 25,546 64,236 RETURN ON INVESTMENT 12% 12% x) For constructive ownership repo r t i n g , i t i s assumed that leased f l i g h t equipment had been financed by 100% debt, i f purchased. TABLE V 4.0.0 summary In chapter I I I , the theory of economic r e g u l a t i o n g e n e r a l l y , and the f a i r r a t e o f r e t u r n r e g u l a t i o n f o r various i n d u s t r i e s s p e c i f i c a l l y , were reviewed. The main purpose o f the chapter was to d e f i n e ( i ) the theory of economic r e g u l a t i o n ( i i ) r e g u l a t o r y c o n s t r a i n t s ( i i i ) approaches taken i n r a t e hearings f o r r e g u l a t o r y d e c i s i o n s ( i v ) the i n t e r r e l a t i o n between f a i r r a t e - o f - r e t u r n r e g u l a t i o n and the theory o f finance The i m p l i c a t i o n s concerning the above can be summarized as fol1ows: D i r e c t monetary s u b s i d i e s , r e s t r i c t i o n of competition and p r i c e - c o n t r o l are the most f r e q u e n t l y a p p l i e d means by a government to enforce economic r e g u l a t i o n . Since r e g u l a t o r y bodies cannot c o n t r o l a l l d e c i s i o n s of the f i r m under r e g u l a t i o n , they must decide on some performance c r i t e r i a to be used as a r e g u l a t o r y c o n s t r a i n t . In the past, the f a i r - r a t e - o f r e t u r n on investment c r i t e r i o n has been most f r e q u e n t l y a p p l i e d as a r e g u l a t o r y c o n s t r a i n t . The f a i r r a t e of r e t u r n c o n s t r a i n t was based on both, book r a t e and discounted cash flow u n i t s . The l e v e l of the FROI t a r g e t depends l a r g e l y on the business and f i n a n c i a l r i s k of the company (Industry) being r e g u l a t e d . - 72 -The main economic c r i t e r i o n f o r the FROI has been, t h a t " i t should be commensurate with returns on investment being earned by i n d u s t r i e s with corresponding r i s k s " . During most p u b l i c u t i l i t y and other rate hearings the predominent method to determine the FROI has been based on the weighted average c o s t o f c a p i t a l c a l c u l a t i o n . For t h i s purpose the c o s t o f debt considered was the embedded c o s t of debt. The c o s t of e q u i t y was based on book returns on e q u i t y investment earned by the companies i n the same r i s k c l a s s . F o llowing, the approaches taken i n past r a t e hearings w i l l be c r i t i c i z e d . Comments are based on the modern theory of finance*. - 73 -IV THE FAIR RATE OF RETURN ON INVESTMENT FOR CANADIAN TRANSCONTINENTAL AIR CARRIERS 1.0.0 Review In the previous chapter, the theory of economic regulation generally, and the FROI-regulation s p e c i f i c a l l y , were reviewed to obtain an o v e r a l l impression of the regulatory process. In the beginning of t h i s chapter, recent l i t e r a t u r e concerning p a r t i c u l a r issues of the FROI-regulation w i l l be reviewed. These p a r t i c u l a r issues demonstrate the approaches taken i n recent rate hearings to solve controversial problems. They also provide the basis f o r the proposed approach to determine the FROI f o r Canadian transcontinental a i r c a r r i e r s . In p a r t i c u l a r , the following subjects w i l l be discussed: FROI and the comparable earnings standard, FROI and the com-p e t i t i v e market, i n f l a t i o n , c a p i t a l s t r u c t u r e , and estimation of the cost of equity. As stated before, the legal precedent f o r s e t t i n g the f a i r return to equity has been stated in the Supreme Court "Hope" de c i s i o n : "The return to an equity owner should be commensur-ate with returns on investments in other enterprises having corresponding r i s k s . " The loose d e f i n i t i o n of the Hope de c i s i o n , however, allows d i f f e r e n t i n t e r p r e t a t i o n s . The t r a d i t i o n a l and most widely accepted approach defines "returns" as the book rates of returns of other firms. Those who advocate the t r a d i t i o n a l approach i n t e r p r e t the Hope decision in t h e i r p a r t i c u l a r v/ay, namely: "The return to the 1.1.0 FROI and Comparable Earnings Standard - 74 -equity owner should be commensurate with RECENT BOOK returns on PAST investments MADE BY other enterprises having corres-" 1) ponding r i s k s . ' This i n t e r p r e t a t i o n has some obvious weaknesses. F i r s t , the method i s not consistent with the concept of opportunity cost, which i s a marginal and future-oriented concept. The opportun-i t y cost of investing i n an asset i s usually defined as the anticipated rate of return on an incremental investment i n the best a l t e r n a t i v e . On the contrary, observed book rates or return are average returns on past investments. ' Second, the t r a d i t i o n a l i n t e r p r e t a t i o n of comparable earnings ignores c a p i t a l markets. This i s despite the statement made i n the court decision "the return to the equity owner" when the equity owner i s predominantly represented i n the c a p i t a l market. The shareholder i s not d i r e c t l y interested i n the r a t i o of book earning to the book value of a company he invests i n . He rather looks a t a n t i c i p a t e d dividends and c a p i t a l gains r e l a t i v e to the stock p r i c e he has to pay. However, the t r a d i t i o n a l approach i s not completely wrong, when shareholders base t h e i r a n t i c i p a t i o n s concerning dividends and/or c a p i t a l gains on the past perform-ance of the company. The a l t e r n a t i v e to the above approach suggested by the finance  theory i s to define "commensurate return" as the rate of return investors a n t i c i p a t e when they purchase equity shares of compar-able r i s k . This i s a market rate of return, defined in terms of 1) See Myers (25A) pp. 62-63. 2) The term "book" i s used to r e f e r to data based on income statements and balance sheets. Thus the book rate of return to equity i s the r a t i o of reported net income to net worth as shown on the firm's balance sheet. - 75 -anticipated dividends and c a p i t a l gains r e l a t i v e to stock p r i c e s . I d e a l l y , t h i s i s the rate that should be used to c a l c u l a t e the cost of equity. 1.2.0 FROI and the Competitive Market Under optimum conditions, regulation forces the company/ industry to operate at competitive l e v e l s of investment, p r i c e , output and p r o f i t . In p r a c t i c e , t h i s s i t u a t i o n i s d i f f i c u l t to achieve. Rate of return regulation can reduce or eliminate "monopoly p r o f i t s " . However, i t i s d i f f i c u l t to determine, whether such regulation produces the investments, outputs or prices that would occur i f a competitive s o l u t i o n could be achieved. Because of t h i s d i f f i c u l t y the f a i r rate of return regulation i s here assumed to be used f o r eliminating "monopoly p r o f i t s " . The problem, therefore, i s to set a f a i r rate of return that would be obtained in a competitive market. The theory of competitive markets implies that the cost of c a p i t a l of a regulated firm should be equal to the "market cost of c a p i t a l " and not to the h i s t o r i c a l rate of return on invest-ment concept. Myers supports t h i s argument as follows: An unregulated firm that has recently been able to earn more than i t s cost of c a p i t a l may not n e c e s s a r i l y be earning "mono-poly p r o f i t s " . The f i r m may be in an industry in which high p r o f i t s were not expected and therefore the rate of return a c t u a l l y earned came as a pleasant s u r p r i s e . This superior - 76 -r a t e o f return i s j u s t a "short-run" phenomen i n competitive markets and w i l l erode as markets s h i f t towards long-run e q u i l i b r i u m . However, short-run p r o f i t s or l o s s e s are more of t e n the r u l e than the exception. The adjustment to long-run e q u i l i b r i u m w i l l not be smooth, because o f u n c e r t a i n t y and con-3) tinuous t a r g e t changes. ' T h i s i s why the h i s t o r i c a l rates o f returns cannot be d i r e c t l y a p p l i e d . I t i s more r e l e v a n t to consider a n t i c i p a t e d r a t e s o f r e t u r n . Long-run e q u i l i b r i u m i n a competitive market implies t h a t the average expected r a t e o f return on new c a p i t a l investment equals the c o s t o f c a p i t a l . I f the average expected r a t e of r e t u r n does not equal the c o s t o f c a p i t a l then there w i l l be e n t r y o r e x i t from the i n d u s t r y . Thus i f the aim i s to e l i m i n a t e mono-poly p r o f i t s , the f o l l o w i n g r u l e should be accepted: Regulation should assure that the average expected r a t e o f  r e t u r n on d e s i r e d new investment i s equal to the r e g u l a t e d  firm's market cost of c a p i t a l . I f the above r u l e i s accepted, i t f o l l o w s that r a t e o f r e t u r n r e g u l a t i o n should be based on f i n a n c e theory and the market c o s t o f c a p i t a l . The above approach w i l l be taken during the study o f FROI f o r a i r c a r r i e r s . The embedded c o s t o f debt concept w i l l be replaced by the market c o s t o f debt. Likewise the h i s t o r i c a l c o s t o f e q u i t y w i l l be replaced with the market c o s t of e q u i t y . 3) Myers (25A) pp. 79-80, SUPRA - 77 -1.3.0 I n f l a t i o n Approaches taken during past r a t e hearings d i d not consider the p o s s i b l e e f f e c t s o f i n f l a t i o n . The f a i r r a t e o f r e t u r n requirement was based on book estimates and i t i n turn was a p p l i e d to a book value r a t e base. The book value r a t e base i s the o r i g i n a l c o s t of an a s s e t l e s s d e p r e c i a t i o n . Neither one of these components was adjusted to r e f l e c t a c t u a l i n f l a t i o n . F a i r r a t e of r e t u r n r e g u l a t i o n should i n c l u d e an " i n f l a t i o n adjustment" to e i t h e r the r a t e base or the allowed r a t e o f r e t u r n . In Canada, the i n f l a t i o n a r y adjustment to the r a t e base i s d i f f i c u l t as long as c o s t l e v e l accounting i s not a standard accounting procedure. U n t i l s t a n d a r d i s a t i o n i s p o s s i b l e the adjustment has to be made to the f a i r r a t e o f r e t u r n p e r m i s s i b l e . * In the f o l l o w i n g chapter which deals i n d e t a i l with FROI f o r a i r c a r r i e r s an automatic i n f l a t i o n adjustment i s i n c l u d e d . As s t a t e d p r e v i o u s l y the FROI equals the c o s t o f c a p i t a l which can a l s o be defined as the i n v e s t o r s opportunity c o s t . When i n v e s t o r s determine t h e i r minimum r e t u r n requirement on t h e i r investment they have to consider i n f l a t i o n and i t s probable e f f e c t on the r e g u l a t e d f i r m . Therefore when the r e g u l a t o r estimates t h i s r e t u r n r e q u i r e d by the i n v e s t o r s , using the stock p r i c e s as i n d i c a t o r s he w i l l o btain a r a t e which a u t o m a t i c a l l y includes the i n f l a t i o n adjustment. * T h i s adjustment requirement a p p l i e s to book r a t e of r e t u r n c a l c u l a t i o n s o n l y . - 78 -The proposed concept, which i s based on market values and investors expectations f o r the determination of the FROI does not consider the time i n t e r v a l s or parameters which require a re-evaluation of the FROI. Short term market f l u c t u a t i o n s and changes i n investors expectations may influence the market cost of c a p i t a l , but they are e s s e n t i a l l y s e l f - c a n c e l l i n g . In addi t i o n , the complexity and time requirements to change the FROI make i t p r o h i b i t i v e and impossible to accommodate short term f l u c t u a t i o n s . However, over a longer period market fl u c t u a t i o n s and changes i n investors expectations w i l l indicate a trend which must be considered. These market f l u c t u a t i o n s represent a potential weakness of an approach s t r i c t l y based on market values. In f a c t , there are two problems involved. F i r s t , investors may be wrong about t h e i r i n f l a t i o n expectations. A numerical example i l l u s t r a t e s the problem. The cost of equity i s 14% and the rate base ( a l l equity investment) i s $100. Suppose the 14% rate of return includes investors' expectation of 4% year i n f l a t i o n . Thus the regulators allow earnings of .14(100) = $14. Share price "PQ" i s EPS, D, 14 P 0 = "Tc = F ~ = = $ 1 0 ° U ke ke :14 The above equation i s based on the assumption of constant earnings that are a l l paid out in dividends. - 79 -Next, assume that there i s a c t u a l l y 12% i n f l a t i o n i n t = l , 8% more than expected. However, by the s t a r t of t=2, investors expect i n f l a t i o n to drop to the "normal" 4% l e v e l . Then k g i s again 14 at the s t a r t of period 2. I f the regulator now looks at the market cost of equity again, no adjustments i n the allowed return i s necessary. Share p r i c e w i l l remain at $100. The shareholders wealth i s $114 at the s t a r t of t=2, including earnings paid out during t = l . Obviously, the real rate of return to the investors i s very minimal. Whether t h i s i s f a i r i s a subjective question. ^ However, since investors also gain the benefits i f i n f l a t i o n i s less than a n t i c i p a t e d , the r i s k involved i s a part of the investment game. Based on th i s there i s l i t t l e or no reason to invoke any regulating strategy. The objective of the above discussion was to emphasize that the market value approach i s v a l i d , despite the f a c t that investors may be wrong about t h e i r i n f l a t i o n expectations. Further, there i s another equally important f a c t o r to be recognized when s e l e c t i n g the market approach. This second consideration i s market e f f i c i e n c y . In past rate hearings regulators have found i t d i f f i c u l t generally to base regulatory decisions on something as v o l a t i l e as the stock 4) See Myers (25A) p.78 - 80 -market. However, t h i s v o l a t i l i t y i s b a s i c a l l y a r e f l e c t i o n of the degree of r i s k of an asset. The stock market has to f l u c t u a t e , since part of i t s function i s to act as a locus f o r risk-bearing i n the economy. The question therefore i s , whether the stock market i s t r u l y e f f i c i e n t i n r e f l e c t i n g the r i s k and returns of alternate investment opportunities. An " e f f i c i e n t " market i s one in which at any point in time sec u r i t y prices f u l l y r e f l e c t a l l information a v a i l a b l e at that point i n time, and in which prices react quickly to new information as i t becomes a v a i l a b l e . ' The evidence so f a r indicates that the U.S. c a p i t a l markets are b a s i c a l l y e f f i c i e n t with respect to a r e l a t i v e l y broad set of information. The evidence i s summarized by Fama. ^ Since the Canadian and U.S. c a p i t a l markets i n t e r a c t very c l o s e l y , i t can be assumed that the same applies to Canada. Market e f f i c i e n c y , therefore confirms that stock prices are c l o s e l y coupled to information about the possible r i s k s and returns of a l t e r n a t i v e investment opportunities. The market's i r r a t i o n a l i t y or imperfection has only minor e f f e c t on market f l u c t u a t i o n s . Therefore, the market cost of c a p i t a l concept should be followed i n regulatory hearings. 5) See Fama (17) 6) Ibid pp. 383-417 - 81 -The l a s t hearing to determine the FROI f o r trunk c a r r i e r s i n the U.S.A. was held i n 1971. 7 ^ In Canada, Canadian a i r l i n e s have made ap p l i c a t i o n f o r fare increases twice during the l a s t two years, j u s t i f i e d by t h e i r 4. • 8) cost increases. ' While the lates t , four year period of review i n the U.S.A. i s obviously too long, the demand f o r rate increases on a ye a r l y basis by the Canadian c a r r i e r s seems to indic a t e that also the FROI could be reviewed y e a r l y . Whether the change in the cost of c a p i t a l i s r e a l i s t i c enough to j u s t i f y the adjustment of the FROI remains a matter of judgement by the C.T.C. F.ex. the double-digit i n f l a t i o n and the d i s t o r t i o n of the t r a d i t i o n a l r e l a t i o n s h i p between the y i e l d s earned by short-and long-term financing instruments i n 1974 necessitated the review of the FROI. Only i f and when the rate of i n f l a t i o n s e t t l e s on a lower level and the c a p i t a l market shows more s t a b i l i t y , a longer i n t e r v a l between reviews i s j u s t i f i e d . As stated previously, short-term market f l u c t u a t i o n s are e s s e n t i a l l y s e l f - c a n c e l l i n g , and do not invoke any regulatory a c t i o n . In contrast, long-term market f l u c t u a t i o n s demand att e n t i o n . A yearly or bi - y e a r l y review of the FROI w i l l assure that long-term market f l u c t u a t i o n s are considered. 7) See (6) 8) The fare increases were granted in J u l y 1974 and May 1975 - 82 -1.4.0 Capital Structure The problem of an appropriate c a p i t a l structure has been the most controversial issue i n past rate hearings. B a s i c a l l y , there are two questions to be answered. F i r s t , whether actual or optimal c a p i t a l structure should be used f o r the cost of c a p i t a l c a l c u l a t i o n . Second, i f an optimal c a p i t a l structure i s selected, how w i l l t h i s structure be derived at? 1.4.1 Actual vs. Optimal Calcu l a t i o n of F.R.O.I, should be performed f o r transcontinental c a r r i e r s on a group basis. The existence of substantial d i r e c t and i n d i r e c t competition within the group makes t h i s procedure necessary. The needs of individual c a r r i e r s cannot be considered, only the requirements of the group as an e n t i t y . I f the F.R.O.I, and consequent fare l e v e l s were to be based on the f i n a n c i a l need of the weakest c a r r i e r , the strongest c a r r i e r would probably r e a l i z e excessive p r o f i t s . On the other hand i f the fare s t r u c -ture were to be based on the f i n a n c i a l needs of the strongest competitor, the weaker c a r r i e r s would be denied an opportunity to earn a f a i r return and face even greater f i n a n c i a l d i f f i c u l t y . One could argue that basing the fare structure on the f i n a n c i a l needs of the strongest competitor would force the weaker ones to improve t h e i r e f f i c i e n c y . However, there i s an economic l i m i t to e f f i c i e n c y improvements. For comparison we assume two c a r r i e r s of the same s i z e and structure as measured by unit costs (cost per a v a i l a b l e seat m i l e ) . The c a p i t a l structures are - 83 -represented by debt/equity r a t i o s of 70/30 and 45/55. Generally, s a l a r i e s and fuel represent almost 60% of the oper-ating expenses. The remaining 40% includes maintenance, land-ing fees, t r a f f i c oriented and f i x e d expenses. Unless some d r a s t i c technological advances are made i t i s u n l i k e l y that the e f f i c i e n c y can be improved by the weaker c a r r i e r s u b s t a n t i a l l y to improve i t s f i n a n c i a l p o s i t i o n . How-ever, i f an a t t r a c t i v e FROI can be established i t w i l l give the weaker c a r r i e r an opportunity to improve i t s c a p i t a l structure and thereby i t s f i n a n c i a l p o s i t i o n . During the CAB passenger-fare i n v e s t i g a t i o n in 1971, Bureau Counsel urged that the overall rate of return be computed on the basis of the actual c a p i t a l structure of the domestic trunk-al l i n e industry as a whole. ' The Examiner held that the actual c a p i t a l structure should be employed, based on two f a c t s . F i r s t , the use of a hypothetical c a p i t a l structure would require adjustment of the cost rates f o r the debt and equity components ^ and second, the apparent absence of regulatory precedent f o r s u b s t i t u t i n g a lower hypo-t h e t i c a l debt r a t i o in place of the a c t u a l . The Examiner proved that no other u t i l i t y regulatory agency has to date substituted a hypothetical f o r an actual c a p i t a l struc-ture in determining a u t i l i t y ' s allowable rate of return, where the r e s u l t s would have been to increase the c a p i t a l costs 9) Their recommended debt/equity r a t i o was 60/40, the actual r a t i o as of December 31, 1969. 10) The argument i s that unless the cost rates are adjusted f o r changes in the debt/equity r a t i o s , i t i s not possible to choose a hypothetical c a p i t a l structure which w i l l avoid wide difference in rates of equity earnings of the i n d i v i d -ual companies when t h e i r actual c a p i t a l i z a t i o n vary widely, and at the same time achieve desirable economic r e s u l t s . - 84 -chargeable to the ratepayers. On the contrary, the use of the actual c a p i t a l structure i s almost the i n v a r i a b l e r u l e , with the only exception being (1) case involving wholly owned s u b s i d i a r i e s and (2) cases where the debt component of a u t i l i t y ' s c a p i t a l structure i s adjusted upward to avoid unduly burdening the ratepayers. ^ One of the witnesses, Mr. Kosh, contended that the return should be based upon an optimum c a p i t a l structure of 40% debt and 60% equity, assuming that leased equipment i s treated as construct-i v e l y owned. In the event the Board determines to recognize only the lease expenses r e l a t e d to the equipment, then he 12) recommends a debt r a t i o of 30/70. ' This contention i s based on the proposition that any r a t i o other than the optimum may well r e s u l t i n such low earnings as to (1) make i t impossible to improve c a p i t a l structure or (2) cause v o l a t i l e equity earnings, which renders i t more d i f f i c u l t to a t t r a c t equity c a p i t a l . Among the witnesses Mr. Kosh was the only one who attempted to determine in d e t a i l the optimal c a p i t a l structure. His c a p i t a l structure i s based upon debt/equity r a t i o which provides the trunk a i r l i n e s the same cushion against coverage of f i x e d charges - ( i . e . twice such charges - in the event of assumed declines in revenues and increases in expense) - as enjoyed by the e l e c t r i c u t i l i t i e s during 1963-1968. 11) See (6) Appendix A to dissent. 12) IBID, p. 5. 13) IBID, pp. 13-14. - 85 -F i n a l l y , the Board decided to compromise between the demands 14) f o r actual and optimal c a p i t a l s t r u ctures. ' I t concluded that under the present circumstances a f f e c t i n g the industry, a c a p i t a l structure of 45% debt and 55% equity should be u t i l i z e d . This w i l l represent a reasonable compromise between the actual stru c t u r e , the i n t e r e s t i n maintaining a reasonable amount of low cost debt c a p i t a l and the i n t e r e s t i n maintaining a soundly financed industry. The determination of t h i s c a p i t a l structure was based upon the following considerations: F i r s t , the a i r transport industry i s so heavily burdened with debt as to jeopardize the f i n a n c i a l s t a b i l i t y of many c a r r i e r s , and the D/E r a t i o w i l l have to improve i f the industry i s to obtain c a p i t a l on reasonable terms. Secondly, the p o l i c y of continuing to use the actual c a p i t a l structure would serve to perpetuate the present unsound structure. T h i r d l y , the use of a hypothetical c a p i t a l structure i s more applicable when dealing with a wide range of c a r r i e r s whose actual c a p i t a l structures vary widely and are c l e a r l y unsound. It should be emphasized that the Board's decision to use a debt/equity r a t i o of 45/55 i s based on t h e i r own judgement only. The Board agreed that Mr. Kosh provided a convincing argument supporting the v a l i d i t y of a debt component as low as 30%. ) Nevertheless, i t concluded that a debt component of 45% should be established. The use of a debt component any lower than t h i s 14) IBID, pp. 5-6. - 86 -would r i s k excessive returns to the equity holders as long as the industry average i s as high as 60%. A 45% debt component represents a reasonable point within the actual range of i n d i v i d -ual c a r r i e r debt proportions of t o t a l c a p i t a l (33% to 74%). In the Board's judgement t h i s represents a f a i r balance between the actual r a t i o s and a th e o r e t i c a l optimum. 1.4.2 Determination of Optimal Capital Structure Past rate hearings have not given much consideration to the deter-mination of an optimal c a p i t a l s tructure. The main reason f o r not considering t h i s was the regulatory bodies' p o l i c y to use actual c a p i t a l structures as mentioned above. Some consideration was given to t h i s issue i n the e a r l i e r A,T&T case i n 1959. It was emphasized then that an appropriate c a p i t a l structure f o r a p a r t i c u l a r enterprise i s a matter of experience and sound business judgement and no mathematical or s t a t i s t i c a l formula alone can determine a proper c a p i t a l structure. However, there are some important factors to be considered. These factors f a l l i n to two major categories: a) Nature and ov e r a l l r i s k of the business b) Necessity f o r maintaining high c r e d i t standards. The business r i s k i s r e f l e c t e d in the earnings h i s t o r y of the enterprise. The degree of earnings f l u c t u a t i o n s under changing economic conditions i s a major f a c t o r i n determining the advis-able balance between debt and equity c a p i t a l i n the business. 15) See Butters (2) pp. 235-241 - 87 -A company with the r i s k of widely f l u c t u a t i n g earnings may face serious cash flow d i f f i c u l t i e s i n periods of low earnings, and therefore cannot carry as high a debt as a company with r e l a t i v e l y stable earnings. Further, a company with a high operating r a t i o faces a greater r i s k of reduction of income with a drop in revenues than a company with a low operating r a t i o , since a l l expenses are not d i r e c t l y c o n t r o l l a b l e . When a high operating r a t i o i s accompanied by v o l a t i l e revenues, the investors earnings are subject to wide f l u c t u a t i o n s . It i s , therefore, necessary to l i m i t the debt c a r r i e d by the company to insure adequate coverage of f i x e d charges at a l l times. The A.T&T study indicated that i n the past debt r a t i o s have con-formed broadly to the respective i n s t a b i l i t y measures associated with each industry analysed. E l e c t r i c u t i l i t i e s , with r e l a t i v e l y stable earnings maintain a high average debt r a t i o . On the other hand, manufacturing com-panies, with r e l a t i v e l y unstable earnings, maintain a low average debt r a t i o . The Fixed Charge Coverage (Earnings Coverage) r a t i o i s a generally accepted c r i t e r i o n f o r debt capacity. It i s expressed as follows: Earnings before Fixed HXED CHARGE COVERAGE . J^ I^L Since d i f f e r e n t i n d u s t r i es have d i f f e r e n t amounts of non-cash expenses, EBIT i s not always an adequate representation of the cash a v a i l a b l e f o r debt s e r v i c i n g . Therefore the above r a t i o does not always provide comparable r e s u l t s . Another r a t i o should - 88 -be computed, where non-cash expenses are f i r s t added back to EBIT. The maintenance of a high c r e d i t standard i s necessary to obtain needed c a p i t a l on most favorable terms. Good c r e d i t means not only the a b i l i t y to r a i s e c a p i t a l but also to r a i s e i t at reason-able costs, and in time. This i s s p e c i a l l y important to a company, which must enter the c a p i t a l markets repeatedly. In conclusion, past rate hearings indicated major factors to be considered when determining the appropriate c a p i t a l structure. The d e c i s i o n , however, i n each case i s a matter of experience and judgement. - 89 -1.5.0 Estimation of Cost of Equity Capital The basic proposition underlying the cost of equity c a p i t a l concept i s , that the p r i c e of s e c u r i t i e s at any point i n time i s such that a l l s e c u r i t i e s of equivalent r i s k ( i . e . a l l secur-i t i e s i n a r i s k class) o f f e r the same expected rate of return. To estimate the cost of equity f o r the company being regulated, the basic problem i s to determine the expected rate of return f o r the p a r t i c u l a r r i s k class or the s e c u r i t y . There i s no mechanical way to solve t h i s problem. Measurement of expectations i s extremely d i f f i c u l t . There are, however, several types of evidence that can be evaluated and applied to derive a hopefully reasonable estimate. Foilowing ; approaches taken in past rate hearings w i l l be discussed. 1.5.1 DCF - Method Myers used the DCF-method as a means to determine the cost of analysing past trends and possible future developments of share-holders expectations. F i r s t , Myers assumed that the investors' expectations about A,T&T's future growth would be governed s o l e l y by i t s past growth in earnings and dividends per share. The dividend stream was expected to grow i n d e f i n i t e l y at a con-stant rate. Cost of equity was then calculated by applying the Gordon Formula: Myers r e a l i z e s that f o r u t i l i t i e s , f o r which a constant moderate 16) See Myers (26) pp. 31-38 f o r a more extensive review of the a p p l i c a t i o n of the DCF-Formula. Also, see Myers (25a) pp. 69-70. equity f o r A,T&T in 1971. 16) He used the DCF-formula f o r both + 9 - 90 -long-term trend i n earnings and dividends i s t y p i c a l the above formula i s a reasonable rule of thumb f o r estimating k g. How-ever, i t i s dangerous to assume the future growth rate to be constant and mechanically project i t to i n f i n i t y . Therefore, Myers secondly assumed that d i f f e r e n t growth rates are anticipated by the investor f o r d i f f e r e n t future periods. He used a simple s t r u c t u r a l model of the firm to project the possible dividend streams under d i f f e r e n t conditions of short-term growth, long-term growth and year-by-year book p r o f i t a b i l i t y . The dividend stream and the f i n a l estimate of the cost of equity c a p i t a l were based on these simulations. During the C.A.B. Passenger Fare Investigation i n 1971, ^ Mr. Kosh was the only one of the three p r i n c i p a l witnesses to employ the DCF-technique d i r e c t l y to a i r c a r r i e r data i n his cost of equity c a l c u l a t i o n . Kosh derived his dividend y i e l d s of a i r l i n e stock from the r e l a t i o n s h i p of dividends to market prices during the three 1 8 ) year period of 1967-69. ; To t h i s he added the percent of annual growth which he concluded a r a t i o n a l investor would have expected when he purchased shares of a i r l i n e stock i n 1967-69. In determining the growth f a c t o r , Kosh examined the growth in dividends as well as the growth in book equity f o r the period 1957 to 1969. 1 9 ) 17) See (6) pp. 19-23 f o r d e t a i l . 18) A 15-percent allowance f o r f l o a t a t i o n and "pressure" was added to the y i e l d s . 19) Because of the e r r a t i c nature of the dividend history f o r most of the a i r l i n e s Kosh u t i l i z e d dividend growth f o r only two of the c a r r i e r s and growth i n book value per share f o r the remainder, on the theory that growth i n book value would be r e f l e c t e d i n earnings. - 91 -However, the precise period used varied from c a r r i e r to c a r r i e r , based upon Kosh's judgement as to the period which a rati o n a l investor would examine in each instance. In f a c t , Kosh rejected in most cases data r e l a t i n g to the e a r l i e r part of the period analysed. His argument was that the e a r l i e r data would not be representative of investors' expectations of the future. Despite Mr. Kosh's q u a l i f i e d opinion on the matter, the Board considered i t l i k e l y that the sophisticated investor purchasing a i r l i n e stock in the 1967-69 period would have given weight to the e a r l i e r periods because of the widely known c y c l i c a l nature of the industry. The use of growth i n book value per share i n l i e u of dividend growth could also be c r i t i c i z e d . However, i t i s very hard to prove that, considering the e r r a t i c nature of a i r l i n e dividend growth, i t would have been more appropriate to u t i l i z e that f a c t o r rather than growth i n book value. The two other witnesses in the hearing rejected the a p p l i c a t i o n of the DCF-technique to a i r l i n e data as u n r e l i a b l e . The reason stated was the e r r a t i c dividend h i s t o r y and speculative nature of the assumptions which have to be made, regarding both investors' growth expectations, and the r e l a t i o n s h i p between stock market p r i c e s , a i r l i n e earnings, dividends and net worth. 2 ° ) While a i r l i n e earnings may have been e r r a t i c and stock prices unstable, (which can be expected from the market) the above 20) See Brown (7) and Foster (8) (Exhibits) f o r h i s t o r i c a l a i r l i n e data. - 92 -objection s t i l l remains a matter of opinion. H i s t o r i c a l l y , an erronous assumption i s made with the DCF-technique, p a r t i c u l a r l y when applied to an industry with v o l a t i l e earnings. This e r r o r i s the unquestioned v a l i d i t y of the assumption that the investor i n f a c t estimates future growth prospects s o l e l y by looking at past performance. However, assuming that because of the major changes i n the industry the investors give only minor consideration to past performance and major one to future developments of the company, the DCF-technique provides new useful information. The future-oriented DCF formula, used by Myers in the A,T&T case i n 1971, could be appropriate to the a i r l i n e industry. During the l a s t ten years the industry went through two major changes: from propellers to j e t s and from narrow bodied a i r -c r a f t to wide bodied equipment. Therefore, past performance alone, without considering technical advances, i s not relevant f o r forecasting future growth. Generally, the DCF-technique appears to produce r e s u l t s which are confirmed by other evidence, such as the earnings in com-parable i n d u s t r i e s . Accordingly, subject to the above caveats the DCF-technique i s a useful t o o l . However, the r e s u l t s s h a l l be considered in conjunction with the evidence, obtained through other techniques. 1.5.2 Capital Asset P r i c i n g Model The previously discussed Capital Asset P r i c i n g Model has not been widely used i n past rate hearings. The best known case, where the CAPM has recently been applied, i s the A,T&T hearing - 93 -i n 1971. ' Since there i s an apparent r e l a t i o n s h i p between the r i s k of firms in d i f f e r e n t r i s k classes and t h e i r relevant cost of c a p i t a l , Myers calculated a market s e n s i t i v i t y index (beta-factor) f o r A,T&T as well as f o r other l a r g e , well established firms. For comparison purposes, he then plotted each firm's average r i s k premium against the beta-factors as a • • 22) r i s k measure. ' Myers used the CAPM only f o r r i s k and return comparison. He did not attempt to use the model to obtain d i r e c t l y a cost of equity^ estimate f o r A,T&T. Although not intended f o r use in regulatory proceedings, Weston's study i s worth mentioning. Weston used the CAPM to determine d i r e c t l y the cost of equity f o r General Motors and Chrysler Corporation in order to obtain a hurdle rate f o r investment 23) decisions. ' With some reservations as discussed in the follo w i n g , his approach can be used for rate making purposes as w e l l . The c a p i t a l asset p r i c i n g model provides a t h e o r e t i c a l l i n k between corporate a c t i v i t i e s and the equilibrium market return a r i s i n g from owning the firm's shares. Thus, given the r i s k free r a t e of i n t e r e s t , the expected return and variance of the return to the market, and the corporate-beta, the equilibrium set of prices in the c a p i t a l market may be derived. Since the beta-f a c t o r i s the only variable which i s dependent on the 21) See Myers (26) pp. 15-24. 22) Myers obtained the figures f o r 75 firms i n three groups: the 25 l a r g e s t i n d u s t r i a l s i n Moody's 125 I n d u s t r i a l s , a random sample of 25 from remaining 100 firms on the Moody's 125 I n d u s t r i a l s and Moody's 24 u t i l i t i e s . 23) See Weston (35) pp. 25-32. - 94 -performance or the s p e c i f i c corporation under i n v e s t i g a t i o n , i t follows that the determination of t h i s f a c t o r i s c r i t i c a l f o r the e f f e c t i v e use of the c a p i t a l asset theory i n rate regulation. Breen and Lerner emphasize some dangers that are involved, i f 24) the beta-factor i s used in regulatory proceedings. ' They stress that the beta-factor i s a t h e o r e t i c a l concept which i s not d i r e c t l y measurable. Breen and Lerner established some standards that the beta-factor s h a l l meet from the perspective o f r e g u l a t i o n : The estimation procedure f o r beta should be well understood and the empirical findings should be unambiguous. Also there should be agreement on the data base, from which beta i s estimated. Following t h i s they state that estimates of beta prepared to date do not meet these standards. Market i n e f f i c i e n c y , i n s t a b i l i t y of beta and the choice of market index are l i s t e d as major estimating d i f f i c u l t i e s . Breen and Lerner point out that beta cannot be a s u f f i c i e n t r i s k measure unless the market i s in equilibrium. I f equilibrium does not e x i s t in the equity market, a portion of the firm's t o t a l r i s k cannot be d i v e r s i f i e d away by holding a large number of s e c u r i t i e s i n a p o r t f o l i o . Thus, unless e q u i l i -brium holds, beta w i l l not capture a l l the r i s k that i s associated with a p o r t f o l i o . They also emphasize that beta i s not stable over time and that regulatory decisions may increase the i n s t a b i l i t y . This may again l i m i t the accuracy of any conclusions, unless ways can be found to explain and p r e d i c t s h i f t s in beta. 24) See Breen-Lerner (15) pp. 612-617 - 95 -Further, Breen and Lerner argue that beta can change s i g n i f i -c a n tly i f d i f f e r e n t market indexes are constructed d i f f e r e n t l y and are not equally v o l a t i l e . Myers concludes that the choice of a market index should not 25) lead to excessive d i f f i c u l t i e s . ' The CAPM theory s p e c i f i e s the true market rate of return ( r j as the return on a market p o r t f o l i o composed of a l l shares. The appropriate index should be constructed from observed returns on a l l stocks, weighted by the r e l a t i v e market values of the outstanding shares of each stock. At present, there i s no a v a i l a b l e index which measures r m exactly. According to Myers t h i s i s not serious so long as the indexes are highly correlated with each other and with the true market return r . Therefore, such broadly based indexes as the Standard and Poor's 500 or the New York Stock Exchange Index should serve as s u i t a b l e proxies f o r the market. In the event of a major change in a company or industry, beta-factors based on past returns cannot be given much weight, as was the case with the DCF formula. The same kind of forecasting that i s used to estimate future growth rates f o r the DCF formula i s required f o r forward-looking estimates of beta. In addition to the above measurement d i f f i c u l t i e s , Myers emphasizes that the c a p i t a l asset p r i c i n g model does not indicate a l l facets about r i s k and return, on e i t h e r a t h e o r e t i c a l or empirical basis. 2 6 ^ I t would be short sighted to propose the CAPM formula as the exclusive technique f o r cost of equity estimation. However, the f a c t that the model may not be exact does not mean that i t should be thrown away. The information 25) See Myers (15c) pp. 624-625. 26) IBID pp. 626-627. - 96 -provided by the beta-factors, with the l i m i t a t i o n s as discussed above, can be used as a contribution to the evidence in regulatory proceedings. - 97 -1.5.3. Comparable Earnings Approach The comparable earnings approach i s governed by the p r i n c i p l e that the return to equity holders should be commensurate with returns on investments i n other enterprises having correspond-27) mg r i s k s . ' This i s also the p r i n c i p l e of rate of return regulation. In the previously discussed CAB hearing i n 1971, the witness f o r a group of a i r c a r r i e r s , Mr. Foster, followed t h i s approach. He believed that the earnings of the trunklines have been so e r r a t i c and market prices of t h e i r stocks so unstable that analyses of earnings and dividends r e l a t i v e to stock prices provided no useful i n d i c a t i o n of the current cost of common stock c a p i t a l . ^ Therefore, he chose to estimate the cost of equity f o r the trunklines i n the following two-step procedure. 1) The cost of common stock c a p i t a l i s determined f o r industry groups having r e l a t i v e l y stable earnings and earnings growth rates by using the DCF-technique. 2) Differences i n f i n a n c i a l , operating and market c h a r a c t e r i s t i c s as between the trunklines and the reference groups are analysed i n order to permit appropriate adjustment f o r the differences i n r i s k 29) and return requirements. ' 27) This i s from the Supreme Court Decision on Federal Power Commission et a l . v. Hope Natural Gas Company, 320 U.S. 591 (1944) at 603. 28) See Foster (8) p.26 supra. 29) The reference groups were 10 large e l e c t r i c u t i l i t i e s , 12 intermediate e l e c t r i c u t i l i t i e s , 9 gas pipelines and 11 food processors. - 98 -In other words, Foster used the estimated current market cost of equity of the reference groups as benchmarks, against which he estimated the current cost of common equity c a p i t a l to the trunk!ines by making upward adjustments f o r differences in r i s k . He also used as benchmarks the actual h i s t o r i c a l returns of the reference groups. The witness Brown employed the comparable earnings approach by e s t a b l i s h i n g only the r e l a t i o n s h i p between r i s k and 3 h i s t o r i c a l returns on book equity f o r d i f f e r e n t i n d u s t r i e s . For t h i s purpose he employed 12 r i s k measures under four categories (business r i s k , f i n a n c i a l r i s k , p r o f i t a b i l i t y r i s k , and investor r e a c t i o n ) , which were calculated f o r the 31) a i r l i n e s , four i n d u s t r i a l composites ' and 15 industry subgroups. While Foster only selected groups with a stable earnings h i s t o r y and with a r e l a t i v e l y low o v e r a l l r i s k , Brown t r i e d a l s o to f i n d i n d u s t r i e s with r i s k l e v e l s s i m i l a r to a i r l i n e s . A f t e r having established that the a i r l i n e s have more r i s k than the i n d u s t r i a l composite, Brown concluded that the appropriate cost of equity c a p i t a l f o r a i r l i n e s would l i e i n the range of those industry sub-groupings with the highest experienced returns. This i s the reason why he then divided 30) See Brown (7) pp.17-33 31) Moody's 125 I n d u s t r i a l s , and 24 E l e c t r i c U t i l i t i e s and Poor's 3 Telephone U t i l i t i e s and 11 Gas U t i l i t i e s r 9 9 -the i n d u s t r i a l composite into f i f t e e n industry sub-groups f o r a further study of the r e l a t i v e r i s k components. The major weakness of t h i s sub-group study was that Brown di d not pay any attention to the actual c a p i t a l structures of these sub-groups, as compared to the a i r l i n e s . He only compared the degree of r i s k i n terms of EPS, ROE, dividends/share and other p r o f i t a b i l i t y r i s k i n d i c a t o r s , ignoring f i n a n c i a l r i s k i n d i c a t o r s . Generally, the Brown study cannot be given much weight, because i t was based on h i s t o r i c a l data only. The mere f a c t that a p a r t i c u l a r industry group has achieved a rate of earnings l e v e l over a period of time does not e s t a b l i s h that rate as a reasonable leve l o f earnings f o r that industry. Earnings experienced i n a p a r t i c u l a r industry may well be more than needed to a t t r a c t c a p i t a l . Reliance upon such earnings alone f o r regulatory purposes could r e s u l t i n the establishment of an excessive rate of return. Foster's study i s more v a l i d , because he used both h i s t o r i c a l and current market data. While the comparable approach i t s e l f i s sound, i t s a p p l i c a t i o n and the conclusions drawn from i t can be ambiguous. There i s considerable room f o r subjective choices and conclusions. This approach may be used r e l i a b l y only i f i t takes into account a broad range of industry data. Even then, i t should not provide the major foundation f o r e s t a b l i s h i n g the cost o f equity estimate f o r FROI-determination. Rather, i t should be used as another bench mark f o r estimating the cost of equity. - 100 -1.5 .4 . Conclusion The r e s u l t s derived from the a p p l i c a t i o n of the DCF-technique and the CAPM, to the industry involved, combined with the r e s u l t s of the comparable earnings approach, to i n d u s t r i e s with s i m i l a r r i s k c h a r a c t e r i s t i c s , provides use-f u l information f o r the cost of equity estimation. In a d d i t i o n , the past i n t e r e s t rates and ex post rates of return to investors should also be considered. However, the f i n a l value of the cost of equity w i l l be an estimate based on the most objective evaluation possible of the methods and t h e i r r e s u l t s stated above. - 101 -2.0.0 The Approach Most Consistent With the Theory of Finance This chapter discusses how a f a i r rate of return standard should be determined for a Canadian transcontinental a i r c a r r i e r , con-s i s t e n t with the p r i n c i p l e s of modern finance theory. The results of the previous review of past fare hearings, e v a l -uating the advantages andweaknesses of the approaches taken, w i l l be used as a guide l i n e f o r t h i s chapter. Available sources of finance for Canadian a i r c a r r i e r s , c a p i t a l structures, determination of the cost of debt and equity c a p i t a l w i l l be discussed. 2.1.0 A l t e r n a t i v e Sources of Finance CANADIAN AIR CARRIERS DEPEND ON THE FOLLOWING MAJOR SOURCES OF FINANCE: A. INTERNAL FINANCING The two p r i n c i p a l sources of internal financing are e s s e n t i a l l y depreciation and retained earnings*; depreciation being the most important source. B. EXTERNAL FINANCING 1. Export-Import Financing With respect to external f i n a n c i n g , export financing continues to be the major sin g l e source of borrowing - 102 -for a l l non-U.S. a i r l i n e s , including Canadian a i r c a r r i e r s . Ten-year term loans are now a v a i l a b l e from the U.S. Export-Import Bank on narrow-body j e t s . Until recently these loans were a v a i l a b l e only f o r the d i r e c t financing of wide-body j e t s . The EXIM Bank rate was recently increased to 7% from the previous 6% l e v e l . 2. Leasing Leasing i s becoming increasingly popular as an alternate source of finance among the a i r l i n e s . However, the main source of lease financing remains in the U.S. where a l l major a i r c r a f t manufacturers are located and where a i r c r a f t leasing i n s t i t u t i o n s are more numerous than in Canada. . This creates d i f f i c u l t i e s f o r a non-U.S. lessee. The a i r l i n e becomes an operator of a U.S. owned and registered a i r c r a f t , with a l l the associated l e g a l , insurance and safety regulation problems. For example a U.S. registered a i r c r a f t i s subject to U.S. airworthiness regulations. This w i l l require the a i r c r a f t to be subjected to an overhaul at the manufacturers plant, with a r e s u l t i n g appreciation i n value f o r which the lessee has to pay the duties on return of the a i r c r a f t to Canada. - 103 -3. The Canadian Capital Market The natural source of external finance f o r a Canadian transcontinental a i r c a r r i e r should be the Canadian c a p i t a l market. Recent developments in the general economy and in the stock market have badly shaken the investors' confidence i n the stock market. Therefore, the equity market has been p r a c t i c a l l y closed as a source of financing f o r Canadian firms. What, funds are a v a i l a b l e , are at exceptionally high cost. In the past, investors have generally had a r e a l i s t i c idea of the long-run real growth potential of the cor-porate sector. However, f o r many years they v/ere overly o p t i m i s t i c about the long-run i n f l a t i o n rate. As a r e s u l t , investors have recently been receiving minimal, even negative real rates of returns on t h e i r p o r t f o l i o s . In 1975, investors l i v e d in a world i n which investors' uncertainty was reaching i t s highest peak. The desire f o r s e c u r i t y and l i q u i d i t y has depressed real y i e l d s on short-term and low-risk paper and sharply raised required rates of return on long-term and r i s k y instruments. It may s t i l l take quite some time, before the investors' confidence i n the stock market w i l l return. Also, the recent high long-term i n f l a t i o n expectations may decline very slowly. - 104 -2.2.0 Capital Structure As discussed i n the review section of t h i s chapter, e i t h e r the actual or optimal c a p i t a l structure can be used, when c a l c u l a t i n g the weighted average cost of c a p i t a l . The choice w i l l depend on the factors given major importance in each s i t u a t i o n . 2.2.1 Actual Capital Structure The debt/equity r a t i o of A i r Canada was 95/5 at the end of 1974. CP A i r ' s corresponding ratio, was 85/15, assuming c a p i t a l i z a t i o n of leases. Had the leases not been c a p i t a l -i z e d , the debt/equity r a t i o would have been 50/50. 2.2.2 Optimal Capital Structure As emphasized before, i t i s very d i f f i c u l t i n a c t u a l i t y to determine an optimal c a p i t a l structure f o r an operating company. Therefore, an attempt has to be made to e s t a b l i s h at l e a s t a "reasonable" c a p i t a l structure f o r t r a n s c o n t i -nental a i r c a r r i e r s . The Fixed Charge Coverage r a t i o i s a generally accepted c r i t e r i o n f o r debt capacity. In add i t i o n , other benchmarks are provided by the actual c a p i t a l structures of other Canadian industry groups, regional and U.S. t r u n k c a r r i e r s . - 105 -FIXED CHARGE COVERAGE MULTIPLE During the U.S. rate of return i n v e s t i g a t i o n , an optimum debt/equity r a t i o was developed which would provide the trunklines an earnings cushion equal to twice the amount of i n t e r e s t and other f i x e d charges. Thereby, i f there i s a decline of revenue or an increase i n operating expenses, the f i x e d charges would s t i l l be covered. The amount o f th i s cushion i s the same as that, which was enjoyed by the more stable e l e c t r i c u t i l i t i e s during 1963-1968 in the U.S.A. 3 3 ) In Canada, the average f i x e d charge coverage multiple f o r e l e c t r i c , gas and water u t i l i t i e s as a group, in 1972 and 1973, was 2.2. (ATTACHMENT- C5). If depreciation i s added back to EBIT, the multiple i s 2.7. Since a i r l i n e s are more vulnerable to f l u c t u a t i o n s i n revenues and expenses than u t i l i t i e s , a coverage greater than twice the fi x e d charges may be j u s t i f i a b l e . However, the high non-cash expenses of the a i r l i n e act as a compen-sator i n a year of a large f l u c t u a t i o n , reducing the r i s k of cash insolvency. Therefore, the u t i l i t i e s and a i r l i n e s should be able to manage with a s i m i l a r f i x e d charge coverage r a t i o . 33) See (6) p.p. 13-14. - 106 -The past v a r i a t i o n s i n Earnings before Interest and Taxes (EBIT) are expressed here as v a r i a t i o n of the operating margin. Operating margin expresses EBIT as a percentage of operating revenue. During the period of 1962-1973, the operating margin of A i r Canada ranged from 4% to 7.8%. During the same period, the operating margin of CP A i r ranged from 2.5% to +13.3%. (ATTACHMENT C8). It can be seen from the above attachment that a f t e r 1967 CP A i r ' s large operating margin f l u c t u a t i o n s started to l e v e l out. In 1967-1973, the range was 4.4.-7.4%. The year of 1974 was a year of low earnings f o r both c a r r i e r s . Recorded operating margin of A i r Canada was 4% and of CP A i r 5%. Based on past experience, a low operating margin of 2-3% i s very exceptional, and can be used as a lower l i m i t f o r estimating the v a r i a t i o n s in the future EBIT. I f earnings should f a l l below the above l e v e l , a i r c a r r i e r s s t i l l have s u f f i c i e n t cash flow a v a i l a b l e . (EBIT discussed was obtained a f t e r deducting depreciation.) EXHIBIT 4 demonstrates the determination of the range o f reasonable amount of debt c a p i t a l that can be c a r r i e d by Transcontinental A i r c a r r i e r s . I f the operating margin i s - 107 -as low as 3%, the a i r c a r r i e r s are able to pay i n t e r e s t on 43% of debt c a p i t a l and s t i l l make f u l l use o f t h e i r c a p i t a l cost allowance. EXHIBIT 3 shows the number of times the a i r c a r r i e r ' s earnings would cover the f i x e d charges i n 1974, assuming a debt/equity r a t i o of 45/55 and an average operating margin 5-6%. With an operating margin of 6%, the multiple i s 1.9 a f t e r depreciation and 5.0 before depreciation. Based on the above f i n d i n g s , the 45/55 equity r a t i o appears reasonable. CANADIAN INDUSTRIAL DEBT/EQUITY RATIOS The debt/equity r a t i o s of selected Canadian industries at the end o f 1974 were as follows: Debt/Equity Transportation Equipment Industries 12/88 E l e c t r i c a l Products Industries 16/84 A l l Industries 29/71 Transportation 47/53 U t i l i t i e s 56/44 The f a c t that even u t i l i t i e s , a low r i s k group, have in excess of 40% equity and that the o v e r a l l industry average i s 71% equity, c l e a r l y indicates that at l e a s t 55% equity in the a i r c a r r i e r s ' c a p i t a l structure i s j u s t i f i a b l e . - 108 -Since the a i r transport industry i s more r i s k y than Canadian industries on the average (see Risk Analysis in the next chapter), the above debt/equity r a t i o s indicate that a i r c a r r i e r s should have even more than 70% equity i n t h e i r c a p i t a l structures. This i s not, however, necessary because the a i r c a r r i e r s have very 34) high non-cash expenses as compared to other i n d u s t r i e s . The high non-cash expenses of the a i r l i n e act as a compen-sator i n a year of a large f l u c t u a t i o n , thereby reducing the r i s k of cash insolvency. DEBT/EQUITY RATIOS OF CANADIAN REGIONAL CARRIERS The debt/equity r a t i o s of the f i v e Canadian regional c a r r i e r s at the end of 1974 were as follows: Debt/Equity Eastern Provincial 70/30 Nordair 59/41 P a c i f i c Western 60/40 Quebec A i r 66/34 Transair 61/39 34) In 1973, non-cash expenses as a percentage of t o t a l operating expenses were as follows: Transcontinental "Carriers 10.9% A l l Industries 3.1% Transportation Equipment Industries 1.1% E l e c t r i c a l Product Industries 1.8% - 109 -While i t i s recognized that the business r i s k c h a r a c t e r i s t i c s of regional and transcontinental c a r r i e r s are quite d i f f e r e n t , the above r a t i o s give some i n d i c a t i o n , on what l e v e l the debt/ equity r a t i o s of transcontinental c a r r i e r s could be. The above r a t i o s show that the regional c a r r i e r s are even more heavily loaded with debt than the Canadian u t i l i t i e s . Government subsidies may have some e f f e c t in reducing the v o l a t i l i t y of earnings and therefore, the c a r r i e r s can manage with such high debt r a t i o s . The general f e e l i n g i s , however, that i f the c a r r i e r s wish to a t t r a c t new equity c a p i t a l in the market at reasonable cost, they f i r s t have to reduce the amount of debt 35) in t h e i r c a p i t a l structures. ' In conclusion, transcontin-ental c a r r i e r s which are assumed to operate independently without any subsidies, should d e f i n i t e l y have les s than 60% debt in t h e i r c a p i t a l structures. DEBT/EQUITY RATIOS OF U.S. TRUNK CARRIERS The debt/equity r a t i o s of the eleven U.S. trunk c a r r i e r s at the end of 1974 were as follows: Debt/Equity American 46/54 B r a n i f f 60/40 Continental 69/31 Delta (30/6/74) 44/56 35) Meeting of f i n a n c i a l representatives of the a i r c a r r i e r s to discuss the return on investment subject in Vancouver, November 1974. See also the 1971 CAB Hearing in the U.S. as discussed in IV.1.4.1. - n o -Debt/Equity Eastern 60/31 National (30/6/74) 46/54 Northwest 27/73 Pan American 74/26 TWA 69/31 United 54/46 Western 46/54 Eastern, Pan Am and TWA obviously have an excessive amount of debt i n t h e i r c a p i t a l structures. This f a c t has been contributing to t h e i r recent f i n a n c i a l d i f f i c u l t i e s . Out of the remaining eight c a r r i e r s four have a debt/equity r a t i o on the 45/55 l e v e l . In 1971, the 45/55 l e v e l structure was considered by the C.A.B. an optimum industry average f o r trunk c a r r i e r s . I t was accepted as a reasonable compromise between the desire of maintaining a reasonable amount of low cost debt c a p i t a l and of maintaining a soundly financed industry. Although the decision was c r i t i c i z e d at the time, the debt/ equity r a t i o selected cannot be too f a r from the th e o r e t i c a l optimum representing the ideal c a p i t a l structure. This i s best proven by the f a c t that U.S. trunk c a r r i e r s a c t u a l l y are t r y i n g to increase the equity content in t h e i r c a p i t a l - I l l -structures to bring the debt/equity r a t i o to the 45/55 l e v e l , (e.g. the debt/equity r a t i o of American and Western in 1973 was 54/46). Based on the above and previous discussions, the debt/equity r a t i o of 45/55 i s recommended as a reasonable c a p i t a l structure f o r Canadian transcontinental c a r r i e r s . 2.3.0 Cost of Debt The current market cost of debt before tax i s the rate at which new long term debt financing i s at present a v a i l a b l e to a i r c a r r i e r s at approximately 10.5 - 11.5%. This estimate i s based on l a t e s t corporate bond y i e l d s as indicated by McLeod, Young and Weir 10 I n d u s t r i a l s . (Exhibit 9A). Interest rate trends w i l l be discussed in more d e t a i l i n Chapter V. It should be emphasized that a i r c a r r i e r s can obtain some of t h e i r debt financing from the EXIM Bank at 7%. If e.g. 50% i s acquired from Canadian sources at 11% and 50% from EXIM Bank at 7%, the weighted current cost of debt would be 9.0%. 2.4.0 Cost of Equity One of the economic c r i t e r i a f o r the f a i r rate of return requirement was, that FROI should be commensurate with returns on investment being earned by industries with corresponding r i s k s . This c r i t e r i o n i s consistent with - 112 -the p r i n c i p l e i n the theory of finance that the cost of equity c a p i t a l i s not something unique to each firm. Rather, i t i s s i m i l a r f o r an en t i r e c l a s s of equivalent r i s k s e c u r i t i e s . Therefore, there i s no need to base the estimate of an a i r c a r r i e r ' s cost of equity s o l e l y on data pertaining to a c a r r i e r . One can and should broaden the analysis by using data of other firms. The i n t e r p r e t a t i o n of t h i s data again depends on the r i s k of the a i r c a r r i e r ' s stock r e l a t i v e to other firms' stocks. As was concluded i n the review s e c t i o n , there i s no mechanical way to determine the expected rate of return f o r the cl a s s i n which the stock f a l l s . A l l the tools used f o r the evaluation have t h e i r own weaknesses. However, when the several types of evidence, obtained through a p p l i c a t i o n of various techniques, are combined, the ultimate judgement can be made and considered reasonable. Evidence should be c o l l e c t e d by applying the following techniques: 1 . Interest Rates Interest rates on corporate bonds and other debt instruments can be r e a d i l y observed to provide a base f o r the estimate. Change in the basic l e v e l of i n t e r e s t rates normally correspond i n d i r e c t i o n to changes in the cost of equity c a p i t a l . - 113 -2. Ex Post Rates of Return to Investors Averaging of ex post rates of return gives some in d i c a t i o n of the relevant range of expectations. These averages are most helpful to the extent that they cover a long period of time (30-50 years) and many stocks. ^ 3. DCF-Formulae DCF-formula should be applied to a i r c a r r i e r data, by considering both past experience and future-oriented growth rates. 4. CAPM-Model The CAPM-model could also be used with some reservations. 3 ^ 5. Comparable Earnings Approach Comparable earnings study should be performed to determine the cost of equity f o r regulated and non-regulated industry groups with d i f f e r e n t l e v e l s of r i s k and determine where the a i r c a r r i e r s f i t i n t h i s p i c t u r e . 36) For instance, Fisher and Lorie (18) made an extensive study. 37) See discussion i n IV.1.5.2. - 114 -3.0.0. P r a c t i c a l Limitations due to the Unique C h a r a c t e r i s t i c s of the Canadian Transcontinental A i r C a r r i e r s v The above approach described "how i t should be done", i . e . how the cost of c a p i t a l should be calculated f o r a Canadian transcontinental a i r c a r r i e r , which competes fo r new debt and equity c a p i t a l i n an e f f i c i e n t c a p i t a l market. However, there are some severe problems, shares of A i r Canada or CP A i r are not traded on any Stock Exchange. Even i f the r e l a t i v e degree of r i s k of these two companies could be determined, by using t r a d i t i o n a l variables r e f l e c t i n g business and f i n a n c i a l r i s k as a measure, the cost of equity f o r these companies may not be the same as f o r the other companies in the same r i s k c l a s s . The return on equity required by the shareholders of these two companies may d i f f e r from the returns required by investors in other companies f o r the following reasons. 3.1.0 A i r Canada The actual high debt/equity r a t i o indicates obviously a very high f i n a n c i a l r i s k . However the shareholders may and do not require as high a return as compensation f o r the apparent high f i n a n c i a l r i s k as they would i n any other company. This can be explained by the nature of the shareholders. The major shareholder i s Canadian - 115 -National, which again i s a Crown Corporation. In f a c t , both the majority of debt and equity c a p i t a l i s provided by the same source - the Federal Government. Therefore, the theory of finance about leverage, r i s k and returns required cannot be applied i n the unique case of A i r Canada - as i t stands at the present. The dividend p o l i c y of A i r Canada during the l a s t 10 years gives some in d i c a t i o n of the current s t a t i c s i t u a t i o n . The same steady dividend of $4 per share has been paid out every year. There has been no growth i n dividends, nor any interruptions in dividend payments, despite the fl u c t u a t i o n of the annual net income and portion of debt in the c a p i t a l structure. A dividend of $4 per share based on the par value of the share of $100 re s u l t s i n a y i e l d of 4%. I t i s , however, very d i f f i c u l t to estimate how the share would rate on the market and what growth expectations the possible investors would have. As f a r as cost of debt i s concerned, i t i s obvious that Government Bonds are a cheaper form of debt financing than most of the other instruments of debt f i n a n c i n g , a v a i l a b l e f o r non-Crown corporations. 3.2.0 CP A i r At present, CP A i r ' s only shareholder i s the parent company, Canadian P a c i f i c Ltd. (CP Ltd.) - 116 -The return required on equity investment depends on the inherent r i s k which, in turn, i s affected by the degree of d i v e r s i f i c a t i o n by an investor. CP Ltd. has a l a r g e , well d i v e r s i f i e d investment p o r t f o l i o as shown in the following. CP Ltd. owns the second l a r g e s t r a i l r o a d i n Canada. I t i s also engaged in non-railroad a c t i v i t i e s through a holding company f o r non-transportion i n t e r e s t s in Cominco Ltd., in Pan Canadian Petroleum Ltd., in P a c i f i c Logging, CP Hotels and Marathon Realty Co. Its subsidiary, CP S e c u r i t i e s Ltd., finances the c a p i t a l projects of the a f f i l i a t e s . Other a c t i v i t i e s include a telecommunication system, CP Steamdships Ltd., and 3 wholly owned trucking s u b s i d i a r i e s . Within t h i s investment p o r t f o l i o CP A i r complements the d i v e r s i f i c a t i o n . I f the n o n - d i v e r s i f i e d investors would determine the market p r i c e s , the return on investment in CP A i r required by CP Ltd. could be lower than the return required by an investor in another company of the same r i s k c l a s s . In r e a l i t y , the investors l i k e Pension Funds and Insurance Companies hold even more d i v e r s i f i e d port-f o l i o s than CP Ltd. Therefore, the return required by CP Ltd. may be equal to or higher than the return required on the market. Although there i s no market pr i c e f o r CP A i r shares, a vague estimate about the past expectations of CP Ltd. can be derived from the issue price per share and dividends - 117 -paid during the l a s t eight years; assuming that r e a l i t y happened to coincide with expectations. DQ = the dividends declared payable on December 3 1 , 1974 and on June 2 8 , 1974 PQ = market price i s assumed to be the issue p r i c e . This can be defended by the f a c t that CP A i r has maintained i t s dividends f o r 5 years, while increasing the net book value of common shares. g = actual average annual growth of dividends since 1968. As f a r as debt financing i s concerned, CP A i r ' s p e c u l i a r p o s i t i o n as rela t e d to i t s parent company i s again obvious. CP A i r cur r e n t l y has a $11 ,000 ,000 loan from the Export-Import Bank. The remaining financing arrangements are with CP Ltd.: A $18 ,000 ,000 demand loan from CP S e c u r i t i e s Ltd., and lease arrangements with the parent company valued i n fj + g = .54 + .05 = 15.8%, where 5.00 K g = return on equity c a p i t a l expected excess of $100 ,000 ,000 . These leases are curr e n t l y shown as long term debt i n the f i n a n c i a l statements. I t should be emphasized, however, that financing through the parent company i s not low cost - 118 -financing f o r CP A i r . For the $18,000,000 demand loan CP A i r pays i n t e r e s t at prime rate + 3/4 of 1%. And although the benefits gained by the lessor (CP S e c u r i t i e s Ltd.) remain with the same parent company, CP A i r i s charged as a minimum the p r e v a i l i n g prime rate f o r i t s lease arrangements. Nevertheless, the main point i s that these leases are r e a d i l y a v a i l a b l e , without g r e a t l y increasing the cost of equity c a p i t a l due to the r i s k s normally involved with leas i n g . Because the shareholder and the le s s o r i s the same corporate e n t i t y , no additional r i s k i s created to the shareholder due to the lease arrangement and there-fore no higher return on equity may be required. I t appears that without the parent company, CP A i r would not be able to lease finance over 90% of i t s f l e e t . In summary, CP A i r does not b a s i c a l l y benefit from i t s pec u l i a r p o s i t i o n with the parent company i n the form of lower cost of debt or equity financing. The only benefit f o r CP A i r from the above arrangement i s a highly l e v e r -aged c a p i t a l structure.caused by the lease arrangements which may not greatly increase the cost of equity c a p i t a l . - 119 -4.0.0. The Approach Selected to Determine the FROI for Canadian Transcontinental A i r Ca r r i e r s 4.1.0 Hypothetical C a r r i e r - Canadian Continental Given the preceding sections of t h i s chapter, there are b a s i c a l l y two a l t e r n a t i v e approaches f o r determining the FROI. 1. Determine the FROI f o r the two Canadian transcontinental c a r r i e r s as they a c t u a l l y e x i s t , considering t h e i r unusual c a p i t a l structures and re l a t i o n s h i p s with the Federal Government and CP Ltd. 2. Determine the FROI f o r a hypothetical independent transcontinental c a r r i e r which would be financed by r a i s i n g funds e x c l u s i v e l y i n the market. Both CP A i r and A i r Canada have an excessive amount of debt c a p i t a l as compared with the "reasonable" c a p i t a l structure f o r c a r r i e r s which was discussed previously. I f the cost of c a p i t a l c a l c u l a t i o n was based on the actual c a p i t a l structures, the FROI determined would be low and would tend to indicate an u t t e r l y u n r e a l i s t i c condition as compared with the current c a p i t a l market. With the allowable earnings l i m i t e d to the level set by the FROI as st i p u l a t e d above, both c a r r i e r s would face great di f f i -c u l t y to obtain any new c a p i t a l i n the market. 38) In 1975, the c a r r i e r s w i l l hardly meet even t h i s le v e l of earnings. These comments are meant f o r future and better years. - 120 -In comparison with the foregoing, by using the model of a hypothetical a i r l i n e with a more reasonable c a p i t a l structure as a basis, a more representative FROI can be determined. The level of t h i s FROI would be higher than the current cost of c a p i t a l f o r e i t h e r A i r Canada or CP A i r . This FROI d i f f e r e n t i a l could then serve as a guide to both the c a r r i e r s and the regulator to progress-i v e l y permit a change i n the c a r r i e r s c a p i t a l structure to a more reasonable l e v e l . The second approach also i s more appropriate based on the p o s s i b i l i t y that both transcontinental c a r r i e r s may go public i n the near future. This assumption can be j u s t i f i e d as follows: a) The Federal Government i s reported to be exploring the p o s s i b i l i t i e s of refinancing A i r Canada by writing o f f some of i t s debts. This can be seen as a f i r s t step towards 39) becoming a more independent a i r l i n e . ' b) In a major p o l i c y statement on transportation, June 16, 1975, Transport Minister Jean Marchand proposed l e g i s l a t i o n to separate A i r Canada from the Canadian National Railways and giving i t a separate corporate e n t i t y . 39) This i s assuming that A i r Canada a c t u a l l y uses the opportunity given, and does not s t a r t to accumulate a new heavy load of debt. - 121 -c) CP A i r i s also planning to go to the open market f o r new equity c a p i t a l . A preliminary prospectus was prepared in 1974. However, the plan was suspended because of the weak market s i t u a t i o n . Based on the foregoing considerations t h i s thesis i s an attempt to determine a FROI f o r a hypothetical independent transcontinental a i r c a r r i e r , and thereby determine what return the investors at large would a n t i c i p a t e in the event that A i r Canada and/or CP A i r went pu b l i c . To make the approach selected more r e a l i s t i c , a hypothetical independent transcontinental c a r r i e r "Canadian Continental" w i l l be created. This c a r r i e r w i l l have a normal c a p i t a l structure compatible with a competitive c a p i t a l market. Based on the previous discussion about the c a p i t a l s t r u c t u r e , the debt Equity r a t i o assumed w i l l be 45/55. It i s assumed, that "Can-Con" i s a public company, whose shares are traded on the Toronto Stock Exchange. It competes f o r new debt and equity c a p i t a l market with other Canadian and possibly American companies representing d i f f e r e n t i n d u s t r i e s . "Can-Con" derives most of i t s operating revenue (90%) from scheduled passenger operations. Approximately 6% of the revenue comes from cargo and mail operations, while the - 122 -remaining 4% consists of charter and incidental revenue. This assumed operation pattern i s very much l i k e the one of A i r Canada and CP; A i r . 4.2.0. Basic Assumptions 1• Total System Operations For determining the FROI, the t o t a l system operations concept w i l l be considered. Scheduled passenger transportation, cargo and charter operations are not separated. This i s despite the f a c t that FROI may be used for the c a l c u l a t i o n of passenger fares and in t h i s case, scheduled passenger transportation should be considered as a separate item. The reasons f o r not separating the operations are as follows: a) In 1974, the scheduled passenger operation revenue of trans-continental c a r r i e r s represented approximately 85% of the t o t a l operating revenue. Because of t h i s predominence of scheduled passenger operations the operations are not separated. The d i f f e r e n t business r i s k s concerning the cargo and charter operations i s recognized, but considering t h e i r l i m i t e d impact ignored in t h i s study. b) I t i s p r a c t i c a l l y impossible to c a l c u l a t e the cost of c a p i t a l f o r scheduled passenger service separately from the other a c t i v i t i e s of the carrier.,, I f the f r e i g h t or charter operations f l e e t would be separate from the scheduled operations f l e e t , the task would be e a s i e r , A i r Canada's and CP A i r ' s a i r c r a f t carry both f r e i g h t and passengers in continuously changing r a t i o s . None of the a i r c r a f t are s p e c i f i c a l l y assigned to charter operations. Therefore, i t i s - 123 -extremely d i f f i c u l t to d i s t i n g u i s h between the scheduled passenger operation - related investment and others. After Tax Basis A f a i r rate of return can be determined on e i t h e r , before or a f t e r tax basis. For the purpose of t h i s study and to enable a comparison with the CAB - f a i r rate of return, the f a i r rate of return w i l l be calculated on an a f t e r tax basis, but before i n t e r e s t on long-term debt. Therefore, no allowance has to be made for taxes i n the rate of return. In other words, the FROI i s that percentage, which when applied to the investment base, produces enough current d o l l a r s to meet the annual i n t e r e s t payments and give the required compensation to the equity holders. In the cost of c a p i t a l c a l c u l a t i o n t h i s assumption means that the cost of debt has to be calculated on a before tax basis. The following example i l l u s t r a t e s the p r i n c i p l e : A i r C a r r i e r Investment Debt $ 45,000 at 8.5% Equity $ 55,000 at 17.0% Total $100,000 A i r C a r r i e r Operating Results EBIT $22,525 Interest 3,825 Cost $3,825 (before tax) $9,350 ( a f t e r tax) The Actual ROI Net Income a f t e r tax $ 9,350 Net Income before tax $18,700 Net Income a f t e r tax $ 9,350 + Interest Return Base Investment Base ROI 3,825 $ 13,175 $100,000 13.2% The F a i r ROI Weighted average cost of c a p i t a l : .45 (8.5%) + .55 (17.0%) = 13.2% - 124 -4.3.0 Sources of Evidence f o r Cost of Equity Estimation As a hypothetical c a r r i e r , Can-Con i t s e l f cannot provide any actual data. Therefore, e x i s t i n g market and operational data of other c a r r i e r s has to be used to create the hypothetical c a r r i e r . 4.3.1 DCF-Formula and Beta-Factors Since neither the shares of A i r Canada nor CP A i r are p u b l i c l y traded, a i r l i n e stock market data f o r Can-Con could be acquired from the remaining two sources: Canadian regional c a r r i e r s or from U.S. trunk c a r r i e r s . The business r i s k c h a r a c t e r i s t i c s of Canadian regional and transcontinental c a r r i e r s are quite d i f f e r e n t . The demand f o r the services provided by the regional c a r r i e r s depends to a large extent on the economic conditions of the region served. In comparison, transcontinental c a r r i e r s are more affected by the general economic conditions of the country. Also, the operational c h a r a c t e r i s t i c s of the two c a r r i e r groups d i f f e r . Regional c a r r i e r s provide short-haul, m u l t i -stop service with small a i r c r a f t , while the stage length of transcontinental c a r r i e r s i s longer and requires l a r g e r a i r -c r a f t . At present, Canadian regional c a r r i e r s are also more charter-40) oriented than the transcontinental c a r r i e r s . ' 40) In 1974, 26% vs. 3% of operating revenue. - 125 -Another important factor contributing to r i s k d i f f e r e n t i a l i s Government subsidies to c a r r i e r s providing service on unprofitable routes. Based on the above business r i s k d i f f e r e n t i a l s , the use of regional c a r r i e r stock market data as a source of information i s rejected. There are more s i m i l a r i t i e s to be found between U.S. trunk and Canadian transcontinental c a r r i e r s . Both groups are faced with comparable f l u c t u a t i o n s i n the demand of t h e i r 41) services and t h e i r operational c h a r a c t e r i s t i c s are s i m i l a r . E x h ibit 5 shows the seat-mile cost comparison between Canadian c a r r i e r s and an average U.S. c a r r i e r . Although there are quite s i g n i f i c a n t differences in some ind i v i d u a l cost cate-gories the ove r a l l comparison indicates s i m i l a r i t i e s in operating economics, e s p e c i a l l y between CP A i r and an average U.S. c a r r i e r . The proportions of v a r i a b l e , f i x e d and non-cash expenses are on the same l e v e l . E x h i b it 6 shows the average stage lengths, which are an i n d i -cation of the route structures. The stage length of most c a r r i e r s i s approximately 500 miles. Only c a r r i e r s operating a large international network have longer average system stage lengths. When i t i s recognised that CP A i r domestic stage length i s approximately 600 miles, an assumption of s i g n i f i c a n t 41) Some comparison was made by the Boeing Company in October 1975 in the study "U.S. Trunk and Canadian C a r r i e r Operating Economics". - 126 -s i m i l a r i t i e s i n the domestic route structures can be made. It can be concluded that the business r i s k s i m i l a r i t i e s previously stated, between U.S. trunk and Canadian trans-continental c a r r i e r s , j u s t i f y the use of market data of an American c a r r i e r f o r the DCF-formula a p p l i c a t i o n . In the 1971 CAB-hearing i t was argued that because of i t s e r r a t i c nature, stock market data was not s u f f i c i e n t l y 42) r e l i a b l e . ' However, i t can be argued that unstable stock prices are a r e f l e c t i o n of the future earnings potential of a stock. Therefore, t h i s i n s t a b i l i t y i s i n s u f f i c i e n t reason for r e j e c t i n g the d i r e c t market approach based on the a i r c a r r i e r market data. This applies e s p e c i a l l y , i f pre-ference i s given to the future oriented DCF-Formula. Then the a i r l i n e data should provide useful information in addition to other evidence c o l l e c t e d . A f t e r deciding to use U.S. a i r l i n e market data several a i r c a r r i e r s should be selected. The U.S. trunkline industry has evolved in recent years into two economically disparate groups of c a r r i e r s : the so-called Big Five (American, Eastern, TWA, United and Pan Am), and the "Other" Six. Over a period of s i x years (1968-73), the Big Five have accounted for approximately 74% of the trunkline 42) See discussion in IV.1.5.1. Use of stock market data as a basis for cost of c a p i t a l c a l c u l a t i o n s . - 127 -t r a f f i c (80.7 of 109.3 b i l l i o n revenue ton m i l e s ) , 72% of revenues ($37.1 of $51.7 b i l l i o n ) , but less than 5% of trunkline net p r o f i t s ($34.2 of $763 m i l l i o n ) . 4 3 ^ In sharp contrast, over the same period the s i x smaller trunk c a r r i e r s with only 26% and 28% of the trunk l i n e t r a f f i c and revenues r e s p e c t i v e l y , have accounted f o r 95% ($728.7 m i l l i o n ) of trunkline net p r o f i t s . Trunkline net p r o f i t (loss) as a percentage of a i r l i n e operating revenues as tabulated below, gives an i n d i c a t i o n of the earnings v o l a t i l i t y between the two groups: Year Big Five (%) Other Six (%) 1968 2.70 7.07 1969 1.36 4.92 1970 (2.96) 3.83 1971 (0.52) 3.45 1972 0.84 4.74 1973 0.36 5.86 Because of the poor and very unstable f i n a n c i a l performance of the Big Five and t h e i r excessively high actual debt r a t i o s , the a i r c a r r i e r w i l l be selected from the "Other" Six, the more stable group. It would also be very d i f f i c u l t to predn'ct the f i n a n c i a l future of the Big Five f o r the next f i v e years. 43) A i r Transport World, September 1974 "How the Big Five Compare with Other Trunks" - 128 -It i s assumed that i n size and type of operations the Canadian independent c a r r i e r i s more l i k e the medium s i z e American c a r r i e r s . Within the "Other Six" c a r r i e r s , Delta, National and Western have a c a p i t a l structure s i m i l a r to the one decided f o r Canadian Continental (45/55). Also, these c a r r i e r s have been re g u l a r l y paying out dividends during the l a s t ten years, v/hich allows a more accurate prediction of anticipated dividends, Based on the above two reasons the market data of these three c a r r i e r s w i l l be used to a s s i s t in estimating the market cost of equity f o r Canadian Continental. Special attention w i l l be given to Western A i r l i n e s , which i s the kind of a i r l i n e considered to be a model by many other 44) c a r r i e r s . 'It has a good, s o l i d route system, with long- and short-haul balance and a good seasonal t r a f f i c d i s t r i b u t i o n . In recent years Western A i r l i n e s has given a f a i r l y stable performance, f a i l i n g to make a p r o f i t only once during the l a s t ten years. This happened in 1969, when i t suffered a s t r i k e and most other a i r l i n e s had losses. Exhibits 5A, 6 and 7 show the s i m i l a r i t i e s of the operational c h a r a c t e r i s t i c s of Western A i r l i n e s and Canadian c a r r i e r s as r e f l e c t e d in the stage length, seat-mile cost, and load f a c t o r values. 44) ' A i r Transport World, September 1974 "Western Emphasizes Marketing in S t a f f Alignment f o r Future" - 129 -Like the Canadian c a r r i e r s , Western A i r l i n e s also concentrates in scheduled passenger operations. The d i s t r i b u t i o n of operat-ing revenue in 1974 was as follows: WA AC CP Scheduled Passenger Revenue 89% 83% 85% Cargo Revenue 6% 9% 8% Other Revenue 5% 8% 7% 100% 100% 100% 4.3.2 COMPARABLE EARNINGS STUDY, RELATIONSHIP BETWEEN RISKS AND RETURNS For the comparable earnings study, A i r Canada, CP A i r , and regional c a r r i e r s ' operational s t a t i s t i c s and f i n a n c i a l data w i l l be used to obtain relevant data f o r analysing the r e l a t i v e degree of r i s k of the transcontinental c a r r i e r s . The data w i l l be used keeping mind the l i m i t a t i o n s of i t s a p p l i c a b i l i t y due to the unique c h a r a c t e r i s t i c s of A i r Canada and CP A i r . The main area, where A i r Canada and CP A i r data cannot be used d i r e c t l y i s the analysis of f i n a n c i a l r i s k . This involves variables l i k e debt/equity r a t i o and fixed coverage multiple. As previously stated, the variables describing the f i n a n c i a l r i s k of A i r Canada and CP A i r , in a comparative r i s k a n a l y s i s , would indicate a much higher rate of return required on the open market than what i s a c t u a l l y now expected by the share-holders of A i r Canada or CP A i r . Therefore, adjustments are - 130 -made to r e f l e c t the normalized c a p i t a l structure with the debt/ equity r a t i o of 45/55 that was selected f o r Can-Con. To determine the r e l a t i o n s h i p between r i s k s and returns, several regulated and unregulated industries w i l l be evaluated and used as reference groups with the a i r transport industry. As a f i r s t step, the business and f i n a n c i a l r i s k c h a r a c t e r i s t i c s of the a i r transport industry w i l l be compared with the average of a l l Canadian industries and two regulated i n d u s t r i e s . The group " A l l Industries" combines a l l regulated and unregulated industries and thereby provides an average degree of r i s k i n d i -cation f o r Canadian Industries. A. REGULATED REFERENCE GROUPS The e l e c t r i c , gas and water u t i l i t i e s and the transportation  industries were selected to represent the regulated indus-t r i e s . The reason for s e l e c t i n g u t i l i t i e s i s to e s t a b l i s h the lowest bench mark f o r the return on equity estimate f o r the a i r c a r r i e r s . These major regulated u t i l i t i e s with t h e i r long, stable earnings h i s t o r y , and c o n s i s t e n t l y low r i s k l e v e l , provide r e l i a b l e and useful information. The transportation industries were included to obtain a general view of the industry as a whole to which a i r c a r r i e r s belong as a sub-group. B. UNREGULATED REFERENCE GROUPS The r e s u l t s of the r i s k a n a l y s i s , which w i l l be discussed - 131 -in d e t a i l i n the following chapter, show that the trans-continental c a r r i e r s obviously face r i s k s greater than the average f o r a l l Canadian i n d u s t r i e s . Therefore, i t was concluded that the appropriate cost of equity c a p i t a l for a i r c a r r i e r s would l i e i n the cost of equity range of the industry sub-groups with the highest h i s t o r i c a l returns. To further l i m i t the s e l e c t i o n of representative i n d u s t r i e s , i t can be assumed that a i r c a r r i e r s belong to the r i s k c l a s s of industry groups with the highest h i s t o r i c a l returns and a debt/equity r a t i o of approximately 45/55. (Assumed optimal c a p i t a l structure f o r a i r c a r r i e r s ) . However, these assumptions have to be viewed with some reservation. The experienced returns may not necessa r i l y indicate the shareholders' expectations. Also, the c a p i t a l structure assumption may not be cor r e c t . As discussed before, the a i r c a r r i e r s have a greater percentage of non-cash expenses than most other i n d u s t r i e s . These expenses function as a cushion against the v o l a t i l i t y of earnings. Therefore, the a i r c a r r i e r s do not need as much equity i n t h e i r c a p i t a l structures as other industries with s i m i l a r business r i s k . Based on the above, the task of find i n g unregulated industry groups belonging to the same r i s k c l a s s as a i r c a r r i e r s i s d i f f i c u l t . I t was f i n a l l y decided to analyse transportation equipment and e l e c t r i c a l products i n d ustries as unregulated reference groups. These two industry groups - 132 -have experienced returns higher than the average of a l l Canadian i n d u s t r i e s , and the equity content in t h e i r c a p i t a l structures i s greater than the a i r c a r r i e r s ' . Also, these industries appear to have business r i s k c h a r a c t e r i s t i c s s i m i l a r to a i r c a r r i e r s , as w i l l be discussed in the following. Generally, business r i s k i s d i r e c t l y r e l a t e d to the demand of the i n d u s t r i e s ' products and t h e i r operating c h a r a c t e r i s t i c s . 1. Demand f o r the industry's product Like the a i r transport industry, the transportation equipment and e l e c t r i c a l products industries are highly c y c l i c a l , f l u c t u a t i n g c l o s e l y with the "Gross National Product". As the economy slows down, consumer reaction i s to reduce spending on luxury items such as t r a v e l l i n g and durable goods. An attempt was made to demonstrate the above argument numerically in Exhibit 8 , where the following indicators were plotted to r e f l e c t the f l u c t u a t i o n of the industries output with the real GNP: A i r Transport: Revenue passenger miles fl'own in Canada (CP A i r ) Transportation Number of North-American cars sold in Equipment: Canada E l e c t r i c a l Products: Manufacturers' sales of made-in-Canada appliances (washing machines and dryers) - 133 -The percentage change over the previous; quarter was calculated f o r seasonally adjusted figures and compared 45) with the same change in the GNP. Although some c o r r e l a t i o n can be shown, the findings are rather ambiguous. There are so many variables a f f e c t i n g the industry's output that a p e r f e c t , p o s i t i v e c o r r e l a t i o n cannot be demon-strated. However, since no better method of proving the argu-ment was found the indicators in Exhibit 8 r e f l e c t to some extent the c y c l i c a l i t y of the three i n d u s t r i e s . 2. OPERATING CHARACTERISTICS For d i f f e r e n t but related reasons each of the three industries i s strongly affected by the energy c r i s i s . a) A i r c a r r i e r s loose passengers because of higher fares required to cover escalated fuel cost. b) The decreasing demand f o r transportation equip-ment i s p a r t i a l l y due to higher product p r i c e s , caused by the escalation of raw material p r i c e s . In addition to the above, operating expenses f o r transportation equipment has increased consider-ably again in r e l a t i o n to the increasing cost of f u e l . c) Approximately 60% of the monetary value of the e l e c t r i c a l product i n d u s t r i e s ' production i s related to e l e c t r i c a l power products. Durable 45) Source: S t a t i s t i c s Canada - 134 -goods such as appliances, represent approximately 40% of the production. Raw material prices a f f e c t e d d i r e c t l y e l e c t r i c a l power products where the material component i s high and d i r e c t l y related to the cost of fuel required f o r raw materials. Similar considera-tions apply to durable goods. The energy c r i s i s i s of great importance, when ana-ly z i n g the future business r i s k faced by these industry groups. The energy problem i s unsolved. Neither price nor a v a i l a b i l i t y of fuel can be estimated with c e r t a i n t y . Investors must recognize t h i s f a c t when forming expectations about the return required on investing i n these i n d u s t r i e s . In conclusion, the foregoing business r i s k character-i s t i c s discussed i n d i c a t e that a i r c a r r i e r s should be considered to be in the same r i s k class as the two unregulated industry groups, transportation equipment and e l e c t r i c a l products i n d u s t r i e s . Whether the actual data proves t h i s assumption to be c o r r e c t , w i l l be determined in the next chapter. The market cost of equity w i l l be determined f o r the two industry groups stated. The cost of equity estimate f o r a i r c a r r i e r s w i l l then be based on a r e l a t i v e r i s k and return on equity comparison between - 135 -a i r c a r r i e r s and each of the industry groups. The comparable earnings approach i s neither the best nor the only a l t e r n a t i v e to determine the cost of equity. The determination of the industry groups belonging to the same r i s k c l a s s leaves considerable room f o r more research and i s c r i t i c a l in the a p p l i -cation of t h i s approach. Results obtained through the comparable earnings approach can at best be con-sidered as an additional bench mark for a r r i v i n g at the ultimate cost of equity estimate. - 136 -5 . 0 . 0 Summary Chapter IV outlines the approach taken to determine the FROI fo r Canadian transcontinental a i r c a r r i e r s . The r e s u l t s of the review of past fare hearings in IV.1 were used as a guideline f o r the approach selected. This approach involves applying the market cost of debt and equity to the optimal c a p i t a l structure to obtain the weighted average cost of c a p i t a l , which equals the FROI - requirement. Since there i s no unique method f o r estimating the market cost of equity, several types of evidence and facts obtained through,application of various techniques have to be combined. This evidence includes i n t e r e s t r a t e s , ex post rates of return to investors, and f a c t s obtained by the a p p l i c a t i o n of the DCF-Formulas, CAPM-Model and the comparable earnings approach. Based on t h i s combined evidence a decision can be made. Because of the unique f i n a n c i a l c h a r a c t e r i s t i c s of A i r Canada and CP A i r , and the anticipated changes in the f i n a n c i a l struc-tures of these c a r r i e r s , they can not be used to determine a relevant FROI f o r transcontinental c a r r i e r s . Therefore, the FROI w i l l be determined f o r a hypothetical, independent trans-continental a i r c a r r i e r , financed by r a i s i n g funds e x c l u s i v e l y in the open market. - 137 -V EMPIRICAL FINDINGS REGARDING THE COST OF EQUITY In t h i s chapter, the empirical findings regarding i n t e r e s t r a t e s , ex post rates of return to investors, DCF-formula and CAPM-model a p p l i c a t i o n s , and the comparable earnings study w i l l be discussed. Based on these findings and ultimately by some judgement, the cost of equity f o r Canadian trans-continental a i r c a r r i e r s w i l l be estimated. 1.0.0 Interest Rates 1.1.0 Trends A b r i e f review shows that since 1972 the y i e l d of long-term p r o v i n c i a l , municipal and corporate bonds was continuously r i s i n g . In the f i r s t quarter of 1973 i t was approximately 8%, reaching i t s peak in the t h i r d quarter of 1974 at approxi-mately 11%. (Exhibit 9). A downward trend beginning at the end of 1974 reversed i t s d i r e c t i o n soon, and in October 1975 the nominal y i e l d s were again at the 11% l e v e l . ^ (Exhibit 9A). The above follows the f l u c t u a t i o n of the Canadian Prime Bank Rate, which increased from 6% in January 1973 to 11.5% in June 1974 ( E x h i b i t 10). The peak of 11.5% was retained from June 1974 to October 1974. For some months following the trend was progressively towards lower i n t e r e s t l e v e l s . 1) Financial Post October 1975 - 138 -During the l a t t e r part of 1975 the trend was towards higher i n t e r e s t l e v e l s . Wood Gundy's, John Grant sees i n t e r e s t rates r i s i n g through to the second quarter of 1976, with possible Bank Prime Rates above 11%. Grant's forecast s p e c i -f i c a l l y assumes a tougher monetary and f i s c a l p o l i c y than Canada has had so f a r . ' Forecasting the i n t e r e s t rates f o r 1976 and 1977 i s a complex task considering the assumptions that have to be made about U.S. and Canadian monetary p o l i c y . A l l of the forecasts made are based on the assumption that the Bank of Canada w i l l maintain i t s intended p o l i c y to reduce the rates of money and c r e d i t expansion from recent heights (see Wood Gundy above). Based on the Conference Board's forecast the follow-ing can be expected. Interest rates w i l l progressively increase a l l through 1976. Finance Company paper i s expected to reach a rate of 10.5% versus a rate of 9.3% at the end of 1975. Conventional mortgage rates w i l l increase from 12.8% in 1975 to 13% by the end of 1976. 3^ 1.2.0 Real versus Nominal Yields In the past, there has been a d e f i n i t e r e l a t i o n s h i p between real y i e l d s earned by short- and long-term financing instruments. Wood Gundy studied these r e l a t i o n s h i p s over the period of 4) 1956-1974. ' Ex h i b i t 10A shows the average real y i e l d s 2) Financial Post September 27, 1975 3) Financial Post September 27, 1975 4) See Wood Gundy (36) - 139 -earned by various instruments during the above time span. The real average y i e l d curve of Government of Canada bonds has in the past shown real y i e l d s ranging from about 2% on 90-day treasury b i l l s through 2.40% on one-to-three year bonds to about 3.30% on long-term issues. Rates on corporate debt are n a t u r a l l y higher, but followed a s i m i l a r curve, with a 90-day finance company paper rate of approximately 2.5% and y i e l d s on medium grade long-term corporate bonds of 4%. The i m p l i c i t real discount rate on the Toronto Stock Exchange Industrial Index averaged at 5.5% over the same period. At the prices p r e v a i l i n g at the end of 1974 the r e l a t i o n s h i p between y i e l d s earned by short- and long-term financing instruments was d i s t o r t e d to a degree not experienced since the 1930's. Real y i e l d s were close to zero on short-term paper and s u b s t a n t i a l l y negative on treasury b i l l s and short-term Government of Canada bonds. The long-term Government bonds appeared to be trading close to t h e i r long-term aver-age real y i e l d s , but the " r i s k premium" on long-term corporate bonds has increased to a range between 5 - 5.5% and on the TSE Indus t r i a l s to the 8% l e v e l . These percentage values r e f l e c t a world i n which investor uncertainty has reached i t s summit. The desire f o r s e c u r i t y - 140 -and l i q u i d i t y has depressed real y i e l d s on short-term and low-risk paper and sharply raised the required rates of return on long-term and r i s k y instruments. The findings of the Wood Gundy study ind i c a t e that an additional r i s k premium ' i s required i n the equity market u n t i l i n f l a t i o n slows down, economy recovers and the structure of nominal y i e l d s w i l l begin to revert to a more normal shape, i . e . under normal conditions the real y i e l d of the TSE Industrial Index i s approximately 2% above the long term Government bond y i e l d s . However at the end of 1974 the premium was nearly 5%. The following example i s an i l l u s t r a t i o n of a hypothetical real y i e l d curve, coupled with an i n f l a t i o n f o r e c a s t , possible by l a t e 1975. 6 ^ Real Nominal I n f l a t i o n Y i e l d Y i e l d Expectation 90-day Finance Paper 0.75 8.65 7.90 Canadas (1 to 3 years) 3.00 8.35 6.70 Canadas (long-term) 2.00 8.70 5.35 Long-term Corporate 4.75 10.10 5.35 TSE Industrial Index 7.50 12.85 5.35 Discount rate This forecast was prepared in e a r l y 1975, and i t i s obvious in January 1976 that the i n f l a t i o n estimate was too low. Therefore, the nominal discount rate f o r the TSE Industrial Index by the end of 1975 must be assumed to have been above 13%. 5) Risk premium i s here defined as the spread between the equity discount rate and long-term bond y i e l d s . 6) See (36) SUPRA - 141 -As stated previously, a finance company paper i s expected to carry a rate of 10.5% by the end of 1976. Assuming the same r i s k premium f o r the TSE Industrial Index as in the previous example (a d i f f e r e n t i a l of 4.20% i n nominal y i e l d s ) , the nominal discount rate forecast f o r the year ending 1976 would be 14.7%. 2.0.0 Ex Post Rates of Return to Investors The f i r s t careful study of long-run rates of return on common stocks was performed by Fisher and L o r i e . I t was based on shares traded on the New York Stock Exchange during the period of 1926-65 and published in 1968. 7 ^ The predominant feature of t h i s research that impressed investors in common stocks most i s the 9.3% rate of tot a l return that an investor could have obtained over the f u l l 1926-65 period. This i s assuming a d i v e r s i f i c a t i o n over a l l stocks l i s t e d on the New York Stock Exchange and counting appreciation and assuming reinvestment of dividends. This percentage has been accepted by many investors as a c r i t e r i u m of expectations in terms of compounded average annual return on the stock market. During the same period, the average annual rate of i n f l a t i o n as indicated by the Consumer Price Index in the U.S. was approximately 1.5%. Therefore, the average " r e a l " compounded rate of return in the Fisher and Lorie study could be taken 7) See Fisher and Lorie (18) - 142 -to be approximately 7.8% per annum (9.3%-1.5%). In 1974, an analysis of rates of return on common stocks, long-term high grade bonds and treasury b i l l s , f o r the period 8) 1926-1973, was presented by Ibbotson and Sin q u e f i e l d . This analysis was based upon published and computed indexes, rather than the performance of individual stocks, l i k e the above study. For the purposes of p r a c t i c a l f o r e c a s t i n g , t h i s analysis i s probably more useful than the Fisher Lorie study. The following table summarizes the major conclusions drawn by Ibbotson and Sin q u e f i e l d . 1926 to 1973 MARKET INDICATORS Geometric Avg Annual Rate of Return Standard Deviation in Rate of Return Geometric Avg "Real" Annual Rate of Return Standard & Poor's Composite ("500") Common Stock Index 9.3% (8.4%) 21.9% 7.3% (6.2%) Long Term High Grade Bonds 3.6 (3.5) 5.0 1.6 (1.3) Treasury B i l l s 2.2 (2.3) 1.8 .2 (0.1) Rate of I n f l a t i o n 2.0 (2.2) (Figures i n parentheses are updated to cover 1926-74) The geometric or compound average rate of return i s the best measure of the p r o f i t a b i l i t y of an investment. However, the geometric average " r e a l " rate of return i s an even more useful 8) See Ibbotson and Sinquefield (37) - 143 -number. Concerning common stocks, the 7.3% average " r e a l " return deduced by Ibbotson and Si n q u e f i e l d i s not f a r from the 7.8% " r e a l " return that comes from the Fisher and Lorie study. While the geometric average rate of return gives an i n d i c a t i o n about long run rates of return, the arithmetic mean of annual rates of return gives the best estimate of what the investor can expect to earn i n any future year. This rate was found to be 10.9%, by Ibbotson and Si n q u e f i e l d . In Canada, s i m i l a r known published studies are not a v a i l a b l e . However, during the winter session 1975/76 at U.B.C. an attempt was made to compute returns earned by Canadian 9) investors. Following are the r e s u l t s obtained: 1 1965 to 1973 Geometric Average Annual Rate of MARKET INDICATORS Return Nominal Real TSE Gold 8.8% 4.4% TSE Metal 6.5% 2.1% TSE O i l 12.6% 8.1% TSE Industrial 6.9% 2.4% The above findings i n d i c a t e that returns on investments i n stocks were unsatisfactory during the 1965-73 period. In real terms, the average annual return on investment f o r i n d u s t r i a l stocks was only 2.4%. 9) Commerce 575, Winter 1975/76 with Prof. Williamson - 144 -These findings also substantiate the statements made e a r l i e r . Investors under-estimated the rate of i n f l a t i o n f o r a long time, and in p a r t i c u l a r f o r 1974. As a r e s u l t investors uncertainty concerning i n f l a t i o n and general economic con-di t i o n s created a desire for more se c u r i t y and l i q u i d i t y , sharply r a i s i n g the required rates of return on common stocks. The equity market w i l l be burdened with t h i s additional r i s k premium u n t i l the rate of i n f l a t i o n declines, or at l e a s t s t a b i l i z e s . - 145 -3.0.0 Application of DCF-Formula The DCF-technique i s applied to estimate the market cost of equity f o r Delta A i r Lines, National A i r l i n e s , and Western A i r l i n e s . These estimates w i l l then a s s i s t in a r r i v i n g at the cost of equity f o r an independent Canadian a i r c a r r i e r . 3.1.0 H i s t o r i c a l Financial Performance of U.S. A i r l i n e s The selected s t a t i s t i c s shown below, i l l u s t r a t e the past f i n a n c i a l performance of the three a i r l i n e s f o r the period of 1965-1974. 1 0 ) Delta National Western Average annual growth of operating revenue: - 1965 - 1974 17.6% 12.2% 14.1% - 1969 - 1974 18.8% 15.3% 14.4% A l . Average annual dividend growth (1965-1974) 8.0% 8.5% 5.0% A2. Average annual growth in EPS (1965-1974) 12.5% 7.0% 6.5% Dividend per Share i n 1974 ($).60 .48 .39 Price Range in 1974 ($)'56-27 21-6 13-5 B. Average Dividend Y i e l d in 1974 (%) 1.4 3.6 4.3 Assuming that the growth of dividends or EPS follows past trends, then according to the Gordon-Formula, investors in 1974 anticipated the following returns on t h e i r investment: 10) Source: Moody's Handbook of Common Stocks, 1975 Growth rates were determined by f i t t i n g a trend l i n e with a constant growth rate to the yearly values. - 146 -Al + B = Expected Rate of Return (%) 9.4 12.1 9.3 A2 + B = Expected Rate of Return (35) 13.9 10.6 10.8 To estimate the rate of return expected by investors i n 1975, the foregoing c a l c u l a t i o n i s repeated, assuming an average share p r i c e and indicated dividends f o r 1975, and a continua-ti o n of the past growth trends. Delta National Western A l . Average Annual Dividend growth (1965-1974) 8.0% 8.5% 5.0% A2. Average Annual Growth in EPS (1965-1974) 12.5% 7.0% 6.! Indicated Dividend per Share in 1975 ($) .60 .50 .47 Price Range in 1975 ($)41-25 15-6 10-6 B. Indicated Average Dividend Y i e l d i n 1975 (%) 1.8 4.2 6.7 Al+B = Expected Rate of Return(%) 9.8 12.7 11.7 A2+B = Expected Rate of Return(%)14.3 11.2 13.2 The above r e s u l t s i n d i c a t e the following. I f investors' expectations were based on past experience only, a return on investment of 9.3% minimum and 14.3% maximum was expected during 1974-75 in an a i r l i n e stock. 0 - 147 -3.2.0 Future Prospects of the A i r Transport Industry 3.2.1 -Inflation Versus Productivity E s p e c i a l l y in the case of a i r c a r r i e r s , h i s t o r i c a l performance alone does not provide r e l i a b l e information concerning future developments. Determining the future economic and f i n a n c i a l condition of the a i r transport industry involves an analysis of the following f a c t s : Changes in t o t a l costs per employee, per gallon of f u e l , and in unit costs of other purchases (INFLATION) Changes in the e f f i c i e n c y with which a l l of the above factors are used 1 1 ^ (PRODUCTIVITY) Changes in fares (YIELD) The a i r transport industry in the U.S. has completed an over-a l l analysis of these three f a c t o r s , documenting changes since 1960 and i n d i c a t i n g t h e i r l i k e l y e f f e c t i f t h e i r h i s t o r i c a l 12) trends continue through 1980. ' The findings of the ATA-study concerning i n f l a t i o n and product-i v i t y are shown in Table VI. The major conclusions drawn from t h i s study are as follows: With the advent of the commercially applied j e t engines in the e a r l y 1960's, a i r l i n e p r o d u c t i v i t y increased at rates exceeding 11) This i s t o t a l f a c t o r p r o d u c t i v i t y , i . e . the change in t o t a l output r e s u l t i n g from the use of a l l factors of production or input. 12) See the ATA-study (10A) and Table 5 on the next page. - 148 -145 AIRLINE COST INFLATION COMPARED WITH PRODUCTIVITY AND YIELD CHANGE (Index 1967 =100) 1967-1973 inflation Productivity Plus Yield Productivity 100 1967 1968 1969 1970 1971 1972 1973 SOURCE: U.S. Airline Industry Costs i and Productivity 1967-1973 TABLE VI - 149 -cost i n f l a t i o n . As a consequence, p r o f i t a b i l i t y improved to reach peak earnings in 1966 of $428 m i l l i o n , and a ROI of 11%. During the period of 1962-1966, passenger y i e l d s a c t u a l l y declined by 10%. In early 1967, the s i t u a t i o n was markedly reversed. From 1967 to 1973, a i r l i n e unit costs increased nearly 43%. Productivity increased only 17%, with y i e l d increases contributing a further 18%. This t o t a l p r o d u c t i v i t y plus y i e l d improvements of 35% contrasts with the 43% increase in unit costs. As a consequence, in 1973 the a i r transport industry i n the U.S. earned less than hal f the 1967 p r o f i t s , although the investment base had grown by more than 40%. Obviously, t h i s s i t u a t i o n i s untenable. Many c a r r i e r s cannot survive under these conditions, and the investing public w i l l continue to view the a i r transport industry as unattractive compared to other investment opportunities. As a r e s u l t , t h i s w i l l deprive the industry of needed equity financing and new equipment. Continuation of the 1967-1973 i n f l a t i o n and p r o d u c t i v i t y trends of the industry into 1980 could produce a unit cost l e v e l in excess of 100% above the 1967 l e v e l . The p r o d u c t i v i t y l e v e l would be only approximately 40% higher than in 1967. This means that, unless c o r r e c t i v e action i s taken, the difference between the i n f l a t i o n and p r o d u c t i v i t y rates would become excessive. Substantial fare increases on an annual or more - 150 -frequent basis would be needed to assure adequate earnings l e v e l s . The challenge to the a i r l i n e industry i s to i n s t i t u t e f e a s i b l e concentrated action programs to reduce costs and increase p r o d u c t i v i t y . This i s a necessity to provide r e l i e f from fare increase requirements and to avoid f i n a n c i a l c r i s i s . An equivalent to the ATA-study in the U.S., concerning pro-d u c t i v i t y and i n f l a t i o n , has not been made in Canada. However, an unpublished study, covering CP A i r during 1967-1975, using s i m i l a r c r i t e r i a i s a v a i l a b l e . The findings of t h i s study s u b s t a n t i a l l y support the ATA-report. Moreover, the d e t e r i o r a t i n g p r o f i t a b i l i t y of A i r Canada and CP A i r , as discussed i n Chapter I I , demonstrates that the pro d u c t i v i t y improvements gained by a i r c a r r i e r s combined with y i e l d improvements have not been s u f f i c i e n t to compensate f o r a i r l i n e cost i n f l a t i o n . - 151 -3.2.2 Markets i n 1975-1980 13) The major findings of the ATA-study i n 1974, ' concerning the industry's passenger and cargo market opportunities are as follows: The combination of environmental, f u e l , regulatory, i n f l a t i o n -ary, and fare pressures w i l l lead to greater emphasis on low cost passenger mass t r a v e l . There are recognized but unexploited opportunities in the cargo transport market of great p o t e n t i a l . However, to tap t h i s p o t e n t i a l , integrated industry action i s required. Passenger Markets The following table shows the yearly percentage increase i n scheduled service RPM's f o r U.S. trunk and Canadian transcon-13) tinental c a r r i e r s during 1964-1974. ' U.S. (%) Canada (55) 1965 17.4 20.0 1966 16.3 16.8 1967 23.6 22.7 1968 15.4 8.3 1969 10.1 6.3 1970 5.0 13.9 1971 3.0 .5 1972 12.3 20.6 1973 6.3 17.3 1974 1.0 13.5 S c r u t i n i z i n g the above data indicates that with increasing industry maturity the rapid growth declined p a r t i c u l a r l y in the U.S. Therefore, new markets and growth opportunities must be sought. 13) See the ATA-study (10B) p. 34, Supra RPM = Revenue Passenger Mile Canadian RPM's from S t a t i s t i c Canada pub l i c a t i o n 51-206 - 152 -Previous grov/th l e v e l s were attained in the 1950's l a r g e l y through a s h i f t from surface to a i r t r a v e l . In the 1960's th i s s h i f t continued and was accelerated by a coincidence of other f a c t o r s . These included the introduction of the j e t engine with the reduced t r a v e l l i n g time, improved safety, discount fares introducing a i r travel to a i r travel novices, and higher consumer disposable income. Changes i n the industry t r a f f i c volume are now more coinciding with national economic indic a t o r s such as the Gross National Product. Growth rates ranging from 2 to 8% per annum may be expected over the next f i v e years, depending on general economic conditions. An underlying factor supporting the outlook f o r a moderate growth in the 1975-1980 period i s the past exposure of youth in the 1960's to a i r t r a v e l . Young people now consider a i r travel to be a normal part of t h e i r d i s c r e t i o n a r y spending. Moving into the adult stage, they w i l l have smaller f a m i l i e s , tend to l i v e in apartments, and with a l a r g e r proportion of working wifes, w i l l have more funds a v a i l a b l e f o r pleasure including a i r t r a v e l . Cargo Markets The a i r cargo market has been characterized by an u n r e a l i s t i c outlook f o r a sustained high growth rate. Committees of the ATA developed long range forecasts f o r both domestic and i n t e r -national f r e i g h t growth rates f o r U.S. a i r c a r r i e r s . In 1969, the Industry Planning Committee, looking at the decade of the 1970's, foresaw a domestic average annual f r e i g h t ton mile - 153 -growth rate of 19%. 14) The actual annual growth rate that has occurred since 1969 was 8.8%. Recent estimates of i n t e r -national cargo growth f o r U.S. scheduled c a r r i e r s suggest an average growth rate of about 10%. Three p r i n c i p a l factors w i l l a f f e c t cargo development in the U.S. and Canada: 1. New shipping concepts, including expanded use of conta i n e r i z a t i o n 2. The impact of wide-body a i r c r a f t 3. The a v a i l a b i l i t y and pr i c e of j e t f u e l . 14) Ibid. pp. 39-41 - 154 -3.2.3 A i r l i n e Technology Although few advances are a n t i c i p a t e d i n airframe and engine tech-nology during the 1975-1980 p e r i o d , general technology i s expected to c o n t r i b u t e to system e f f i c i e n c y and p r o d u c t i v i t y . More extensive use o f computers, improvement i n a i r t r a f f i c c o n t r o l , and maintenance operations w i l l c h a r a c t e r i z e the next f i v e y e a r s . T h i s , together with other e f f o r t s such as improvement o f engine e f f i c i e n c i e s e t c . which w i l l a f f e c t the a i r t r a n s p o r t i n d u s t r y a f t e r 1980, are i n progress. T h i s i s the summary of conclusions drawn by the ATA i n t h e i r study of scheduled a i r l i n e s f o r 1975-1980. The t r a n s i t i o n from p r o p e l l e r to j e t d r i v e n a i r c r a f t i n the 1960's brought about major changes i n the speed and s i z e o f the a i r c r a f t . I t provided a major improvement o f p r o d u c t i v i t y . The recent i n t r o -duction of wide-bodied a i r c r a f t , however, d i d not add to the average a i r c r a f t speed, but increased seat c a p a c i t y d r a m a t i c a l l y . By t h i s f a c t the wide-bodied a i r c r a f t created the problem o f o v e r - c a p a c i t y . Consequently, the over expansion i n seat c a p a c i t y reduced the load f a c t o r s to uneconomically low l e v e l s . The coming years w i l l f i n d a i r l i n e s more s e l e c t i v e and c r i t i c a l i n t h e i r acceptance of t e c h n o l o g i c a l Innovations than before, with the high c o s t o f any changes tempering the previous enthusiasm. 15) I b i d . pp. 29-33 - 155 -3.2.4 Equipment and Equipment Financing Although i n d u s t r y equipment purchases w i l l d e c l i n e i n the immediate f u t u r e , i n f l a t i o n w i l l keep a i r l i n e c a p i t a l expenditures a t a high l e v e l , emphasizing the need f o r s a t i s f a c t o r y earnings on a sustained b a s i s . A i r l i n e equipment requirements changed from the e a r l y 1960's, when many c a r r i e r s were unable to purchase needed c a p a c i t y , to the opposite i n the l a t e 1960's and e a r l y 1970's, when the i n d u s t r y was c h a r a c t e r -i z e d by ov e r - c a p a c i t y . An assessment of the 1975-1980 period i n d i c a t e s t h a t the impact o f general economic c o n d i t i o n s and t e c h n o l o g i c a l progress w i l l c u r t a i l c a p a c i t y expansion requirements, and consequently the need f o r new a i r c r a f t investment. As st a t e d p r e v i o u s l y , major t e c h n o l o g i c a l advances i n the form o f airframe or a i r c r a f t engines are not a n t i -c i p a t e d 1n the 1975-1980 p e r i o d . However, to improve the p r o f i t a b i l -i t y o f a i r c a r r i e r s three major a l t e r n a t i v e s , and t h e i r combinations, are p o s s i b l e . They are i n order o f preference, increased u t i l i z a t i o n , l oad f a c t o r improvements and new more e f f i c i e n t equipment. The a p p l i c a t i o n o f these f a c t o r s does not imply that the i n d u s t r y w i l l cease o r d e r i n g new conventional a i r c r a f t . Purchases may be made f o r reasons o f f l e e t s t a n d a r d i z a t i o n , lowered maintenance c o s t s , or retirement o f i n e f f i c i e n t , o l d e r a i r c r a f t . In a d d i t i o n , new a i r -c r a f t may be requ i r e d i f c u r r e n t t r a f f i c p r o j e c t i o n s are r e a l i z e d or exceeded. - 156 -Whatever the a i r c r a f t purchases shall be, the industry w i l l have to obtain the necessary funds. As in recent years, the a b i l i t y to do so w i l l be l i m i t e d , unless the industry r e a l i z e s s a t i s f a c t o r y earnings on a sustained basis. 3.2.5. Summary The i n f l a t i o n vs. p r o d u c t i v i t y discussion indicated that the a i r transport industry has to i n s t i t u t e f e a s i b l e action programs to avoid f i n a n c i a l c r i s i s . The market analysis emphasized that the years of rapid growth in the passenger t r a f f i c a r e past. The forecast f o r the next f i v e years indicates a period of a moderate growth. Growth prospects are contingent on general economic conditions, a i r c a r r i e r s ' capab-i l i t y of f i n d i n g new markets, and maintenance of a reasonable fare structure. The future development of the cargo market i s even more uncertain than the passenger market. Recent developments of a i r l i n e technology are i n d i c a t i v e that the r i s k of investing i n the a i r transport industry has been s l i g h t l y reduced since the early 1970's. Introduction of wide-bodied equipment i s nearly completed. Moreover, no major technical improvements concerning airframes or engines are anticipated during 1976-1980. B a s i c a l l y business r i s k , indicated by the i n s t a b i l i t y of a firm's earnings, i s a r e f l e c t i o n of the s t a b i l i t y of the economic environment and the firm's c a p a b i l i t y to cope by c o r r e c t l y f o r e -casting the business climate. The 1976 economic environment i s - 157 -uncertain, and i t may be even more so than i t was i n the e a r l y 1970's. This uncertainty indicates that the a i r transport industry as an investment a l t e r n a t i v e i s as r i s k y as i t was i n the e a r l y 1970's. However, t h i s r i s k has now been mitigated by a major change i n the growth forecasting philosophy of a i r l i n e management groups. In the e a r l y 1970's, forecasting was performed on an overly o p t i m i s t i c basis. The past high growth rate of passenger t r a f f i c was extra-polated without consideration of possible r e s t r a i n t s and future saturation. Consequently, a i r l i n e managements made in c o r r e c t invest-ment dec i s i o n s , acquiring capacity to meet the demands of the forecasted growth which was never r e a l i z e d . A i r c a r r i e r s are now in the process of reducing excess capacity by a t t r i t i o n , reducing current f l e e t and/or delaying f l e e t expansion. A i r l i n e management long term planning i s now based on a more r e a l i s t i c outlook. As a r e s u l t , the a i r transport industry's earnings and p r o f i t s are expected to s t a b i l i z e . The main implication of the above, f o r the subsequent discussions i n Chapters V.3.3. and V.5.2., i s that the business r i s k of the a i r transport industry i s not increasing, and may be even reduced. It should be emphasized that most of the U.S. a i r c a r r i e r s are s t i l l considered to be an investment of speculative grade. Following i s the investment r i s k evaluation of U.S. trunk c a r r i e r s by Moody's analysts, published during the l a t t e r part of 1975: - 158 -I n t r i n s i c Investment Quality Speculative Grade Medium Grade American Delta B r a n i f f National Continental Northwest Eastern Pan American TWA United Western - 159 -3.3.0 Future-Oriented DCF-Formula In the f o l l o w i n g , the prospects o f Western A i r l i n e s w i l l be analysed i n more d e t a i l as r e l a t e d to the a p p l i c a t i o n o f the f u t u r e - o r i e n t e d DCF-Formula. As s t a t e d p r e v i o u s l y , the p r o f i t a b i l i t y o f a U.S. a i r l i n e i n 1975-1980 w i l l depend on the f a r e increases granted by the C.A.B., and on the a i r l i n e ' s c a p a b i l i t y to reduce c o s t s and in c r e a s e p r o d u c t i v i t y . I t i s d i f f i c u l t to p r e d i c t c o r r e c t l y i n v e s t o r s ' expectations concern-ing the p r o f i t a b i l i t y o r growth o f Western A i r l i n e s . However, i t i s p o s s i b l e to explore the consequences o f a l t e r n a t i v e assumptions, w i t h i n a reasonable range, about these e x p e c t a t i o n s . The method a p p l i e d i s s i m i l a r to the one Myers used, when determining a c o s t o f eq u i t y estimate f o r A,T&T i n 1971. ^ The model used allows the c a l c u l a t i o n o f the c o s t o f eq u i t y c a p i t a l , contingent on the c u r r e n t p r i c e o f Western A i r l i n e s ' stock and on i n v e s t o r s ' expect-a t i o n s about: 1) Western A i r l i n e s ' book r a t e o f r e t u r n on e q u i t y 2) The long-term growth of Western A i r l i n e s ' t o t a l e q u i t y c a p i t a l - i . e . growth o f book net worth, and 3) The divid e n d payout r a t i o . The model i s described 1n d e t a i l i n Attachment A. I t i s assumed t h a t long-term i n v e s t o r s ' expectations about Western's book r a t e o f re t u r n 16) See (26) pp. 34-39 - 160 -on e q u i t y are a t l e a s t 13% and at most 18%. The minimum di v i d e n d payout r a t i o i s assumed to be .3. Western's book net worth i s assumed to grow a t a minimum o f 9.1% and a t a maximum o f 12.6% per annum. Following i s the r a t i o n a l behind the above range, i n which i n v e s t o r s ' expectations are assumed to be: F i r s t , i t i s u n l i k e l y that i n v e s t o r s expect Western to earn more than 18% on book e q u i t y . During the l a s t ten y e a r s , t h i s r e t u r n was exceeded only once. ^ In a d d i t i o n , the FROI-standard s e t by the C.A.B., on which the f a r e increases are based on, assumes a c o s t o f e q u i t y o f 16.75% o n l y . 1 8^ At the same token, i t i s unreasonable to suppose that i n v e s t o r s expect l e s s than 13% p r o f i t a b i l i t y i n the long-term. T h i s i s the 19) a r i t h m e t i c mean of book returns over the past ten y e a r s . ' Assuming the i n v e s t o r s a n t i c i p a t e d l e s s than 13%, t h e i r investment i n Western stock would y i e l d only s l i g h t l y more than u t i l i t y stocks 20) or corporate bonds. ' A r a t i o n a l i n v e s t o r would not i n v e s t i n Western on t h i s b a s i s . Secondly, the expectations about the growth o f book net worth and the r e t u r n on book e q u i t y are c l o s e l y r e l a t e d . Western i s i n c r e a s i n g l y 21) using l e a s e - f i n a n c i n g i n t h e i r f l e e t expansion program. ' T h i s i s incorporated i n the model s t r u c t u r e by the assumption t h a t the a s s e t 17) 21.4% i n 1966, see Attachment A3 18) See (6) c o n c l u s i o n s , Supra 19) See Attachment A3, Supra 20) See (26), Attachment F 21) The present value o f minimum l e a s e commitments a p p l i c a b l e to non-c a p i t a l i z e d " f i n a n c i n g " leases a t December 31, 1974 was 24.9% o f net book value of p r o p e r t i e s and equipment. - 161 -growth 1s e n t i r e l y financed through i n t e r n a l s o u r c e s . ^ T h e r e i s no need to r a i s e new e q u i t y c a p i t a l to f i n a n c e the f l e e t a d d i t i o n s r e q u i r e d to meet the f o r e c a s t e d t r a f f i c growth. Consequently, growth o f book net worth w i l l depend e n t i r e l y on the assumptions regarding the above r e t u r n on book e q u i t y (ROE) e x p e c t a t i o n s , and the d i v i d e n d payout r a t i o . The minimum payout r a t i o of cash dividends was assumed 22) to be .3 based on past experience. ' With a ROE estimate range from 13% to 18%, r e s u l t i n g growth expectations w i l l range from 9.1% to 12.6%. F u r t h e r , the d i v i d e n d payout r a t i o can be expected to be increased to a maximum l e v e l guarantying a minimum growth i n book net worth o f 9.1%. X^0wned a s s e t s , excluding lease financed a s s e t s . The growth r a t e range f o r the book net worth de r i v e d through the above l o g i c i s reasonable, when compared with past growth r a t e s . A growth 23) o f 9.4% i s i n d i c a t e d by the past growth trend o f t o t a l a s s e t s . ' The slow growth r a t e i n d i c a t e d during the l a s t 3-4 years i s explained by the increased Tease f i n a n c i n g . During 1969-1974, the average 24) annual growth r a t e o f o p e r a t i n g revenues was 14.4% ' and of book 25) value per share 10.6%. ' According to the assumptions incorporated i n the model concerning the growth o f book e q u i t y , i n v e s t o r s a l s o expect dividends and earnings per share to grow at an average r a t e o f 9.1-12.6%. These rates are c o n s i d e r a b l y higher than r a t e s experience i n the past. 2 6^ 22) Average l e v e l i n 1965-1974 23) See Attachment Al 24) See Attachment Al 25) See Attachment A2 26) See Attachment A2 - 162 -However, there are i n d i c a t i o n s that Western's f u t u r e f i n a n c i a l per-formance w i l l surpass the average o f the past ten y e a r s . One of the i n d i c a t o r s i s Western's promising t r a f f i c growth prospects. Many i n d u s t r y observers contend that U.S. a i r l i n e s ' growth w i l l be 27) predominantly i n the pleasure t r a v e l business. ' Western's r a t i o o f pleasure to business t r a f f i c i s now approximately 60/40. Only f i v e years ago the same r a t i o was 40/60. 2 8 ^ The a i r l i n e ' s big success i n the pleasure t r a v e l business i s the Hawaiian market, which i s n e a r l y 90% pleasure t r a v e l . Another key l e i s u r e market area i s Mexico. Another i n d i c a t i o n i s e f f i c i e n c y improvements made, whose impact has not been f u l l y r e a l i z e d y e t . In 1973-1974, fundamental changes were made i n the p o l i c i e s and corporate s t r u c t u r e of Western. The new p r e s i d e n t , Mr. A. K e l l y , r e a l i g n e d and d e c e n t r a l i z e d the management s t r u c t u r e . The new o r g a n i z a t i o n defines market areas with one manager each r e s p o n s i b l e f o r both s a l e s and s e r v i c e s . P r e v i o u s l y , s a l e s and s e r v i c e d e c i s i o n s were made independently. Frequently s a l e s and s e r v i c e management groups competed f o r funds and explanations f o r poor performance. In a d d i t i o n , a corporate planning u n i t was created to co-ordinate decision-making f u n c t i o n s . T h i s new u n i t i s r e s p o n s i b l e f.ex. f o r improved f l e e t planning by c o - o r d i n a t i n g c a p a c i t y with f u t u r e t r a f f i c 29) requirements. ' 27) See a l s o the d i s c u s s i o n i n V.3.2.2 28) A i r Transport World, September 1974, p.31 29) I b i d , pp.31-34 - 163 -I t w i l l take time to r e a l i z e the impact o f the corporate s t r u c t u r e changes made, but p o s i t i v e r e s u l t s should become obvious i n the near f u t u r e . Attachment A4 shows the r e s u l t s obtained by applying the DCF-Formula to the Western market data. For example, the c o s t o f e q u i t y c a p i t a l i s 19.84% i f i n v e s t o r s expect Western to grow a t a r a t e o f 9.1% and to earn an 18.0% r e t u r n on book e q u i t y . I f expectations of growth and r e t u r n are 9.1% and 13.0% r e s p e c t i v e l y , then the c o s t of e q u i t y c a p i t a l i s 13.90% o n l y . As emphasized p r e v i o u s l y , i t i s very d i f f i c u l t to p r e d i c t i n v e s t o r s ' expectations about Western's growth and p r o f i t a b i l i t y . Based on the f a c t s discussed above these expectations should be i n the middle of the range shown i n Attachment A4. Thus, i t i s my assessment t h a t a r a t i o n a l i n v e s t o r would expect a growth o f 10.5 to 11.2% and a p r o f i t a b i l i t y o f 15 to 17%. T h i s i m p l i e s t h a t the c o s t o f e q u i t y c a p i t a l i s i n the range o f 16.0 to 18.3%. - 164 -4.0.0 A p p l i c a t i o n of CAPM-Model According to the C a p i t a l Asset P r i c i n g Model (CAPM) a stock's systematic r i s k can be measured by the b e t a - f a c t o r , the "market 30) s e n s i t i v i t y index". ' In t h i s chapter, the b e t a - f a c t o r s f o r Delta A i r L i n e s , National A i r l i n e s , and Western A i r l i n e s w i l l be computed. The d e r i v e d beta-f a c t o r s w i l l then be used to determine d i r e c t l y the c o s t o f e q u i t y c a p i t a l estimate f o r the above a i r l i n e s . The method a p p l i e d 1s the same as used by Weston when determining the c o s t o f e q u i t y f o r General 31) Motors and C h r y s l e r Corporation. ' Attachment Bl i l l u s t r a t e s how the estimates o f market parameters were c a l c u l a t e d . The c a l c u l a t e d expected market r e t u r n , E(R m)» f o r the p e r i o d o f 1965-1974 i s based on r i s k premia o f Standard & Poor's 32) Common Stock Index. ' The r i s k - f r e e r e t u r n o f 3.2% i s the geo-m e t r i c , average annual r a t e o f r e t u r n on long-term U.S. Government bonds. The negative value o f -2.6% f o r ECR^) i s s t r o n g l y i n f l u e n c e d by the poor market performance of common stocks during 1973 and 1974. Attachments B2 and B4 show the computation o f b e t a - f a c t o r s f o r i n d i v i d u a l a i r l i n e s . The magnitude of the b e t a - f a c t o r range obtained (from .235 to 1.769) i s i n c o n c e i v a b l e . I t i s d i f f i c u l t to e x p l a i n t h a t three firms with s i m i l a r f i n a n c i a l s t r u c t u r e s , w i t h i n the same i n d u s t r y , have such a variance i n t h e i r b e t a - f a c t o r s . 30) See d i s c u s s i o n i n III.3.3.1 31) See (35) pp. 25-33 32) T h i s i s the d i f f e r e n t i a l between annual geometric mean r a t e o f r e t u r n on common stocks and t r e a s u r y b i l l s as computed by Ibbotson and S i n q u e f i e l d - 165 -Because the a i r l i n e s provide s e r v i c e s , demand f o r which has a r e l a t i v e l y high income e l a s t i c i t y , t h e i r b e t a - f a c t o r s are expected to be greater than one (market b e t a ) . For t h i s reason the beta-f a c t o r s f o r National and Western appear more f e a s i b l e than the one f o r D e l t a . I t could a l s o be argued t h a t s u p e r i o r management p r a c t i c e s , i n c l u d i n g s p e c i a l emphasis given to f o r e c a s t i n g , has enabled Western to keep i t s b e t a - f a c t o r c l o s e to one. Due to the c o n f l i c t i n g outcome o f the a n a l y s i s , the v a l i d i t y o f the CAPM-Model should be questioned again. As Breen and Lerner emphas-i z e d , beta v a r i e s i n time. In a d d i t i o n , r e g u l a t o r y d e c i s i o n s may 33) f u r t h e r i n c r e a s e t h i s i n s t a b i l i t y . ' Route awards or f a r e increases granted during a p a r t i c u l a r y e a r , and/or to a p a r t i c u l a r a i r l i n e , could have a strong impact on the r e s u l t s of the data analysed. T h i s w i l l l i m i t the accuracy o f any conclusions drawn. The above a p p l i e s to both past and f u t u r e b e t a - f a c t o r s . Because o f the reasons s t a t e d above, the r e s u l t s f o r Delta w i l l be ignored. Minor c o n s i d e r a t i o n w i l l be given to the information provided by the b e t a - f a c t o r s o f National and Western. Annual market returns performed t h e i r f u n c t i o n s a t i s f a c t o r i l y , while betas were c a l c u l a t e d . However, a negative expected market r e t u r n i s not r e a l i s t i c . To c a l c u l a t e the c o s t o f e q u i t y estimates f o r the a i r -l i n e s the negative F.(Rm) was, t h e r e f o r e , replaced by an 8.4% r a t e . T h i s r a t e i s the annual geometric mean r a t e of r e t u r n on Standard & Poor's Common Stock Index over 1926-1974. 33) See d i s c u s s i o n i n IV.1.5.2 - 166 -The a p p l i c a t i o n of the CAPM-Model using an 8.4% f o r E(R m) produced a cost of equity estimate of 12.4% f o r National and 8.7% f o r Western, as shown in Attachment B5. - 167 -5.0.0. Application of Comparable Earnings Approach The comparable earnings approach s t i p u l a t e s that the greater the attendant investment r i s k , the greater the expected return must be i n order to a t t r a c t new equity c a p i t a l . To perform the study as outlined previously, ' a group of business and f i n a n c i a l r i s k i n d i c a t o r s were selected to r e f l e c t the r e l a t i v e degree of r i s k of the industry groups analysed. Risk indicators were divided into the following three groups: 1) Indicators r e f l e c t i n g business r i s k 2) Indicators r e f l e c t i n g f i n a n c i a l r i s k 3) Indicators r e f l e c t i n g f i n a n c i a l r i s k combined with business r i s k . The r a t i o n a l f o r the s e l e c t i o n o f in d i v i d u a l r i s k i n d i c a t o r s and the methodology applied i s discussed i n ATTACHMENT C in more d e t a i l , while a more comprehensive discussion of r i s k can be found in Chapter I I I . l . 3 . 3 . 5.1.0. Empirical Findings A) Business Risk ATTACHMENT CI indicates that i n 1962-1973 a i r c a r r i e r s experienced the second highest growth rate (13.7%) i n operating revenues a f t e r the transportation equipment industries (15.1%). However, i n 1968-1973 a i r c a r r i e r s experienced a higher rate of growth than any other of the groups analysed. See Discussion i n IV.4.3.2. - 168 -The index f o r " S t a b i l i t y of Revenue Growth" over the same periods i s shown i n ATTACHMENT C2. While the transportation equipment industry appears to be the most ins t a b l e i n d u s t r i a l group, a i r c a r r i e r s as a group indicate a r e l a t i v e l y stable exponential growth trend. The operating margins f o r each group are shown in ATTACHMENT C3. While u t i l i t i e s have a very safe, high operating margin of 26.8%, "transportation equipment i n d u s t r i e s " have the lowest margin of 5.5% and the a i r transport industry a s l i g h t l y higher margin of 6.8% i n 1973. The business r i s k i n d i c a t o r data presented i n ATTACHMENTS CI to C3 shows that transportation equipment in d u s t r i e s v/ere subjected to greater business r i s k i n 1962-1973 than any other group analysed. The a i r transport industry indicated the second highest r i s k l e v e l . B) Financial Risk ATTACHMENT C4 shows common equity as a percentage of the t o t a l invested c a p i t a l f o r ind i v i d u a l groups. In 1.973, the actual equity c a p i t a l of the a i r c a r r i e r s was only 13% of the to t a l c a p i t a l , while the transportation equipment industries and e l e c t r i c a l products industries had 86% and 84% equity of total c a p i t a l . The high f i n a n c i a l leverage of the a i r transport industry generally i s heavily influenced by A i r Canada's actual c a p i t a l structure. For reasons previously discussed, a normalized debt-equity r a t i o of - 169 -45/55 w i l l be assumed f o r the a i r transport industry. Even a f t e r t h i s normalization, the possible investors i n a i r c a r r i e r s are subject to a greater f i n a n c i a l r i s k than the investors in trans-portation equipment or e l e c t r i c a l products i n d u s t r i e s . ATTACHMENT C5, showing the "Fixed Charge Coverage" before and a f t e r depreciation, also supports the above conclusion that a i r c a r r i e r s had a high f i n a n c i a l r i s k f o r t h e period analysed. Assuming debt/equity r a t i o of 45/55 at the end of 1973, A i r Canada would have had a f i x e d charge coverage r a t i o of 7.2 and CP A i r of 7.4 before depreciation. These values are close to the average r a t i o f o r a l l i n d u s t r i e s , but s t i l l f a r below the r a t i o s of the two industry groups that indicated a business r i s k more l i k e the a i r c a r r i e r s ' . ATTACHMENTS C6a and C6b i n d i c a t e the s t a b i l i t y of return on equity i n the form of "sample standard d e v i a t i o n " and " c o e f f i c i e n t of v a r i a t i o n " . If a i r c a r r i e r s had a debt/equity r a t i o of 45/55, the performance of a i r c a r r i e r s would have been l e s s stable than the one of the average f o r a l l i n d u s t r i e s , but more stable than the one f o r e l e c t r i c a l products i n d u s t r i e s . However, i n terms of c o e f f i c i e n t of v a r i a t i o n the return earned by a i r c a r r i e r s was l e s s stable than the one earned by any of the other industries analysed. ATTACHMENT C7 demonstrates the s e n s i t i v i t y of Net Income to the changes in operating revenues or expenses. This c a l c u l a t i o n emphasizes the difference between the more and the l e s s c a p i t a l - 170 -intensive i n d u s t r i e s . For example, a 5% increase in operating expenses reduces the net income of public u t i l i t i e s by 14.3% only, while the same increase reduces the net income of A i r Canada by 99.4% and CP A i r by 77.7%. This i s again assuming that both a i r c a r r i e r s have a normalized c a p i t a l structure. The s e n s i t i v i t y of the net income of these two a i r c a r r i e r s i s f a i r l y comparable to the s e n s i t i v i t y of the net income of transportation equipment i n d u s t r i e s (71.2%), only s l i g h t l y higher. ATTACHMENTS C6 and C7 indicate that transcontinental a i r c a r r i e r s experienced a combined f i n a n c i a l and business r i s k during the 1962-1973 period equal to or s l i g h t l y higher than the r i s k of the transportation equipment i n d u s t r i e s . E l e c t r i c a l products i n d u s t r i e s indicated a somewhat lower r i s k . The u t i l i t i e s represented the lowest r i s k o f a l l the groups analysed. Based on the above findings i t i s not possible to conclude that any one of the unregulated industry groups belongs to exactly the same r i s k c l a s s as the transcontinental a i r c a r r i e r s . Business r i s k i n d i c a t o r s c l a s s i f y transportation equipment i n d u s t r i e s into a more r i s k y category than a i r c a r r i e r s . In contrast, f i n a n c i a l r i s k and combined r i s k i n d i c a t o r s imply that a i r c a r r i e r s face the highest r i s k of the three groups compared. Consequently, empirical findings show the following reasonable, j u s t i f i a b l e conclusion: 1) The transportation equipment i n d u s t r i e s ' o v e r a l l r i s k i s s i m i l a r to a i r c a r r i e r s ' r i s k 2) The e l e c t r i c a l products i n d u s t r i e s ' o v e r a l l r i s k i s s l i g h t l y lower than a i r c a r r i e r s ' r i s k . - 171 -5.2.0. Cost of Equity Capital f o r Reference Groups A f t e r completion of the r i s k a n a l y s i s , the cost of equity estimate f o r transcontinental a i r c a r r i e r s w i l l be based on a r e l a t i v e r i s k and return on equity comparison between a i r c a r r i e r s and each of the industry groups. The h i s t o r i c a l returns on book equity, f o r regulated and unregulated members of the reference groups, were ca l c u l a t e d f o r the periods of 1962 to 1973 and 1968 to 1973. The r e s u l t s are tabulated f o r the above groups and the associated r i s k l e v e l s as follows: Return on Book Equity  1962-1973 1968-1973 Regulated Industries with a lower r i s k l e v e l than a i r c a r r i e r s ( u t i l i t i e s ) 10.38% 11.90% Unregulated Industries with a lower r i s k l e v e l than a i r c a r r i e r s ( e l e c t r i c a l products industries) 10.76% 11.90% Unregulated Industries with a r i s k l e v e l s i m i l a r to a i r c a r r i e r s (transportation equipment in d u s t r i e s ) 14.30% 17.00% The rate of return required by investors i n the transportation equipment and e l e c t r i c a l products industries should be estimated by c a l c u l a t i n g the market cost of e q u i t y for a representative sample of each of the two i n d u s t r i e s . Because of the recognized weaknesses 35) of the comparable earnings approach ' and the r e s u l t i n g minor 3 5 ^ See IV.1.5.3. - 1 7 2 -consideration given to i t in t h i s study,, no e f f o r t was made to compute these costs. H i s t o r i c a l rates of return on book equity earned by the industries analysed, provide at l e a s t suggestive evidence concerning the cost of equity c a p i t a l l e v e l s f o r the purposes of t h i s t h e s i s . - 173 -6.0.0 A d d i t i o n a l C r i t e r i a 6.1.0 Cost of Equity C a p i t a l f o r U.S. A i r C a r r i e r s as decided by the C.A.B. The conclusions drawn i n the 1971 C.A.B. Hearing, discussed i n IV.1.5.1, can be summarized as f o l l o w s . One o f the witnesses, Dr. F o s t e r , i n h i s 1970 study o f "Cash Flow and Comparable Earnings" estimated the c o s t of e q u i t y f o r trunk 41) c a r r i e r s to be w i t h i n a range of 17 to 19%. ' Another witness, Dr. Brown, recommended i n his 1970 study a c o s t 42) o f e q u i t y of 16% f o r trunk c a r r i e r s . ' In the l a t e s t domestic passenger f a r e i n v e s t i g a t i o n , A p r i l 1971, the C.A.B. concluded t h a t the c o s t o f e q u i t y f o r domestic trunk l i n e 43) c a r r i e r s was 16.75%. ' However, there i s doubtless a j u s t i f i a b l e argument t h a t economic changes s i n c e 1971 warrant an upward a d j u s t -ment i n t h i s c o s t o f e q u i t y estimate. (See d i s c u s s i o n i n V.1.2.0.) 6.2.0 Cost o f Equity C a p i t a l Estimate by the C.T.C. Estimates f o r the c o s t o f e q u i t y c a p i t a l f o r other regulated i n d u s t r i e s r e c e n t l y published by the Canadian Transport Commission (C.T.C.) a l s o provide some useful information f o r A i r C a r r i e r s ' c o s t of e q u i t y . In 1974 the C.T.C. s e t a new permissive r a t e o f r e t u r n on t o t a l c a p i t a l f o r B e l l Canada o f 8.6-9.1%. They a l s o considered the r e t u r n on common 44) e q u i t y and a r r i v e d a t a range of 11-12%. ' In e a r l y 1975, before 41) See (8) 42 See (7 43) See (6) 44) See F i n a n c i a l Post, August 1974 - 174 -approving the rate increase a p p l i c a t i o n by B. C. Telephone, the C.T.C. stated that a reasonable return on common equity f o r t h i s company at the time of a p p l i c a t i o n would range between 12.8% and 13.8%. 4 5 ^ 45) See Financial Post, February 1975 - 175 -7.0.0 Summary Multiple forms of evidence, applicable to a more or l e s s e r extent, in estimating the cost of equity c a p i t a l f o r Canadian t r a n s c o n t i -nental a i r c a r r i e r s have been analysed. The r e s u l t s of t h i s analysis and t h e i r implication on the cost of equity c a p i t a l f o r a i r c a r r i e r s are summarized below. Reference Rate of Return Range (%) Risk') Level Cost o f 2 ) Equity Current Interest Rates - Prime Rate, Bond Yields - Finance Paper Plus Risk Premium f o r TSE Industrial Index 9.75-11.0+ 14.70 Lower Lower Higher Higher Ex Post Rates of Return (TSE Industrial Index) 6.90 Lower Higher Application of DCF-Formula - Past performance of U.S. a i r l i n e s as a base - Future performance of Western A i r l i n e s as a base 11.20-14.30 16.00-18.30 Equal Equal Equal Equal Application of CAPM-Model 8.70-12.40 Equal Equal App l i c a t i o n of Comparable Earnings Approach - Book Return on Equity (*I) - Book Return on Equity (II) , 11.90 17.00 Lower Equal/ Higher Higher Equal/ Lower U.S. Trunk Carr i e r s - Average -16.75 Equal Equal Bell Canada 1974 11.00-12.00 Lower Higher B. C. Telephone 1975 12.80-13.80 Lower Higher 1) Risk l e v e l of the reference compared with transcontinental a i r c a r r i e r s 2) Suggested cost of equity f o r a i r c a r r i e r s as compared to the rate of return of the reference. - 176 -Any one value, tabulated in the summary, i s in i t s e l f i n s u f f i c i e n t to determine the cost of equity for Canadian transcontinental a i r c a r r i e r s . However, j u d i c i o u s l y combined the evidence supports the following conclusion: The c a p i t a l market forecast f o r 1976 indicates that the cost of equity c a p i t a l f o r a i r c a r r i e r s ought to be above 14.7%. This i s the expected rate of return on the TSE Industrial Index Stock. The a p p l i c a t i o n of the DCF-Formula to the past and future performance of U.S. a i r l i n e s demonstrates t h a t economic changes since 1971 warrant an upward adjustment of the cost of equity c a p i t a l f o r a i r c a r r i e r s set by the C.A.B. in 1971. Future performance of Western A i r l i n e s shows a maximum of 18.3% i n expected returns. The h i s t o r i c a l book rate of return on equity earned in the trans-portation equipment industries indicate that the a i r c a r r i e r s ' cost of equity c a p i t a l should be approximately at the 17% l e v e l . The discussion in V.3.2.5. indicated that the r i s k of investing i n the a i r transport industry i s not increasing. Instead, i t appears that business r i s k i s reduced by a changed a i r l i n e management forecasting philosophy, thereby decreasing the cost of equity. However, the cost of equity i s influenced by factors other than the business r i s k . Changes i n the cost of equity c a p i t a l normally correspond to basic i n t e r e s t rate l e v e l changes. This i s to maintain the r i s k premium paid f o r investing i n equity c a p i t a l in preference to - 177 -more secure bonds. Presently, y i e l d s on long term corporate bonds are at the 11% l e v e l . This compares with 7-8% i n the early 1970's, suggesting an increase i n the cost of equity c a p i t a l . Consequently, the above two f a c t s , when combined, indi c a t e that the cost of equity c a p i t a l f o r a i r c a r r i e r s should not d i f f e r s i g n i f i c a n t l y from the l e v e l found i n 1971. Based on the above considerations, a cost of equity c a p i t a l i n the range of 16-18% for Canadian transcontinental a i r c a r r i e r s i s a j u s t i f i e d estimate as of early 1976. Table VII i l l u s t r a t e s the s e n s i t i v i t y of the cost of c a p i t a l -to changes in the c a p i t a l structure and the cost of equity, assuming the before tax cost of debt at 10.5%. - 178 -SENSITIVITY ANALYSIS OF k d = 10.5% (constant) 1 1 1 1— .4 .6 .8 1,0 EQUITY TOTAL CAPITAL [ ' > TABLE VII - 179 -SUMMARY 1.0. F a i r Rate of Return Versus Weighted Average Cost of Capital  The objective of t h i s chapter i s to consolidate the conclusions of the previous chapters, and attempt to formulate a weighted average cost of ca p i t a l f or Canadian transcontinental a i r c a r r i e r s . Major conclusions derived previously are as follows: Chapter IV.2.2.2. concluded that a debt/equity r a t i o of 45/55 represents a reasonable, i f not optimal, c a p i t a l structure f o r transcontinental a i r c a r r i e r s . According to Chapter IV.2.3.0. the current market cost of debt before tax i s approximately 10.5-11.5%. Therefore, on an a f t e r tax basis the cost of debt would range from 5.25% to 5.75%. The discussion of i n t e r e s t rate trends i n Chapter V.1.1.0. indicated an upward trend f o r 1976. In Chapter V.7.O.O., the evaluation of empirical findings regarding the cost of equity c a p i t a l produced a cost estimate range of 16-18%. Based on the above, the weighted average cost of c a p i t a l a f t e r tax for Canadian transcontinental a i r c a r r i e r s can be computed as follows MINIMUM MAXIMUM  Weight Cost Weight Cost Weight % % % % DEBT .45 5.25 2.36 5.75 2.58 EQUITY .55 16.00 8.80 18.00 9.90 WEIGHTED AVERAGE COST OF CAPITAL 11.16 12.48 11.2% 12.5% - 180 -As emphasized i n Chapters III.3.2.0. and IV.4.2.0., Canadian a i r c a r r i e r s follow the C.A.B. method of c a l c u l a t i n g the actual return on investment. This involves adding the i n t e r e s t on long term debt before tax back to the net income a f t e r tax, to obtain the return base. For an F.R.O.I.. to be comparable with the actual rate of return, i t has to be based on the weighted average cost of c a p i t a l  that r e f l e c t s the before tax cost of debt. Therefore, to be consistent the weighted average cost of c a p i t a l f o r estimating the F.R.O.I, f o r a i r c a r r i e r s w i l l be calculated as fol1ows: MINIMUM MAXIMUM  Weight Cost Weight Cost Weight % % % % DEBT .45 10.5 4.72 11.5 5.17 EQUITY .55 16.0 8.80 18.0 9.90 WEIGHTED AVERAGE COST OF CAPITAL 13.52 15.07 13.5% 15.1% Chapter IV.1.2.0. (F.R.0.1. and the Competitive Market) concluded that regulatory bodies should assure that "the average expected rate of return on desired new investment i s equal to the regulated firm's market cost of c a p i t a l " . Therefore, the rate of return regulation should be based on the market cost of c a p i t a l concept. Based on the above, the following ultimate recommendations are made: The F.R.0.1. of a regulated firm s h a l l be equal to i t s market cost of c a p i t a l . - 181 -For Canadian transcontinental a i r c a r r i e r s i n 1976, the F.R.O.I, i s within the range of 13.5% to 15.1%. The Federal Government, through i t s agency, the C.T.C, sanctions the method of determination of the F.R.O.I, outlined above and the proposed F.R.O.I, l e v e l , thereby e s t a b l i s h i n g a sanctioned rate of return on investment. 2.0. Considerations f o r the F.R.O.I. Application When inv e s t i g a t i n g a fare increase a p p l i c a t i o n by an a i r c a r r i e r , the C.T.C. should use the sanctioned rate of return (expressed as a percentage) as a guide. This percentage, when m u l t i p l i e d by the investment rate base, w i l l r e s u l t i n enough current d o l l a r s to cover the fixed charges of debt c a p i t a l , and w i l l provide f a i r com-pensation to the common equity holders of the a i r c a r r i e r s . The forecasted operating revenues and expenses of ind i v i d u a l a i r c a r r i e r s i n d i c a t e , whether the increase requested i s reasonable i n terms of the above rate of return. 2.1. Investment Rate Base The discussion in Chapter III.1.3.2.2. emphasized that the F.R.O.I, percentage should be applied against the book, rather than the market value rate base. Adopting market value as a rate base would amount to a commitment confirming investors' expectations, regardless of what they are based on. According to the C.A.B. method, the investment rate base consists of the company's long term debt and equity c a p i t a l . There are, however, cases when the above rate base might enable the a i r c a r r i e r s to earn excessive 182 -returns. The rate base may be overstated because of the i n c l u s i o n of unproductive investments, assets not in active use, and other u n j u s t i f i e d inclusions of s i m i l a r n a t u r e . ^ The following example i l l u s t r a t e s the problem of an unproductive investment. Suppose, a transcontinental a i r c a r r i e r acquired three new wide-bodied a i r c r a f t at a cost of approximately $90 m i l l i o n . These planes represent an annual depreciation and i n t e r e s t charge 2) of $3X.l m i l l i o n during the f i r s t year. ' Disregarding the f a c t that the actual service demand may not require t h i s additional capacity, the rate'base i s increased. Because of t h i s change a fare increase could be applied f o r without any change in the F.R.0.1. or the operating cost l e v e l . Despite the additional i n t e r e s t and depreciation charges f o r the new a i r c r a f t , excess p r o f i t s could be possible i n the event the fare increase was granted. 3) To avoid t h i s , an adjustment i n the investment base may be.required. ' A i r c r a f t u t i l i z a t i o n and passenger loadfactor s t a t i s t i c s maintained by a i r c a r r i e r s provide an i n d i c a t i o n , whether unproductive components are included i n the rate base. See (10C), page 11, comments by the witnesses of the Consumers' Association Depreciation 30% on the de c l i n i n g balance, 45% debt financed at 10%. See (10C), comments by Dr. Gordon See also III.3.3.0. regarding leased f l i g h t equipment in the investment base..: - 183 -2.2. System Operations versus Routes A i r c a r r i e r s divide t h e i r to t a l system operations into domestic and international routes. It should be emphasized that the idea of a sanctioned rate of return i s a system wide concept. Yet, fare increases are normally applied for and granted on a route basis. Therefore, i t could be argued that the sanctioned rate of return should not be e x c l u s i v e l y used as a j u s t i f i c a t i o n f o r fare increases. Both Canadian transcontinental a i r c a r r i e r s f l y international and domestic routes. It may be a Government p o l i c y to have foreign routes earn a substantial p r o f i t to subsidize domestic routes. Then, the requirement that company's operating p r o f i t s cover the cost of c a p i t a l does not apply for each ind i v i d u a l route. As discussed in Chapter IV.4.2.0., i t i s very d i f f i c u l t to determine the cost of c a p i t a l f o r a p a r t i c u l a r route and f o r separate passenger or cargo operations. Therefore, by necessity the system wide concept of a sanctioned rate of return should be adopted. When analysing the performance of a route, a i r c a r r i e r s normally a l l o c a t e the system investment base to the route on the basis of a v a i l a b l e ton miles. This makes i t possible to c a l c u l a t e the actual return on investment f o r each route. The same procedure should be followed when a i r c a r r i e r s f i l e with the C.T.C. f o r fare increases. The regulatory body can then use the sanctioned rate of return as a guide against the following two c r i t e r i a : F i r s t , the f i n a n c i a l r e s u l t s of the route return on investment before and a f t e r the fare increase should be reviewed separately, - 184 -and r e l a t e d to the sanctioned rate of return and Government p o l i c y concerning t h i s route. Second, the e f f e c t of the requested fare increase on the system  return on investment should be judged against the sanctioned rate of return. 3.0. t o p i c s f o r Further Research During the writing of t h i s thesis many fr i n g e problems worthy of further and more d e t a i l e d research were encountered. One of these i s the choice and d e f i n i t i o n of the investment base. The question being, should the calculated FROI be applied to the book value or market value investment base when determining the allowable earnings. For instance, f o r an a i r c a r r i e r with a f l e e t mix of o l d , nearly f u l l y depreciated, and new a i r c r a f t with minimum depreciation, the book value investment base i s reasonable. However, i f the a i r c a r r i e r ' s f l e e t mix would c o n s i s t on the average of older a i r c r a f t , the concept of replacement value of the a i r c r a f t may provide a more equitable investment base. Problems related to lease financing are another worthwhile t o p i c . Does lease financing e f f e c t the cost of equity c a p i t a l ? Do investors conceive the r i s k related to conventional debt financing d i f f e r e n t l y than the r i s k related to lease financing? While i t i s not a f i n a n c i a l problem, the passenger loadfactors assumed have a d i r e c t impact on the fares necessary to produce allowable earnings. - 185 -The CAB i s assuming a standard loadfactor of 55% f o r a l l routes, disregarding operation modus and type of a i r c r a f t used. A d e t a i l e d study may reveal the necessity f o r a d i f f e r e n t approach required i n Canada. Further, the price e l a s t i c i t y of demand as related to passenger c l a s s i f i c a t i o n (business versus pleasure t r a v e l l e r s ) provides another research t o p i c . The impact of fare increases and various discount fares on passenger loadfactors should be analysed i n more d e t a i l . - 136 -CALCULATION OF EMBEDDED COST OF DEBT December 31, 1973 The Actual Embedded cost of Debt" = the actual carrying costs of company's outstanding long term debt. k, = Net current i n t e r e s t expense 1 0 0 Net long term debt outstanding Interest on Debt P r i n c i p a l + Amortization of Discount and Expense - Amortization of Premium - Interests Associated with current l i a b i l i t i e s = Net current i n t e r e s t expense — Long term Debt + Current portion of long term debt + Unamortized premium on debt - Unamortized discount and expense on debt + Advances from associated companies = Net long term debt outstanding ACTUAL EMBEDDED COST OF DEBT A. Interest on Long Term Debt Long Term Debt Advances from Associated Companies Cap i t a l i z e d A i r c r a f t Leases Unamortized Discount and Expenee on debt Current Portion of Long Term Debt B. TOTAL OUTSTANDING LONG TERM DEBT ACTUAL EMBEDDED COST OF DEBT (A T B) GROUP I December 31, 1973 ($ 000's ) A i r Canada 38,912 295,942 377,820 C P . A i r 6,960 5,671 18,000 17,234 91 ,964 (970) 4,675 14,126 694,701 129,761 5.60% 5.36% Eastern Provincial 932 12,654 Nordair 1,587 15,072 GROUP II P a c i f i c Western Quebecair 2,111 710 27,201 3,831 6,072 919 ' J;668 4,162 1 ,402 13,573 16,740 31,363 11,305 Transair 361 3,340 1,202 4,542 6.87% 9.48% 6.73% 6.28% 7. GROUP II AVERAGE - 7.35% oo Source: Annual Reports to Shareholders EXHIBIT 2 FIXED CHARGE COVERAGE BY CANADIAN AIR CARRIERS TOTAL Assumptions: Debt/Equity r a t i o of 45/55 1974 f i n a n c i a l data of A i r Canada and CP A i r Operating Margin 5% EBIT before DRPC EBIT af t e r DPRC Operating Margin 6% EBIT before DPRC EBIT a f t e r DPRC AIR CANADA Fixed Charge Coverage 4.7 1.5 5.0 1.7 CP AIR Fixed Charge Coverage 4.9 2.1 5.3 2.5 Fixed Charge Coverage 4.7 1.6 5.0 1.9 EXHIBIT 3 DEBT CAPACITY OF CANADIAN AIR CARRIERS Assumptions: A i r c a r r i e r s ' actual f i n a n c i a l data i n 1974 A i r Canada CP A i r Total ($000) ($000) ($000) Average Long Term Debt 799,325 157,794 957,119 I n t e r e s t Expense 55,368 11,785 67,153 Embedded Cost o f Debt 6.9% 7.5% 7.0% Investment a t the year end 937,616 196,619 1 ,134,235 Operating Revenue (O.R.) 848,582 276,787 1 ,125,369 Debt Capacity A. B. C. Operating Margin (O.M.) 2% 3% 4% A i r Canada EBIT (OMxO.R.) « I n t e r e s t Expense 16,972 25,457 33,856 Debt Capacity 245,966 368,949 490,667 ( I n t e r e s t Expense/Cost o f Debt Debt/Equity 26/74 40/60 52/48 CP A i r EBIT 5,536 8,304 11,071 Debt Capacity 73,810 110,715 147,620 Debt/Equity 38/62 56/44 75/25 TOTAL EBIT 22,508 33,761 45,015 Debt Capacity 321,534 482,301 643,068 Debt/Equity 28/72 43/57 57/43 EXHIBIT 4~ SEAT-MILE COST COMPARISON (</ASM) COST CATEGORY 1974 FIRST QUARTER 1975 CP-AIR AIR CANADA A V G . U.S. CARRIER CP AIR AIR CANADA A V G . U.S. CARRIER Flying Operations 1.27 1.35 Passenger Service .52 .56 Maintenance .45 " .67 A/C and Traffic Servicing .69 .79 Promotion and.Sales .75 .66 G & A .21 .27 Total Operating Costs 4.09 4.85 Depreciation & Amortization .29 .56 Non-Operating Expense (jj) ® Total Costs 4.23 5 J 6 YIELDS - (C/RPM) CP Air Air Canada Avg. U.S. Carrier (Non-Weighted) LOAD FACTORS CP Air Air Canada Avg. U.S. Carrier (Non-Weighted) 1974 1974 6.01 6.90 7.09 BREAKEVEN ACTUAL DIFFERENCE 61.0 65.9 52.6 61.4 64.0 54.3 0.4 0.9) 1.7 1.43 1.51 1.43 .57 V57 .42 .49 .72 .55 .65 .87 .79 .82 .67 .49 .29 .29 .30 4.61 5.23 4.34 .36 .61 .36 .20 .36 .09 4.81 5.59 4.43 FIRST QUARTER 1975 6.19 7.49 7.45 FIRST QUARTER 1975 BREAKEVEN ACTUAL DIFFERENCE 61.6 63.5 52.9 58.V 57.7 49.8 (3.5) (5.8) (3.2) SOURCE: "U.S. Trunk and Canadian C a r r i e r Operating Economics" A comparison prepared by the Boeing Company EXHIBIT 5 TOTAL OPERATING EXPENSE PLUS N O N -OPERATING EXPENSE (INCOME) 1974 1ST QUARTER 1975 RANK AIRLINE </ASM RANK AIRLINE </ASM 1 Northwest 3.20 1 Northwest 3.47 2 Braniff 4.02 2 National 3.78 3 Western 3 Continental 4.21 4 United 4.19 4 Braniff 4.26 5 CP Air IS 5 United 4.43. 6 TWA 4.23 6 Western 4.48 7 National 4.23 7 Delta 4.60 8 Delta 4.27 8 American 4.75 9 Continental 4.33 9 CP Air 4.81 10 American 4.65 10 TWA 4.83 11 Pan Am 4.71 11 Eastern 4.87 12 Eastern 5.08 12 Pan Am 5.08 1 3 - Air Canada iS 13 Air Canada 5.59 AVERAGE U.S. CARRIER* 4.27 AVERAGE U.S. CARRIER* 4.43 CP AIR 4.23 CP AIR 4.81 AIR CANADA 5.16 AIR CANADA 5.59 * Non-weighted SOURCE: "U.S. Trunk and Canadian Carrier Operating Economics" AVERAGE STAGE LENGTHS Because certain costs have terminal as well as per mile contributions it is worthwhile to look at the average stage length for the 13 carriers in order to determine if this is the governing factor in seat-mile costs. The following are the average stage lengths (statute miles) for the 13 carriers. 1974 AVERAGE ST. LENGTH 1 QTR '75 AVERAGE ST. LENGTH CP AIR V£25^ 898 AIR CANADA ( § ) 566 AMERICAN 783 780 EASTERN 513 533 TWA 943 889 •UNITED 691 682 BRANIFF 529 533 CONTINENTAL 546 560 DELTA 428 433 NATIONAL 498 489 NORTHWEST 630 639 PAN AM • 1365 1371 WESTERN (594) 591 SOURCE: "U.S. Trunk and. Canadian Carrier Operating Economics" BREAK-EVEN LOAD FACTORS (Cont'd.) 1974 AIRLINE SCHED.PASS. B.E.L.F. ACTUAL L.FC 1 Northwest 41.7% 45.8% 2 National 45.8 51.4 3 Braniff 46.3 49.9 4 Delta . 50.8 56.7 5 Continental 52.8 53.9 6 United 54.6 58.9 7 TWA 55.3 52.4 ® Western 56.6 60.3 9 Pan Am 57.5 50.4 10 American 57.7 58.1 11 Eastern 59.9 60.0 12 CP Air 61.0 61.4 13 Air Canada 65.9 64.0 AVG. U.S. CARRIER 52.6 ' 54.3 (NON-WEIGHTED) 1ST QUARTER 1975 DIFFERENCE ACTUAL L.F.' B.E.L.F. SCHED.PASS. B.E.L.F. ACTUAL L.F. DIFFERENCE ACTUAL L.F. B. E.L.F.' 4.1 44.2% 43.6% (0.6) 5.6 45.4 49.3 3.9 3.6 47.7 48.6 0.9 5.9 52.3 51.7 (0.6) 1.1 48.0 48.5 0.5 4.3 56.2 52.5 (3.7) (2.9) 57.2 44.4 02.8) 3.7 60.7 60.7 0.0 (7.1) 57.0 43.9 (13.1) 0.4 58.3 50.5 (7.8) 0.1 54.6 . 54.1 (0.5) 0.4 61.6 58.1 (3.5) (K9) 63.5 57.7 (5.8) 1.7 52.9 49.8 • (3.2) SOURCE: "U.S. Trunk and Canadian Carrier Operating Economics" t V T I T T i T T 1 GNP (%) 3.0 2.5 2.0-1.5 -1.0 .5 REAL GNP VERSUS MANUFACTURERS SALES OF MADE-'IN-CANADA APPLIANCES .5 1.0 1.5 2.0 2.5 TABULATION OF COMPARATIVE EARNING POWER FOR CANADIAN STOCKS AND BONDS Long-Term Provincial Bonds Ontario Quebec Manitoba MARCH 7.91 7.89 7.94 1973 JUNE SEPT. 8.17 8.18 8.18 % 8.33 8.75 8.59 DEC. 8.28 8.70 8.50 MARCH 8.68 8.76 9.06 1974 JUNE SEPT. % 9/40 9.90 9.95 % DEC. 10.73 9.41 10.11 10.91 10.25 10.17 Long-Term Municipal Bonds Toronto Montreal Long-Term Corporate Bonds Bell Canada Domtar Ltd. Union Gas Co. of Canada 7.98 8.19 7.87 7.94 8.17 8.25 8.39 8.2 7 8.21 8.37 8.63 8.95 8.76 8.68 8.81 8.58 8.87 8.59 8.52 8.58 9.20 9.11 9.18 79.85 10.25 9.84 9.70 9.79 10.65 11.35 10.25 10.75 10.66 10.23 10.70 10.41 10.92 10.55 Stocks Aver. Y i e l d of 64 Common Industrials Aver, of 18 Preferred And "A" Shares 3.41 3.70 3.95 4.61 4.84 5.07 6.54 7.03 6.38 6.57 6.77 7.00 7.42 7.85 8.69 9.36 SOURCE: FINANCIAL POST EXHIBIT 9. COMPARATIVE EARNING POWER FOR CANADIAN STOCKS AND BONDS MONTH TREASURY BILLS MC LEOD 10 Municipals YOUNG WEIR 10 Industrials TSE STOCK DIVID-END YIELDS 1974 1975 1974 1975 1974 1975 1974 1975 Jan. % 6.28 % 6.65 % 8.99 % 10.05 % 8.98 % 10.44 % 3.57 % 5.13 Feb. 6.11 6.34 9.01 10.00 8.98 9.99 3.52 5.06 March 6.28 6.29 9.29 10.14 9.26 10.15 3.69 5.16 Apri 1 7.13 6.54 9.86 10.84 9.91 10.75 4.15 5.12 May 8.24 6.90 10.21 10.61 10.12 10.62 4.45 5.03 June 8.68 6.96 10.55 10.59 10.45 10.57 4.60 4.97 July 8.92 7.29 10.84 10.90 10.81 10.93 4.60 4.97 Aug. 9.09 7.72 11.28 10.93 11.02 10.94 5.19 5.01 Sept. 9.03 8.37 11.00 11.30 10.99 11.40 5.75 5.32 Oct. 8.60 8.31 10.52 10.99 10.40 11.15 5.38 5.60 Nov. 7.73 8.44 10.54 11.04 10.34 11.15 5.77 -Dec. 7.32 - 10.54 - 10.72 - 5.88 -SOURCE: I. P. Sharp Data Base EXHIBIT 9A - 199 -TREND OF CANADIAN PRIME BANK RATE 1973 - 1975 Prime Rate Month 1973 1974 1975 % % % January 6 9h 10% February 6 9h 9-3/4 March 6 9h 9 A p r i l 6h 10% 9 May 7 11 9 June 7-3/4 11% 9 J u l y 7-3/4 11% 9 August 8% Uh 9 September 9 Uh 9-3/4 October 9 Uh 9-3/4 November 9 11 9-3/4 December 9h 11 9-3/4 AVERAGE 7.65 10.80 9.45 Source: The Money Market Wood Gundy L t d . EXHIBIT 10 ESTIMATED REAL SECURITY YIELDS TO MATURITY (For explanation see text) TSE Industrial Index 8 9 10 11 12 13 14 15 16 17 18 19 20' 7«o Term to Maturity (Years) SOURCE: Wood Gundy Canadian Economy, Forecast EXHIBIT 10A - 201 -BOOK REFERENCES: 1 BAILEY, E.E. "Economic Theory o f Regulatory C o n s t r a i n t " D.C. Heath and Company Lexington, Massachusetts 1973 2 BUTTERS, J.K., FRUHAN, W.E. & PIPER, T.R. "Case Problems i n Finance" American Telephone and Telegraph Company I l l i n o i s 1972 3 LUSZTIG, P.A. AND SCHWAB.B. "Managerial Finance i n a Canadian S e t t i n g " Montreal 1973 4 TRIPP, F.G. " A i r c r a f t Leasing: An Ev a l u a t i o n i n Terms o f the P u b l i c I n t e r e s t o f Con s t r u c t i v e Ownership Versus D i r e c t Expense Reporting by the Domestic A i r C a r r i e r s " D i s s e r t a t i o n a t The American U n i v e r s i t y 1972 5 VAN HORNE, J.C. (1971) " F i n a n c i a l Management and P o l i c y " Englewood C l i f f s N.J. 1971, Pr e n t i c e - Hall PRINTED STUDY REFERENCES 6 Docket 21866-8 Domestic Passenger Fare I n v e s t i g a t i o n Phase 8 - Rate o f Return Decided: A p r i l 9, 1971 C i v i l Aeronautics Board Washington, D.C. U.S.A. 7 Before the C i v i l Aeronautics Board D i r e c t Testimony o f V i c t o r H. Brown Rate o f Return, Docket 21866-8 Domestic Passenger Fare I n v e s t i g a t i o n TOUCHE ROSS & CO. 8 Before the C i v i l Aeronautics Board In the Matter of Domestic Passenger Fare I n v e s t i g a t i o n Testimony o f J . Rhoads Foster on Rate of Return o f the Domestic Trunklines FOSTER ASSOCIATES, INC. Washington, D.C. - August 1970 U.S.A. - 202 -9 "Economic S i t u a t i o n o f the A i r l i n e Industry" (Review o f Future Cap i t a l Financing and Options f o r Action) Study by IATA, F i n a n c i a l and Economic Studies Sub-Committee A p r i l 1974 10A "U.S. A i r l i n e Industry, Costs and P r o d u c t i v i t y 1967-1973" A i r Transport A s s o c i a t i o n o f America Economics and Finance Department May 1974 10B "The Scheduled A i r l i n e s , 1975-1980" A i r Transport A s s o c i a t i o n o f America December 1974 10C Canadian Transport Commission A i r Transport Committee Fare Hearing, May 13-23, 1975 T r a n s c r i p t 10D A CASE STUDY IN AIR TRANSPORT BY R.D. GRITTA: (1974) "The Impact o f the C a p i t a l i z a t i o n o f Leases on F i n a n c i a l A n a l y s i s " F i n a n c i a l A n a l y s t J o u r n a l , March-April 1974 pp 47-52 PUBLISHED ARTICIIE REFERENCES: 11 AVERCH, H. AND JOHNSON, L.L. (1962) "Behaviour o f the Firm under Regulatory C o n s t r a i n t " American Economic Review, V o l . 52 (Dec. 1962) pp. 1053-1069 12 BAILEY, E.E. AND MALONE, J.C. (1970) "Resource A l l o c a t i o n and the Regulated Firm" The B e l l Journal of Economics and Management Science V o l . 1. No. 1, pp. 129-142 13 BAUMOL, W.J. AND KLEVORICK, A.K. (1970) "Input Choices and Rate of Return Regulation -An Overview o f the Di s c u s s i o n " The B e l l Journal o f Economics and Management Science Vol . 1. No. 2. pp. 162-190 14 BEAVER, W.H. KETTLE, P. AND SCHOLES, M. (1970) "The A s s o c i a t i o n Between Market Determined and Accounting Determined Risk Measures" Accounting Review, XLV (October 1970) pp. 654-682 15A BREEN, W.J. AND LERNER, E.M. (1972) "On the Use o f Beta i n Regulatory Proceedings" The B e l l Journal o f Economics and Management Science Autumn 1972 pp. 612-618 - 203 -15B BREEN, W.J. and LERNER, E.M. (1974) "Corporate F i n a n c i a l S t r a t e g i e s and Market Measures o f Risk and Return" Journal o f Finance, XXVIII (May 1974), pp. 339-352 16 COOTNER, P.H. AND HOLLAND, D.M. (1970 "Rate o f Return and Business Risk" The B e l l Journal of Economics and Management Science V o l . 1. No. 2 pp. 211-226 17 FAMA, E.F. (1970) " E f f i c i e n t C a p i t a l Markets: A Review o f Theory and Empirical Work" Journal of Finance, Vol 25, No. 2, (May 1970) pp. 383-417 18 FISHER, L. AND LORIE, J.H. "Rates o f Return on Investments i n Common Stock" The Year-by-Year Record, 1926-65" Journal o f Business, V o l . 41, No. 3 ( J u l y 1968) pp. 291-316 19 KEELER, T.E. (1972) " A i r l i n e Regulation and Market Performance" The B e l l Journal o f Economics and Managerial Science V o l . 3. No. 2 pp. 399-424 20 KLEVORICK, A.K. (1966) "The Graduated F a i r Return: A Regulatory Proposal" American Economic Review, V o l . 56, (June 1966) pp. 477-84 21 KLEVORICK, A.K. (1971) "The "Optimal" F a i r Rate o f Return" The B e l l Journal o f Economics and Management Science V o l . 2. No. 1, pp. 122-153 22 McKIE, J.W. (1970) "Regulation and the Free Market: The Problem o f Boundaries" The B e l l Journal o f Economics and Management Science V o l . 1. No. 1, pp. 6-26 23 MODIGLIANI, F. AND MILLER, M.H. (1958) "The Cost o f C a p i t a l , Corporation Finance and the Theory o f Investment" American Economic Review, 48 (June 1958) - 204 -24 MORTON, W.A. (1970) "Guides to a F a i r Rate o f Return" P u b l i c U t i l i t i e s F o r t n i g h t l y V o l . 86, No. 2 ( J u l y 2, 1970) pp. 17-30 25A MYERS, S.C. (1972) "The A p p l i c a t i o n o f Finance Theory o f Pu b l i c U t i l i t y Rate Cases" The B e l l Journal o f Economics and Management Science V o l . 3. No. 1 pp. 58-97 25B MYERS, S.C. (1973) "The R e l a t i o n between Real and F i n a n c i a l Measures of Risk and Return" Presented a t the A,T&T Conference on Risk and Return V a i l , Colorado, August 1973 25C MYERS, S.C. (1972) "On the use of Beta i n Regulatory Proceedings: A Comment" B e l l Journal o f Economics and Management Science Autumn 1972 pp. 622-627 26 MYERS, S.C. (1971) "What was A.T&T's Cost of Ca p i t a l i n E a r l y 1971?" ABSTRACT 27 SOLOMON, EZRA (1970) " A l t e r n a t i v e Rate o f Return Concepts and T h e i r Implications For U t i l i t y Regulation" The B e l l Journal o f Economics and Management Science V o l . 1. No. 1 pp. 65-81 28 STIGLER, G.J. (1971) "The Theory of Economic Regulation" The B e l l Journal o f Economics and Management Science V o l . 2. No. 1. pp 3-21 29 TAKAYAMA, A. (1969) "Behaviour o f the Firm Under Regulatory C o n s t r a i n t " American Economic Review V o l . 59 (June 1969) pp. 255-60 30 THOMPSON, H.E. (1972) "Ca p i t a l S t r u c t u r e Coverage Ratios and the Rate o f Return i n P u b l i c U t i l i t i e s " F i n a n c i a l Analysts J o u r n a l , Jan. - Feb. 1972 pp. 69-73 - 205 -31 TODD, K.R. "Re l a t i o n s h i p o f Earnings Growth to Return on Investment and F i n a n c i a l P o l i c i e s " F i n a n c i a l Executive, June 1970 pp. 52-58-7 32 VERNON, T.H. " A i r C a r r i e r s ' Return on Investment, Probing the Mysteries" F i n a n c i a l Analysts Journal/January-February 1971 pp. 44-53 33 WEINTRAUB, S. (1968) "Rate Making and an Incentive Rate o f Return" P u b l i c U t i l i t i e s F o r t n i g h t l y , V o l . 81 ( A p r i l 25, 1968) pp. 23-33 34 WILLIAMSON, 0. (1963) "Managerial D i s c r e t i o n and Business Behaviour" American Economic Review V o l . L I I I , No. 5 (Dec. 1963) 35 WESTON, F.J. (1973) "Investment Decisions using C a p i t a l Asset P r i c i n g Model" F i n a n c i a l Management, Spring 1973 pp. 25-33 36 WOOD GUNDY (1975) "Canadian Economy - Forecast" Toronto, January 1975 37 SINQUEFIELD, R.A. AND IBBOTSON, R.G. (1974) "Stocks, Bonds, B i l l s , and I n f l a t i o n : The Past and The Future" Paper presented a t the Seminar on the A n a l y s i s o f S e c u r i t y P r i c e s , Center f o r Research i n S e c u r i t y P r i c e s , Graduate School o f Business, U n i v e r s i t y o f Chicago, May and November, 1974. STATISTICAL DATA COLLECTION: Annual Reports o f the A i r l i n e s A i r l i n e Data provided by Canadian Business S e r v i c e A i r l i n e Data provided by F i n a n c i a l Post Corporate S e r v i c e A i r Transport World C i v i l A v i a t i o n Canadian Scheduled C a r r i e r s by Company 1962-1969 Dominion Bureau o f S t a t i s t i c s A i r C a r r i e r F i n a n c i a l Statements 1970-1973 S t a t i s t i c s Canada, Catalogue Number 51-206 - 206 -Corporation F i n a n c i a l S t a t i s t i c s 1962-1971 S t a t i s t i c s Canada, Catalogue Number 61-207 I n d u s t r i a l Corporations, 1962-1973 F i n a n c i a l S t a t i s t i c s S t a t i s t i c s Canada, Catalogue Number 61-003 Moody's Handbook o f Common Stocks, 1975 Selected Corporate Ratios 1962-1971 Canadian Imperial Bank o f Commerce - 207 -A T T A C H M E N T A THE MODEL USED TO ESTIMATE WESTERN AIRLINES' COST OF CAPITAL ATTACHMENT AT: WESTERN AIRLINES' RATE OF GROWTH ATTACHMENT A2: WESTERN AIRLINES' GROWTH IN EARNINGS, DIVIDENDS AND BOOK VALUE PER SHARE ATTACHMENT A3: WESTERN AIRLINES' PROFITABILITY ATTACHMENT7A4: COST OF EQUITY CAPITAL ESTIMATES BASED ON THE MODEL - 208 -ATTACHMENT A THE MODEL USED TO ESTIMATE WESTERN AIRLINES COST OF  EQUITY CAPITAL Purpose o f Model The model c a l c u l a t e s the c o s t of e q u i t y c a p i t a l implied by the c u r r e n t share p r i c e , given i n v e s t o r s ' expectations o f Western's long term book r a t e o f r e t u r n on e q u i t y (ROE), and the long term grov/th r a t e o f the book e q u i t y ( g ^ ) . ^ Time Horizon ? Q = Average 1975 share p r i c e = $8.00 (1975 P r i c e Range: $10.00 - $6.00) P.] = Expected share p r i c e at the end o f 1976 D.| = Dividends expected to be paid out i n 1976 D 2 = Dividends expected to be paid out i n 1977 Assumptions The main assumptions are the f o l l o w i n g : 1. In 1976, the dividend payout r a t i o n (b^) i s .3. A f t e r 1976, the minimum payout r a t i o i s .3 each year. The maximum payout r a t i o i s one t h a t guarantees a minimum growth (g^) o f 9.1%. 2 . Growth i n book investment at the r a t e g ^ r i s e n t i r e l y finance by r e t a i n e d earnings. i . e . g A = ( l - b A ) (ROE) This approach i s Myers'. D e t a i l s and model development from here on i s by the w r i t e r . - 209 -3. Western's book p r o f i t a b i l i t y w i l l be constant a f t e r 1976. In 1976, that p r o f i t a b i l i t y i s three percent-age points less than the long term p r o f i t a b i l i t y , to allow f o r a period of recovery from the economic slow down. 4. The book value per share at the end of 1976 (BVPS-j) w i l l equal the estimated value as of Jan. 1, 1976 plus earnings reinvested during 1976. P r o f i t a b i l i t y Data Input Actual 1974 Estimate 1975 x? Forecast 1976 Return on Book Equity (X) 18.2 4.7 13.0-18.0 Book Equity Per Share January 1 ($) 8.75 9.95 9.95 EPS ($) 1.59 .47 1.29-1.79 Dividends per Share ($) .39 .47 .39-.54 Retained Earnings Ratio H-b^) Long Term Growth Rate of Book Equity (g^) 9.1% 9.8% 10.5% 11.2% 11.9% 12.6% ROE 13% .700 14% .650 .700 15% .670 .653 .700 16% .569 .612 .656 .700 17% .535 .576 .618 .659 .700 18% .506 .544 .583 .622 .661 .700 - 210 -Formula Applied Given the above assumptions, the p r i c e a t the end o f 1976 w i l l be given by p = D 2 = ^ ( B V P S ^ R O E ) where g i s the long term growth r a t e i n earnings and dividends per share. K g, the estimated c o s t of e q u i t y c a p i t a l , can be determined by s o l v i n g .47 + P. $8.00 = ^ + K' x) ' Nine months ending September 1975: EPS $ .45 Div. $ .47 WESTERN AIRLINES RATE OF GROWTH YEAR TOTAL ASSETS ($000) GROWTH RATE {%) % INCREASE TOTAL ASSETS FROM PREVIOUS YEAR OPERATING REVENUES OPERATING REVENUES ($000) GROWTH RATE (%) 1965 157 973 _ - 140 598 \ 66 192 008 (+) 21.5 (+) 26.0 177 184 67 231 342 (+) 20.5 (+) 8.6 192 482 68 69 349 039 367 588 • 9.4 (+) 50.9 (+) 5.3 (+) 15.3 ('+) 8.3 221 953 240 352 >14.1 70 355 168 (-) 3.4 (+) 24.0 298 109 71 72 340 352 342 531 •1.6 (-) 4.2 (+) .6 (+) 9.2 (+) 12.3 325 595 365 663 14.4 73 377 457 (+) 10.2 (+) 15.2 421 286 1974 396 825 ') J (+) 5.1 (+) 15.9 488 397 ' ) Growth rat e s are determined by f i t t i n g trend l i n e with a constant growth rate to the y e a r l y values. SOURCE: Moody's Handbook, Western A i r l i n e s Annual Reports. ATTACHMENT - A l -WESTERN AIRLINES GROWTH IN EARNINGS, DIVIDENDS, AND BOOK VALUE PER SHARE OF STOCK YEAR PER SHARE % INCREASE EARNINGS GROWTH (55) DIVIDENDS GROWTH (%) BOOK VALUE GROWTH (%) PER YEAR \ 4.69 \ 1965 .92 .26 — 66 1.22 .33 5.69 (+) 21.3 67 .82 .33 6.19 (+) 8.8 68 .56 '6.5* .33 •5.0* 6.44 4.9° (+) 4.0 69 (0.81) \ .16 5.44 \ (-) 15.5 70 .04 - 5.48 (+) -7 71 .39 'N.A. - >20* 5.92 >10.6° (+) 8.0 72 .75 .08 - 6.62 (+) 11.8 73 1.35 .24 7.77 (+) 17.4 1974 1.59 ) J .39 J ) 8.76 ) > (+) 12.7 ° C a l c u l a t e d as i n attachment - A l -* Because o f the poor trend f i t , the average growth r a t e equals the annual r a t e a t which the 1965 values have to grow to reach 1974 l e v e l . SOURCE: Moody's Handbook, Western A i r l i n e s Annual Reports ATTACHMENT -A2-WESTERN AIRLINES PROFITABILITY YEAR RETURN ON TOTAL INVESTMENT (X) EQUITY {%) 1965 15.4 19.6 66 16.3 21.4 67 10.3 13.2 68 6.5 8.6 69 .7 (14.9) 70 5.2 .7 71 5.9 6.6 72 6.3 11.3 73 11.0 17.4 1974 9.6 18.1 ARITHMETIC AVERAGE 9.6 13.0 (Excluding 1969) The above values have been c a l c u l a t e d according to the CAB-method. SOURCE: Western A i r l i n e s Annual Reports ATTACHMENT -A3-- 214 -COST OF EQUITY CAPITAL ESTIMATES BASED ON THE MODEL Long Term Growth Rate o f Book Equity (g«) 9.1% 9.3% 10.5% 11.2% 11.9% 12.6% ROE 13% 13.90 14% 15.11 14.95 15% 16.34 16.18 16.00 16% 17.51 17.38 17.24 17.05 17% 18.70 18.56 18.42 18.29 18.14 18% 19.84 19.71 19.58 19.43 19.30 19.11 ATTACHMENT A4 - 215 -A T T A C H M E N T B CAPITAL ASSET PRICING MODEL APPLICATION ATTACHMENT B1: ESTIMATES OF MARKET PARAMETERS ATTACHMENT B2: CALCULATION OF BETA FOR DELTA AIRLINES ATTACHMENT B3: CALCULATION OF BETA FOR NATIONAL AIRLINES ATTACHMENT B4: CALCULATION OF BETA FOR WESTERN AIRLINES ATTACHMENT B5: REQUIRED RATE OF RETURN FOR AIR CARRIERS - 216 -ESTIMATES OF MARKET PARAMETERS : YEAR Rmt x) [Rmt-E(Rm)] [Rmt-E(Rm)] 2 R f t X X ) (1) (2) (3) (4) (5) 1965 .082 .108 .0117 1966 (.141) (.115) .0132 1967 .190 .216 .0467 1968 .056 .082 .0067 1969 (.141) (.115) .0132 1970 (.024) .002 .0000 1971 .096 ,122 .0149 1972 .146 .172 .0296 1973 (.202) (.176) .0310 1974 (.319) (.293) .0858 (,257)/10 .2528/9 E(Rm) = (.0257) : > VAR(Rm) = .0281 + Rf = 3.2% x) Risk premia on Standard & Poor's Composite ("500") Common Stock Index as computed by Ibbotson and S i n q u e f i e l d xx) Geometric Average Annual (1926-1974) Rate of Return on Long-term Government Bonds, as computed by Ibbotson and S i n q u e f i e l d ATTACHMENT Bl CALCULATION OF BETA FOR DELTA AIRLINES YEAR (1) Pt (2) ~ P t " Pt-1 (3) -1 Dt Pt (4) R j t (5) [Rjt-E(Rj)] (6) [Rm-E(Rm)] (7) (6) (7) (8) 1964 11.50 1965 15.00 .304 .019 .323 .121 .108 .0131 1966 32.50 1.167 .010 1.177 .975 (.115) (.1121) 1967 36.50 .123 .010 .133 (.069) .216 (.0149) 1968 30.50 (.164) .013 (.151) (.353) .082 (.0289) 1969 33.00 .082 .012 .094 .108 (.115) (.0124) 1970 29.00 (.121) .016 (.105) (.307) .002 (.0006) 1971 42.00 .448 .012 .460 .258 .122 .0315 1972 55.00 .310 .009 .319 .117 .172 .0201 1973 51.50 (.064) .011 (.053) (.255) (.176) .0449 1974 41.50 (.194) .014 (.180) (.382) (.293) .1119 2.017/10 .0526/8 E(Rj) = .2017 BETAj COV(Rjm) _ VAR(Rm) " .0066 .058T COV(Rj,Rm) .235 .0066 ATTACHMENT B2 CALCULATION OF BETA FOR NATIONAL AIRLINES YEAR Pt Dt Pt Rjt [ R j t - E ( R j ) ] JRm-E(Rm)] (6) (7) (1) (2) (3) (4) (5) (6) (7) (8) ; 1964 13.00 1965 27.50 1.115 .008 1.123 .994 .108 .1074 1966 40.00 .455 .008 .463 .334 (.115) (.0384) 1967 38.50 (.038) .008 (.030) (.160) .216 (.0346) 1968 34.50 (.104) .009 (.095) (.225) .082 (.0185) 1969 34.00 (.014) .010 (.004) (.134) (.115) .0154 1970 16.50 (.515) .024 (.491) (.621) .002 (.0012) 1971 25.00 .515 .004 .511 .382 .122 .0466 1972 40.00 .600 - .600 .471 .172 .0810 1973 22.00 (.450) .018 (.432) (.562) (.176) .0989 1974 13.50 (.386) .036 (.350) (.480) (.293) .1406 1.295/10 .3972/8 E(Rj) = .1295 BETAj = _ COV(Rj,Rm) _ .0497 VAR(Rm) .0281 COV(Rj,Rm) = .0497 1.769 ATTACHMENT B3 CALCULATION OF BETA FOR WESTERN AIRLINES YEAR 0) Pt (2) (3) Dt Pt (4) R j t (5) [Rjt-E(Rj)] (6) [Rm-E(Rm)] (7) (6). (7) (8) 1964 12.00 1965 12.00 .000 .021 .021 (.050) .108 (.0054) 1966 13.50 .125 .023 .148 .077 (.115) (.0089) 1967 14.50 .074 .023 .097 .026 .216 .0056 1968 11.00 (.241) .029 (.212) (.283) .082 (.0232) 1969 9.50 (.136) .016 (.120) (.191) (.115) .0220 1970 4.50 (.526) - (.526) (.597) .002 (.0012) 1971 10.50 1.333 - 1.333 1.262 .122 .1540 1972 12.50 .190 .006 .196 .125 .172 .0215 1973 9.50 (.240) .024 (.216) (.287) (.176) .0505 1974 9.00 (.053) .043 (.010) (.081) (.293) .0237 .708/10 .2386/8 E(Rj) = .0708 C0V(Rj,Rm): = .0298 RPTfl - COV(Rj,Rin) _ .0298 = , n f i n B E T A " V A T T O .028T 1- 0 6 0 ATTACHMENT B4 REQUIRED E(Rj) RATE OF RETURN FOR AIR CARRIERS = Rf + [E(Rm) - Rf] BETAj Delta A i r l i n e s A) E(Rj) = .032 + B) E(Rj) = .032 + National A i r l i n e s A) E(Rj) = .032 + B) E(Rj) = .032 + Western A i r l i n e s A) E(Rj) = .032 + B) E(Rj) = .032 + -.026 - .032) (.235) = .018 .084 - .032) (.235) = .044 -.026 - .032) (1.769) = -.071 .084 - .032) (1.769) = .124 -.026 - .032) (1.060) = -.029 .084 - .032) (1.060) = .087 ATTACHMENT B5 - 221 -A T T A C H M E N T COMPARABLE EARNINGS APPROACH APPLICATION ATTACHMENT CI: ATTACHMENT C2: ATTACHMENT C3: ATTACHMENT C4: ATTACHMENT C5: ATTACHMENT C6: a b ATTACHMENT C7 ATTACHMENT C8 AVERAGE ANNUAL GROWTH RATE OF OPERATING REVENUE STABILITY OF REVENUE GROWTH COMPARATIVE OPERATING MARGINS EQUITY AS A PERCENTAGE OF TOTAL INVESTED CAPITAL COMPARATIVE FIXED CHARGE COVERAGE RATIOS STABILITY OF RETURN ON EQUITY SAMPLE STANDARD DEVIATION COEFFICIENT OF VARIATION SENSITIVITY ANALYSIS AIR CARRIERS OPERATING MARGIN - 222 -ATTACHMENT C  RATIONAL FOR SELECTION OF RISK INDICATORS Business Risk Business r i s k i s the o v e r a l l r i s k determined by the business environment and represents the u n c e r t a i n t y that a company might experience a d e c l i n e i n i t s earning power. F i r s t , to r e f l e c t the business r i s k a s s o c i a t e d with product demand, the r a t e o f growth o f operating revenues and s t a b i l i t y o f growth were s e l e c t e d as r i s k i n d i c a t o r s . Although growth i s almost always considered as a h i g h l y p o s i t i v e symptom i n company a n a l y s i s , i t can c r e a t e business r i s k , p a r t i c u l a r l y when i t i s accompanied by i n s t a b i l i t y . For example, growth can c r e a t e equipment shortages, overexpansion, lack of r e q u i r e d experienced personnel, c o n t r o l problems, e t c . Secondly, to r e f l e c t business r i s k s a s s o c i a t e d with operating c h a r a c t e r i s t i c s of d i f f e r e n t i n d u s t r i e s , the operating margin was s e l e c t e d as a r i s k i n d i c a t o r . The operating margin (operating income as a percentage of operating revenues) i s a s i g n i f i c a n t i n d i c a t o r i n an a i r t r a n s p o r t i n d u s t r y a n a l y s i s because o f the f i x e d nature o f the a i r l i n e ' s expenses. Low expenses, r e s u l t i n greater reductions o f the operating income with d e c l i n e s i n revenue than do e i t h e r high operating margins or low operating margins combined with l a r g e l y v a r i a b l e expenses. The methodology a p p l i e d i s explained below. - 223 -Business Risk I n d i c a t o r s by Category 1) Annual Growth Rate of Operating Revenue The growth i n d i c a t o r i s developed by using the l e a s t squares technique. This procedure determines the trend l i n e of "best f i t " through a pattern o f data p o i n t s . The growth i n d i c a t o r c a l c u l a t e d , i s the constant percentage r a t e of growth of t h i s trend l i n e over the years considered. 2) S t a b i l i t y of Growth The s t a b i l i t y index has the same basis as the growth i n d i c a t o r . The l e a s t squares technique i s used to develop a "best f i t " trend l i n e f o r the data being measured f o r s t a b i l i t y . Through another c a l c u l a t i o n , the s t a b i l i t y i s expressed as the c o e f f i c i e n t of determination, which i n d i c a t e s the p o r t i o n of variance that i s explained by the trend l i n e . For example, a s t a b i l i t y index of 1 i s an i n d i c a t o r of p e r f e c t l y s t a b l e growth, while an index of .95 shows a l e s s s t a b l e g r o w t h — o n l y 95% of the v a r i a t i o n i s explained by the trend l i n e . 3) Operating Margin: Operating Income » ,Q,W Operating Revenues 0 Operating margin r e f l e c t s the operating income as a percent o f s a l e s . While most of the r i s k i n d i c a t o r s were c a l c u l a t e d f o r the period 1962-1973, t h i s r a t i o was computed f o r reference groups only f o r 1972 and 1973. T h i s i s due to the f a c t t h at S t a t i s t i c s Canada r e p o r t i n g included the f i n a n c i n g expenses i n the operating expenses u n t i l 1971 and t h e r e f o r e , the operating income was not a " t r u e " one, ( i . e . - independent of the c a p i t a l - 224 -st r u c t u r e ) and comparable with a i r l i n e s ' f i n a n c i a l r e p o r t i n g . F i n a n c i a l Risk F i n a n c i a l r i s k represents the r i s k s i n c u r r e d by c r e d i t o r s and stockholders as the r e s u l t o f the d e c i s i o n by management to i s s u e d i f f e r e n t kinds o f s e c u r i t i e s . The r i s k i n d i c a t o r s were s e l e c t e d to r e f l e c t , p a r t i c u l a r l y , the f i n a n c i a l r i s k i n c u r r e d by stock h o l d e r s . F i n a n c i a l Risk I n d i c a t o r s by Category 1) F i n a n c i a l Leverage: To t a l Equity Y , n f W T o t a l Invested C a p i t a l * I U U 7 ° The r a t i o o f the t o t a l e q u i t y as a percentage o f t o t a l i nvested c a p i t a l i s computed as an i n d i c a t i o n o f f i n a n c i a l leverage. As t h i s r a t i o decreases, the i n v e s t -ment o f common eq u i t y holders becomes su b j e c t to i n c r e a s i n g r i s k due to the i n c r e a s i n g proportion o f debt i n the company's f i n a n c i a l s t r u c t u r e . 2) Fixed Charge Coverage: Earnings Before Fixed Charges & Before Taxes Fixed Charges Before Taxes The r a t i o o f f i x e d charge coverage i s a l s o an i n d i c a t i o n o f the f i n a n c i a l r i s k to common equity holders. The lower the r a t i o , the l a r g e r the r i s k . Due to the same la c k o f inform-a t i o n t h a t was explained i n connection with the operat i n g margin, the r a t i o s were c a l c u l a t e d only f o r 1972 and 1973. The r a t i o i s c a l c u l a t e d both before and a f t e r d e p r e c i a t i o n . F i n a n c i a l Risk Combined with Business Risk The net e f f e c t o f the business and f i n a n c i a l r i s k s discussed above should flow through to the earnings r e c e i v e d by the common share-h o l d e r s . Some r i s k i n d i c a t o r s are s e l e c t e d i n an attempt to q u a n t i f y - 225 -the combined e f f e c t of business and f i n a n c i a l r i s k . This i s to e s t a b l i s h the r e l a t i v e t o t a l r i s k o f the a i r transport industry as compared to the other industry groups. Combined Business and Financial Risk Indicators by Category 1) S t a b i l i t y of Return on Equity: Standard Deviation C o e f f i c i e n t of Variation To e s t a b l i s h the s t a b i l i t y or i n s t a b i l i t y of i n d u s t r i e s ' return on equity, the sample standard deviation from the sample mean is f i r s t determined. This expresses in absolute percentage terms the v a r i a t i o n of return on equity f o r each industry. In order to compare the r e l a t i v e importance of the v a r i a t i o n between various i n d u s t r i e s , the c o e f f i c i e n t of v a r i a t i o n i s determined. This i s the r a t i o of standard deviation to mean. The larger the c o e f f i c i e n t of v a r i a t i o n , the more unstable are the earnings of an industry. 2) S e n s i t i v i t y of Net Income to Changes in Operating Revenues/Expenses This r i s k i n d i c a t o r i s c l o s e l y connected with the above. The following two s e n s i t i v i t y analyses are to be performed: 1. Reduction in Net Income that would r e s u l t from a 5% decline of operating revenue, assuming a l l other factors except income tax unchanged. 2. Reduction in Net Income that would r e s u l t from a 5% increase of operating expense, assuming a l l other factors except income tax unchanged. As the operating margin d e c l i n e s , other factors being equal, the company and i t s investors experience an increased exposure to - 226 -r i s k . Any given f l u c t u a t i o n of operating expenses or revenue has an i n c r e a s i n g l y pronounced impact on net income. T h i s reduction o f net income increases d i s p r o p o r t i o n a l l y as compared to the d e c l i n i n g operating margin because of the r e l a t i v e l y i n c r e a s i n g p r o p o r t i o n of f i n a n c i n g expenses. T h e r e f o r e , the returns r e q u i r e d as compensation f o r r i s k - t a k i n g are a higher percentage of the invested c a p i t a l f o r the i n d u s t r i e s having a low oper a t i n g margin. 227 . ^ AVm'XGE ANNUAL GROlvTH RATE OF OPERATING REVENUE Transportation Equipment .7. L S-; I n dustr-iMiElectr-ical a...4-i 1 5 . 1 A i r Transport Transportation ILZUtilities: 7'.-5S ; j • ;1962-i i • 1973: 4__ "\ " j I n d u s t r i a l '. E l e c t r i c a l AirJTransport at ion o r t a t i o n . Equipment - j 11.5? U t i l i t i e s -!•— 9.0% 0.3.2S 196S - 1973 S t a t i s t i c s Canada 61-003 Attachment - 220 -STABILITY OF REVENUE GROWTH Comparison Between Various Industries S t a b i l i t y Index In d u s t r i a l E l e c t r i c a l i .98 .98 Transportation Equipment - .97 --1 9 6 2 A i r Transportation Transport .99 .99 < to Less Stable 1 9 7 3 Pe r f e c t l y Stable •Industrial ..'92 J h E l e c t r i c a l -.98, i l Transportat ion " Equipment .85 \ A i r -Transportation Transport .98 .98 I Li-Less Stable Per f e c t l y 1 9-6. 1 9 7 3 Stable S t a t i s t i c s Canada 61-003 Curve Linear Exponential Attachment C - 229 -COMPARATIVE OPERATING MARGINS FOR DIFFERENT INDUSTRIES 1972 1973 A l l I n d u s t r i e s 6.5% 7.6% E l e c t r i c a l 6.9 7.2 Tr a n s p o r t a t i o n Equipment 6.0 5.5 Tr a n s p o r t a t i o n 11.5 11.3 U t i l i t i e s 29.3 26.8 A i r Transport 7.9 6.8 A i r Canada 7.8 6.7 CP A i r 7.4 5.8 ATTACHMENT C3 - 231 -COMPARATIVE FIXED CHARGE COVERAGE RATIOS 1972 1973 Before A f t e r Before A f t e r DPRC DPRC DPRC DPRC A l l I n d u s t r i e s 7.6 5.6 8.5 6.6 E l e c t r i c a l 13.0 10.5 11.4 14.8 Tr a n s p o r t a t i o n 18.5 15.6 17.4 14.8 Equipment T r a n s p o r t a t i o n 5.1 3.2 4.8 3.2 U t i l i t i e s 2.8 2.2 2.7 2.2 A i r Transport 4.0 1.9 3.6 1.7 A i r Canada 3.7 1.6 3.5 1.3 CP A i r 5.8 2.7 4.2 2.2 Assuming 45/55 C a p i t a l S t r u c t u r e : A i r Canada 7.7 3.3 7.2 2.8 CP A i r 9.1 4.3 7.4 3.9 '"ATTACHMENT C5 232 ! i M l ! i STABILITY OF -RETURN •••ON EQU ~i —I _AV: Sainple 'Standard D e v i a t i o n ; M i ! ! M M i i ( M l ! I I ' ' M M M M i I i - M M ;..:...'AIr. T^-ransppTt~ j +10.28% _! i„.j_ -Transportation-~ Equipment"""'"-" -+3.65%-- I ; I M M ! E l e c t r i c a l . —:±2.48% : J "Indus Lr i a l p 4-1-• . T f a n s p o r t a t i o n . . U t i l i t i e s T . -40..0 : 9.0 8.0 - 7.0 " " i -6.0 -5.0 i • I. 4.0 i.. -3.0 2.0 1.87' - 1 . 0 M e a n — 1 ) -1.0 —A -2.0. -3.0 ! I ..MM 4._:.: -4.0 —k.o J....Z -6.0 H - - . 7 . 0 -• -- -8.0 i 4; r .v : :-9 .0 -10.0 i t ~ * Assuning 45/55 I>/E R a t i o -; '"""Source:"" S t a t i s t i c s Canada 61-003 Attachment .-£.(a) M 233 -STABILITY OF RFTUPO?; ON EQUITY t-T-;--" C o e f f i c i e n t o f V a r i a t i o n r;__L„.i..u _! i_i_L4 L e s s ': S t a b l e .20 1J.0Q A i r T r a n s p o r t T r a n s p o r t a t i o n '.. - . —..j-.L.'.-:.-. Equipment E l e c t r i c a l Indus t r i a l : ! ; ; .13. 23 .26 Transp^pxtJtiM .18 U t i l i t i e s .0,8 8d 40 -120 . P e r f e c t l y ; * Assuming 45/55 D/E Ratio S t a b l e ;;; Attachment ..6(b) Source: S t a t i s t i c s Canada 61 -003 - 234 -SENSITIVITY ANALYSIS THE REDUCTION IN NET INCOME With an Assumed Operating Margin R e s u l t i n g Return Margin With a 5% Decrease i n Operating Revenues* With a 5% Increase i n Operating Expenses* 26.8% ( U t i l i t i e s ) 12.8% 19.5% 14.3% 11.3% (Transportation) 6.58% 38.0% 33.7% 10.9% ( I n d u s t r i a l ) 4.96% 50.4% 45.0% 9.8% ( E l e c t r i c a l ) 4.69% 53.3% 48.0% 6.8% ( A i r Transport) 1.66% 150.6% 140.4% 5.5% (Tran s p o r t a t i o n Equipment) 3.32% 75.3% 71.2% A) ACTUAL CAPITAL STRUCTURE 6.65% A i r Canada .88% 284.1% 265.9% 5.85% CP A i r 2.26% 110.6% 108.41% 8.58% Regional C a r r i e r s 5.54% 45.1% 41.2% B) NORMALIZED CAPITAL STRUCTURE A i r Canada 106.7% 99.4% CP A i r 82.5% 77.7% EXAMPLE: I n d u s t r i a l - 6. Net Income A f t e r Tax 4.96 2.46 5. Net Income Before Tax 9.92 4.92 4. I n t e r e s t Expenses "758" ~79"8~ 3. Operating Income 10.90 5.90 2. Operating Expenses 89.10 89TT0" 1. Operating Revenue 100.00 95.00 Reduction 50.4% * Factors other than Income Tax Unchanged. ATTACHMENT C7 

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