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SU HAN CHAN
KO WANG

HONG KONG DRAGON AIRLINES LIMITED (A):
DETERMINING THE COST OF CAPITAL
In early January 2006, a taskforce at Hong Kong Dragon Airlines (“Dragonair”) led by engineering manager John Walters and finance manager Bevis Ho was formed to evaluate ways to replace a spare engine that had been determined to be beyond economic repair
(“BER”).1 A few potential options were on the table: either to purchase the engine outright or to lease the engine via a direct lease or a sale-and-leaseback arrangement. In order to assess and compare the attractiveness of each option, the taskforce first had to determine the appropriate discount rate to use.

Dragonair: Company Background2,3,4
Hong Kong-based Dragonair was founded in May 1985 as a wholly owned subsidiary of
Hong Kong Macau International Investment Co by local industrialist K.P. Chao. The airline started operations in July 1985 with a Boeing 737 and service between Hong Kong and Kota
Kinabalu in Malaysia. With a fleet of only one aircraft, Dragonair was known in its early days as the “when-it’s-in-the-air-there’s-nothing-on-the-ground” airline. After much effort by Chao to rally support from both the Chinese central government and the British government,
Dragonair began service to Phuket and six cities in mainland China in 1986.
In 1990, CITIC Pacific, the Swire Group 5 and Cathay Pacific Airways (“Cathay Pacific”) acquired an 89% stake in Dragonair. After the acquisition, Cathay Pacific transferred its
1

In the aviation industry, a piece of equipment was usually deemed BER when the cost of repair exceeded 70–80% of the new equipment cost.
2
Wikipedia (2008) “Hong Kong Dragon Airlines Company Ltd.”, http://en.wikipedia.org/wiki/Dragonair (accessed June 2008).
3 Dragonair (2008) “About Dragonair”, http://www.dragonair.com/da/en_INTL/aboutus/aboutdragonair/history (accessed June
2008).
4 Wharton Hong Kong (2007) “Biography of K.P. Chao”, http://www.whartonhongkong07.com/bio-s-chao.html (accessed June
2008).
5
The Swire Group was also the largest shareholder of Cathay Pacific Airways.
Andrew Lee prepared this case based on published sources and interviews with industry observers under the supervision of
Professor Su-Han Chan and Professor Ko Wang for class discussion. This case is not intended to show effective or ineffective handling of decision or business processes. Timing, figures and values presented in the case are estimates only and are not intended to represent any actual timing, figures and values. Persons, names and titles used in the case are fictitious.
© 2009 by The Asia Case Research Centre, The University of Hong Kong. No part of this publication may be reproduced or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise (including the internet)—without the permission of The University of Hong Kong.
Ref. 09/457C

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For the Dragon Airlines Limiteduse of J.the Cost of Capital exclusive (A): Determining, 2016.
Hong Kong

Beijing and Shanghai services to Dragonair, along with its Lockheed L1011-1 TriStar aircraft.
But soon Dragonair embarked on an aggressive fleet-renewal programme. In 1991, Dragonair chose the Airbus A320 aircraft with International Aero Engines AG’s V2500 engines for its narrow-body fleet.6 With the delivery of six A320s in 1993, Dragonair phased out all its five
737s. Two years later, the airline replaced its aging TriStar fleet with three Airbus A330 wide-body aircraft.
The new millennium marked a watershed in Dragonair’s development when it moved into its purpose-built headquarters at the Hong Kong International Airport in Cheklapkok in June
2000 and began its all-cargo service with a Boeing 747-200 in July. Dragonair’s fleet expansion continued through 2005. In 2002, its fleet of freighters included three Boeing 747300s. On the passenger side, it operated eight A320s, four A321s and nine A330s. Between
2003 and 2005, Dragonair increased its total fleet size by more than 40%, adding one 747-200 freighter, three A320s, two A321s and four A330s.

Spare Engine Acquisition
A spare V2500 engine, the type used for Dragonair’s A320-family aircraft, was purchased as part of the expansion plan for Dragonair’s A320-family fleet between 2003 and 2005, and was delivered in late 2003. This additional spare engine would have increased Dragonair’s number of spare V2500 engines to four. However, another engine on the fleet was deemed
BER during a heavy maintenance event in late 2002. Whilst the airline could support itself with three spares until 2006, the expected number of engine maintenance events from early
2007 onwards would call for a replacement spare V2500 engine by early 2007. Dragonair’s board of directors had agreed to the requirement in principle, subject to detailed analysis of the various options by the taskforce.

Determining the Discount Rate
On 13 January 2006, the taskforce met to discuss how best to determine the discount rates to use for analysing the options. The exchange during the meeting between Walters and Ho went as follows:
Ho:

The objective of our meeting today to is to discuss what discount rates we should use to evaluate and compare the different options for acquiring a replacement
V2500 engine.

Walters: Well, I’m just an engineer. Tell me about these discount rates.
Ho:

I’ve been asked by our CFO to take this opportunity to review our capital budgeting process and recommend the appropriate discount rates to use for this purpose. Our choices include the cost of debt, the cost of equity, and the weighted-average cost of capital, which takes into account both the cost of debt and the cost of equity.

Walters: Boy, that’s confusing. So, what do we do?
Ho:

6

We need to come up with these rates. I suggest we use Cathay Pacific as a proxy because Dragonair is not a listed company but Cathay Pacific is and we are in the same industry. Also, to the best of my knowledge, our risk profile and the type and

International Aero Engines AG (2008) “History of IAE”, http://www.v2500.com/company/history.shtml (accessed June 2008).

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maturity of debt we use are very similar. We should get Cathay Pacific’s last two to three years’ balance sheet information.
Walters: Sure thing. Okay, I can see where the cost of debt comes from. But how do you go about determining the cost of equity?
Ho:

Please help me gather the relevant capital market information. We will also need to get Cathay Pacific’s beta. We know that the corporate tax rate is 17.5%.

Walters: So, once we have the discount rates, how do we decide which one to use for our analysis? Ho:

It all depends on the riskiness of the cash flow stream we are discounting. Let’s review the various options for replacing the BER engine.

Walters: We have the option of purchasing a new engine from the manufacturer. However, we are also looking into sale-and-leaseback or direct lease offers. These leases qualify as operating rather than capital leases.
Ho:

For the purchase option, the cash flow items will be pretty straightforward. There should be only the purchase price and the residual value. The direct lease should be straightforward too. It’ll just be the monthly lease rental payments.

Walters: Not really. These leasing companies also require us to pay maintenance reserves on a monthly basis when the engine is installed and used.
Ho:

What does that mean?

Walters: You see, the lease rental that we pay only represents the return on the lessor’s investment in the engine and has nothing to do with maintaining the engine, which is where the maintenance reserves per hour and cycle come in. For every hour and cycle the engine is operated, it sustains some degree of wear and tear.7 It is only paid for when the engine is removed from the aircraft and sent to a repair and overhaul facility for a major maintenance event. Let’s assume that the lessor takes an engine back when it has sustained US$1 million worth of wear and tear from operations, but the engine can still operate for, let’s say, another two years. The next lessee that leases the engine is only willing to pay for the wear and tear sustained through its own operation of the engine, and not through that of the previous lessee. So, the lessor will have to supplement the cost of repairing the engine in its next major maintenance event, and that money comes from the maintenance reserves paid by the previous lessee. Of course, the current lessee also pays its share of maintenance reserves throughout its lease term. When it puts the engine through heavy maintenance, it can claim some money back from the lessor, but any maintenance reserves left in the lessor’s account at the end of the lease will be kept by the lessor.
Ho:

I see. In that case, we need to think about how to treat the maintenance reservesrelated cash flows. But first, let’s get to work and gather the data we need.

Walters: Okay. Let’s meet again on 22 January and try to come up with these discount rates.
7

Every hour or part thereof during which an aircraft was airborne counted toward flight hours. One take-off and landing amounted to one cycle.

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For the Dragon Airlines Limiteduse of J.the Cost of Capital exclusive (A): Determining , 2016.
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Homing In on the Rates

On 21 January 2006, Ho and Walters were reviewing the data they had collected for their meeting the following day. Walters and his team had obtained the 2003 and 2004 balance sheet information for Cathay Pacific [see Exhibit 1]. They had also collected capital market information for Hong Kong [see Exhibit 2]. It was now up to Ho and Walters to make sense of all the data they had gathered and determine the discount rate that they should use.

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EXHIBIT 1: CATHAY PACIFIC AIRWAYS BALANCE SHEETS FOR
31 DECEMBER 2003 AND 2004 (HK$ MILLION)
2004

Non-current liabilities
Long-term liabilities
Related pledged security deposits
Net long-term liabilities
Retirement benefits obligations
Deferred taxation
Current liabilities
Current portion of long-term liabilities
Related pledged security deposits
Net current portion of long-term liabilities
Trade and other payables
Unearned transportation revenue
Taxation
Total liabilities
Total assets less current and non-current liabilities FINANCED BY
Share capital
Reserves
Minority interest

51,357
405
1,661

4,076
57,975

1,263
54,686
398
4,753
15,200
20,351
75,037

(33,022)
11,604
(21,418)
(181)
(7,762)
(29,361)

(7,096)
2,127
(4,969)
(7,163)
(3,622)
(1,497)
(17,251)
(42,295)

(6,754)
1,875
(4,879)
(5,543)
(2,839)
(1,259)
(14,520)
(43,881)

32,989

31,156

674
32,181
134
32,989

Total assets

51,808
348
1,743

(27,698)
10,036
(17,662)
(102)
(7,280)
(25,044)

Current assets
Stock
Trade and other receivables
Liquid funds

2003

524
5,311
11,474
17,309
75,284

ASSETS AND LIABILITIES
Non-current assets
Fixed assets
Intangible assets
Investments in associated companies
Other long-term receivables and investments 669
30,383
104
31,156

Source: Cathay Pacific Airways (2003–2004) “Annual Report”.

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EXHIBIT 2: CAPITAL MARKET INFORMATION
1995–JANUARY 2006

Year
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
Jan 2006
Average

1-Year
Hong Kong
Exchange
Fund Bill
5.51%
5.00%
9.41%
5.72%
5.82%
5.38%
2.22%
1.39%
0.26%
0.58%
3.90%
3.74
4.11%

10-Year
Hong Kong
Exchange
Fund Note
N/A
7.27%
9.22%
6.36%
7.74%
6.46%
6.22%
4.39%
4.37%
3.63%
4.18%
4.18
5.98%

Beta of Cathay Pacific Airways (Jan 2006)

Note 1:
Note 2:

Hang Seng
Index
Annual
Return
23.0%
33.5%
-20.3%
-6.3%
68.8%
-11.0%
-24.5%
-18.2%
34.9%
13.2%
4.5%

Best
Lending
Rate
8.75%
8.50%
9.50%
9.00%
8.50%
9.50%
5.13%
5.00%
5.00%
5.00%
7.75%
7.42%

8.9%
0.78

All data are as of the end of the period.
The issuance of 10-Year Hong Kong Exchange Fund Notes only began in 1996.

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...The Significance of Eve’s Dreams in Paradise Lost Some of the most telling aspects of John Milton’s Paradise Lost are in the few instances in which the reader is privy to the contents of Adam and Eve’s dreams, and these instances contribute significantly to the outcome and overall meaning of the poem. Milton’s use of dreams in Paradise Lost serves several distinct purposes. These passages allow us to glean insight to the inner workings of both Adam and Eve’s subconscious, as well as to God’s respective plans for them. Adam and Eve’s dreams illustrate the differences inherent within them and their very different relationships with God. Eve’s dreams are particularly dramatic in their substance, and in their drastic contrast before and after the fall. I propose that Milton’s use of dreams in Paradise Lost demonstrates that prelapsarian Eve could never have truly comprehended good and evil. All of Adam’s dreams in the poem are divinely inspired, while Eve’s first dream is induced by Satan, and her final, postlapsarian dream a vision from God that shows her that she will go on to bear the “promised seed” (12.623) that will deliver salvation. This essay will examine the different ways in which Adam and Eve receive information and how it affects their understanding and, consequently, their actions. We are first introduced to Adam and Eve as Satan is observing them in the Garden of Eden, acting as the first anthropologist in order to ascertain how to bring about their demise. Satan...

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Adam & Eve Lost in Paradise

...Paradise Lost by John Milton: Discuss the relationship between Adam and Eve, as portrayed in Book 9 of Paradise Lost. How does Milton’s portrayal compare to or differ from how Adam and Eve are typically portrayed, described, or understood? Thoughts of Eve conjure images of a meek woman who is submissive and created to serve her husband. Adam is thought of as a strong, beautiful man created in the likeness of God. He is the ruler of land and sea and leader of all mankind. Their relationship is thought of as idyllic and unified, even throughout and after their fall. However, Milton casts a different light on their relationship and personal traits in Book 9 of Paradise Lost. Adam’s submissive helpmate becomes an independent, contrary, challenging woman in Book 9 where he becomes a mild, somewhat weak pushover. Adam appears to be the voice of reason. He is seen as the one enamored with his wife and protective of her well-being. Eve though challenges his trust and gets frustrated with his attempt to keep her close. It’s like she feels smothered by his presence and feels that a little separation from each other would be beneficial to their relationship. The birth of women’s manipulative power over men begins right there in the Garden (speculation of course). She tells him, “Frail is our happiness, if this be so, / And Eden were no Eden thus exposed” (2098). Adam becomes a pushover when Eve wears him down with her constant rebuttals and grants her wish, but warns her that she knows...

Words: 767 - Pages: 4