"Flying with heavy loads"; capital structure considerations for the US airline industry , England, GB University of Southampton
(Discussion Papers in Accounting & Finance, AF-10-01).
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The paper discusses a hidden aspect of a firm's capital structure through the use of a real options application. It is applied to the US airline industry, characterized by over levered balance sheets, and one which on some estimates, has made zero cumulative profit taking the years of the last century together. The paper introduces the notion of "financial flexibility", defined as the freedom (or flexibility) enjoyed by a conservatively geared firm to respond quickly and secure positive NPV projects, as opposed to an over levered firm. This "flexibility" is then valued as a real option using a model based on arithmetic Brownian motion involving a path dependant option pricing framework. It analyses the implications of debt financing in the US airline industry and develops a capital structure model that incorporates the value of "financial flexibility" enjoyed by conservatively geared carriers. This model essentially balances the quantified value of financial flexibility enjoyed by conservatively geared carriers against the relevant cost of obtaining this flexibility (i.e. the cost of carrying a sub optimal capital structure) and factors in the implications of "fire sales" (Pulvino, 1998) which is specific to the US airline industry. In its application to South West Airlines the paper concludes that the optimal capital structure, if the value of financial flexibility is incorporated - should move closer to the origin. A methodology of integrating the value of financial flexibility into the traditional theories of capital structure is proposed and demonstrated that (at least) in the US airline industry, failure to do so can result in a significant misstatement in a firm's value and its optimal capital structure. This paper makes two key contributions to the existing body of academic literature. The notion of valuing financial flexibility as a real option has been introduced previously by Beneda and Nelson (2003). However their quantification of the option value is through a standard Black Scholes equation where the underlying assumptions of this are not valid in quantifying a real option of this nature and this chapter makes a modification of the standard Black Scholes equation to reflect reality. Furthermore the paper applies the concept of financial flexibility specifically to the US airline industry and develops a conjecture on how this can be incorporated into the traditional theories of capital structure which is another contribution to the academic literature.
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