Hong Kong Dragon Airlines Limited (A): Determining the Cost of Capital case study discusses the problem of Dragonair in replacing what seemed to be an unrepairable engine. The airlines are faced with three choices which are: to buy the engine but would have to order it 12 months in advance from its supplier and pay a downpayment, or it could choose to enter into a sale-and-leaseback agreement or completely rent a new engine from a leasing company.
Su Han Chan, Ko Wang, Andrew Lee
Harvard Business Review (HKU882-PDF-ENG)
January 15, 2010
Case questions answered:
Determine the weighted average cost of capital calculations for Hong Kong Dragon Airlines Limited.
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Case answers for Hong Kong Dragon Airlines Limited (A): Determining the Cost of Capital
This case solution includes an Excel file with calculations.
Determine the weighted average cost of capital calculations for Hong Kong Dragon Airlines Limited
To determine the weighted average cost of capital calculations for Hong Kong Dragon Airlines Limited, the Discount rate that should be used when using the WACC is 5.51% or 5.54%, depending on the bond rating when it is issued. By comparing bonds issued by similar companies, Cathay Pacific, which Hong Kong used as a proxy for their firm issued AAA bonds and Hainan Airlines (Hong Kong) Co Limited, issued AA bonds.
I used the 10-year note issued in Jan 2006 with a risk-free rate of 4.18% after looking at historical spreads between the treasury notes and corporate bonds. I added 83 basis points if the bond issued was rated AAA and 90 basis points if the bond issued was AA. Giving the bonds a yield of 5.01% (AAA) and 5.08% (AA), the tax rate that was given was 17.5%.