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The Fuqua School of Business at Duke University

FUQ-10-2006
March 7, 2006

Air Deccan Cutting Costs, Not


Corners
The Story of Indias First Low Cost Airline

Background
The Indian economy has been booming in recent years. The aviation industry in India has
also been growing rapidly. However, the market remains largely under penetrated. The
Government of India has historically heavily regulated the aviation industry. In recent years,
there has been a relaxation in the regulation policy of the Government and this has paved the
way for several new airlines to enter the market.
Air Deccan, Indias first low cost carrier is one of these new entrants and is looking to
capitalize on the vast potential that is inherent in the aviation market. However, to do so it
needs to expand its operations significantly to sustain its market share in light of the growing
number of competitors that is entering the industry. The company is looking to do an IPO to
fund its expansion.

Sources and Uses of Funds


To fund its expansion needs and preserve its competitive position, Air Deccan is looking to
raise $250-300 million from its IPO. The Exhibit below details the proposed uses of the IPO.

Prepared by Ruchika Chinda, Ruibin Chen, Rishi Gupta, Anuj Sharma under the supervision
of Campbell R. Harvey. Copyright 2006. All Rights Reserved.

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Risk Analysis of Air Deccan


Air Deccan has the following inherent risks due to the nature of the aviation industry and
prevalent sociological and political environment in India.

Symmetric Risks
Demand/Price: The company returns are dependent on the growth in the airline traffic in
India in the coming years. Since the market is highly under penetrated with only 62 out of
450 airports being utilized in India, the potential for the industry is huge. Also, with an
increase in the disposable income in the middle class, more and more people are choosing to
fly rather than avail of other alternatives. The passenger growth in the last few years has been
significantly high (27% in 2005) which further emphasizes the demand in the industry.
However, the price elasticity of customers in India is still very high, thus providing both the
potential and a tremendous advantage to LCCs. The success of this model can be estimated
through the fact that an estimated 40% of Air Deccans passengers are first time flyers. The
increasing number of players in the market could lead to excess capacity in case the demand
does not grow as expected. And since the aviation industry is characterized by high fixed
costs, this would result in a possible exit of many players from the market, including Air
Deccan.
Mitigation: The risk is greatly mitigated due to the expected increased demand in the
Indian market. Moreover, LCCs will be the last to hit as they would still have the
capacity to attract customers through competitive pricing even as the industry faces
excess capacity.
Input/Supply (Resources) Risk:
Labor The airline industry in India has experienced a shortage of skilled personnel,
especially pilots from time to time. Some of Air Deccans competitors offer more
attractive wage and benefit packages than Air Deccan. While the recent past has also
witnessed poaching of pilots by competing airlines, the Government of India imposed a
minimum six months notice period for resigning pilots. Any relaxation of their directions
in the future could worsen the shortage.
Oil Price Air Deccan is extremely vulnerable to fluctuations in the price and availability
of fuel since Government regulations do not permit domestic airlines to hedge against oil
prices.
Covenants Air Deccan has several existing agreements with its lenders that contain
restrictive covenants relating to the companys right to effect a change in its capital
structure, raise additional finance, expand the companys business and change its debt
equity ratios.
No approval for call center Air Deccan has registered, but not yet received approval
from the Department of Telecommunications for operation of the call center at Bangalore.
If this registration is refused, the company might be forced to procure call center services
from third parties, which they might be unable to do in a cost effective and timely
manner.
Limited number of suppliers One of the key elements of the low cost business model
strategy for Air Deccan is to operate only a few types of aircraft, with aircraft within each

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Air Deccan Cutting Costs, Not Corners

Title
type having similar equipment. This commonality provides Air Deccan with many
operational and cost benefits. However, the dependence on these types of aircraft and
engines makes Air Deccan vulnerable to any design defects or mechanical defects that
might arise with such aircraft or engines.
Mitigation: Although little can be done to mitigate an increase in the world oil prices,
Air Deccan can lock resources like labor via contracts to lessen possible resource
risks. In addition, Air Deccan should also invest in diversifying its supplier base (to
the industry average) or else target agreements with its current suppliers to cover
design and manufacturing defects. Finally, since decisions in India still tend to be
governed by the political ambitions of the government officials, it would help Air
Deccan in the long run to invest in gaining political insurance of the local
governments.
Currency, Interest Rate and Inflation: A significant portion of expenses such as fuel,
aircraft and engine maintenance services and interest and principal obligations under the
terms of foreign debt and aircraft lease payments are denominated in or linked to U.S. dollars.
In Fiscal 2005, 35.96% of Air Deccans expenses were incurred in currencies other than
Indian rupees. While some of the inputs are in U.S. dollars, all the outputs are in Rupees,
thereby exposing the company to direct currency risk.
Mitigation: Inflation in India has been pretty constant over the past decade and the
exchange rate fairly stable. Thus the risk of hyperinflation is not as high in
comparison with other emerging economies. However, investors can mitigate this risk
by hedging against this currency risk in the world markets.

Binary Risks
Direct Expropriation: With India being a democratic nation, the risk of direct expropriation
is low. However, with the leftist parties still enjoying some political clout, a change in the
ruling coalition may see the aviation sector monopolized again (Air Corporations Act of
1953).
Mitigation: The involvement of international partners could decrease the intensity of
this risk. Additionally, the companys future plans of reaching every developing area
in the nation may provide incentives for the Indian government to cooperate fully in
the success of this project, which would reduce the risk of expropriation even more.
Regulatory Risk: Since 1991, the Government of India has pursued policies of economic
liberalization and has relaxed certain regulatory restrictions in order to encourage foreign
investment in specified sectors of the economy, including the aviation sector. However, there
is no certainty that these liberalization policies will continue, as a collapse of the current
coalition government could trigger significant changes in Indias economic liberalization and
deregulation policies, thereby disrupting the business conditions in India. In addition, Indian
laws limit Air Deccans ability to raise capital outside India through the issuance of equity or
convertible debt securities and restrict the ability of non Indian companies to acquire Air
Deccan.
Mitigation: Air Deccan should try to involve international and multilateral agencies
as its promoter to mitigate this risk. Such involvements can mitigate the risk to some
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extent as any change in the legal environment which might affect the project would
come under extensive international scrutiny. However, complete mitigation of this risk
is not possible as it is difficult to ascertain how much influence international bodies
could have on the sovereign authorities and on the sovereign laws of a democratic
country.
Technology Risk: There seems to be little technology risk present in this project since the
technique has been tried, tested and proven across the world over many years. However, one
of the key elements of the low cost business model strategy for Air Deccan is to operate only
a few types of aircraft, with aircraft within each type having similar equipment. This
commonality provides Air Deccan with many operational and cost benefits. However, the
dependence on these types of aircraft and engines makes Air Deccan vulnerable to any design
defects or mechanical defects that might arise with such aircraft or engines.
Mitigation: Whatever little technology risk there might be above could be mitigated
through investing in insurance.
Risk of Default: There seems to be risk of default because of the high front loaded
investments that the project demands, and the high dependence on fixed costs like world fuel
prices. Moreover, with the success of Air Deccans business model, new competition is
entering the LCA industry. Kingfisher Airlines, Royal Airlines, Air India Express and Visa are
just a few of the airlines that are establishing LCCs. In addition, the recent exit of Air Sahara
from the market (acquired by Jet Airways) may be an indication of decreasing profitability in
the industry.
Mitigation: The involvement of multilateral agencies could reduce the incidence and
the impact of default.

Asymmetric Risks
Creeping Expropriation: As per the expropriation risks discussed in the section above, it is
very likely that political leadership in India might decide to divert cash flows from the project
through higher royalties or taxes.
Mitigation: However, this risk is partly mitigated due to the importance that the
aviation industry plays in the overall development of the economy.
Sociological Risk: In the past, there have been military confrontations along the India
Pakistan border. The potential for hostilities between the two countries is high due to ongoing
terrorist incidents in India and troop mobilizations along the border. Military activity or
terrorist attacks in the future could influence the Indian economy by disrupting
communications and making travel more difficult.
Mitigation: In the mitigation of this risk, much depends on the policies and
procedures of the current government. Also, incidents and intensity of such risks can
be expected to be reduced with the development of the nation.

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Competitive Analysis
The Indian aviation industry is set for sustainable high growth in the near future.
India has a huge potential for growth in its airlines industry. The Indian domestic aviation
industry has been a laggard relative to its potential in the past. Regulatory and infrastructure
bottlenecks have prevented accelerated growth in the industry despite low penetration levels
and robust economic growth. However, all of this is starting to change with the government
proactively looking to address the bottlenecks. The long term potential of the industry is
immense. Below is a five force analysis on the Indian airline industry.
1.

Rivalry: Competitive pressures has increased due to numerous new entrants and
undergoing expansion by incumbents
After witnessing Air Deccans success, many other low cost carriers have been
established, including Kingfisher Airlines, Spice Jet, Air One, and Go Air.
The competitive landscape for the airline industry is likely to change significantly as
several of these new players with different positions enter the market. In addition,
existing players like Indian Airlines, Jet airway, Sahara and Deccan are aggressively
adding to their fleets for domestic operations.
While demand growth is estimated to keep pace, if further newer players come in or if
demand growth does not sustain, then there could be excess capacity that could lead to
price wars, once fleet additions gain momentum.
The industry will see a clear segmentation in terms of passenger profile. While Jet, Sahara
and Indian Airlines are likely to continue focusing on premium service and trunk routes,
Air Deccan, Go Air (and Royal Airways probably) are likely to play the low fare and
small destination game. The positioning of Kingfisher Airlines is an intermediate between
full service and no frills.

2.

Barriers to Entry: Easy entry but execution doubtful


After years of dormant competitive dynamics, the Indian aviation market is likely to see a
large number of new entrants in the market. Starting up an airline in India is fairly easy,
capital being the only constraint. But execution can be a major hurdle for all the new
players, due to a host of internal and infrastructure issues.
Tightly Regulated: Airlines in India are required to fly to economically less developed
areas and this lowers load factors. Director General of Civil Aviation (DGCA) also
regulates route frequencies and schedules, aircraft registration and employment of foreign
pilots.
The new private airlines will have to compete against established players that have
network, time slots and a strong brand in place. Network would be a key challenge due to
the limited size of operations, and also due to regulatory requirement on route dispersal
norms. Lack of a good network will also mean lower utilization of the aircrafts. These
make up barriers to new entries.

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Poor Infrastructure: Airport infrastructure in India is woefully lacking. Infrastructure


issues limit new comers choices on time slots and trunk routes. The inadequate
infrastructure creates entry barriers for newer players during peak flying hours.
3.

Suppliers: Inadequate airport infrastructure, shortage of pilots and high fuel costs.
Airport congestion: Congestion at key airports is a debilitating infrastructure problem
faced by the industry. While India has over 400 airports, just 62 of them are in use.
Moreover, Delhi and Mumbai account for more than 40% of the total traffic, resulting in
congestion at these airports. In that sense, the bargaining power from airports is high
because there is no substitute for the landing spots.
Shortage of Pilots and Trained Crew: With aggressive fleet additions by new entrants
as well as incumbents, the industry is witnessing a shortage of pilots and skilled crew.
This could result in an imbalance in supply/demand, which could increase the bargaining
power of crews and cause HR costs to rise sharply. Airlines may look to recruit pilots
from international carriers putting pressure on employee costs.
High Fuel Costs in India on a Global Comparison: In India, fuel costs are nearly 80%
higher (120% two years ago) than international base prices because of high duties. For
most international carriers, fuel costs as a % of revenues is 15 20%, while that for
Indian carriers is nearly 25% (would be nearly 35% for LCCs). Although excise and
import duties have reduced in the recent budget, fuel costs of Indian carriers are still 60%
higher. If sales tax is reduced from current levels of 22% to say 10%, then fuel prices
would be 45% higher than international base prices.

4.

Customers: Business travelers sector intensified by GDP growth, leisure customer


market has huge growth opportunity.
The rise in income levels and the number of high income households have a direct effect
on air travel market. India is still in the growth phase of economic development, and both
the rise in income levels and high income households favor strong airline market growth.
Business travelers: Business customers are already fairly well penetrated and they
usually are price inelastic. The business traveler sector should grow in line with overall
economic growth.
Leisure travelers: Leisure travel, which is highly price elastic and under penetrated, has
significant scope for growth. In fact, the entry of a low cost airline like Air Deccan in the
domestic airspace has introduced connectivity to several cities that were not covered by
any airline and brought the price of air travel down to a level where it is comparable with
high end railway fares. Over the next several years, the leisure traveler sector is expected
to grow dramatically. This is because the basic infrastructure will be in place in over 400
Indian cities in the foreseeable future, and most of them are currently under penetrated.

5.

Substitutes: decreasing threats from substitution means of transportation

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India is one of the least penetrated markets for air travel in the world. The reason for this
is that India historically has been putting high level taxes on aircraft fuel and other
aspects of air travel like airport taxes and taxes on tickets. Other means of low cost
transportation, therefore, impose substitution pressure on the airline industry.
To promote the civil aviation industry, the government has reduced customs duty to 10%
(from 20%) and excise duty to 8% (from 16%) in the recent budget. If airlines pass on the
benefits of lower fuel costs to their passengers, fares could fall further and thereby reduce
threats from the substitutes.

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Pros and Cons of Doing an IPO


The decision to go public is an important one and should not be taken lightly. The following
discusses both the advantages and disadvantages of going public.
Advantages of going public:
Liquidity: Companies go public when their equity capital needs increase to the point
where the opportunity cost of remaining private and compensating investors for the lack
of liquidity becomes too great relative to the lower cost of capital derived from liquid
public markets. Once shares of a company are traded on a public exchange, those shares
have a market value and can be resold.
New Capital: Almost all companies go public because they need to raise money. This
capital can be used for various corporate purposes such as working capital and R&D and
also to fund the companys expansion through long term capital expenditures and
potential acquisitions.
Future Capital: If a company has a successful IPO, subsequent offerings are usually
readily accepted by the market, thereby enabling the company to raise additional equity at
favorable terms. Further, a successful offering will improve a firms debt to equity ratio,
thereby improving the companys credibility as a borrower and would allow the firm to
lever up at favorable terms. Convertible securities are another example of an alternative
available to a publicly traded company.
Cashing Out: When owners sell their shares in the secondary market, it sends a negative
signal to the market. However, an IPO gives owners an opportunity to cash out some of
their wealth, thereby giving them greater diversification.
Increased wealth: An IPO has the potential to provide substantial financial reward for all
parties involved. Previously, these shares were illiquid and had a subjective price. With an
IPO, these shares can be sold in the secondary market to the public, usually after the
lockup period has expired. Even if the owners cannot realize the proceeds from the
issuance immediately, a successful IPO would give them an opportunity to use the
publicly traded stock as collateral to borrow for other investments.
Valuation: IPO sets a value for the company that is set by the public markets and not
through subjective standards of private investors. This allows other companies to notice
and evaluate the firm for potential synergies.
Image and Visibility: Taking a company public is one of the acknowledgements of success
in a business. Further, it increases the visibility of a company and could potentially
generate new interest from customers and suppliers, allowing the company to obtain a
larger market for their goods and services. Heightened visibility may provide a
competitive advantage over a privately held company.
Acquisition: Equity in public companies can be used as currency for future acquisitions.
Personnel: Offering stock options to employees can be a powerful incentive for attracting
and retaining quality personnel and aligning employees incentives with those of the
firms.

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Disadvantages of going public:
Time and Costs: An IPO is time consuming and expensive. A successful IPO can take up
to a year or more to complete and has several costs associated with it. These costs are one
time costs like underwriter and legal fees and ongoing costs which result from the need to
report timely information to investors and regulators.
Loss of Control: If a substantial proportion of the shares are sold to the public, outsiders
could take control and the company could face a hostile takeover. While there are
provisions against these takeovers, the market may view certain anti takeover devices as
unacceptable in an IPO. Anti takeover provisions increase agency costs. Further,
defending a hostile bid can be time consuming and expensive.
Dilution: Current shareholders percentage of ownership is diluted in an IPO. Further,
earnings per share are also diluted.
Disclosure: SEC disclosure requirements for public companies are very extensive. A
public company must regularly provide information about the company that would
otherwise not be available to the public. This information can be used by competitors,
thereby giving them potential advantages.
Market Pressure: Market pressure may cause management to focus on short term results
to maintain stock prices, thereby foregoing possible future NPV projects, which might be
essential for the long term success of the company.
Regulatory Review: A public company is open to review by the SEC to ensure that the
company is making all the appropriate filings with relevant disclosures.
Falling Stock Price: If the companys stock price falls, the market may lose confidence in
the company, which would result in a decreased valuation for the company. This could
affect the companys lines of credit and ability to maintain employees.
Restrictions on Management: Typically, IPO entrepreneurs cannot cash out for many
months after an IPO. Further, management may not be able to act as quickly at it could
under a private structure, as they need to comply with SEC proxy rules when obtaining
shareholder votes.
As with any important decision, it is imperative that the owners and principals of a private
company carefully weigh the advantages and disadvantages in light of the goals they have set
for the company. They should consider all the other alternatives available at their disposable
and conduct extensive due diligence before the decision is made to go public.

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Valuation
Cost of Capital Calculation
Below is an analysis of our cost of capital calculation for the Air Deccan:
Risk Premium Calculation
U.S. risk free rate We took this as 4.50% based on the current 10 year Treasury bond
rate.
U.S. risk premium We assumed the market risk premium to be 3%.
Current U.S. credit rating We took the U.S. country rating of 92.5.
Institutional investor country credit rating We took this to be 57.0 in 2006 and
gradually increased it to 72 in 2013. Our underlying assumption here was that the current
liberalization policies of the Government of India will continue to lead to future
investments in the country, thereby increasing the countrys credit rating.
Industry Adjustment
Industry Beta We estimated this to be 1.10 based on the current average beta for the
airline industry.
Project Risk Mitigation
Sovereign
Currency (direct) We thought that Air Deccan was exposed to some currency risk as
some of its inputs were denominated in U.S. dollars, while all of it outputs were
denominated in Rupees, also its debt to finance fleet expansion is mostly foreign debt.
We assigned this a value of 4.
Currency (indirect) Value of 0 due as indirect currency risk should be similar to what it
would be for the country itself.
Expropriation We though that Air Deccan was exposed to the risk of expropriation due
to the heavy regulation of the airline industry had faced in the past. We assigned it a value
of 2.
Commercial international partners Value of 0 due to the absence of any commercial
international partners.
Involvement of multilateral agencies Value of 0 due to the absence of any multilateral
agencies.
Sensitivity of project to wars We attributed a value of 2 to the company due to the risk
associated with there being union strikes in India, terrorism and geo political factors like
the risk of war with Pakistan.
Sensitivity of project to natural disasters We assumed this to be 0 as we felt that Air
Deccan was as vulnerable to natural disasters as any other company in the country.
Operating
Resource risk We had a value of 4, as there was resource risk due to scarcity of pilots
and infrastructure, which was needed to enter into new airports.
Technology risk We had a value of 9 due to the low risk associated with Air Deccans
proven technology. We would have attributed a higher value had Air Deccan not
purchased their aircrafts from a few suppliers.

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Financial
Probability of default We assigned this a value of 3 as we thought that there was risk of
default due to the high capital requirements of Air Deccan and the possibility that new
entrants would capture a substantial market share, at Air Deccans expense.
Political risk insurance We assigned a value of 0 due to the absence of any political
insurance.
Under these assumptions, Air Deccans cost of capital is 18.19% compared to 16.07% for a
company of average risk in India. Please refer below for our cost of capital worksheet.
However, we need to add 2.23% (difference in the rate of inflation between India and the US)
to normalize this cost of equity calculation. This makes the cost of equity for Air Deccan in
the year 2006 to be 20.49%.
EXHIBIT A
Cost of Capital Worksheet for Air Deccan
Worksheet calculates cost of equity capital in nominal U.S. dollar terms.
Convert local currency cash flows to USD by the assumption of Purchasing Power Parity, i.e. the expected
annual depreciation in the FX rate is exactly equal to the difference between local and U.S. inflation rates.
Risk Premium Calculation
Inputs
4.50
3.00
92.50
57.00

Output

Category
U.S. risk free in %
U.S. risk premium in %
Current
U.S.
Credit
RatingInstitutional Investor country credit rating (0-100)
16.07 Anchored Cost of Equity Capital for project of average risk in country
(ICCRC)
8.57 Country
Risk
Premium

Industry Adjustment
1.10

Beta
(Industry)
0.30 Sector adjustment

Project Risk Mitigation


(-10 to 10; where 10=risk completely eliminated, 0=average for country)
Impact
on
Countr
y
Premium
Weights
Score
Sovereign
0.40
-4.00
1.37 Currency (direct, e.g. convertibility)
0.10
0.00
0.00 Currency (indirect, e.g. political risk caused by crisis)
0.15
-2.00
0.26 Expropriation (direct, diversion, creeping)
0.05
0.00
0.00 Commercial International partners
0.05
0.00
0.00 Involvement of Multilateral Agencies
0.05
-2.00
0.09 Sensitivity of Project to wars, strikes, terrorism
0.05
0.00
0.00 Sensitivity of Project to natural
disasters
.

0.05
0.03

Operating
0.17 Resource
-risk Technology risk

-4.00
9.00
0.19

0.05
0.03

-3.00
0.00

Financial
0.13 Probability
of
Default
0.00 Political Risk Insurance
Sum of weights (make sure = 1.00)

1.00
Project Cost of Capital

18.19

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Please refer below to our sensitivity analysis on Air Deccans cost of capital assuming that
Indias country rating improves gradually till due to the influx of investments in the country.
Due to the difference in the rate of inflation of 2.3% between India and the US, we added
back 2.3% to the cost of equity calculated from Harveys Cost of Capital method (Exhibit A).
In calculating the WACC for Air Deccan, we assumed the following to be constant
Long Term D/V = 35%
Long Term Tax rate = 36%
Further, we assumed Rd to be higher in the initial years (10% through 2008), gradually
tapering off to 8% in 2013 as Air Deccan turns profitable and uses its free cash flow to pay
down its debt, thereby improving its ability to raise debt at more favorable terms. Please refer
to the table below for our WACC calculations.

As can be seen from above, Air Deccas WACC in 2006 is 15.6%, but by 2013 it falls to
12.0%.

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Projections
Under Penetrated Market
After sluggish growth of 4.1% per annum over 2000 2004, despite high GDP growth of
5.7% over the same period1, the Indian aviation sector has been going through a boom period
2005 onwards. Indias domestic air travel market has grown 4.1% per annum over the past
five years. However, due to the booming economy and consumer base and GDP growth
hovering around 8%, a growing number of people are reaching middleclass levels and, thus,
are finding flying affordable. The results have started to show, with domestic traffic in FY05
growing by 26%Error: Reference source not found.
Traffic in Asia has grown at about 1.5x GDP (around 2.0x for China) 2. The aviation sector in
India has been marred by the under investment in infrastructure and a restrictive regulatory
regime. However, the issues that have held back natural demand growth are improving. The
government is taking initiatives to improve airport infrastructure and is adopting a more
liberal approach to aviation regulations.
Due to strong growth in the domestic market driven by affordability, a booming economy and
increased capacity, it is forecasted that the aviation sector in India is going to see booming
years ahead. Air Deccan is well positioned to exploit this buoyancy as it has positioned itself
in the underrepresented markets as an extensive network, a growing brand and great low cost
operational strengths. Growth in total number of passenger seen in 2005 is likely to continue
for few more years before stabilizing at 1.5xGDP growth, in line with the other Asian
countries. Analysts projections are that airline passenger growth will slow down to 12% per
annum by year 20123 and 10% per annum by year 2013.
Market Share Gain
While new competition is coming in, we believe it will be a few years before the new players
can match Air Deccan due to operational challenges or copy its low cost no frills model due
to infrastructure issues. Deccan strengthened its position and gained market share from 6.5%
in FY 2005 ending on March 31 st to 11% in October 2005. Even though it is unlikely that Air
Deccan will continue to gain market share at the same rate, it is likely that the firm will
further strengthen its position and gain further market share from the current 11% per annum
to 19% in the domestic market in 2013.
Load Factor and Yield Growth
The Load Factor for Air Deccan in grew from 63% in year 2004 to 76% in year 2005 and is
likely to be 72% to 75% for the next couple of years, which is in line with the load factors for
its competitors. Due to the firms policy of higher utilization of its plans, it is likely that Air
Deccans load factor might be a few percentage points higher than its competitors. However,
as the competition intensifies in the civil aviation industry in India, Air Deccan will find it
harder to maintain such high levels of load factors for its planes. Also, there is some
possibility that due to Deccans aggressive aircraft acquisition policy, load factor might lag by
few percentage points before reaching its full potential. High load factors will also likely to
1

From DB Research report on Jet Airways dated 11 March, 2005.


From Air Deccan prospectus (red herring) filing.
3
Morgan Stanley report on Jet Airways dated March 2005.
2

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continue for some more time as the continued boom in the aviation sector is not likely to be
matched by infrastructure improvement in the near term and airline companies are likely to
be only moderately successful in taping in to this boom due to infrastructure bottlenecks.
Because of the factors discussed above, the load factor for Air Deccan is likely to come down
to a more moderate level of 68%.
With inflation hovering around 4.5% and continued high fuel prices, it is likely that some of
these costs would be passed on to the customer in the form of improvements in yield.

Expenses
Rental Expenses and Capital Expenditures
Air Deccan plans to add around 100 aircrafts by year 2013, approximately half of which are
to be through operating leases and the balance outright hire purchases. Most of the direct
purchase will be financed through foreign denominated debt. Due to this off balance sheet
arrangement, rental expenses for Air Deccan are likely to remain high and would be
significantly higher as a percentage of revenue compared to the 7%4 level for its more
established peers. Rental expenses for the six months ended September 30 th, 2005 were
15.4% of revenues and are likely to remain close to this high level for the next 3 4 years.
These expenses are likely to come to down to more moderate levels of 8% of revenues by
year 2013.
Due to Air Deccans aggressive aircraft policy, capital expenditures are likely to be a very
significant portion of its total revenue and these fleet expansions will have to be financed
through debt or by issuing equity. These additional aircraft orders represent approximately
Rs. 133.50 million in new amounts payable in the current fiscal year in respect of pre delivery
payments and deposits, plus approximately Rs. 44,056.62 million in additional commitments
(which are subject to change to the extent prices are adjusted over time pursuant to the terms
of orders)5.

From Morgan Stanley research report on Jet Airways dated March 15, 2005.
From Air Deccans prospectus (red herring) under section SIGNIFICANT DEVELOPMENTS AFTER
SEPTEMBER 30, 2005.
5

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Title
Fuel Expenses
Fuel expenses are the most significant part of the operating expenses. Due to the increase in
international crude oil prices over past year and half, fuel costs for Air Deccan rose to 38.7%.
However, international crude oil prices have come down to more moderate levels since then
and are likely to average around $57.50/barrel for year 2006 and expected to average
$55.00/bbl in year 2007. These oil prices are still very high compared to the average prices of
$30.93/bbl and $41.30/bbl in year 2003 and 2004 respectively. Due to the high oil prices, Air
Deccans fuel cost are likely to be around 35% in year 2006 and come down (in line with
most oil analysts forecast) to 30% by year 2013. Also, aviation fuel prices in India are among
the highest in the world due to the Government of Indias regulations that preclude airline
companies from entering into fuel hedging contract. However, it is likely that as the Indian
economy opens up, some of these regulations will be relaxed and taxes on aviation fuel might
also come down to levels more in line with the international markets.

Administrative and General Expenses


Administrative and general expenses for Air Deccan have been lower than its competitors and
are likely to remain at low to moderate levels due to its low cost operational model. These
costs were significantly lower for Air Deccan at around 8% of revenue for the six months
ended September, 2005 compared to the 12 13% level for its peers. As Air Deccan expands
its operations and other lower costs airlines enter the market, these costs might go up to 11%
or more by 2013 and fall more in line with its competitors.
Other Direct Operating Expenses and Aircraft/Engine Repairs and Maintenance
Being a start up airline, Air Deccan incurred more costs on Operating expenses and also on
Aircraft/Engine repairs and maintenance, partly due to the age of its fleet (old aircrafts) and
partly due to the start up costs to establish maintenance facilities. Together, these costs
accounted for 39.8% of revenue during the six months ended September 2005. However, as
Air Deccan acquires new fleet, these costs are likely to fall more in line with its comparables
at around 24% by year 2013.

Employee remuneration and benefits


At around 12% of revenues, theses costs for Air Deccan are higher than the 7 8% for its
peers. However, costs are significantly higher internationally and are likely to go up in India
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as the Indian economy opens up more. If going forward, Air Deccan could lower these costs
by a few percentage points, and then it would be an achievement. However, due to its low
cost model and emphasis on cost reductions, Air Deccan is likely to keep these costs at
around the 8.5% level by year 2013.

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Title

Sensitivity Analysis
We conducted a Tornado analysis to determine the sensitivity of the various parameters on the
IPO price of Air Deccan. The following were the results:

The IPO price was found to be mot sensitive to capital expenditures followed by operating
and fuel expenses, market growth and the target debt to equity ratio.
The table on the next table illustrates that a 5% increase in capital expenditures results in a
20% decrease in the share price on average. Similarly a 5% increase in the market growth
results in a 53% increase in the share price on average.
Thus we feel that even if Air Deccan does not remain the most competitive airline around, the
sheer momentum of the growing market makes it an attractive investment choice.

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Air Deccan Cutting Costs, Not Corners

Title

Real Options
In our analysis of Air Deccans IPO decision, we came up with the following options that
need to be evaluated that could boost the value of the decision.
1. Access to the capital market
Given that two other airlines are planning to do an IPO within a couple of months after
Air Deccan, this first mover advantage will help Air Deccan. An IPO now (first mover)
will help Air Deccan access the limited investor capital in the market.
2. Increase in liquidity
Divesting a part of a company through an IPO increases the liquidity of Air Deccan. The
management will get additional benefit from this increased liquidity during valuation in
case of an acquisition. The Indian aviation industry is already in a mode of consolidation
evidenced by the recent Jet Airways and Air Sahara merger. Also, with its successful LCC
model, Air Deccan could be an attractive acquisition target to one of the other seasoned
players. An IPO now makes sense if the management has hopes of selling off the
company altogether.
Other options provided by Air Deccans growth strategy are discussed below.
3. Low cost developing areas
Only 62 out of the 450 airports in India are developed. Thus there is a huge untapped
market waiting in the wings. Unlike other airlines, Air Deccan has in the past and will
continue to target these underdeveloped areas as opposed to major trunk routes. This
provides Air Deccan a first mover advantage as they will able to establish airport and
other infrastructure in those areas at very attractive costs. Since most of airline costs are
fixed costs, this advantage helps Air Deccan maintain a competitive edge over its
competitors and other new entrants.
4. Increase in flight revenue
An estimated 5% of Air Deccans revenue comes from in flight services. Air Deccan has
the option here to increase prices on these and other fringe services (extra baggage etc)
going forward to increase its revenues.

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Conclusion
Air Deccan has revolutionized the Indian aviation industry by being its first LCC. Recent
liberal government policies, a growing but under penetrated aviation market and a booming
economy are just a few of the factors that Air Deccan has capitalized on. Air Deccans
success has led to many new entrants entering the LCC market.
To sustain its competitive position in light of the increased competition, the company needs
to raise capital to expand and is planning to do an IPO. Our analysis reveals that issuing debt
is a cheaper option for Air Deccan than raising equity, given its higher cost of equity due to
the risks inherent in its business. Further, issuing equity also dilutes shareholder ownership.
We are skeptical of Air Deccans ability to capture market share given the entry of several
new players in the industry. Additionally, we believe that management might be doing an IPO
so that some of it stakeholders can cash out and diversify their holdings given the sharp rise
in the Indian equity markets. Another possible reason for the IPO could be a two part sale
strategy, whereby the company goes to the public markets for an IPO to gain visibility and
credibility with the goal to be acquired quickly.

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