'Flying with Heavy Loads' Capital Structure Considerations for the US Airline Industry
University of Southampton
February 18, 2010
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 financial distress. 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. 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. 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 are not valid in quantifying a real option of this nature and this paper addresses this issue. 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, another contribution to the academic literature.
Keywords: Financial Flexibility, Capital Structure, US airline industry, Real options, Arithmetic Brownian motion, path dependent options
JEL Classification: G31, G32
Date posted: March 18, 2010