1.

Based on the information provided in the case, estimate the cost of debt and the cost of equity for
Dragon Air.
After-Tax Cost of Debt
The After-tax Cost of Debt for Dragon Air is estimated using the best lending rate in Exhibit 2 for Cathay
Pacific Airways as Bevis mentioned that the firm should use Cathay Pacific as a proxy firm. In the Exhibit
2, the most recent best lending rate is 7.42% on Jan 2006. I suggest using that lending rate for as the cost
of debt for Dragon Air
Since the cost of debt in the WACC formula after tax as the interest expense is tax deductible, we need to
consider the tax effect using the corporate tax rate of 17.5% as Bevis suggested in the case:
After-tax Cost of Debt = 7.42% x (1 17.5%) = 6.12%

Cost of equity
The cost of equity is estimated using the CAPM formula: Re = f + RB
f Risk-free rate
The risk-free rate is estimated using the long-term government bond with a time horizon similar to the
length of the investment. In exhibit 2, we have the 1-yr Hong Kong Exchange Fund Bill and 10-Yr Exchange
Fund Note. I suggest using the most recent 10-yr Exchange Fund Note of 4.18% as the risk-free rate.

R risk premium of market return above the long-term risk-free rates

The R is equal to the average market return minus the average risk-free rate. In Exhibit 2, the average
return between 1995 and 2005 for the 10-yr Hong Kong Exchange Fund Note is 5.98% and the average
annual return of the Hang Seng Index is 8.9%.
Market risk premium = Market return Risk-free rate = 8.9% - 5.98% = 2.92%

B Beta of the firm

As Dragon Air is not publicly traded, we need to find public companies having similar business risks. In this
case, Bevis has states that Cathay Pacific has similar risk profile and debt maturity. Therefore, we can
assume that Dragon Airs beta is the same as Cathay Pacifics Beta of 0.78

CAPM = Ke = 4.18% + 0.78 x 2.92% = 6.46%

2. What is a reasonable range for Dragon airs weighted average cost of capital? Explain and justify how
you arrived at those estimates.
Dragon Airs weighted average cost of capital (WACC) can be estimated using Cathay Pacifics financials.
In Exhibit 1, we have Cathay Pacifics balance sheet in 2013 and 2014. The possible range for Dragon Air
WACC includes the WACC in 2003, 2004 and the WACC using the average of 2003 and 2004

WACC using 2003 figures:

D = (21,418 + 4,879) = 26,297; E = 31,156
D / (D + E) = 26,297 / (26,297 + 31,156) = 45.78%
E / (D + E) = 31,156 / (26,297 + 31,156) = 54.22%
WACC = 45.78% x 6.12% + 54.22% x 6.46% = 6.3%

WACC using 2004 figures:

D = (17,662 + 4,969) = 22,631; E = 32,989
D / (D + E) = 22,631 / (22,631 + 32,989) = 40.69%
E / (D + E) = 32,989 / (22,631 + 32,989) = 59.31%
WACC = 40.69% x 6.12% + 59.31% x 6.46% = 6.32%

WACC using average of 2003 and 2004 figures:

D = (26,297 + 22,631)/2 = 24,464; E = (31,156 + 32,989)/2 = 32,072.5
D / (D + E) = 24,464 / (24,464 + 32,072.5) = 43.27%
E / (D + E) = 32,072.5 / (24,464 + 32,072.5) = 56.73%
WACC = 43.27% x 6.12% + 56.73% x 6.46% = 6.31%

The possible range for Dragon Airs WACC is from 6.3% to 6.32% which depend on the change in the
weight of Debt and Equity. As the cost of equity is slightly higher than the cost of debt, the increase in
weight of equity ( as in 2004) will lead to an increase in WACC.