Finance project needed

Rocky Mountain Regional Airlines – Fall 2020

When William Paul arrived for work on January 15, 2019, he was called into a meeting in

his supervisor’s office. The topic of the meeting was the possible merger of small and privately

held Rocky Mountain Regional Airlines, into his company’s client, larger, international, and

publicly traded Goliath Airlines.

Goliath Airlines, based in Los Angeles, controlled a significant share of the air travel

market along the Pacific Rim and throughout the continental United States. Rocky Mountain

Regional Airlines (Rocky), in contrast, was a well-run regional airline, providing service in the

Rocky Mountain and adjoining states. Its desirable routes, modern fleet, efficient and motivated

employees, and strong growth made it an excellent candidate for acquisition by Goliath, which

wished to increase its presence in the inland West and feed its profitable Pacific routes. Since

Rocky was privately held, its value of equity was unknown, and Paul was assigned the task of

determining this value. With merger negotiations between Rocky and Goliath beginning in one

week, Paul’s valuation of Rocky’s equity would be a critical piece of information for Goliath’s

management.

History

Rocky Mountain Regional Airlines was founded in Denver, Colorado, in early 2005.

Following the example of established and successful airlines, its business strategy was to provide

low cost, high quality, point-to-point service, with an emphasis on efficient operations and quick

turn arounds. Rocky’s home base was the relatively new Denver International Airport (opened

February 28, 1995), which served the growing population of the Colorado front range. Rocky

began operations in late 2005, providing service to and between Albuquerque, Boise, Las Vegas,

Phoenix, Tucson, and Salt Lake City.

Rocky was a new competitor in the industry, and for some months consumers were

reluctant to try Rocky’s service. Consumers who did fly with Rocky, however, were very

satisfied with the experience. Rocky’s low fares and excellent on-time performance gave it a

competitive advantage over traditional hub and spoke carriers, driving steady growth in Rocky’s

passenger loads, and the airline quickly generated positive operating profits, as well as positive

operating cash flows. During its 14-year life Rocky expanded its operations in a careful and well

thought out manner, and by January of 2019 the airline provided service to all 7 of the original

cities, as well as San Diego, Orange County, Los Angeles, Oakland, Sacramento and Portland.

This expansion had been successful, and during the last five years, Rocky had experienced

revenue growth of 14% per year, more than double the industry average of 6.25%.

Financial statements for 2018 and 2017 for Rocky Mountain Regional Airlines are

presented in Exhibit 1.

Operations

Rocky’s management believed the two key factors in its success and growth were its low

fares and its superior on-time performance. Rocky was able to operate profitably, in spite of

fares consistently among the lowest in the industry, due to its highly efficient operations.

Rocky’s aircraft were typically turned around (arrival at gate, disembarking of passengers,

unloading of luggage, boarding of passengers, loading of luggage, re-fueling, departure from

gate) in forty-five minutes, far quicker than a traditional trunk airline running a hub and spoke

system. By keeping its planes in the air more often, and on the ground less often, Rocky was

able to generate additional revenue per seat.

Rocky’s commitment to low fares was also facilitated by its choice of aircraft. From

inception Rocky had operated single-aisle aircraft from the Airbus 320 family only. Airbus’

technological improvements and commonality of design, maintenance, and flight operations gave

Rocky a competitive advantage in efficiency and cost, allowing it to operate profitably in spite of

its low fare structure. This strategic operating choice made Rocky’s fleet among the youngest

and most efficient in the industry.

The Future

Management at Rocky Mountain Regional Airlines planned to continue its successful

strategy of well-considered expansion. For example, Rocky will expand into Seattle-Tacoma in

2019, and addition expansion, consistent with Rocky’s operating strategy, was planned.

Management expected Rocky to continue to grow faster than the industry until 2023, at which

time growth in revenue, income, and free cash flow was expected to slow to the industry average

of a 6.25% per year constant and perpetual rate, for years 2023 and beyond.

Valuation

William Paul remembered from his college coursework valuation that two different

methods were available to estimate the value of an entire enterprise and the company’s owners’

equity:

1. Valuation by multiples using comparable firms, and 2. Discounted cash flow valuation.

To determine the value of owners’ equity through multiples valuation, Paul needed

information on both Rocky and its industry peers. Paul quickly obtained this information from

recent annual reports and information intermediaries. This information is presented in Exhibit 2.

The second valuation method, discounted cash flow, required Paul to determine the free

cash flows to all capital providers of Rocky Mountain Regional Airlines, discount these cash

flows at the appropriate risk-adjusted cost of capital, and apportion total enterprise value to debt

and equity holders. Paul had access to Rocky’s forecasted income statements and partial balance

sheets from 2019 to 2023, as presented in Exhibit 3, and he estimated the cost of capital (also

called the discount rate or the required rate of return) for Rocky was 8.3%

Assignment

William Paul was assigned the critical task of determining the value of equity of Rocky

Mountain Regional Airlines. He was given two days to develop and present this value to his

supervisor, as well as justify his choice of valuation method and the inputs to the chosen

valuation methodology.