Lufthansa Group using a Group-wide Beta and WACC - 2750 Words

Lufthansa Group using a Group-wide Beta and WACC (Essay Sample) Content: Client's nameInstructor's nameCourse titleDateConsiderations for Lufthansa Group using a Group-wide Beta and WACC for All of Its InvestmentsReasons to Use a Separate Beta in the WACC of Segments In order to conduct a proper analysis of the topic, it is necessary to put the structure of Lufthansa Group into perspective. The company operates globally, as a transnational corporation, covering countries with different aspects of systemic risk. According to the 2016 annual report, Lufthansa Group had a WACC of 4.8 percent in which the cost of debt was 2.4 percent and that of equity was 7.2 percent (Lufthansa Group 18). The group considers a long-term proportion strategic position in which the proportion of debt and equity are equal. The cost of equity consisted of a 5 percent market risk premium being added to the product of the risk-free rate (1.7) percent and 1.1 as the beta factor. It reflects the theoretical formula as expressed in Da et al. (207) as well as in Stubelj et al. (66). The annual report also indicates that different segments have different levels of WACC, including the Passenger Airline Group (4.8%), Logistics (5.1%), MRO (4.6%), and 4.6 percent for the Catering segment (Lufthansa Group 18). In the Lufthansa Group case, using a single beta may cause the organization to underestimate the betas of specific segments and their subsidiaries. The size of a company and the book-to-market ratio affect the expected returns of stock (Da et al. 209). Lufthansa Group's beta can fluctuate by a smaller variance to the market returns due to its size and number of subsidiaries. Operating in the aviation industry, Lufthansa Group consists of about 540 subsidiaries as well as its equity stake in other firms (Lufthansa Group). The company conducts its business in five segments, which include the Passenger Airline Group, Logistics, MRO Services, Catering, and Other Activities (Lufthansa Group). Lufthansa, as a group, may have fewer effects of firm-speci fic risk compared with individual segments and their associated subsidiaries. Lufthansa Group appears well-diversified within the aviation industry. It may mean that it would have a smaller beta since the beta is derived from the sensitivity of the group's returns to that of the market index. Lufthansa Group (18) uses a beta of 1.1, which can be considered a lower beta, indicating that the stock return varies 1.1 times the market returns. The group has five segments. Passenger Airline Group segment contributed 73.5 percent of revenue in the financial period that ended December 31, 2016. It can be compared with 11.1 percent for MRO, 8.1 percent for Catering, and 6.5 percent for Logistics (Lufthansa Group u3). The low beta is likely to be used in non-core segments because Passenger Airline Group would contribute over 70 percent of the beta, based on its contribution to the group's revenue. It would mean that riskier investments, such as Catering and Logistics segments, would be consid ered to have more stable returns than the actual measure of their risk. A different scenario would occur when the group uses a higher beta for all divisions. Within the group, there could be segments that are experiencing higher growth than others. In addition, there are segments and subsidiaries that are larger in size than others. According to Da et al. (207), high capitalization firms may have lower CAPM betas compared with stocks experiencing high growth. Some segments within the Lufthansa Group involve high growth subsidiaries, such as MRO Services, which deserve to be allocated higher betas. The problem with allocating a lower beta to such a segment is that some projects may be approved while they have been allocated a lower cost of equity derived from a lower beta. It can lead to outcomes that do not maximize value for investors. Having the core division taking a large size of the group's revenue is another reason for avoiding the use of one beta for all divisions. Lufthansa Group, as discussed earlier, has the Passenger Airline Group accounting for 73.5 percent of revenue (Lufthansa Group u3). Krueger et al. (1277) discuss that the group is likely to impose betas of the core division to other divisions when the core division contributes a large proportion of revenues. It can result in the core division starving some of the non-core divisions with their financial needs when the core division has a high beta. In Lufthansa Group, the core segment operates in the airline business. Lufthansa Group (7) explains that its stock returns are lower than that of the DAX 30 and higher than those of its peers. It can support the perception that the airline business is a low margin industry. As exhibited in the group's 2016 annual report, MRO had an adjusted profit margin of 8.0 percent compared to the Passenger Air Group's 6.4 percent and 3.3 percent for Catering (Lufthansa Group u3). Using a high group beta would reduce investments in the Catering segment while in creasing investment in MRO. This occurs without putting into consideration the business risk associated with each segment. In such a situation, Krueger et al. (1254) suggest that the group would be likely to over-invest in riskier ventures while under-investing in safer ventures. That would be the case if riskier ventures are selected because they promise higher returns than safer investments. Such a behavior of the group could lead to tendencies that destroy value for shareholders. As a result, it fails to compensate investors with higher returns for accepting riskier investments. Krueger et al. (1253) go a step further to suggest that firms ought to use project-specific betas. It would enable the organization to avoid value-destroying tendencies associated with using one beta for all divisions. Using one beta for all segments would result in what Luci and Lleshaj (347) describe as profit-maximizing decisions rather than value-maximizing decisions. It means that the group's manag ers will be financing projects that maximize profits while having little consideration of the risks they bear. Each of Lufthansa group's segment has different levels of systemic risk that ought to be considered in decision making. The managers would not be rewarding shareholders adequately for investing their capital in riskier segments. It would be as if the managers are misrepresenting the risks that shareholders are accepting. The debt to equity ratio of different subsidiaries may affect the value of the beta since a higher size of debt increases risk for shareholders. As Berry et al. express, "higher degrees of leverage commensurately lead to higher levered betas and thus a higher cost of equity" (18). According to Berry et al. (18) the cost of equity is calculated by adding the risk free rate to the product of the levered beta and the market risk premium. Their explanation indicates that it may be important to consider different betas when each subsidiary raises debt capita l on its own or is liable for its own debt. While highlighting the financial strategy of the group, the 2016 annual report fails to indicate whether the company raises capital as a group (Lufthansa Group 14). Its Web site is also quiet about raising capital at the subsidiary level or group level. (Lufthansa Group). Most of Lufthansa's subsidiaries indicate that they are entities with limited liabilities. It suggests that each subsidiary is liable for its own debts. This supports the use of different betas for segments, even if the capital is centrally raised. Venture capital may be raised at the group level at a lower cost, considering the good credit ratings of the group (Lufthansa Group 14). Creditors demand a higher interest rate when they perceive higher firm-specific risk. As a group, Lufthansa is more diversified than any of its segments. Thus, it is less riskier than the segments to creditors. Separate liabilities for segments and subsidiaries support the use of different bet as for each segment. The segments can be affected by interest rates based on where they raise capital. Interest rates are higher in some countries than others. When they raise capital in a country with volatile interest rates it can affect the levered beta of the segments. Lufthansa Group (14) suggests that it favors debt with floating rates. These can lead to the need to alter the levered beta that is used to calculate the cost of equity in the period in which an investment is to be evaluated. Using one beta without having similar proportions of debt and equity for the segments would not result in one WACC for all segments. The reason is that the WACC is based on the cost of equity and debt. Selecting one beta does not solve the problem of using a unique WACC for each segment since the proportions of debt and equity will alter the WACC of different segments, even if they have similar betas. There are a number of factors that may create risk in a business environment. These includ e inflation rates, exchange rates, interest rates, business cycles, new or disruptive technology, and new government policies (Batra and Verma 29). These factors differ, depending on the countries in which a subsidiary operates and where it raises capital. These factors also contribute to the systematic risk, which is measured by the beta. For instance, in the case of the Lufthansa Group, the Passenger Airlines segment may be more responsive to changes in fuel prices than subsidiaries in the MRO segment. Beta being an indication of the level of risk or the possibility in which expected returns may change above or below the market index, it is better to use a different beta for each subsidiary or segment. There is a lot of homogeneity within a segment, with the exception of country risk, that supports the use of one beta and WACC for each segment than for the group, which is known for heterogeneity among segments. Country risk, mentioned above, is one of the factors th...