Acquisition of Easy Jet by Leverage Buyout: A Case Study

In order to acquire EasyJet, a firm needs to purchase at least 60% shares to obtain substantial control. One popular method is the equity purchase method, which involves financing the deal through loans from banks or retained earnings. The use of debt and retained earnings is recommended over private equity due to its lower cost of finance. Additionally, using debt may not affect a firm's decision-making process as private equity would.

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TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................3
(a)Methods of estimating cost of capital and limitation of computed figures.............................3
(b) Valuation of Easy jet by using varied methods......................................................................7
© Method of purchasing Target Company................................................................................11
CONCLUSION..............................................................................................................................12
REFERENCES..............................................................................................................................13
Table 1Calculation of cost of debt without considering tax for Easy jet.........................................3
Table 2 Cost of debt without considering tax for Easy jet..............................................................4
Table 3 Cos of equity for Easy jet...................................................................................................4
Table 4 Cost of capital by using earning yield method...................................................................5
Table 5 Cost of capital on the basis of CAPM model.....................................................................5
Table 6 Calculation of enterprise value...........................................................................................5
Table 7Computation of WACC.......................................................................................................6
Table 8 Four year cash flows of Easy jet.........................................................................................7
Table 9 Growth rate on year on year basis of Easy jet....................................................................8
Table 10 Cost sheet of Easy jet for last four financial years...........................................................8
Table 11 Present value of cash flows at 4.08% discount rate..........................................................8
Table 12 Calculation of terminal value as percentage of total value...............................................9
Table 13 Calculation of equity value...............................................................................................9
Table 14 Intrinsic value of shares of Easy jet..................................................................................9
Table 15 PE ratio of Easy jet and industry....................................................................................10
Table 16EV/EBITDA ratio............................................................................................................11

INTRODUCTION
Valuation methods are commonly used by the firms to make decisions. In the current report
varied methods of valuation are described in detail. Some methods like cost of debt before and
after tax and WACC are applied on the firm data and results are interpreted. At end of the report,
methods like DCF, PE ratio and EV/EBITDA are applied on the firm data and results are
interpreted.
(a)Methods of estimating cost of capital and limitation of computed figures
Cost of capital refers to the cost of equity and debt (Dhaliwal and et.al., 2011). Methods
for computing cost of debt and equity are given below.
Cost of debt
There are two approaches that are commonly used for computing cost of debt. One can
either compute cost of debt before and after making tax adjustment. Formula for computing cost
of debt before tax adjustment is as follows.
Kd= Interest/principal*100
Table 1Calculation of cost of debt without considering tax for Easy jet
Interest 11
Principal 504
Cost of debt 2%
In this formula only principal amount up to which debt is taken and interest are used to compute
cost of debt. Tax is not considered in calculation.
Interpretation and limitation of figures
Cost of debt for Easy jet is only 2% when tax is not taken in to consideration. Main
limitation of this figure is that tax amount is not considered in calculation (Li, 2010). It can be
observed that in income statement after deducting interest
Opposite to this there is another approach of calculating cost of debt under which after
considering tax cost of debt is computed. Formula for same is explained below.
Kd= Principal amount*interest rate*(1-tax rate)

Table 2 Cost of debt without considering tax for Easy jet
Principal 504
Interest rate 2%
Tax rate 20%
Cost of debt 8.8
Interpretation and limitation of figures
After considering tax cost of debt for the business firm is only 8.8%. It can be said that
after and before considering tax rate big difference comes in the cost of debt. There is no
limitation of figure because in this tax factor is consider to calculate cost of debt.
Cost of equity
Like debt there are two methods that are used to compute cost of equity. These two
approaches are dividend yield method and dividend yield plus growth method (Damodaran,
2012). Formula for computing cost of equity by using dividend yield method are given below
Ke= DPS/Net proceeds
.
Table 3 Cos of equity for Easy jet
DPS 55.2
Net proceeds 767
Ke 7%
In this formula only dividend per share and net proceeds that are received per share are taken in
to account. Other method that is used to compute cost of equity is earning yield method. Formula
of this method is given below.
Ke= EPS/Net proceeds
Table 4 Cost of capital by using earning yield method
EPS 139.1
Net proceeds 767
Ke 18%
Interpretation and limitation of figures

Cost of equity is 18% which is very high. The main limitation of value is that EPS is
considered to compute cost of equity. Earnings per share refers to the earning that is received by
shareholder on each unit he hold in the specific firm. Investor receive dividend amount out of
earning on each unit of specific company share (Boubakri and et.al., 2012). Means that he does
not receive entire EPS amount from the firm. Hence, figure 18% does not reveal actual cost of
equity.
Weighted average cost of capital
This is another method that is used to estimate cost of capital (Chen and et.al., 2011). In this
method weight is given to the debt and equity in the overall capital structure and on this basis
cost of capital is computed.
Table 5 Cost of capital on the basis of CAPM model
CAPM
Assumptions
K(e) 4.08%
RFR 1.0%
Beta 0.44
Rp 8%
Table 6 Calculation of enterprise value
Enterprise Value
(EV)
Current Market Price 1,000
Diluted Shares 3.97
Market Capitalization 3,970
Long Term Liabilities

322
Less: Cash & Cash Equivalents 650
Enterprise Value 3,642
Table 7Computation of WACC
Debt Equity Weightage
E/(D+E) @ Enterprise
Value 99.92%
D/(D+E) @ Enterprise
Value 7.50%
Interest Rate (%) 8%
Tax Rate (@) 20%
WACC Calculation
WACC 2.63%
Interpretation and limitation of figures
Weighted average cost of capital is 2.63% which means that on average basis overall cost of
capital for Easy jet is 2.63%. Hence, it can be said that firm cost of capital is very low.
Limitation of this method is that beta value is taken in to consideration (Chen and et.al., 2011).
With every day change in price and index value WACC value also change slightly. Hence, in
order to compute cost of debt by using WACC method one needs to do calculation of beta every
time.
It can be said that most methods that are used to compute cost of capital are different from each
other. Each of these methods have some advantages and disadvantages. So, it depends on the
managers that which method they used to compute cost of capital.

(b) Valuation of Easy jet by using varied methods
In corporate finance valuation of the firms is usually done in order to evaluate value of the
company. The valuation that is reflects by the relevant model is used to make firm purchase and
investment in security related decisions. There are varied methods of the valuation that are
available to the relevant intellectual people (Bhattacharya and et.al., 2011). All these methods
have some strong and weak points and it depends on the analyst that which approach it consider
most appropriate to do company valuation. Some methods of valuation are explained below in
detail. Discounted cash flow model: Discounted cash flow model is the method that is widely
used by the research analysts to do company valuation. Under this method past year
values are taken in to consideration in order to prepare projections about income and
expenditure. In this regard growth rate of revenue is estimate and percentage that
expenses cover of revenue is determined (Damodaran, 2016). On this basis cash flows
under DCF model are computed. Thereafter, by using discount rate present value of cash
flows is computed. Thereafter, enterprise value is calculated and divided by issues
shares. In this way intrinsic value is computed.
Table 8 Four year cash flows of Easy jet
2012 2013 2014 2015
Seat revenue 3794 4194 4462 4616
Non seat revenue 60 64 65 70
Total revenue 3854 4258 4527 4686
Fuel 1149 1182 1251 1199
Airport and ground handling 955 1078 1107 1122
Crew 432 454 479 505
Navigation 280 294 307 313
Maintenance 203 212 212 229
Selling and marketing 104 101 103 102
Other costs 200 10 245 276
EBITDAR 3323 3331 3704 3746

531 927 823 940
Aircraft dry leasing 95 102 124 114
Depreciation 97 102 106 125
Amortization of intangible assets 8 10 12 13
Operating profit 331 713 581 688
Interest receivable and other financing income 11 5 11 9
Interest payable and other financing
charges 25 24 11 11
Net financing charges -14 -19 0 -2
PBT 317 694 581 686
Tax charge 62 80 131 138
Net profit or FCF 255 614 450 548
Table 9 Growth rate on year on year basis of Easy jet
Growth rate 10.54% 6.39% 3.45%
Table 10 Cost sheet of Easy jet for last four financial years
Cost sheet
Cost of material 30.28% 31.15% 28.04% 25.97%
Purchase of stock in trade 25.17% 28.41% 24.81% 24.31%
Inventory 11.39% 11.97% 10.74% 10.94%
Employee benefit expenses 7.38% 7.75% 6.88% 6.78%
Finance cost 5.35% 5.59% 4.75% 4.96%
Depreciation 2.74% 2.66% 2.31% 2.21%
Other expenses 5.27% 0.26% 5.49% 5.98%
Table 11 Present value of cash flows at 4.08% discount rate
PV at 4.08% WACC
Present year 1 2 3 4
Discounting factor 0.960799 0.92313546 0.886948 0.85217907

PV of cash flows 245.0038 566.805171 399.1266 466.994133
Table 12 Calculation of terminal value as percentage of total value
Terminal Value
Sum of PV of FCF for explicit forecast 1,678
WACC 4.08%
Long term growth in Revenues 3%
Present Value of terminal value 36,784
Terminal Value as % of Total Value 95.637%
Table 13 Calculation of equity value
Equity Value
Enterprise Value 38,462
- Debt 322
+ Cash 650
Net Debt 38,790
Equity Value 77,253
Table 14 Intrinsic value of shares of Easy jet
Intrinsic
Value
Equity
Value 77,253
Diluted
Shares 108
Intrinsic
Value 715
Interpretation
It can be seen from the table given above that intrinsic value of the firm shares is 715.
This means that by considering firm revenue real value of the Easy jet shares is 715. Current
market price is 1000 which reflects that valuations of the firm shares are not correct and they are
overvalued. Means that investors are buying shares of Easy jet at a very high price. There are

some issues with DCF approach. In this approach growth rate of cash flows and stock market is
estimated. If wrong estimation will be made then shares wrong value will be computed by using
DCF method. Hence, this is one of the major limitation of DCF method. PE ratio multiple: PE ratio is the one of the most important valuation method because by
using same it is identified whether firm shares are overvalued or undervalued. In this
method simple comparison of firm is made with the industry in terms of earning. Output
of PE ratio reflects whether or not firm shares are fairly valued (McInnis, 2010). If PE
ratio of the Easy jet will be greater than same of industry then it will be assumed that firm
shares are not fairly valued and price of same is very high in the stock market. Contrary
to this, if PE ratio of the firm is lower than industry than in that case it is assumed that
shares are undervalued. On comparison of DCF and PE ratio method it can be identified
that both methods do valuation of the firm in different way. Means that in DCF method
cash flows are considered and real value of the shares is computed. Contrary to this, in
case of PE ratio value of shares is not computed and only on the basis of comparison it is
identified whether firm shares are overpriced.
Table 15 PE ratio of Easy jet and industry
CMP 1000
EPS 139.1
PE ratio 7.189073
Industry PE
ratio 9.496667
Interpretation
PE ratio reflects the ratio that is between share price of the company and earning per
share. It can be seen form the table that price earnings ratio of Easy jet is 7.18 and same of
industry is 9.49. On comparison of both it can be said that firm shares are undervalued in
comparison to the industry. There is some issue with this approach. In this method along with
earning market price is also taken in to account. Market price apart from earning is affected by
number of factors that are out of control of the business firm. Hence, firm shares are overvalued
or undervalued cannot be fairly judged by using this method. EV/EBITDA multiple: In this method company current capital structure is taken in to
account and its comparison is made with the firm EVITDA. If the value of ratio is low
then it is assumed that relevant financial instrument is trading below its fair value.

Contrary to this, if value of ratio is high then it is assumed that shares are trading above
their fair value. Capital structure greatly influence the firm profitability and financial
position as well as business condition (The Single-Best Metric: EV/EBITDA, 2016). This
ratio reflects the proportion of the earning that is covered by the capital structure. Low
ratio reflects that small proportion of total earning is encompassed by capital structure
means that firm is in good condition and finance cost does not cover big portion of the
earning of the business firm.
Table 16EV/EBITDA ratio
EV 38,462
EBITDA 3746
EV/EBITDA 10.27
Interpretation
EV/EBITDA ratio value is high 10.27 and this means that Easy jet shares are overvalued
and are available at higher price. Hence, one must abstain from making investment in the Easy
jet shares at current price level. The main issue with this method is that there is no standard that
is determined by using which one can identify whether firm shares are overvalued or
undervalued. Thus, while using this method one use his own judgments to obtain specific result
on valuation of the firm shares.
© Method of purchasing Target Company
There are some specific methods that are used to purchase a target company. Relevant
methods are explained below.
 Private equity and Leverage buyout: In this method purchase acquirer which is IAG will
purchase entire debt of the Easy jet by paying a specific amount to the Directors of the
latter firm. Further, IAG will be responsible to pay all debt related obligations of the IAG.
While acquiring Easy jet it is very important for the firm to ensure that assets of the
mentioned firm will generate sufficient amount of return and IAG without facing any
problem will be able to pay principal amount with interest to the creditors. Funds for
purchase can be raised through private equity firm. Mentioned type of firms have their
own department for the LBO funds which after considering number of factors allow firm
to finance LBO deal. This method of purchase is widely used in current time period by

the business firms. It can be said that this method of firm purchase is appropriate for the
IAG.
 Retained earnings and debt (Equity purchase): This is another method of firm purchase
and under this IAG needs to purchase equity stock in the Easy jet. It will need to purchase
60% shares of the Easy jet in order to obtain to substantial control on same. Like leverage
buyout this method of purchase is quite popular among the business firms (Dhaliwal and
et.al., 2011). It can be said that equity purchase is the traditional method that is followed
by one firm to acquire other one. In order to finance equity purchase firm can take loan
from the banks. If one bank is not ready to finance entire deal than consortium finance
can be used to arrange entire amount of finance. Retained earnings can also be used by
the firm to purchase Easy jet. There is no cost of the mentioned source of finance and due
to this reason it is commonly used by the business firms for acquiring other firm.
On comparison of both source of finance it can be said it will be better to purchase Easy
jet by using retained earnings and debt. This is because in case of private equity PE firm will
obtain stake in IAG and will affects its decision making process. Moreover, cost of finance
through PE is also high in comparison to debt. Hence, it can be said that it will be better to
acquire Easy jet by raising fund from debt than private equity.
CONCLUSION
On the basis of above discussion it is concluded that there are varied techniques of valuation
and all of them have some positive and negative points. Hence, with due care specific valuation
method must be used by the managers to make decisions. Debt must be used to finance purchase
of firm relative to equity because cost of finance is low in case of former one.

REFERENCES
Books & journals
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the cost of equity. Journal of Financial and Quantitative Analysis. 46(01). pp.25-58.
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any asset . John Wiley & Sons.
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finance . John Wiley & Sons.
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Online
The Single-Best Metric: EV/EBITDA, 2016. [Online]. Available through :<
http://www.crossingwallstreet.com/archives/2014/02/the-single-best-metric-evebitda.html>.
[Accessed on 30th December 2016].