Valair Limited Mock Evaluation Cpa

CPA Mock Evaluation

Finance Elective

Page 1

THE CASE IS PROVIDED TO ILLUSTRATE STYLE ONLY. ELECTIVE ( FINANCE)Elective examinations will be 3 hours in length. Candidates will be given 4 hours to complete the examination, providing an extra hour to formulate their responses. The intention is to reduce the time constraint. Elective examinations may use a mix of objective format, single-competency and multicompetency area questions, but greater than 50% of assessment opportunities need to be related to the Elective area being examined. The split and length of questions may vary across the Electives to adapt to the learning outcomes required. Elective examinations use larger and more complex cases than those used for Core 1 and Core 2, requiring a minimum of 60 and a maximum of 120 minutes to complete. The assessment of professional skill will continue in a multi-competency environment, environment, always building on prior learnings. Elective cases require candidates to simulate the “roles” they will play in real life, and therefore access will be provided to the reference tools they would use, where practical to do so. Below is an example of a maximum length (120 minute) case that focuses heavily on the Finance competencies, but also includes Core Financial Reporting and Strategy and Governance competencies. competencies. Extra time is provided to complete the calculations that would be required. This case illustrates the use of preloaded information and forms e.g. here the investment investment information and excel from the question could be preloaded into the candidate’s excel and word files for them to be able to use as starting point in their response. VALAIR LIMITED Suggested Time: 120 minutes (represents the time judged necessary to complete the question)

It is now Friday August 6, 2014. The board of Valair Limited (Valair) are considering a listing on the Toronto Stock Exchange (TSE). The Initial Public Offering (IPO) would be for 20,338,983 common shares which would then represent 28% of the issued common shares of the company at Admission. Valair is seeking to raise $60 million from the IPO. You are Marketa Praskova and your firm, Omega Corporate Finance (OCM), has been asked to act as sponsor and financial advisor to the board of Valair. Jed Ward (JW), the senior partner of OCM, is due to attend a meeting with the board of Valair at 9am on Monday August 9, 2014. JW has asked you, over the weekend, to prepare a draft report for the board of Valair which he will review on Sunday evening. He asks that the draft report cover the areas listed below and that in all areas you provide supported conclusions. Your draft report should include the following: 1. An assessment of the financial health of Valair which must must include the following: a. Comment upon the company’s liquidity, efficiency and solvency position b. The identification of key trends c. Suggest a target debt to equity ratio (which may be used in WACC computations)

CHARTERED PROFESSIONAL ACCOUNTANTS OF CANADA, CPA CANADA, CPA. © 2013, Chartered Professional Accountants Accountants of Canada. All Rights Reserved.

CPA Mock Evaluation

Finance Elective

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2. A range of values of Valair based on discounted cash flow and multiples, using a threeyear time horizon in your discounted cash flow valuation (estimates of revenue for 2015, 2016 and 2017 are provided on the Capital IQ spread sheets) [There will be separate excel files – these would be provided in a preloaded excel spreadsh spreadsh eets eets to the ]. ]. You must provide your opinion on whether the price range will support a candidates price that will raise the $60 million that the board would like to raise from the IPO. 3. The board of Valair has indicated that if the listing on the TSE is successful it will consider making an offer for a small regional airline. The purchase consideration is likely to be in the region of $70 million. Assuming that the board proceeds with this purchase, how will Valair ’s ’s financial situation change after the purchase? 4. Assess whether the IPO aligns with Valair ’s ’s stated strategy. Overview of Valair

Headquartered in Toronto, Canada, Valair is Ontario’s largest regional airline. Valair also operates one of Canada’s leading regional aircraft maintenance, repair and overhaul businesses. The company currently operates 68 aircraft on 115 routes from 51 domestic airport bases. Business model

Valair has established a business model that has created a market niche and comprises the following key characteristics:    

 

a convenient regional network throughout Ontario, Quebec and Atlantic Canada; Canada; cost effective sector lengths; an attractive attractive high frequency schedule and route density; full commitment to a modern regional aircraft fleet, which which helps to deliver a low breakeven load factor; an attractive passenger profile; and complementary maintenance, repair and overhaul and developing training businesses.

Financial Statements and Other Financial Information

The financial statements and other relevant financial information for Valair is included as Exhibit I. (note: these spreadsheets may also be provided in electronic format in order to assist candidates with their response) Key strengths

Valair considers that its principal strengths are: 



a strong competitive position in the domestic domestic and regional airline markets built built on an extensive regional route network and appealing high frequency flight schedules; a modern fuel efficient fleet of 68 regional aircraft aircraft chosen specifically to suit Valair ’s business model;


CPA Mock Evaluation  

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Finance Elective

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an aircraft order profile profile which provides flexible fleet growth options; a track record record of ancillary ancillary revenue generation and growth based on an unbundled product offering; complementary maintenance, repair and overhaul businesses; and a strong and experienced management team.

Strategy

Valair ’s ’s strategy is focused on becoming Canada’s largest and most profitable regional aviation group. The key elements underpinning this strategy are to: 

  

leverage the company’s historical investments and market position to: capitalise on sector recovery recovery in its existing domestic and regional leisure markets; and o drive expansion, through organic growth, relationships with other major carriers (such o as codeshare, contract flying and joint ventures), and selected acquisitions; build on the company’s track record of passenger revenue growth; deliver the lowest cost base for the regional airline sector; and reduce its its financial and business risks

Reasons for listing on the TSE and use of proceeds

The directors believe that the listing will: 



provide the Company with capital to assist in the expansion expansion of its operations within within Canada; provide the Company with a platform for future growth through acquisitions using using the Company’s listed securities as consideration;

The gross proceeds of the Offer for the Company are expected to be $60 million, out of which it will pay underwriting commissions and other estimated fees and expenses of approximately $3.1 million. Consequently, it is expected that the Company will receive net proceeds of approximately $56.9 million. The Company intends to use: 



approximately 50% of the net proceeds from the Offer to provide itit with capital to assist in funding its aircraft fleet expansion programme; and approximately 50% of the net proceeds from the Offer Offer to further strengthen its cash position, providing strategic flexibility to pursue additional growth opportunities (such as the expansion of codeshare arrangements, strategic arrangements with other European airlines and targeted acquisitions) should such opportunities present themselves.

Capital Expenditure and aircraft order profile

Valair will be taking delivery of 35 88-seat E-Series regional jets between June 2014 and October 2020. The Company has negotiated attractive debt financing arrangements for all 35 of these orders at a loan to value ratio of 85%.


CPA Mock Evaluation

Finance Elective

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Based on these delivery dates, and assumed sale/return dates of Valair ’s ’s existing owned and operating leased aircraft, these aircraft will increase Valair ’s ’s seat capacity from 5,864 to 7,262, a 24% increase over the six year period to October 2020. Corporate Governance

The directors are committed to the highest standards of corporate governance. Mr Jim French serves as both Chairman and Chief Executive Officer of Valair and is expected to remain in both roles in the near term. There are also four additional members of the company’s board as follows:    

Les Neilson, CA (CFO) Nell Goodman (VP of Operations) Amanda Fairchild (VP Marketing) Sally French (daughter of Jim French)

Financing arrangements The bank loans are repayable by instalments. The bank loans are secured on the assets to which they relate. The maturity of the bank loans as at March 31, 2014 is as follows: VAL AIR GROUP INC. BANK LOANS As at March 31, 2014 (in millions o f Canadian dollars)

In one year or less, or on demand Between one and two years Between two and five years In five years or more

$

9.3 11.8 30.4 31.6

$

83.1

The weighted average cost of the above loans for the year ending March 31, 2014 was: Floating rate Canadian$ loans: $43.0 million at 3.6% Floating rate US$ loans: $27.0 million at 3.1% Fixed rate Canadian$ loans: $13.0 million at 7.1% Taxation

The Company paid no corporation tax during the period under review. Taxable profits generated have been fully offset by tax losses carried forward from previous financial years and capital allowances on aircraft purchases. The Company has recorded a tax credit in both the 2011/12 and 2012/13 financial years. The Company’s effective rate of tax charged for the 2013/14 financial year was 9.8%. Not all of the available losses have been recognised historically, due to uncertainty over their recovery.


Finance Elective

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The current rate of tax is 28%, reducing to 27%, which is effective from April 1, 2015. The Government has indicated that it intends to enact future reductions in the main tax rate of 1% each year down to 24% by April 1, 2018. Further Information

The risk free rate: The risk free rate on 6 August 2014 Maturity

Yield

3 year 5 year 10 year

1.61% 1.91% 2.89%

Source:

Financial Times

The risk premium in 2014: Used by analysts: 5.2% Used by companies: 5.6% Source: Fernandez, Pablo and Del Campo Baonza, Javier, Market Risk Premium Used in 2014 by Analysts and Companies: A Survey with 2,400 Answers (May 21, 2014). Inflation: The long-term inflation target is 2%.


CPA Mock Evaluation

Finance Elective

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MARKING GUIDE VALAIR LIMITED (VALAIR) A s s e s s m e n t O p p o r t u n i t y # 1 – Finance (Elective)

The candidate provides an assessment of the financial health of Valair. The candidate demonstrates competence in Finance ( Financial . F inancial Statement Interpretation) Interpretation) CPA Map Comp etencies: etencies:

5.1.1 Evaluates the entity’s financial state ( ElectiveElective- Level A) 5.1.2 Develops or evaluates financial proposals and financing plans (Elective- Level A) 5.2.1 Evaluates the entity’s cash flow and working ca pital (Elective- Level Level A) 5.2.3 Evaluates sources of financing (Elective- Level A) (Candidates are asked to perform an assessment of the financial health and specifically on liquidity, efficiency efficiency and solvency pos itions of the com pany. As well candidates would b e expected expected to com ment on k ey trends and to suggest a target target debt to equity ratio for Valair. Candidates would be provid ed with ratios and oth er financial inform ation for Valair Valair within th e excel excel spreadsheets that would b e provided with the question and w ould be expected to use this information as a starting point w ithin their response.)


Finance Elective

CPA Mock Evaluation

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Analysis of the Financial Health of Valair Appendix 1 - Key Ratios 2009 Asset Turnover Total A s s et Tur nov er Mov ement

Fix ed A s s ets Tur nov er Mov ement ST Liquidity / LT Solvency C Cu urr ent Ratio A v g. Day s Sales Out. Avg. Creditor Creditor Days Days (A P/COG /COGS S * 365) Wor king Capital Cy c le Revenue Grow th Rev enue Gr ow th EBIT Margin EBIT Rev enue EBIT/Rev enue Interest Cover EBIT Inter es t Rec eiv able Gr os s Interes t Ex pens e Inter es t Cov er

2010

2011

2012

2013

2014

NA

1.5x

1.2x -19%

1.4x 20%

1.7x 22%

1.8x 2%

NA

2.9x

2.6x -10%

3.2x 21%

3.9x 23%

4.2x 8%

0.9x NA NA NA

0.7x 20.4 14.3 6.1

1.2x 29.3 29.2 0.1

1.0x 26.8 19.4 7.4

1.0x 22.1 20.2 1.9

1.1x 20.9 19.4 1.5

267.3

304.5 14%

367.5 21%

535.9 46%

572.4 7%

570.5 0%

13.2 267.3 4.9%

(3 (3.5) 30 3 04.5 - 1.2%

5.1 36 3 67.5 1.4%

30.8 53 5 35.9 5.7%

6.1 57 5 72.4 1.1%

8.2 57 5 70.5 1.4%

13.2 0.7 ( 6.8) 2.0

(3 (3.5) 1.2 ( 10.2) - 0.2

5.1 1.1 (3.4) 1.8

30.8 4.5 ( 8.8) 4.0

6.1 1.8 ( 9.6) 0.8

8.2 0.2 (3.2) 2.6

Analysis of working working capital position position and asset turnover turnover

Asset turnover t urnover has remained fairly stable between 1.2 and 1.8x. It is currently at its highest hig hest level for the year ended March 2014. Fixed asset turnover is also at its highest level in 2014, being 4.2x, having reported a low of 2.6x in 20011. Asset turnover levels have fluctuated due to the increasing revenues year on year and significant movements on the level of fixed assets. In 20011, the company reported gross property plant and equipment levels of $180 million compared with $98 million the year prior. This is due to an increase in the number of aircraft and has resulted in a steady increase in the level of asset turnover since then and shows that the company is using the new assets to its advantage to create revenues for the shareholders. Property, plant and equipment decreases from 2011 onwards likely due to depreciation levels coupled with disposals of older assets. The current ratio is currently 1.1x which shows the company to be solvent in the short term. However, this is a relatively low level having only fluctuated from 0.7x to 1.2x in the past 5 years. In 2014, the company has significant levels of cash and short term investments, which exceed $70 million. Cash levels reduced significantly between 2011 and 2012, which links with the increase in property, plant and equipment, so the company would appear to have put the cash to good use, as the asset turnover levels have increased, as we have seen.


CPA Mock Evaluation

Finance Elective

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Investors may take issue with the level of cash being held by the company, especially when interest is being incurred on the loan balances. This will be further exacerbated with the plan to use 50% of the funds from the IPO to strengthen the cash position and to pursue additional growth opportunities. The working capital cycle has been calculated ignoring inventory days as the company does not sell stock as a main business stream. This currently stands at 1.5 days compared with 6.2 in 2010. This is due to decreasing receivables days and stable payables days. This will help the company going forward as the sooner they receive the cash, the sooner they can earn interest or clear debts. Further key trends and comparison Revenue

Annualized growth over the last 5 years is 16% with the majority of the growth being in 20 12, following the purchase of further aircraft when growth between 2011 and 2012. Growth has reduced since and remains flat in 2014. This is attributable to the economic downturn and Valair has seen a stagnant level of revenue for the past two years. The company will therefore need to look at ways of increasing the revenue and have already mentioned the purchase of new aircraft and capacity, which should help increase revenues. Revenue for 2014 is $571 million which exceeds all but three of the 10 comparable companies. The highest level of turnover for the comparable companies is $743 million and the lowest $265 million. million. More information would be useful on the comparable companies to ensure they are truly comparable. Their accounts should therefore be made available. EBIT Margin

The EBIT margin was at its highest in 2012 at 5.7%. It has since declined to 1.4% in 2014. This is due to the lack of revenue growth and the high level of SG&A overheads which are not variable. Depreciation and amortization has also increased which has led to lower EBIT margins. The average EBIT margin for the comparable companies is 6.4%, which is considerably higher than that for Valair. The costs need to be looked into to ensure that they are kept under control during the period of economic uncertainty. Interest Cover

The company has a significant amount of debt, so it is important that they are able to finance the debt to avoid defaulting. Interest cover has fluctuated significantly over the years, but currently stands at 2.6x which is a healthy level. There are no immediate concerns with their ability to finance debt, especially when the company has such a significant level of cash and equivalents. Interest cover was much lower in 2013, due to high level of interest expense, although as some of the debt has been repaid, it would appear they are in a better position to finance the debt going forward.


Finance Elective

CPA Mock Evaluation

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Assessment Assessment of the Debt/Equity Ratio Appendix Appe ndix 2 - Debt /Equity /Equity Ratio 2009

Net Debt Equity Debt/Equity Ratio

58.8 16.5 356%

2010

44.0 ( 13.4) - 329%

2011

38.4 (25.0) -154%

2012

56.6 12.0 470%

2013

49.8 16.5 301%

2014

12.8 18.9 68%

Comparable Companies

Sky mar k A ir lines Inc Allegiant Allegiant Travel Travel Com Company pany Shandong A irlines Co. Ltd. V ueling A irlines SA Keny a A ir w ay s Ltd. Ic elandair Gr oup Aegean Airlines Airlines S.A. Mer idiana Fly Pinnac le A ir lines Corp. Air Partner Partner plc Aver age Debt/E Debt/Equit quity y excluding outliers outliers

5.4% Ex Ex c luded as ex tr emely low in in c omparis on to other s and V alair 8.6% Excluded as extremely extremely low low in comparison comparison to others and Valair Valair 73.6% 18.5% 57.5% 46.4% 33.9% 79.4% 87.5% - Excluded as extremely extremely low low in comparison comparison to others and Valair Valair 57%

The company currently has a level of net debt as a percentage of equity of 68% which is slightly above the average of 57% based on the companies in the same sector. There are benefits of having a certain level of debt in that the interest is tax deductible, so Valair is making the most of this. If the debt level becomes too high, it creates more risk for the shareholders and therefore the company, as the interest is non-discretional. Debt levels have fluctuated significantly, reaching a peak of $450 million in 2011. This has been reduced each year and is low in comparison at $294 million for 2014. The target level of debt for Valair should be 57%. This is the average debt/equity ratio of the comparable companies. With too little debt the company will not have enough funds to finance its expansion plans. Conclusion on the Financial Health

The company has performed well given the extent of the economic down turn and has managed to maintain a solid level of revenue, although they are currently stagnant. The company is liquid in the short term and has significant cash reserves which it can use to fund future growth or reduce debt levels if they became too risky. The EBIT margins are low based on the average for the companies used in comparison, so costs will need to be controlled going forward, something which may be difficult given the extra costs a listing will entail, both upfront and ongoing. Valair will need to be cautious going forward to ensure that any expansion is not at the detriment to its activities.


CPA Mock Evaluation

Finance Elective

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The company is likely to be attractive to potential investors in the IPO given that Valair has kept increasing revenues apart from in 2014, when they fell by a trivial percentage, even in times of economic uncertainty. The business model therefore clearly works and the plans for the expansion in the future, if handled carefully are likely to provide growth going forward. The company has a large amount of debt, but this is offset by a significant level of cash holdings. It may concern potential investors that the funds are not being used to pay dividends. Overall, Valair is considered an attractive target for the IPO investors. A s s e s s m e n t O p p o r t u n i t y –Finance (Electiv e)

The candidate provides a range of values for Valair based on an analysis of discounted cash flows and multiples. The candidate demonstrates competence in Finance ( Valuation) . V aluation) CPA Map Comp etencies: etencies:

5.4.2 Applies appropriate methods to estimate the value of a business (Elective- Level A) (Candidates (Candidates w ould be expected to estimate a range range of v alues for Valair Valair based on mu ltiples and and disc ounted cash flow s. Candidates Candidates would also be expected expected to provid e an opin ion on wh ether the IPO IPO could s upp ort a price of $2.95 $2.95 per per share. Candidates Candidates wo uld be provid ed with all of the inform ation that they need need to perform this analysis using the excel spreadsheets provided.)

Valuation – Multiples Appendix 3 - Multiples Valuation TEV/E TEV/EB BITDA ITDA TEV/E TEV/EB BIT Comparable Companies

Sky mar k A ir lines Inc . Allegiant Allegiant Travel Travel Com Company pany Shandong A irlines Co. Ltd. V ueling A ir lines SA Keny a A irw ay s Ltd. Ic elandair Gr oup Aegean Airlines Airlines S.A. Mer idiana Fly Pinnac le A irlines Cor p. Air Partner Partner plc. Aver age Debt/E Debt/Equity quity excluding excluding outli outliers ers

6.84x 5.63x 4.97x 2.08x 3.81x 2.90x NM NM 7.03x 7.01x 5.88

7.58x 7.67x 7.70x 2.42x 7.97x 5.30x NM NM 11.79x 7.73x 7.33

Excluded xc luded highlighted highlighted items items as not w ithin a reasonable range of other comparables Note that there are insuf f icient details details on comparable companies companies to asses s w hether they are truly tr uly comparable Ideally their accounts w ould be analyzed to ensur e they age truly comparable


CPA Mock Evaluation EV /EBIT DA

Finance Elective Lo w

Ave r ag e

Page 11 High

EBIT D&A EBITDA

8.2 17.1 25.3

8.2 17.1 25.3

8.2 17.1 25.3

Multiple

3.81

5.88

7.03

96.4 62.1 -83.1 75.4 52.3 1.44

148.8 62.1 - 83.1 127.8 52.3 2.44

177.9 62.1 -83.1 156.9 52.3 3.00

Enter pris e V alue Add Cash Les s Debt Mar ket Capitaliz ation Number of Shar es Share Pr ic e

EV /EBIT

Lo w

Ave r ag e

High

EBIT

8.2

8.2

8.2

Multiple

5.3

7.33

7.97

43.5 62.1 -83.1 22.5 52.3 0.43

60.1 62.1 - 83.1 39.1 52.3 0.75

65.4 62.1 -83.1 44.4 52.3 0.85

Enter pris e V alue Add Cash Les s Debt Mar ket Capitaliz ation Number of Shar es Share Pr ic e

Implied Multiples

Current market capitaliztion assuming $60 million raised from 20.3 million shares: Share pr ic e r equir ed Number of Shar es (millions )

2.95 52.3

Mar ket Capitaliz ation Les s Cas h A dd Debt Enter pris e V alue

154.3 - 62.1 83.1 175.3

EBITDA Implied EBITDA Multiple

25.3 6.9

EBIT Implied EBIT Multiple

8.2 21.4

Using the multiples valuations above, the range of potential values varies from a low of $0.43 to $3.00 per share. Note that the EBIT multiples are all significantly lower than the EBITDA multiples as the EBIT for Valair is quite low for the base period used (2014). Had the EBIT for 2012 been used or alternatively an average EBIT for the preceding 3 years, the analysis would have been significantly different. As well, this analysis is historical by its nature and an assessment of the financial prospects of Valair and all of the comparables would need to be performed to enhance this analysis.


Finance Elective

CPA Mock Evaluation

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Valuation – Discounted Cash Flows Ap pe n dix 4 - DCF Calcu lat ion s

Rev enue EBIT EBIT% Tax Rate Les s Tax on EBIT Add: Depreciati Depreciation on Les s : CA PEX Wor king Capital Mov ement

2014 Act ual

570.5 13.2 2.3% 0% 0 17.1 3.6

Fr ee Cas h Flow Ter minal V alue (Note 1) Dis c ount Fac tor Dis c ounted Cas h Flow Enter pris e V alue Add: Cash Cash Les s : Debt Mar ket Capitaliz ation Number of Shar es ( million) Pr ic e per s hare

2015 For e cas t

2016 Fo r e cas t

2017 Fo r e cas t

Te r m inal V alu e

603.4 18.1 3.0% 28% -5.1 30 -10 -5

694.2 27.8 4.0% 27% - 7.5 25 - 100 - 5.75

749.2 44.9 6.0% 26% - 11.7 20 - 20 - 6.2

28.0

- 60.5

27.0

27.0

0.8740364 23.62

1064.34 0.8740364 930.27

0.9561144 26.80

0.9141547 - 55.27

925.43 62.1 - 83.1 904.43 52.3 17.29

Note 1 - Terminal Value

FCF x (1 + g)/( WA CC - g)

1064.34

Grow th rate assumed assumed to be the long term inflation inflation rate of 2% f or prudence. FCF based on FCF in final year of forecast into perpetuity Working Capital assumed to be NIL and Depreciation assumed to equal CAPEX in terminal period WACC is discount r ate used (s ee WACC calciulations below )

Assumptions: The average EBIT margin for the sector data provided was 6.4%. As a result, it is assumed that the EBIT margin will increase to the industry average and be maintained at 6% throughout the terminal period. The discount factor used for the calculations was was 4.59% as this is the WACC for Valair based on the target debt to equity ratio of 57% (see further analysis below) It is assumed that the tax loss loss carry forwards will not last last in perpetuity and therefore taxes have been included in the above analysis based on the taxation information provided within the scenario. Depreciation increases due to the delivery of new aircraft expected in the upcoming years and is expected to equal CAPEX by the terminal period. CAPEX is expected to increase in in 2016 due to the new aircraft being delivered. CAPEX will reduce again to equal depreciation by the terminal period. The movement in working capital is is linked to the movement in revenues as the company needs to finance sales growth. 

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Finance Elective

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Note that I have some reservations about the numbers provided as they have been based on some very subjective amounts. The primary period (three years) in the above analysis is very short and is based upon forecasts that have been made by management. We do not know how accurate these forecasts are and it would be helpful to analyse previous forecasts made by management to gain some comfort over these amounts. As well, the terminal period makes up a very large portion of the valuation. This is also based on the final year of the forecast produced. The net present value of the terminal period uses a WACC which is quite low. The calculation is based on the CAPM which makes significant assumptions regarding the risk free rate and the equity betas of comparable companies. Summary of Valuation

The DCF valuation ($17.29) is not in line with the multiples valuation or the current share price by a very large amount which leads me to believe that this valuation methodology is not producing accurate results for Valair. This is likely due to the optimistic forecasts produced by the company and we will need to further analyse these forecasts to determine if they are reasonable. For now I will disregard this value as it is not in line with the other values generated. The best estimates are likely the ones that use EBITDA as with aircraft, there may be significant depreciation levels with differing policies between different companies. A value range of between $1.44 and $2.44 per share is advised based on EBITDA. The company currently has implied multiples of 6.9x for the EBITDA compared with an average of 5.88 so the company may be potentially overvalued at present. As such, we have gone with the low to average for a price for the company. As such, we do not believe that the IPO could support supp ort an offer price of $60 million and this should be reduced to between $29.3 million and $49.6 million. A s s e s s m e n t O p p o r t u n i t y # 3 –Financ e (Elective) (Elective)

The candidate calculates a weighted average cost of capital (WACC) for Valair and explains any assumptions. The candidate demonstrates competence in Finance (WA . (WA CC) CPA Map Comp etencies: etencies:

5.2.4 – 5.2.4 – Evaluates Evaluates decisions affecting capital structure (Elective- Level A) 5.2.5 – 5.2.5 – Evaluates the entity’s cost of capital ( ElectiveElective- Level A) (Candidates (Candidates are required to determine a WACC in o rder to co mp lete the valuation valuation required (see above). Again, candidates wou ld begin w ith the inform ation included within the preloaded excel excel spreadsheets as a starting po int for the WACC calculations presented below.)


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Weighted Average Cost of Capital Calculations Appendix 5 - WACC Calculations We ighte d Ave r age Cos t of De bt $

Floating Rate Canadian$ Loans Flaoting Rate US$ Loans Fix ed Rate Canadian$ Loans

Rat e

43 27 13

3.6% 3.1% 7.1%

We ight ing

0.5180723 0.3253012 0.1566265

83

We ighte d Rat e

1.9% 1.0% 1.1% 3.99%

Ass ume ume a tax tax rate of 24% as this this is therate at w hich itit w ill stabalize stabalize Kd = I x ( 1 -T)

3.03%

Be t a

Sky mar k A ir lines Inc . Allegiant Allegiant Travel Travel Com Company pany Shandong A irlines Co. Ltd. V ueling A irlines SA Keny a A ir w ay s Ltd. Ic elandair Gr oup Aegean Airlines Airlines S.A. Mer idiana Fly Pinnac le A ir lines Corp. Air Partner Partner plc.

Equity Be t a 0.63 0.51 1.16 0.64 0.4 ( 0.26) 0.63 1.85 1.63 0.65

M ar k e t Ca p 649.23 531.83 376.46 254.88 133.01 128.94 122.41 92.17 66.79 52.56

De bt ( 102.6) (75.4) 386.7 ( 174.4) 138.3 62.0 (76.4) 17.3 455.9 (11.4)

Aver age

De ge ar 0.63 0.51 0.65 0.64 0.22 -0.26 0.63 1.62 0.26 0.65

0.698750 0.698750

Highlighted ighted items items w ere excluded as they are too low w hen compared compared w ith other compani companies es Ass umed umed a tax tax rate of 24% being being the stabilized stabilized rate - how ever given the the companie companies s are fr om all over the w orld f urther information could provide prov ide a better assum ass umption ption Ass umed umed equity equity beta beta = degeared beta where w here net debt is is negative negative CAPM Ris k f r ee rate - as s umed 10 y ear rate Ris k pr emium is mid point f or analy s t and c ompanies

2.89% 5.40%

Rf + Beta * RP

6.66%

WACC Mve x Ke + Mvd x Kd/Mvd + Mve Ass ume ume gearing gearing of 57% as this this is the suggested suggested gearing gearing in in appendix appendix 2.

WA CC =

4.59%

Note: This This is the WACC based on the target debt/equi debt/equity ty ratio of 57% and is w hat the company company w ill w ork tow ards


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Finance Elective

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A s s e s s m e n t O p p o r t u n i t y # 4 –Financial Reporting (Core)

The candidate analyses the potential acquisition of the small regional airline. The candidate demonstrates competence in Financial Reporting (Financial Position after . the IPO) CPA Map Comp etencies: etencies:

1.4.5 – 1.4.5 – Analyzes Analyzes and predicts the impact of strategic and operational decisions on financial results (Core- Level B) (This (This ind icator has no t been fully developed and th ere may be additional case facts that could b e added added to th e simulation for c andidates to be able prov ide a more meaningfu l analysis. It has has been includ ed here to demons trate that that other com petency areas areas wo uld be available available for testing beyon d thos e comp etencies within the Finance area exclu sively)

Analysis of Available Financing Appendix 6 - Funds Available Available for Acquisition

Ass umptio umption n - IP IPO @ $2.44 per share (high end of the valuatio valuation n range from fr om above)

Total inc ome f rom IPO Les s : c os ts as s oc iated w ith IPO Add: tax benefit benefit of IPO IPO costs @ 28% 28% Funds f rom IPO 50% av ailable to f und gr ow th Add: current cash balance balance Total c as h av ailable f or ac quis ition Les s : purc has e pr ic e of regional airline Remaining c as h

$ millions 49.6 -3.1 0.9 47.4 23.7 62.1 85.8 -70 15.8

Assuming a value attributable to the IPO of $2.44 per share and $49.6 million raised, the company could finance the acquisition of a regional airline in cash and remain with a cash balance of $15.8 million. (Note: not included above is the $23.7 million or 50% of the IPO financing that would be used to finance the aircraft purchases from June 2014 through 2020.) This would leave a significant amount of cash for other projects and distribution to shareholders, together with adequate interest cover on the debt. The working capital would be seriously prejudiced though, given that the cash balance would reduce so significantly and there would not be the same reduction in debt as with the cash. This would increase the risk of the company as it may become significantly illiquid in the short term.


CPA Mock Evaluation

Finance Elective

Page 16

The debt levels of the potential acquisition target will also need to be carefully looked into as Valair currently has a significant amount of debt. If this became significantly higher than it could cause issues for the company in meeting the debt repayments. Assessment Assessment Opportunity #5 –Strategy and Governance (Core)

The candidate analyses the proposed courses of action for Valair in connection with its stated strategy. The candidate demonstrates competence in Strategy and Governance Governance (Alignment with Strategy) CPA Map Competencies: 2.2.1 – 2.2.1 – Assesses Assesses whether management decisions align with the entity’s mission, vision and values (Core- Level B) (This (This ind icator has been includ ed here to demon strate that other comp etency areas areas wo uld be available available for testing beyon d thos e comp etencies etencies with in the Finance area area exclusively.)

Proposed Course of Action – Listing on the TSE

Valair is considering a listing on the TSE. This course of action would allow Valair to raise substantial amounts of capital within the equity markets both through the IPO and in the future through additional equity issues if desirable. This course of action appears to satisfy all of Valair’s stated strategies: 

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It would allow allow Valair to generate funds for expansion and growth through both organic growth and through acquisitions (including the potential addition of a small regional airline at some point in the future for $70 million) It would provide the necessary funds to afford Valair the opportunity to capitalize capitalize on the recovery in the domestic airline market Through growth (organic or other) other) it would allow the company to build on its its track record of passenger revenue growth (through increased capacity) It would provide financing for Valair with minimal minimal additional expenses (just (just the costs of of maintaining a public entity) and therefore would allow it to focus on its low cost strategy It would also add to the equity basis of the company, reducing its financial and business risks

Proposed Course of Action – Capital Expenditures

Valair will be taking delivery of 35 88-seat E-Series regional jets between June 2014 and October 2020. The company has negotiated attractive debt financing arrangements for these orders at a loan ratio of 85%.


CPA Mock Evaluation

Finance Elective

Page 17

While this course of action would provide Valair with additional capacity (thereby allowing Valair to help meet its strategy for organic growth and passenger revenue growth), the debt financing goes against Valair’s other strategies as follows: The debt payments would lead to increased interest interest costs and the additional planes would lead to additional depreciation costs. These would go against the plan to become the lowest cost base airline in the sector. However, it could be argued that these new planes are more efficient (perhaps from a fuel usage point of view) and therefore these new purchases may not go against the low cost strategy. The high debt ratio (85%) significantly significantly increases the debt of of the company and on an ongoing basis its interest and principal payments. As a result it would increase (not decrease) the financial and business risk of Valair. 

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Proposed Course of Action – Purchase Small Regional Airline

Valair is also considering the purchase of a small regional airline. While the details on this acquisition would need to be analysed in far greater detail, initially this would appear to meet the stated strategy of Valair: It would allow Valair the opportunity to capitalize capitalize on the recovery in the domestic airline airline market (through increased capacity) It would allow the company to build on its track record of passenger revenue growth (through increased capacity) It would provide additional capacity for Valair with minimal additional expenses (this assumes that the funds from the IPO and existing cash would be used to finance the purchase and that the target would not add significant debt to the company) and therefore would allow it to focus on its low cost strategy It would also add capacity and potentially profitable operations to Valair, reducing its financial and business risks 

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Additional details det ails would need to be analysed ana lysed on all of these courses of action before bef ore a final decision could be made with respect to the adherence to Valair’s strategy. A s s e s s m e n t O p p o r t u n i t y # 6 – Overall / Enabling Enabling Co mp etencies etencies

The candidate performs an integrated analysis and determines if it is likely that Valair can raise $60 million through the IPO proposed The candidate demonstrates competence in the Enabling Competencies. Competencies. CPA Map Comp etencies: etencies:

1.3 – 1.3 – Maintains Maintains a stakeholder focus 2.1 – 2.1 – Demonstrates Demonstrates a cohesive process for using professional judgment to solve problems and make decisions 3.2 – 3.2 – Writes Writes and speaks to enhance work performed (This indicator has been included here to demonstrate that the assessment of enabling com petencies could also b e built into the Elective ca cases.) ses.)


CPA Mock Evaluation

Finance Elective

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The proposed IPO strategy by Valair is an excellent plan from a variety of perspectives: (i) It would allow Valair to raise additional funds to continue its growth and allow it to fund additional capacity. This could be performed through organic growth (the funding of the 35 aircraft currently on order), or through targeted acquisitions (such as the small regional airline proposed). (ii) It would also allow Valair to strengthen its financial position. Specifically, Valair’s equity position would increase by fourfold from about $18 million to over $74 million. This would reduce its risk profile considerably. However, as noted above, the price proposed for the IPO ($2.95) is aggressive. As such, we would suggest that Valair reduce the price proposed for the IPO to approximately $2.44 per share. It should also develop more concrete plans for the use of the proceeds as the current intentions are quite vague. Ideally Valair would also provide a more detailed forecast to substantiate the IPO and the use of the funds. We should enquire to ensure Valair has performed this analysis.


Valair Limited Mock Evaluation Cpa

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