Divestment of Air India

1. Divestment of Air India Ashish Parikh Manavendra Singh Sial Nikolay Nazarov Pallav Jain

2. Agenda • Case Introduction • Background Duke Air • Background India • Background Air India • Transaction • Issues • Our Analysis • Our Valuation • Case Update

3. Case Introduction Synopsis • Duke Air is considering an investment in Air India Learning Objectives • Cost of capital considerations • Comprehensive DCF Modeling

4. Background: Duke Air • Finland’s leading airline • Most profitable European airline in 2000 • European revenues make majority of total revenues • Interested to diversify into other markets

5. Background: India • Largest Democracy • Second largest country - population • Per capita GDP $471 • Huge income disparity • In the midst of economic liberalization • Severe corruption

6. India: Key Economic Indicators

7. Background: Privatization “…Learning from our experience, especially over the last decade, it is evident that disinvestment in public sector enterprises is no longer a matter of choice, but an imperative…” Address by the President to Parliament in the Budget Session

8. Background: Privatization Process

9. Background: Air India • Founded in 1932 as Tata Airlines • Nationalized in 1946 and turned into Air India • 1999 Revenues - $1B (Rs 44B) • 1999 Assets - $834M (Rs 36B) • 18,000 employees • 200 world-wide destinations • 3.37 million passengers annually

10. Background: Air India • 100% Government owned • Strong Brand image • Strong Operational Capabilities • Strategic partner would increase operational efficiencies • Competitive disadvantage due to small fleet size

11. Transaction • Acquire a 40% equity stake in Air India • Requirement of an Indian partner • Foreign partner can not have more than 26% stake • Additional 20% to be sold to Indian institutional investors • All cash transaction • Possibility of Indian Airlines divestment

12. Option to buy Indian Airlines • Probability of IA divestment by 2005 – 40% • Probability of acquiring IA after acquiring Air India – 50% • Expected synergies from such a transaction – 15% of Air India’s operating cash flows

13. Air India operating details • Air India travel market share of 21% (air traffic in India) • Indian Airlines travel market share of 11% • Major markets: • India/U.S. • India/U.K. • India/Europe • India/South East Asia

14. Air India operating details • Other sources of revenue (MM USD):

15. Air India operating details • Fleet size

16. Air India projections • Revenue growth of 10% • Major costs – aircrafts and fuels tied to US dollars • Fuel costs based on a stable oil price of 27.5 USD/barrel • High capital expenditure in 2003-2004 and 2006-2007 for fleet augmentation • Prices consistent with competitive carriers • Debt refinancing assumed to maintain high D/E ratio

17. Air India projections

18. Issues to consider • Adjustment to operating cash flows • Adjustments to cost of capital • Other adjustments • Incorporating Indian Airlines option (probability of 0.4 and 0.5) • Other qualitative issues

19. Our Analysis

20. Analysis: Risks

21. Analysis: Mitigants

22. Analysis: Cost of Equity • ICCRC India • Assumptions: • Risk Free Rate = 4% • US Market Risk Premium = 3% • Anchored to US • ICCRC Cost of Capital for India Cost of Equity (ICCRC) 19.5%

23. Analysis: Cost of Equity

24. Analysis: Use of Multiples • Acquisition Multiples • Not meaningful, due to regional and other differences • Trading Multiples • P/E: Regional differences, AI negative earnings • EBITDAR: Best multiple for industry, but also problematic due to high leverage and lack of comparables

25. Analysis:Changes in Valuation • DCF approach - Free Cash Flow to Common Equity (FCFCE). • Operating Cash Flows were adjusted down by 5% to reflect resource risk and operational inefficiencies. • Risk adjustments reduced the cost of equity capital from19.5%to19.03%

26. Analysis: Changes in Valuation • Scenario wrt. equity investment in Indian Airlines (real option) • Terminal Value growth rate – 2% • Exchange rate is determined from the Purchasing Power Parity - Assumptions - US inflation rate 2% - Indian inflation rate 5%

27. Our Valuation

28. DCF Model • FCFCE projections for the next 13 years • Main Issues • Revenue Projections (10% growth rate over the next 10 years) • Alliance/Consolidation Benefits • Fuel Costs • Debt Pay down

29. Valuation • Monte Carlo Simulation • Jet fuel price is modeled as a function of oil price. • Simulation of oil price as random walk with a drift. • Embedded parameters in oil price simulation are conservative. • Since jet fuel is a part of COGS, after-tax effect is imputed.

30. Expected Value AI

31. AI Value with IA option

32. DCF Present Value • For AI only Expected PV– US $75.16 million Likelihood of positive NPV – 80.76% • For AI considering the synergistic benefits from acquiring IA Expected PV (median) – US $115.96 million

33. Valuing AI with real option • Probability of IA divestment – 40% • Probability of acquiring IA by Air India – 50% • Decision tree framework – expected value for Air India

34. Decision tree

35. Multiples Valuation(regional airlines)

36. Bid Valuation: Bid Value • Bid - 77 MM USD • AI great strategic fit

37. Case Update • Duke Air did not win the bid • Political issues surrounded the privatization process • Trade unions raise concerns over divestment • Government defers divestment of Air India

38. Questions?

39. Air India References • Information memorandum and valuation model from a leading Investment Bank • Other Emerging Market cases • Presentation by HSBC on divestment in India • Discussions with Ministry of Civil Aviation • Some of the case facts, cash flow projections and probabilities have been modified for simplification