Conduct an examination of Delta, Alaska, and Southwest Airlines exposure to default risk. Although a thorough assessment is not possible due to unavailable particulars, using
Conduct an examination of Delta, Alaska, and Southwest Airlines exposure to default risk. Although a thorough assessment is not possible due to unavailable particulars, using rough estimates deploy the Merton Default Model and interpret various outputs. Delta Airlines (DAL) Delta Airlines originated from the purchase of an 18-plane fleet of dust-cropping planes by principal founder C.E. Woolman. The first passenger routes were flown in 1929 on a route from Dallas, TX to Jackson, MS. In 1941, the Delta Air Lines headquarters moved from Monroe to Atlanta, Georgia. Delta Airlines ceased crop-dusting operations and began non-stop flights from Los Angeles to Atlanta in the 1960s. Throughout the 1970s and 80s, Delta continued to expand nationally and eventually internationally. With its purchase of Pan Am in 1991, Delta truly became the global carrier that it is today. Alaska Air (ALK) Alaska Air Group was formed in 1932 offering flights from Anchorage, Alaska. Today, it is the fifth largest airline in the U.S. The largest hub in in SeaTac, Washington but also operates hubs in Anchorage, Los Angeles, Portland, and San Francisco. Alaska Air has large air cargo operation on the U. S. west coast transporting Alaskan seafood south and U. S. Postal Service mail and other supplies for Alaskan communities. Southwest Airlines (LUV) Southwest Airlines was formed in 1967 flying between Dallas, Houston, and San Antonio. Today, Southwest Airlines has about 60,000 employees and operates roughly 4,000 departures per day during peak travel times. Further, Southwest transports the largest number of U.S. passengers.
1. Review the Merton Default Model in Chapter 14 and class handouts (pp. 363-374). Explain how option theory and common stock prices can be used to provide default risk metrics.
2. Based on publicly available information, provide reasonable estimates (or guestimates) of the relevant inputs to the Merton Default Model for both Delta Airlines and Southwest Airlines.
3. Based on your inputs in the previous question, interpret the numerous outputs available from the Merton Default Model.
Merton Probability of Default Model ALASKA AIRLINES - Merton Default Model Company Ticker ALK Firm Value $14.43 V(0) Result of analysis Firm Volatility 15.563796 s(V) Result of analysis Debt at T $67451 D(T) Input: Bond documents Interest Rate (CC) 1.55000% y'(T) Input: Debt market, "risk-free" interest rate or base rate Time to Maturity 5.0000 T Input: Weighted average duration of liabilities Dividend Yield 0.0000% dy Input: Analysis of company Equity Volatility 27.270096 s(E) Input: Options market Equity Value $8.1930 E(0,Actual) Input: Equity market, number of shares outstanding times current share price OUTPUT Equity Value (Model) $8.193033 E(0,Merton) Output: BSM OVM, equity as option Equity Value (Vol) 58.193021 E(0,Vol) Output: BSM OVM, equity volatility is volatility of option Solver $0.00 =[E(0,Merton)-E(0,Actua|)]"2+[E(0,Vo|)E(0,Actual)]"2 Probability of Default 1.27677% p(T) N[-d(2)] Debt at 0 $6.23 D(O) V(0) - E(O) Debt Yield 1.58% y(T) |n[D(T)/D(0)] /T Credit Spread (bps) 2.78 cs(bps) [y(T) y"(T)]*10000 Promised Debt Payment $6.24 6(0) D(T) * exp(y*(T)T) Expected Debt Loss 0.14% EDL [6(0) D(0)]/G(0) Expected Recovery 89.11% R [p(T) EDL]/p(T) Distance to Default 2.23321 DD d(2), measured in standard deviations Notes: Volatility of rm: = Equity Volatility * Equity Value/ [N(d1)*Firm Value] Implied equity value (vol based) = [N(d1)'Firm Volatility'Firm Value]/Equity Volatility DAL current dividend: 2.0300% equity volatility (30 day at the $ calls): 27.2700% stock price: 66.61 shares outstanding: 123.00 current liabilities: 2,942.00 non-current liabilities: 2 602.00 5,544.00 833- rated debt assumption: 4.0000% 6,745.12 Merton Probability of Default Model DELTA AIRLINES - MERTON DEFAULT MODEL Company Ticker DAL Firm Value $91.65 V(0) Result of analysis Firm Volatility 7.6267% s(V) Result of analysis Debt at T $56.6705 D(T) Input: Bond documents Interest Rate (CC) 1.55000% y*(T) Input: Debt market, "risk-free" interest rate or base rate Time to Maturity 5.0000 T Input: Weighted average duration of liabilities Dividend Yield 0.0000% dy Input: Analysis of company Equity Volatility 17.8200% s(E) Input: Options market Equity Value $39.2112 E(0, Actual) Input: Equity market, number of shares outstanding times current share price OUTPUT Equity Value (Model) $39.211108 E(0, Merton) Output: BSM OVM, equity as option Equity Value (Vol) $39.211130 E(0, Vol Output: BSM OVM, equity volatility is volatility of option Solver $0.00 =[E(0,Merton)-E(0,Actual)]^2+[E(0, Vol)-E(0,Actual)]^2 Probability of Default 0.07156% P(T) N[-d(2)] Debt at 0 $52.44 D(0) V(0) - E(0) Debt Yield 1.55% y(T) In [D(T)/D(0)] / T Credit Spread (bps) 0.07 cs(bps) [y(T) - y*(T)]*10000 Promised Debt Payment $52.44 G(0) D(T) *exp(-y* (T)T) Expected Debt Loss 0.00% EDL G(0) - D(0)]/G(0) Expected Recovery 95.34% R [P(T) - EDL]/P(T) Distance to Default 3.18828 DD d(2), measured in standard deviations Notes: Volatility of firm: = Equity Volatility * Equity Value / [N(d1)*Firm Value] Implied equity value (vol based) = [N(d1)*Firm Volatility*Firm Value]/Equity Volatility DAL current dividend: 2.8700% equity volatility (30 day at the $ calls): 17.8200% stock price: 56.50 shares outstanding: 694.00 current liabilities: 18,578.00 non-current liabilities: 28,001.00 46,579.00 BBB- rated debt assumption: 4.0000% 56,670.48Market Value Balance Sheet Assets Total Assets Liabilities and Equity Total Liabilities Total Equity Total Liabilities and Equity Market Data Interest Rate Cost of Debt Capital Cost of Equity Capital Asset Relative Volatility Firm Data Weighted Average Cost of Capital Implied Perpetual Free Cash Flow Distance to Default Probability of Default Market Value Balance Sheet Assets Total Assets Liabilities and Equity Total Liabilities Total Equity Total Liabilities and Equity Market Data Interest Rate Cost of Debt Capital Cost of Equity Capital Asset Relative Volatility Firm Data Weighted Average Cost of Capital Implied Perpetual Free Cash Flow Distance to Default Probability of Default ALASKA AIRLINES - Merton Default Model $14.43 $6.23 Five year zero coupon bond $8.19 No dividends $14.43 1.55% Continuously Compounded, Risk-Free Rate 1.58% Continuously Compounded Rate 10.00% Continuously Compounded Rate 30.00% Alternate source of input 6.36% Continuously Compounded Rate $ 0.92 1.27 DD(ActuaI) d(2), measured in standard deviations 10.17% p(T) (Actual) N[-d(2)] DELTA AIRLINES - MERTON DEFAULT MODEL SUMMARY $91.65 $52.44 Five year zero coupon bond $39.21 No dividends $91.65 1.55% Continuously Compounded, RiskFree Rate 1.55% Continuously Compounded Rate 10.00% Continuously Compounded Rate 30.00% Alternate source of input 5.17% Continuously Compounded Rate $ 4.73 0.77 DD(ActuaI) d(2), measured in standard deviations 22.18% p(T) (Actual) N[-d(2)] Market Value Balance Sheet Assets Total Assets Liabilities and Equity Total Liabilities Total Equity Total Liabilities and Equity Market Data Interest Rate Cost of Debt Capital Cost of Equity Capital Asset Relative Volatility Firm Data Weighted Average Cost of Capital Implied Perpetual Free Cash Flow Distance to Default Probability of Default SOUTHWEST AIRLINES (LUV) - Merton Default Model $48.21 $18.23 Five year zero coupon bond $29.97 No dividends $48.21 1.55% Continuously Compounded, Risk-Free Rate 1.55% Continuously Compounded Rate 10.00% Continuously Compounded Rate 30.00% Alternate source of input 6.80% Continuously Compounded Rate $ 3.28 1.51 DD(ActuaI) d(2), measured in standard deviations 6.61% p(T) (Actual) N[-d(2)] Merton Probability of Default Model SOUTHWEST AIRLINES (LUV) - Merton Default Model Company Ticker LUV Firm Value $48.21 V(0) Result of analysis Firm Volatility 12.51 19% s(V) Result of analysis Debt at T $19.7024 D(T) Input: Bond documents Interest Rate (CC) 1.55000% y*(T) Input: Debt market, "risk-free" interest rate or base rate Time to Maturity 5.0000 T Input: Weighted average duration of liabilities Dividend Yield 0.0000% dy Input: Analysis of company Equity Volatility 20.1200% s(E) Input: Options market Equity Value $29.9728 E(0,Actual) Input: Equity market, number of shares outstanding times current share price OUTPUT Equity Value (Model) $29.972894 E(0,Merton) Output: BSM OVM, equity as option Equity Value (Vol) $29.972714 E(0, Vol Output: BSM OVM, equity volatility is volatility of option Solver $0.00 =[E(0,Merton)-E(0,Actual)]^2+[E(0, Vol)-E(0,Actual)]^2 Probability of Default 0.04262% P(T) N[-d(2)] Debt at 0 $18.23 D(0) V(0) - E(0) Debt Yield 1.55% y(T) In [D(T)/D(0)] / T Credit Spread (bps) 0.05 cs(bps) [y(T) - y*(T)]*10000 Promised Debt Payment $18.23 G(0) D(T) *exp(-y* (T)T) Expected Debt Loss 0.00% EDL G(0) - D(0)]/G(0) Expected Recovery 94.38% R [P(T) - EDL]/P(T) Distance to Default 3.33517 DD d(2), measured in standard deviations Notes: Volatility of firm: = Equity Volatility * Equity Value / [N(d1)*Firm Value] Implied equity value (vol based) = [N(d1)*Firm Volatility*Firm Value]/Equity Volatility LUV current dividend: 1.2500% equity volatility (30 day at the $ calls): 20. 1200% stock price: 57.64 shares outstanding: 520.00 current liabilities: 7,905.00 non-current liabilities: 8,485.00 16,390.00 BBB+ rated debt assumption: 3.7500% 19,702.42
