Cost of Capital

The cost of capital was performed based on FactSet for Frontier Airlines (ULCC), including capital structure, component cost, and the sensitivity of WACC to Beta for the fiscal year 2021. Data used in these calculations was used from Factset and S&P Capital IQ.

Frontier Airlines' cost of capital is the return it should achieve to justify the cost of performing the "capital project," whether purchasing new airplanes or new locations at airports.

Capital Structure was calculated for ULCC in the form of WACC, as seen in the figure below. WACC is the "Weighted Average Cost of Capital" and shows the distribution of weights assigned to long-term debt and Equity. From a calculation standpoint, the WACC focuses on the Current Portion of LT Debt, the Current Portion of Leases, LT Debt, and LT Leases. The second part of the figure calculates the market value of common Equity. The current stock price was multiplied by the outstanding shares to find this. This allowed for the finding of total ltd plus Equity. To find the weights for LTD, divide the long-term debt by the Total LTD + Equity. To find the weighted percentage for common Equity, use the same formula or LTD but instead use common Equity and divide it by Total LTD + Equity. This information allowed for the finding of WACC, which was calculated by multiplying the weight by component cost. This led to a WACC of 9.71% for Frontier Airlines. The WACC of 9.71% means Frontier Airlines must pay almost $0.10 on average to fund an additional $1. Companies typically have an average WACC of around 5%, so ULCC is not far off.

Figure 2.8: ULCC Capital Structure. Source: Excel

Component Costs

Cost of Debt

The cost of debt is the effective interest rate a company pays on its obligations. To calculate this, as seen in the figure below, I took the pre-tax cost of debt from the overview section in Factset. This calculation was at 8.53%. Then the tax rate of 29.17% was taken from Frontier Airlines' income statement in Fiscal Year 2021. The after-tax cost of debt was calculated by taking the pre-tax cost (8.53%) and multiplying it by one minus the tax rate of 29.17%. This gave an after-tax cost of debt of 6.04%.

Figure 2.9: ULCC Cost of Debt. Source: Excel

Cost of Common Equity

The figure below focuses on the cost of common equity of Frontier Airlines, which was calculated using the CAPM model. The CAPM model allows us to see the relationship between risk and expected return for assets like stocks. First, we used the riskless rate of 3.97%, representing the ten-year government yields. Second, I pulled the beta from Factset of 1.70. Then the MRP of 5.50% came from Fernandez et al.2021. Finally, with the three inputs determined, I added the risk-free rate to the beta and times it by the MRP. This delivered a cost of equity for Frontier Airlines of 13.32%. This output represents the company, and investors can expect a 13.32% return when investing or focusing on a specific initiative set forth by Frontier.

Figure 3.0: ULCC Cost of Common Equity. Source: Excel

Sensitivity Analysis

Unfortunately, Frontier Airlines did not have enough data to provide a sufficient sensitivity analysis due to the new nature of the business and the change in accounting standards that impacted ULCC. However, we can still analyze the Beta of 1.70. This Beta would cause the cost of equity to increase as well as the WACC. From an investor standpoint, the Beta of 1.70 is riskier than the S&P 500 index. As a result, ULCC's stock price fluctuates more than the market average.

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