Deccan Proposed Solution

The Fuqua School of Business at Duke UniversityFUQ-10-2006

March 7, 2006

Air Deccan – Cutting Costs, Not Corners

The Story of India’s First Low Cost Airline

Background

The Indian economy has been booming in recent years. The aviation industry in India has also been growing rapidly. However, the market remains largely under penetrated. The Government of India has historically heavily regulated the aviation industry. In recent years, there has been a relaxation in the regulation policy of the Government and this has paved the way for several new airlines to enter the market.

Air Deccan, India’s first low cost carrier is one of these new entrants and is looking to capitalize on the vast potential that is inherent in the aviation market. However, to do so it needs to expand its operations significantly to sustain its market share in light of the growing number of competitors that is entering the industry. The company is looking to do an IPO to fund its expansion.

Sources and Uses of Funds

To fund its expansion needs and preserve its competitive position, Air Deccan is looking to raise $250-300 million from its IPO. The Exhibit below details the proposed uses of the IPO.

Prepared by Ruchika Chinda, Ruibin Chen, Rishi Gupta, Anuj Sharma under the supervision of Campbell R. Harvey. Copyright © 2006. All Rights Reserved.

10-2006Air Deccan – Cutting Costs, Not Corners

Risk Analysis of Air Deccan

Air Deccan has the following inherent risks due to the nature of the aviation industry and prevalent sociological and political environment in India.

Symmetric Risks

Demand/Price: The company returns are dependent on the growth in the airline traffic in India in the coming years. Since the market is highly under penetrated with only 62 out of 450 airports being utilized in India, the potential for the industry is huge. Also, with an increase in the disposable income in the middle class, more and more people are choosing to fly rather than avail of other alternatives. The passenger growth in the last few years has been significantly high (27% in 2005) which further emphasizes the demand in the industry. However, the price elasticity of customers in India is still very high, thus providing both the potential and a tremendous advantage to LCC’s. The success of this model can be estimated through the fact that an estimated 40% of Air Deccan’s passengers are first time flyers. The increasing number of players in the market could lead to excess capacity in case the demand does not grow as expected. And since the aviation industry is characterized by high fixed costs, this would result in a possible exit of many players from the market, including Air Deccan.

Mitigation: The risk is greatly mitigated due to the expected increased demand in the Indian market. Moreover, LCCs will be the last to hit as they would still have the capacity to attract customers through competitive pricing even as the industry faces excess capacity.

Input/Supply (Resources) Risk: Labor – The airline industry in India has experienced a shortage of skilled personnel,

especially pilots from time to time. Some of Air Deccan’s competitors offer more attractive wage and benefit packages than Air Deccan. While the recent past has also witnessed poaching of pilots by competing airlines, the Government of India imposed a minimum six months notice period for resigning pilots. Any relaxation of their directions in the future could worsen the shortage.

Oil Price – Air Deccan is extremely vulnerable to fluctuations in the price and availability of fuel since Government regulations do not permit domestic airlines to hedge against oil prices.

Covenants – Air Deccan has several existing agreements with its lenders that contain restrictive covenants relating to the company’s right to effect a change in its capital structure, raise additional finance, expand the company’s business and change its debt equity ratios.

No approval for call center – Air Deccan has registered, but not yet received approval from the Department of Telecommunications for operation of the call center at Bangalore. If this registration is refused, the company might be forced to procure call center services from third parties, which they might be unable to do in a cost effective and timely manner.

Limited number of suppliers – One of the key elements of the low cost business model strategy for Air Deccan is to operate only a few types of aircraft, with aircraft within each type having similar equipment. This commonality provides Air Deccan with many

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10-2006 Air Deccan – Cutting Costs, Not Corners

operational and cost benefits. However, the dependence on these types of aircraft and engines makes Air Deccan vulnerable to any design defects or mechanical defects that might arise with such aircraft or engines.

Mitigation: Although little can be done to mitigate an increase in the world oil prices, Air Deccan can lock resources like labor via contracts to lessen possible resource risks. In addition, Air Deccan should also invest in diversifying its supplier base (to the industry average) or else target agreements with its current suppliers to cover design and manufacturing defects. Finally, since decisions in India still tend to be governed by the political ambitions of the government officials, it would help Air Deccan in the long run to invest in gaining political insurance of the local governments.

Currency, Interest Rate and Inflation: A significant portion of expenses such as fuel, aircraft and engine maintenance services and interest and principal obligations under the terms of foreign debt and aircraft lease payments are denominated in or linked to U.S. dollars. In Fiscal 2005, 35.96% of Air Deccan’s expenses were incurred in currencies other than Indian rupees. While some of the inputs are in U.S. dollars, all the outputs are in Rupees, thereby exposing the company to direct currency risk.

Mitigation: Inflation in India has been pretty constant over the past decade and the exchange rate fairly stable. Thus the risk of hyperinflation is not as high in comparison with other emerging economies. However, investors can mitigate this risk by hedging against this currency risk in the world markets.

Binary Risks

Direct Expropriation: With India being a democratic nation, the risk of direct expropriation is low. However, with the leftist parties still enjoying some political clout, a change in the ruling coalition may see the aviation sector monopolized again (Air Corporations Act of 1953).

Mitigation: The involvement of international partners could decrease the intensity of this risk. Additionally, the company’s future plans of reaching every developing area in the nation may provide incentives for the Indian government to cooperate fully in the success of this project, which would reduce the risk of expropriation even more.

Regulatory Risk: Since 1991, the Government of India has pursued policies of economic liberalization and has relaxed certain regulatory restrictions in order to encourage foreign investment in specified sectors of the economy, including the aviation sector. However, there is no certainty that these liberalization policies will continue, as a collapse of the current coalition government could trigger significant changes in India’s economic liberalization and deregulation policies, thereby disrupting the business conditions in India. In addition, Indian laws limit Air Deccan’s ability to raise capital outside India through the issuance of equity or convertible debt securities and restrict the ability of non Indian companies to acquire Air Deccan.

Mitigation: Air Deccan should try to involve international and multilateral agencies as its promoter to mitigate this risk. Such involvements can mitigate the risk to some

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extent as any change in the legal environment which might affect the project would come under extensive international scrutiny. However, complete mitigation of this risk is not possible as it is difficult to ascertain how much influence international bodies could have on the sovereign authorities and on the sovereign laws of a democratic country.

Technology Risk: There seems to be little technology risk present in this project since the technique has been tried, tested and proven across the world over many years. However, one of the key elements of the low cost business model strategy for Air Deccan is to operate only a few types of aircraft, with aircraft within each type having similar equipment. This commonality provides Air Deccan with many operational and cost benefits. However, the dependence on these types of aircraft and engines makes Air Deccan vulnerable to any design defects or mechanical defects that might arise with such aircraft or engines.

Mitigation: Whatever little technology risk there might be above could be mitigated through investing in insurance.

Risk of Default: There seems to be risk of default because of the high front loaded investments that the project demands, and the high dependence on fixed costs like world fuel prices. Moreover, with the success of Air Deccan’s business model, new competition is entering the LCA industry. Kingfisher Airlines, Royal Airlines, Air India Express and Visa are just a few of the airlines that are establishing LCC’s. In addition, the recent exit of Air Sahara from the market (acquired by Jet Airways) may be an indication of decreasing profitability in the industry.

Mitigation: The involvement of multilateral agencies could reduce the incidence and the impact of default.

Asymmetric Risks

Creeping Expropriation: As per the expropriation risks discussed in the section above, it is very likely that political leadership in India might decide to divert cash flows from the project through higher royalties or taxes.

Mitigation: However, this risk is partly mitigated due to the importance that the aviation industry plays in the overall development of the economy.

Sociological Risk: In the past, there have been military confrontations along the India Pakistan border. The potential for hostilities between the two countries is high due to ongoing terrorist incidents in India and troop mobilizations along the border. Military activity or terrorist attacks in the future could influence the Indian economy by disrupting communications and making travel more difficult.

Mitigation: In the mitigation of this risk, much depends on the policies and procedures of the current government. Also, incidents and intensity of such risks can be expected to be reduced with the development of the nation.

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Competitive Analysis

The Indian aviation industry is set for sustainable high growth in the near future.

India has a huge potential for growth in its airlines industry. The Indian domestic aviation industry has been a laggard relative to its potential in the past. Regulatory and infrastructure bottlenecks have prevented accelerated growth in the industry despite low penetration levels and robust economic growth. However, all of this is starting to change with the government proactively looking to address the bottlenecks. The long term potential of the industry is immense. Below is a five force analysis on the Indian airline industry.

1. Rivalry: Competitive pressures has increased due to numerous new entrants and undergoing expansion by incumbents

After witnessing Air Deccan’s success, many other low cost carriers have been established, including Kingfisher Airlines, Spice Jet, Air One, and Go Air.

The competitive landscape for the airline industry is likely to change significantly as several of these new players with different positions enter the market. In addition, existing players like Indian Airlines, Jet airway, Sahara and Deccan are aggressively adding to their fleets for domestic operations.

While demand growth is estimated to keep pace, if further newer players come in or if demand growth does not sustain, then there could be excess capacity that could lead to price wars, once fleet additions gain momentum.

The industry will see a clear segmentation in terms of passenger profile. While Jet, Sahara and Indian Airlines are likely to continue focusing on premium service and trunk routes, Air Deccan, Go Air (and Royal Airways probably) are likely to play the low fare and small destination game. The positioning of Kingfisher Airlines is an intermediate between full service and no frills.

2. Barriers to Entry: Easy entry but execution doubtful

After years of dormant competitive dynamics, the Indian aviation market is likely to see a large number of new entrants in the market. Starting up an airline in India is fairly easy, capital being the only constraint. But execution can be a major hurdle for all the new players, due to a host of internal and infrastructure issues.

Tightly Regulated: Airlines in India are required to fly to economically less developed areas and this lowers load factors. Director General of Civil Aviation (DGCA) also regulates route frequencies and schedules, aircraft registration and employment of foreign pilots.

The new private airlines will have to compete against established players that have network, time slots and a strong brand in place. Network would be a key challenge due to the limited size of operations, and also due to regulatory requirement on route dispersal norms. Lack of a good network will also mean lower utilization of the aircrafts. These make up barriers to new entries.

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Poor Infrastructure: Airport infrastructure in India is woefully lacking. Infrastructure issues limit new comers’ choices on time slots and trunk routes. The inadequate infrastructure creates entry barriers for newer players during peak flying hours.

3. Suppliers: Inadequate airport infrastructure, shortage of pilots and high fuel costs.

Airport congestion: Congestion at key airports is a debilitating infrastructure problem faced by the industry. While India has over 400 airports, just 62 of them are in use. Moreover, Delhi and Mumbai account for more than 40% of the total traffic, resulting in congestion at these airports. In that sense, the bargaining power from airports is high because there is no substitute for the landing spots.

Shortage of Pilots and Trained Crew: With aggressive fleet additions by new entrants as well as incumbents, the industry is witnessing a shortage of pilots and skilled crew. This could result in an imbalance in supply/demand, which could increase the bargaining power of crews and cause HR costs to rise sharply. Airlines may look to recruit pilots from international carriers putting pressure on employee costs.

High Fuel Costs in India on a Global Comparison: In India, fuel costs are nearly 80% higher (120% two years ago) than international base prices because of high duties. For most international carriers, fuel costs as a % of revenues is 15 – 20%, while that for Indian carriers is nearly 25% (would be nearly 35% for LCCs). Although excise and import duties have reduced in the recent budget, fuel costs of Indian carriers are still 60% higher. If sales tax is reduced from current levels of 22% to say 10%, then fuel prices would be 45% higher than international base prices.

4. Customers: Business travelers sector intensified by GDP growth, leisure customer market has huge growth opportunity.

The rise in income levels and the number of high income households have a direct effect on air travel market. India is still in the growth phase of economic development, and both the rise in income levels and high income households favor strong airline market growth.

Business travelers: Business customers are already fairly well penetrated and they usually are price inelastic. The business traveler sector should grow in line with overall economic growth.

Leisure travelers: Leisure travel, which is highly price elastic and under penetrated, has significant scope for growth. In fact, the entry of a low cost airline like Air Deccan in the domestic airspace has introduced connectivity to several cities that were not covered by any airline and brought the price of air travel down to a level where it is comparable with high end railway fares. Over the next several years, the leisure traveler sector is expected to grow dramatically. This is because the basic infrastructure will be in place in over 400 Indian cities in the foreseeable future, and most of them are currently under penetrated.

5. Substitutes: decreasing threats from substitution means of transportation

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India is one of the least penetrated markets for air travel in the world. The reason for this is that India historically has been putting high level taxes on aircraft fuel and other aspects of air travel like airport taxes and taxes on tickets. Other means of low cost transportation, therefore, impose substitution pressure on the airline industry.

To promote the civil aviation industry, the government has reduced customs duty to 10% (from 20%) and excise duty to 8% (from 16%) in the recent budget. If airlines pass on the benefits of lower fuel costs to their passengers, fares could fall further and thereby reduce threats from the substitutes.

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Pro’s and Cons of Doing an IPO

The decision to go public is an important one and should not be taken lightly. The following discusses both the advantages and disadvantages of going public.

Advantages of going public: – Liquidity: Companies go public when their equity capital needs increase to the point

where the opportunity cost of remaining private and compensating investors for the lack of liquidity becomes too great relative to the lower cost of capital derived from liquid public markets. Once shares of a company are traded on a public exchange, those shares have a market value and can be resold.

New Capital: Almost all companies go public because they need to raise money. This capital can be used for various corporate purposes such as working capital and R&D and also to fund the company’s expansion through long term capital expenditures and potential acquisitions.

Future Capital: If a company has a successful IPO, subsequent offerings are usually readily accepted by the market, thereby enabling the company to raise additional equity at favorable terms. Further, a successful offering will improve a firm’s debt to equity ratio, thereby improving the company’s credibility as a borrower and would allow the firm to lever up at favorable terms. Convertible securities are another example of an alternative available to a publicly traded company.

Cashing Out: When owners sell their shares in the secondary market, it sends a negative signal to the market. However, an IPO gives owner’s an opportunity to cash out some of their wealth, thereby giving them greater diversification.

Increased wealth: An IPO has the potential to provide substantial financial reward for all parties involved. Previously, these shares were illiquid and had a subjective price. With an IPO, these shares can be sold in the secondary market to the public, usually after the lockup period has expired. Even if the owners cannot realize the proceeds from the issuance immediately, a successful IPO would give them an opportunity to use the publicly traded stock as collateral to borrow for other investments.

Valuation: IPO sets a value for the company that is set by the public markets and not through subjective standards of private investors. This allows other companies to notice and evaluate the firm for potential synergies.

Image and Visibility: Taking a company public is one of the acknowledgements of success in a business. Further, it increases the visibility of a company and could potentially generate new interest from customers and suppliers, allowing the company to obtain a larger market for their goods and services. Heightened visibility may provide a competitive advantage over a privately held company.

Acquisition: Equity in public companies can be used as currency for future acquisitions. Personnel: Offering stock options to employees can be a powerful incentive for attracting

and retaining quality personnel and aligning employee’s incentives with those of the firm’s.

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Disadvantages of going public: – Time and Costs: An IPO is time consuming and expensive. A successful IPO can take up

to a year or more to complete and has several costs associated with it. These costs are one time costs like underwriter and legal fees and ongoing costs which result from the need to report timely information to investors and regulators.

Loss of Control: If a substantial proportion of the shares are sold to the public, outsiders could take control and the company could face a hostile takeover. While there are provisions against these takeovers, the market may view certain anti takeover devices as unacceptable in an IPO. Anti takeover provisions increase agency costs. Further, defending a hostile bid can be time consuming and expensive.

Dilution: Current shareholders’ percentage of ownership is diluted in an IPO. Further, earnings per share are also diluted.

Disclosure: SEC disclosure requirements for public companies are very extensive. A public company must regularly provide information about the company that would otherwise not be available to the public. This information can be used by competitors, thereby giving them potential advantages.

Market Pressure: Market pressure may cause management to focus on short term results to maintain stock prices, thereby foregoing possible future NPV projects, which might be essential for the long term success of the company.

Regulatory Review: A public company is open to review by the SEC to ensure that the company is making all the appropriate filings with relevant disclosures.

Falling Stock Price: If the company’s stock price falls, the market may lose confidence in the company, which would result in a decreased valuation for the company. This could affect the company’s lines of credit and ability to maintain employees.

Restrictions on Management: Typically, IPO entrepreneurs cannot cash out for many months after an IPO. Further, management may not be able to act as quickly at it could under a private structure, as they need to comply with SEC proxy rules when obtaining shareholder votes.

As with any important decision, it is imperative that the owners and principals of a private company carefully weigh the advantages and disadvantages in light of the goals they have set for the company. They should consider all the other alternatives available at their disposable and conduct extensive due diligence before the decision is made to go public.

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Valuation

Cost of Capital Calculation

Below is an analysis of our cost of capital calculation for the Air Deccan: –

Risk Premium Calculation – U.S. risk free rate – We took this as 4.50% based on the current 10 year Treasury bond

rate. U.S. risk premium – We assumed the market risk premium to be 3%. Current U.S. credit rating – We took the U.S. country rating of 92.5.

Institutional investor country credit rating – We took this to be 57.0 in 2006 and gradually increased it to 72 in 2013. Our underlying assumption here was that the current liberalization policies of the Government of India will continue to lead to future investments in the country, thereby increasing the country’s credit rating.

Industry Adjustment Industry Beta – We estimated this to be 1.10 based on the current average beta for the

airline industry.

Project Risk Mitigation

Sovereign Currency (direct) – We thought that Air Deccan was exposed to some currency risk as

some of its inputs were denominated in U.S. dollars, while all of it outputs were denominated in Rupees, also its debt to finance fleet expansion is mostly foreign debt. We assigned this a value of 4.

Currency (indirect) – Value of 0 due as indirect currency risk should be similar to what it would be for the country itself.

Expropriation – We though that Air Deccan was exposed to the risk of expropriation due to the heavy regulation of the airline industry had faced in the past. We assigned it a value of 2.

Commercial international partners – Value of 0 due to the absence of any commercial international partners.

Involvement of multilateral agencies – Value of 0 due to the absence of any multilateral agencies.

Sensitivity of project to wars – We attributed a value of 2 to the company due to the risk associated with there being union strikes in India, terrorism and geo political factors like the risk of war with Pakistan.

Sensitivity of project to natural disasters –We assumed this to be 0 as we felt that Air Deccan was as vulnerable to natural disasters as any other company in the country.

Operating Resource risk – We had a value of 4, as there was resource risk due to scarcity of pilots

and infrastructure, which was needed to enter into new airports. Technology risk – We had a value of 9 due to the low risk associated with Air Deccan’s

proven technology. We would have attributed a higher value had Air Deccan not purchased their aircrafts from a few suppliers.

Financial

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Probability of default – We assigned this a value of 3 as we thought that there was risk of default due to the high capital requirements of Air Deccan and the possibility that new entrants would capture a substantial market share, at Air Deccan’s expense.

Political risk insurance – We assigned a value of 0 due to the absence of any political insurance.

Under these assumptions, Air Deccan’s cost of capital is 18.19% compared to 16.07% for a company of average risk in India. Please refer below for our cost of capital worksheet. However, we need to add 2.23% (difference in the rate of inflation between India and the US) to normalize this cost of equity calculation. This makes the cost of equity for Air Deccan in the year 2006 to be 20.49%.

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EXHIBIT A Cost of Capital Worksheet for Air Deccan

Worksheet calculates cost of equity capital in nominal U.S. dollar terms.Convert local currency cash flows to USD by the assumption of Purchasing Power Parity, i.e. the expected annual depreciation in the FX rate is exactly equal to the difference between local and U.S. inflation rates.

Risk Premium CalculationInputs Output Category

4.50 U.S. risk free in %3.00 U.S. risk premium in %

92.50 Current U.S. Credit Rating57.00 Institutional Investor country credit rating (0-100)

16.07 Anchored Cost of Equity Capital for project of average risk in country (ICCRC)8.57 Country Risk Premium

Industry Adjustment1.10 Beta

(Industry)0.30 Sector adjustment

Project Risk Mitigation (-10 to 10; where 10=risk completely eliminated, 0=average for country)

Weights Score

Impact on Country Premium

Sovereign0.40 -4.00 1.37 Currency (direct, e.g. convertibility)0.10 0.00 0.00 Currency (indirect, e.g. political risk caused by crisis)0.15 -2.00 0.26 Expropriation (direct, diversion, creeping)0.05 0.00 0.00 Commercial International partners0.05 0.00 0.00 Involvement of Multilateral Agencies0.05 -2.00 0.09 Sensitivity of Project to wars, strikes, terrorism0.05 0.00 0.00 Sensitivity of Project to natural

disasters.

Operating0.05 -4.00 0.17 Resource

risk0.03 9.00 -0.19

Technology risk

Financial0.05 -3.00 0.13 Probability of

Default0.03 0.00 0.00 Political Risk Insurance

1.00 Sum of weights (make sure = 1.00)

Project Cost of Capital 18.19


Please refer below to our sensitivity analysis on Air Deccan’s cost of capital assuming that India’s country rating improves gradually till due to the influx of investments in the country. Due to the difference in the rate of inflation of 2.3% between India and the US, we added back 2.3% to the cost of equity calculated from Harvey’s Cost of Capital method (Exhibit A).

In calculating the WACC for Air Deccan, we assumed the following to be constant Long Term D/V = 35%Long Term Tax rate = 36%

Further, we assumed Rd to be higher in the initial years (10% through 2008), gradually tapering off to 8% in 2013 as Air Deccan turns profitable and uses its free cash flow to pay down its debt, thereby improving its ability to raise debt at more favorable terms. Please refer to the table below for our WACC calculations.

India's AD's CostYear ICCR of Equity Rd WACC

2006 57 20.49% 10.00% 15.6% 2007 59 19.75% 10.00% 15.1% 2008 61 19.04% 10.00% 14.6% 2009 63 18.34% 9.00% 13.9% 2010 65 17.67% 9.00% 13.5% 2011 67 17.02% 9.00% 13.1% 2012 69 16.39% 9.00% 12.7% 2013 71 15.78% 8.00% 12.0% 2013 72 15.48% 8.00% 11.9%

As can be seen from above, Air Decca’s WACC in 2006 is 15.6%, but by 2013 it falls to 12.0%.

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Projections

Under Penetrated Market

After sluggish growth of 4.1% per annum over 2000 – 2004, despite high GDP growth of 5.7% over the same period1, the Indian aviation sector has been going through a boom period 2005 onwards. India’s domestic air travel market has grown 4.1% per annum over the past five years. However, due to the booming economy and consumer base and GDP growth hovering around 8%, a growing number of people are reaching ‘middleclass’ levels and, thus, are finding flying affordable. The results have started to show, with domestic traffic in FY05 growing by 26%Error: Reference source not found.

Traffic in Asia has grown at about 1.5x GDP (around 2.0x for China)2. The aviation sector in India has been marred by the under investment in infrastructure and a restrictive regulatory regime. However, the issues that have held back natural demand growth are improving. The government is taking initiatives to improve airport infrastructure and is adopting a more liberal approach to aviation regulations.

Due to strong growth in the domestic market driven by affordability, a booming economy and increased capacity, it is forecasted that the aviation sector in India is going to see booming years ahead. Air Deccan is well positioned to exploit this buoyancy as it has positioned itself in the underrepresented markets as an extensive network, a growing brand and great low cost operational strengths. Growth in total number of passenger seen in 2005 is likely to continue for few more years before stabilizing at 1.5xGDP growth, in line with the other Asian countries. Analysts projections are that airline passenger growth will slow down to 12% per annum by year 20123 and 10% per annum by year 2013.

Market Share Gain

While new competition is coming in, we believe it will be a few years before the new players can match Air Deccan due to operational challenges or copy its low cost no frills model due to infrastructure issues. Deccan strengthened its position and gained market share from 6.5% in FY 2005 ending on March 31st to 11% in October 2005. Even though it is unlikely that Air Deccan will continue to gain market share at the same rate, it is likely that the firm will further strengthen its position and gain further market share from the current 11% per annum to 19% in the domestic market in 2013.

Load Factor and Yield Growth

The Load Factor for Air Deccan in grew from 63% in year 2004 to 76% in year 2005 and is likely to be 72% to 75% for the next couple of years, which is in line with the load factors for its competitors. Due to the firm’s policy of higher utilization of its plans, it is likely that Air Deccan’s load factor might be a few percentage points higher than its competitors. However, as the competition intensifies in the civil aviation industry in India, Air Deccan will find it harder to maintain such high levels of load factors for its planes. Also, there is some possibility that due to Deccan’s aggressive aircraft acquisition policy, load factor might lag

1 From DB Research report on Jet Airways dated 11 March, 2005.2 From Air Deccan prospectus (red herring) filing.3 Morgan Stanley report on Jet Airways dated March 2005.

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by few percentage points before reaching its full potential. High load factors will also likely to continue for some more time as the continued boom in the aviation sector is not likely to be matched by infrastructure improvement in the near term and airline companies are likely to be only moderately successful in taping in to this boom due to infrastructure bottlenecks. Because of the factors discussed above, the load factor for Air Deccan is likely to come down to a more moderate level of 68%.

With inflation hovering around 4.5% and continued high fuel prices, it is likely that some of these costs would be passed on to the customer in the form of improvements in yield.

Revenue Assumptions

Year ended March 31, 2003 2004 2005 2006E 2007E 2008E 2009E 2010E 2011E 2012E 2013E

Market Size (in millions) 19.90 25.47 32.09 39.48 47.37 55.43 63.18 70.77 77.84Market Growth 12.90% 26.80% 28% 26% 23% 20% 17% 14% 12% 10%Market Share 6.50% 12% 14% 16% 17% 18% 18% 19% 19%Available seats flown (in millions) - 0.24 1.29 3.06 4.49 6.32 8.05 9.98 11.37 13.45 14.79Passenger Load Factor - 62.64% 76.36% 74% 73% 71% 70% 69% 68% 68% 68%Passengers flown (in millions) - 0.15 0.99 2.26 3.28 4.48 5.64 6.88 7.73 9.14 10.06Revenues per Passenger (Rs.) - 2,055.00 2,704.00 3,028.20 3,179.61 3,338.59 3,505.52 3,680.80 3,864.84 4,058.08 4,260.98 Revenues per Passenger Growth 31.58% 5% 5% 5% 5% 5% 5% 5% 5%Revenues (INR millions) - 314.18 2,669.46 6,849.53 10,429.38 14,972.01 19,761.48 25,337.81 29,889.81 37,103.22 42,854.21

Expenses

Rental Expenses and Capital Expenditures

Air Deccan plans to add around 100 aircrafts by year 2013, approximately half of which are to be through operating leases and the balance outright hire purchases. Most of the direct purchase will be financed through foreign denominated debt. Due to this off balance sheet arrangement, rental expenses for Air Deccan are likely to remain high and would be significantly higher as a percentage of revenue compared to the 7%4 level for its more established peers. Rental expenses for the six months ended September 30 th, 2005 were 15.4% of revenues and are likely to remain close to this high level for the next 3 – 4 years. These expenses are likely to come to down to more moderate levels of 8% of revenues by year 2013.

Due to Air Deccan’s aggressive aircraft policy, capital expenditures are likely to be a very significant portion of its total revenue and these fleet expansions will have to be financed through debt or by issuing equity. These additional aircraft orders represent approximately Rs. 133.50 million in new amounts payable in the current fiscal year in respect of pre delivery payments and deposits, plus approximately Rs. 44,056.62 million in additional commitments (which are subject to change to the extent prices are adjusted over time pursuant to the terms of orders)5.

4 From Morgan Stanley research report on Jet Airways dated March 15, 2005.5 From Air Deccan’s prospectus (red herring) under section SIGNIFICANT DEVELOPMENTS AFTER SEPTEMBER 30, 2005.

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Fuel Expenses

Fuel expenses are the most significant part of the operating expenses. Due to the increase in international crude oil prices over past year and half, fuel costs for Air Deccan rose to 38.7%. However, international crude oil prices have come down to more moderate levels since then and are likely to average around $57.50/barrel for year 2006 and expected to average $55.00/bbl in year 2007. These oil prices are still very high compared to the average prices of $30.93/bbl and $41.30/bbl in year 2003 and 2004 respectively. Due to the high oil prices, Air Deccan’s fuel cost are likely to be around 35% in year 2006 and come down (in line with most oil analysts’ forecast) to 30% by year 2013. Also, aviation fuel prices in India are among the highest in the world due to the Government of India’s regulations that preclude airline companies from entering into fuel hedging contract. However, it is likely that as the Indian economy opens up, some of these regulations will be relaxed and taxes on aviation fuel might also come down to levels more in line with the international markets.

Administrative and General Expenses

Administrative and general expenses for Air Deccan have been lower than its competitors and are likely to remain at low to moderate levels due to its low cost operational model. These costs were significantly lower for Air Deccan at around 8% of revenue for the six months ended September, 2005 compared to the 12 – 13% level for its peers. As Air Deccan expands its operations and other lower costs airlines enter the market, these costs might go up to 11% or more by 2013 and fall more in line with its competitors.

Other Direct Operating Expenses and Aircraft/Engine Repairs and Maintenance

Being a start up airline, Air Deccan incurred more costs on Operating expenses and also on Aircraft/Engine repairs and maintenance, partly due to the age of its fleet (old aircrafts) and partly due to the start up costs to establish maintenance facilities. Together, these costs accounted for 39.8% of revenue during the six months ended September 2005. However, as Air Deccan acquires new fleet, these costs are likely to fall more in line with its comparables at around 24% by year 2013.

Employee remuneration and benefits

At around 12% of revenues, theses costs for Air Deccan are higher than the 7 – 8% for its peers. However, costs are significantly higher internationally and are likely to go up in India

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as the Indian economy opens up more. If going forward, Air Deccan could lower these costs by a few percentage points, and then it would be an achievement. However, due to its low cost model and emphasis on cost reductions, Air Deccan is likely to keep these costs at around the 8.5% level by year 2013.

Expenses Assumptions

Year ended March 31, 2003 2004 2005 2006E 2007E 2008E 2009E 2010E 2011E 2012E 2013E% of Total

Income% of Total

Income% of Total

Income% of Total

Income% of Total

Income% of Total

Income% of Total

Income% of Total

Income% of Total

Income% of Total

Income% of Total

IncomeAircraft fuel expenses 5.34% 13.72% 29.03% 35.0% 34.0% 33.0% 32.0% 31.0% 31.0% 30.0% 30.0%Aircraft/engine repairs and maintenance 1.32% 13.13% 15.39% 12.0% 11.0% 9.0% 9.0% 9.0% 8.0% 8.0% 8.0%Aircraft/engine lease rentals 24.36% 15.80% 14.09% 14.0% 13.0% 12.0% 11.0% 10.0% 9.0% 8.0% 7.0%Other direct operating expenses 24.74% 24.89% 23.00% 23.0% 21.0% 19.0% 18.0% 18.0% 17.0% 16.0% 16.0%Employee remuneration and benefits 11.24% 10.61% 9.92% 11.5% 10.5% 9.5% 9.0% 8.5% 8.5% 8.5% 8.5%Administrative and general expenses 14.71% 11.22% 6.34% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%Employee stock compensation cost - - - 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Advertisement and business promotion expenses 2.30% 0.47% 1.97% 2.0% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5%Finance and banking charges 6.46% 5.74% 3.19% 3.0% 3.0% 3.5% 4.0% 4.5% 4.5% 4.5% 4.5%Amortisation 3.35% 1.47% 1.79% 1.5% 1.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Depreciation 1.39% 1.66% 0.96% 2.0% 2.0% 3.0% 5.0% 7.0% 8.0% 9.0% 9.0%Total Expenditure 95.21% 98.71% 105.68% 112.0% 105.0% 98.5% 97.5% 97.5% 95.5% 93.5% 92.5%

Capital Expenditure 2.0% 2.0% 5.0% 39.0% 32.0% 25.0% 21.0% 10.0%

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Sensitivity Analysis

We conducted a Tornado analysis to determine the sensitivity of the various parameters on the IPO price of Air Deccan. The following were the results: –

SensIt - Sensitivity Analysis - Tornado

0%

0%

40%

1%

0%

2%

3%

4%

0%

5%

0%

0%

5%

5%

20%

0%

5%

30%

95%

15%

8%

20%

15%

20%

20%

25%

80%

25%

50%

40%

55%

50%

(4,000.00) (3,000.00) (2,000.00) (1,000.00) 0.00 1,000.00 2,000.00

Capital Expenditure

Aircraft fuel expenses

Other direct operating expenses

Market Growth

Aircraft/engine lease rentals

D/V

Aircraft/engine repairs and maintenance

Revenues per Passenger Growth

Employee remuneration and benefits

Administrative and general expenses

Depreciation

Advertisement and business promotion expenses

Amortisation

Passenger Load Factor

Market Share

Finance and banking charges

Implied price per share (Rs./Share)

The IPO price was found to be mot sensitive to capital expenditures followed by operating and fuel expenses, market growth and the target debt to equity ratio.

The table on the next table illustrates that a 5% increase in capital expenditures results in a 20% decrease in the share price on average. Similarly a 5% increase in the market growth results in a 53% increase in the share price on average.

Thus we feel that even if Air Deccan does not remain the most competitive airline around, the sheer momentum of the growing market makes it an attractive investment choice.

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286.60 286.60 286.60 286.60 5% (4.04) 0% 350.59 40% 121.13 0.0% 168.81 10% 24.98 2% 339.93 44% 140.59 1.5% 199.71 15% 68.07 4% 329.26 48% 160.06 3.0% 234.26 20% 130.32 6% 318.60 52% 179.53 4.5% 272.80 25% 218.22 8% 307.93 56% 199.00 6.0% 315.71 30% 339.96 10% 297.26 60% 218.46 7.5% 363.40 35% 505.77 12% 286.60 64% 237.93 9.0% 416.31 40% 728.25 14% 275.93 68% 257.40 10.5% 474.91 45% 1,022.85 16% 265.27 72% 276.87 12.0% 539.69 50% 1,408.35 18% 254.60 76% 296.33 13.5% 611.20 55% 1,907.36 20% 243.93 80% 315.80 15.0% 690.02 60% 2,546.97 22% 233.27 84% 335.27 16.5% 776.76 65% 3,359.39 24% 222.60 88% 354.73 18.0% 872.08 70% 4,382.73 26% 211.94 92% 374.20 19.5% 976.70 75% 5,661.79 28% 201.27 96% 393.67 21.0% 1,091.35 80% 7,249.01 30% 190.61 100% 413.14 22.5% 1,216.85

286.60 286.60 286.60 286.60 0% 829.08 0% 663.98 0.0% 380.94 0.0% 286.60 2% 758.32 1% 616.80 0.5% 357.36 0.4% 286.60 3% 687.56 2% 569.63 1.0% 333.77 0.8% 286.60 5% 616.80 3% 522.46 1.5% 310.18 1.2% 286.60 6% 546.05 4% 475.29 2.0% 286.60 1.6% 286.60 8% 475.29 5% 428.11 2.5% 263.01 2.0% 286.60 9% 404.53 6% 380.94 3.0% 239.43 2.4% 286.60 11% 333.77 7% 333.77 3.5% 215.84 2.8% 286.60 12% 263.01 8% 286.60 4.0% 192.25 3.2% 286.60 14% 192.25 9% 239.43 4.5% 168.67 3.6% 286.60 15% 121.50 10% 192.25 5.0% 145.08 4.0% 286.60 17% 50.74 11% 145.08 5.5% 121.50 4.4% 286.60 18% (20.02) 12% 97.91 6.0% 97.91 4.8% 286.60 20% (90.78) 13% 50.74 6.5% 74.32 5.2% 286.60 21% (161.54) 14% 3.57 7.0% 50.74 5.6% 286.60 23% (232.29) 15% (43.61) 7.5% 27.15 6.0% 286.60

286.60 286.60 286.60 286.60 20% 994.18 5.0% 616.80 0% 947.01 0% 1,371.56 24% 805.49 6.5% 546.05 2% 852.66 3% 1,230.04 28% 616.80 8.0% 475.29 4% 758.32 6% 1,088.52 32% 428.11 9.5% 404.53 6% 663.98 9% 947.01 36% 239.43 11.0% 333.77 8% 569.63 12% 805.49 40% 50.74 12.5% 263.01 10% 475.29 15% 663.98 44% (137.95) 14.0% 192.25 12% 380.94 18% 522.46 48% (326.64) 15.5% 121.50 14% 286.60 21% 380.94 52% (515.33) 17.0% 50.74 16% 192.25 24% 239.43 56% (704.01) 18.5% (20.02) 18% 97.91 27% 97.91 60% (892.70) 20.0% (90.78) 20% 3.57 30% (43.61)64% (1,081.39) 21.5% (161.54) 22% (90.78) 33% (185.12)68% (1,270.08) 23.0% (232.29) 24% (185.12) 36% (326.64)72% (1,458.77) 24.5% (303.05) 26% (279.47) 39% (468.15)76% (1,647.46) 26.0% (373.81) 28% (373.81) 42% (609.67)80% (1,836.14) 27.5% (444.57) 30% (468.15) 45% (751.19)

286.60 286.60 286.60 286.60 0% 247.61 0.0% 234.61 0% 432.93 0% (10.67)1% 273.60 1.5% 273.60 5% 67.10 5% (2.95)2% 299.60 3.0% 312.59 10% (298.72) 10% 5.99 3% 325.59 4.5% 351.58 15% (664.55) 15% 16.39 4% 351.58 6.0% 390.57 20% (1,030.37) 20% 28.56 5% 377.57 7.5% 429.56 25% (1,396.20) 25% 42.89 6% 403.57 9.0% 468.55 30% (1,762.02) 30% 59.93 7% 429.56 10.5% 507.54 35% (2,127.85) 35% 80.36 8% 455.55 12.0% 546.53 40% (2,493.67) 40% 105.14 9% 481.55 13.5% 585.52 45% (2,859.50) 45% 135.64 10% 507.54 15.0% 624.51 50% (3,225.32) 50% 173.79 11% 533.53 16.5% 663.50 55% (3,591.15) 55% 222.56 12% 559.53 18.0% 702.49 60% (3,956.97) 60% 286.60 13% 585.52 19.5% 741.48 65% (4,322.80) 65% 373.70 14% 611.51 21.0% 780.47 70% (4,688.62) 70% 498.02 15% 637.50 22.5% 819.45 75% (5,054.45) 75% 688.14

Lease Rentals Operating Expenses

D/VCapital Expensiture

Passenger Load Factor Revenue/Passenger Growth

Finance & Banking ChargesAdvertisement

DepreciationAmortisation

Sensitivity Analysis

Market Growth Market Share

Admin & General ExpenseEmployee Benefits

Fuel Expenses Repair & Maintenance

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Real Options

In our analysis of Air Deccan’s IPO decision, we came up with the following options that need to be evaluated that could boost the value of the decision.

1. Access to the capital marketGiven that two other airlines are planning to do an IPO within a couple of months after Air Deccan, this first mover advantage will help Air Deccan. An IPO now (first mover) will help Air Deccan access the limited investor capital in the market.

2. Increase in liquidityDivesting a part of a company through an IPO increases the liquidity of Air Deccan. The management will get additional benefit from this increased liquidity during valuation in case of an acquisition. The Indian aviation industry is already in a mode of consolidation evidenced by the recent Jet Airways and Air Sahara merger. Also, with its successful LCC model, Air Deccan could be an attractive acquisition target to one of the other seasoned players. An IPO now makes sense if the management has hopes of selling off the company altogether.

Other options provided by Air Deccan’s growth strategy are discussed below.

3. Low cost developing areasOnly 62 out of the 450 airports in India are developed. Thus there is a huge untapped market waiting in the wings. Unlike other airlines, Air Deccan has in the past and will continue to target these underdeveloped areas as opposed to major trunk routes. This provides Air Deccan a first mover advantage as they will able to establish airport and other infrastructure in those areas at very attractive costs. Since most of airline costs are fixed costs, this advantage helps Air Deccan maintain a competitive edge over its competitors and other new entrants.

4. Increase in flight revenueAn estimated 5% of Air Deccan’s revenue comes from in flight services. Air Deccan has the option here to increase prices on these and other fringe services (extra baggage etc) going forward to increase its revenues.

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Conclusion

Air Deccan has revolutionized the Indian aviation industry by being its first LCC. Recent liberal government policies, a growing but under penetrated aviation market and a booming economy are just a few of the factors that Air Deccan has capitalized on. Air Deccan’s success has led to many new entrants entering the LCC market.

To sustain its competitive position in light of the increased competition, the company needs to raise capital to expand and is planning to do an IPO. Our analysis reveals that issuing debt is a cheaper option for Air Deccan than raising equity, given its higher cost of equity due to the risks inherent in its business. Further, issuing equity also dilutes shareholder ownership.

We are skeptical of Air Deccan’s ability to capture market share given the entry of several new players in the industry. Additionally, we believe that management might be doing an IPO so that some of it stakeholders can cash out and diversify their holdings given the sharp rise in the Indian equity markets. Another possible reason for the IPO could be a two part sale strategy, whereby the company goes to the public markets for an IPO to gain visibility and credibility with the goal to be acquired quickly.

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Documents

Deccan Proposed Solution