WACC Calculation Case Study: Lease Liabilities and Cost of Capital for a Hong Kong Airline

The accounting treatment of operating leases under HKFRS 16 has been mandatory for Hong Kong-listed entities since 1 January 2019, but its impact on weighted average cost of capital (WACC) calculations remains a persistent blind spot in corporate finance practice. The issue has sharpened in 2025 as airline balance sheets face renewed pressure: jet fuel prices have averaged USD 95/bbl in Q1 2025 (IATA data), the HKMA’s Base Rate stands at 4.75% as of March 2025, and Cathay Pacific Airways Limited (0293.HK) reported a net debt-to-equity ratio of 1.42x in its 2024 annual results, up from 1.18x in FY2023. For a Hong Kong airline, where aircraft leases represent 30-50% of total liabilities, misclassifying lease obligations as pure operating expenses rather than debt-like instruments produces a WACC that is systematically understated by 50-150 basis points. This miscalculation cascades into flawed capital budgeting decisions — overvaluing fleet expansion projects, underestimating refinancing risk, and mispricing the equity risk premium that investors demand from a highly levered, fuel-exposed carrier. This case study examines how to reconstruct the cost of equity, cost of debt, and capital structure weights for a Hong Kong-domiciled airline, using Cathay Pacific’s FY2024 financials as the primary data source, to produce a WACC that reflects the true economic leverage embedded in lease liabilities.

The Lease Liability Problem in Capital Structure

The fundamental error in many WACC calculations for airlines is treating operating lease commitments as off-balance-sheet expenses. HKFRS 16 eliminated this distinction for lessees by requiring virtually all leases to be recognised on the balance sheet as right-of-use (ROU) assets and corresponding lease liabilities. For a Hong Kong airline, this represents a structural shift in reported leverage.

Debt Equivalency of Lease Liabilities

Cathay Pacific’s FY2024 annual report (published March 2025) shows total lease liabilities of HKD 54.2 billion, comprising HKD 28.1 billion in current lease liabilities and HKD 26.1 billion in non-current lease liabilities. This figure represents 37.4% of total reported liabilities of HKD 144.9 billion. Critically, the airline’s total debt — defined as bank loans, bonds, and finance leases — stood at HKD 48.7 billion. Adding lease liabilities produces an adjusted total debt of HKD 102.9 billion, or 71.0% of total liabilities. The market capitalisation as of 31 December 2024 was HKD 48.2 billion, yielding an adjusted debt-to-capital ratio of 68.1%, versus 50.3% when only reported debt is considered.

The SFC’s Code on Corporate Governance Practices (Appendix 14 to the HKEX Listing Rules, effective 1 January 2024) requires listed issuers to disclose gearing ratios in their annual reports. Cathay Pacific reported a net gearing ratio (net debt divided by total equity plus net debt) of 0.42x in FY2024. However, this computation excluded lease liabilities from the numerator. When lease liabilities are included as debt equivalents, the net gearing ratio rises to 0.68x — a figure that would materially alter a credit analyst’s assessment of financial risk under the HKMA’s Supervisory Policy Manual module CA-S-1 on credit risk assessment.

Cost of Debt for Lease Liabilities

The cost of debt component in WACC must reflect the effective interest rate on lease liabilities, not merely the coupon rate on outstanding bonds. Cathay Pacific’s FY2024 notes to the financial statements (Note 16) disclose that lease liabilities carry an average incremental borrowing rate of 4.85% per annum, based on the prevailing rates at lease inception. This compares to the airline’s outstanding HKD 1.5 billion 3.375% notes due 2026 and its HKD 1.0 billion 4.125% notes due 2028. Using only the bond yields would understate the cost of debt by approximately 70-100 basis points.

The blended pre-tax cost of debt is calculated as follows: total adjusted debt of HKD 102.9 billion comprises HKD 48.7 billion in financial debt (weighted average cost of 4.20%, based on the yield-to-maturity of the airline’s outstanding bonds as of December 2024) and HKD 54.2 billion in lease liabilities (cost of 4.85%). The weighted average pre-tax cost of debt is 4.54%. Applying the Hong Kong profits tax rate of 16.5% yields an after-tax cost of debt of 3.79%.

Reconstructing the Cost of Equity for a Levered Airline

The cost of equity for a Hong Kong airline is not a generic market beta applied to the Hang Seng Index. It must account for the airline’s specific operating leverage, fuel price sensitivity, and the regulatory environment governing Hong Kong’s aviation sector.

Beta Decomposition and Unlevered Beta

The levered equity beta for Cathay Pacific, estimated from a trailing 60-month regression against the Hang Seng Index (HSI) as of 31 December 2024, is 1.35. This reflects the airline’s high fixed-cost base and exposure to macroeconomic cycles. To isolate the business risk, the beta must be unlevered using the adjusted capital structure. The standard Hamada equation is applied:

Unlevered beta = Levered beta / [1 + (1 – tax rate) × (adjusted debt / equity)]

Using the adjusted debt of HKD 102.9 billion and equity market value of HKD 48.2 billion, and a tax rate of 16.5%, the unlevered beta is 0.78. This figure represents the airline’s pure business risk — the volatility of its operating cash flows relative to the market, independent of financing structure.

Relevering with Lease-Adjusted Ratios

The unlevered beta of 0.78 is then relevered to reflect the target capital structure that includes lease liabilities. Assuming the current adjusted debt-to-equity ratio of 2.13x (HKD 102.9 billion / HKD 48.2 billion) is the target, the relevered beta is:

Relevered beta = 0.78 × [1 + (1 – 0.165) × 2.13] = 2.17

This beta of 2.17 is 60.7% higher than the raw equity beta of 1.35, because the raw beta already embeds the market’s pricing of the airline’s existing financial leverage but does not fully capitalise the economic leverage from leases. The HKEX’s Listing Decision LD43-3 (2012) on the classification of aircraft leases for listing purposes reinforces that lease obligations are akin to debt instruments in substance, supporting this analytical treatment.

Equity Risk Premium and Risk-Free Rate

The risk-free rate is the yield on the 10-year Hong Kong Government Bond as of December 2024, which stood at 3.82% (HKMA data). The equity risk premium (ERP) for the Hong Kong market, as estimated by Duff & Phelps (now part of Kroll) in its 2024 Valuation Handbook, is 6.50% for large-cap equities. Applying the Capital Asset Pricing Model (CAPM):

Cost of equity = 3.82% + (2.17 × 6.50%) = 17.93%

This cost of equity is substantially higher than the 12.60% that would result from using the raw beta of 1.35 and ignoring lease-adjusted leverage. The 533-basis-point difference directly reflects the additional equity risk premium that shareholders demand for bearing the economic risk of the airline’s lease obligations.

WACC Calculation and Sensitivity Analysis

With both the cost of debt and cost of equity reconstructed to include lease liabilities, the WACC can be calculated using market-value weights.

Base Case WACC

The market value of equity is HKD 48.2 billion. The market value of adjusted debt is HKD 102.9 billion (note: for lease liabilities, book value approximates market value because these are contractual obligations with fixed payment streams). Total capital is HKD 151.1 billion. The weights are 31.9% equity and 68.1% debt.

WACC = (0.319 × 17.93%) + (0.681 × 3.79%) = 8.30%

If lease liabilities are excluded — using only reported debt of HKD 48.7 billion and equity of HKD 48.2 billion — the WACC would be:

WACC (excluding leases) = (0.497 × 12.60%) + (0.503 × 3.51%) = 8.03%

The difference is only 27 basis points in this simplified comparison, but this masks the critical error: the cost of equity of 12.60% used in the exclusion case is itself understated because it was computed using the raw beta that does not reflect full economic leverage. When both the cost of equity and the cost of debt are correctly adjusted, the true WACC is 8.30%, compared to a naive WACC that might be calculated at 6.5-7.0% using conventional methods that ignore lease liabilities as debt equivalents.

Sensitivity to Fuel Price and Interest Rate Shocks

The WACC is highly sensitive to changes in the cost of debt, which in turn is sensitive to the HKMA Base Rate. A 100-basis-point increase in the HKMA Base Rate to 5.75% would raise the average incremental borrowing rate on new leases to 5.85%, increasing the pre-tax cost of debt to 5.04% and the after-tax cost to 4.21%. Holding all else constant, the WACC would rise to 8.59%.

Fuel price sensitivity is captured through the beta. A sustained increase in jet fuel prices to USD 120/bbl would compress operating margins, increasing the unlevered beta to an estimated 0.85 (based on Cathay Pacific’s fuel cost sensitivity disclosed in its FY2024 annual report, where a 10% increase in fuel prices reduces operating profit by HKD 1.8 billion). Relevering this beta at the same capital structure yields a cost of equity of 19.22% and a WACC of 8.72%.

Regulatory and Practical Implications

The SFC’s Consultation Paper on the Regulation of Sponsors (2012) and subsequent Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (paragraph 17.6) require sponsors and financial advisers to use appropriate valuation methodologies. For a Hong Kong airline, excluding lease liabilities from the capital structure in a WACC calculation would likely be considered a failure to apply a reasonable methodology under paragraph 17.6(b), which requires “reasonable care” in financial analysis.

The HKMA’s Guideline on the Application of the Banking (Capital) Rules (2019) for credit risk assessment of airline exposures explicitly requires banks to treat aircraft operating leases as credit risk equivalents to secured lending. The same principle applies to cost of capital estimation: lease liabilities are not optional expenses; they are fixed obligations that rank alongside secured debt in bankruptcy. The Hong Kong Companies (Winding Up and Miscellaneous Provisions) Ordinance (Cap. 32) provides that lessors have re-entry rights on default, making lease liabilities effectively senior to unsecured bondholder claims.

Actionable Takeaways

1. Include all HKFRS 16 lease liabilities in the debt component of the capital structure when calculating WACC for any Hong Kong airline, using the incremental borrowing rate disclosed in the financial statements as the cost of that debt.
2. Unlever the equity beta using the lease-adjusted debt-to-equity ratio, then relever to the target capital structure that incorporates lease obligations as permanent financing.
3. Verify that the cost of equity computed from a raw equity beta is not used without adjustment, as this understates the risk premium by 400-600 basis points for a typical Hong Kong carrier.
4. Test WACC sensitivity to a 100-basis-point increase in the HKMA Base Rate and a 20% rise in jet fuel prices, as these represent the two most material macro risk factors for airline valuation.
5. Disclose the lease-adjusted WACC alongside the conventional WACC in any valuation report or financial analysis submitted to the HKEX or SFC, with a clear reconciliation of the adjustments made and the regulatory basis for treating leases as debt equivalents.