The Cost of Capital for Space Tourism Ventures

Abstract

In order to attract investors from the capital markets, the cost of capital for a space tourism venture has to be quantified and qualifying financing models have to be set up. This leads to the two really significant terms for investors, namely those of Net Present Value (NPV) and Cost of Capital. In order to derive the latter, this paper uses a comparables method to estimate the business risk index (Beta) for a typical future space tourism operation. This results in a relatively high cost of capital of 17.6% (!); compared to the 6% which had been used for earlier evaluations of space tourism.Then the paper goes on to apply this cost figure to some existing business scenarios in order to derive the NPVs of typical space tour ventures. As can be seen in the results, the high cost of capital represents a significant challenge for the sophistication and professionalism of future business plans and financial models. Based on a concluding sensitivity analysis and on some recent experiences from ongoing commercial space projects, some lessons learned are presented. If applied properly, these will help to make space tourism economically viable.

The History of Market Demand for Space Tourism

Space tourism is an old idea. The first waiting lists for commercial trips to the Moon have been around for almost fifty years now.(1) The first scientific study on the subject was done by the late Krafft Ehricke in 1967.(2) But only in the 1990s, when the Cold War was over and government space programs started to run into problems, experts started to look into space tourism in earnest. The first serious market studies, involving a survey of potential customers, were done under the auspices of the Japanese Rocket Society in 1993.(3)

The results for Japan were so positive that they motivated surveys in other countries like the USA, Germany and Canada. Even NASA, still the space agency, confirmed in writing that there is enough demand for space tourism to make it commercially feasible.(4)

The following gives a brief overview of the key findings in several studies (all numbers referring to flights into Low Earth Orbit):

Japanese Rocket Society study (1993)(5)

• 1,000,000 space tourists per year in Japan
• Annual turnover of $14 billion for ticket prices of $14,000 (all $ in 1995 values)

Daimler-Benz Aerospace business plan for RLV (1995)(6)

• 450,000 space tourists per year in Europe
• Annual turnover of $20 billion for ticket prices of under $50,000

NASA/STA study (1997)(7)

• $10­20 billion per year "general public spacetravel and tourism" business

TU Berlin study (1997/98)(8)

• 100,000 space tourists per year globally
• Annual turnover of $9 billion for ticket prices design (Fig. 1), reference concept of the of under $100,000

While all these demand figures look quite high, maybe even too optimistic, the core question remains: How are all these people going to fly into space?

The Failure of Government Space Programs

Although the required technology exists, governments have miserably failed for the last decades to give the average tax payer access to space. Even after having spent trillions of dollars on government space activities, space still remains to be the domain of some happy few, government-paid astronauts.

Today, there simply is no such thing as a passenger-rated space launch system for tourism applications. The US Space Shuttle, which is the closest it gets today to having an airliner-type space transport vehicle, is far too expensive for commercial passenger transportation to orbit. Depending on the way one accounts for the Shuttle's R&D depreciation, a ticket can cost up to $100 million.

But even if somebody was willing to pay so much, he or she would not be allowed to fly, since NASA officially ruled out the Shuttle for space tourism in 1985.(9) In that context, it does not help very much that the Russians currently offer Soyuz flights to Mir for $10­20 million. Despite the recent hype about the upcoming Dennis Tito flight(10), selling surplus transport capacity on government-funded space infrastructure seems not to be a viable business model for the future.

For some years, there still was hope that the government is at least going to pay for some reusable launch vehicle. Many such designs have been proposed over the years, for instance the Shuttle II, Delta Clipper (USA), Hotol (UK), Radiance (France), just to name a few. Given the possibility of having an economically viable system available soon, a lot of research was done in the field of defining additional, tourism-like applications for future space launch vehicles. Especially the German SÄNGER German hypersonics technology program(11), was subject to several studies of its space tourism potential, some of them very detailed in terms of ticket cost.(12)

Fig. 1: SÄNGER launch system(13)

Typically, the rough business plans laid out in those studies assumed that the government is going to pay for R&D of the respective vehicle. The space tour operator just had to buy a fleet of vehicles (some spaceplanes, for instance), set up the infrastructure, open a spaceport and start to fly tourists. In the financing models of these optimistic, government-confident scenarios, there was not much emphasis on the cost of capital. Usually rates around 6% were assumed, as in other big public sector projects. At least, government was expected to pay the hefty R&D bill and after that the operational system would be available for doing business.

Unfortunately, it did not work out that way. SÄNGER was more or less terminated in 1995 and so were almost all the other government-funded launcher projects. It became quite obvious that the kind of space launch vehicles that is required to achieve affordable space transportation "for the rest of us" is not going to be paid for by government space programs.

So, it is now the turn of the private sector to finally open up space for the public.

A Typical Private Sector Venture in Space Tourism

Some of the most detailed and thoroughly researched scenarios of a private space tourism venture are those developed at the Technical University of Berlin in 1997/98.(14) They all relied on using the Japanese Kankoh-Maru rocket - developed by Kawasaki Heavy Industries (see Fig. 2) - for flying space tourists to LEO (Low Earth Orbit) and back.(15)

Fig. 2: Kankoh-Maru rocket for 50 passengers(16)

A number of different market scenarios was analyzed and the findings were documented in several reports. One, the so-called "reference scenario" can be used as an example for demonstrating some financial key parameters ($ in 1998 values):

• 100% privately funded
• Investment: $7,800 million
• Required rate of return: 6% per year (equal to government-backed loan)
• Max. capacity: 100,000 passengers per year to LEO
• Ticket price: $50,000 (average)

This reference scenario as a typical case study justifies investing in space tourism by quoting a short-enough Payback Period and a sufficient Return on Investment (ROI). The following figures are quoted from the presentation of the reference scenario at the ISST '97(17):

• Payback Period: 17 years
• ROI after 20 years: 16.6%
• ROI after 50 years: 31.7%

The interesting thing about this scenario, which has been widely communicated in the space tourism community, is that it assumes the same cost of capital as for government-backed loans. The big question here is whether this is a realistic assumption for the yet-to-be-proven business of space tourism. Probably not.

The Problems of Private Rocket Companies

During the 1990s many startup companies have been established in the field of space transportation vehicles. Some of them explicitly quoted space tourism as a major revenue stream for their intended businesses. A brief scan of space-related sites on the Internet delivers the following company names(18):

• Bristol Spaceplanes Limited
• Cerulean Freight Forwarding Company
• General Astronautics
• Kelly Space & Technology
• Kistler Aerospace
• Pioneer Rocketplane, Inc.
• Platforms International Corp.
• Rotary Rocket
• Space Access
• Texas Spacelines, Inc.
• TGV-Rockets, Inc.
• Tour2Space (SpaceVan)
• Truax Engineering, Inc.

While some of these companies have been able to raise a large amount of private capital (particularly Kistler and Rotary), most of their competitors are still cash-starved and seeking equity funding for their projects. "The biggest challenge for us is raising capital, plain and simple," says Bob Davis, CEO of Kelly. So, it seems to be very hard to get funding for rocket ventures.(19)

No Bucks, No Buck Rogers

Although the existing market studies look very promising, private capital seems to be hard to get for a full-blown space tourism venture.

Why is this so?

For obvious reasons, it is hard to get insight into the business plans of all these ventures, so we will have to rely on assumptions here:

It is very likely that many finance people still perceive the space sector as being stuck with the old "high cost/high performance paradigm" of the Apollo days. Back then, technological merit was all what counted; economic performance was secondary. For forty years, private capital was not a big issue in the "old rocket economy". All the big projects were government-funded.

Many rocket scientists have yet to learn to sell their technology by demonstrating its profitability. Therefore, in view of lacking investor response, a hypothesis of missing proof comes to mind:

To the capital markets, it is still unproven whether space tourism is profitable and potential investors are waiting for proof. Obviously, Payback Period and ROI as in the Kankoh-Maru example are not sufficient as good investment criteria. So, what is wrong with payback period and return on investment?

The Payback period is not such a good investment criterion, because:

• Payback gives equal weight to all cash flows before payback date, no weight at all to subsequent flows
• Projects that are equally attractive in terms of payback may have widely differing overall performance
• The choice of cutoff period often relies on pure guesswork

Return on investment (ROI) is a better choice criterion, but still not good enough, because it might pretend too optimistic results. The ROI calculation is based on book costs and therefore contains, for example, depreciation: depreciation stretches costs over a long period and hence does not reflect economic reality. Thus, there need to be better criteria for investment decisions.

The Advent of Rocket Finance

The space tourism business has to be described in a language that is understandable to the capital markets. According to the school of thought in corporate finance the two really significant terms for investors are those of Net Present Value and Cost of Capital.(20)

Net Present Value (NPV):

The net present value rule says that one only accepts investments that have positive net present values.

Cost of Capital (r):

The rate-of-return rule says that one only accepts investments that offer rates of return in excess of their opportunity costs of capital.

The key features of Net Present Value (NPV) make it so important as an investment criterion:

• Recognizes the time value of money ("one dollar today is worth more than a dollar tomorrow")

• Depends solely on forecasted cash flows and on the opportunity cost of capital (independent from accounting rules; "depends only on cash")

• Any attempt to make up NPVs comes down to a change in basic assumptions (like distribution of revenues or cash costs)

The formula for the NPV is:

NPV = C₀ + C₁/(1+r) + C₂/(1+r)² + ... + C_T/(1+r)^T

C₀

Initial investment (= negative cash flow)

C_t

Cash flow of the respective year

r

Opportunity cost of capital

T

Number of years Return on investment (ROI) is a better

Thus, in order to calculate an NPV, one needs the cost of capital. The cost of capital accounts for the intrinsic risk of future revenue streams, therefore it adds a new quality of information that is not present when just talking about payback and ROI.

The more revenue predictions reach into the future, the more difficult they become:

• the revenue risk varies by industry (volatile vs. mature industries)

• the annual discount percentage (1/(1+r)^t) is a reward to investors and compensates them for uncertainty in future revenues

The capital market is primarily interested in ventures that return more than their cost of capital. Usually the cost of capital is modeled by applying the CAPM (Capital Asset Pricing Model).

According to the CAPM, the cost of capital for a risky investment is:

r = r_f + (r_m - r_f)

r

Cost of capital

r_f

Risk-free interest rate (Treasury bills; around 3.8%)(21)

r_m

Expected rate of return on the market portfolio (S& P 500; around 13%)(22)

Measure for business risk ("Beta")

In order to quantify the cost of capital for space tourism, the business risk index (Beta) has to be known.

The "Beta" describes the average volatility of individual stocks or other assets relative to the market as a whole (S& P 500's Beta = 1.0) over some specified period of time.

The Beta formula goes as follows:

_asset = _debt × (Debt/Capital)
                  + _equity × (Equity/Capital)

For the ease of calculation, 100% equity of capital were assumed (_asset = _equity).

But: how to derive a Beta for a still non-existent industry like space tourism?

There are several methods for determining a Beta (Tab. 1). But in the case of space tourism, the comparables method is the only appropriate one, because up to now, historic data is not available.

Which method	How it works	When to apply
Use Beta book	Look up beta values in reference book	Firm/industry quoted in beta book Firm/industry exists for at least two years
Regression analysis	Analyze stock performace in comparison to S& P 500	Firm quoted on stock exchange Historic data available
Comparables method	Analyze betas of similar firms and/or industries	Firm and/or industry does not exist yet

Tab. 1: Different methods for determining Betas

A comparable industry for estimating a Beta has to have similar characteristics to space tourism. That prospective industry is characterized by:

• Product (mostly intangible: experience, thrill, high tech, not an investment)
• Quantity (rather low, luxury)
• Customer Segment (rich people)
• Purchasing Patterns (once-in-a-lifetime)
• Company Position in the value chain (design; build; operate; promote)

The following industries which have similar characteristics come to mind:

• Recreational Activities (especially cruise lines)
• Luxury Apparel & Accessories
• Wedding Party Services

The Betas of all these existing industries (or of single companies) can be looked up conveniently in the respective sources for evaluation.(23)

Space Tourism's Opportunity Cost of Capital

The estimated Beta (see Tab. 2) for space tourism indicates a relatively high volatility of the respective cash flows, because, according to the CAPM, the resulting cost of capital for a space tourism venture is:

Industry/Company (Ticker Symbol)	Beta*	Comparability
Recreational Activities	1.30**	good
Carnival Corporation (CCL)	1.26	very good
Europa Cruises Corp. (KRUZ)	1.34	very good
Royal Olympic Cruise Lines (ROCLF)	1.29	very good
Royal Carribean Cruises (RCL)	2.06	very good
Luxury Apparel & Accessories	1.55**	fair
Donna Karan (DK)	1.21	fair
Gucci Group (GUC)	1.50	fair
LVMH (LVMHY)	1.89	fair
Wedding Party Services	N/A	--
N/A	--	--
Estimated Beta for Space Tourism	1.50

*) Relevered Betas; all equity, no debt (Source: Ibbotson.com, Multex.com)
**) Industry Beta

Tab. 2: Determining the space tourism industry Beta with the comparables method

Even seen over a period of 50 years, this orbital space tour venture still has a negative NPV of almost $3 billion! With the government-backed credit at 6% per year, as initially assumed, the venture would at least have a positive NPV after year 20, but the internal rate of return with only 10.7% is relatively low (see Appendix).

r = r_f + (r_m - r_f)

r = 3.8% + 1.5(13% ­ 3.8%)

r = 17.6%

assuming all-equity financing, no debt.

Obviously, a typical space tourism venture has to return 17.6% per year, otherwise it won't be a good investment. If this figure is now applied to the calculation of the Net Present Value of the aforementioned business case with the Kankoh-Maru rocket (for complete NPVs, see Appendix), it becomes obvious that it won't be a good investment:

• NPV over 10 years: -4,781 million ('98$)
• NPV over 20 years: -3,553 million ('98$)
• NPV over 50 years: -2,993 million ('98$)

These rather surprising results ask for a sensitivity analysis. Higher leverage, that is: increasing the share of debt financing, can help to increase long-term NPV. In a theoretical exercise that can be seen in the following table, a total Debt/Equity ratio of 10 (equals a Debt/Value ratio of 90%) brings the cost of capital close to the 6% as initially assumed in the Kankoh Maru scenario (see Tab. 3).

Debt/Value	assets*	r	NPV10[$ M]**	NPV20[$ M]	NPV50[$ M]
0%	1.5	17.6%	-4,781	-3,553	-2,993
50%	0.8	11.16%	-5,549	-2,736	-378
75%	0.45	7.94%	-6,024	-1,651	3,571
90%	0.24	6.01%	-6,345	-596	8,080
95%	0.17	5.36%	-6,461	-145	10,209
99%	0.11	4.85%	-6,554	248	12,170

*) _debt = 0.1;
**) Index gives number of years (NPV₁₀ = NPV over 10 years etc)

Tab. 3: NPVs with increasing financial leverage

In these simple calculations, the cost of capital drops as financial leverage increases. But this overstates the advantages of debt. For example, costs of financial distress encountered at high debt levels have not been taken into account; in reality they would affect the cost of equity, because a firm with a debt level of 99% would be virtually bankrupt.

Lessons Learned

We can learn from this that space tourism ventures - at least those planning to fly into orbit, thus needing billions of dollars - will require professional business plans and sophisticated financial models to make them commercially feasible. Especially the optimization of the debt to equity structure promises to become a rather complex task, since a pure equity investment does not provide positive returns in a typical $7.8 billion LEO tourism project.

The major problem which has such a negative impact on the project's NPV is the long time for R&D (7 years) and the high initial investment.

So, it may be asked: Why do space tourism projects have to be so big? In recent years, many small firms have been emphasizing that it is much more attractive to start with suborbital space tourism, because:

• The required technology is much less complex
• The ticket costs are much lower
• The up-front investments are more in the range of millions, not billions
• There is an X-Prize of $10 million waiting to be won(24)

While preparing this paper, the authors conducted a financial study of a typical X-Prize vehicle, a small spaceplane with up to four seats.(25) As can be seen from the NPV calculation in the Appendix, small really means beautiful in this context:

• NPV over 10 years: 13.22 million ('98$)
• Investment needed: 45 million (`98$)

Even the high cost of capital of 17.6% does not have an overly negative impact, because the project performs with an Internal Rate of Return (IRR) of 28% (over 10 years). These are indeed very positive prospects for suborbital tourism as a viable first step towards public space travel!

Conclusion

The typical annual rate of return so often used before in the financial modeling of space tourism (around 6%) is not realistic, because such a rate can only be achieved with a government-backed loan. The latter is virtually unavailable for startups.

A more realistic estimation of space tourism's opportunity cost of capital, using a comparables method, delivers a much higher value of 17.6% per year (based on a Beta of 1.5). Using this value, a pure equity investment does not provide any positive returns for a typical large-scale orbital tourism venture. Higher leverage (more debt) would help positive returns, but would also require a sophisticated financing system.

Small projects promise a positive NPV due to their smaller up-front investment needs. Therefore, from the perspective of rocket finance, it makes perfect sense to go suborbital first.

References

1. Thomas Cook's "Moon Register" was initiated in England in 1954
2. Krafft A Ehricke: "Space Tourism". Advances in the Astronautical Sciences 23 (1968): 259­291.
3. There were earlier surveys, for instance the one done in the UK by American Express in the mid-1980s, but the Japanese one was the first which actually asked people what they were willing to pay for a trip to space
4. In a joint NASA/STA study on space tourism (see: Daniel O'Neil et al)
5. Patrick Q Collins et al: Potential demand for passenger travel to orbit. Study report. Tokyo: Japanese Rocket Society, 1993
6. _______: European Business Plan for the X-33/ RLV. Internal Study Report conducted under subcontract for McDonnell-Douglas's bid for the NASA X-33 project. Bremen: DASA RI, 1995.
7. Danial O'Neil et al: General Public Space Travel and Tourism. Volume 1. Washington, DC: National Aeronautics and Space Administration/Space Transportation Association, 1998
8. Sven Abitzsch: Chancen und Entwicklungsmöglichkeiten der Weltraumtouristik. Dissertation. Berlin: Technische Universität Berlin, 1998
9. See: Patrick Q Collins and David M Ashford, "Potential Economic Implications of the Development of Space Tourism". Acta Astronautica 17 (1988): 421­431.
10. See: "Investment manager Dennis Tito announced Monday, June 19 that he wants to be the first tourist on the Mir space station." http://www.space.com/businesstechnology/business/mircorp_tourist_000619_wg.html
11. See for instance: P Kania: "The German Hypersonics Technology Program: Overview". Technical Paper AIAA-95-6005, presented at the 6th International Aerospace Planes and Hypersonics Technologies Conference, April 3­7, 1995, Chattanooga, Tennessee
12. See for instance: F Eilingsfeld and S Abitzsch: "Space Tourism for Europe: A Case Study". Technical Paper IAA 1.2-93-654. Presented at the 43rd International Astronautical Congress, October 18­22, 1993, Graz, Austria
13. Picture from: P Kania (© 1995 by Daimler-Benz Aerospace)
14. Sven Abitzsch: "Global Market Scenario of a Space Tourist Enterprise". Presented at the 1st International Symposium on Space Tourism, March 20­22, 1997, Bremen, Germany
15. K Isozaki et al: " Considerations on Vehicle Design Criteria for Space Tourism". ". Technical Paper IAF-94-V.3.535. Presented at the 44th International Astronautical Congress, October 10­14, 1994, Jerusalem, Israel
16. Picture from: K Isozaki (© 1994 by Kawasaki Heavy Industries)
17. See: Sven Abitzsch: "Global Market Scenario of a Space Tourist Enterprise"
18. For instance: http://www.space-frontier.org/COMMSPACE/ as of September 20, 2000
19. See Joseph C Anselmo: " RLV Ventures Strained by Funding Problems". Aviation Week and Space Technology 151.1 (July 5, 1999): 24.
20. See: Richard A Brealey, and Stewart C Myers: Principles of Corporate Finance. Sixth Edition. Boston, etc: Irwin/McGraw-Hill, 2000
21. See: Ibbotson Associates, Inc., 1998 Yearbook
22. Ibid
23. www.ibbotson.com and www.multex.com
24. See www.xprize.org
25. For instance: Ascender; see http://www.bristolspaceplanes.com/