ARTICLE IN PRESS - AirBusiness Academy

1 Journal of Air Transport Management 10 (2004) 427 433 Theory and practice in aircraft financial evaluationWilliam Gibsona, , Peter MorrellbaAirBusiness Academy , 19, av. Le onard de Vinci, 31700 Blagnac, FrancebAir Transport Group, Cranfield University, Beds MK43 0AL, UKAbstractThis paper explores the state of practice regarding aircraft financial evaluation. Traditional measures of aircraft economicviability, including direct operating cost comparison, ignore both the non-cash elements of costs, and the time value of adopting more advanced techniques often go straight to the net present value calculation using an industry standarddiscount rate, ignoring critical problems such as estimating the cost of capital, quantifying the highly uncertain economicenvironment airlines face, and valuing the flexibility offered by manufacturer options and operating leasing.

2 We propose takingadvantage of the potential flexibility of the net present value approach by close attention to the choice of discount rates to flesh outinvestment/financing interactions, use of Monte Carlo analysis to quantify risk up front, and real options analysis to betterunderstand the value of flexibility to aircraft Published by Elsevier :Capital budgeting; Investment analysis; Aircraft evaluation; Real options analysis1. The changing sources of airline capitalIn many countries, airlines have historically beenviewed at least partially as an infrastructure investment,required to promote economic development and implies that for many governments airline financingcan be viewed as part of the state s overall infrastructurefinancing. Further, because of the strategic and militarybackground of aviation, many of the world s airlineswere initially financed using state funds.

3 In thishistorical perspective, the cost of financing investmentin aircraft is the government s own cost of financing,which depends on the willingness (or obligation) oftaxpayers to provide interest-free financing, and theinterest rate on government debt. The latter will bedetermined by investors assessment of the state screditworthiness, often based on work by ratingagencies such as Moody s Investor Service, Fitch, andStandard and Poor notion that national governments should fundaircraft investment out of general revenues to supportoverall economic development, rather than to produceprofits, is contradictory to the current view of airlines asgenerators of economic wealth. Financiers correctlypoint out that the relatively low cost of governmentfinancing can encourage dramatic over-investment,when the airline is competing against profit-orientedairlines in the international arena.

4 A large amount ofairline equity, however, remains in the hands ofgovernments. Among the world s alliance members,the state is the largest shareholder in 45% of the airlinesalliance members surveyed by Airline of the world s airlines seek to make more use ofcapital market financing. The wave of privatisation is farreaching. China Eastern, Thai International, ChinaSouthern in Asia, and LAN Chile in South Americaare examples of airlines partially or fully privatised inthe last 20 years. The most dramatic wave of privatisa-tion has been in Western Europe; British Airways,Iberia and Lufthansa have all been fully privatised. Inany case, state-owned airlines rarely receive capital forexpansion from their governments. In addition, $ -see front matterr2004 Published by Elsevier Corresponding Gibson).airlines with sound business plans are finding privatecapital readily available.

5 Notable examples are India sSahara and Jet, not to mention such fast-growing start-ups as easyJet and Ryanair in Europe, JetBlue in theUS, and AirAsia in trend toward the use of private capital points upthe need for a solid and transparent financial justifica-tion for the large investments needed to support growthand Aircraft economic evaluationThere is agreement that cash-based measures providethe soundest indicator of investment viability, if for noother reason than that investors are putting up cash, anddemand a cash return from the project. The mostcommon cost element used to compare aircraft in termsof economic performance, however, remains directoperating cost (DOC), that reflects a profit and lossapproach, including non-cash items such as aircraftdepreciation. Moreover, DOC averages critical costssuch as training, financing, and maintenance over theaircraft life, rather calculate them on an as-incurredbasis.

6 Finally, the notion of the time value of money isabsent in this using cash-based investment appraisal toolssuch as net present value (NPV), there is a strongtemptation to compensate for the volatility of theindustry by artificially increasing the discount rate usedin the analysis, thus making the project more difficult tojustify. This approach has the disadvantage of funnel-ling all the risk through the discount rate, and alsoreduces the value of the analysis itself: a fundamentaltask of management is to deal with risk effectively ratherthan insuring it away by using an artificially high cost suggest that a better approach to uncertainty is touse a moderate cost of capital, either using marketmeasures such as Lufthansa has done, or alternatively,using broad, long-term regional benchmarks such asthose identified inDimson et al (2002). We then capturecash-flow volatility using Monte Carlo simulation,calculate expected NPV and the probability of success,and extend the investment analysis using real Operating lease versus purchase analysisOperating leasing has benefits for operators ofaircraft, offering a level of fleet flexibility and residualvalue risk reduction unobtainable when far beyond their origins as a cheap or moreaccurately, low initial cash-out solution to aircraftfinance, operating leases are the financing vehicle ofchoice for around a quarter of new large civil aircraftbeing delivered, extensively used today by the world slargest airlines.

7 Companies use operating leases forflexibility when adopting a new aircraft type. BritishAirways, for example , has financed 10 of its 15 A320family fleet under 10-year extendible operating , operating leases can form part of an aircrafttype exit strategy, as in the case of Singapore Airlines 747 400 fleet. The aircraft are financed under leasesrunning from 4 10 years, with 2-year extension optionsand full sub-leasing correct discounted cash flow (DCF) or NPVanalysis of leasing versus purchasing should at leastestimate the cost of the flexibility benefits offered byoperating lessors, when compared to debt financing. Theclassic pitfall in using NPV for aircraft investmentanalysis is including and comparing the operating leasecash flows in the analysis, and comparing the resultagainst the purchase cash flows. In aviation accounts,operating lease payments are viewed as operating costs,while interest is presented below the operating profitline.

8 Economically, lease payments include both invest-ing and financing cash flows (Fig. 1), as well as a riskpremium for the the cash flows are discounted at the weighted-average cost of capital (WACC), the result is inevitablyfavourable to leasing because of the large up-frontinvestment in purchasing, and places undue emphasis onaircraft residual values. Viewed graphically, the differ-ences are apparent, asFig. 2shows. This problem isdiscussed from a theoretical standpoint inMyers (1974),Myers, et al. (1976),Copeland and Weston (1982),andapplied to aviation inStonier (1998).Leasing is fundamentally a financing vehicle, andshould be compared with the costs of borrowing ortaking on a finance lease (known in the US as acapital lease). To estimate the cost of leasing, werecommend using a variant of the well-documentedadjusted present value (APV) concept.

9 Under APV,cash flows of different risk classes are discounted atthe discount rates that reflect the risk class of thecash proposed extension of the APV method consistsof discounting the lease payments and loan repaymentsat the cost of debt to quantify the cost of leasingflexibility, and discounting the high-risk investing andoperating cash flows at the cost of equity reflecting theshareholders approach clarifies two points that are lost in aWACC-based NPV: the risks of owning and operating aircraft are borneby the equity investors, andARTICLEINPRESS1 This method is discussed from a theoretical standpoint inMyers(1974),Myers et al. (1976),Copeland and Weston (1982) andCopeland et al. (2000).W. Gibson, P. Morrell / Journal of Air Transport Management 10 (2004) 427 433428 the extraordinary flexibility of operating leases has aquantifiable cost to operators of thus propose taking a step beyond classic APV,where only the tax deductions on interest payments arediscounted at the cost of debt, capturing leveragebenefits.

10 Just as WACC has been thoroughly acceptedin spite of its theoretical pitfalls and the difficulty inestimating cost of equity, this variant of APV should beexamined and adopted to compare leasing versuspurchasing in an NPV it comes time to finance deliveries, aircraftfinance specialists recommend that operators discountthe term sheets offered by different financiers todetermine the best offer. Our approach to investmentanalysis using APV extends this tactical approach tolong-term strategic investment final practical problem in comparing leasing andpurchasing concerns the investment horizon. Operatingleases are generally less than 10 years in length, and areoften three, five, or seven years, with or without optionsto extend. To properly compare leasing and purchasingover a longer term, it is necessary to assume that a leaseis renewed over the investment horizon.