Written Assignment 2: Fleet Replacement Analysis
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This assignment has three objectives, to: 1) become familiar with the type and magnitude of mainline aircraft operating costs; 2) understand the operating economics of new versus older aircraft; and, 3) learn how net present value analysis is used in capital acquisition decision-making. Allegiant has engaged the aviation consulting firm SH&E to evaluate whether it should continue its fleet expansion with new aircraft instead of the aging McDonnell Douglas MD-80 aircraft that are the backbone of its small fleet. You are the senior financial analyst with SH&E assigned to this project and will prepare a memorandum with your conclusions to Allegiant’s Chief Financial Officer D. Scott Sheldon.
Note: The assignment has detailed requirements similar to those that would be given to a financial analyst. Be certain to read carefully before beginning work.
Allegiant Air bills itself “America’s favorite small cities to world-class destinations, Allegiant makes leisure travel affordable and convenient.” As of 2013, it is the most profitable U.S. airline based on margin on revenue and unique in that it operates only used aircraft. The backbone of the fleet is 57 MD-80 aircraft, but it also operates 6 Boeing 757-200s and is adding 9 Airbus A319 aircraft. Allegiant acquired 18 of its early MD-80s from Scandinavian Airways System paying roughly $4 million dollars per plane in an all cash transaction. Allegiant believes it can continue its aggressive fleet expansion with additional used MD-80s acquired for the same price as American Airlines and Delta Air Lines reduce their large MD-80 fleets. Although these aircraft have a useful service life of 15 more years, Allegiant recognizes it must eventually modernize its fleet. As with all older aircraft, the MD-80 burns more fuel and requires more maintenance than new generation aircraft of equal mission capability. Escalating and volatile fuel prices have added to senior management’s interest in evaluating new aircraft. Because it already operates Airbus 319s, the slightly larger Airbus A-320 is its preferred option. As you will see, this decision is critically dependent on your projection for future fuel costs and the discount rate employed.
An Excel template is provided as an attachment for conducting your net present value analysis. You will need to insert costs and performance figures into the template. You may wish to review the template before reading further.
In order to complete your analysis, you will need to obtain current aircraft operating data and prices from authoritative sources. The sources listed below are sufficient and adequate for your project:
Aircraft prices: Airbus publishes its aircraft list prices periodically. Search the Airbus Industries website or simply do a Google search for “Airbus aircraft list prices.”
Aircraft performance data and operating costs: The Airline Monitor publishes extensive airline data needed for your analysis. The Airline Monitor is available through the Hunt Library Aerospace/Aviation electronic databases. When you’ve accessed The Airline Monitor, select Online Edition, then Block Hour Operating Costs (pdf). This is a large document. Be certain to use Allegiant’s reported data for the MD-80 and industry data for the A-320 (use the data for the A-320, not the A0320neo). The data you need looks like this:
Fuel Prices: Your estimate of fuel prices over the next twenty years is critical. Historical data on jet fuel prices are available from several sources. The Airline Monitor includes this data in the Block Hour Operating Cost document (above). Data are also available from the industry association Airlines for America. Select Economics & Analysis, then Traffic & Financial Results. Scroll down to select the appropriate reports. You may also find long-range forecast energy prices from the American Energy Information Administration useful.
Note that fuel prices increased dramatically during the global economic expansion of the mid-2000s peaking at nearly $4 per gallon in June 2008, but plummeted during the subsequent recession. Fuel costs will certainly increase again when world demand recovers. You will need to estimate future fuel costs for the analysis. Be certain that the fuel price for the first year is the current jet fuel spot price (available from several sources via a web search). Conduct a sensitivity analysis for a range of projected fuel prices. This is often done using optimistic, pessimistic, and most likely projections.
Return on invested capital (the discount rate): The appropriate rate varies by airlines; however, the following extracts from the financial press are illustrative. Alaska Air Group CEO Bill Ayer pointed to “its target of 10% return on invested capital (ROIC). For its part Delta, is also targeting a 10% sustainable return on invested capital, according to President Ed Bastian.” (CAPA, 2010, June 16). Southwest Airlines is looking for a 15% ROIC. Your fleet replacement decision will depend on what rate you choose. Airlines with the best credit can borrow at the lower rates which also decreases the discount rate. You should perform a sensitivity analysis (work the problem with several discount rates) to better understand and defend your recommendation.
SH&E staff have surveyed Allegiant’s management to arrive at several critical assumptions about aircraft costs and performance.
1. Airlines with solid balance sheets, such as Allegiant, can normally obtain new aircraft for about two-thirds (2/3) of list price. After 15 years, an A-320 is estimated to be worth about half of the original purchase price (not list price) in the used market whereas an MD-80 will have only $100,000 in scrap value 15 years hence. Even if Allegiant should continue to operate the new planes beyond 15 years, these values still represent an opportunity cost.
2. Because Allegiant’s segment lengths are relatively long, it believes fuel burns (gallons per block hour) on a new A-320 will meet the lowest of any airline and that speed in miles per block will equal the highest of any airline.
3. Although Allegiant’s business model does not provide for high aircraft utilization, because of the A-320 greater range capability, annual utilization (block hours per year) for the A-320 will be 20% higher than for the MD-80. Note: This annual utilization is for one aircraft, not the entire fleet.
4. Allegiant plans to outsource its heavy maintenance, so it will pay another airline or maintenance repair facility for both direct and burden (overhead) costs. If it decides to purchase a new fleet type, Allegiant believes that its first year maintenance expense will equal the lowest for any airline operating the Airbus 320 but that these costs will increase by 2% per year. However, as the current fleet of MD-80s age, Allegiant believes that maintenance costs for this fleet will increase by 5% per year.
5. Allegiant configures its aircraft in high density, all-coach configuration. It plans a seating capacity equal to the highest of any airline.
6. Allegiant does not expect crew expenses to change with the choice of aircraft, so this and other immaterial costs are not included in the analysis (an extra flight attendant will be required but this cost is ignored here).
Enter data into the Excel template. Run a few “sensitivity” analyses with varying fuel and discount rates to see how the fleet replacement decision changes. Remember that the net present value obtained is a total cost of operation. The spreadsheet computes the cost per available seat mile (CASM). The aircraft with the lowest net present value CASM is the best financial choice. Prepare a memorandum (not more than 2 pages) to Mr. Sheldon summarizing your analysis and making a recommendation. Remember that executive management will need to understand how the analysis was conducted. Explain your assumptions and methodology concisely. Insert (copy and paste) and reference Excel worksheets as appendices to support your fleet replacement recommendation. Use other tables and graphs as appropriate to support your recommendation.
Check carefully to ensure the inputs and results of the discounted cost analysis are reasonable. The NP CASM should be between 3 and 6 cents depending on the input variables. This is lower than reported CASM for US airlines because many costs that do not affect the choice of aircraft type are not included. The Airline Monitor report can be used to check for reasonableness.
You may wish to present your sensitivity analysis of projected fuel prices and discount rates in a single table. A 3 by 3 table with 9 combinations of prices and discount rates is one method.
Excel spreadsheets should not be submitted separately; Mr. Sheldon wants the entire report in a single document. The assignment is not in APA style. It’s a report for Mr. Sheldon in a business format.
Remember that you are writing for Mr. Sheldon. He is very knowledgeable of airline operations and costs, but has not been directly involved in your analysis. SH&E is a consultant hired to provide a carefully researched recommendation.
See Purdue OWL for guidance on writing business memoranda and memo format. Search OWL for “memorandum.”