Assignment 2: Fleet Replacement Analysis
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.
WestJet, Canada’s second largest airline behind Air Canada, has engaged the aviation consulting firm IFC International to evaluate whether it should continue its expansion to Europe with used Boeing 767-300s or purchase new Boeing 787-8 aircraft. You are the senior financial analyst with IFC assigned to this project and will prepare a memorandum with your analysis and recommendations to Mr. Harry Taylor, WestJet’s Chief Financial Officer.
Note: The assignment has detailed requirements similar to those that would be given to a financial analyst. Read it very carefully before beginning work. Ensure that your submission includes all required elements.
WestJet was founded in 1996 based on the low-cost carrier model. It has since grown rapidly expanding to the US and the Caribbean with a fleet of Boeing 737 aircraft. WestJet has recently added European destinations utilizing used Boeing 767-300s. The start-up of European service was plagued by delays and cancellations, in part due to the lower reliability of older aircraft. Mr. Taylor, new to WestJet, has questioned whether the operational problems might have been avoided had the airline opted for new Boeing 787 aircraft rather the 25 year-old Boeing 767s. He believes that his staff may not be able to conduct an unbiased assessment having participated in the selection of the Boeing 767, so he has contracted with IFC to develop a financial comparison of the two aircraft types.
Used B-767-300 aircraft are available from several sources as other airlines are beginning to replace their B-767 fleets with newer aircraft. The price for a 20 to 25 year old B-767-300 is around $10 million, but WestJet has invested an additional $10 million in refurbishment of each aircraft it has acquired. Additional aircraft are available on the same terms. As with all older aircraft, the B-767 burns more fuel per available-seat-mile and requires more maintenance than new generation aircraft of equal mission capability. Though well-used, the B-767 still has a remaining useful life of at least 15 years. The Boeing 787-8 Dreamliner is much more expensive to operate but promises better reliability and reduced fuel burn.
Your team has developed an MS Excel template which 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: Boeing periodically publishes list prices for its aircraft. Search the Boeing website or simply do a Google search for “Boeing 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. IFC would have access to WestJet’s performance and cost data, but for this assignment, assume that WestJet’s costs are the same as Hawaiian Airlines. For your analysis, use Hawaiian’s reported data for the B-767-300 and US industry data for the B-787-8. The data you need looks like this example of data for the B-737:
? Fuel Prices: Your estimate of fuel prices over the next fifteen years is crucial. 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. Alternatively, you may wish to use long-range forecast energy prices from the American Energy Information Administration, the Federal Aviation Administration, or another authoritative source.
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 seem likely to 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). Because fuel prices are difficult to predict, develop estimates for a range of projected fuel prices. The US Energy Information Administration does this with optimistic, pessimistic, and most likely scenarios.
? Return on Invested Capital: The appropriate return on invested capital (the discount 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). According to President Ed Bastian, Delta Air Lines is also targeting a 10% sustainable return on invested capital. 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.
IFC staff have surveyed WestJet’s finance staff to arrive at several critical assumptions about aircraft costs and performance.
1. Airlines with solid balance sheets, such as WestJet, can normally purchase new aircraft for about two-thirds (2/3) of list price. After 15 years, a B-787-8 is estimated to be worth about half of the original purchase price (not list price) in the used market whereas a B-767-300 will have only $500,000 in scrap value 15 years hence. Even if WestJet should continue to operate the new planes beyond 15 years, these values still represent an opportunity cost.
2. Because WestJet’s segment lengths are relatively long, it believes fuel burns (gallons per block hour) on a new B-787-8 will meet the lowest of any airline and that speed in miles per block will equal the highest of any airline.
3. Although WestJet’s business model does not provide for high aircraft utilization, because of the B-787 greater range capability, annual utilization (block hours per year) for the B-787 will be 20% higher than for the B-767. Note: This annual utilization is for one aircraft, not the entire fleet.
4. WestJet 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, it believes that its first year maintenance expense will equal the lowest for any airline operating the Boeing 787 but that these costs will increase by 2% per year. However, as the fleet of B-767s age, WestJet believes that maintenance costs for this fleet type will increase by 5% per year.
5. WestJet has a small business class in its 767s, but most of the cabin is configured in high density coach class for a total of 262 seats. It will configure new 787s similarly with the same seating capacity.
6. WestJet does not expect crew expenses to change with the choice of aircraft, so this and other immaterial costs are not included in the analysis.
Enter data into the Excel template. Ensure that the spreadsheet is fully complete; there should be no empty cells. As you will see, this decision is critically dependent on your projection for future fuel costs and the discount rate employed. 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 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 not including appendices) to Mr. Taylor summarizing your analysis and making a recommendation. Remember that Mr. Taylor and his staff 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. (Not incidentally, if spreadsheets are not attached, it isn’t possible to verify that the data were correctly extracted from the Airline Monitor). 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 2 and 4 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. Total annual operating costs should be in the millions of dollars. 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 fuel prices in rows and discount rates in columns is one way to the present the statistics.
Excel spreadsheets should not be submitted separately; Mr. Taylor wants the entire report in a single document. The assignment is not in APA style. It’s a report for Mr. Taylor in a business memorandum format. See Purdue OWL or another online source for guidance on writing business memoranda and memo format. Search OWL for “memorandum.”
Finally, remember that you are writing for Mr. Taylor. You may assume that he understands aircraft operating costs and financial analysis including net present value, but do not assume that he is intimately aware of all the assumptions underlying the analysis or how the comparison between the aircraft was developed. Although he has not been directly involved in your analysis, he will need to explain the details to his senior management team. IFC International is a consultant hired to provide a carefully researched recommendation. Include sufficient detail in the memorandum and appendices so that he will not have to ask for additional information.
Preview of Assignment-2-Fleet-Replacement-Analysis.docx
Preview of Assignment-2-Fleet-Replacement-Analysis.xlsx