The Time Value of Money - A powerful tool in evaluating different cash flows

Aviation is an expensive pursuit. When looking at various options for air transport alternatives, we need a way to compare the costs of those alternatives.

One way that many get caught on is just looking at a single cost, such as the acquisition cost. Aircraft A costs $1 million while Aircraft B costs $1.5 million. So buy Aircraft A.  The US Government got into using that as the sole determinant on picking between various acquisitions. Once bidders knew the rules, they underbid the acquisition cost and grossly overpriced the costs of support, spare parts and upgrades.  In the early 1960s Secretary of Defense McNamera put an end to that practice and specified that they would look at the total cost of a project, including the cost to acquire, operate, and dispose of the asset.  This was called Life Cycle Costing.

In aircraft life cycle costing, you attempt to consider all of the costs associated with the aircraft. While acquisition cost is important, so too are the operating costs of the aircraft. In fact, after a while, the total costs of operation exceed the initial acquisition expense. 

When you finally dispose of the aircraft by selling the aircraft, that residual value reduces the total costs of ownership.  So a simple life cycle cost might look like:

 

               Aircraft A.         Aircraft B.

Acquisition     $1 Million          $1.5 Million

Op. Costs       $1.4                $1.2

Residual Value ($0.5)              ($0.85)

Total:         $1.9 Million         $1.85 Million

In this simplification, Aircraft B actually has a lower life cycle cost. While this is a far superior method than just acquisition cost alone, we need, or should, do more of an analysis. Allow me a diversion for a moment.

Suppose that Jeremy Cox owes you $10,000.  He offers to either pay you now, or in 5 years. Jeremy is a man of his word, but yet, any of us would choose to get paid now. 

What if the reverse were the case. One of you owes Jeremy Cox $10,000.  If you had the same terms of paying now or in 5 years, again I think all of us would tell poor Jeremy to wait it out the full 5 years to get his money.

What we have just done is assigned a Time Value to money. In both cases, $10,000 is the sum. But we correctly chose to pay our debt as far into the future as we can while asking for our income or revenue up front. 

In the case of the debt, in order to pay Jeremy now, I need the full $10,000. But if I can wait 5 years to pay him, I can put about $6,800 into an investment that returns 8% per year.  After 5 years, I will have the $10,000 for Jeremy.

So with an 8% cost of money or rate of return, my future value of $10,000 is really $6,800 today. The Time Value of money assigns not only the cost, but assigns a time cost or value to when the money is paid out or comes in.  If you do this sort of analysis with every cost and revenue involving our Life Cycle Cost, you end up with a financial analysis that not only tells what the total costs are, but also assigns a time value to each of those costs.  Summing these time values up and considering our initial investment (aircraft acquisition) gives us what is called the Net Present Value of the proposition.  This is the tool to use when considering high dollar, complex proposals such as aircraft. 

With a business use aircraft, the analysis will include things such as tax depreciation, the cost of a lease or loan and the opportunity to use the money for the aircraft in other areas.  A high net worth individual may make more money with their investments than the cost of a loan.  If the aircraft is for personal use, that same individual cannot use the tax depreciation of a business, so a lease may be a better deal in terms of the Net Present Value.

To calculate a Net Present Value, a spreadsheet can be used.  Inputs are the costs, revenues, time, and the cost of money (also called rate of return or desired return on investment). 

The Time Value of money is a powerful tool in evaluating different cash flows. It need not be for a business. It can help you to evaluate complex finances and be used as a tool to evaluate the true costs of owning and operating an aircraft.

Have any of you been involved in the financial analysis of an aircraft acquisition (or any high dollar acquisition such as a costly computer network for a business)? If so please reply and tell us your experiences.  We all learn if you share.