Money is valuable. So is Time.
Back in 2011, I wrote about the time value of money in the aircraft acquisition process. A financial decision involves not only what the total costs are, but when the expenses and revenues occur. That article prepares you for the Net Present Value (NPV) discussion.
An NPV analysis takes into account the time value of money, as well as income and expense cash flows, type of depreciation, tax consequences, and residual value of the various options under consideration. When an expense (or revenue) occurs can be as important as the amount of that item. For example, taking into account an aircraft's resale value, a cash purchase will have lower total costs than the finance option or lease option (for a long term lease). The cash purchase is due up front. The principal and interest, or lease payments, are paid over time.
The NPV calculation applies a time value of money rate to when income and expenses occur. This time value of money is referred to as internal rate of return (IRR) or return on investment (ROI). Many organizations have a published IRR or ROI target. For companies that don't, a way to estimate it is by dividing the profit before taxes of the organization by the equity and expressing as a percentage the return the organization expects to make on the money it invests in the enterprise. For many organizations, such as Fortune 500 companies, this is typically from 10% to 15%. The rate could be higher when accounting for financial risk. Government agencies can use the current rate of return for Treasury Bills or State Bonds. High Net Worth individuals may use their current returns they are getting from investments, or the interest rate when they borrow money.
Paying cash may not have the best NPV when the value of money is high. In general, if internal rates of return are greater than the financing terms, and allowing for the tax depreciation of the aircraft, the NPV favors the finance option over the lease for most of our corporate clients. Lease NPVs tend to be favored when there is little or no tax depreciation benefit, or the term is very short - under five years.
By using the time-value of money, you can judge whether a project will yield a better or worse return than the average return experienced on a company-wide basis. Thus, the NPV analysis allows the comparison of different cash flows based on a set target return. It also allows comparisons of buy versus lease versus finance options of the same aircraft. This type of analysis is also the only effective way of judging the finances of a purchase, finance, or lease, especially if different conditions and interest rates apply to each alternative. It is the standard financial analysis technique used by the chief financial officers of major organizations.
An NPV of zero means that the target return has been met. A negative (less than zero) NPV means the target return has not been met. A positive (greater than zero) NPV means the target return has been exceeded. For something like a business aircraft acquisition, the only revenue generated is if there is some charter revenue and when the aircraft is sold. Business aircraft, and privately flown aircraft, will have a negative NPV. In order to compare non-revenue NPV, the NPV closet to zero (or "least negative") is the most favored financial option.
Companies will compare at the NPV of very different projects. The NPV comparison may include the purchase of an aircraft along as compared to the acquisition of land for a factory. $20 million buys a very nice business jet, or a lot of land. The finance terms and tax advantages of both can be very different. They company may decide to purchase the aircraft and use financing for the land. They may not finance either due to wanting to avoid too much long term debt on their balance sheet. Companies may avoid financing an aircraft simply to avoid having the aircraft debt on the balance sheet.
When I'm doing a financial analysis for a corporation, they may have me provide only the cash expenses. They then run their own internal NPV analysis so they can look at the corporate debt and taxes at a higher level. Sometimes, the company will purchase the aircraft for cash without an NPV analysis as a matter of internal policy. Government agencies tend to have very clearly defined criteria for their capital acquisitions.
For any aircraft acquisition, the assumptions used need to be clearly spelled out. The costs should cover a specific period and take into account an expected aircraft value at the end of the term. Comparisons of two or more options should also cover the same period of time and utilization. This provides a fair (or "apples-to-apples") comparison. A complete Life Cycle Cost also accounts for the time-value of money in an NPV analysis. This way, the differing cash flows form two or more options that can be compared and analyzed from a fair and complete perspective.
The NPV may not be the final determinant in an acqusition, but it should be considered. The smart money says so.