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Financial Analysis Part 2 - Time Value of Money

by David Wyndham 29. June 2018 11:15
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Aircraft Financial Analysis

In the previous blog post I introduced the criteria for a financial analysis.  Recall that the goal of the financial analysis is to identify the aircraft that does the job for the least money.

The financial analysis should analyze all of the costs associated with the aircraft: acquisition cost, operating costs, depreciation and taxes, and the potential residual value after a set term. If the aircraft is to be used in a commercial operation, you will need to make assumptions regarding potential revenues as well. All of these considerations are important and needed to complete the analysis. Use the same set of assumptions for each aircraft to ensure that you get a true comparison.

The analysis tool to perform the financial analysis is the life cycle cost. In addition to showing the expenses, revenues, taxes as necessary, and a cash flow, there is one more thing remaining. The time-value of money.

The cash flow, or the monies in and out for pre and post tax, may be very different for the aircraft and the scenario. For instance, option A may be a cash purchase, option B, a loan, and option C, an operating lease. For the same aircraft, the cash flows will be dramatically different. Option A has a large cash outflow at the start in the form of the acquisition cost. Option B just has a down payment, but also has interest on the outstanding balance of the loan. Both of these purchase options do have the revenue in the form of the residual value estimate at the end of the term. The lease has no acquisition cost, but no revenue at lease end either. 

For a commercial operation, cash flow is king. At any given time if the money leaving in the form of expenses is not covered by the revenue coming in plus the money in the bank, you are not in business much longer. For a not-for-hire operation, the cash flow remains negative until you sell the aircraft where they may be a “profit.”

There is one more important consideration to consider, the timing of the expenses and revenues. Regardless of for hire or not, when the expenses occur as well as their magnitude is important. 

The time-value of money places importance on the timing of a revenue or expense occurs. Think of interest. If I invest $1,000 at 5% per year, I'll have $1,050 at the end of a year. Similarly, if I owe you a $1,000, and I pay you today, I need $1,000. But, if I can wait a year to pay you, I can invest $953 at 5% and end up with $1,000 after a year. Taking the time-value of money into account allows you to compare different streams of revenues and expenses  (i.e. cash flows) to see which one has the better time-value. Each future revenue and expense has a value in today’s dollars, or a Present value.

The Net Present Value is the sum of the present values of these future cash flows (revenues and expenses) less my initial investment. It takes into account my assigned value of money and inflation. An NPV greater than zero means I’ve made a profit. A zero NPV is break-even while a negative NPV is a loss. For a not-for-hire operation, minimizing the loss is the goal.

Terms used to describe the time-value "interest rate" include return on investment (commercial operations) and net present value (non-revenue operations like a corporate flight department or government). These are usually abbreviated as ROI and NPV respectively. 

What is a typical percent to use for the ROI/NPV analysis? You usually don't have to make one up. Government agencies usually look at the cost of borrowing money - Treasury Bill interest rates for example. Corporations have expected returns and use that for all major purchases. If you are in a large organization, just call the financial department, the CFO, comptroller, etc. and ask them for the relevant rate and your organization's marginal take rate. They will be impressed at your level of understanding!

Now that you have your costs, ROI/NPV rate, and marginal tax rate, how do you perform the analysis? Prior to spreadsheets, it was a time-consuming process. Today, there are spreadsheet applications that, given the proper data entry, will quickly calculate cash flows and ROI/NPV. Our company has a tool, Life Cycle Cost, that has a built in aircraft database that allows you to do all of the analysis mentioned here. I believe it is the only database plus software of its kind that does all these calculations specifically for aircraft.

The financial analysis with NPV takes into account all of the variables and calculates the net return for the option. This financial analysis allows you to rank order the capable aircraft to find the one that does the required job for the money.

One last warning, never let a spreadsheet make your decision for you. 

Aircraft A may be technically adequate for your mission and have the most favorable NPV. Aircraft B may exceed all your requirements but have a less attractive NPV. Since both Aircraft A and Aircraft B meet your technical needs, Aircraft A is the financial best alternative. But, the financial decision maker may feel that Aircraft B has a better value, or “more bang for the buck” and favor that option. As a consultant or analyst, my job stops at the technical and financial ranking. The decision maker, the person who signs the check, gets the final word.

 

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David Wyndham | Flight Department



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