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Return on Investment

by David Wyndham 1. April 2005 00:00
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It's not just for bankers.

When working with our clients on an aircraft requirements analysis, we almost always look at several forms of ownership and in the case of full-ownership, look at several ways to pay for the aircraft. Often, we compare a lease or loan with cash purchase. On the surface, the loan should cost more, right? After all, you pay interest on the amount borrowed. That's not quite the full story.

Whether you are an individual, a sole-proprietorship or a WalMart, there is always a limited amount of money. Successful companies keep a close control on their cash and look at something called "return on investment" or ROI. Depending on the context used, this term can also be called the "hurdle rate" or even "cost of capital." Individuals can also manage their money in much the same way.

One way is to use cash to invest in items that generate income. Unless the aircraft is used for hire it does not directly generate income any more than the computer I am using to write this article generates income for our company. If a company buys an aircraft for cash, it is cash that they cannot put into something that directly generates income. If money is tied up in an aircraft, that money cannot be out there "working" for you.

Large companies typically try to generate fifteen cents or more (on average) for each dollar spent. That amount is their ROI. When evaluating a large purchase, a company applies ROI to the purchase to see if that is the best use of their capital. High net worth individuals also make the same comparison, "where can I put my money so that it has the most return for me?"

For example, let's assume that Company A has a 15% ROI and the bank is willing to loan money to buy and aircraft at 8%. Company A can use their cash to generate income at fifteen cents for each dollar and it will "cost" them only 8 cents on each dollar loaned. In an over-simplification, Company A will make 15 cents and spend eight cents in interest for a net of seven cents. If our fictitious Company A were acquiring an aircraft, they most likely would not pay cash, but instead take out a loan and "invest" the cash somewhere within the company where it could earn returns greater than the cost of the loan.

Of course, the calculations are a bit more complex, but for many companies and individuals, it does not "pay" to buy for cash. The IRS even encourages loans by allowing companies to write off the interest as an expense.

As part of the calculation, risk must be considered. A loan is either for a fixed rate, or variable. The fixed rate has a guaranteed cost, so there is essentially no financial risk. A variable rate of interest involves some risk in that the cost of capital may increase. Similarly, investing in something that generates income also involves the risk of that investment not making its return.

As you can see the lease/loan/purchase decision isn't as simple as whether you can afford to pay outright. It involves a decision on whether you do more with your money and still have an aircraft.

Please take a moment and tell us what has worked best from your flight departments' perspective. Your participation could be invaluable to the other readers of this article, not only in monetary practices but also in determining which methods are better than others.


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