The purpose of this article is to encourage the idea of syncing how your company views capital expense to your fleet plan.Treasury belongs in fleet planning because it yields a more nimble, valuable asset (your airplane) which can result in a lower life cycle cost.
In the past, it was not uncommon for aviation to have very little to do with any of the discussion about cash, finance, book depreciation schedules or leasing. Aviation managers, when included in the equipment decision, were sought to discuss the appropriate type of aircraft to fly and the best practices to operate safely. Once acquired, as delivery approached, Treasury was included and the decision to pay cash, finance or lease was made in purely financial terms. Book depreciation schedules were often as conservative as possible in order to preserve earnings and not considered again until it was time to sell. At that time the loss or gain was trued up, often coming as a surprise in either direction. Lower book depreciation also favored the aviation manager that was absorbing that expense in the flight department budget. Aviation managers are often consulted on participation in engine programs but often times it is from a cost perspective as opposed to enhancing aircraft value. We want to discuss the advantages of bringing all these topics together.
Let’s review some definitions we need in this conversation.
Cash purchase: We pay cash for the airplane, it’s an asset on our balance sheet. The plane is expensed to the P & L over the life of the asset through book depreciation.
Debt purchase: The aircraft is financed with debt, the plane is still an asset on the balance sheet, it just has a corresponding liability equal to the size of the loan balance. In addition to the book depreciation like the cash purchase, the interest on the loan is also treated as a P & L expense
Book Value: We develop a book depreciation schedule for this particular class of asset that attempts to match the value of the asset to the market. A typical schedule might be 20 years to a 50% salvage value. Ex: $10M airplane, Annual Book depreciation =. ((10,000,000/2)/20) = $250,000/year. At the end of the first year, we would have expensed $250,000 on the P & L and we would have an asset on our books for $9,750,000. If we sold the airplane on the first day of year 2 for $9,650,000, we would take an additional expense for the book loss of $100,000. If we sold for $9,850,000, we would incur a $100,000 profit on the sale and it would be treated as ordinary income.
Tax basis: For the purposes of calculating income tax, the IRS allows an accelerated tax depreciation schedule that allows a 5 year write off for Part 91 aircraft (5 year MACRS actually takes 6 years and the annual deductible expense schedule y1-6 is, 20%, 32%, 19.4%, 11.4%, 11.4%, 5.72%, __%). The larger the deductible expense and income tax bracket, the larger the incentive to replace equipment for companies with profits to offset. When a fully depreciated asset is sold, income tax is due on the gain of the sale unless the gain is deferred in a 1031 like kind exchange.
Aircraft Lease: In a traditional operating lease, a third party lessor steps in, buys the airplane and leases it to the operator. This allows the operator to not show the airplane as an asset of the company. As such, it does not depreciate the asset from either a book or tax basis. The capital expense to the P & L is simply the sum of the annual lease payments. Leases typically have fixed terms and the ability of the lessee to walk away at the end.
Residual (Terminal) value: The amount the airplane is worth at the end of the period of time being considered. This is either a projection based on historical data in an ownership scenario or the calculated purchase option at the end of a lease for the Lessee if Lessee would prefer not to just toss the keys and walk away.
Fleet plan: Determine the right aircraft, the right number of aircraft and the right timing for aircraft replacement.
Now let’s look at some of the issues we want to consider as aviation managers that are managing assets.
Optimal ownership period
In addition to the right aircraft and the right number of aircraft, it is integral to fleet planning to consider the replacement schedule for the existing equipment. When aircraft replacement is not being driven by negative factors, obsolescence, poor reliability, near term significant maintenance, poor company performance, public opinion lately, it begs the question, “What is the optimal ownership period?” Understanding treasury functions is crucial to this.
When deciding how often to replace, an obvious starting point is every five years. That is when tax depreciation benefits are essentially gone. Five year warranties from manufacturers keep operating cost lower during that period than subsequent years. Residual values are higher with lower time equipment than older aircraft.
From a cash flow perspective, before considering the time value of money, life cycle costs almost always point to replacing in five years. Depending on the discount rate as the cost of capital, that period of time can stretch out to 7-10 years as an optimal ownership period. Defining that period of time to own, using treasury’s capital expenditure criteria, can’t be done without being attune to the finance function.
Paying Cash vs Debt
Paying cash for an airplane yields the most flexible approach to managing an asset. The down side is the opportunity cost of the money and the competition for capital vs. investments that earn returns.
Understanding Net Present Value (time value of money) analysis for capital expenditures can help the case for debt vs. cash. In low interest rate conditions, financing will always beat cash purchases in an NPV comparison. It’s true that in out of pocket terms, interest always adds to the life cycle cost but it wins the NPV math due to the return on the capital that is preserved by not paying cash.
When considering debt which carries amortization schedules and potentially balloon payments, the current aircraft value calculation and projected aircraft residual values during the ownership period need always be considered in relation to the unamortized balance of the loan. This allows an asset manager to see where he stands in relation to current market conditions and what he owes. Any asset with a positive relationship between aircraft value and loan balance is a more liquid, or nimble asset as discussed in the opening.
Book Value – creating schedules and keeping them current
Another important liquidity feature for treasury is the relationship of aircraft value calculation and book value (mark to market). Again, an aircraft value that is lower than book yields a hit to earnings which is a detriment to selling even if other factors favor it(less liquid). Also, even if there is agreement to sell, there can often be disagreement about publishing an ask price below the value of the asset on the books which will cause the asset be considered impaired(FASB 144) and immediately written down, often months or quarters before a sale is realized. Keeping the book value in sync with the market value yields a more nimble asset.
Staying right side up
Being “upside down” in a loan or book conversation can often drive strategy that makes the airplane more difficult to sell. I am not discussing liquidity in it’s purest academic sense which is the time and ease of converting an asset to cash. I am using the term because of our familiarity with liquidity. I prefer the term nimble because always truing our current aircraft value calculation to book and amortization schedules over the life of the asset, gives us more flexibility and options. The significant savings that come to the asset manager are from more dynamic market opportunities as opposed to non starters that take us by surprise. Staying in an asset because of a hit to earnings or cash is a trap that we want to avoid. If we can’t avoid it at least we need to be prepared with a contingency plan.
Let’s look at leasing as a great way to avoid the two traps we just discussed. All of our exposure in owning is relative to poor resale markets that make the airplane less than we thought it would be in the future. A great way to avoid those threats is to lease. Leasing spreads our capital cost over time, fixes our replacement term, has all the NPV advantages that debt offers and allows us to throw away our crystal ball about future values.
There are two downsides, first, life cycle cost goes up, meaning out of pocket cash and the corresponding aviation budget. Second, you trade liquidity for predictability, our nimble factor. If something happens to change the mission or requirement for the airplane, the lease still stands. So this conversation certainly belongs in fleet planning which led us to say, in our opening remarks, if we choose a fixed term, it is done proactively. We pay expensive early termination values to get out early, so we can be stuck, by choice but still stuck.
Engine programs produce equity which can be transferrable and keep the airplane in the economic equivalent of zero time engines as long as the hourly fees are being paid to the engine program administrator. While it is fairly easy to calculate the buy in to an engine program, there are times during the life of the engine where buying in is, neutral, favorable and unfavorable. In unfavorable conditions, there can be negative consequences to for the owner resulting in a less liquid asset.
Winning means spending less.
Let’s define winning, it is spending less over the life of the asset since this a non revenue producing asset. While our goal is to spend less, we still have the biggest impact on that by taking advantage of market opportunities. Market opportunities that create the largest win for operators do not occur at predictable, foreseen times. As we create fleet plans, we are not privy to new product announcements, precipitous economic changes, new regulatory requirements, changes in our own company circumstances or the economic condition of aircraft manufacturers. Private jets are certainly amongst the most elastic capital goods. This elasticity is what compels us to focus on the liquidity of our asset. A well managed asset within a current and vibrant fleet plan should always be evaluated as to replacement opportunities.
By keeping an asset in a condition in which it has fewer barriers to trade, it is more likely to always be able to take advantages of replacement opportunities as they arise. The treasury function belongs in the fleet planning process.