MBAA 523 – Fleet Replacement Assignment

| August 14, 2017

Fleet
Replacement Analysis

This
assignment has three objectives, to: 1) become familiar with the type and
magnitude of mainline aircraft operating costs; 2) understand the operating
economics of new versus older aircraft; and, 3) see how net present value
analysis is used in capital acquisition decision-making. Allegiant Airlines has
engaged the aviation consulting firm SH&E to evaluate whether it should
continue its fleet expansion with new aircraft instead of the aging McDonnell
Douglas MD-80 aircraft that are the backbone of its small fleet. You are the
senior financial analyst assigned to this project and will prepare a memorandum
with your conclusions to Allegiant’s president Andrew Levy.

Background

Allegiant
Airlines, a small successful US low-cost- carrier, has been aggressively
expanding by purchasing used MD-80 aircraft. In its latest acquisition of 18 MD
-80s from Scandinavian Airways System, Allegiant paid roughly $4 million
dollars per plane in an all cash transaction. Although these aircraft have a
useful service life of 20 more years, Allegiant recognizes it must eventually
modernize its fleet. As with all older aircraft, the MD-80 burns more fuel and
requires more maintenance than new generation aircraft of equal mission
capability. Skyrocketing fuel prices during the summer of 2008 added to senior
management’s interest in evaluating new aircraft. As you will see, this
decision is critically dependent on your projection for future fuel costs and
the discount rate (interest rate) employed.

The Analysis

An
Excel template is provided as an attachment for conducting your net present
value analysis. You will need to insert costs into the template. You may wish
to review the template before reading further.

Allegiant can purchase new Boeing-737-800
or Airbus A-320 aircraft for $60 million each. After twenty years, either of
these new aircraft are estimated to be worth $25 million in the used market
whereas an MD-80 will have only $100,000 in scrap value twenty years hence.
Even if Allegiant should continue to operate the planes beyond 20 years, these
values still represents an opportunity cost.

Your
estimate of fuel prices over the next twenty years is critical. Review fuel
cost data provided on the Air Transport Association website (Economics and
Energy/Annual Crude Oil and Jet Fuel Prices and Monthly Jet Fuel Cost and
Consumption Report:

ATA Annual
Crude Oil and Jet Fuel Prices

ATA
Monthly Jet Fuel Cost and Consumption Report

Note that fuel prices
increased dramatically during the global economic expansion of the mid-2000s
peaking at nearly $4 per gallon in June 2008, but plummeted during the
subsequent recession. Fuel costs will certainly increase again when world
demand recovers. You will need to estimate future fuel costs for the analysis.

In preparing your analysis
for Allegiant, you have obtained relevant cost data from the US Department of
Transportation. Data are in the tables at the bottom of this document. Here are
other relevant facts and assumptions needed to complete the analysis:

All
future operating costs are discounted to the present value at a discount
rate. Although Baye refers only to the interest rate, finance theory tells
us that the Weighted Average Cost of Capital is appropriate. This discount
rate is the estimated return that shareholders demand of an airline from a
purchase of new capital equipment. Derivation of this discount rate is
beyond the scope of

this course but might vary between 8 and 20%.
As one example, United Airlines raised some operating capital by selling
corporate bonds secured by its spare parts inventory. The effective interest
rate on this sale was 17%. Your fleet replacement decision will depend on what
rate you choose. You should perform a sensitivity analysis (work the problem with
at least two discount rates) to better understand and defend your
recommendation.

Although
Allegiant’s business model does not provide for high aircraft utilization,
it estimates that a new aircraft’s annual utilization (block hours per
year) will be 15% higher than the MD-80.Allegiant
plans to outsource its heavy maintenance, so it will pay another airline
or maintenance facility for both direct and burden (overhead) costs. For
the A-320, it estimates maintenance cost will be similar to JetBlue and USA
3000, both of which operate relatively new aircraft. All Boeing 737-800s
are relatively new, so the industry average maintenance cost is a good
estimate.Allegiant
configures its aircraft in high density, all-coach configuration like
other LCCs USA 3000 Airlines and Sun Country.

5. Both
the A-320 and B-737-800 are somewhat faster than the MD-80. Estimated block to
block (taxi out to gate arrival) speed for A-320 and B-737 is 366 mph versus
340 mph for the MD-80.

6.
Allegiant does not expect
crew expenses to change with the choice of aircraft, so this and other minor
immaterial costs are not included in the analysis (an extra flight attendant
will be required but this cost is ignored here).

Task

Choose either the Airbus A-320 or the Boeing
737 for comparison with the existing MD-80. Enter data into the Excel template.
Run a few “sensitivity” analyses with varying fuel and discount rates to see
how the fleet replacement decision changes. Remember that the net present value
obtained is a total cost of operation. The spreadsheet computes the cost per
available seat mile (CASM). The fleet alternative with the lowest net present
value CASM is the best financial choice. Prepare a short memorandum to the
President summarizing your analysis and making a recommendation. Remember that
executive management needs to understand what you have done but will not read a
memorandum more than two pages long. Explain your assumptions and methodology
concisely. Insert or attach and reference Excel spreadsheets as appendices to
support your fleet replacement recommendation.

See Purdue OWL
for guidance on writing business memoranda and memo format. Search OWL for
“memorandum.”

The
following page supplies the operating cost and statistics charts for McDonnell
Douglas and Boeing aircraft.

Source:
Aviation Daily. Available through Aviation Week
Intelligence Network (AWIN), Hunt Library databases.

MBAA
523 – Fleet Replacement Assignment CV 1010

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MBAA
523 – Fleet Replacement Assignment CV 1010

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