Research

Aircraft Value, Global Economy and Volatility

Estimating an aircrafts value and forecasting its future price is a complex process. Aircraft values depend not only on such factors as aircraft overall condition, maintenance quality, the time to the next major check, fuel and seat capacity, they also depend on general economic conditions. Wear and tear of an aircraft is appraised on the basis of flight hours and on the number of cycles. Since the same type of aircraft can be operated on different stage lengths (i.e., routes with different distances), the average number of landings per hour can vary. Therefore, factors determining an aircrafts value include the aircrafts age, physical condition, maintenance status, maintenance documentation, and the inflation rate. By Dr. Bijan Vasigh, Embry-Riddle University and Dr. G. Rod Erfani, Transylvania University result in lower aircraft values. The value of an aircraft also depends on internal and external factors. Internal factors are directly related to the aircrafts documentation and specifications, such as age, size and technical status. These factors have a major influence on the aircrafts value, but the aircraft price also depends on the external factors. For instance, old wide-bodied aircraft are on demand when there is a capacity shortage or significant diminution in fuel costs. Technological progress reducing operating costs of new aircraft and environmental regulations, in combination with high fuel prices, would have dampening effects on the values of old equipment. Old aircraft are retired when break-even load-factors are too high to generate enough revenues to cover operating costs. Fuel efficiency, range, seat capacity, maintenance expenditures, and airport fees mainly determine operating costs. In general, higher operating costs During the period of 1992-1999, the air transportation industry realized steady growth and high profits. In 2000, earnings remained sluggish. Plummeting profits triggered a host of bankruptcies in aviation, most noticeably US Airways, United Airlines, Swissair and Midway Airlines. Over the past several decades, aircraft values followed business cycles; increasing steadily during economic expansion, and tumbling during economic contraction or recession. As the following chart shows, the Worlds airlines collectively lost more 24 billion dollars in 2001 and 2002 (Table 1).

between the supply and the demand in the market. Over capacity results in decreasing aircraft values while higher demand results in increasing aircraft values. Commercial aircraft with price tags between $30 and $240 million are like industrial plants, which create revenue, but unlike a plant an aircraft has a very high mobility and can be sold all over the world. Despite dealing with a single market, it is hardly possible to determine one single price for a specific used aircraft type. Even aircraft built at the same time with similar technical configurations, with equivalent maintenance and wear and tear conditions are often traded at considerably different prices. Additionally, there are aircraftspecific characteristics that determine an aircrafts value. Maintenance quality and remaining time toward the next major check, number of cycles and hours an aircraft was utilized and technical configurations are considered in an aircraft-specific evaluation process. One additional aspect is the configuration of the aircraft. Since each airline orders the new aircraft according to their specifications, less than 50% of a new aircraft is standardized. Correspondingly, the price one customer pays for a new aircraft type at a certain point in time is rarely the same price paid by another customer. The combination of varying new prices, customized configurations, and different technical conditions make it hard to determine current market values of used aircraft. The development of environmental regulations may also affect the economic life of older aircraft. Even more difficult is the task of predicting an aircrafts future value. Assuming

Complexity of aircraft valuation procedure Like any other physical asset, a crucial element determining the value of an aircraft is the relationship

10 In $Billions 5 0 -5 -10 -15

Table 1: Net Profits of World's Scheduled Passenger and Cargo Airlines (In Billions) 8.5 8.2 3.7

1998'

1999'

2000'

2001'

2002'

-13 Year

-11.3

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that the current market value of an aircraft is known, there are still many other factors determining an aircrafts future value. Often the external factors discussed will have a similar impact on the valuation of all commercial aircraft, regardless of age or manufacturer (see Figures 1 and 2). Operating costs of an aircraft have a major impact on the theoretical value, called base value. The base value represents the net present value of an aircrafts future cash flow generating potential. Increasing operating costs and lower utilization reduce the net cash flows, thereby reducing the value of aging aircraft. Even though the aircrafts life is theoretically unlimited, the increasing operating cost will at one point in time exceed the revenue generating capacity and thereby end the aircrafts economical life. Forecasting Methodologies The forecasting models used by aircraft appraisal companies produce future and current market values. Various assumptions regarding the global economy, the air transport industry, and supply and demand cycles are necessary to determine the aircraft values. Then, the derived values reflect transactions of single aircraft from willing sellers to willing buyers, paid in cash. To forecast the state of the economy, the appraisal uses GDP, inflation, interest rates, and fuel price data according to reputable financial institutions statistics. Furthermore, these variables are main indicators to determine an airlines degree of expansion. It is assumed that rising fuel prices and low interest rates make airlines acquire new rather than used equipment. The forecasted GDP growth, in combination with predicted yields and the degree of improvement, are the foundation of the traffic growth calculations. The demand for additional aircraft is estimated by using the economic indicators and environmental regulations that estimate the expected number of retired aircraft. In summary, a variety of different and complex factors are involved in the

process of evaluating an aircraft and determining its price at a particular stage of its useful life. These factors rely heavily on economic indicators and the market demands. Through modelling and forecasting, it is possible to obtain values that can be used to fairly determine current resale value of used aircraft by examining base values as well as future values. These estimates are valuable to airlines, as they allow them to make informed decisions with regards to continuing to maintain an older aircraft versus purchasing a newer, more cost-efficient one. Maintaining cost-effectiveness within their fleet is one way that airlines can keep operating costs down, and improve the potential for future profit and growth. Application of financial theory in aircraft appraisal process The aircraft industry is characterized by high capital investment, long payback periods and a highly cyclical environment. In making long-term

conditions and the state of the economy. In order to analyze the impact of the different cost and revenue components (such as fuel cost, labour cost or load factors) a NPV model is used to examine the impact of changes in these inputs on aircraft values.

The following approach is used to estimate an investments expected value in current dollars:

NPV = present value of net cash flows initial outlay (net investment) NCF = Net cash flow (inflows outflows) k = cost of capital (required rate of return / riskiness of the estimated cash flows) t = year n = expected project life

capital investment decisions, the time value of money must be considered where the discount rate should reflect the actual cost of investment. According to financial theory, the value of an asset (or aircraft) reflects the net present value (NPV) of the revenue-generating capacity over the economic life of the asset. The economic life terminates when the operating costs exceed the revenue generating capacity. To estimate the NPV of an aircraft, the expected future cash flows, the risk of cash flows and the passenger growth rate must be estimated. The rate of return for a cash flow is determined based on its riskiness and the returns available on other investments. The study of different valuation methodologies shows these methods do not lead to a unique pricing mechanism. The preliminary results provide evidence to support the hypothesis that the value of an aircraft is greatly influenced by market

The above equation could be applied to aircraft valuation based on the following formula:

Aircraft ownership expenses are highly variable. Ownership cost includes; the initial aircraft purchase price as well as required modification, service, support, upgrades, training, downtime and other factors. Further, operating income should be adjusted for taxes, as well as for non-cash items such as depreciation and amortization.

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In order to find if investment in an aircraft is profitable, expected future cash flows (inflows and outflows) should be discounted at the rate of return or the cost of capital. The market-determined rate of return depends on the market's perceived level of risk associated with the investment. Market valuation theories such as the Capital Asset Pricing Model (CAPM) can be used to calculate discount rates. The market valuation theory reflects the process of adding a risk premium, generally the market average, to the risk free rate (krf ). The discount rate derived from the CAPM reflects the return required by investors for a project's specific risk. k = krf + (km - k rf ) where: km = expected rate of return on the market portfolio = beta The following illustrations provides a methodology to estimate aircraft value based on the airline market conditions and aircraft specifications. Table 1, looks at the 30-year projected value of a Boeing 737-300 built in 2004, along with various economic conditions and yields. Due to space considerations, only certain years are shown.

Table 1: Aircraft Value Estimation Model: Boeing 737-300

Age in Years Calendar Year Revenue: Yield (cents) Passenger revenue Cargo and other revenue Total Revenue (000) Expenses: Flying labor/Block Hour Fuel/Block Hour Maintenance/BH Total/BH BH cost Mkt, G&A, etc. Ownership cost Total Costs (000) Pretax profit Pretax margin % 370 419 87 876 3152 7212 1200 11564 0.227 374 427 89 890 377 .. 389 436 .. 463 91 .. 96 904 .. 948 393 .. 489 472 .. 729 494 744 1 2004 13 14490 467 14957 2 3 .. 6 7 .. 29 30

2005 2006 .. 2009 2010 .. 2032 2033 13 481 13 .. 14 14 .. 18 18

14490 14490 .. 15606 15606 .. 20064 20064 495 .. 541 558 .. 1068 1101 14971 14985 .. 16147 16164 .. 21132 21165

98 .. 151 154 963 .. 1370 1392

3184 3215 .. 3313 3346 .. 4206 4248 7284 7357 .. 7580 7656 .. 9529 9624 1200 1200 .. 1200 1200 .. 1200 1200 11668 11772 .. 12093 12202 .. 14935 15072 0.221 0.214 .. 0.251 0.245 .. 0.293 0.288

$3,393 $3,303 $3,213 .. $4,055 $3,962 .. $6,197 $6,092

Theoretical Price (NBV) 46,746,300

To illustrate the valuation methodology the above example shows a simplified calculation technique. One can measure the value of a Boeing 737 aircraft by using the following assumptions:
i. The yield remains constant for a 5-year period, and then rises $.01 for each subsequent 5 year period to compensate for inflation and rising costs. ii. The aircraft has no residual value at the end of the 30-year lifespan. iii. The discount rate or the cost of capital assumed to be fixed at 8 per cent annual rate. iv. To incorporate an increase in productivity flying labor/block hour will increase at 1 percent annually. v. Two percent increase in fuel/block hour annually. vi. Two percent increase in maintenance/block hour annually. vii. Constant annual ownership cost. viii. Three per cent increase in cargo revenue annually.

Table 3: Scenario Analysis, Boeing 737 Theoretical Price Under Different Market Conditions. Yield >> Discount 0.7 0.8 0.9
Assumptions: I. A yield of $.12/RPM for the first 10 years, and $.13 for the next 10 years and $0.13 for the last 10 years. II. A yield of $.12/RPM for the first 15 years and $.14 for the last 15 years. III. A yield of $.13/RPM for the first 5 years, and an increase of $.01 for each subsequent 5year period. IV. A yield of $.12/RPM for the first 5 years, and an increase of $.01 for each subsequent 5year period.

II

III

IV

10,884,670 9,887,800 9,037,760

19,848,99 21,778,83 24,050,81

52,337,980 46,746,300 42,031,600

37,664,420 33,548,150 30,077,410

Value if Boeing 757 and Airbus A320 are shown on Figures 1 and 2 respectively. The figures show the trend in the value of new Boeing and Airbus aircrafts and their price at 5 and 10 years of age from 1990-2003. As we can see, there is significant correlation among these two type aircraft. The value of Boeing aircraft moved along with the value of Airbus during the same period. In summary, to calculate the value of an aircraft we need to make various assumptions in relation to the state of economy, air transport industry, and supply demand cycles. Nonetheless, the actual transaction price varies significantly from one transaction to another. Rising fuel prices and low interest rates make airlines acquire rather new than used equipment.

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Figure 1: Boeing B757-700 Valuation Trend Value (in millions $) 60 55 50 45 40 35 30 25 New Aircraft

Aircraft at 5 years of age Aircraft at 10 years of age

Source of Data: Airline Monitor

19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03
Year
Figure 2: Airbus A320 Valuation Trend 50,00 45,00 40,00 35,00 30,00 25,00 20,00 15,00
19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03

Value (in millions $)

New aircraft

Aircraft at 5 years of age Aircraft at 10 years of age

Year

Source of Data: Airline Monitor

About the authors Bijan Vasigh is professor of Economics and Finance in the Department of Business Administration at EmbryRiddle Aeronautical University, Daytona Beach Florida and a Managing Director at Aviation Consulting Group, LLC. Dr. Vasigh received a Ph.D. degree in Economics from the State University of New York in 1984, and he has written and published many articles concerning the aviation industry. The articles have been published in numerous academic journals such as the Journal of Economics and Finance, Journal of Transportation Management, Transportation Quarterly, Airport Business, Journal of Business and Economics, and Journal of Travel Research. He was consultant with the International Civil Aviation Organization (ICAO) and provided assistance on evolution of aeronautical charge structure for the Brazilian Institute of Civil Aviation (IAC). He is currently a member of the international faculty at the International Air Transport Association (IATA) Learning Center, where he is faculty leader of the Airline Finance and Accounting Management. He is a member of editorial board of Journal of Air Transport Management and Journal of Air Transportation World Wide. He worked on a NASA Research Grants on Determination of Statewide Economics Benefits of the Small Aircraft Transportation System (SATS). in 2001 and 2003. Dr. G. Rod Erfani is a Professor of Economics at Transylvania University, Lexington, KY. He received his Ph.D in Economics from Florida State University. Dr. Erfani has made professional presentations throughout the United States and in many foreign countries and has travelled extensively throughout Europe, the former Soviet Union, and Latin America. He has many publications in refereed academic journals. Dr. Erfani's current research interests are in the fields of international economics and international business. Acknowledgment: The authors appreciate the contribution of graduate student Matthew Frankel (Embry-Riddle Aeronautical University) for help in assembling graphs and tables and reviewing early drafts. Any errors or emission are the responsibilities of the authors.

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