- 20 Oct 2020
- David Wyndham
What is the Net Present Value of owning and operating a business jet, and how can it highlight the differences between acquisition options? David Wyndham provides an outline…Back to Articles
The economics of owning and operating aircraft are important criteria in the decision to buy, sell or upgrade. How can an understanding of the Net Present Value (NPV) help?
Previously, we discussed the Life-Cycle Costing of aircraft ownership. That method accounts not only for the costs of operating the aircraft, but the cost to acquire it and the recognition of the aircraft’s residual value after the end of the ownership cycle.
Table A provides a general example of the costs for the same aircraft over five years when purchased and when leased. (Be aware, however, that making the decision on either acquisition or operating costs will yield an incomplete answer, as we will explore below.)
From the example in Table A, the acquisition cost exceeds the lease payments while operating costs are the same since they are for the same aircraft. The total life-cycle cost favors acquisition, primarily because of the resale value at the end of the ownership cycle.
Table B compares two different models – our original Aircraft A and a competitive model (Aircraft B). While Aircraft A has the lower total Life-Cycle Costs, Table B shows that – on the surface, at least – the difference is negligible.
The way to really see how these options compare is to look not only at what the costs are, but when they occur. This involves something called the ‘Time Value of Money’. Using a spreadsheet, add a time value of money calculation to the magnitude and the timing of a cost or revenue. The formula is called the Net Present Value (NPV).
NPV analysis considers the amount and timing of all cash flows from a present time perspective, calculating what amount of present money would be equivalent to the funds spent as time goes on.
The further out into the future a cost or revenue is, the lower relative value it has today.
As a simple example, imagine you owed me $1,000. If you paid today, you would need to hand over $1,000. If you could wait a year, investing the money at 6% before paying the debt, you could invest $926 today and have the money grow to $1,000 in 12 months.
Better still, if you could wait two years to pay, then you would need to invest only $857 today at 6% interest. Therefore, in accounting parlance the Present Value of $1,000 in two years, at a 6% rate of return, is $857). You don’t need an accounting degree to know it makes good sense to have income sooner and pay bills later.
If you do this analysis on an investment (with expenses and revenues occurring at various times while the aircraft is operated), summing everything up, you end up with an NPV analysis. An NPV analysis allows you to look at different cash flows, calculating the Present Value for each one. You then add them all up and subtract any initial investment to arrive at your NPV.
When a company uses its internal funds to cover an aircraft cost, that is money that might have been invested in other activities. Companies typically have an ‘internal rate of return’, which is the percentage the firm expects to earn when investing its internal funds for equipment or expenses. These rates are often adjusted, based on risk.
A few years ago, a venture capitalist was looking to buy or lease a business aircraft. He would lose money on four ventures, but double or triple it on the fifth. This individual expected an average 20% return on investment. He could either invest $10m in an aircraft, or $10m in a new company. If he spent the money on an aircraft, he essentially lost the ability to get a return from his investments.
Companies and high net-worth individuals do NPV calculations all the time, and the analysis helps decide between two or more possible options.
The NPV concept enables corporations and individuals to evaluate the complex costs of owning and operating high value assets like business aircraft, and it provides a tool for making financial judgments in a language everyone understands.
Using a 10% return for Aircraft A (purchased), Aircraft A (leased) or Aircraft B (purchased),Table C (above) provides an example of this.
The negative NPV value is a result of zero income other than the resale value. In this instance, the ‘least negative’ value (closest to zero) is Aircraft A, leased, despite it having a higher LCC than a purchase of Aircraft A. That is because the initial investment is $0 on the lease. With the purchase of Aircraft A, $2.5m is spent up front without generating any income until the resale in year five.
Another part of the analysis would be taxes (as applicable). For business use, the benefits of tax depreciation can make a significant difference. The NPV is the final calculation from a cost-benefit perspective and helps account for not only the magnitude of expenses and revenues, but also the timing.
Finally, it is worth noting that the financial analysis can help in the decision making, but it cannot differentiate in the mission capability between different aircraft. That is the basis for a separate analysis…