William E. Gibson Aircraft Investment Planning and Uncertainty COLLEGE OF AERONAUTICS Ph ...

342 Pages·2011·2.76 MB·English

William E. Gibson

Aircraft Investment Planning and Uncertainty

COLLEGE OF AERONAUTICS

Ph.D THESIS
William E. Gibson

Aircraft Investment Planning and Uncertainty

COLLEGE OF AERONAUTICS

Ph.D THESIS

ACADEMIC YEAR 2009-2010

Supervisor: Dr. Peter S. Morrell

May 2010

This thesis is submitted in partial fulfillment of the requirements
for the degree of Doctor of Philosophy

© Cranfield University 2011. All rights reserved. No part of this publication may be reproduced
without the written permission of the copyright owner
Abstract

This research sets out to determine whether there is a best way to perform
aircraft investment analysis. The question of best practice is found to be
linked to corporate ownership: world airline shareholding patterns are
identified and linked to investment analysis practices, and to airline financial
performance over the last aviation cycle.
A key weakness identified by surveying airline practice concerns the treatment
of uncertainty in the financial analysis. This research critically examines the
state of practice regarding treatment of uncertainties embedded investment
valuation assumptions, in airline fleet planning around the world, and
proposes structured application of advanced analytical techniques to valuation
in today’s world of volatile and diverse aviation markets.
The assumptions underlying valuation are embedded in modern financial
theory, which has been developed and tested over the last century. The
validity and usefulness of financial valuation models is examined from both
theoretical and practical perspectives, and the state of practice regarding
these models in the airline industry is established, both quantitatively through
survey research, and qualitatively through aviation executive interviews in the
field. This combined approach has allowed the establishment of ‘paradigms’
characterizing the concrete application of financial theory to the question of
aircraft investment.
Regional patterns of airline shareholding are identified in a detailed analysis of
ownership structure and business models. The resulting governance typology
is analyzed in aggregate, and associated with production, and profitability by
region. The tendency of each airline ownership type to use modern financial
valuation techniques has to some extent been established by applying survey
results to the different regions.
The fleet planning process and the positioning of investment valuation within it
is discussed, and key uncertainties underlying fleet planning assumptions are
identified and mapped in a risk map framework. A method for strategic
analysis of fleet financing alternatives is derived from classical theory, and
applied to the specifics of the aircraft market.
The uncertainties surrounding several key modelling assumptions are found to
be substantial in the minds of today’s fleet planners, and the assessments of
uncertainty vary substantially between airline fleet planners and third-party
advisors. The identified practices in applying classical financial theory are
found to be strikingly inadequate in treatment of these uncertainties.
A model is developed for valuing the acquisition of aircraft under uncertainty,
using extensions of the classical financial framework entailing more advanced
quantitative techniques. The model’s application to a specific analytical
situation analysis show that investment valuations under deterministic models
are contradicted when applying uncertainty to key uncertainties present in
today’s markets, and a process that yields insights beyond classical finance is
proposed.
Acknowledgments

This thesis research has been a part-time labour of love since 2003. In that
year, Professor Paul Clark, Managing Director of AirBusiness Academy,
provided the strong encouragement necessary to embark on this research,
which has a natural synergy with my work as a lecturer and advisor on fleet
finance and evaluation. ABA’s current M.D., Michèle Oberto, has also been
very supportive of this research, as was our interim M.D., David Bradley.
Over the years, Dr. Peter Morrell has consistently encouraged and supported
the research process by graciously accepting to co-author papers, and by
providing rigorous, precise and critical commentary and editorial suggestions
on the evolving thesis. Professors Clark and Morrell have written the
definitive texts in their respective fields, and their support to this research has
been a great honour to receive.
Among the many contributors of ideas and perspectives to this research, the
most illuminating and inspiring have been Stéphane Daillencourt, Ignacio de
Torres Zabalá, Nils Hallerström, Jorge Otero Rodriguez, and Claude
Pluzanski.
The critical reviews and comments provided by the referees of the Journal of
Air Transport Management and its editor Professor Kenneth Button, have
been both encouraging and edifying. The publication and conference
presentation opportunities offered by the Air Transport Research Society
(ATRS), which accepted four papers fundamental to this research, have
provided important perspective, in its unique forum of academics and
practitioners. Jacques Tournut’s continued confidence in my abilities as a
lecturer in Finance at the Toulouse Business School has been equally
important, giving me the opportunity to test these ideas
Identifying company practice in the strategic areas of fleet planning and
investment valuation was made possible by the enthusiastic co-operation of a
large number of executives from airlines, financial institutions in Europe, who
must remain anonymous due to the promise of confidentiality.
The time away from family necessary to complete this thesis is a gift from my
wife Mireille and sons Luke and Emerick, and I could never sufficiently thank
them for this.
Table of contents

1. Introduction and objectives............................................................................11
1.1. Airline fleet planning and investment analysis.......................................................11
1.1.1. Aircraft investment, airline profitability and uncertainty.................................14
1.2. Thesis aims and objectives....................................................................................21
1.2.1. Research methodology..................................................................................22
1.2.2. Thesis structure.............................................................................................24
2. Financial theory and the cost of investment.................................................26
2.1. Traditional views of investment costs and returns.................................................26
2.2. Capital structure and investment costs..................................................................31
2.3. Portfolio theory and the cost of equity capital........................................................40
2.3.1. The foundation: Modigliani and Miller............................................................40
2.3.2. Quantifying the risk-return tradeoff: Markowitz..............................................41
2.3.3. Firm-specific risk and return in a diversified portfolio: CAPM........................43
2.4. Capital structure and Weighted Average Cost of Capital.......................................51
2.5. Conclusions............................................................................................................52
3. Classical theory and aircraft investment analysis........................................54
3.1. From portfolio theory to corporate capital budgeting.............................................54
3.2. Practices identified in the literature........................................................................57
3.2.1. Investment valuation techniques used in the business community...............58
3.2.2. Cost of capital estimation – evolution of practice..........................................63
3.2.3. Pitfalls in cost of capital estimation................................................................66
3.2.4. Cost of capital estimation – summary and conclusions................................72
3.3. Airline investment analysis practice.......................................................................74
3.3.1. Research methodology..................................................................................74
3.3.2. Current investment valuation practices.........................................................78
3.3.3. Valuation techniques in airlines.....................................................................80
3.3.4. Airline cost of capital estimation....................................................................85
3.4. Conclusions............................................................................................................91
4. Financial markets, airline ownership and investment analysis...................93
4.1. Investment returns and the information revolution.................................................94
4.1.1. The definitive study: Triumph of the Optimists..............................................94
4.1.2. Data scope and corrections for statistical biases..........................................95
4.1.3. Estimates of the equity risk premium............................................................98
4.2. Airline ownership and financing patterns.............................................................104
4.2.1. Political and legal restrictions to capital flows.............................................104
4.2.2. International financial markets and financing opportunities........................111
4.2.3. Regional patterns of airline shareholding....................................................115
4.2.4. Airline ownership and financial performance...............................................118
4.2.5. Listed carrier equity finance and investment analysis.................................122
4.2.6. Value-based management in listed carriers................................................127
4.2.7. Government-owned carrier equity finance & investment analysis..............130
4.2.8. Closely-held carrier equity finance & investment analysis..........................137
4.2.9. Other airline-owned carrier equity finance and investment analysis...........143
4.2.10. Conclusions.................................................................................................149
5. Fleet planning and investment appraisal.....................................................154
5.1. Strategic issues in fleet planning..........................................................................155
5.1.1. Strategic drivers of long-haul route development........................................155
5.1.2. Aircraft size and service frequency..............................................................157
5.1.3. Manufacturer influence on fleet development strategies.............................161
5.1.4. Fleet development modelling literature.......................................................171
5.2. Fleet planning and airline planning processes.....................................................176
5.3. Executive views on fleet planning & investment appraisal...................................182
5.3.1. Three paradigms of economic valuation.....................................................183
5.3.2. Neo-classical fleet planning: NPV as project justification............................184
5.4. Uncertainties in fleet planning assumptions.........................................................190
5.4.1. Panel composition and overall results.........................................................190
5.5. Conclusions..........................................................................................................205
6. Airline practices in risk valuation and management..................................207
6.1. Risk valuation field research................................................................................208
6.1.1. Evolution of risk valuation methods in the general business community....208
6.1.2. Risk valuation methods in aircraft projects..................................................211
6.2. Airline approaches to fleet investment risk..........................................................215
6.2.1. Risk assessment methods in airlines..........................................................215
6.2.2. Adjusting investment valuation for project risks..........................................218
6.2.3. Risk quantification in the neo-classical paradigm........................................219
6.3. New perspectives on risk management in aircraft projects..................................221
6.3.1. Risk quantification as a negotiating strategy...............................................221
6.3.2. Aircraft financier views of investment valuation & risk assessment............227
6.4. Investment-financing interactions and risk management.....................................230
6.4.1. Valuation of operating leases......................................................................232
6.4.2. Extending APV to aircraft operating lease vs. purchase analysis...............234
6.4.3. Aircraft as commodity: integration of investment and financing..................241
6.5. Conclusions..........................................................................................................246
7. Advanced financial theory, investment & uncertainty................................248
7.1. Game theory application to fleet strategy.............................................................248
7.2. Real Options Analysis..........................................................................................251
7.2.1. Foundation and early applications of options pricing..................................252
7.2.2. Recent aviation applications of real options................................................254
7.2.3. Aircraft family conversion option value in today’s environment...................259
7.3. Environmental cost modelling..............................................................................276
7.4. Agency, information, and signalling in aviation markets......................................278
7.4.1. Asymmetries of information and financing choices.....................................278
7.4.2. Lufthansa & British Airways investor information and signalling.................281
7.5. Conclusions..........................................................................................................284
8. Conclusions and further research................................................................286
8.1. Research findings and conclusions......................................................................286
8.1.1. Review of research motivations...................................................................286
8.1.2. Is modern financial theory coherent, usable, and used?.............................287
8.1.3. Financial performance of classical valuation practitioners..........................288
8.1.4. Do global equity ownership patterns foster rigorous financial analysis?.....292
8.1.5. Does advanced theory offer solutions to valuing project uncertainties?.....293
8.2. Contributions to the field......................................................................................294
8.3. Opportunities for further research........................................................................303
8.3.1. Airline governance and agency problems...................................................303
8.3.2. Potential applications of behavioural finance..............................................304
8.3.3. Database refinement and updates..............................................................304
References..............................................................................................................306
Bibliography...........................................................................................................311

List of Appendices
Appendix A – Airline CFO Survey questionnaire & results....................................................................313
Appendix B – Airline ownership, production, revenue and profits, 2004-2008......................................320
Appendix C – Airbus and Boeing delivery forecast comparison............................................................334
Appendix D – Large civil aircraft delivery history...................................................................................335
Appendix E – Aircraft Investment model input and output.....................................................................336
List of Tables
Table 1.1: Debt-Equity ratios of selected airlines. Source: Jacobs Consultancy (2006)........................17
Table 2.1: Effect of financial leverage on profits and returns to shareholders, author example..............32
Table 2.2: comparison of traditional and classical valuation approaches................................................53
Table 3.1: Methods used by US companies in 1978 survey (Schall et al.)..............................................60
Table 3.2: Methods used by US companies in 1980 survey (Oblak and Helm)......................................61
Table 3.3: Methods used by Fortune 500 and Forbes 200 companies in Trahan and Gitman (1995)....62
Table 3.4: Cost of capital estimation methods in Schall et al. (1978)......................................................64
Table 3.5: Beta estimation parameters identified in Bruner et al. (1998)................................................68
Table 3.6: Explanatory power of historical and Barra betas in Rosenberg (1985)..................................70
Table 3.7: Historical estimates of equity market risk premia in Bruner et al. (1998), Dimson et al. (2002)
................................................................................................................................................................71
Table 3.8: Practitioner estimates of equity market risk premia in Bruner et al. (1998)............................72
Table 3.9 Black and Decker cost of equity values in Bruner et al. (1998)...............................................73
Table 3.10: Airline CFOs surveyed and responses by ICAO region.......................................................77
Table 3.11: Type of companies using cash vs. non-cash measures in 1999 survey (Graham and Harvey)
................................................................................................................................................................79
Table 3.12: Variability in Beta estimation among service providers, from Turner and Morrell (2003).....87
Table 3.13: Variability in Beta estimation for airlines, from Turner and Morrell (2003)............................88
Table 4.1: List of countries covered by MSCI indexes..........................................................................102
Table 4.2: Bloomberg sample cost of capital estimates for world airlines, May 9, 2007.......................103
Table 4.3: National airline equity ownership restrictions in Chang and Williams (2004).......................106
Table 4.4: Reasons cited for imposing national ownership regulations in Chang & Williams (2004)....110
Table 4.5: Majority ownership of 249 large airlines in 2009, by region..................................................117
Table 4.6: Majority ownership of 249 airlines, weighted by 2004-2008 RPK production.......................118
Table 4.6a: 2007 RPK distribution of 150 largest revenue producing airlines.......................................120
Table 4.7: 2007 profit distribution of 150 largest revenue producing airlines........................................120
Table 4.8: Airlines with largest listed shareholders in Asia-Pacific........................................................123
Table 4.9: Airlines with largest listed shareholders in Europe...............................................................124
Table 4.10: Airlines with largest listed shareholders in North America..................................................125
Table 4.11: Airlines with largest listed shareholders in the Middle East, South America, and Africa....126
Table 4.12: Cost of capital parameters & results: BA & SAS from Morrell (2003), LH from annual reports
..............................................................................................................................................................129
Table 4.13: Airlines with largest government shareholders in Asia-Pacific...........................................131
Table 4.14: Airlines with largest government shareholders in Europe..................................................133
Table 4.15: Airlines with largest government shareholders in the Middle East, Africa, and North America
..............................................................................................................................................................134
Table 4.16: Airlines with largest closely-held shareholders in Asia.......................................................138
Table 4.17 Airlines with largest closely-held shareholders in Europe...................................................139
Table 4.18: Airlines with largest closely-held shareholders in North America.......................................140
Table 4.19: Airlines with largest closely-held shareholders in South America.......................................141
Table 4.20: Airlines with largest institutional investors worldwide.........................................................142
Table 4.21: Airlines with largest other-airline ownership in Asia-Pacific................................................144
Table 4.22: Airlines with largest other-airline ownership in Europe.......................................................146
Table 4.23: Airlines with largest other-airline ownership in the Americas.............................................147
Table 4.24: Summary of production-dominant governance model and equity investment patterns by
region....................................................................................................................................................151
Table 5.1: Delivery forecasts comparison: Airbus forecast higher (+) or lower (-) than Boeing.............164
Table 5.2: Conclusions to Swan (2002), from Cyberswans.com, routenetworkhistory.ppt....................165
Table 5.3: Aircraft seat counts used for cost estimation in Swan and Adler (2006)..............................166
Table 5.3b: Aircraft seat counts used for delivery trend analysis (Source: Airbus, Boeing)..................167
Table 6.1: Tendency of airline CFOs using NPV to adjust valuations by raising the bar.......................219
Table 6.2: Types of fleet investment, perceived risk, and focus of analysis among aircraft financiers..227
Table 6.3: typical characteristics of finance and operating leases for aircraft.......................................231
Table 6.4: Cash flows categories and discount rates in lease vs. purchase analysis in Bower (1973).232
Table 6.5: Distribution of roles and risks in the aircraft as commodity paradigm...................................244
Table 7.1: NPV under certainty and MC simulation results...................................................................269
Table 7.2 project values under volatility estimates from MC simulation................................................273
Table 7.3 binomial lattice of A320 family conversion option gross values under varying states of nature
..............................................................................................................................................................274
Table 7.4: calculation of the net option value (premium) at contract signature.....................................275
Table 7.5: social costs by category and total cost per seat from Morrell and Lu (2007)........................277
Table 7.6 Environmental cost per seat for Bypass / Hub-and Spoke service, from Morrell and Lu (2007)
..............................................................................................................................................................277
Table 8.1: Shares of RPK and net profits by region and ownership, 2004-2008...................................292
Table 8.2: Summary of classical techniques used to value investments, pros, and cons.....................295
Table 8.3: Airline ownership and recommended primary valuation metric............................................298

List of Figures

Figure 1.1: Airline profits and aircraft orders. Source: Airline Business, Airbus.....................................14
Figure 1.2: Airline profits and aircraft deliveries. Source: Airline Business, Airbus................................15
Figure 2.1: Value maximisation through use of debt Source: Brealey & Myers (2000).....................38
Figure 2.2: the efficient frontier of portfolios, following Markowitz (1952)................................................45
Figure 2.3: The dominant combination of risk-free and risky assets, from Sharpe (1964)......................46
Figure 2.4: Efficient portfolios in equilibrium, from Sharpe (1964)...........................................................47
Figure 2.5: Relationship of individual security returns to portfolio return, from Sharpe (1964)................48
Figure 3.5: NPV and PBK depicted graphically, showing the difference in breakeven points.................84
Figure 3.6: range of cost of equity estimates in Turner and Morrell (2002).............................................89
Figure 3.7: Airline preferences for cost of capital estimation, author survey...........................................90
Figure 3.8: Airline preferences for cost of equity estimation....................................................................91
Figure 3.9: Regional preferences for cost of equity estimation...............................................................91
Figure 4.1: 101-year equity investor returns in 16 countries in Dimson et al. (2002)..............................95
Figure 4.2: 101-year equity risk premia in 16 countries in Dimson et al. (2002)......................................99
Figure 4.3: Estimates of future risk premia in Dimson et al. (2002)......................................................100
Figure 4.4: Short- and long-term debt in company capital structures in Booth et al., 2001...................113
Figure 4.5: Company ownership structures in LaPorta et al., 1999.......................................................114
Figure 4.6: Company ownership structures in LaPorta et al., 1999.......................................................114
Figure 4.7: Majority ownership of the world’s airline alliance members (left), and airline survey (right) in
Gibson and Morrell (2005)....................................................................................................................115
Figure 4.8: Number of different shareholder types among 249 largest airlines.....................................122
Figure 4.9: Valuation technique use by all airlines vs. majority listed airlines, Gibson & Morrell (2005)127
Figure 4.10: Frequency of valuation technique use by all airlines & majority government airlines........136
Figure 4.11: Frequency of valuation techniques used by all airlines, listed airlines & majority closely-held
airlines...................................................................................................................................................143
Figure 4.12: Frequency of valuation techniques used by all airlines, listed airlines & other airline-owned
airlines...................................................................................................................................................149
Figure 4.13: Profits and growth in the world’s aviation regions, 2004-2008..........................................152
Figure 4.14: Profits, growth and largest share ownership, 2004-2008..................................................153
Figure 5.1: Forecasts of aircraft deliveries 2009 – 2028 from Airbus Global Market Forecast (GMF) &
Boeing Current Market Outlook (CMO), 2009 editions from each manufacturer...................................163
Figure 5.2: average seats per airplane from Swan (2007)....................................................................165
Figure 5.3: average seats per airplane from Swan (2007) and percentage of total seats delivered in
short-haul aircraft..................................................................................................................................168
Figure 5.4: trend in average aircraft seat count, Swan (2007) and deliveries, 1985-2007....................169
Figure 5.6: Position of fleet planning and investment appraisal, lectures by Professor Paul Clark.......178
Figure 5.7: The product development process, adapted from Weber and Williams (2001)...................180
Figure 5.8: The Boeing’s business planning “roadmap” (2006).............................................................181
Figure 5.9: Market segmentation by specific origination and destination..............................................184
Figure 5.10: Modelling in the neo-classical paradigm. Source: Richard Wyatt.....................................186
Figure 5.13: Range of expert opinions regarding strategic uncertainty: O = Low, 10 = High................193
Figure 5.14: Range of expert opinions regarding strategic impacts......................................................194
Figure 5.14: Distribution of jet fuel prices 2007-2009 in US¢, courtesy of Claude Pluzanski, Airbus....195
Figure 5.15: Correlation of crude oil prices with the euro:$ rate, courtesy of Claude Pluzanski, Airbus196
Figure 5.16: expert assessments of the economic cycle risks..............................................................197
Figure 5.17: expert assessments of aircraft manufacturer EIS and delivery date reliability..................198
Figure 5.19: British Airways (BA), Emirates (EK), Lufthansa (LH) total capacity 2001 – 2009. Source:
company reports...................................................................................................................................200
Figure 5.20: British Airways (BA), Emirates (EK), Lufthansa (LH) total traffic, 2001 – 2009. Source:
company reports...................................................................................................................................200
Figure 5.21: traffic between London and Barcelona catchment areas: Source: Prof. Rigas Doganis...201
Figure 5.22: expert assessments of demand evolutions over the fleet planning horizon......................202
Figure 5.23: expert assessments of aircraft performance uncertainties over the fleet planning horizon203
Figure 5.24: Expert panel assessment of aircraft operating cost uncertainties: risk map......................204
Figure 5.25: expert assessments of environmental cost uncertainties over the fleet planning horizon.205
Figure 6.1: methods of estimating and adjusting for risk in Schall et al. (1978)....................................208
Figure 6.2: methods of adjusting for international project risk in Oblak and Helm. (1980)....................209
Figure 6.3: Methods in adjusting valuations for project risk in Trahan and Gitman (1995)....................210
Figure 6.4: adjusting for various types of risk in Graham and Harvey (2001)........................................211
Figure 6.5: Project NPV as a function of Discount Rate........................................................................213
Figure 6.6: “Contour” indifference curves showing RJ cost compared to PR, from Smirti and Hansen
(2009)....................................................................................................................................................214
Figure 6.7: “Contour” indifference curves showing NB cost compared to PR, from Smirti and Hansen
(2009)....................................................................................................................................................215
Figure 6.8: Number of different valuation techniques used to evaluate airline investments..................216
Figure 6.9: Methods used to assess risk among Airline CFO respondents...........................................216
Figure 6.10: Strength of preference for risk assessment methods among Airline CFO respondents....217
Figure 6.11: frequency of use of risk estimation techniques “sometimes” or “all the time”....................217
Figure 6.12: Airline methods to adjust investment valuations for project risk........................................218
Figure 6.13: Example of reverse cumulative distribution of Net Present Value under Monte Carlo
analysis.................................................................................................................................................225
Figure 6.14: Airline CFO use of DCF analysis for lease vs. purchase decisions...................................234
Figure 6.15: examples of operating lease use in U.S., Europe, Asia, from Gibson (2003)...................235
Figure 6.16: cash flows for purchase and resale, compared to operating lease flows.........................236
Figure 6.17: Valuation differences between NPV and APV for a single-aisle aircraft............................238
Figure 6.18: APV sensitivity to aircraft lease rate and lease value advantage over purchase..............239
Figure 6.19: NPV sensitivity to aircraft residual value and purchase value advantage over lease........239
Figure 7.1: Distribution of international Jet Fuel prices, 2005-2009 used for MC simulation.................263
Figure 7.2: Demand growth modelled over the cycle............................................................................264
Figure 7.3a: annual operating cash flows from A319 investment..........................................................265
Figure 7.3b: annual operating cash flows from A320 investment..........................................................266
Figure 7.4a: A319 cumulative and expected NPV over MC iterations...................................................267
Figure 7.4b: A320 cumulative and expected NPV over MC iterations...................................................268
Figure 7.5: distribution of NPVs for the A310 and A320 investments....................................................269
Figure 7.6: Crystal Ball “Sensitivity chart” for the A320 simulation........................................................270
Figure 7.7: distribution of LN(PV / PV ) for MC simulation, large number of undefined returns 273
Year 1 Year 0
Figure 7.8: Airline CFO ranking of preferences for project financing.....................................................280
Figure 7.9: Airline CFO preferences in selecting appropriate debt levels.............................................281
Figure 7.10: Lufthansa estimate of WACC, from 2001 annual report....................................................283
Figure 7.11: Lufthansa estimate of WACC for each business unit. Source: 2009 LH Annual Report..283
Figure 7.12: BA WACC estimates at various levels of debt Source: 2008 Investors Day presentation284
Figure 8.1: net profit margins of listed and other European airlines, 2004-2008...................................289
Figure 8.2: Listed European airlines share of net profits in the region, 2004-2008...............................290
Figure 8.3: Cash Value Added for Lufthansa Group companies, 2000-2009 (Group) and 2005-2009
business units Source: 2009 LH Annual Report...................................................................................291
Figure 8.4: Lufthansa share market value and CVA.............................................................................291