Aviation Economics & Finance Professor David Gillen (University of British Columbia )& Professor Tuba Toru - Delibasi ( Bahcesehir University) Module 3: 23 November 2015 Istanbul Technical University Air Transportation Management M.Sc. Program
Aviation Economics & Finance
Professor David Gillen (University of British Columbia )&Professor Tuba Toru-Delibasi (Bahcesehir University)
Module 3: 23 November 2015Istanbul Technical UniversityAir Transportation Management M.Sc. Program
OUTLINE
• Module 3 (2 hours) – Aspects of Airline Finance
– Airline Cost Classification
– Assessing performance
– Investment appraisal and financial evaluation
• Risk management (foreign currency / fuel price / etc.)
November 23-28 3
AIRLINE COST STRUCTURE
November 23-28 4
UNDERSTANDING COSTS
• Accounting profit: Total Revenue-Total explicit cost
– Not just difference in cash inflows and cash outflows out but value
of assets generated by business activity less asset value lost due to
business activity
• Economic Profit: = Total Revenue – Total Expenses (explicit
expenses + opportunity cost)
– Time value of money
• Cost categories versus cost behaviour
– Accounting assigns cost based on a view to cost responsibility-
where the cause of a cost originates
– Cost causality based on underlying cost behaviour with respect to
some variable(s)
November 23-28 5
WAYS OF THINKING ABOUT COSTS
Broad categories
• Startup costs
• Production costs
• Fixed costs
• Variable costs
• Marginal costs
Detail of Explicit Costs
• Selling and general administrative
expenses
• Fuel costs
• Flight & cabin crew costs
• Direct maintenance expenses
• Landing fees and capital equipment
charges
• Distribution costs (sales & promotion)
• Station costs
• Ground expenses
• Passenger services
• Interest expenses
• Taxes
November 23-28 6
COSTS – THE DETAILS
• Startup costs
– Costs incurred to begin a business or service a portion of which are
generally (but not always) sunk
– ‘sunk cost fallacy’
• Production costs
– What resources are used up in order to produce a product or
service
– Joint/common costs and assignment
– ‘what is the opportunity cost of a air marshal’?
November 23-28 7
COSTS – THE DETAILS CONT’D
• Fixed costs
– Costs that do not change when the amount or rate of output
changes
– These costs are not ‘avoidable’; e.g. aircraft ownership
– Semi-fixed – no significant change over a broad output range –
happens with lumpy inputs (e.g. gates)
– In aviation FC are large
• Variable cost
– Cost varies as output varies; e.g. fuel, labour, materials & supplies
– Some variable costs are ‘semi-variable’, again due to lumpiness
November 23-28 8
COSTS RELATIONSHIPS
• Total costs TC) = Fixed cost (TFC) + Variable cost (TVC)
• Average Total Cost (ATC) = AFC + AVC
• Airline types of costs:
• CASM = TOTAL COST/ASM
• CASMOPERATING = OPERATING COST/ASM
• Marginal cost = 𝑀𝐶 =Δ𝑇𝐶
Δ𝑄=
𝜕𝑇𝐶
𝜕𝑄𝑜𝑟 =
𝜕𝑇𝐶
𝜕𝑄𝑖
• E.g. Aircraft catering Costs as f(airplanes catered)
• TC, FC, VC, AFC, ATC, MC
• MORE ON COSTS AND DETAIL ON TUESDAY
November 23-28 9
AN EXAMPLE WITH AIRCRAFT CATERING COSTS
November 23-28 10
AIRCRAFT CATERED TC FC VC AFC AVC ATC MC
0 $200,000 $200,000 $0 $0 $0 $0 $0
1 $300,000 $200,000 $100,000 $200,000 $100,000 $300,000 $100,000
2 $400,000 $20,000 $200,000 $100,000 $100,000 $200,000 $100,000
….
12 $1,400,000 $200,000 $1,200,000 $16,667 $100,000 $116,667 $100,000
WHY MIGHT COSTS VARY
November 23-28 11
Factor prices Productivity Taxes/Public policy
Costs are a product of factor hired x factor productivity (VMP or MRP)
SOME EXAMPLES OF DIFFERENCES IN CASM
November 23-28 12
Source: Oliver Wyman, Airline Economic Analysis (November 2014)
SOME EXAMPLES OF DIFFERENCES IN CASM
November 23-28 13
Source: Oliver Wyman, Airline Economic Analysis (November 2014)
COSTS THE DETAILS
FIXED COSTS
• Fixed salaries & benefits, and crew
training do not vary with aircraft usage
• Maintenance costs – labour & contracted
services costs of annual inspections
• Leased costs based on time
• Depreciation
• Operations overhead
• Administrative overhead
• Self-insurance costs
VARIABLE COSTS
• Crew costs (travel, overtime, wages of
hourly staff)
• Maintenance costs based on hour usage of
assets (aircraft) or flying cycles
– Labour, parts, contracts, engine
overhaul
• Modifications
• Fuel and other fluids
• Lease costs based on flights hours
• Landing fees and airport and enroute
charges
November 23-28 14
ANOTHER FORM OF COSTS BREAKDOWN
November 23-28 15
Operating Costs (OC)Direct OC Flight crew Aircraft fuel and oil Airport fees Navigation charges Direct maintenance:
labour & materials Depreciation/Rentals/
Insurance: Flight equipment
Indirect OC Marketing Ground property & equipment
o Depreciation, insurance, maintenance
Administration & saleso Services administrationo Reservations & saleso Advertising & publicityo General
Servicingo Passenger serviceso Aircraft serviceso Traffic services
Non-operating Costs (NOC) Depreciation Interest Insurance Losses from retirement of property Losses from affiliated companies Other loss items (e.g. foreign
exchange)
WHY MIGHT COSTS & CASM VARY ACROSS AIRLINES
• Differences in stage length
• Differences in seating density
• Differences in Productivity
November 23-28 16
HOW STAGE LENGTH PLAYS A ROLE
November 23-28 17
Source: Oliver Wyman, Airline Economic Analysis (November 2014)
November 23-28 18
Source: Oliver Wyman, Airline Economic Analysis (November 2014)
HOW SEATING DENSITY PLAYS A ROLE
November 23-28 19
Source: Oliver Wyman, Airline Economic Analysis (November 2014)
November 23-28 20
Source: Oliver Wyman, Airline Economic Analysis (November 2014)
November 23-28 21
Source: Oliver Wyman, Airline Economic Analysis (November 2014)
PRODUCTIVITY-PERFORMANCE
• Partial productivity metrics
• Total factor productivity (TFP)
• Operational performance indicators
November 23-28 22
KEY STRATEGIC PERFORMANCE INDICATORS (PARTIAL)
November 23-28 23
Source: IATA
FINANCIAL PERFORMANCE INDICATOR: REVENUE & COSTS
November 23-28 24
OPERATIONAL KEY PERFORMANCE INDICATORS
• Fuel cost efficiency
• Staff Productivity
• Employment costs
November 23-28 25
November 23-28 26
STAFF PRODUCTIVITY
November 23-28 27
November 23-28 28
November 23-28 29
OTHER PERFORMANCE INDICATORS THAT COULD BE TRIED
• Daily utilization by aircraft type
• Direct operating expenses per flight-hour
• Direct operating expenses per aircraft
• Flight operating expenses
• Maintenance and Overhaul Expenses per flight hour
• Fuel & Oil Expenses per flight hour
• How do we handle connecting flights?
• IS CASM more straightforward than RASM?
November 23-28 30
MEASURING AND MANAGING RISK
November 23-28 31
WHERE IS THE RISK?• Make a distinction between risk (unknown) and uncertainty
(measurable).
– Risk-we don’t know what will happen but we know the distribution
– Uncertainty – we don’t know what is going to happen and we do not know
the distribution.
• Just as an investment portfolio has an expected return so does a
network of flights
• Think of the expected return on a network as
𝐸 𝑁 =
𝑖=1
𝑛
𝑤𝑖 𝜌𝑖 𝑘𝑖
• where w is the importance or weight of route i in the network and is
the probability that an outcome will occur (e.g. state of the economy
for route r and k is the return on a route (or a flight)
November 23-28 32
MANAGING AND MEASURING RISK
• Variance = 2 = 𝐸 𝑁 = σ𝑖=1𝑛 𝑤𝑖 𝜌𝑖[𝑘𝑖 − 𝑘𝑖]
2
• that is there is a difference between the actual and anticipated
return.
• Standard deviation, , is 𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒
– St. dev associated with normal distribution
• In a normal distribution 68% of all measures fall within 1 st. dev of
the mean, and 95% fall within 2 st. dev of mean.
November 23-28 33
DIFFERENT STANDARD DEVIATIONS
November 23-28 34
EACH PROCESS (ACTIVITY) HAS A RISK DISTRIBUTION
• Basic airport processes:
– Curbside, check-in, security, boarding, airside infrastructure
services
– Ancillary services: sources of non-aviation revenue
• Basic airline processes:
– Decisions within the airline (see next slide)
– Infrastructure provision (airport services, ATC)
– Exogenous influences: weather, politics, SARS, war
• Risk tolerance:
– Safety – 0 tolerance
– On-board services – risk averse
November 23-28 35
STYLIZED AIRLINE PROCESS MAPPING
November 23-28 36
BETA MEASURE OF RISK
• In stock returns beta is a risk measure that describes the
relationship between an individual security expected return to
that of the market.
• Use the same idea to express the relationship between the
expected return from an individual route and the return in a
network or region.
𝛽𝑖 =𝑐𝑜𝑣 𝑘𝑖 , 𝑘𝑛𝜎2 𝑘𝑛
• Where n is network or you could use a region
• Beta is used to calculate WACC
November 23-28 37
NEED TO KNOW BETA
• Check multiple sources,
different sources give different
numbers
• Beta is ‘backward looking,
based on past events but
should adjusted to reflect risk
profile going forward.
• unlevered-value of if firm
had no debt
• levered by using s projected
debt/equity ratio
November 23-28 38
Source: Sheelah Turner and Peter Morrell (2003), An evaluation of airline beta values
and their application in calculating the cost of equity capital, Journal of Air Transport
Management,9, 201-209
BETA AND WACC
November 23-28 39
𝛽𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 =𝛽𝑐𝑢𝑟𝑟𝑒𝑛𝑡
1 + (1 − 𝑡) ൗ𝐷 𝐸 𝑎𝑐𝑡𝑢𝑎𝑙
𝛽𝑙𝑒𝑣𝑒𝑟𝑒𝑑 = 𝛽𝑢𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 1 + (1 − 𝑡) ∙𝐷
𝐸𝑡𝑎𝑟𝑔𝑒𝑡
𝑊𝐴𝐶𝐶𝑡 = 𝑘𝑑 1 − 𝑡𝐷
𝑉+ 𝑘𝑝𝑠
𝑃𝑆
𝑉+ 𝑘𝑒
𝑒
𝑉kd is cost of debt (i rate on bonds)
kps is cost of preferred stock
ke cost of common equity (common stock, retained earnings)
t is effective tax rate
D is market value of debt
E is market value of equity outstanding
Where does enter?
November 23-28 40
Industry
Number of
firms Beta D/E Ratio Tax rate
Unlevered
beta
Cash/Firm
value
Unlevered
beta corrected
for cash HiLo Risk
Standard
deviation of
equity
Air Transport 22 0.98 81.51% 18.71% 0.59 3.63% 0.61 0.4971 53.32%
Auto & Truck 22 1.09 105.95% 4.45% 0.54 7.78% 0.59 0.6152 43.52%
Banks (Regional) 676 0.53 77.69% 20.66% 0.33 12.56% 0.37 0.1969 37.41%
Beverage (Alcoholic) 22 1.06 21.88% 8.54% 0.88 1.66% 0.89 0.5838 55.14%
Business & Consumer Services 177 1.19 30.41% 13.30% 0.94 5.17% 1.00 0.5382 52.77%
Computer Services 119 1.16 27.56% 10.48% 0.93 5.64% 0.99 0.5193 59.41%
Electrical Equipment 126 1.24 16.86% 5.99% 1.07 6.52% 1.14 0.5870 65.34%
Entertainment 84 1.21 27.52% 4.11% 0.95 3.26% 0.99 0.6339 58.48%
Green & Renewable Energy 26 1.32 109.96% 1.94% 0.63 6.10% 0.68 0.7017 53.18%
Healthcare Products 261 0.99 15.67% 6.73% 0.86 4.54% 0.90 0.5028 64.48%
Machinery 137 1.23 20.43% 15.64% 1.05 5.94% 1.11 0.4598 46.22%
Paper/Forest Products 22 0.84 51.02% 11.54% 0.58 3.25% 0.59 0.4571 44.94%
Restaurant/Dining 79 0.89 27.87% 15.14% 0.72 2.35% 0.74 0.3574 44.43%
Retail (Automotive) 30 1.18 50.19% 18.76% 0.83 1.34% 0.85 0.4353 48.06%
Retail (General) 23 1.03 31.37% 21.36% 0.83 2.68% 0.85 0.3159 46.36%
Shipbuilding & Marine 14 1.36 53.62% 6.75% 0.91 3.49% 0.94 0.4613 71.45%
Steel 40 1.31 64.03% 13.99% 0.85 6.31% 0.90 0.3778 52.45%
Transportation 21 0.86 21.03% 20.08% 0.73 4.11% 0.77 0.3829 42.36%
Transportation (Railroads) 10 1.05 20.21% 21.30% 0.90 1.76% 0.92 0.3456 30.73%
Trucking 30 1.32 66.66% 27.38% 0.89 2.72% 0.92 0.3604 48.49%
Total Market 7887 1.06 66.14% 10.76% 0.67 4.95% 0.70 0.4697 53.60%
BROADER VIEW OF RISK MANAGEMENT
November 23-28 41Source: easyjet 2014 annual report
END OF MODULE 3
November 23-28 42