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