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MBAA 523 ? Fleet Replacement Assignment

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Question;Fleet;Replacement Analysis;This;assignment has three objectives, to: 1) become familiar with the type and;magnitude of mainline aircraft operating costs, 2) understand the operating;economics of new versus older aircraft, and, 3) see how net present value;analysis is used in capital acquisition decision-making. Allegiant Airlines has;engaged the aviation consulting firm SH&E to evaluate whether it should;continue its fleet expansion with new aircraft instead of the aging McDonnell;Douglas MD-80 aircraft that are the backbone of its small fleet. You are the;senior financial analyst assigned to this project and will prepare a memorandum;with your conclusions to Allegiant?s president Andrew Levy.;Background;Allegiant;Airlines, a small successful US low-cost- carrier, has been aggressively;expanding by purchasing used MD-80 aircraft. In its latest acquisition of 18 MD;-80s from Scandinavian Airways System, Allegiant paid roughly $4 million;dollars per plane in an all cash transaction. Although these aircraft have a;useful service life of 20 more years, Allegiant recognizes it must eventually;modernize its fleet. As with all older aircraft, the MD-80 burns more fuel and;requires more maintenance than new generation aircraft of equal mission;capability. Skyrocketing fuel prices during the summer of 2008 added to senior;management?s interest in evaluating new aircraft. As you will see, this;decision is critically dependent on your projection for future fuel costs and;the discount rate (interest rate) employed.;The Analysis;An;Excel template is provided as an attachment for conducting your net present;value analysis. You will need to insert costs into the template. You may wish;to review the template before reading further.;Allegiant can purchase new Boeing-737-800;or Airbus A-320 aircraft for $60 million each. After twenty years, either of;these new aircraft are estimated to be worth $25 million in the used market;whereas an MD-80 will have only $100,000 in scrap value twenty years hence.;Even if Allegiant should continue to operate the planes beyond 20 years, these;values still represents an opportunity cost.;Your;estimate of fuel prices over the next twenty years is critical. Review fuel;cost data provided on the Air Transport Association website (Economics and;Energy/Annual Crude Oil and Jet Fuel Prices and Monthly Jet Fuel Cost and;Consumption Report;ATA Annual;Crude Oil and Jet Fuel Prices;ATA;Monthly Jet Fuel Cost and Consumption Report;Note that fuel prices;increased dramatically during the global economic expansion of the mid-2000s;peaking at nearly $4 per gallon in June 2008, but plummeted during the;subsequent recession. Fuel costs will certainly increase again when world;demand recovers. You will need to estimate future fuel costs for the analysis.;In preparing your analysis;for Allegiant, you have obtained relevant cost data from the US Department of;Transportation. Data are in the tables at the bottom of this document. Here are;other relevant facts and assumptions needed to complete the analysis;All;future operating costs are discounted to the present value at a discount;rate. Although Baye refers only to the interest rate, finance theory tells;us that the Weighted Average Cost of Capital is appropriate. This discount;rate is the estimated return that shareholders demand of an airline from a;purchase of new capital equipment. Derivation of this discount rate is;beyond the scope ofthis course but might vary between 8 and 20%.;As one example, United Airlines raised some operating capital by selling;corporate bonds secured by its spare parts inventory. The effective interest;rate on this sale was 17%. Your fleet replacement decision will depend on what;rate you choose. You should perform a sensitivity analysis (work the problem with;at least two discount rates) to better understand and defend your;recommendation.;Although;Allegiant?s business model does not provide for high aircraft utilization;it estimates that a new aircraft?s annual utilization (block hours per;year) will be 15% higher than the MD-80.Allegiant;plans to outsource its heavy maintenance, so it will pay another airline;or maintenance facility for both direct and burden (overhead) costs. For;the A-320, it estimates maintenance cost will be similar to JetBlue and USA;3000, both of which operate relatively new aircraft. All Boeing 737-800s;are relatively new, so the industry average maintenance cost is a good;estimate.Allegiant;configures its aircraft in high density, all-coach configuration like;other LCCs USA 3000 Airlines and Sun Country.;5. Both;the A-320 and B-737-800 are somewhat faster than the MD-80. Estimated block to;block (taxi out to gate arrival) speed for A-320 and B-737 is 366 mph versus;340 mph for the MD-80.;6.;Allegiant does not expect;crew expenses to change with the choice of aircraft, so this and other minor;immaterial costs are not included in the analysis (an extra flight attendant;will be required but this cost is ignored here).;Task;Choose either the Airbus A-320 or the Boeing;737 for comparison with the existing MD-80. Enter data into the Excel template.;Run a few ?sensitivity? analyses with varying fuel and discount rates to see;how the fleet replacement decision changes. Remember that the net present value;obtained is a total cost of operation. The spreadsheet computes the cost per;available seat mile (CASM). The fleet alternative with the lowest net present;value CASM is the best financial choice. Prepare a short memorandum to the;President summarizing your analysis and making a recommendation. Remember that;executive management needs to understand what you have done but will not read a;memorandum more than two pages long. Explain your assumptions and methodology;concisely. Insert or attach and reference Excel spreadsheets as appendices to;support your fleet replacement recommendation.;See Purdue OWL;for guidance on writing business memoranda and memo format. Search OWL for;?memorandum.?;The;following page supplies the operating cost and statistics charts for McDonnell;Douglas and Boeing aircraft.;Source;Aviation Daily. Available through Aviation Week;Intelligence Network (AWIN), Hunt Library databases.;MBAA;523 ? Fleet Replacement Assignment CV 1010;MBAA;523 ? Fleet Replacement Assignment CV 1010

 

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