William E. Gibson Aircraft Investment Planning and Uncertainty
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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