Part 1 (b)
In part A we looked at Osgar’s options in relation to one project i.e. to replace old metal-extrusion machines now or in three years. In answering this part of the assignment, it is assumed that the term ‘’capital’’ means fixed assets such as the metal-extrusion machines in Osgar’s case, working capital provided by the company owner or its financiers and the fact that in most companies, more than one capital investment decision may be under review at any given time.
When the management of a company make plans for the long term, they must decide whether and how much to invest in fixed assets and working capital to maintain or increase the productive capacity of the business.
Capital appraisal is the application of quantitative (financial) and qualitative (opinions) analyses which give management guidance in making medium to long term investment decision. In deciding on any capital investment project and for a business to succeed, it must first understand which projects will have a successful outcome. Many project ideas can be brought forward by the owner/entrepreneur, plus the management and staff, each having different capital requirements, but it is the role of the management accounting team to ensure the cash inflows and outflows of medium to long term projects can be predicted with certainty and in the best interest of the overall company.
In developing and implementing a new programme for capital appraisal, as most companies have limited resources, the management accountants should carefully consider the following;
• The number of proposed projects, are they worthy of being carried out.
• The total level of finance (cash and debt) that can be committed to new and worthwhile projects.
• Where does the finance come from, if debt, does it subject the business to onerous financial and cash covenants.
• After the project was completed, assess if the investment in the project was a success or not.
See Appendix 1 – Planning and Control for Capital Investment Decisions.
Shareholders and management may have different views on projects and the financial benefit to the company, some examples of different views;
• Focus on cash. Cash invested is paid back quickly generating cashflow and profit to re-invest.
• Focus on return on assets. Cashflow generated but is growing profit more important to the market / shareholders / reputation.
• Focus on re-investment, min. costs are covered, further capital expenditure, pay or increase dividend to shareholders.
Management accountants look at various ways of evaluating capital expenditure, they include:
• Payback method: Calculates the length of time required for the cash inflows to match the original cash outflow.
• Accounting Rate of Return (ARR): Calculated by taking the average annual profits from a project as a % of the capital employed.
Avg. annual profits = avg. annual cash flows less annual depreciation.
• Net present value method (NPV): The NPV of a project is equal to the present value of the cash inflows minus the present value of the cash outflows, all discounted at the company’s cost of capital or weighted average cost of capital. Cashflows are calculated as profit before depreciation and amortisation. NPV decision rules are: Positive NPV = Project worth pursuing. Zero NPV = No surplus of cash & costs is met, decision to go ahead with zero return project maybe for strategic reason i.e. benefit to future business or projects / key customer requirement. Negative NPV = Project declined.
• Internal rate of return (IRR): Discounted rate at which the present value of the cashflows generated by a project is equal to the present value of the capital invested so that the net present value of the project is zero.
Each of the above methods come with advantages and disadvantages and should be carefully considered by the business, as most businesses have limited resources.
Payback method:
Advantages: Easy to calculate and understand, shows how long it take to recoup the cost so useful when resources are limited. This is useful at time of first review of a project.
Disadvantages; Does not consider time value of money and ignores cashflow after payback period. It is difficult to differentiate projects with the same payback period. Ignores the variability of cashflows and can lead to significant investment in short term projects and timing of payback may differ which could lead to several projects being grouped together.
ARR method:
Advantages: Easy to calculate but more akin accounting procedures and profits rather than cashflow.
Disadvantages; Does not consider time value of money, ignores cashflow timing. ARR is calculated using profit, not cashflow, depreciation (non-cash) is not a relevant cost in decision making. ARR does not consider the size or timing of investment. Ignores the variability of cashflows and can lead to significant investment in short term projects, timing of payback may differ which like payback could lead to several projects being grouped together.
NPV method:
Advantages: Considers the time value of money, and handle all types of cashflows (variable/fixed/stepped etc.) Cashflows are used instead of accounting profits unlike ARR, all cashflows throughout the project term are considered.
Disadvantages; Can be difficult to calculate and need to be discounted (cost of capital or WACC is used.
IRR method:
Advantages: Considers the time value of money, expressed in percentage terms and easy to understand.
Disadvantages; Can take time to calculate to achieve appropriate results. Unlike NPV, it can’t be used if cashflows change.
Therefore, the method or methods used may different from business to business or within businesses based on project size and respective timing of cashflow and of utmost important when capital rationing comes into play. Capital rationing is the limiting of a business’s capital budget, resulting in a situation whereby all projects cannot be carried out. Soft capital rationing refers to situation whereby for various reason, the business itself impose a limit on capital expenditure for internal reasons, and by contract, hard capital rationing occurs when capital expenditure is limited due to external factors such as a company’s inability to raise external financing from the its banks or capital markets as was seen during 2008-2010 financial crisis by many SMEs. Some examples of capital rationing; limited cash/ability to raise debt at reasonable cost, adverse or uncertain market conditions such as the stock market, intangible reasons such as no wish to increase debt or issue company stock.
In relation to the various methods used, there have been many surveys carried out on the various methods used by management accountants, but they are only pointers as a survey done in the boon vs. during the financial crisis can give very different results (due to cost of capital / interest rates).
However, there are some themes; most companies use more than one method, payback period mostly used in the UK (appears to be small businesses/small-medium projects) while discounted cashflows is preferred in the US. IRR is more popular than NPV and used by large companies with operations in different countries, therefore allowing them set different IRRs reflecting risk of those countries.
As we used NPVs in the case of Osgar (albeit only one project to review), had we been given details on other projects and assuming this was a small-medium size Irish business, I would first use the NPV method followed by PI (Profitability Index) i.e. NPV divided by total capital budget and then rank the projects in order of their profitability and only projects with a score of 1 or more would proceed. However, if the capital budget is expected to be restricted in more than one period, ranking of project using PI cannot be used as it does not consider the financing restrictions in future periods, in this case, Linear programming should be used (two variables) or simples method (more than two methods).
If we look at Ireland, we exited the bailout at the end of 2013 and since then we’ve seen good economic growth, that growth is expected to continue but the last 10 years can be divided in two, 5 years of recession / austerity measures and the last five in recovery mode. The key indicator on recovery being employment level, up from just over 1.8m, at its lowest point in 2012, to 2.1M+ in Jun ‘18. (peak was 2.2M in 2007). Economic growth, even allowing for the distorting impact of multinational activity, has been robust and the exchequer is close to balancing its books. Despite the economic growth, we continue to have a significant housing crisis since the financial crisis, the construction industry was decimated with many developers and builders going bust or into Nama.
Hard capital rationing was at its ultimate peak in the first five years, banks could not lend and under pressure to shrink their loan books. The Governments investment in housing was slashed and since then the social crisis that has been caused means housing is also a constraint on economic growth. In terms of attracting companies to invest here, this is now a real issue for the economy, companies rely on talent and talent need houses to live in at reasonable cost and a chance of a decent lifestyle. The Government faces the two challenges; dealing with the legacy of the financial crisis and the challenges of the recovery. The threat of Brexit, which could yet deliver a hard shock in 2019 (assuming the UK to leave the EU without a deal), remains.
The big lesson from the crisis was that, it was too late to act by the time the crash came in 2008, measures needed to be addressed in the preceding five years. However, this time it is different, but that doesn’t mean it won’t come without new challenges, this time we don’t have a credit-driven housing bubble, but we are still at risk of watching prices rise above sustainable levels. The public finances are sounder but remain vulnerable to volatile corporate-tax receipts. Inflation is low, but prices still make Ireland an expensive place to live, hitting people’s lives and threatening competitiveness. If Brexit ends favourably for us, we could be looking at a few more years of decent growth, albeit at a slower rate as the economy starts to approach capacity but will help the public finances and hopefully helps us make headway in the housing crisis.
Looking forward, the next few years will come with its ups and downs, the UK will leave the EU, interest rates will rise, growth across the industrialised world will, sooner or later will be impacted in one way or another by some crisis, be it financial, political, weather, corruption. The challenge for the Government is to make prudent decisions on capital expenditure now and get value for money (do the hard work now), building up adequate resources to allow sufficient protections/liquidity needed for the future. It is difficult to see how the Government could make significant tax cuts or allow overspending, for us to go through another financial crisis again in the future.
Part 2
Since the early 1700s, we have seen significant corporate failures due to lack of good corporate Governance, such failures include (i) Enron (2001), directors and executives concealed large losses, (ii) Arthur Anderson (2002) obstruction of justice by shredding documents relating to Enron, (iii) Bearing Bank (1995) employee signing off on his own trades, (iv) Worldcom (2001) directors used fraudulent accounting methods to push up share price and (v) several banks during the global recession financial crisis that began in 2008 found themselves over exposed to the sub-prime market and or subsequently became insolvent or nationalised e.g. Royal Bank of Scotland Group (2008) and Anglo Irish Bank (2009).
Corporate Governance was initially developed in response to a call by the OECD Council in April 1998, to develop, in conjunction with National Governments, international organisation and private sector businesses, a set of corporate governance standards and guidelines. These standards and guidelines were established in 1999. For many companies, they form the basis of good corporate governance in OECD and non-OECD counties since then and are the basis of the corporate governance component of the World Bank IMF Reports on the Observance of Standards and Code (ROSC).
Corporate governance is the mechanisms or system in which a company is directed and controlled and primarily concerned with protecting weak and widely dispersed shareholders from self-interested boards of directors or executive management teams.
Boards of directors are responsible for the governance of the company and the Shareholders role in governance is to appoint the Board of Directors and Auditors to ensure appropriate governance structures are in implemented and adhered to.
There are four core values of the OECDs standards and guidelines which form the basis of a good Governance Framework in any corporation, they are:
1. Fairness: Should protect shareholder rights, ensure equitable treatment of all shareholders (minority & foreign).
2. Responsibility: Recognise rights of stakeholders as established by law, encourage active co-operation between corporations and stakeholders in creating wealth, jobs and sustainability of financial sound enterprises.
3. Transparency: Ensure timely and accurate disclose is made on all material matters regarding the company including its financial situation, performance, ownership and governance structure. Recent example: Oct 17th Flybe (UK regional carrier) announced a deepening of its pre-tax losses being greater than expected. Share price dropped by 38% after trading opened on Oct 17th. Share prices across the aviation industry including IAG (parent of Aer Lingus / British Airways a 3 % s/h in Flybe / Iberia / Vueling) dropped ~2-3%.
4. Accountability: Ensure strategic guidance of the company, effective monitoring of management by the board and the boards accountability to the company and shareholders.
In addition, The Cadbury Report (1992) was established by the Financial Reporting Council, the London Stock Exchange and the accountancy profession due to the increasing lack of investor confidence in listed companies surrounding honesty and accountability after the collapse of Coloroll & Nadir’s Polly Peck. Their published accounts did not provide any indication that either company was at risk of failure. Before the report was completed, two further scandals shook the financial world; Bank of Credit & Commerce International (criminal practices) and the Maxwell Group (Robert Maxwell’s misappropriate of funds). These major scandals had a significant impact on the integrity of the UKs financial institutions / markets. The final report was published (after much debate from the Institute of Directors), the central components being:
• Clear division of responsibilities at the top, Chairman of the board separate from Chief Executive or there are strong independent elements on the board.
• Majority of the Board is made up of outside directors.
• Remuneration committees for board members is clear and majority are non-executive directors.
• An Audit committee appointed, including at least three non-executive directors.
With the above, Strategic Management Accounting is critical in every business today in achieving an organisations strategy and objectives therefore providing management and senior executives with information and advice to make decision on future courses of action. CIMAs definition of Management Accountants role is:
The provision of information required by management for such purpose as:
1. Formulation of Policies
2. Planning & controlling the activities of the enterprise
3. Decision taking on alternative courses of action
4. Disclosure to those external to the enterprise (shareholders and others)
5. Disclosures to employees
6. Safeguarding of assets ’
In addition, Risk Management is now at the forefront of every company’s corporate governance strategy, the risk management process aims to support internal control by addressing uncertainty in the business environment, addressing the impact of probabilities of perceived risk and deciding on mitigating actions to reduce the rise and eliminate any residual risk.
See Appendix 2 – Risk Management Table
Considering the above, strategic management accounting is the key element in achieving the recurrence of good performance and strategic planning. Management accounting techniques support these processes in helping management with decision making in the areas of planning and control after considering the business risk and opportunities through the risk management table.
Strategic management/processes, one of the key objectives of any organisation is to maximise the present value of future cash-flow to ensure resources, scarce or otherwise are allocated to the maximum benefit, and some of the issues to be consider here are:
• The economic mission of the company
• Type of business the company should be carrying out
• Type of goods and services it should or can provide
• The share of market in respect of the goods and services the company provides
• Profit expectations
• Sales growth, assets, liabilities and resources including equity that is required to support profit expectations
Strategic management should also monitor performance vs objectives and not only financial objectives but also employee and quality control. Not only should a company have a mission with related objective, it must have performance management and management information systems to monitor outcomes against plans.
The following chart shows the relationship between strategic management and management accounting.
Objectives set the direction in which management wish to be leading, these are broken downs as follows:
Mission of the company: General term on the broad purpose and reason for their existence.
Corporate objectives: Directives from the Board of Directors to management which relate to the entire company and include financial targets, returns expected on capital, market share and growth expectations.
Business unit objectives: Expectations set down for business units of large organisations (generally held under a holding company).
Strategic planning is top level decision making, it involves looking at all course of action or strategies to allow the company to achieve its objectives. If we take Ryanair as an example, they operates a fleet of 400 Boeing 737-800 aircraft today and have an order book for a further 115 B737s plus in September 2014, they announced a further order for up to 200 Boeing 737 MAX 8s (100 confirmed and 100 options) for over $22Bn. While Ryanair has an extremely strong cash position, their decision on such a significant order came after lengthy negotiations with Boeing & Airbus and in period of time, bearing in mind the preceding years were post the 2008 financial crisis, when airlines and their main competitors were struggling to survive given the challenging financial and banking environment. Airlines struggled to survive and to raise liquidity via the capital markets or through their banks or financiers, be it credit facilities or long-term debt, with some having to cease operations. Ryanair’s corporate objective and strategy was to grow its fleet to 585 by 2024, further lower its fares and grow traffic from 120m customers in 2013 to 200m p.a. in 2024 while at the same time maintaining is fleet age at ~6.5 years.
To be able to announce an order of such magnitude, strategic planning and management would have considered their future financial objectives, competitor position, regulatory issues and staffing etc. Significant route analyses would have been performed and they would have carried our extensive cashflow analyses on the cost benefits on whether to order Airbus or Boeing aircraft. During the negotiation period, and while they are a Boeing operator, both airframe manufactures competed heavily to win the 200 aircraft order which led to Ryanair achieving what we believe, very keenly priced B737 MAX 8s, again meeting the corporate objective (keenly priced aircraft resulting in lower debt/per a/c) vs. other airlines thus achieving its growth targets and maintaining is low cost base.
Given the challenges airlines face; the industry is cyclical, they must comply with strict safety regulations, which can be costly plus they can be impacted overnight by factors outside their control such as the ash cloud in 2010, 9/11, wars, earthquakes, rising fuel prices, foreign exchange volatility for example. The relationship between Strategic Management and Management Accounting is critical in this regard, as the above examples are risks that need to be considered, to most critical now is Brexit which is almost on our doorstep. Brexit is posing new challenges and risks, causing airlines within Europe huge concern. Staying with Ryanair in this regard, as they have a very significant operation out of Stanstead in the UK, daily reviews are being carried out to establish the impact Brexit is going to have on non-UK airlines. Ryanair and others are working with the Aviation Working Group (AWG) to establish the likely outcome on issues such as; UK pilot licences, maintenance facilities operating under EU licences within the UK is causing significant concern which may leave the likes of Ryanair airlines faced with a lack of maintenance facilities to turn to carry out overnight maintenance plus higher cost may be demanded for other EU licenced facilities therefore impacting budgets, strategic plans, capital expenditure and corporate strategy.
Over the past two years, Ryanair have found themselves having to deal with issues surrounding pilot rostering, which led to the mutual resignation of a senior executive, the introduction of Unions to the airline and pilot strikes. All resulted in a significant number of flight being cancelled (rostering) and the uncertainty & disruption passengers endured because of flight cancellations (strike). These issues brought to the fore the bigger issues about corporate governance and sustainability and came weeks after the UK government’s reforms in trying to improve transparency and regain public trust in the corporate world, Ryanair were seen by the public and shareholders as having disregard for the value of people and service delivery. The value of the Ryanair shares dropped over ~$1.5M (largely restored since then) and the cost of the rostering debacle was €25-30M.
In addition to the cost factors and impact on the share price above, many continue to believe that Ryanair’s strategy is geared towards shareholders and not towards staff or corporate ethics as Michael O’Leary is known for using bad press as part of his mission. Ryanair has, for a long time, poor reputation in relation to how it treats staff, the flight cancellations highlighted that issue, thus bringing into focus the role of the consumer in shaping the employment governance and human resource management to a greater extent. Noting also, O’Leary reference to the pilots as ‘glorified taxi drivers’. No organisation should ever display such disregard for employees. Without more regulatory policy interventions being put in place, to curb the likes of Ryanair, probably will advance their own interests over those of others.
Part 3
To: The Senior Leadership Team (SLT)
From: Strategic Management Accounting Team (SMAT)
Re: Lessor Portfolio Management in a Downturn – Fleet Roll-Off & Order Book
Following the recent demise of two airlines in Europe, SMAT carried out a reviewed our business strategy in terms managing our portfolio in a downturn, as the industry faces many challenges such as:
• increasing fuel prices
• currency volatility to the US$ (given lease rates and fuel are in US$ world-wide)
• strong competition from other Lessors
• airlines becoming more sophisticated
• political uncertainties due to recent and upcoming presidential elections (e.g. Mexico, Brazil, Argentina, Colombia) in some of our major markets
• Brexit
• USA / Trump – NAFTA, Mexico signed in Q2 however uncertainties remain in respect of Canada
• liquidity challenges for airlines
• strong competition among airlines and finally
• Airbus new aircraft delivery delays
Keeping the above backdrop very much at the forefront of our mind and the SLT strategy in respect of Portfolio management which is:
• Business Net Income – $30Bn. (Net income is calculated by taking revenues and adjusting for the costs of doing business; i.e. depreciation, interest, taxes, technical expenses etc).
• Business ROI – 3% (Return on Investment: A measure of the effectiveness with which a business utilises its invested capital. (IRR of the after-tax cashflows). Calculated as annualised net income divided by average net investment for a given period)
• Business ROE – 30% (Return on Equity: A measure of the shareholders’ return on funds invested in a business. (IRR of the after-tax Equity Cashflows). Calculated by dividing annualised net income for the period by the average common equity for the same period)
• Transactions; No of aircraft to be placed; New 75; Used 100. ROI & ROE vs. Business targets to be met.
• Number of aircraft on the ground (AOG) < 5.
• Volume targets, Purchase and Leaseback (PLB) transactions, $20Bn. ROI & ROE vs. Business targets to be met.
• Transition costs between leases <$2M per aircraft
• Maintenance of a healthy and balanced portfolio of customers, 65% of customers rated CCC and above
• Appropriate fleet allocation
As we navigate through the next industry downturn and considering our current fleet of 1,600 aircraft, leased to over 250 customers in 50 countries, of which 100 aircraft (80% being narrow-bodies) will return off lease within the next 36 months in addition to 100 unplaced orderbook aircraft from both Boeing and Airbus, SMAT carried out an in-dept review of our processes, policies and procedures and sought input from each function within in the business.
The SMAT also continues to focus on the company’s capital structure (implemented by Head Office) i.e. the relationship between debt to equity (financial leverage), the primary driver in relation to the difference between the ROI & ROE. ROE is measured only on common equity whereas ROI is measured on total capital (debt and equity). The portion of investment funded with debt v’s equity i.e. if Leverage then ROI but ROE . For the purposes of this report, there are no change expected in respect to the various leverages applicable to our different financial products i.e. Loans, Operating Lease, Single Investor Leases, Volume (PLBs).
The cross functional team that contribute to the SMATs strategy thus the corporate strategy are as follows:
For the purposes of this report and the current industry environment, SMAT is focusing only on the following key functions; Pricing/Valuations, Risk and to a lesser degree, Technical & Legal.
Pricing/Valuations:
Key function within the business, responsible for pricing each deal transaction, existing fleet, orderbook and volume. Transactions are sourced by the Marketing team (sales) and their first port of call when a deal is at origination stage is to the Pricing/Valuations function. Implements the SMATs strategy in terms of funding costs, ROI and ROE targets and targeted technical costs (new aircraft or existing fleet aircraft). Collects market intelligence such as industry challenges, where possible how we are preforming vs. competitors, market rents and security expectations.
Asset performance is an important factor, in particular during a downturn as many older generation may be parked or returned off lease early due to high maintenance cost, less fuel efficient technology vs. newer aircraft or simply liquidity issues thus enabling the SMAT to evaluate existing pricing guidelines and set new ones, for example, rent expectations may change in the market due to funding costs (internal and external), another example, an aircraft may requires a different rental structure such fixed, floating, stepped (lower in the winter, higher in the summer or possibly short periods of ‘power by the hour’ rents (rent paid based on hours flown by an agreed rate).
This function is also responsible for managing the orderbook with manufactures, ensure correct aircraft prices, escalation factors etc, and monitoring any delays in delivery which in turn may impact our customers and possibly the ourselves. Recent example, Primera were unable to take delivery of our orderbook aircraft due to delayed delivery of their own aircraft from Airbus which in turn meant they lost out on summer trading which they had planned, leaving them cash strapped and unable to raise new equity in the markets.
SMAT see this as a key function, enables the SMAT to make sound corporate decision in relation to the returns on each transaction. As this function collates industry intelligence a recent example, a customer in Asia requested an aircraft slot swop from 2019 to 2022 (due to financial difficulties), the SMAT evaluated this request (following input from other functions, largely Risk & Technical) and agreed with the swop while at the same time maintain ROI/ROE and IRR. In relation to our orderbook aircraft at Primera, SMAT continues to adapt a forward-looking approach to evaluating and continuously monitoring airline financial performance and had recommended the remarketing of the aircraft well advance of Primera ceasing operations. The Pricing / Valuations function collated market intelligence via the marketing team and were able to recommend a list of possible alternative customers to SMAT who in turn reviewed the list of prospective customers with input from Risk, Pricing / Valuations and the Technical Functions. The aircraft was reallocated after reviewing the NPVs of the various transactions as the credit standing of each airline was different, transition costs was a key factor as they aircraft had been configured for Primera and therefore NPV analyses of each transaction had to be completed and considered as the lease term also differed, all the time keeping an eye on business ROI and ROE targets which need to be achieved. .
Risk
Essential function in today’s world whereby corporate governance is of utmost importance, comprising of underwriters and analysts. Responsible for challenging assumptions vs. targets set by SMAT, ensuring compliance surrounding the approval process, sign off on payment of aircraft purchases (order book and volume) for underwriting our airline customers; not only having an in-depth understanding of the airlines financial position, on and off-balance sheet but also understanding their franchise, competitive position, treats and weaknesses, access to capital markets and lines of credit plus their management team. As our business is a global one, airlines in one region may be suffering due to FX volatility or political / economic uncertainties e.g. Mexico & Brazil while another region may be thriving, that is not necessarily true today given fuel prices are increasing and raising additional equity / new lines of credit is challenging world-wide. Brexit, the outcome of which is still being determined, take Ryanair for example, while an Irish airline it has a significantly operation at Stansted with all pilots operating under EASA rules, the question remains what will need to change post Brexit, the same issue applies in terms of maintenance operators based in the UK, who have significant contracts with Ryanair (again under EASE standards).
Factors outside airlines control can also have a detrimental or significant impact on their business. Take Brazil as an example and excluding rising fuel prices and FX issues, airline financial results will reflect lower revenues, yields, net results due to the political uncertainty surrounding the Presidential election, the truck driver’s strike and the World Cup final. At the end of Q2 and into Q3 airline fuel could not be transported to many airports, and while some airports have piped fuel, many destination airports don’t and therefore airlines and passengers were stranded or chose not to fly, the strike lasted two weeks, consumers cancelled or did not book flights due to uncertainty on how long the strike would last or how the Government would intervene. In addition, during any World Cup final, Brazilian’s do not travel, both factors (Strike & World Cup) happened around the same time. SMAT work closely with the Risk function which again enables the company to meet its targets by setting corporate guidelines, for the Risk function, these guidelines include the level of investment the business can make and approve at the business level. The guidelines are agreed with the Risk function after considering the following:
• Credit rating of the airline (Determined from the financial statements / ratio analyses etc. using internal rating model like S&P ratings model).
• Credit rating output is based on qualitative (financial) and quantitative (Opinions) outputs.
• Current exposure already with the airline
• Customer performance to-date
• Underwriters view of customer/market derived from regular dialogue with the airlines CFO/Mgt. Essential in the business.
• Country risk, political & stability of the Legal system.
As above, in the re-allocation of the aircraft, with input from the Risk function, the slot was allocated to an alternative airline, only after a full credit review was carried out due to potential concerns flagged by the underwriter and subsequently mitigated following an in-dept review of the credit standing of the airline and meeting with the CFO. The concerns of the underwriter were confirmed however the airline CFO provided satisfactory evidence that the shareholder was providing addition equity thus supporting the airlines future.
In addition, the Risk function continuously monitor payment performance, this is a key indicator that an airline is facing financial difficulty as many airlines survive on having access to credit facilities or shareholder funds. In the case of Primera, with increasing fuel prices, delayed deliveries and lack of available credit facilities, all of which had been closely monitored by the underwriters, the SMAT was appraised and acted quickly in deciding to reallocate the aircraft elsewhere as outlined above and in addition avoiding an AOG, a key metric rating agency monitor.
Technical
Responsible for the transition of aircraft from manufacture or prior airline to the next while operating within target budgets. Key function in the formation of every transaction, work closely with the Pricing/Valuations function to ensure transactions are priced accurately in achieving the business ROI/ROE, plus ensures aircraft are protected and maintained in FAA / EASA approved facilities, reducing the risk of liens being imposed. Work closely with the airlines Technical Departments and given the longevity of our business, seen as leaders in the industry from a Lessor perspective when it comes to transitioning aircraft from one airline to another due to hands on approach and expertise. Key function for the business in times of aircraft repossession, to-date, almost all our repossessions have been considered amicable due to close relationship with our customers.
Legal
Not only are is the Legal function responsible for documenting our transactions within the law, they also provide updated jurisdiction analyses a recent example, Argentina recently adapted Cape Town which places aircraft Lessors in more favourable position when it comes to repossession of assets, under Cape Town, a register of assets is known which mitigates the risks associated with repossession / liens that previously could have been imposed prior to Cape Town being ratified. In evaluating country exposure or risk, a process like the Risk exposure in terms of asset value placed with an airline, is carried out, if the legal system is unfavourable from a Lessors point of view, SMAT limits the value of assets to be placed in that country. In the case of Argentina, SMAT view the ratification of Cape Town as a positive and will evaluate the current exposure limited, however given the IMF recently provided almost $70Bn in support to Argentina, the current currency devaluation and the upcoming electing in ’19, a decision on amending the country exposure level is being deferred to a later date.
Conclusion:
On reviewing the fleet roll off and orderbook facing the business over the next 36 months in conjunction the corporate strategy, existing policies and procedures plus the challenges facing the business / industry, the SMAT believe we are well poised to successfully manage through this industry down turn on the following basis:
• The business has implemented and continuously monitors policies and procedures surrounding transactions and aircraft allocations and re-allocations, changes are made based on actuals (verified) vs. targets, to support changes. For example, market rents on some aircraft types have declined. Customer ratings likely to decline post 2018-year end results, many impacted by FX & increase fuel prices, may impact customer exposure levels. Plus, jurisdiction updates expected to change view on possible exposure levels in a small number of countries.
• Continue to monitor Brexit, still very little clarity on likely outcome for our industry, SMAT to revert once greater clarity is available as the consequences to the airline industry is very difficult to quantify currently. SMAT may need to revert to the SLT with recommendations on alternative course of action for the business.
• Some leases may require early termination, SMAT appointed a Restructuring Leader who will monitor all possible problem accounts.
• In-depth reviews by underwriters continue, and report to Restructuring Leader who is working closely with the Pricing/Valuations function to ensure NPV analyses on existing fleet aircraft is being carried out when evaluating early terminations/re-deployment vs. restructuring at lower rents (due to market demand) with a possible QPQ of an extend lease term.
• Employees, cross functional transactions teams have been trained to address problem accounts and to report immediately to the Restructuring Leader and in turn SMAT.
• In the event of repossessions, safeguarding of assets remains a key priority with the Legal function taking the Lead in this regards as possible issues arise.
• Following on from the last point, Corporate Governance continues to be at the fore front of everyone mind as we navigate our way to through this downturn, controls in relation to payment demands in respect of possible lines continue to be reviewed, noting the recent collapse of Cobalt in Cyprus has disclose this is not a favourable jurisdiction for Lessors to do business as liens such as fuel, Eurocontrol, airports, and airport service cost have been imposed on the leasing companies aircraft.
• Continue to monitor external factors such as the new president in Brazil and the direction or impact the new president has on the future policies of the country,
• Monitor the economic issues in Argentina given IMF funding is under way and up- coming election in 2019. Given our exposure in this country is low, and we recently had our leases restated following the ratification of Cape Town, SMAT deem our exposure in Argentina to be Low Probability / Low Impact on the Risk Management Table.
Bibliography
Business knowledge
IPA Manual – Year 3 & 4.
Drury 9th Edition
Watson / Head 6th Edition
https://corporate.ryanair.com/about-us/our-fleet/
https://nscpolteksby.ac.id/ebook/
Appendices
Appendix 2: Risk Management Table
High
1 2
Impact
3 4
Low
Low Probability High
Management focuses on business risked based on the probability and impact, quadrant 2 type risk is deemed high impact & high probability to the business. Quadrants 1 & 4 can be tolerated and quadrant 3 should be looked at but is deemed lease risk (low probability low risk to the business.
2018-11-15-1542278896