Question

Depreciation and advance prepayments

Pan Asia Airlines was founded in 1980. Headquartered in Hong Kong, the publicly traded company has routes throughout Asia and to major airports throughout Europe and North America. While Pan Asia charges a premium of 10 to 20% over its competitors, customers have not been deterred from using the airline because of the high quality of service.

A key reason for this reputation for high quality is the company's relatively young fleet of aircraft, with an average age of five years and no plane older than eight years. To maintain a young fleet, Pan Asia replaces its planes regularly to ensure that the planes are equipped with the latest technology and operate efficiently. Other airlines typically have fleets with an average age of 10 years, while discount airlines have even older fleets, with an average age of 15 years. A well-maintained aircraft can last for 20 to 25 years, or even more in some cases.

Each of five regional managers has responsibility for all investment and operating decisions for his/her region. The company evaluates each region as a profit centre. The decentralized structure allows each region to respond quickly to changes in its market.

Financially, the company has been consistently profitable in recent years. Stock analysts have projected a target price that is 20% higher than the current price of $32.50 per share, based on their projections of earnings before interest, taxes, depreciation, amortization (EBITDA). Because of its solid financial performance, Pan Asia has earned a high credit rating, allowing it to borrow at a rate of 6%. Debt currently comprises about 40% of assets, while liquid assets amount to about 10% of assets, which total approximately $2 billion.

It is now February 2012. A new chief executive officer (CEO), William Chan, has been appointed following the retirement of the founding CEO. Chan has a background in mechanical engineering and previously served as Pan Asia's chief operating officer for the past 15 years. While Chan has a thorough understanding of the company's central operations, he is less familiar with other aspects of the company. Consequently, he has spent the last three months reviewing the company's marketing program, human resources, information systems, treasury, as well as accounting.

During this review, Chan has identified a few issues that he would like you, the chief financial officer, to explain to him.

1. The CEO noted that Pan Asia uses the declining-balance method of depreciation. He also noted that many (though not all) competitors use the straight-line method. He wonders whether Pan Asia should consider conforming to the majority in the industry.

2. One of Pan Asia’s manufacturers has recently started a promotion that offers a significant discount to airlines that make advance payments on their aircraft orders. The discount amounts to 15% of the regular price. To obtain the discount, Pan Asia would need to pay in full when it orders a plane, rather than when the manufacturer delivers it. Typically, the amount of time between order and delivery is two years. Chan is unsure whether he should encourage the regional managers to take up this offer. He is also wondering what the effects might be for the financial statements.

Required: Draft a memo to the CEO that addresses the issues raised.

Answer 1

Facts given:

Current EBITDA = $32.50 per share

Predicted EBIDTA = $39 per share

Avg age of flight = 5 years

Debt borrowing rate = 6%

Debt = 40% of assets

liquid asset (10% of asset) = $2billion

workings

liquid asset =10% of asset= $2 billion

Total asset = $20 billion (2/0.1)

Total Debt = $8 billion (40% total asset)

interest on debt(6%) = $0.48 billion ($8*6%)

Findings

1. the company should follow the declining-balance method of depreciation. This is because the company uses a young fleet of airlines ranging from 5 to 8 years. So providing depreciation at this method will provide a reduced burden of depreciation expense on the company. And also the competitors use the airlines for more than 10 years, so so using straight line of the method is not appropriate.

2. Yes, the company should buy the flights for a discount of 15% offered by the manufacturer. Since debts are available at a cheap rate of 6%, using debt finance for the purchase of flights will act as a leverage in boosting the profits.