To: | D. Scott Sheldon, Chief Financial Officer, Allegiant Air | From: | Kristen Harris, Senior Financial Analyst, SH&E | Date: | September 5, 2014 | Re: | Evaluation of Fleet Expansion – A-320 vs. MD-80 | | |
SH&E conducted an intense, detailed and comprehensive analysis, that included thorough research and exploration into Allegiant Air’s fleet expansion needs. To complete this analysis we compared existing and current market statistics, which pertains specifically to the fleet expansion needs. It is the recommendation of SH&E, that Allegiant Air purchase the McDonnell Douglas MD-80’s at a price of $4,000,000. It is the belief of SH&E, that the purchase of the McDonnell Douglas MD-80’s, is a prudent and sensible decision, versus a price of $62,600,000 for the Airbus A-320.
SH&E thorough research showed that given the net present value, also known as NPV, the expenses for the McDonnell Douglas MD-80 is estimated at $44,200,000, in comparison to the Airbus A-320’s NPV of $93,600,000. If Allegiant Air were to purchase the McDonnell Douglas MD-80, over the fifteen year lifespan, this would allow Allegiant Air to save approximately $50,000,000 in operating costs.
There is a summary below of the analysis and research that includes the methodology and assumptions that were used to conduct and thus support SH&E’s recommendation. The McDonnell Douglas MD-80 has a different seating capacity than the Airbus A-320.To compare these aircraft, a Cost per Available Seat Mile, also known as CASM, was used as the suitable decision criterion. Another way to think of this comparison is to use an example-for instance, SH&E would never recommend to a bus transportation business or company that it should purchase a fleet of small vehicles. The reason for the recommendation is that the costs of operating the vehicles are less than the cost of fifty bus seats, but not practical for a bus company.

Summary of Fleet Expansion Recommendation
Methodology
SH&E used various methods to formulate the assumptions. Some of the methods comprised of evaluating existing market data from numerous influential, prominent and leading sources. The methods and sources used are described and explained as follows:
Aircraft Performance and Operating Costs
To conduct an evaluation of aircraft performance and operating costs, Airline Monitor was used as the principal source. Airline Monitor, is a leading source for the airline industry data, facts, information and statistics for commercial aircraft and global airlines. The detailed operating costs for the McDonnell Douglas MD-80 were acquired from Allegiant Air’s described data. To calculate the Airbus A-320’s operating costs, SH&E calculated this by means of industry data, which factored in some of the key assumptions below. * Aircraft Pricing. Published on Airbus’ website, www.Airbus.com, SH&E found the 2014 aircraft pricing evidence and statistics, for the purchase of the Airbus A-320. Allegiant Air has very high creditworthiness and an extremely robust balance sheet, so the purchase price for the Airbus A-320, would have a 33% discount off of the purchase list price. The price of the price of further purchases of McDonnell Douglas MD-80’s was set at $4 million. This is founded on Allegiant Air’s assurance and confidence that it can remain acquiring these aircrafts at the same price, especially considering that several industry airlines, such as American Airlines and Delta Airlines, are slated to decrease their fleet of MD-80s. * Jet Fuel Prices. In SH&E’s analysis, the future forecasts and projections of jet fuel prices was extremely critical. For the first year, the present jet fuel prices were used. On the other hand, because of the petroleum’s price, which is extremely volatile in nature, future forecasts and estimates are somewhat unpredictable. Nonetheless, two sources for fuel price forecasts were examined. They were the U.S. Energy Information Administration (EIA) and the International Air Transport Association (IATA). The EIA and the IATA, over the next few years, both expect a decline initially in the jet fuel prices. Both the EIA and the IATA state that after the decline, there will be a steady incline over the following decade. Upon reviewing all of the data, SH&E relied on the information from EIA’s Annual Energy Outlook 2014 Early Release Overview. This provides an analysis which is more comprehensive, in regards to the price of fuel. This overview also comprised an annual projection for the next fifteen years (please see attachment 2). While the fifteen year projection shows an average annual growth rate of 2.0%. However, the EIA expects the annual growth rate to be more realistically at 2.5%, between 2014 and 2040. SH&E selected the higher rate of increase in our examination, especially because of the volatility of fuel prices. The 2.5% rate of increase was used in years 2–15 (please see attachment 1). * Discount Rate: SH&E attained Allegiant Air’s financial figures and information from the Allegiant Air website, www.allegiantair.com. SH&E was particularly researching Allegiant Air’s Return on Investment Capital (ROIC). In Allegiant Air’s 2012 Annual Report, the ROIC was 15.6%. In a 2013 press release, Allegiant Air’s fourth quarter ROIC was 16.4%. SH&E averaged the 15.6% and 16.4% for a discount rate of 16%
Key Assumptions. SH&E used the subsequent critical assumptions in the investigation: 1. Due to Allegiant’s solid balance sheet, the price of the Airbus A-320 has a 33% discount off the purchase price. 2. For the Airbus A-320, year sixteens sale price shows a price of the A-320 at one-half of the purchase price. For the McDonnell Douglas MD-80, in year sixteen, the sale price also shows an opportunity cost for scrap metal at $100,000. 3. For the Airbus A-320, when considering the hourly block for maintenance and gallons of fuel, it is comparable to Spirit Airlines, which reportedly have the lowest costs. Also, the Airbus A-320 hourly block costs for operating for speed, are comparable to Virgin Airlines, which reportedly has the highest reported costs. 4. Considering the maintenance costs for the aging fleet of McDonnell Douglas MD-80’s, SH&E shows and increase cost of 5% annually, while the Airbus A-320’s maintenance costs decline 2% annually. 5. While the Airbus A-310 has a greater range capability, the hourly block cost is about 20% greater than the McDonnell Douglas MD-80 annually. 6. For the reason that expenses related to the aircraft crews are not anticipated to change, SH&E have not included them in the analysis.
In Attachment 1: Allegiant Air Fleet Replacement NPV Analysis, shows the comparison of the NPV costs of the McDonnell Douglas MD-80 and the Airbus A-320, which also includes the operational cost annually. SH&E also conducted sensitivity analysis, while changing the discounts rates from 10% to 20%, however this analysis did not alter SH&E’s recommendations. Likewise, SH&E also completed a sensitivity analysis on anticipated fuel prices, which included increases from 1% to 5% annually. This also did not alter SH&E’s recommendation. In both scenarios, using the sensitivity analysis over fifteen years, the NPV cost for the McDonnell Douglas MD-80 was lower than the Airbus A-320,
In SH&E’s analysis of the cost per available seat mile (CASM), the cost for the McDonnell Douglas was $0.01837, while the Airbus A-320, was $0.02629. SH&E recommendation is that the McDonnell Douglas MD-80 is the best decision financially for Allegiant Air. This recommendation will allow for sustained aggressive development with the further addition of the McDonnell-Douglas MD-80s at $4,000,000.
On behalf of SH&E, thank you Mr. Sheldon, for allowing SH&E to provide information and analysis to you and Allegiant Air. SH&E greatly appreciates the consulting contract. If you have any other questions or need more analyses, please do not hesitate to contact me. Again, thank you!

Attachments (2): 1. Allegiant Air Fleet Replacement NPV Analysis; 2. Projected Jet Fuel Prices

Notes:
1. This graph was prepared from data and statistics found in the Energy Information Administration’s Annual Energy Outlook 2014 Early Release Overview-Energy Prices by Sector and Source from www.eia.gov/forecasts/aeo/er/index.cfm.
2. The data source for the jet fuel price projections were initially shown in dollars per million British thermal units (BTUs) and successively adapted to dollars per gallon of jet fuel using the conversion rate of 1,000,000 BTUs = 7.8782549283200005 gallons of naphtha type jet fuel.
3. Over the 15 year period, the average growth rate was 2.0%. The EIA forecasts a 2.5% annual growth rate from 2012–2040.