Sources of Funding for Airline Start-up - Coursework Example

Airline Business Introduction One of the most pertinent features of the contemporary airline market is that airlines today come and go, which means that as one airline exits a specific market, it is replaced by another airline, usually an airline start-up (Vasigh et al, 2012: p29). Moreover, there has been an exponential rise in the number of low-cost airline carriers, which has led to the market entry of numerous new airlines over the past ten years. In essence, airline start-ups need to access two primary funding sources that include aircraft finance and working capital. Indeed, Abu-Taieh (2011: p58) notes that while an airline may put together the best management team and business plan, failure to access sufficient funding and finance makes short term success of the airplane impossible. At present, start-up capital required to finance the working capital needs is readily available by historic standards, specifically if the project is right for investors. This paper analyse possible sources of funding for an investor seeking to launch an airline start-up, while also discussing the advantages and disadvantages of the different sources of funding. Moreover, the paper will seek to identify factors that investors are likely to consider prior to evaluating funding requests. Sources of Funding for Airline Start-up Direct Lending and Direct Purchase Agreements One source of funding that an airline start up could use is a direct lending. In this case, an airline could decide to take out an unsecured or secured loan as working capital but more specifically to purchase commercial aircraft (Wynbrandt, 2014: p47). Moreover, the airline start-up may receive a loan for a syndicate of banks since the transaction may be quite large. Since commercial aircraft costs could reach several hundreds of millions of dollars, security interest accompanies most aircraft purchase direct lending, which means that the loaning bank could repossess the aircraft if the start-up fails to pay back the loan. Generally, obtaining private financing that is unsecured to purchase an aircraft is very difficult unless the airline start-up is considered especially creditworthy. Still, there are some governments that use the Large Aircraft Sector Understanding to fund exports of aircraft produced domestically, an agreement is providing for aircraft purchase financing at close to 175 points for ten years over the prime rate (Wynbrandt, 2014: p47). In addition, there is also an option for the start-up airline to lock interest rates in up to twelve weeks before receiving the loan. Such terms tend to be more attractive for start-up airlines, rather than large operators, since the latter can obtain less expensive aircraft using other means of financing (Alcock, 2014: p136). Because this source of funding results in airline star-ups owning the aircraft directly, it is possible for them to deduct costs of depreciation for the purpose of filing tax returns, as well as to spread out the costs of depreciation to improve profits. However, before introduction of leasing for commercial aircraft thirty years ago, airlines owned by private firms were vulnerable to fluctuations in the market because they were required to take up high debt levels so as to buy new aircraft and equipment (Alcock, 2014: p136). With time, leases have afforded commercial airline start-ups more flexibility in the amount of debt they can accumulate. A more specific form of direct lending in the airline sector is the direct purchase agreement, in which the airline start-up buys the aircraft from the vendor or manufacturer directly using a structured finance lease or a secured mortgage loan (Vasigh et al, 2010: p61). In this case, the advance amount for the aircraft could vary by almost ninety percent, which will be dependent on the start-up airline and the capital it has available. Generally, such loans are structured in a mortgage style amortization with a term of up to twelve years, while the interest rates could either be floating or fixed in nature. As noted above, several lenders are likely to come together and form a syndicate, which will provide the start-up airline larger loan packages. Direct purchase agreements possess several advantages when used to directly buy aircrafts for a start-up airline. For example, a start-up airline that uses direct lending or direct purchase agreements can build up equity in the purchased airplanes as it repays the finance lease or the mortgage (Vasigh et al, 2010: p61). Moreover, the start-up airline will own the aircraft they purchase, which means that they can continue to modify the airplane to its preferred exact requirements. Finally, direct purchase agreements have an advantage in that the start-up airline that owns the aircraft can gain substantial benefits of taxation in majority of countries (Bjelicic, 2012: p12). However, use of direct lending or direct purchase agreements has several disadvantages for the start-up airline. For instance, at the end of the lending or purchase agreement term, the start-up airline will be subjected to residual value risks. In addition, this source of funding presents a form of ownership that is less flexible, especially when compared to operating leases that will also be discussed. Finally, Using this source of funding for a start-up airline could weigh down the start-up’s balance sheet, in turn influencing other covenants made with banks (Bjelicic, 2012: p12). Operating Leasing Generally, start-up airlines can lease commercial aircraft through the GE Commercial Aviation Services and the International Lease Financing Corporation, which are offered by commercial Aircrafts Leasing and Sales companies. Typically, operating leases tend to be short term with a duration of up to ten years, which makes them especially attractive for start-up airlines, although it is also attractive for established carriers that wish to expand tentatively (Schofield, 2011: p20). Such a short duration is particularly useful in preventing airplanes from being rendered obsolete, which has become especially important in many countries because of changing environmental and noise laws. For countries where a start-up airline may be considered less creditworthy, such as in less economically developed countries, this source of funding may be the only choice where start-up’s want to acquire new aircraft. In addition, using operating leases gives the start-up airline more flexibility, which enables them to more closely manage the composition and size of their fleet, thus contracting and expanding their fleet in response to demand (Schofield, 2011: p20). The residual value of the airplane when the operating lease ends is a critical consideration for aircraft owners, specifically since they could require that the start-up airline returns the aircraft in the same condition maintenance-wise as was delivered to enhance the next operator’s turnaround. Security deposits are required for operating leases, just as in other funding fields (Butler et al, 2010: p33). The wet lease is one form of operating leasing, whereby an airplane and a crew are leased together. Normally short-term in nature, wet leases are meant to cover demand fluctuations, such as during the tourism season. In this case, the aircraft operates using the airline code of the start-up airline, as well as part of the start-up airline’s fleet, although it normally keeps its owner’s livery. Different countries have different operating leases accounting rules, in which some like the UK allow for the capitalization of expenses from operating leases on the balance sheet of the airline, while others like the US generally report expenses from operating leases as operating expenses (Butler et al, 2010: p34). Leaseback, which is related to the operating lease concept, would involve the start-up airline selling their aircraft and then leasing them back for periodic payments (Mueller, 2014: p54). Such funding enables the start-up airline more flexibility in altering the size of their fleet. In the operating lease, a start-up airline has to agree to a contract that enables it to utilize the airplanes for a set payment and a specific time period. By paying the rental fee, the start-up airline will have the permission to use the airplane, rather than to own it as with the direct purchase agreement. In this case, the leaser retains title ownership to the aircraft after they purchase it from the vendor or manufacturer. The operating lease period is normally shorter than the leasing entity would get if they used a finance contract, although wide body aircrafts have longer lease periods than narrow body airplanes that last for three to seven years (Mueller, 2014: p55). When the aircraft lease ends, the start-up airline can either return the aircrafts or offer to buy them. The start-up airline is usually required to at least give the leaser a security deposit of three months rental that the leaser returns when the lease ends, although this is dependent on the aircraft being returned in the agreed-upon condition. Market demand is a critical determinant of monthly costs of the rental, although Bowyer and Davis (2012: p370) approximate that most monthly rental costs are roughly 1% of the aircraft’s purchase cost. Just as with direct lending and direct purchase agreements, operating leases have several advantages, one of which is that the start-up airline has reduced initial capital requirements. In addition, operating leases eliminate residual value risk, which will be retained with the aircraft’s owner or the leaser. Moreover, operating leases have less banking restriction impacts as liabilities are not included on the balance sheet. However, this source of funding has several disadvantages, such as the fact that the lessee owner retains all the aircraft’s built up equity. Operating leases also avail smaller tax benefits in general (Bowyer & Davis, 2012: p371). Finally, it is possible that the aircraft’s owner could impose restrictions on the aircraft’s use that is erroneous. Finance Leasing Also referred to as capital leasing, finance leasing is an arrangement whereby start-up airline will come closer to being the “owner” of the leased aircraft, especially since it is generally loner-term in nature compared to operating leases (Schofield, 2013: p32). In this case, the transaction is more complicated whereby the leaser buys the airplane through equity financing and debt, after which they lease the aircraft to the airline start-up. Thus, the airline start-up could opt to buy the airplane when the lease expires, while they may also receive the airplane when the lease expires. Generally, a finance lease involves the leaser getting most of the rights of aircraft ownership, as well as where the present minimum lease payment values for the lease’s period is more than 90% of the aircraft’s fair value on the market. As such, a finance lease is considered as the start-up airline’s asset, as compared to operating leases where the aircraft only affects the cash flow of the start-up airline (Schofield, 2013: p32). Finance leasing is especially attractive to start-up airlines because they can claim deductions based on depreciation over the useful life of the aircraft. This, in turn, offsets lease profits for the purpose of taxation, while also enabling the deduction of paid interest to creditors involved the purchase’s financing (Canaday, 2014: p48). As such, aircrafts have become increasingly attractive for investors seeking tax shelters, while also making finance leasing cheaper to direct purchasing agreements and operating leases. There are several types of finance leasing available to airline start-ups. One of them is the equipment trust certificate, which is where investor trusts buy an aircraft and lease it to the start-up airline. In this case, the start-up airline is required to receive the aircraft’s title when the lease is completed. According to Pilon and Sonokpon (2014: p44), equipment trust certificates are increasingly becoming a hybrid between secured lending and finance leasing, tending more towards securitization agreements. Another form of finance leasing available to start-up airlines is the extendible operating lease, in which the start-up airline possesses the option to end the aircraft lease at particular periods, such as after every two years. Therefore, it is possible to consider this source of funding as an operating lease, depending on the applicable accounting rules of the start-up airline, as well as the termination right’s timing (Pilon & Sonokpon, 2014: p45). Finance leasing has several advantages, one of which is that the capital lease has numerous qualities of an aircraft purchase. Lease terms for the aircraft will extend for almost 75% of the aircraft’s lifetime, which means that the airline start-up will get more from the aircraft as compared to the aircraft’s real owner (Copur, 2014: p54). Finance leases also provide the airline start-up with the option to purchase the aircraft when the lease ends, normally at a market discount price. Another advantage has to do with tax deductions; particularly regarding the fact that the start-up airline can claim tax deductions on the finance lease’s cost. In this case, the start-up airline can acclaim deductions for every year they operate the leased aircraft, which is considered as depreciation. However, finance leasing also portends several disadvantages to the airline start-up. One of these has to do with reporting, whereby the start-up has to record the capital lease agreement in their financial statements (Copur, 2014: p55). As such, all future lease payments at present value are included as debt, which increases liability value on the start-up airline’s balance sheet. The start-up’s finances see less attractive as a result, imposing banking restrictions for future borrowing (Cantle, 2012: p6). Thus, some start-up may seek to avoid finance leases so as to reduce their balance sheet liabilities. Finally, finance leases also possess a disadvantage regarding maintenance responsibilities, in which the start-up airline has to care for the maintenance and repairs of the leased aircraft. In turn, this could reduce the firm’s profits as it increases expenses. Moreover, any long-term deterioration of the aircraft during the term of the lease will mean that the start-up has to purchase the aircraft and take full ownership. This means that any decline in the aircraft’s value in case it is made obsolete by new technology or it sustains damage will cause the start-up to suffer losses (Cantle, 2012: p7). Factors of Interest to Potential Investors in the Airline Start-Up In order to determine whether to invest in the start-up airline, there are several factors that investors will have in their checklist. The first factor they may consider is the capacity of the start-up airline to repay their investment (Moores, 2012: p52). In this case, the investor will want to ascertain how the start-up airline intends to repay the investment funds prior to approving the investment. Investors use several means to evaluate the capacity of the start-up airline, including their expected cash-flow from the business plan. Projected cash-flow, as in this case, is defined as the income that the airline expects to generate against the expenses that the airline will incur in its operations (Moores, 2012: p52). For instance, if the start-up airline expects to generate $10 million every month as revenue with expenses of $8 million, an interested investor would come to the conclusion that the cash flow per month is $2 million, which the airline could use to refinance the investor. Should the cash flow be zero or below zero, the investor would be less likely to invest in the airline because of concerns about how the company will repay the investment. Potential investors may also use payment history, which is defined as the previous timeliness of payments on previous investments, to evaluate the capacity of the start-up airline (Haslinger, 2011: p614). While investors may have found it difficult to determine the payment history of smaller entities in the past, credit ranking companies and more collaboration between different investment banks has made it easier to learn of an entities previous history. Another way that potential investors may find out about that capacity of the start-up airline is by considering contingent repayment sources, which are other sources of income that the entity behind the start-up may use to furnish the investment, such as personal assets and current bank accounts. Ultimately, if the start-up airline selects direct lending as the source of funding, capacity would be the most important requirement, specifically through checking the projected cash-flow of the start-up airline (Haslinger, 2011: p615). Potential investors in the start-up may also consider the capital possessed by the start-up. Generally, the owner of any start-up must invest and risk their own funds before an investor is willing to consider investing in the company (Morrell, 2013: p50). This capital is defined as the personal investment of the start-up’s owner into the airline, which would mean that they would also lose their own investment if the start-up fails. According to Mandell (2012: p22), most airline investors prefer that the owner of the business invests at least 25% of the total funding required for the start-up. Potential investors may also consider collateral owned by the start-up airline’s owner(s), including bonds and stocks, heavy machinery, and other business assets, which they could sell in case the owners are not able to repay their debts. In this case, the personal assets of the owner(s) are required by investment banks in order to approve any investment funds (Holloway, 2010: p62). When the start-up airline can provide the personal asset(s) of its owners to guarantee funding for its business, this means that these assets can be sold if the start-up cannot be repaid. References Abu-Taieh, E. M. O. (January 01, 2011). Foundations of Airline Finance: Methodology and Practice. International Journal of Aviation Technology, Engineering and Management (ijatem), 1, 1, 58-60. Alcock, C. (January 01, 2014). 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