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. Since it began operations, Pan Asia has been consistently recognized for its 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 sells and replaces its planes regularly. The frequent replacement ensures that the planes are equipped with the latest technology and operate efficiently. Other full-service airlines typically have aircraft fleets with an average age of 10 years, while discount airlines have even older fleets, with an average age of 15 years. These older ages are partly due to the airlines using the same aircraft for more years, and partly a result of them buying used aircraft sold by other airlines and leasing companies. A well-maintained aircraft can last for 20 to 25 years, or even more in some cases.
The company has a decentralized management structure. Each of five regional managers has primary responsibility for all investment and operating decisions for his/her region (Asia north of Hong Kong, Asia south of Hong Kong, West Asia/Middle East, Europe, and North America). 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, and amortization (EBITDA). Because of its solid financial performance, Pan Asia also 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 (cash, short-term investments) amount to about 10% of assets, which total approximately $2 billion (Canadian dollars).
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 past 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. In recent conversations with stock analysts, Chan noted that they often ask about the company’s EBITDA and what his outlook is for that figure. He is wondering about the merits of using this figure in comparison to the bottom line net income that is reported in the financial statements.
3. One of the two aircraft manufacturers that Pan Asia uses 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 price that Pan Asia would otherwise have to pay. 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 he raised.