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Monday, July 03, 2017

Bankruptcy process and the utilisation of assets

by Ajay Shah.

The capital cost per day of a plane


An Airbus that's typically used in India costs roughly \$100 million and works for roughly 25 years. The pure capital cost is roughly \$4 million a year for the depreciation and \$9 million a year for interest (assuming the borrower pays 9% in USD). This adds up to \$13 million a year for the privilege of owning the plane for 365 days. This maps to \$35,616 per day.

In other words, each day of down time by the plane is a cost of \$35,616 or roughly Rs.2.3 million.

Efficient use of planes by a dictator


If you were a dictator and ran the economy efficiently, you would be very focused on down time. The most important thing is to keep a plane working every day. You would try to ensure that the plane flies on every single day.

The economic inefficiency in airline failure


Airlines are vulnerable to fluctuations of fuel prices and fluctuations in traffic. The world over, private airlines fail a lot.

If an airline fails, and if the planes that belong to it sit idle on the tarmac, that is a substantial cost. Each day of down time for a plane is a cost of capital of Rs.2.3 million. As an example, it appears that 40 planes belonging to Kingfisher sat idle for a year. Going by our rough calculation, that's an opportunity cost of capital of Rs.33.8 billion. For a moment, let's not think about who paid this cost. A cost is a cost. Someone paid the cost; it was a cost to society. A plane that does not fly is capital that is wasted. The dictator would be laughing at our inefficiency - he would say that he would never waste capital like this.

In addition, airline bankruptcies can also be extremely disruptive if people have purchased tickets for flights, well ahead of time, and if the bankruptcy leads to flights being cancelled.

A market with multiple competing private airlines is better than a dictator as there is competition and innovation. But the efficiency of capital use is degraded if there are repeated bankruptcies, and if each airline failure gives a protracted patch of wastage of planes that are idle. The efficiency of the economy is hampered if people show up at the airport and find that the flight was cancelled.

A well functioning bankruptcy process


If the bankruptcy process works well, the airline should be protected as a going concern.

No planes should be grounded. No flights should be cancelled.

Efficiency for the economy is about the physical planes performing their scheduled flights. Nothing should change on this.

The airline is an ephemeral legal person that owns the planes. The bankruptcy process should rip up the structure of liabilities of the airline, impose losses upon the previous holders of equity and debt, and replace them with a new configuration of equity and debt. A great churning would take place in the financial structure of the firm. The fact that this drama is taking place should not interfere with the efficient use of planes on the scheduled flights.

Capitalism is messy. A well functioning bankruptcy process protects the efficiency of capital use while the messy events play out.

Conclusion


A good bankruptcy process is one where fluctuations in the firm and its financing structure do not interfere with the core business of planes that fly continuously. Customers should never see a disruption of service, and the planes should never sit idle.

For a country to harness the efficiency and innovation that comes from multiple private competing airlines, a sound bankruptcy process is the secret sauce that achieves the normative ideal for the efficiency of capital utilisation -- the use of planes by a dictator.

1 comment:

  1. From a process perspective if i was just make a point from Indian perpective, it requires pre packs as an option under IBC 2016. The same is missing and players wont risk geeting into it unless it is specifically provided for in law and regulations.

    Otherwise the government's role is to create and maintain conducive environment , design incentives in a manner that the overall cost to society or country is minimized.

    Unfortunately that is not the case , people involved in the process invariably focus on visible costs and over look the invisible ones & end up in sub optimal outcomes.


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