1 March 2000

Hon Derek Quigley
C/o The Department of Prime Minister & Cabinet
5th Floor Reserve Bank Building
2 The Terrace
WELLINGTON

Dear Mr Quigley

As requested, please find a copy of our final report on the financial issues associated with the lease of the F-16 A/B aircraft attached to this letter.

Bryan Wilson
for Secretary to the Treasury

FINANCIAL ISSUES ASSOCIATED WITH THE LEASE OF THE F-16 A/B AIRCRAFT

Executive Summary

• The 1998 Air Combat Capability policy study focused on defining New Zealand's future air combat capability requirements within the policy context of the 1997 Defence Assessment (DA97). It considered the F-16 'type' aircraft to be the most suitable option for replacing the A-4 Skyhawk and fulfilling New Zealand's future air combat capability requirement.

• A Net Present Value (NPV) calculation of the F-16 A/B 'lease-to-buy' deal results in a net cost saving of $316 million compared to the purchase of new F-16 C/D aircraft to replace the A-4 Skyhawks (A-4s) at a later stage. However, bringing forward the replacement of the A-4s adds pressure to NZDF's budget - generating a tension between the long-term cost effectiveness and the short-medium term fiscal impact of the lease-to-buy option.

• Excluding the operating costs, the capital cost of the F-16 A/B project is estimated at $1022 million. However, this figure assumes that all the equipment purchase options will be exercised, for example the purchase of the aircraft after ten years ($287 million), and does not allow for possible sale proceeds from the A-4s (US$60-70 million). Some risk still remains around some of the other costs, for example, the support package ($238 million), due to possible Foreign Military Sales scheme (FMS) price increases.

• Confirmation of the lease results in the Government facing the short-medium term fiscal impacts of the deal - but enables it to replace its air combat capability at least-cost (on the assumption that a deal like this is unlikely to eventuate again).

• Cancellation of the lease requires 180 days notice. Payments during this time will accrue. Legal advice indicates that New Zealand may be entitled to a refund of all or part of these payments. The support package can be stopped at any time without further payments accruing upon termination. However, NZ must pay all costs incurred by the US Government (USG) and its contractors. Payments made to the USG for the lease and support package to date amount to approximately $35 million. The next payment of $57 million is due on 15 March 2000. Payments to (and including) 15 September 2000 amount to approximately $111 million.

• Other options for deferral and amendment require further investigation and will require discussions with the USG. The costs of these options are unclear at this stage.

• In our view, there is still significant risk around some of the figures provided by the NZDF and the MoD. In particular, around the figures in the Defence Capital Plan (DCP).

Purpose

The purpose of this paper is to outline the fiscal impacts of the issues raised in the terms of reference iii, v, vi, and vii in the Lease of F-16 Aircraft: Review.

Four annexes are also attached:

• Annex 1: Capital, outlining the history of the Defence Capital Plan and current pressures on the Plan;

• Annex 2: Operating, outlining the background to the operating baseline and current operating pressures;

• Annex 3: Estimated total operating costs of the F-16 A/Bs over 25 years (25YrD11ABX); and

• Annex 4: Estimated total operating costs of the A-4s and replacement F-16 C/Ds over 25 years (25YrD11CDX).

This report assumes that New Zealand will continue with its policy of maintaining a balanced force ⁴, capable of operating with the forces of partner countries. In our view, it is important to consider the F-16 acquisition in light of the broader Defence policy context and the overall Defence budget.

Information sources

The figures in this report are based on information supplied by the New Zealand Defence Force (NZDF) and the Ministry of Defence (MoD). Where possible, we have tested them for consistency but have not independently assessed whether they are reasonable. For example, we have not tested whether the operating overhead reduction in the capability elimination option is reasonable.

In our view, there is still significant risk around some of the figures provided by the NZDF and the MoD. In particular, around the figures in the Defence Capital Plan (DCP), which have changed on a number of occasions as new best estimate information has come to hand.

We are not in a position to verify or test the remaining life of the capital assets in the DCP, or the existing NZDF defence equipment, or whether refurbishment is possible to current NZDF military equipment such as the C130 Hercules aircraft. We have relied on NZDF and MoD advice in such areas.

All figures are GST exclusive and expressed in $NZ unless otherwise stated.

Analysis

Value for money

The 1998 Air Combat Capability policy study (also known as the Whineray report) focused on defining New Zealand's future air combat capability requirements within the policy context of the 1997 Defence Assessment⁵. The Study identified the need for a multi-role fighter and considered the F-16 C/D to be the most suitable aircraft to replace the A-4 Skyhawk and fulfil this role⁶. The Study also considered that the F-16 A/B variant, with suitable upgrades, could also provide the capability requirement.

Two options to acquire an A-4 replacement have been considered. They are, to:

• purchase a fleet of new F-16 C/Ds (or similar type) aircraft when the A-4s are due to be retired (over the period 2007/08 to 2009/10); or

• lease-to-buy a fleet of 28 second-hand F-16 A/Bs now and sell the A-4s (ie the current deal with the USG).

A critical factor in the decision making process to date has been a Net Present Value (NPV) calculation comparing these two options.

The original NPV calculation in the November 1998 Cabinet paper showed a net cost saving of $431 million. Since then, more up-to-date information and more robust assumptions have been included⁷. The most recent NPV analysis shows a net cost saving of $316 million of going ahead with the lease-to-buy deal⁸. This saving comprises two main benefits:

• acquiring the F-16 A/Bs now and selling the A-4s, compared with retaining the A-4s until retirement and purchasing F-16 C/Ds. This saving is calculated to be $216 million; and

• leasing rather than purchasing the F-16 A/Bs outright. This is assumed to exist only for the current F-16 A/B deal (i.e it is not assumed to be available for the subsequent F-16 C/D option). This saving is calculated to be $100 million.

The current NPV analysis clearly shows the F-16 A/B option to be the least-cost option for replacing the A-4s. However, as a consequence of going ahead with this option (and bringing the replacement the A-4s forward), there is a significant cash impact on Defence's budget.

NPV analysis is a useful tool for recognising the time value for money, and comparing cost options. However, it can also be sensitive to changes in key variables. For example, in this instance, the cost of F-16 C/D aircraft.

Although there is no way of accurately forecasting the availability of replacement aircraft in seven years time, current analysis suggests that the only aircraft likely to be available at a later date will be either new aircraft or old highly-used second hand aircraft needing expensive refurbishing. For the purposes of the current NPV analysis the cost of new F-16 C/D aircraft has been used, estimated at $US30 million per aircraft (excluding spares and support).

However, if the cost of the F-16 C/D aircraft was changed to $US12.5 million per aircraft (excluding spares and support costs), then relatively speaking, it would be worthwhile proceeding with the purchase of F-16 C/Ds in 2007/08 rather than going ahead with the current offer. However, it should be noted that the cost of $US12.5m each for F-16 C/Ds is regarded as highly unlikely.

To further illustrate how attractive the lease-to-buy offer is relative to maintaining the A-4's and purchasing the F16C/D aircraft later, an NPV calculation can be made with the following assumptions:

• 10% inflation rate for the F-16 A/B Mid-life Upgrade (compared to a 0% inflation rate for the F-16 C/D MLU);

• a conservative A-4 sale value of $US30 million (compared to current estimates of $US 60-70 million); and

• favourable lease option on the F-16 C/Ds (similar to that currently offered on the F-16 A/Bs);

An NPV calculation based on the above assumptions still shows the F-16 A/B lease-to-buy offer to be the most favoured option, resulting in a positive net cost saving of approximately $21 million.⁹

Cost of the current F-16 offer

Excluding the F-16 operating costs (which are detailed further in this report), the total capital cost of the project is estimated at $1022 million. However, this figure assumes that all the equipment purchase options will be exercised, for example, the purchase of the aircraft after ten years ($287 million), and does not allow for possible sale proceeds from the A-4s (US$60-70 million).

To date, $363 million has been approved for the project (by the previous government), including:

• lease payments ($125 million, comprising $38 million and $87 million in each of the two five-year lease periods respectively); and

• support equipment and regeneration services ($238 million).

The remaining costs and options of $659 million (that are likely to be incurred or exercised later in the project) have yet to be approved. These include:

• the outright purchase of the aircraft after ten years ($287 million);

• ECM pods to allow the aircraft to be deployed into hostile situations, and a structural integrity maintenance system ($42 million);

• engine hush-house (new, $8 million); and

• Mid-Life Upgrade (MLU, $322 million).

All these costs have been included in the NPV calculation, with the exception of the ECM pods, structural integrity maintenance system and engine hush-house.

These figures are based on current best estimates. Some escalation risk remains, for example, to the Support Package ($238 million). Although this figure is based on current Foreign Military Sales scheme (FMS) costs of $217 million and Non-FMS costs of $21 million - these are subject to change if the price of items increase.

Payments

To date, New Zealand has paid approximately $35.4 million. The next payment is due on 15 March 2000. Further payments are as follows (rounded):

	Lease Payments	Support Package Payments	Cumulative total
Initial Deposit	2.5	29.1	31.6
15 Sep 99	1.9	0.0	33.5
15 Dec 99	1.9	0.0	35.4
15 Mar 00	1.9	19.4	56.7
15 Jun 00	1.9	24.4	83.0
15 Sep 00	1.9	25.6	110.5

4 A mix of naval, air and land combat forces; maritime surveillance aircraft; and air, sea, and land transport and support forces. return

5 The Defence Assessment included a figure of $653 million (1997 dollars) for A-4 replacement aircraft (18 second-hand F-16 C/Ds, including support and spares). return

6 The Study did not look at or test the number of aircraft required to fulfil this capability - the number of aircraft was treated as a 'given' under the current policy at that time. return

7 The earlier NPV did not cover the through life costs of the investment proposal over 25 years (it used 12 years), nor did it value the cash flows from the project separately from the financing package. return

8 The net cost saving of $316 million is based on the most recent costing information from NZDF. It uses a 10% discount rate as the Weighted Average Cost of Capital (WACC) for the project costs and a 6% discount rate for the lease costs. This figure differs slightly from the net cost saving presented in the 'F-16 Robustness testing' paper by Arthur Grimes, February 2000, which uses earlier costing information and different discount rates (for the reasons explained in his paper). return