A disposal process for the A-4s is underway with Ernst & Young.

The Philippines has expressed early interest in the A-4s and plans to send a six-person evaluation team to New Zealand to assess them in late February/early March. However, recent reports also suggest that the Philippines may be interested in a fleet of F-5s from Saudi Arabia.

Timing of the disposal is important if the Government is to gain the best possible sale price. Delaying the sale will reduce the obtainable sale price - the aircraft will be less attractive to buyers and the airframes will have aged with greater wear and tear. The current sale price is estimated between $US60-70 million.¹⁵

(ii) Cancel the lease

This option raises questions over the future of the air combat capability. As mentioned earlier, an NPV analysis shows that replacing the A-4s with the F-16 C/Ds at a later stage will cost the Crown more in the long-run compared to the current lease-to-buy offer.

Cancellation therefore implies one of two things - that New Zealand is willing to either:

• accept the risk of incurring a higher future cost of replacing the A-4s; or

• lose its air combat capability.

Decisions (and the costs) associated with the disposal of the A-4s will be affected by these options. For example, retaining the A-4 fleet (and maintaining the capability) will require additional capital expenditure to upgrade them to modern standards - $54 million for a weapons capability upgrade and $42 million for an electronic warfare capability upgrade. Neither of these items would be required if the A-4s were not to be replaced or not deployed into any mid-level intensity conflict.

Under the US Foreign Military Sales (FMS) scheme New Zealand is responsible for meeting all the costs incurred by the New Zealand and US Governments and their contractors (e.g Lockheed Martin).

Upon notice of cancellation of the lease, rental payments will continue to accrue for 180 days in accordance with the schedule. However, according to a US legal opinion ('Sullivan and Cromwell', 19 January 2000), New Zealand may be entitled to a refund of some or all of these payments.

For the support and regeneration package, the Ministry of Defence advises that no further payments would accrue upon notice of cancellation. However, any refund of amounts already paid or still to be paid will largely depend on current contract commitments.

There may also be foreign exchange costs (or benefits) associated with 'unwinding' the deal. To establish these, the Debt Management Office (DMO) will need to undertake an analysis at the time of cancellation; in particular an assessment of the foreign exchange and interest rate movements at the time of the unwind.

Cancelling the lease and support package will free up funding (both operating and capital) already committed (or that is to be committed) to the project approximating the differences shown between (A) and (B) in the Tables 2 and 3 above.

Cancel the lease and eliminate the Air Combat Capability

The major savings resulting from eliminating the air combat capability would be operating savings. The reasons for this are outlined below.

Capital Impact

The assumptions behind eliminating the air combat capability include: terminating the F-16 lease, disposing the A-4s, disposing the Air Macchi trainers and disposing a base (probably Whenuapai) and relocating to Ohakea.

The scenario calculations undertaken for capital planning purposes (Table 2 and 4) include a figure of $11 million (based on recent information from the US) to cover the exit costs of cancelling the F-16 offer. This cost could be offset by a financial benefit gained through unwinding the DMO hedging arrangement. However, the cost to NZ and the benefit from the unwind are sensitive to the exchange rate and any rate movement could result in a further gain or (cost) to New Zealand.

The implications on the current Defence Capital Plan of eliminating the air combat capability can be seen in Table 4 which compares the capital injections required for all priority one projects, including the F-16s (A) with the capital injections required if the air combat capability was eliminated entirely (B).

		99/00	00/01	01/02	02/03	03/04	04/05	05/06	06/07	07/08	08/09	Total
A	All Priority One including current F-16 deal	0	153	321	111	51	162	125	76	0	0	999
B	All Priority ones less F16s and air combat capability	0	111	230	117	70	158	128	100	0	0	914
	Difference	0	42	91	-6	-19	4	-3	-24	0	0	85

The marginal change in the level of capital injections is not solely linked to the removal of the F-16s or air combat capability. In addition to the reduction of the cost of acquiring the capability there is also a reduction of the level of depreciation funding (attached to each of the assets). This explains why the removal of the F-16s and the air combat capability from the capital acquisition process does not have a dollar for dollar impact on the level of capital injections required.

Table 4 indicates a net capital injection saving of approximately $85 million over the ten-year period from 1999/00 to 2008/09 as a result of eliminating the air combat capability. This scenario assumes zero proceeds from the sale of the Macchis and an airbase and also includes an exit cost of $11 million (based on information recently received from the US).

The figures in Table 4 are sensitive to sales revenue. For example, if net sale revenue were received for the sale of the Macchis ($75 million) and an RNZAF base ($20 million), then the total figure in Table 4 would increase to approximately $180 million.¹⁶

Operating Impact

The air combat capability currently includes the A-4s and the transition to F-16s, the Macchis, most of the operations, personnel, and infrastructure at RNZAF Base Ohakea.

Elimination of this Output would mean rationalising surplus assets and disposing one of the RNZAF Bases (probably Whenuapai). It may also result in some redundancies. This would result in annual savings to the NZDF annual baseline of approximately $140 million per annum. These savings also take into account the costs of relocating to Ohakea but do not include income from the sale of real estate.

This figure includes depreciation of $19 million and Capital Charge of $48 million per annum. Depreciation in this context is an operating saving. Capital charge is the levy on the Crown's investment in this capability. The funding for both these amounts could be returned to the Crown.

Excluding depreciation and capital charge, totalling $67 million above, the direct savings (personnel and operating costs, and taking into account any loss in revenue earned from the Nowra agreement) are more in the region of $73 million per annum. There would be some time delay in fully achieving these savings associated with the disposal time for the capital assets and real estate and redeployment and downsizing of personnel. Based on previous restructuring within elements of the NZDF these savings are likely to take 2-3 years to be achieved.

(iii) and (iv) Deferral or Amendment to the lease

The implications of deferral will depend largely on discussions with the US and the length of time of deferral. Lease and support package payments (including payments to US contractors) would likely be affected depending on the arrangement reached. Other costs associated with delaying the acquisition may also be accrued. These have not been quantified.

The costs and benefits of options to amend the current deal need to be further tested and investigated with the US. Although Air Staff have provided some high level information on the costs of fewer aircraft, these need to be tested.

Annex 1: Capital

The 10-year Defence Capital Plan last underwent a major review in 1996/97 as part of the Defence Assessment 1997 (DA97), which led to the 1997 White Paper. A 20-year plan was also produced which showed the intended capability acquisitions needed to maintain a balanced NZDF.

The 1997 Capital Plan was based on exchange rates as they were in mid 1997. By 1998 there had been a significant reduction in the value of the New Zealand dollar, particularly in relation to the United States dollar. Following advice from Government in late 1998 that the funding guide-line provided in DA97 was to continue to be adhered to, and no new funding should be expected, it became necessary to strictly prioritise the capital plan to ensure that the highest priority projects remained above the funding line. The projects were categorised into priorities. Priority 1 were those deemed essential for rebuilding the NZDF. The remaining projects dropped below the indicative funding line and were placed in categories priority 2 to 5.

At the time of the DA97 the Government recognised that capital injections would be required to purchase the required capabilities in addition to the depreciation funding generated from NZDF. The Capital Plan is now not affordable within the funding envelope that was set aside (refer Table 5).

	99/00	00/01	01-/02	02/03	03/04	04/05	05/06	06/07	07/08	08/09	Total
DA 1997 (All priorities)	56	135	101	10	-28	53	74	38	38	32	509
Current Dec 1999 (Priority 1 only)	0	153	321	111	51	162	125	76	0	0	999

This figure represents those capital contributions to purchase new or replacement defence capability.¹⁷ This injection requirement also includes those capital injections required to meet the current contractual obligations. This is the immediate funding requirement to meet the costs of those projects to which Government approval-to-commit has already been given.

15 The capital plan scenarios include a figure of $50 million ($US26 million) for the net sale proceeds of the A-4s. Any sale revenue in excess of this figure will reduce the amount of capital injections required currently presented in Table 2 (Table 4 will not be affected as the sale of A-4s is common to both scenarios). return

16 $180m = $75m (Macchis) + $20m (Base) + $85m (Table 4). return