HKDA

Lease and Sales & Leaseback

Details of the Background Knowledge Required

Time value of money (discounted cash flow) Pros and cons of Purchase Pros and cons of Leasing

Case Background

Case deals with the situation that arose in Hong Kong Dragon Airlines Limited to find a replacement for an engine that was beyond economic repair (BER). The case is set in early 2006. the company has 8 Airbuses A 320s, 4 Airbus A321s, 9 Airbuses 330s and 3 Boeing 747 freights. Both A 330 and A321were powered by V2500 engines which were manufactured by IAE. For expansion purposes, Dragon Airlines needed the spare engines. The decision of how to approach the purchase or lease of the engine had to be taken up very soon as the company planned to expand and the construction of the engines took almost 12 – 15 months to manufacture. The engine when installed had a lifespan before it had to be removed for major repair. Some of the parts in the engine also had limited lifespan and had to be removed after certain air cycles. Dragon Airlines wanted to increase their spare engine capacity to 4. But one of the primary engines went BER and thus they had to buy/lease a new engine. The case mainly concentrates upon a conversation between two executives of the organisation Walters and Ho who met to discuss the various options. There are three options in front of them

1) The first option is to simple buy the engine. They would have to place an order with the IAE and expect to get the engine in late 2007. The problem with the scheme was the fact that the cost of the engine could get escalated and their was no full proof way to determine the exact cost of purchase of the engine. But an average of 3 to 5% escalation was expected. But considering the fact that the engine cost was around $4.5 million, such an escalation was harmful to the company

2) The second option was sale and leaseback wherein the company had already consulted and arranged for another engine lease company to buy the engine from them and give them in lease. The rent would be 0.8% of the purchase price. But there are complications in this case relating to the maintenance cost the lease company bearing the cost of the maintenance but having put some constraints on Dragon Airlines for them

3) The third option was to simply lease from the concerned company. The problem was the fact that there was a long queue for talking lease as the engine was popular and the lease company was ready to buy the engine only if Dragon Airlines assured them that they would take up the engine. So in the end, its left with only two choices.

The company which leased out the engine also had rules about the return condition in which they would accept the engine and had stringent measures if the return condition were not met. Jo and Walters then also considered the fact that they lacked certain information that they needed to make an informed decision and thus decided to meet after getting the information. The information they wanted to get was the depreciation policy of the company, the cost of heavy maintenance and some other information. Now Dragon Airlines has to decide which medium of buy/lease to follow for the V2500 engine.

Questions

Q. 1 What are the after-tax cash flows relevant to the purchase option and what discount rate should be used for those cash flows?

We should use cost of capital to firm because company is not going for new debt or equity but using its internal cash. This cash could have been utilized for getting rid of existing debt or buying equity from market, so WACC should be used for cash flows.

Purchase ProgramYear CapEx Maintenanc

eDepreciation Tax

SavingsCapital Gain

Net Outflow Discounted Cash Flow

2006 1.259175 -1.259175 -6.942616

2007 7.135325 -7.135325

2008 0.335780 0.0587615 0.058762

2009 0.671560 0.117523 0.117523

2010 0.671560 0.117523 0.117523

2011 0.671560 0.117523 0.117523

2012 1.9 0.671560 0.450023 -1.449977

2013 0.671560 0.117523 0.117523

2014 0.671560 0.117523 0.117523

2015 0.671560 0.117523 0.117523

2016 0.671560 0.117523 0.117523

2017 0.671560 0.117523 2.75 2.867523

Q. 2 What are the after-tax cash flows relevant to the sale-and-leaseback option and what discount rate should be used for those cash flows?

We should use cost of capital to firm because company is not going for new debt or equity but using its internal cash. This cash could have been utilized for getting rid of existing debt or buying equity from market, so WACC should be used for cash flows.

Sales and Lease Back Program

CapEX Sales Deposit Lease Rental Hour Reserve

Cycle Reserve

Tax Savings

Net Cash Flow Discounted Cash Flow

1.259175 -1.259175 -6.117392

7.135325 8.3945 0.1947052 0.38164057 0.682829

0.000000 0.776350202 0.185848 0.08103 0.11721745 -0.926011

0.000000 0.776350202 0.371696 0.16206 0.2344349 -1.075671

0.000000 0.776350202 0.371696 0.16206 0.2344349 -1.075671

0.000000 0.776350202 0.371696 0.16206 0.2344349 -1.075671

0.000000 0.776350202 0.371696 0.16206 0.2344349 -1.075671

0.000000 0.776350202 0 0 0.1410276 -0.635323

0.000000 0.776350202 0 0 0.1410276 -0.635323

0.000000 0.776350202 0 0 0.1410276 -0.635323

0.000000 0.776350202 0.278772 0.121545 0.21108308 -0.965584

0.000000 -0.201468 0.092924 0.040515 0.16437943 0.232408

Q.3 What are the pros and cons of each option given in the case?

Purchase Program Purchase and LeaseBack Program

Pros Tax shield can be obtained due to depreciation

Tax shield can be obtained due to lease rental

Scrap value of the asset can also be recovered at the end of the life of the asset

It becomes easier to adapt to Dynamically changing technology

Cons

Loss of tax shield due to lease rental

Loss of tax shield due to Depreciation

Technology is dynamic in nature and hence Obsolescence can be a major problem

Scrap value of the asset cannot be recovered at the end of the useful life of the asset

Q. 4 Which option did you choose? Why? Provide quantitative support.

From the excel sheet attached it is clear that discounted cash out flow is less in case of “Sales and LeaseBack Program”. So clearly company should go for “Sales and LeaseBack Program”.

Q.5 Perform sensitivity analyses to identify the key bets in your decision.

Below is sensitivity analysis done for escalation value from 1% to 5%. In each case, discounted cash outflow is less for “Purchase and Lease Back Program”. Hence company should for the same.

Buy: Discounted Cash Lease: Discounted Cash

Escalation value

-6.942616 -6.117392

1% -6.802641955 -6.03199538

2% -6.872629134 -6.074693719

3% -6.942616314 -6.117392057

4% -7.012603493 -6.160090396

5% -7.082590672 -6.202788734