Get instant access to this case solution for only $19

Hong Kong Dragon Airlines Limited (B) Lease vs. Buy Decision Case Solution

Solution Id Length Case Author Case Publisher
767 1834 Words (5 Pages) Su Han Chan, Ko Wang, Andrew Lee University of Hong Kong : HKU884
This solution includes: A Word File A Word File and An Excel File An Excel File

Hong Kong Dragon Airlines is considering a decision; whether to buy or lease the air plane engine model V2533. Hong Kong Dragon Airlines has detailed data for both the options and the analysis of both the options is under way. This report contains the analysis of the options and recommendations as to which option should be opted to acquire the engine.

The report starts by giving the cash flows for buying option. The cash flows are the tax adjusted figures and are discounted to present values using WACC as the discount rate. The NPV for buying decision turns out to be -$3.438037674.

After the purchase option, the cash flows for the sale and lease back option are given. These cash flow figures are also adjusted for tax and are discounted to present values using WACC. The NPV for sale and lease back option comes out to be -2.282913505.

The WACC of a company does not change with the purchase of an asset out of the cash available at hand. It also does not change if an asset is acquired on rent from another party.  The Weighted Average Cost of Capital of a company changes only when the debt to equity ratio or the tax rate applicable to the company changes. The discount rate is the same for both the options since neither the debt to equity ratio nor the tax rate have changed.

Following questions are answered in this case study solution:

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

  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?

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

  4. Perform sensitivity analysis to identify the key bets/assumptions in your decision.

11630928159.png
41630928159.png
51630928159.png
31630928159.png
61630928159.png
21630928159.png

Hong Kong Dragon Airlines Limited B Lease vs Buy Decision Case Analysis

The sale and lease back option also gives the advantage of maintaining separate reserves for the flight hours and flight cycles so that when the major maintenance becomes due, the huge payment may not become troublesome for the company. However, the lease agreement stipulates that any reserve remaining at the termination of the lease term will remain with the lessor which seems fair because the reserves are accumulated based on the usage of the engine.

These NPV figures have been calculated after taking into account the major maintenance cost that will become due in 2012 because of the usage of the engine.

The merits and demerits of taking either of the options are then stated. The pros of sale and lease back transaction exceed the pros of buying the engine and the cons of lease option are significantly lesser than that of the purchase option which strongly suggests that sale and lease back transaction is the right way to go. This fact has also been supported by the sensitivity analyses.

Towards the end of the report, a sensitivity analysis of the NPV with respect to purchase price and WACC is done. The sensitivity analysis also shows that the sale and lease back option provides least fluctuation in NPV for these two factors which also supports that the sale and lease back transaction should be opted.

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

Year

Cash Flows

Present value

Feb-06

-1.265470875

-1.265470875

Mar-07

-7.171001625

-6.765095873

Mar-08

0.556807185

0.495556412

Mar-09

0.556807185

0.467506049

Mar-10

0.556807185

0.441043443

Mar-11

0.556807185

0.416078720

Mar-12

0.224307185

-0.076271665

Mar-13

0.556807185

0.370308579

Mar-14

0.556807185

0.349347716

Mar-15

0.556807185

0.329573317

Mar-16

0.556807185

0.310918224

Mar-17

0.556807185

0.293319079

Mar-17

2.26875

1.195149198

NPV

 

-3.438037674

March 2012 cash flows include the major maintenance cost (1.9 million), major maintenance tax shield (1.9million*0.825) and depreciation tax shield.

The cash flow in February 2006 is the down payment of 15% of the estimated price of the aircraft engine assuming that the cost would rise by 3% annually.

The payment in March 2007 is the remaining amount that is payable before delivery.

The remaining cash flows (except for March 2012) are the depreciation tax shields calculate using the formula:

Depreciation tax shield = (Depreciation charge)*(1-tax rate)

The second cash flow in March 2017 is the sale proceeds from the sale of engine. The value of the engine after ten years is assumed to be somewhere between 2.5 million to 3 million. For calculations, 2.75 million (average) is assumed.

These cash flows will be discounted using the Weighted Average Cost of Capital. The purchase of an asset does not change the weighted average cost of capital of a firm and thus there is no adjustment to the WACC of 6%. WACC depends on the debt to equity ratio of the firm and the tax rate. Since the company has enough cash to finance its purchase (mentioned in the case), there is no change to the underlying factors of WACC and thus the rate, 6%, is appropriate. 

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?

Year

Cash Flows

Flight cycle reserve

Flight hour reserve

Total Cash flow

Present Value

Feb-06

-0.20247534

 

 

-0.20247534

-0.20247534

Feb-06

-1.265470875

 

 

-1.265470875

-1.265470875

Mar-07

1.265470875

0.08103

0.185848

0.998592875

0.94206875

Mar-08

-0.141732738

0.162060

0.371696

-0.675488738

-0.601182572

Mar-09

-0.141732738

0.162060

0.371696

-0.675488738

-0.56715337

Mar-10

-0.141732738

0.162060

0.371696

-0.675488738

-0.535050349

Mar-11

-0.141732738

0.162060

0.371696

-0.675488738

-0.50476448

Mar-12

1.198399262

0

0

1.198399262

0.844824191

Mar-13

-0.141732738

0

0

-0.141732738

-0.094260366

Mar-14

-0.141732738

0

0

-0.141732738

-0.088924873

Mar-15

-0.141732738

0.121545

0.278772

-0.542049738

-0.320838407

Mar-16

-0.141732738

0.040515

0.092924

-0.275171738

-0.153654461

Mar-17

-0.141732738

0

0

-0.141732738

-0.074663038

Mar-17

0.4403487

0

0

0.4403487

0.231970202

Mar-17

0.20247534

0

0

0.20247534

0.106661483

NPV

 

 

 

 

-2.282913505









































 

March 2012 cash flows are calculated after taking into account the excess amount needed to undertake a major maintenance, the maintenance tax shield and the depreciation tax shield.

The cash flow in February 2006 is the down payment required to place the order for the engine and the three month rent to the leasing company.

The cash flow in March 2007 includes the remaining amount due to IAE (engine manufacturing company) and the proceeds from the sale of engine to the engine leasing company.

All the remaining cash flows (except for March 2012 and March 2017) include the net after tax effect of the rent expense and rent tax shield, outflow for flight cycle reserves and flight hour reserves. Both these reserves are maintenance reserves and are not tax deductible.

The second cash flow in March 2017 is the tax shield enjoyed from expensing out the reserves. The agreement stipulates that the reserves at the end of the lease term will remain with the lessor. Hence, Hong Kong will have to expense this reserve. The third cash flow is the initial deposit return.

Operating lease is an off-balance sheet financing technique and hence it does not affect the debt to equity ratio of the firm. All the underlying factors in the calculation of WACC are unchanged. So, the discount rate of 6% is appropriate to discount these cash flows.

The net cost of obtaining the lease is lower than buying the engine. Obtaining the operating lease is a better option but pros and cons of both options should be considered while making a decision.

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

Advantages of buying the engine
  • Hong Kong Dragon Airlines can claim the ownership of the engine. Engine has a long useful life and market research shows that the V2500 engines will be popular even after 10 years. Thus owning the aircraft engine would give an advantage of capital appreciation or increased useful life. Also, company is not facing any cash flow problem, buying can be a good option.

  • Depreciation tax shields are an incentive to buy the engine. The tax shields allow saving tax expense over the life of the asset.

  • The engine can be sold before 10 years if the technology becomes obsolete and other technologically advanced engines are available.

  • Buying the asset would give the balance sheet a healthy look it would send a signal to the investors that the company has built its asset base.

  • The appreciation in the value of the engine is enjoyed by the company.

Disadvantages of buying the engine
  • Huge outlay of cash on purchasing the engine.

  • If the engine becomes obsolete before the end of the useful life, an unplanned outflow of cash will be required to make up for the obsolescence.

Get instant access to this case solution for only $19

Get Instant Access to This Case Solution for Only $19

Standard Price

$25

Save $6 on your purchase

-$6

Amount to Pay

$19

Different Requirements? Order a Custom Solution

Calculate the Price

Approximately ~ 1 page(s)

Total Price

$0

Get More Out of This

Our essay writing services are the best in the world. If you are in search of a professional essay writer, place your order on our website.

Essay Writing Service
whatsapp chat icon

Hi there !

We are here to help. Chat with us on WhatsApp for any queries.

close icon