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

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?

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?

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.