Question

“Amazon's Battle for the Air Just Got Easier; Airlines are dumping old planes, giving the ecommerce
giant the perfect opportunity to expand its cargo fleet at a time of constrained supply
Wall Street Journal; New York, N.Y.; 01 May 2020.
…Due to Covid-19, airlines are now dumping older planes. According to international
advisory firm Ishka, lease rates are down: Renting a Boeing 747-8 freighter is 13% cheaper
than in January. Amazon might even consider using some of its vast cash holdings—$27 billion
at the end of March—to start owning its own fleet. The market value of five-year-old 777s and
Airbus 330s is down almost 10% this year, Ishka said…”
Jupiter Airline Ltd (JAL) is evaluating the possibility of tendering for the license to operate
international flights from Canberra to Queenstown (NZ) for a 5-year period. If its bid is
successful, JAL will have to acquire a new aircraft. Tupoloev Corporation has offered to sell
JAL an aircraft at a price of $70 million. It could be depreciated at a rate of 10 per cent per
annum, straight-line. The estimated disposal value in 5 years' time is $20 million. Alternatively,
JAL can lease the aircraft from Hendrix Leasing. The lease contract calls for five annual lease
payments of $15 million, due at the beginning of each year. Additionally, JAL must make a
security deposit of $1 million that will be returned when the lease expires. JAL can issue bonds
with a yield of 11 per cent per annum and the company income tax rate is 30%.
Required:
Considering both financial and non-financial aspects, advise with reasonings if JAL should
purchase or lease the aircraft given the current market conditions. Show all workings where
calculations are required.

Answer 1

First of all let's look into the fianncial aspect. Let's try to find the net advantage of leasing.

Case 1: Leasing

Annual lease payments = 15

Post tax lease payment = Pre tax payment x (1 - T) = 15 x (1 - 30%) = 10.50

Post tax cost of debt = Pre tax YTM x (1 - T) = 11% x ( 1- 30%) = 7.70%

NPV of leasing = - Security deposit - PV of all the year beginning lease payment as annuity + PV of security deposit released after 5 yers

= - Security deposit - PV (Rate, Nper, PMT, FV, Type) + Security deposit x (1 + r)^-n

= - 1 - PV (7.70%, 5, 10.50, 0, 1) + 1 x (1 + 7.70%)^-5

= - 45.82

Case 2: Buy

Annual depreciation = Cost x depreciation rate = 70 x 10% = 7

Annual depreciation tax shield = abbual depreciation x T = 7 x 30% = 2.10

Book value after 5 years = Cost - annual depreciation x term = 70 - 7 x 5 = 35

Salavage value = 20

Loss on sale = book value - salvage value = 35 - 20 = 15

Tax credit due to loss pon sale = Loss x T = 15 x 30% = 4.50

Hence, post tax salvage value = sale value + tax credit = 20 + 4.50 = 24.50

NPV of buy = - C0 + PV of depreciation tax shield as annuity + PV of post tax salvage value

= - Cost to buy + PV (Rate, Nper, PMT, FV) + Post tax salvage value x (1 + r)^-n

= - 70 + PV (7.70%, 5, 2.10, 0) + 24.50 x (1 + 7.70%)^-5

= -44.64

Net advantage of leasing = NPV of leasing - NPV to buy = - 45.82 - (-44.64) = -1.18

Hence, JAL should purchase the aircrafts because:

• Net advantage of leasing is negative, it financially makes sense to buy the aircrafts.
• Market value of the aircrafts are fallen, it's good time to buy
• Disruptions in the market is temporary. The covid scare will be over and once markets return to normalcy, the aircraft will become costlier and financially it may not make sense to buy then.