Western Airlines is considering a new route that will require adding an addition

Question

Western Airlines is considering a new route that will require adding an additional Boeing 777 to its fleet. Western can purchase the airplane for $225 million or lease it for $25 million per year. If it purchases the airplane, its seating can be optimized, and the new route is expected to generate profits of $50 million per year. If leased, the route will only generate profits of $35 million per year. Suppose the appropriate cost of capital is 12.5% and that, if purchased, the plane can be sold at any time for an expected resale price of $225 million. Ignore taxes.

a. As a one-year decision, does purchasing or leasing the plane have higher NPV?

b. Suppose the funds to purchase o rlease the plane will come from equity holders (forexample, by reducing the amount of Western’s current dividend). Western also has one-year debt outstanding, and there is a 10% (risk-neutral) probability that over the next year Western will declare bankruptcy and its equity holders will be wiped out. Otherwise, the debt will be rolled over at the end of the year. Is purchasing or leasing the plane more attractive to equity holders?

c. At what probability of default would equity holder’s preference for leasing versus purchasing the plane change?

Explanation / Answer

(a)

COmpute the NPV of both the options taking one year as base.

(b)

The Leasing option is better for the equity share holders even in this case as after one year the equity share holders are going to receive dividend of $31.11.

Compute the NPV of Purchasing option. Year Cash Flows Discount@12.5% Present value of cash flows 0 -225 1.00 (225.00) 1 50 0.89 44.44 1 225 0.89 200.00 Net Present Value 19.44 Compute the NPV of Leasing Year Cash Flows Discount@12.5% Present value of cash flows 0 0 1.00 0.00 1 35 0.89 31.11 Net Present Value 31.11

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