HKDA

Lease and Sales

& Leaseback

Details of the Background Knowledge Required
y Time value of money (discounted cash flow)
y Pros and cons of Purchase
y 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 ar e the aft er-tax cash fl ows rel evant t o the purchase option and what discount r ate
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 Program
Year CapEx Maintenance Depreciation Tax
Savings
Capital
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 fl ows r elevant to the sal e-and-l easeback 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 easi er 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