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INTRODUCTION

        Hong Kong Dragon Air is Hong Kong-based international airline, belonging to of the Cathay
Pacific Group. The airline was established in 1985, and  operates a fleet of  narrow-body A320s and A321s, which were both
powered by V2500 engines manufactured by International Aero Engines AG (“IAE”) for both passenger and cargo service  to destinations to destinations across the
Asia-Pacific region, and  China.(REF) Their vision is to be the World’s best regional airline serving
China and beyond. Their missions; places emphasis on safety and operational excellence with customer focus. The airline
seeks to embrace innovation by implementing ideas that improve their business. (REF).

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        In January 2006, the management of Hong Kong Dragon
Airlines (Dragon Air) recognized the need to find a replacement by early 2007
for one of its spare engines that was deemed beyond economic repair (BER). (REF).
To this end they were faced with a situation where they had to find the best
option for replacing the BER engine. ( ref) . The options available to them for
acquiring the replacement engine were outright purchase, lease, and sale and
leaseback. In this case study analysis, we discuss the purchase, lease, and
sale and leaseback options with a view to shedding more light on what they are,
explain their differences, and pros and cons. We
determine after-tax cash flows relevant to
each option together with the discount rate that should be used for each cash
flows option.. We carryout a financial Analysis of the above mentioned options
and a sensitivity Scenario analysis
to identify the key drivers in the case. We determine the best option for Hong
Kong Dragon Air, together with supporting quantitative financial data and
sensitivity analysis. We end with a current update on the case in which we
discuss the growing aircraft leasing industry in China together with our
conclusion on the case.

 

Financial Analysis – Buy vs. Lease

       
Dragon Air in their quest to replace a spare engine that was deemed
beyond economic repair in 2007, were faced with three options; they
would either have to out rightly purchase the engine, lease the engine or
acquire the engine through sale and leaseback option.  With outright purchase Hong Kong Air would
have to pay the full purchase price of the engine with cash amounts and
thereafter own it. With the lease option they would have to enter into a
contract arrangement with the lessor of the engine which would give them the
right to use the engine in return for periodic payments to the lessor. (Ross .S
et al 2013). If Hong Kong Air decides to go for the sale and leaseback option;
they company would have to buy the engine and sale it to another airline and
receive cash for it, and thereafter immediately lease it back for their use.
(Ross .S et al 2013).

        Lease or buy decision requires
applying capital budgeting principles to determine if leasing as
asset is a better option than buying it. In finding out whether leasing is better
than buying, we identified the periodic cash flows under both the options and
discounted them using the after-tax cost of debt to determine the present value
of the cost of the leasing option and compared it the present value of the cost
of the buying option.

        The NPV with lower present value of
cash outflows was selected as the best option. The most significant component
of cash outflows in case of purchase option was the cost of the replacement spare
engine. Our cash flows included the tax shield on
depreciation, and maintenances costs associated with the purchase and use of
the engine. We determined the after tax cash flows under both options, in case
of Dragon Air ‘purchase’ option, the after-tax cash flows are; cost of the
V2500 spare engine, the tax shield on depreciation and maintenances costs and
the after tax discount rate was used. In case of the ‘lease’ option, the
after-tax cash flows are; include; monthly rental at 8% of
engine price, rate per flight hour, rate per engine cycle all over the period
of the lease not less than 10 years.(ref) The discount rate used was the after
tax cost of debt. We worked out the
net present values of each option and thereafter picked the option that has lower
present value of cash outflows. Our
NPV calculations for both options are supported with sensitivity scenario
analysis of both the buy and leas options.

Sensitivity
Scenario Analysis

        Sensitivity
analysis scenario is used to show how changes in one or more variables below
and above the used variables would affect the intended results. In our
sensitivity analysis scenario for Dragon Air ‘lease vs buy’ decision we varied
the cost of capital between 1% and 5% as the main driver in the case. The table
1 below shows the results.

Sensitivity
Scenario Analysis Buy Option

Table
1

 

BUY

LEASE

Discount Rate

NPV-  outflow

NPV-  outflow

1%

$6877994.52

$7685831.75

3% Applied Rate

$7016890.24

$7791948.92

5%

$7155785.95

$7698066.08

Sensitivity Scenario Analysis in table 1, for
the ‘Buy vs lease’ option, at both 1% and 5% discount rate shows the ‘BUY’
option with low cash outflow NPV as compared to the ‘LEASE’ option. NB: See attached Excel spreadsheets for
details.

        By making an outright purchase of the
replacement spare engine, Hong Kong Dragon Air would gain tax and other
benefits inherent with owning the engine.

 This would be the best option if the company
has capital available to support the purchase or if they are unable to
negotiate favorable loan terms. A loan would be the most attractive purchase
option for Hong Kong Air in that it would give them tax benefits of ownership,
if they do not have the upfront capital to make the purchase or have a more
advantageous use of their capital. (Snyder, 2012).

          In trying to pick among the available options
Hong Kong Dragon Air would have to consider, several factors, including:
opportunity cost of capital, and expected return, interest rate; applicable tax
rate benefit; and replacement cycle of the engine costs. They would also have
to consider pros and cons of each option. We append below the pros and cons of
each option.

Pros
and Cons for Outright Purchase

Pros:

1.      Outright
purchase would give Dragon Air tax advantage. The company can deduct the
equipment costs or take depreciation deductions to lower its taxable income. With
accelerated depreciation, the company can take large depreciations (up to 50%
of the purchase cost) during the first few years to offset its taxes even more,
but this depreciation decreases in later years.(ref)

2.      Outright
purchase gives Drago Air ownership of the engine and can do whatever they want,
including selling and replacing it with newer engine.

3.      Compared
to lease purchase, with outright purchase Dragon Air does not require to maintain
the engine to pre-defined specifications or guidelines as may be the case under
lease.

4.      Outright
purchase process is easier than lease as it does not require preparing detailed
financial information or time consuming negotiations on purchase terms.

Cons:

1.      Higher
initial capital outlay. Outright purchase of the spare engine with cash may be
less expensive than leasing, in the long run. 
But this requires spending more money upfront. If the purchase is done
by a loan, Dragon Air would have to make a down payment and will be responsible
for interest payments.

2.      Higher
upfront costs required in outright purchase leaves Dragon Air with less available
liquidity. This means less cash available to reinvest in other parts of the
business.

3.      Aircraft
engines become obsolete over time, as technology changes and also from aging
and hence the need to replace them earlier than expected, even if the company
is still paying against the loan.

4.      Difficult
to sale old or obsolete or aircraft engine and recoup enough money to pay off
the loan or recoup enough finance for replacement engine. (ref).

As
with outright purchase Dragon Air would also have to scrutinize the pros and
cons of sale leaseback options .We highlight below the pros and cons of each
option lease, sale leaseback of capital equipment have pros and cons.(ref)

Pros
and Cons of Sale and Leaseback

Pros:

1.       With a sale-leaseback, Dragon Air would convert equity into cash
and regains possession and continued use of the aircraft for term
of the lease.

2.      Leasing
has tax advantages in that Dragon Air can keep the engine off its balance sheet
and deduct the entire lease payment over the term of the lease or leave it on
the balance sheet and apply straight- line the depreciation during the term of
the lease.

3.      Lower rate. Borrowers can trade the depreciation benefits to the
lender in return for a lower interest rate, which lowers the total cost of the
lease.

4.     
Leasing
makes Dragon Air budging easier because of fixed rate and as such it is easier
to calculate lease costs for the lease term.

5.     
Leasing
presents no upfront costs as Dragon Air can finance up to 100% of the purchase
price as opposed to making a down payment.

6.     
Leasing
would improve available liquidity for Dragon Air in that leased engine would
not tie up cash and can be reinvested in other parts of the business to
generate a higher rate of return.

7.     
Leasing
would enable Dragon Air negotiate a more flexible payment options by
customizing lease terms to match engine utilization.

8.     
It
would enable Dragon Air to easily upgrade the engine in a short period of time and
pass the burden of unloading an obsolete engine to the lessor.

9.     
Residual
value risk remains with the lessor.

Cons:

1.     
Loss of
flexibility in the use of the leased engine due to lessor restrictions.

2.     
Payment
obligation for the entire term. Hong Kong Air must pay the lease for the entire
term, even if they stop using the engine before the lease expires. Some leases
allow airlines to cancel the lease or pay it off early, but these options often
come with expensive termination fees.

3.     
Higher overall costs. While
there are tax benefits to leasing equipment, companies usually have higher
overall costs when leasing compared to purchasing outright. The variance may depend
on interest rates, the rate of inflation, and opportunity costs of the
borrower.

4.     
Maintenance
records. Leased engine must be maintained to certain standards, and Dragon Air
must keep accurate engine maintenance records to ensure they comply with lease
requirements.

5.     
 Dragon
Air would take on the risk of engine return penalties if they do not meet the
engine return conditions are not met at the end of the lease.

Having
exhausted the financial analysis and sensitivity scenario analysis, together
with pros and cons of each option, we determined the best option for Dragon Air
in their buy vs. leas decision.

Best option for Hong Kong Dragon Air in this case

        Based on the financial analysis and
sensitivity analysis scenarios the ‘BUY’ option has NPV cash outflow of
$7016890.24 and the ‘LEASE’ option has NPV cash outflow $7,791,948.92.The
sensitivity analysis scenarios in both the buy and lease option and the
respective pros and cons of each option we found the best option for Dragon Air
buy versus lease decision would be to buy the replacement spare engine.as
opposed to leasing it. We attach the Excel spreadsheet with supporting
quantitative financial analysis.

 

 

Current updates on the case

        We discuss the latest developments in aircraft
purchase financing and leasing in china which according to the US Financial Times
report of  2017 is gaining momentum. Dragon
air is based in Hong Kong, which is part of the mainland China. According to the
Financial Times, (2017). ‘Chinese capital is expected to
claim more than a third of the aircraft leasing market by 2022’. There is a
rapid rise of Chinese banks and lessors in the business of financing aircraft
purchases. The momentum of Chinese finance has been increased by a national
strategy to build a global aviation industry as demand for domestic air travel accelerates.
(REF). China is expected to be the single fastest-growing market for aircraft
sales in the next 20 years.(ref) In this case study.  Airlines like Dragon Air will find lease
financing  to be cheaper than  outright purchase when the industry peaks as
the increase in the number of leasing companies in China will heighten
competition among leasing companies resulting in depressing the already depressed
global market due to overcapacity. Aircraft manufacturers have started to
expedite the backlog of aircraft orders leading to increase in the number of
aircraft available for lease. This has depressed the leasing cost of aircraft.
PWC, (2013).

Conclusion and
Recommendations

      
 Having carried out qualitative
and quantitative analysis of Drago Air- buy versus lease decision for their replacement
spare V2500 engine in 2006, as contained in the referenced Dragon Air Case
Study document together with accompanying additional information. Based
on the financial analysis and sensitivity analysis scenarios the ‘BUY’ option
has NPV cash outflow of $7016890.24 and the ‘LEASE’ option has NPV cash outflow
$7,791,948.92.The
sensitivity analysis scenarios in both the buy and lease option and the
respective pros and cons of each option we found the best option for Dragon Air
buy versus lease decision would be to buy the replacement spare engine.as
opposed to leasing it. We conclude and recommend that the best options as mentioned
above for Dragon Air would have to be outright purchase of the replacement
V2500 spare engine as opposed to leasing the engine. We attach supporting
evidence leading to our conclusion and recommendations.

 

 

 

 

 

 

 

 

 

 

 

References

Alliance
FT, (2017). Put your airplane to Work for you. Retrieved January 11, 2018 from
–    http://allianceflighttraining.com/aircraft-rental-fleet/aircraft-leaseback-opportunities/

Gennaro T. , (2016). Airlines’ Lease vs. Buy.
Retrieved from-https://www.brookfieldav.com/single-post/2016/09/09/Airlines%E2%80%99-Choice-Leasing-vs-Buying

Financial Times, ( 2017). Current Updates- Aircraft leasing
in china. Retrieved from https://www.ft.com/content/33a53748-bcde-11e7-9836-b25f8adaa111

Obaidulla J.
(2013). Lease or buy decision. Retieved Junuary 19 2018 from – https://accountingexplained.com/managerial/capital-budgeting/lease-or-buy-decision

PWC, (2013). Aviation Finance Fasten Your Seat Belts. Retrieved from https://www.pwc.com/im/en/publications/assets/shipping-aircraft-space/pwc-aviation-finance-fastern-your-seat-belts-pdf.pdf

Raiche & Company CPAs, 2016. Differences between
leas and outright purchase. Retrieve from- https://www.raichecpa.com/blog/what%E2%80%99s-difference-between-lease-and-outright-purchase-when-acquiring-car

Ross S.A., Westerfield R.W., Jaffe
J. (2013). Corporate Finance, 10th ed. McGraw-Hill

Snyder J. (2012) .Lease vs Purchase: A Critical
decision. Retrieved January 11, 2018 from-

https://commercial.bmoharris.com/media/hero_image/1.3.4.29_Equipment_Finance_Critical_Decision_Whitepaper.pdf

 

 

 

 

 

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