Objective:

This case illustrates the lease-versus-buy decision and what factors are important in the decision-making process.

Case Discussion:

Continental Airlines is the fifth largest airline in the United States. Continental would like to expand its fleet by adding two Boeing 757s. Continental has the opportunity to lease or buy the two aircraft.

Questions / Methodology:

1. Calculate the net advantage to leasing, using the expected residual value and assuming Continental can use all the tax benefits of ownership with a tax rate of 40% and straight line depreciation to the expected residual value. Assume that Continental issues 80% secured debt and 20% unsecured debt to finance a purchase.

a. Calculate rt--the project cost of capital.

b. Calculate the expected lease residual value per aircraft.

c. Calculate the quarterly CFAT per aircraft under the leasing option.

• Hint: It should be the same each quarter hroughout the term of the lease.

• The lease payment is tax deductible.

• Under the leasing option Continental forgoes the depreciation tax deduction.

d. Calculate the NAL.

• Assume quarterly compounding to match the lease payments.

• Continental’s required return on the asset—r, is given.

• Assume no incremental difference in operating expenses between the purchasing and leasing options.

• Assume that the lessor claims the ITC.

2. Calculate the net advantage to leasing, assuming Continental cannot use any of the tax benefits of ownership and the residual value is (i) the expected residual value, (ii) $50 million, and (iii) $10 million

3. Determine the residual value that would make the net advantage to leasing equal zero, assuming Continental cannot use any of the tax benefits of ownership. Hint: Set NAL = 0 and solve for SAL.

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