WILL LEASING FLY AT CONTINENTAL Sara Crider Drew

WILL LEASING FLY AT CONTINENTAL? Sara Crider, Drew Siebert, Jason Stone, & Darin Wolding

Continental Airlines History � � � � Founded in 1934 as Varney Speed lines Renamed to Continental in 1937 Acquired by Texas Air Corp. in 1981 Merged with Texas International in 1982 Chapter 11 Bankruptcy in 1983 Merged with People Express, Frontier, and New York Air in 1987 Chapter 11 Bankruptcy in 1990 Merged with United Airlines in 2010

Continental Airlines � � � Currently operating independent from United Headquarters in Chicago, IL 2400 Departures Daily 130 Domestic Destinations 132 International Destinations Fleet of 348 airplanes

Statement of the Problem Continental Airlines must determine the most cost effective way to add two Boeing 757 aircraft to its fleet for the next fifteen (15) years. POTENTIAL OPTIONS FOR MANAGEMENT REVIEW � Many variables must be considered in rent vs. buy decisions: NET ADVANTAGE TO LEASING � Tax deductions and tax credits of ownership � � Cash flow considerations � Depreciation tax credits (opportunity cost to lessee) � Time Value of Money: Initial Cash Outlay Avoided � � Continental must assess their tax position. � � Can Continental take advantage of tax credits? If so, buying may be a better option than leasing. Continental must reconcile the opportunity cost of capital used to purchase new planes. � What does Continental earn on invested money? The Net Advantage to Leasing (NAL) method considers all variables relevant to the rent vs. buy decision. Continental must consider the residual value of the assets in their decision. Residual value is an opportunity cost to the lessee � The lessee forgoes the benefit of liquidating the asset at the end of the lease period. � High residual values may negate the Time Value of Money benefit associated with avoiding high initial cash outlay. �

Impact of Residual Values on Net Advantage to Leasing NAL $4, 000 Net Advantage to Leasing $3, 000 $2, 000 $1, 000 $0 $0 $10, 000 $20, 000 $30, 000 $40, 000 $50, 000 $60, 000 $70, 000 $80, 000 ($1, 000) ($2, 000) ($3, 000) ($4, 000) Residual Values

$4 $5 ($15) 0 ($35) $2 Effect of Years Without Tax Deductions on NAL (in Millions) $0 2 ($2) ($4) 4 ($8) ($12) 6 ($17) ($23) 8 ($32) 10 14 ($63) ($55) ($75) Net Advantage of Leasing 12 ($45) ($94) ($95) ($115) ($135) ($155) ($175) ($195) ($215) ($235) ($255) ($275) ($295) ($315) ($339) ($335) ($355) ($375) Years With No Taxes 16

1. Calculate the net advantage to leasing. Use the expected residual value and assume Continental can use all the tax benefits of ownership. It’s tax rate is 40%. Assume straight-line depreciation to the expected residual value. Probability Value 0. 05 $ 10, 000. 00 $ 500, 000. 00 0. 1 $ 15, 000. 00 $ 1, 500, 000. 00 0. 1 $ 20, 000. 00 $ 2, 000. 00 0. 15 $ 25, 000. 00 $ 3, 750, 000. 00 0. 2 $ 30, 000. 00 $ 6, 000. 00 0. 15 $ 35, 000. 00 $ 5, 250, 000. 00 0. 1 $ 40, 000. 00 $ 4, 000. 00 0. 1 $ 45, 000. 00 $ 4, 500, 000. 00 0. 05 $ 50, 000. 00 $ 2, 500, 000. 00 1 $ 30, 000. 00 Expected Residual Value Probability 0. 8 0. 2 1 Rate 10% 12% (1 -T) 0. 08 0. 024 10. 4% Total Interest Cost ( r) 0. 6 r 0. 104 Quarterly r 0. 026

Question 1 cont…… Quarterly A/P Cost Tax Rate (T) $ 4, 000. 00 0. 4 $ 1, 600, 000. 00 Tax deduction Airplane Cost (A/P Cost) $ 125, 000. 00 $ 30, 000 Expected Residual Value (ERV) Tax Rate (T) Years Quarters per year Number of Periods 0. 4 15 4 60 $ 633, 333 $ 3, 033, 333 Depreciation Tax Credits NAL = Quarterly CFAT A/P Cost @ M 79 125000000 117631571. 80 ITC $ 3294844. 57 4, 073, 583. 63 NAL

Cont…. Period Quarterly CFAT 1 $ 3, 033, 333. 33 2 $ 3, 033, 333. 33 3 $ 3, 033, 333. 33 4 $ 3, 033, 333. 33 5 $ 3, 033, 333. 33 6 $ 3, 033, 333. 33 7 $ 3, 033, 333. 33 8 $ 3, 033, 333. 33 9 $ 3, 033, 333. 33 10 $ 3, 033, 333. 33 11 $ 3, 033, 333. 33 12 $ 3, 033, 333. 33 13 $ 3, 033, 333. 33 14 $ 3, 033, 333. 33 15 $ 3, 033, 333. 33 16 $ 3, 033, 333. 33 17 $ 3, 033, 333. 33 18 $ 3, 033, 333. 33 19 $ 3, 033, 333. 33 20 $ 3, 033, 333. 33 21 $ 3, 033, 333. 33 22 $ 3, 033, 333. 33 23 $ 3, 033, 333. 33 24 $ 3, 033, 333. 33 25 $ 3, 033, 333. 33 26 $ 3, 033, 333. 33 27 $ 3, 033, 333. 33 28 $ 3, 033, 333. 33 29 $ 3, 033, 333. 33 30 $ 3, 033, 333. 33 [1 + (1 -T)r}^t] 1. 0156 $ 2, 986, 740. 19 1. 03144336 $ 2, 940, 862. 73 1. 04753388 $ 2, 895, 689. 96 1. 0638754 $ 2, 851, 211. 07 1. 08047186 $ 2, 807, 415. 39 1. 09732722 $ 2, 764, 292. 43 1. 11444553 $ 2, 721, 831. 85 1. 13183088 $ 2, 680, 023. 49 1. 14948744 $ 2, 638, 857. 31 1. 16741944 $ 2, 598, 323. 47 1. 18563119 $ 2, 558, 412. 24 1. 20412703 $ 2, 519, 114. 06 1. 22291141 $ 2, 480, 419. 51 1. 24198883 $ 2, 442, 319. 33 1. 26136386 $ 2, 404, 804. 38 1. 28104113 $ 2, 367, 865. 68 1. 30102538 $ 2, 331, 494. 37 1. 32132137 $ 2, 295, 681. 73 1. 34193399 $ 2, 260, 419. 19 1. 36286816 $ 2, 225, 698. 30 1. 3841289 $ 2, 191, 510. 73 1. 40572131 $ 2, 157, 848. 30 1. 42765056 $ 2, 124, 702. 93 1. 44992191 $ 2, 092, 066. 69 1. 47254069 $ 2, 059, 931. 76 1. 49551233 $ 2, 028, 290. 42 1. 51884232 $ 1, 997, 135. 12 1. 54253626 $ 1, 966, 458. 37 1. 56659983 $ 1, 936, 252. 82 1. 59103878 $ 1, 906, 511. 25 31 $ 3, 033, 333. 33 32 $ 3, 033, 333. 33 33 $ 3, 033, 333. 33 34 $ 3, 033, 333. 33 35 $ 3, 033, 333. 33 36 $ 3, 033, 333. 33 37 $ 3, 033, 333. 33 38 $ 3, 033, 333. 33 39 $ 3, 033, 333. 33 40 $ 3, 033, 333. 33 41 $ 3, 033, 333. 33 42 $ 3, 033, 333. 33 43 $ 3, 033, 333. 33 44 $ 3, 033, 333. 33 45 $ 3, 033, 333. 33 46 $ 3, 033, 333. 33 47 $ 3, 033, 333. 33 48 $ 3, 033, 333. 33 49 $ 3, 033, 333. 33 50 $ 3, 033, 333. 33 51 $ 3, 033, 333. 33 52 $ 3, 033, 333. 33 53 $ 3, 033, 333. 33 54 $ 3, 033, 333. 33 55 $ 3, 033, 333. 33 56 $ 3, 033, 333. 33 57 $ 3, 033, 333. 33 58 $ 3, 033, 333. 33 59 $ 3, 033, 333. 33 60 $ 3, 033, 333. 33 1. 61585899 $ 1, 877, 226. 51 1. 64106639 $ 1, 848, 391. 60 1. 66666702 $ 1, 819, 999. 61 1. 69266703 $ 1, 792, 043. 73 1. 71907263 $ 1, 764, 517. 26 1. 74589017 $ 1, 737, 413. 61 1. 77312605 $ 1, 710, 726. 28 1. 80078682 $ 1, 684, 448. 87 1. 8288791 $ 1, 658, 575. 10 1. 85740961 $ 1, 633, 098. 76 1. 8863852 $ 1, 608, 013. 75 1. 91581281 $ 1, 583, 314. 05 1. 94569949 $ 1, 558, 993. 75 1. 9760524 $ 1, 535, 047. 01 2. 00687882 $ 1, 511, 468. 11 2. 03818613 $ 1, 488, 251. 39 2. 06998183 $ 1, 465, 391. 28 2. 10227355 $ 1, 442, 882. 32 2. 13506901 $ 1, 420, 719. 10 2. 16837609 $ 1, 398, 896. 32 2. 20220276 $ 1, 377, 408. 74 2. 23655712 $ 1, 356, 251. 22 2. 27144741 $ 1, 335, 418. 69 2. 30688199 $ 1, 314, 906. 16 2. 34286935 $ 1, 294, 708. 70 2. 37941811 $ 1, 274, 821. 49 2. 41653704 $ 1, 255, 239. 75 2. 45423501 $ 1, 235, 958. 79 2. 49252108 $ 1, 216, 973. 99 2. 53140441 $ 1, 198, 280. 81 $ 117, 631, 571. 80

2. Calculate the net advantage to leasing. Assume 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. Probability 0. 8 0. 2 1 Rate 10% 12% 0. 08 0. 024 10. 4% Total Interest Cost ( r) Quarterly 2. 6% r Airplane Cost (A/P Cost) $ 125, 000. 00

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.

4. Suppose Continental believes it will not be in a taxpaying position for a decade or longer. Should it lease, or borrow and buy? Explain. Salvage Value NAL (1 Plane) $30 M $839 k $50 M ($1, 358 k) $10 M $3, 035 k The worst case scenario is for Continental to not be able to use tax benefits for the full 15 year lease. In that situation, leasing is still a positive NPV option at the expected residual value of $30 M per plane. For this reason, Continental should lease.

5. Suppose Continental believes it will not be in a taxpaying position for a decade or longer, and this lease includes the option to terminate the lease at any time without penalty. Should it lease, or borrow and buy? Explain. Evaluating the value of an early termination option on the NAL is difficult because the salvage value of the asset will be different at any possible termination point. Because the NAL is positive for the expected salvage value over 15 years, it is still a good idea to lease because “options” cannot have a negative value. The best value of this option is that it gives Continental flexibility which is valuable to any business. With the ability to break the lease without penalty at any time, Continental can adjust to market conditions like fewer people flying or newer more fuel efficient aircraft.