Question
NorthWest Airlines is considering a new route that will require adding an additional Boeing 777 to its fleet. NorthWest can purchase the airplane for $227.8
NorthWest Airlines is considering a new route that will require adding an additional Boeing 777 to its fleet. NorthWest can purchase the airplane for $227.8 million or lease it for $25 million per year (Lease payments are made at the beginning of each year). If it purchases the airplane, its seating can be optimised, and the new route is expected to generate profits of $51.5 million per year. If leased, the route will only generate profits of $33.6 million per year. Suppose the appropriate cost of capital is 15.9% and that, if purchased, the plane can be sold at any time for an expected resale price of $227.8 million. Ignore taxes. As a one-year decision:
a. Does purchasing or leasing the plane have higher NPV? Show workings to justify your answer. (3 marks)
b. Suppose the funds to purchase or lease the plane will come from equity holders (for example, by reducing the amount of NorthWests current dividend). NorthWest also has one-year debt outstanding, and there is a 10.7% probability that over the next year NorthWest will declare bankruptcy and its equity 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? Show workings to justify your answer. (3 marks)
c. At what probability of default would equity holders preference for leasing versus purchasing the plane change? (3 marks)
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