Question 24

Air Canada plans to replace its entire fleet of wide-body jets. The aircraft replacement costs about $7 billion on the basis of the list price of new airplanes. There are two alternatives Air Canada is considering: lease or borrow to purchase. Aircraft belongs in Class 9 with a CCA rate of 25% for tax purposes. If purchased, Air Canada has to spend 1% of the purchase price for annual maintenance. Of course, if the airplanes are leased, the lessor is responsible for maintenance. As Air Canada lost money in the past, its tax rate is very low at about 20%. If Air Canada decides to purchase these planes, its bank is willing to lend money at an annual rate of 8%. Alternatively, GE Canada Finance Holding Company (GECFHC) is willing to lease these airplanes to Air Canada. GECFHC has a higher tax rate at 40% and wishes to earn a pre-tax rate of return of 6% on the potential deal. Regardless of financing, new airplanes have an economic life of 20 years with zero salvage value at the end. The WACC for Air Canada is 10%.

(1) Calculate the highest pre-tax annual lease payment that would make Air Canada indifferent between leasing and borrowing-to-purchasing alternatives (that is, NAL is equal to 0). At this level of pre-tax lease payment, is GECFHC willing to lease airplanes to Air Canada?

(2) Calculate the lowest pre-tax annual lease payment/revenue that GECFHC should charge Air Canada in order to earn the 6% pre-tax rate of return. At this level of pre-tax lease payment, is Air Canada willing to make a deal to lease airplanes?