Chapter 25, Problem 11P

Western Airlines is considering a new route that will require adding an additional Boeing 777 to its fleet. Western can purchase the airplane for $225 million or lease it for $25 million per year. If it purchases the airplane, its seating can be optimized, and the new route is expected to generate profits of $50 million per year. If leased, the route will only generate profits of $35 million per year. Suppose the appropriate cost of capital is 12.5% and that, if purchased, the plane can be sold at any time for an expected resale price of $225 million. Ignore taxes.

1. a. As a one-year decision, does purchasing or leasing the plane have higher NPV?
2. b. Suppose the funds to purchase or lease the plane will come from equity holders (for example, by reducing the amount of Western's current dividend). Western also has one-year debt outstanding, and there is a 10% (risk-neutral23) probability that over the next year Western will declare bankruptcy and its equity holders 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?

Chapter 21 explains risk-neutral probabilities. If you have not read that chapter, you can work the problem and get the same answers by assuming that the specified probabilities are the actual probabilities of default but the risk of default is purely idiosyncratic risk.

1. c. At what (risk-neutral) probability of default would equity holders' preference for leasing versus purchasing the plane change?