BUSI 685 Week 5 DB Forum 3 Example

Discussion Board Forum 3: Thread and Replies

BUSI 685 Financial Management, Discussion Board Forum 3 (thread and two replies)

Thread by [Student Name]

The forum prompt, the airline, its figures and the classmates are composites standing in for the course's own; the textbook, Scripture and research cited are real, and the requirements follow Liberty's public course guide for BUSI 685.

Thread

The prompt describes a composite regional airline that needs ten new 76-seat jets, about $30 million each, to replace an aging fleet. Its operating margin is 5 percent, its credit rating is BB, and lenders will finance aircraft only with large down payments and covenants. A leasing company offers twelve-year leases. The chief financial officer asks whether leasing or buying creates more value.

The old answer, that leasing keeps debt off the balance sheet, no longer applies. Under ASC 842, which public companies adopted in 2019, the airline would record most of these leases as liabilities anyway. Brealey et al. (2017) view a financial lease as borrowing in another form: the lease payments are discounted at what a comparable secured loan would cost after tax, and asks whether leasing costs less than buying with borrowed money. If the lessor can use depreciation deductions more fully than the airline can, the lease may be cheaper, and in the evidence Graham et al. (1998) assembled, companies facing low marginal tax rates relied more on operating leases, consistent with lessors capturing tax benefits that lessees cannot. A thin-margin airline with past losses is such a firm.

The stronger reason is debt capacity. Eisfeldt and Rampini (2009) argued that leasing has higher debt capacity than secured lending because a lessor can repossess a leased asset more easily than a lender can foreclose on collateral, and they found that more financially constrained firms lease a larger share of their capital. For a BB-rated airline, that difference matters: a lessor who can quickly take back a jet will finance more of its value than a bank that must pursue foreclosure. Leasing lets the airline renew its fleet without exhausting the borrowing capacity it may need in a downturn. For a constrained borrower, the easiest asset to take back is the easiest asset to finance.

Scripture speaks to the obligations of a lessee. Jesus teaches that someone careless with small things and with another person's property will not be trusted with true riches or given property of his own (English Standard Version Bible, 2001/2016, Luke 16:10-12). A leased jet belongs to another. The airline that leases must maintain the aircraft to the lessor's standards and return it in the promised condition, a stewardship of someone else's property.

I would recommend leasing seven jets and buying three with secured debt, preserving capacity while building some owned fleet, and setting aside maintenance reserves from the first month. The mix also limits the airline's exposure to the residual value of an aircraft type that may be less in demand in twelve years.

Reply to Carlos

Carlos, I agree with your recommendation to lease, but not with your main reason, that leasing keeps the jets' cost off the balance sheet and makes the airline look less indebted. Under ASC 842, the airline would recognize lease liabilities for these twelve-year leases, so analysts and lenders would see the obligations. Brealey et al. (2017) also caution that leasing is not free financing; a financial lease displaces borrowing much as a loan would, and its value depends on its cost compared with buying with debt. The better case for your conclusion comes from Eisfeldt and Rampini (2009), who showed that leasing provides more debt capacity than secured lending because repossession is easier, which is why constrained firms lease more. The airline should lease because it gains financing capacity, not because it can hide obligations. Lenders reading the footnotes would see through an off-balance-sheet argument anyway, and a recommendation built on it would not survive the first question from the board's audit committee. Would the recommendation change if the airline's rating improved to investment grade?

Reply to Tessa

Tessa, you made a careful argument that buying is cheaper over the jets' 25-year life because the airline keeps the residual value. For an unconstrained company, that could be right. Brealey et al. (2017) note that the lessor must earn a return on the asset, and if the lessee could borrow on the same terms and use the tax deductions fully, buying would often cost less. But neither condition holds here. Companies with low marginal tax rates lease more, Graham et al. (1998) report, since a lessor can claim depreciation deductions such a lessee would waste, and Eisfeldt and Rampini (2009) found that constrained firms gain debt capacity through leasing. A BB-rated airline with past losses fits both findings. Buying all ten jets might lower the long-run cost on paper while leaving the airline without borrowing room when fuel prices spike. Could a purchase option at the end of the lease capture some of the residual value you are concerned about? That would let the airline keep the jets it values most once its credit improves.

References

Brealey, R. A., Myers, S. C., & Allen, F. (2017). Principles of corporate finance (12th ed.). McGraw-Hill Education.

Eisfeldt, A. L., & Rampini, A. A. (2009). Leasing, ability to repossess, and debt capacity. The Review of Financial Studies, 22(4), 1621-1657. https://doi.org/10.1093/rfs/hhn026

English Standard Version Bible. (2016). Crossway. (Original work published 2001)

Graham, J. R., Lemmon, M. L., & Schallheim, J. S. (1998). Debt, leases, taxes, and the endogeneity of corporate tax status. The Journal of Finance, 53(1), 131-162. https://doi.org/10.1111/0022-1082.55404