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

POTENTIAL OPTIONS FOR MANAGEMENT REVIEW

NET ADVANTAGE TO LEASING

Many variables must be considered in rent vs. buy decisions: 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? Is the Return On Investment higher if

Continental buys the aircraft versus investing the initial cash outlay saved in securities?

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.

Continental Airlines must determine the most cost effective way to add two Boeing 757 aircraft to its fleet for the next fifteen (15) years.

$0 $20,000,000 $40,000,000 $60,000,000 $80,000,000

($4,000,000)

($3,000,000)

($2,000,000)

($1,000,000)

$0

$1,000,000

$2,000,000

$3,000,000

$4,000,000

Impact of Residual Values on Net Advantage to Leasing

NAL

Residual Values

Net

Adv

anta

ge t

o Le

asin

gResidual Value NAL

$5,000,000.00 $3,584,276.00$10,000,000.00 $3,035,135.24$15,000,000.00 $2,485,994.47$20,000,000.00 $1,936,853.71$25,000,000.00 $1,387,712.95$30,000,000.00 $838,572.19$35,000,000.00 $289,431.43$40,000,000.00 ($259,709.33)$45,000,000.00 ($808,850.09)$50,000,000.00 ($1,357,990.85)$55,000,000.00 ($1,907,131.61)$60,000,000.00 ($2,456,272.37)$65,000,000.00 ($3,005,413.14)$70,000,000.00 ($3,554,553.90)

0 2 4 6 8 10 12 14 16

($375)($355)($335)($315)($295)($275)($255)($235)($215)($195)($175)($155)($135)($115)($95)($75)($55)($35)($15)

$5

($339)

($155)

($94)

($63)($45)

($32)($23)($17)($12)($8)($4)($2)$0 $2 $4

Effect of Years Without Tax Deductions on NAL (in Mil-lions)

Years With No Taxes

Net

Adv

anta

ge o

f Le

asin

g Years Without Taxes NAL

14 ($339,772,549.32)13 ($155,569,263.81)12 ($94,168,168.64)11 ($63,467,621.05)10 ($45,047,292.50)9 ($32,767,073.47)8 ($23,995,488.44)7 ($17,416,799.67)6 ($12,300,041.74)5 ($8,206,635.40)4 ($4,857,484.75)3 ($2,066,525.88)2 $295,054.701 $2,319,266.630 $4,073,583.63

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  $  10,000,000.00  $        500,000.00   

0.1  $  15,000,000.00  $    1,500,000.00   0.1  $  20,000,000.00  $    2,000,000.00   

0.15  $  25,000,000.00  $    3,750,000.00   0.2  $  30,000,000.00  $    6,000,000.00   

0.15  $  35,000,000.00  $    5,250,000.00   0.1  $  40,000,000.00  $    4,000,000.00   0.1  $  45,000,000.00  $    4,500,000.00   

0.05  $  50,000,000.00  $    2,500,000.00   1    $  30,000,000.00 Expected Residual Value    

Probability Rate        0.8 10% 0.08  0.2 12% 0.024  1   10.4%Total Interest Cost ( r)  

(1-T) 0.6

r 0.104

Quarterly r 0.026

Question 1 cont……

Quarterly A/P Cost   $                       4,000,000.00 

Tax Rate (T)   0.4

Tax deduction $                       1,600,000.00 

Airplane Cost (A/P Cost)   $                  125,000,000.00 

Expected Residual Value (ERV) $                          30,000,000 

Tax Rate (T)   0.4Years 15Quarters per year 4Number of Periods 60

Depreciation Tax Credits $                        633,333.333 

Quarterly CFAT   $                    3,033,333.333 

A/P Cost  @ M79 ITC NAL

NAL =  125000000 117631571.80 3294844.57 $                         4,073,583.63 

Cont….

  Quarterly  Period CFAT [1 + (1-T)r}^t]

1  $  3,033,333.33  1.0156  $       2,986,740.19 2  $  3,033,333.33  1.03144336  $       2,940,862.73 3  $  3,033,333.33  1.04753388  $       2,895,689.96 4  $  3,033,333.33  1.0638754  $       2,851,211.07 5  $  3,033,333.33  1.08047186  $       2,807,415.39 6  $  3,033,333.33  1.09732722  $       2,764,292.43 7  $  3,033,333.33  1.11444553  $       2,721,831.85 8  $  3,033,333.33  1.13183088  $       2,680,023.49 9  $  3,033,333.33  1.14948744  $       2,638,857.31 

10  $  3,033,333.33  1.16741944  $       2,598,323.47 11  $  3,033,333.33  1.18563119  $       2,558,412.24 12  $  3,033,333.33  1.20412703  $       2,519,114.06 13  $  3,033,333.33  1.22291141  $       2,480,419.51 14  $  3,033,333.33  1.24198883  $       2,442,319.33 15  $  3,033,333.33  1.26136386  $       2,404,804.38 16  $  3,033,333.33  1.28104113  $       2,367,865.68 17  $  3,033,333.33  1.30102538  $       2,331,494.37 18  $  3,033,333.33  1.32132137  $       2,295,681.73 19  $  3,033,333.33  1.34193399  $       2,260,419.19 20  $  3,033,333.33  1.36286816  $       2,225,698.30 21  $  3,033,333.33  1.3841289  $       2,191,510.73 22  $  3,033,333.33  1.40572131  $       2,157,848.30 23  $  3,033,333.33  1.42765056  $       2,124,702.93 24  $  3,033,333.33  1.44992191  $       2,092,066.69 25  $  3,033,333.33  1.47254069  $       2,059,931.76 26  $  3,033,333.33  1.49551233  $       2,028,290.42 27  $  3,033,333.33  1.51884232  $       1,997,135.12 28  $  3,033,333.33  1.54253626  $       1,966,458.37 29  $  3,033,333.33  1.56659983  $       1,936,252.82 30  $  3,033,333.33  1.59103878  $       1,906,511.25 

31  $  3,033,333.33  1.61585899  $       1,877,226.51 32  $  3,033,333.33  1.64106639  $       1,848,391.60 33  $  3,033,333.33  1.66666702  $       1,819,999.61 34  $  3,033,333.33  1.69266703  $       1,792,043.73 35  $  3,033,333.33  1.71907263  $       1,764,517.26 36  $  3,033,333.33  1.74589017  $       1,737,413.61 37  $  3,033,333.33  1.77312605  $       1,710,726.28 38  $  3,033,333.33  1.80078682  $       1,684,448.87 39  $  3,033,333.33  1.8288791  $       1,658,575.10 40  $  3,033,333.33  1.85740961  $       1,633,098.76 41  $  3,033,333.33  1.8863852  $       1,608,013.75 42  $  3,033,333.33  1.91581281  $       1,583,314.05 43  $  3,033,333.33  1.94569949  $       1,558,993.75 44  $  3,033,333.33  1.9760524  $       1,535,047.01 45  $  3,033,333.33  2.00687882  $       1,511,468.11 46  $  3,033,333.33  2.03818613  $       1,488,251.39 47  $  3,033,333.33  2.06998183  $       1,465,391.28 48  $  3,033,333.33  2.10227355  $       1,442,882.32 49  $  3,033,333.33  2.13506901  $       1,420,719.10 50  $  3,033,333.33  2.16837609  $       1,398,896.32 51  $  3,033,333.33  2.20220276  $       1,377,408.74 52  $  3,033,333.33  2.23655712  $       1,356,251.22 53  $  3,033,333.33  2.27144741  $       1,335,418.69 54  $  3,033,333.33  2.30688199  $       1,314,906.16 55  $  3,033,333.33  2.34286935  $       1,294,708.70 56  $  3,033,333.33  2.37941811  $       1,274,821.49 57  $  3,033,333.33  2.41653704  $       1,255,239.75 58  $  3,033,333.33  2.45423501  $       1,235,958.79 59  $  3,033,333.33  2.49252108  $       1,216,973.99 60  $  3,033,333.33  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 Rate  0.8 10% 0.08  0.2 12% 0.024  1 10.4%Total Interest Cost ( r)

    2.6%Quarterly r    

Airplane Cost (A/P Cost)   $ 125,000,000.00

Probability Value0.05 10,000,000.00$   500,000.00$        0.1 15,000,000.00$   1,500,000.00$    0.1 20,000,000.00$   2,000,000.00$    

0.15 25,000,000.00$   3,750,000.00$    0.2 30,000,000.00$   6,000,000.00$    

0.15 35,000,000.00$   5,250,000.00$    0.1 40,000,000.00$   4,000,000.00$    0.1 45,000,000.00$   4,500,000.00$    

0.05 50,000,000.00$   2,500,000.00$    1 30,000,000.00$   Expected Residual Value

Copy Formulae down from Row 15Numerator DenominatorQuarterly CFAT

Period (1 + Quarterly r)^period N/D1 2,400,000.00$        1.026000 2,339,181.29$      2 2,400,000.00$        1.052676 2,279,903.79$      3 2,400,000.00$        1.080046 2,222,128.45$      4 2,400,000.00$        1.108127 2,165,817.20$      5 2,400,000.00$        1.136938 2,110,932.94$      6 2,400,000.00$        1.166498 2,057,439.52$      7 2,400,000.00$        1.196827 2,005,301.67$      8 2,400,000.00$        1.227945 1,954,485.06$      9 2,400,000.00$        1.259871 1,904,956.20$      

10 2,400,000.00$        1.292628 1,856,682.46$      11 2,400,000.00$        1.326236 1,809,632.02$      12 2,400,000.00$        1.360719 1,763,773.90$      13 2,400,000.00$        1.396097 1,719,077.88$      14 2,400,000.00$        1.432396 1,675,514.50$      15 2,400,000.00$        1.469638 1,633,055.07$      16 2,400,000.00$        1.507849 1,591,671.61$      17 2,400,000.00$        1.547053 1,551,336.85$      18 2,400,000.00$        1.587276 1,512,024.22$      19 2,400,000.00$        1.628545 1,473,707.82$      20 2,400,000.00$        1.670888 1,436,362.39$      21 2,400,000.00$        1.714331 1,399,963.35$      22 2,400,000.00$        1.758903 1,364,486.69$      23 2,400,000.00$        1.804635 1,329,909.06$      24 2,400,000.00$        1.851555 1,296,207.66$      25 2,400,000.00$        1.899696 1,263,360.29$      26 2,400,000.00$        1.949088 1,231,345.31$      27 2,400,000.00$        1.999764 1,200,141.63$      28 2,400,000.00$        2.051758 1,169,728.68$      29 2,400,000.00$        2.105104 1,140,086.44$      30 2,400,000.00$        2.159836 1,111,195.36$      

31 2,400,000.00$        2.215992 1,083,036.41$      32 2,400,000.00$        2.273608 1,055,591.04$      33 2,400,000.00$        2.332722 1,028,841.17$      34 2,400,000.00$        2.393372 1,002,769.18$      35 2,400,000.00$        2.455600 977,357.87$          36 2,400,000.00$        2.519446 952,590.52$          37 2,400,000.00$        2.584951 928,450.80$          38 2,400,000.00$        2.652160 904,922.80$          39 2,400,000.00$        2.721116 881,991.04$          40 2,400,000.00$        2.791865 859,640.39$          41 2,400,000.00$        2.864454 837,856.13$          42 2,400,000.00$        2.938929 816,623.91$          43 2,400,000.00$        3.015342 795,929.73$          44 2,400,000.00$        3.093740 775,759.97$          45 2,400,000.00$        3.174178 756,101.34$          46 2,400,000.00$        3.256706 736,940.88$          47 2,400,000.00$        3.341381 718,265.96$          48 2,400,000.00$        3.428257 700,064.29$          49 2,400,000.00$        3.517391 682,323.87$          50 2,400,000.00$        3.608843 665,033.01$          51 2,400,000.00$        3.702673 648,180.32$          52 2,400,000.00$        3.798943 631,754.70$          53 2,400,000.00$        3.897715 615,745.32$          54 2,400,000.00$        3.999056 600,141.64$          55 2,400,000.00$        4.103031 584,933.37$          56 2,400,000.00$        4.209710 570,110.50$          57 2,400,000.00$        4.319163 555,663.25$          58 2,400,000.00$        4.431461 541,582.12$          59 2,400,000.00$        4.546679 527,857.82$          60 2,400,000.00$        4.664893 514,481.30$          

72,519,949.95$    

Given in Case Study (Same as Question 1)Probability Value

0.05 10,000,000.00$   500,000.00$        0.1 15,000,000.00$   1,500,000.00$    0.1 20,000,000.00$   2,000,000.00$    

0.15 25,000,000.00$   3,750,000.00$    0.2 30,000,000.00$   6,000,000.00$    

0.15 35,000,000.00$   5,250,000.00$    0.1 40,000,000.00$   4,000,000.00$    0.1 45,000,000.00$   4,500,000.00$    

0.05 50,000,000.00$   2,500,000.00$    1 30,000,000.00$   Expected Residual Value

(1+ 0.15/4)^number of periodsExpected Residual Value 30,000,000.00$   9.105133609

50,000,000.00$   9.105133609

10,000,000.00$   9.105133609

ITC A/P Cost  @ G74 ITC NAL3,294,844.57$   NAL =  125,000,000.00$           72,519,949.95$          3,294,844.57$   49,185,205.49$    

5,491,407.61$   NAL =  125,000,000.00$           72,519,949.95$          5,491,407.61$   46,988,642.44$    

1,098,281.52$   NAL =  125,000,000.00$           72,519,949.95$          1,098,281.52$   51,381,768.53$    

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.

Airplane Cost (A/P Cost) 125,000,000.00$   Given in Case Study

Given in Case Study (Same as Question 1)Probability Rate

0.8 10% 0.080.2 12% 0.0241 10.4% Total Interest Cost ( r)

2.6% Quarterly r

INPUT VALUE @ K16 for SAL@F75 SAL GET M16 to EQUAL ZERO (rounding to 0.00)

125,000,000.00$         72,519,949.95$                477,837,867.00$       NAL=0 0.069.105133609

Quarterly CFATPeriod (1 + Quarterly r)^period N/D

1 2,400,000.00$   1.026000 2,339,181.29$         2 2,400,000.00$   1.052676 2,279,903.79$         3 2,400,000.00$   1.080046 2,222,128.45$         4 2,400,000.00$   1.108127 2,165,817.20$         5 2,400,000.00$   1.136938 2,110,932.94$         6 2,400,000.00$   1.166498 2,057,439.52$         7 2,400,000.00$   1.196827 2,005,301.67$         8 2,400,000.00$   1.227945 1,954,485.06$         9 2,400,000.00$   1.259871 1,904,956.20$         

10 2,400,000.00$   1.292628 1,856,682.46$         11 2,400,000.00$   1.326236 1,809,632.02$         12 2,400,000.00$   1.360719 1,763,773.90$         13 2,400,000.00$   1.396097 1,719,077.88$         14 2,400,000.00$   1.432396 1,675,514.50$         15 2,400,000.00$   1.469638 1,633,055.07$         16 2,400,000.00$   1.507849 1,591,671.61$         17 2,400,000.00$   1.547053 1,551,336.85$         18 2,400,000.00$   1.587276 1,512,024.22$         19 2,400,000.00$   1.628545 1,473,707.82$         20 2,400,000.00$   1.670888 1,436,362.39$         21 2,400,000.00$   1.714331 1,399,963.35$         22 2,400,000.00$   1.758903 1,364,486.69$         23 2,400,000.00$   1.804635 1,329,909.06$         24 2,400,000.00$   1.851555 1,296,207.66$         25 2,400,000.00$   1.899696 1,263,360.29$         26 2,400,000.00$   1.949088 1,231,345.31$         27 2,400,000.00$   1.999764 1,200,141.63$         28 2,400,000.00$   2.051758 1,169,728.68$         29 2,400,000.00$   2.105104 1,140,086.44$         30 2,400,000.00$   2.159836 1,111,195.36$         

31 2,400,000.00$   2.215992 1,083,036.41$         32 2,400,000.00$   2.273608 1,055,591.04$         33 2,400,000.00$   2.332722 1,028,841.17$         34 2,400,000.00$   2.393372 1,002,769.18$         35 2,400,000.00$   2.455600 977,357.87$             36 2,400,000.00$   2.519446 952,590.52$             37 2,400,000.00$   2.584951 928,450.80$             38 2,400,000.00$   2.652160 904,922.80$             39 2,400,000.00$   2.721116 881,991.04$             40 2,400,000.00$   2.791865 859,640.39$             41 2,400,000.00$   2.864454 837,856.13$             42 2,400,000.00$   2.938929 816,623.91$             43 2,400,000.00$   3.015342 795,929.73$             44 2,400,000.00$   3.093740 775,759.97$             45 2,400,000.00$   3.174178 756,101.34$             46 2,400,000.00$   3.256706 736,940.88$             47 2,400,000.00$   3.341381 718,265.96$             48 2,400,000.00$   3.428257 700,064.29$             49 2,400,000.00$   3.517391 682,323.87$             50 2,400,000.00$   3.608843 665,033.01$             51 2,400,000.00$   3.702673 648,180.32$             52 2,400,000.00$   3.798943 631,754.70$             53 2,400,000.00$   3.897715 615,745.32$             54 2,400,000.00$   3.999056 600,141.64$             55 2,400,000.00$   4.103031 584,933.37$             56 2,400,000.00$   4.209710 570,110.50$             57 2,400,000.00$   4.319163 555,663.25$             58 2,400,000.00$   4.431461 541,582.12$             59 2,400,000.00$   4.546679 527,857.82$             60 2,400,000.00$   4.664893 514,481.30$             

72,519,949.95$       

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)$30M $839k$50M ($1,358k)$10M $3,035k

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 $30M 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.