90.2K

Verified Solution

Link Copied!

The Lease Proposal The deal being reviewed by Su was the purchase and leaseback of three Boeing 757-200 aircraft, each with two Rolls-Royce engines and all related maintenance and technical records (Exhibit 3 lists the equipment). The deal also included two spare engines and the related maintenance and technical records. The two engines would be sold as is without a full QEC (Quick Engine Change).11Under the terms of the initial agreement as detailed in the Letter of Intent (LOI), WNG at lease expiry. Those valuations suggested a residual value of approximately $14 million. However, Su knew that the market for 757s was far less robust than the market for more popular aircraft and that finding a buyer in a timely fashion was often very difficult, unless the seller was willing to reduce the asking price by up to 20%. Also, when he considered the age of the 757s and their LOV, Su doubted that selling the aircraft to another operator would be a viable option when the lease expired. The most likely option in Sus view was to re-lease the equipment to another operator, and for this there was a reasonably healthy market. He expected that when the lease expired at the end of 2014, the aircraft and engines would have up to three years of remaining operating life, and he surmised that the equipment could be re-leased at the same monthly rental rate. Su estimated that the most likely outcome for WNG would be that the equipment would be on lease for 80% of the time during the last three years of operating life, after which WNG would realize $3 million for each aircraft, including parts and engines. Finally, Su considered the lessee. The airline was far less creditworthy than WNGs typical client. It had suffered significant losses in recent years and was heavily in debt, which made Su wonder about the risks of entering into a deal with a heavily indebted and financially challenged counterparty. Would the airline be able to meet its financial obligations to WNG? On the plus side, the airline had completed several sale-and-leaseback deals in the past 18 months, which had substantially improved its balance sheet. The question for Su was whether WNGs usual IRR of 11% to 14% would be sufficient compensation for either WNG or WNGs investors. Therefore, to reflect the higher risk, Su had chosen to use a required annual return of 20% to evaluate the deal. The Side Letter As Su began reviewing all the documents of the deal, he learned that the final inspections had just been completed and WNG had discovered more problems with the condition of the equipment. At the time of the LOI, WNG had assumed that all the engines were serviceable and the trace would be intact for all the equipment except the landing gear. To Sus chagrin, the most recent inspections revealed that one of the two spare engines was not serviceable, and a long list of additional equipment lacked back-to-birth traceability. To deal with these revelations, WNG would draft and send a side letter to the airline, detailing the inspection results and specifying revisions to the terms in the LOI. The first item in the side letter would be a reduction of the purchase price by $750,000 as compensation for the unserviceable engine. The inspection team had estimated the value of the items missing trace documentation as at least US$1.4 million. To compensate for the missing traces, WNG was seeking two adjustments to the LOI terms: a reduction in the purchase price by $1.4 million and an increase in the monthly rent by $140,000 (10% of the $1.4 million). The additional rent would serve as an incentive for the seller/lessee to locate and provide as many of the records as possible and as quickly as possible. If and when the missing documentation was located and provided, the additional 10% in rent for those items would no longer apply. Also, if the airline were to agree to re-lease the equipment beyond 2014, the additional 10% in rent would no longer apply. As Su reviewed the proposed terms of the side letter, it was clear to him that the revisions to the purchase price and the additional rent would have a substantial impact on the value of the lease to WNG. He wondered about the value of the unserviceable engine. Su was aware that a used modern jet engine contained precious metals such as cadmium and palladium that would have some small value in the scrap market. If the engine could be sold for parts, it could be worth in the neighborhood of $50,000, but since the engine was unserviceable, Su was assuming a residual/salvage value of zero for the analysis. Like the purchase price, Sus estimate of the residual value would have to be adjusted for the unserviceable engine and the missing trace. Su estimated that a reduction of the appraisal value by $1.4 million would approximate the impact of the missing trace. If anything, however, the missing trace would make finding a buyer even more difficult than he had originally thought. The prospect of searching for a buyer for months and months made it all the more likely to Su that WNG would follow a re-leasing strategy to stretch out the cash flows for the equipment. With these issues in mind, Su had begun to create a model for computing the net present value (NPV) and IRR of the cash flows. Because of the tax advantages of the SPE structure, Su conducted his analyses with a zero marginal tax rate. Included in the specific cash flows of the deal (Exhibit 5) were the purchase price and rental rates agreed upon in the LOI, plus the adjustments to the purchase price and the additional rent demanded in the side letter. Su wondered whether the airline would be able to locate the missing records, and if not, whether the extra rent would become unaffordable. Maybe it would be better to propose a larger reduction of the purchase price and smaller additional rental payments. Most importantly, however, Su wondered whether this deal would be profitable for WNG. Exhibit 5 WNG Capital LLC Summary of Cash-Flow Assumptions Letter of Intent (LOI) Terms: Lease expiry 15-Dec-14 Purchase price $15,000,000 Monthly rent* $325,000 Side-Letter Adjustments: Published value of unserviceable engine ($750,000) Published value of items missing trace** ($1,400,000) Adjusted purchase price $12,850,000 Additional rent of items missing trace (10% of value) $140,000 Analyst Assumptions: One-year residual value (at time of LOI) $14,000,000 Haircut to residual value for unserviceable engine ($750,000) Haircut to residual value for missing trace ($1,400,000) Revised estimate of residual value $11,850,000 Tax rate 0.0% Annual RRR 20.0% *Rent is due at the beginning of each month with the first payment due at closing. **trace = back-to-birth traceability. Source: Author estimates. Value the cash flows of the lease from the lessors (WNG) perspective and from the lessees (airline) perspective. Do both parties benefit? What are the sources of this value to WNG? To the airline? Conduct a sensitivity analysis on discount rates and cash-flow timing.

Answer & Explanation Solved by verified expert

See Answer