Bliss Air Line Limited Case Study

Fall 2015 A comprehensive report for Mr Michael Bliss

BLISS AIR LINE LIMITED

Purchase or Lease Decision for New Aircraft

Issue

Michael bliss the CEO wants to acquire the latest generation of planes, each of which costs $47 million to buy or $360,000 per month to lease. We can weigh both options and determine which is best for the company.

Option #1 – Purchase the Aircraft

The purchase option would require debt financing, which is available to Bliss Airline. The debt would be floating-rate debt, which exposes the company to potentially unfavourable interest rate risk. However, the interest rate risk can be reduced, if the new planes are purchased, both the assets and the related liability will appear on Bliss airlines’ balance sheet. The expense accounts that would be affected consist of interest on the debt and amortization on the planes.

Option #2 – Lease the Aircraft

A bargain purchase option or renewal term is not included in the deal, thus the reasonable assurance of obtaining ownership criterion for a finance lease is not met. Furthermore, the 14 year term of the lease is 70% of the industry standard amortization period of 20 years, and therefore does not meet the criterion of the lessee receiving all or substantially all of the economic benefits from the leased asset. At Bliss airlines’ incremental borrowing rate of 6.5%, the monthly interest rate is 0.54%. Discounting the 168 monthly payments yields a present value of the lease payments of slightly less than $40 million per plane, which does not meet the criterion of the lessee recovering all or substantially all of the investment including a return on investment. Finally, since the aircraft are not being significantly modified for Bliss airlines’ purposes, the final criterion of a finance lease is not met because the leased asset could provide benefit to other companies as well. The lease option is an operating lease for accounting purposes, therefore leasing the aircraft's provides off-balance sheet financing. The interest rate risk is also eliminated because the the interest rate is implicit which makes it a fixed rather than a floating rate. On the other hand, Bliss airlines’ may prefer to have floating debt rate since their business tends to fluctuate with economic conditions. Following the lease option would limit the company to the implicit rate, but if a floating rate is more desirable, the company will have to engage in an interest-rate swap.With a lease, the company will not report the assets on its balance sheet which will lead to an increase in the return on assets and a non disclosure of debt which will in turn improve the debt-to-equity ratio.The amount of lease payments are the only recognised lease expenses incurred during the reporting period. BALL will lose its tax shield if it owns the planes, even though operating lease would provide some reporting advantages especially in the balance sheet. Based on an after-tax cash flow it is possible that leasing is more expensive than purchasing the planes.

Recommendation

Leasing the new planes will keep both the planes and the debt off of the balance sheet. It also will reduce the overall expense in the early years of the lease because the rent expense will be less than the combination of interest expense and amortization that would result from buying the planes. However, the company will lose the advantage of the tax shield from owning the planes. Therefore, from a financial reporting perspective, the better alternative would be to lease the aircrafts since this meets your needs as it is a fair representation of the transaction to external users and also improves the financial statements. Furthermore, since the requirements for disclosure of leases require that future payments are disclosed, this will also help GE Capital and the lenders to assess the cash flow situation of BALL.

Financial Reporting Implication of 100% Stock Dividend

The issue here is that BALL would like to pay a 100% stock dividend instead of a stock split to ensure that shareholders receive something of value other than cash and to reduce retained earnings so that the shareholders will be less likely to expect cash dividends in the near future.

Option #1 – Stock Dividend : Legally, if BALL issues a stock dividend, it should be accounted for as such. As a result, the shares issued as part of the stock dividend will be valued at fair value and will decrease Retained Earnings and increase Common Shares.

Option #2 – Stock Split: Although legally BALL is going to issue