Magna Charter has been asked to operate a Beaver bush plane for a mining company exploring north


Magna Charter has been asked to operate a Beaver bush plane for a mining company exploring north and west of Fort Liard. Magna will have a firm one-year contract with the mining company and expects that the contract will be renewed for the five-year duration of the exploration program. If the mining company renews at year 1, it will commit to use the plane for four more years. Magna Charter has the following choices.

• Buy the plane for $500,000.

• Take a one-year operating lease for the plane. The lease rate is $118,000, paid in advance.

• Arrange a five-year, non-cancelable financial lease at a rate of $75,000 per year, paid in advance.

These are net leases: all operating costs are absorbed by Magna Charter. How would you advise Agnes Magna, the charter company’s CEO? For simplicity assume five-year, straight-line depreciation for tax purposes. The company’s tax rate is 35 percent. The weighted-average cost of capital for the bush-plane business is 14 percent, but Magna can borrow at 9 percent. The expected inflation rate is 4 percent. Ms. Magna thinks the plane will be worth $300,000 after five years. But if the contract with the mining company is not renewed (there is a 20 percent probability of this outcome at year 1), the plane will have to be sold on short notice for $400,000. If Magna Charter takes the five-year financial lease and the mining company cancels at year 1, Magna can sublet the plane that is, rent it out to another user. Make additional assumptions as necessary.

Cost Of Capital
Cost of capital refers to the opportunity cost of making a specific investment . Cost of capital (COC) is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. COC is the required rate of...
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Principles of Corporate Finance

ISBN: 978-0072869460

7th edition

Authors: Richard A. Brealey, Stewart C. Myers

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