CASE 38
PRIMUS AUTOMATION DIVISION, 2002 Teaching Note
Synopsis and Obje!i"es
In early 2002, analyst Tom Baumann needed to propose terms for leasing one of his company company’s ’s advance advanced d factor factory-a y-auto utomat mation ion syste systems ms to a major major custom customer er.. rom rom the lessor’ lessor’ss standpoint, the challenge !as simply to design an annuity stream that yielded a present value e"ual to or greater than the value of the asset #eing leased. $ertain factors, ho!ever, served to complicate the analysis. The ta% e%posure and de#t rating of the customer !ere uncertain, leaving the analyst to estimate the impact of alternative lease terms under different ta% and interest-rate assumptions. The customer !as also considering the lease of competing systems from companies in &ermany and 'apan( these competing proposals limited )rimus’s fle%i#ility fle%i#ility in tailoring its proposal. In short, the students’ tas* is to design lease terms that e%ploit the lessee’s ta% and interest-rate e%posure !ithin constraints set #y competitive terms. The princi principal pal o#jective o#jective of this this case case is to provid providee a compre comprehens hensive ive e%ercise e%ercise in the econom economics ics of lease lease financ financing ing.. irst, irst, the case case illust illustrat rates es ho! a lease lease in effect effect +sells +sells the depreciation-ta% shield of an asset. econd, the case suggests that leases are an alternative to de#t financing and, thus, are shado!-priced off prevailing interest rates. inally, the case reveals that the distri#ution of economic #enefits from leasing is su#stantially a #argaining outcome and therefore, is su#ject to #argaining strategy, strategy, tactics, and positioning. secondary o#jective of this case is to underscore important insights a#out capital mar*ets, financial innovation, and financial contracting/ alternatives to so-called +plain-vanilla financial contracts arise to fulfill special needs of the issuer and investor. classic concern, for instance, is !hy leases e%ist !hen they are, in effect, de#t. The ans!er must #e that leases e%ploit capital-mar*et imperfections, thus ma*ing leasing attractive for the lessor and lessee. The final o#jective is to provide some institutional #ac*ground on lease financing, !hich includes the dramatic increase in the volume of leasing, accounting considerations, and a general perspective from the lessor’s point of vie!. This is a challenging case in preparation for !hich
This teaching note !as prepared #y o#ert . Bruner !ith the assistance of ean 1. $arr. $opyright � 200 #y the 3niversity of 4irginia 1arden chool oundation, $harlottesville, 4. ll rights reserved. To order copies, send an e-mail to sales5dardenpu#lishing.com. No part of this publication may be reproduced, stored stored in a retrieval system, used in a spreadshe spreadsheet, et, or transmit transmitted ted in any form or by any means—el means—electr ectronic onic,, mechanic mechanical, al, photocopy photocopying, ing, recording, or otherwise—without the permission of the Darden School Foundation.
students !ould #enefit from a lecture on leases and6or a simple e%ercise on the estimation of lease cash flo!s and net present values 7N)48.
S#$$es!ed %#es!ions &o' Ad"ane Assi$n(en! !o S!#den!s
9. :hy is )rimus utomation considering the lease of its factory-automation system to vantjet; 2. %hi#it ?. @.
S#ppo'!in$ Mi'oso&! E)e* Sp'eads+ee! i*e
or the students/ or the instructor/
$ase@C.%ls none
S#$$es!ed S#pp*e(en!a* Readin$s &o' S!#den!s
If this is the students’ first e%posure to leasing, then some supplemental readings !ill #e helpful to them 7see the list #elo!8. Brealey, ichard ., te!art $. Dyers, and ran*lin llen. +Eeasing. $hap. 2?. rinciples of !orporate Finance. "th ed . 7Ne! For*/ Dc&ra!-ducation, 200?8. s!ath, 1amodaran. +n Gvervie! of inancing $hoices. $hap. 9?. !orporate Finance# Theory and ractice. $nd ed . 7Ne! For*/ 'ohn :iley and ons, 20098. oss, tephen, andolph :esterfield, and 'effrey 'affe. +Eeasing. $hap. 29. !orporate Finance. %th ed. 7Ne! For*/ Dc&ra!-ducation, 2008.
-ypo!+e!ia* Tea+in$ P*an
The advance study "uestions form a useful outline for the class discussion. The needs of the students !ill dictate ho! much time and emphasis to give to the analytical details as opposed
to the #ig-picture, capital-mar*ets perspective. In essence, the class discussion !ill have four main components/
Ana*ysis
%hi#its @H, and to complete case >%hi#it ?. The *ey insight is that N)4 and internal rate of return 7I8 are useful measures for evaluating lease proposals. By leasing its factory automation system to vantjet, )rimus is, in effect, #uying a stream of future cash flo!s in much the same !ay that it #uys a stream of cash flo!s associated !ith a real asset. The #asic similarity in the !ays !e evaluate financial assets 7e.g., leases8 and real assets is an important learning point. P'iin$
re leases similar to de#t; Fes.J If similar, then !hy do leases e%ist !hen de#t contracts are more generic and li*ely to #e lo!er-cost than leases; Eeases transfer ta% #enefits in !ays that de#t cannot.J 1oes it appear that aulha#er and
:hat terms should Baumann recommend;
If it leases the system to vantjet, )rimus is in effect ma*ing a credit decision. ccordingly, )rimus assumes various credit-related ris*s and must decide !hether the rate of return on the lease is sufficient to compensate the firm for the ris*. If it does not lease the system, ho!ever, )rimus !ill pro#a#ly lose the customer. Thus, Baumann’s pro#lem is to assess the ris*s and determine !hether the investment is economically attractive. If time permits, the instructor can encourage students to thin* a#out !hich division7s8 should #ear the lease e%posure and in !hat proportions; The utomation 1ivision 718 is pushing to ma*e the lease, #ut )rimus also has an >"uipment inance 1ivision 7>18 that, in effect, serves as a #an* for lease deals. The simple ans!er must #e to house the lease in the >1, !here manufacturing and mar*eting managers 7e.g., in the 18 !ould focus on operating policy and not mingle operating and financing decisions. s long as the >1 invests in only attractive lease deals, )rimus can avoid the temptation to tailor lease terms simply to mas* price cuts to !in a sale.
Case Ana*ysis
The case offers an unusual perspectiveKthat of the lessor !ho is trying to understand the vie!point of the lessee. Dany leasing pro#lems are cast from the standpoint of the lessee only, and thus, amount to estimating the cost of financing. By considering #oth perspectives, this case sho!s that the lessee’s financing pro#lem is the lessor’s investment pro#lem. The other *ey insight provided #y this perspective is that competition among manufacturers to provide lease financing actually replicates competition in the capital mar*ets. $onstrained #y the ris*-adjusted costs of capital 9 and the pressures of competitors’ lease terms, the manufacturers’ proposals tend to cluster in a narro! range. Assess(en! o& !+e "a'io#s *ease !e'(s
G#jective measures of the attractiveness of lease Dis#ssion /#es!ion / :hy is )rimus terms are net present value and internal rate of return. considering the lease of its factoryGne assesses the #enefits of leasing versus #uying #y automation system to vantjet; evaluating the cash flo!s under each alternative. The o#jective is to choose the alternative !ith the lo!est cost, #ecause the use of the asset is the same !hether it is leased or #ought. This assessment is a financial decision rather than an investment decision 7!here financing costs are e%cluded8, #ecause financing flo!s determine the investment 9
The case presents no estimates of the costs of capital of )rimus,
method. The investment analysis justifying the purchase of the e"uipment must #e completed prior to and independent of the lease-versus-#uy decision. The discount rate used for the cash flo!s in the analysis is the after-ta% cost of de#t. This is #ecause the cash-flo! components are de#t-li*e/ 1epreciation flo!s and lease payments are much more sta#le and predicta#le than free cash flo!. Eease flo!s should #e discounted at the same rate as the interest and principal on a #ond or loanKthe after-ta% cost of de#t. ome argue that each item in the cash-flo! analysis re"uires a different discount rate depending on the item’s ris*. Gthers suggest using a different discount rate for the residual value only, #ecause this value is the only item that #ears significantly greater ris* than the other flo!s. In practice, most analysts use a single discount rate, mainly out of convenience. :ith the high o#solescence ris* of much e"uipment today, some analysts !ill use a different rate !ith !hich to determine the present value of the residual. or simplicity, Baumann used a single rate. $ase >%hi#it A illustrates the lease-payment analysis, !here the net present value of the t!o options is e"ual for a firm !ith a @AM ta% rate and a L.M cost of de#t. 3nder these assumptions, any lease payment #elo! 9?0,00@ favors leasing, and any payment e%ceeding it favors the #uy-and-#orro! alternative. $ase >%hi#it also illustrates the lease-payment analysis, as the internal rate of return of the lease is ?.2OM, !hich is the same as the after-ta% cost of de#t for a loan. ny lease rate lo!er than 9?0,00@ results in a lo!er I than the loan. The lessee’s decision rule is to choose the loan or lease depending on !hich one has the lo!er N)4 or I. Baumann has elected to assess four lease payment alternatives, as descri#ed in case >%hi#it @, against four sets of assumptions a#out vantjet’s ta% e%posure and preta% cost of de#t. $ase >%hi#it ? presents a !or*ed-out set of calculations for cenario , and leaves the student to complete the analysis for the other three scenarios. E)+ibi! TN provides a completed ta#le. 7Gne teaching approach !ould #e to project case >%hi#it ? onto a screen !ith an overhead transparency and invite students to fill in the #lan*s8. The completed !or* yields a num#er of insights. The first is ho! dramatically the lease’s attractiveness to a customer can vary depending on the customer’s ta% rate and cost of de#t. The instructor can as* the students to consider three sets of comparisons/ •
Ta) e)pos#'e. comparison of cenarios 7ta% rate of @AM8 and $ 7ta% rate of 0M8 sho!s a si=a#le increase in the cost of financing as vantjet’s ta% e%posure declinesKon average more than 200,000 in N)4 cost, or @20 to A0 #asis points. This is an o#ject illustration of the effect of financing ta% shields.
•
Cos! o& deb! . comparison of cenarios 7L.M cost8 and B 79@M cost8 reveals that as vantjet’s cost of de#t rises, the lease financing #ecomes more attractive.
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In!e'a!ion o& !a) e)pos#'e and os! o& deb! . comparison of cenarios and 1 sho!s that !ith the loss of ta% shields and more e%pensive de#t, lease financing generally dominates the #orro!-and-#uy alternative. P'iin$
If vantjet has a 0M ta% rate and a L.M cost of de#t, as in Dis#ssion /#es!ion 2/ cenario $, leasing option 9 saves them only 99,L@O 7perhaps not %cel8 the student can solve for the #rea*even level of annual lease payments necessary to just e"ual the ne%t most attractive financing alternative in terms of I cost 7see Tab*e TN 8. ocusing on I costs to vantjet o#scures an important competitive advantage/ the comparatively cheaper purchase price of the )rimus system. This price advantage could permit )rimus to as* the second lo!est annual lease payment 79?0,00@8 yet meet its minimum re"uired rate of return of ?.2OM, assuming a ta% rate of @AM and a cost of de#t of L.M. If vantjet is truly cash constrained, and if the )rimus system is #oth cheaper and genuinely compara#le to the others, then vantjet may accept leasing option 2.
Ta#le TN9. $omparison of loan versus leasing.
Sena'io / @AM ta% rate L.M cost of de#t
o1es! Cos!Co(pe!i!i"e A*!e'na!i"e !o P'i(#s in E)+ibi! TN Borro!-and-Buy ?.2OM
B/ @AM ta% rate 9@M cost of de#t
aulha#er &m#h O.9@M
$/ 0M ta% rate L.M cost of de#t
Borro!-and-Buy L.0M
1/ 0M ta% rate 9@M cost of de#t
aulha#er &m#h 99.A2M
Ann#a* ease Pay(en!s Neessa'y &o' P'i(#s !o %#o!e in O'de' !o E/#a* Ne)! 4es! IRR 9?0,00@ 7e"ual to leasing option P28 9?A,AO9 7#et!een leasing options P@ and PA8 9O?,OC? 7a#ove leasing option PA8 9C?,@A 7#et!een leasing options P@ and PA8
Capi!a* (a'.e!s and &inania* inno"a!ion E)+ibi! TN illustrates the range of present values for a lease and loan, depending on the ta% rate and cost of de#t used. Eessees can #enefit !hen they e%change ta% savings that they !ould not #e a#le to use for a lo!er lease payment providing a lo!er total cost than the loan. The lessor gains #y receiving a lease payment that gives a higher return than the cost of #orro!ing and administration from some lessee !illing to pay more for a lease than one !ho has ta%a#le income and lo! de#t costs. s the ta#le suggests, the savings from a lease are not necessarily a huge amount. ome leases are ta*en for convenience, fle%i#ility, and o#solescence protection rather than for e%plicit cost savings. $hief financial officers must e%ploit these ta%and technology-ar#itrage opportunities !hile they e%ist.
Danufacturers !ho lease can only depreciate #ased on the cost #asis of the cost of goods sold . Independent lessors, on the other hand, can depreciate #ased on the full selling price of the asset. Thus, a separate lease division !ithin a corporation provides an attractive +!arehouse for leases, #ecause the division #uys the asset from the manufacturing division and depreciates on the full price. In addition to the depreciation incentive, leasing intermediaries offer e%pertise, possi#ly a lo! cost of capital, portfolio diversification, economies of scale in administration, and potentially fine management of residual values. Eeases may #e vie!ed as nonstandard forms of de#t financing. The o#vious "uestion is, +:hat justifies the innovation; ome classic e%planations include the follo!ing considerations/ •
Cas+ &*o1 / Eease payments are usually lo!er than the payments on conventional loans. The lessee passes ta% savings to the lessor in e%change for a lo! lease payment. The
lessor receives depreciation and ta% savings along !ith any investment ta% credits. This ta%-shield e%change can #enefit #oth parties at the e%pense of the government if the lessor is in a higher ta% #rac*et than the lessee. 3nder an operating lease, the lessee immediately e%penses the lease payment, !hich results in "uic* cost reali=ation, thus decreasing ta%a#le income. Because leases are 900M financing, in contrast to a #an* loan that re"uires some e"uity investment in the asset, leasing provides li"uidity to a cashconstrained company. •
*e)ibi*i!y / Eeases closely match the life of the e"uipment to the term of the lease, unli*e short-term #an* loans. This duration-matching may #e achieved through tailoring of payment periods 7annual, monthly, "uarterly, etc.8, flat versus trended payments 7i.e., rising or falling over time8, tying payments to the asset’s actual use, omitting payments during a cyclical do!nturn, tying payments to floating rates of interest, #alloon payments, advance payments, and si%-month trial options !ith no payments.
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Ao#n!in$ / If structured as an operating lease, the lessee can o#tain +off-#alance-sheet financing that sho!s no lia#ility for the leased property. Thus, leasing can allegedly improve a company’s credit standing. In efficient de#t and e"uity mar*ets, ho!ever, this advantage cannot #e sustained. nother cosmetic advantage is an internal one/ or many companies, leasing is a method for managers to avoid capital-#udgeting system constraints #ecause some capital-#udgeting processes e%clude operating leases 7!hich is apparently the case !ith vantjet8. inally, leasing may #e a means of avoiding lternative Dinimum Ta% 7DT8 #ecause lease payments do not contri#ute to the DT #oo*-income adjustment, !hich shrin*s the difference #et!een #oo* and DT income and helps the company avoid additional ta%.
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Ris. / :ith leasing, the e"uipment user #ears no ris* of large changes in value due to o#solescence 7mainly !ith high-tech e"uipment8. t the end of the lease term, the lessee can negotiate a ne! lease, purchase the e"uipment at fair mar*et value, or merely return the property to the lessor. In addition, lessees often have the a#ility to upgrade to featured, large-capacity, modern e"uipment during the lease term, thus eliminating the ris* of loc*ing into a particular piece of e"uipment !hen technology is rapidly evolving. inally, fi%ed-rate leases eliminate the ris* of interest-rate fluctuations. The instructor might point out that many of these ris*-management features are actually real optionsK the value of !hich can only enhance the !orth of the lease to the lessee.
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Con"eniene / Eeasing is a relatively hassle-free method of ac"uiring the use of an asset. 7The amount of hassle, o#viously, depends on the si=e and sophistication of the asset.8 The lessee often o#tains the e"uipment and the financing simultaneously. ull-service leases and maintenance contracts remove the typical headaches associated !ith o!ning e"uipment !hile providing peace of mind #y promising that someone !ill "uic*ly solve any pro#lems that occur. urthermore, leasing #rings no e%pense associated !ith disposing of the e"uipment. :hen an asset has reached the end of its life or is no longer needed, the lessee simply returns it to the lessor.
Reo((enda!ion
Dany of the considerations that surround ma*ing a Dis#ssion /#es!ion 5/ recommendation have #een surveyed a#ove 7see )ricing section8. :hat lease terms should Baumann recommend; The feasi#ility test for all suggested lease terms is that they must #e lo!er in cost than proposals from
P'i(#s S+o#*d O&&e' Eeasing Gption P2 Eeasing Gption P2 Eeasing Gption P9 Eeasing Gption P9
IRR ?.2OM ?.2OM C.?9M C.?9M
NPV A?L,2O@ A0,CLC ?9,C?@ ?9?,202
tudents may ignore some important "ualitative concerns surrounding recommendation they ma*e. tudents should then #e as*ed the follo!ing "uestions/
any
9. Is )rimus’s system e%actly the same as those of %actly ho! should 'im eldman present this proposal to vantjet; Gne must remem#er that vantjet’s ta% e%posure and preta% cost of de#t are un*no!n to )rimus. If vantjet !ill not tell eldman its ta% and interest-rate e%pectations, then eldman must sell the terms of the lease under all four scenarios. )lainly, this situation calls for sharp presentation s*ills and may form the foundation for a group project or !ritten assignment.
>%hi#it TN9 PRIMUS AUTOMATION DIVISION, 2002
$ompleted ummary Ta#le of the N)4 and I or our Ta% and $ost-of-$apital cenarios
