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
companys advanced factory-automation systems to a major customer. rom the lessors
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 )rimuss fle%i#ility in
tailoring its proposal. In short, the students tas* is to design lease terms that e%ploit the lessees
ta% and interest-rate e%posure !ithin constraints set #y competitive terms.
The principal o#jective of this case is to provide a comprehensive e%ercise in the
economics of lease financing. irst, the case illustrates ho! a lease in effect +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, 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 lessors point of vie!. This is a challenging case in preparation for !hich
This teaching note !as prepared #y 0o#ert . Bruner !ith the assistance of -ean 1. $arr. $opyright 2002 #y the
3niversity of 4irginia 1arden -chool oundation, $harlottesville, 4.. .ll rights reserved. To order copies, send an
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recording, or otherwisewithout 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#$$es!ed %#es!ions &o' Ad"ane Assi$n(en! !o S!#den!s
9. :hy is )rimus .utomation considering the lease of its factory-automation system to
.vantjet;
2. <o! did Tom Baumann analy=e the pro#lem of setting the lease-financing terms; <o!
does he calculate N)4 and internal rate of return 7I008 for the lease and #orro!-and-#uy
alternatives; )lease complete case >%hi#it ?.
@. <o! are aulha#er and <onshu <eavy Industries using their leasing plans;
A. :hat lease terms should Baumann recommend; <o! should )rimuss sales and leasing
divisions structure the terms of the deal !ith .vantjet; <o! !ould you approach the
negotiations !ith .vantjet;
S#ppo'!in$ Mi'oso&! E)e* Sp'eads+ee! ,i*e
or the students/ $aseB@C.%ls
or the instructor/ none
S#$$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, 0ichard .., -te!art $. Dyers, and ran*lin .llen. +Eeasing., $hap. 2?. rinciples of
!orporate Finance. "th ed. 7Ne! For*/ Dc&ra!-<ill <igher >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.
0oss, -tephen, 0andolph :esterfield, and 'effrey 'affe. +Eeasing., $hap. 29. !orporate
Finance. %th ed. 7Ne! For*/ Dc&ra!-<ill <igher >ducation, 20028.
-ypo!+e!ia* Tea+in$ 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
<o! did Baumann #egin analy=ing the pro#lem; :hy did he decide to assess four
scenarios and not just one; :hat are the "uantitative measures #y !hich to evaluate a lease
proposal;
The o#jective of this segment of the discussion is to revie! case >%hi#its @H2, and to
complete case >%hi#it ?. The *ey insight is that N)4 and internal rate of return 7I008 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$
<o! should Baumann choose the set of terms to recommend to 'im eldman; :hat
impact, if any, should the competing proposals #y aulha#er and <onshu have on Baumanns
thin*ing;
The main o#jective of this segment of the discussion is to illustrate the distri#utive nature
of leasing/ )ricing a lease in effect distri#utes economic #enefits #et!een lessor and lessee. If
.vantjet had no #argaining po!er, Baumann could propose lease terms that appropriated all of
the leasing #enefits for )rimus. But .vantjet has limited )rimuss po!er #y inviting t!o other
lessors to ma*e proposals. $onse"uently, Baumann must recommend a set of terms that
dominates the competitors 7from .vantjets point of vie!8 and remains economically attractive
from )rimuss point of vie!.
Capi!a* (a'.e!s and &inania* inno"a!ion
.re leases similar to de#t; IFes.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; IEeases transfer ta% #enefits in !ays
that de#t cannot.J 1oes it appear that aulha#er and <onshu are using their hypothetically lo!
cost of capital in a competitively aggressive !ay; INo.J
The simple o#jective here is to revie! some generic ideas a#out lease financing. The
"uestion a#out foreign costs of capital also invites a perspective on the impact of the glo#al
lease-financing mar*et, if any, and on the pricing of leases in the 3nited -tates.
Reo((enda!ion
:hat terms should Baumann recommend; <o! should he sell his recommendation
inside )rimus;
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, Baumanns 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 7.18 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 lessees financing pro#lem is the lessors 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
terms are net present value and internal rate of return.
Gne assesses the #enefits of leasing versus #uying #y
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, <onshu, or aulha#er( therefore, some
students may argue that they cannot complete a net present value of the respective lease proposals. The instructor
should help students !or* through this error/ Gne aims to select a discount rate for a stream of cash that is
appropriate for the ris* of that stream. .vantjet may very !ell have a different level of ris* from the three
manufacturers. In addition, the !eighted-average cost of capital for any of the three firms !ould #e inappropriate to
use in order to discount a stream of lease payments/ inance theory tells us that leases are li*e de#t, and that the cost
of de#t is the appropriate discount rate. The case indicates that .vantjet can #orro! at the same rate as )rimus, or
L.2M. or the sensitivity analysis, Baumann also estimates the lease N)4s using a 9@M cost of de#t. The cost of
de#t should #e the only relevant hurdle rate for the manufacturers.
Dis#ssion /#es!ion 0/ :hy is )rimus
considering the lease of its factory-
automation system to .vantjet;
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 items
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.2M cost of de#t. 3nder these
assumptions, any lease payment #elo! N9?0,00@ favors leasing, and any payment e%ceeding it
favors the #uy-and-#orro! alternative. $ase >%hi#it 2 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 N9?0,00@ results in a lo!er I00 than the loan. The lessees
decision rule is to choose the loan or lease depending on !hich one has the lo!er N)4 or I00.
Baumann has elected to assess four lease payment alternatives, as descri#ed in case
>%hi#it @, against four sets of assumptions a#out .vantjets 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! TN0 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 leases
attractiveness to a customer can vary depending on the customers 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 .vantjets ta% e%posure declinesKon
average more than N200,000 in N)4 cost, or @20 to A20 #asis points. This is an o#ject
illustration of the effect of financing ta% shields.
Cos! o& deb!. . comparison of -cenarios . 7L.2M cost8 and B 79@M cost8 reveals that as
.vantjets cost of de#t rises, the lease financing #ecomes more attractive.
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.2M cost of de#t, as in
-cenario $, leasing option 9 saves them only N99,L@O 7perhaps not
enough to give up asset o!nership8. Eease payments 2, @, and A are
all more e%pensive than de#t financing on a present-value #asis 7in
-cenario $8 #ecause the discounted value of the loan and lease are
much closer after the ta% savings are erased than they !ere #efore.
)rimus !ould have to lo!er the lease payment even more in order to get .vantjet to lease the
system.
If .vantjet is in the same ta% #rac*et as )rimus #ut pays higher rates on its de#t, 7contrary
to Baumanns assumptions in the case8 then leasing is very advantageous. These various
scenarios and lease payments sho! ho! the lease-versus-#uy decision varies under different
circumstances and ho! the total cost under either method rises significantly !ithout ta% savings.
:hat a#out the competition from aulha#er and <onshu;
-tudents can ans!er this #y comparing the I00 of lease costs of
)rimus, aulha#er, and <onshu. E)+ibi! TN0 reveals that all of
)rimuss leasing options are superior to <onshus lease proposal
under all four scenarios. )rimuss lease payment schemes 9, 2, and
@ dominate aulha#er on an I00 #asis under all the scenarios( Baumann might consider tin*ering
slightly !ith the lease terms to dominate this competitor. By trial and error 7e.g., using the &oal
-ee* tool in Dicrosoft >%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 I00
cost 7see Tab*e TN08.
ocusing on I00 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 7N9?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.2M. 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.
Dis#ssion /#es!ion 2/
<o! did Tom Baumann
analy=e the pro#lem of
setting the lease-financing
terms;
Dis#ssion /#es!ion 3/
<o! are aulha#er and
<onshu using their leasing
plans;
Ta#le TN9. $omparison of loan versus leasing.
Capi!a* (a'.e!s and &inania* inno"a!ion
E)+ibi! TN0 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
Sena'io
2o1es! Cos!3Co(pe!i!i"e
A*!e'na!i"e !o P'i(#s in
E)+ibi! TN0
Ann#a* 2ease Pay(en!s
Neessa'y &o' P'i(#s !o
%#o!e in O'de' !o E/#a*
Ne)! 4es! IRR
./ @AM ta% rate
L.2M cost of de#t
Borro!-and-Buy
?.2OM
N9?0,00@
7e"ual to leasing option P28
B/ @AM ta% rate
9@M cost of de#t
aulha#er &m#h
O.9@M
N9?A,AO9
7#et!een leasing options P@
and PA8
$/ 0M ta% rate
L.2M cost of de#t
Borro!-and-Buy
L.20M
N9O?,OC?
7a#ove leasing option PA8
1/ 0M ta% rate
9@M cost of de#t
aulha#er &m#h
99.A2M
N9C?,2@A
7#et!een leasing options P@
and PA8
lessor receives depreciation and ta% savings along !ith any investment ta% credits. This
ta%-shield e%change can #enefit #oth parties at the e%pense of the government if the lessor
is in a higher ta% #rac*et than the lessee. 3nder an operating lease, the lessee
immediately e%penses the lease payment, !hich results in "uic* cost reali=ation, thus
decreasing ta%a#le income. Because leases are 900M financing, in contrast to a #an* loan
that re"uires some e"uity investment in the asset, leasing provides li"uidity to a cash-
constrained company.
,*e)ibi*i!y/ Eeases closely match the life of the e"uipment to the term of the lease, unli*e
short-term #an* loans. This duration-matching may #e achieved through tailoring of
payment periods 7annual, monthly, "uarterly, etc.8, flat versus trended payments 7i.e.,
rising or falling over time8, tying payments to the assets actual use, omitting payments
during a cyclical do!nturn, tying payments to floating rates of interest, #alloon
payments, advance payments, and si%-month trial options !ith no payments.
Ao#n!in$/ 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 companys 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% 7.DT8 #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%.
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.
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
recommendation have #een surveyed a#ove 7see )ricing section8.
The feasi#ility test for all suggested lease terms is that they must #e
lo!er in cost than proposals from <onshu and aulha#er and the
cost of the #uy-and-#orro! alternative, yet they must meet or e%ceed the ris*-adjusted, re"uired
rate of return as seen #y )rimus 7?.2OM8. In short, Tom Baumann faces a constrained
optimi=ation pro#lem. <e must first assess !hat *ind of customer .vantjet is 7i.e., in terms of ta%
e%posure and cost of de#t8 and then tailor a !inning proposal !ithin the constraints.
In essence, this is a pro#lem of financial engineering/ Gne lease proposal does not fit all
scenarios. -pecifically, students should see that to !in the deal and meet the capital cost hurdle,
)rimus should offer the terms in the follo!ing four scenarios 7Tab*e TN28/
Ta#le TN2. 4arious leasing options.
Sena'io P'i(#s S+o#*d O&&e' IRR NPV
. Eeasing Gption P2 ?.2OM NA?L,2O@
B Eeasing Gption P2 ?.2OM NA20,CLC
$ Eeasing Gption P9 C.?9M N?29,C?@
1 Eeasing Gption P9 C.?9M N?9?,202
-tudents may ignore some important "ualitative concerns surrounding any
recommendation they ma*e. -tudents should then #e as*ed the follo!ing "uestions/
9. Is )rimuss system e%actly the same as those of <onshu and aulha#er; .re there
differences that might justify slightly more e%pensive lease terms than )rimus is
contemplating; -imply pricing to meet the competition might give a!ay some of the
operating advantages of )rimuss system.
2. :hat precedent does this deal set; If !e price this lease to the #are minimum, !ill other
customers hear a#out it and s!itch from #uying to leasing; :hat are the financial
impacts on )rimus if many customers start leasing the factory-automation systems;
@. >%actly ho! should 'im eldman present this proposal to .vantjet; Gne must remem#er
that .vantjets 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.
Dis#ssion /#es!ion 5/
:hat lease terms should
Baumann recommend;
>%hi#it TN9
PRIMUS AUTOMATION DIVISION, 2002
$ompleted -ummary Ta#le of the N)4 and I00
or our Ta% and $ost-of-$apital -cenarios