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This teaching note was prepared by Robert F. Bruner with the assistance of Sean D. Carr. Copyright 2005 by the
University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an
e-mail to sales@dardenpublishing.com. No part of this publication may be reproduced, stored in a retrieval system,
used in a spreadsheet, or transmitted in any form or by any meanselectronic, mechanical, photocopying,
recording, or otherwisewithout the permission of the Darden School Foundation.
students would benefit from a lecture on leases and/or a simple exercise on the estimation of
lease cash flows and net present values (NPV).
Suggested Questions for Advance Assignment to Students
1. Why is Primus Automation considering the lease of its factory-automation system to
Avantjet?
2. How did Tom Baumann analyze the problem of setting the lease-financing terms? How
does he calculate NPV and internal rate of return (IRR) for the lease and borrow-and-buy
alternatives? Please complete case Exhibit 6.
3. How are Faulhaber and Honshu Heavy Industries using their leasing plans?
4. What lease terms should Baumann recommend? How should Primuss sales and leasing
divisions structure the terms of the deal with Avantjet? How would you approach the
negotiations with Avantjet?
Supporting Microsoft Excel Spreadsheet File
For the students:
For the instructor:
Case_38.xls
none
to the big-picture, capital-markets perspective. In essence, the class discussion will have four
main components:
Analysis
How did Baumann begin analyzing the problem? Why did he decide to assess four
scenarios and not just one? What are the quantitative measures by which to evaluate a lease
proposal?
The objective of this segment of the discussion is to review case Exhibits 35, and to
complete case Exhibit 6. The key insight is that NPV and internal rate of return (IRR) are useful
measures for evaluating lease proposals. By leasing its factory automation system to Avantjet,
Primus is, in effect, buying a stream of future cash flows in much the same way that it buys a
stream of cash flows associated with a real asset. The basic similarity in the ways we evaluate
financial assets (e.g., leases) and real assets is an important learning point.
Pricing
How should Baumann choose the set of terms to recommend to Jim Feldman? What
impact, if any, should the competing proposals by Faulhaber and Honshu have on Baumanns
thinking?
The main objective of this segment of the discussion is to illustrate the distributive nature
of leasing: Pricing a lease in effect distributes economic benefits between lessor and lessee. If
Avantjet had no bargaining power, Baumann could propose lease terms that appropriated all of
the leasing benefits for Primus. But Avantjet has limited Primuss power by inviting two other
lessors to make proposals. Consequently, Baumann must recommend a set of terms that
dominates the competitors (from Avantjets point of view) and remains economically attractive
from Primuss point of view.
Capital markets and financial innovation
Are leases similar to debt? [Yes.] If similar, then why do leases exist when debt contracts
are more generic and likely to be lower-cost than leases? [Leases transfer tax benefits in ways
that debt cannot.] Does it appear that Faulhaber and Honshu are using their hypothetically low
cost of capital in a competitively aggressive way? [No.]
The simple objective here is to review some generic ideas about lease financing. The
question about foreign costs of capital also invites a perspective on the impact of the global
lease-financing market, if any, and on the pricing of leases in the United States.
Recommendation
What terms should Baumann recommend? How should he sell his recommendation
inside Primus?
The case presents no estimates of the costs of capital of Primus, Honshu, or Faulhaber; therefore, some
students may argue that they cannot complete a net present value of the respective lease proposals. The instructor
should help students work through this error: One aims to select a discount rate for a stream of cash that is
appropriate for the risk of that stream. Avantjet may very well have a different level of risk from the three
manufacturers. In addition, the weighted-average cost of capital for any of the three firms would be inappropriate to
use in order to discount a stream of lease payments: Finance theory tells us that leases are like debt, and that the cost
of debt is the appropriate discount rate. The case indicates that Avantjet can borrow at the same rate as Primus, or
9.5%. For the sensitivity analysis, Baumann also estimates the lease NPVs using a 13% cost of debt. The cost of
debt should be the only relevant hurdle rate for the manufacturers.
method. The investment analysis justifying the purchase of the equipment must be completed
prior to and independent of the lease-versus-buy decision.
The discount rate used for the cash flows in the analysis is the after-tax cost of debt. This
is because the cash-flow components are debt-like: Depreciation flows and lease payments are
much more stable and predictable than free cash flow. Lease flows should be discounted at the
same rate as the interest and principal on a bond or loanthe after-tax cost of debt. Some argue
that each item in the cash-flow analysis requires a different discount rate depending on the items
risk. Others suggest using a different discount rate for the residual value only, because this value
is the only item that bears significantly greater risk than the other flows. In practice, most
analysts use a single discount rate, mainly out of convenience. With the high obsolescence risk of
much equipment today, some analysts will use a different rate with which to determine the
present value of the residual. For simplicity, Baumann used a single rate.
Case Exhibit 4 illustrates the lease-payment analysis, where the net present value of the
two options is equal for a firm with a 34% tax rate and a 9.5% cost of debt. Under these
assumptions, any lease payment below $160,003 favors leasing, and any payment exceeding it
favors the buy-and-borrow alternative. Case Exhibit 5 also illustrates the lease-payment analysis,
as the internal rate of return of the lease is 6.27%, which is the same as the after-tax cost of debt
for a loan. Any lease rate lower than $160,003 results in a lower IRR than the loan. The lessees
decision rule is to choose the loan or lease depending on which one has the lower NPV or IRR.
Baumann has elected to assess four lease payment alternatives, as described in case
Exhibit 3, against four sets of assumptions about Avantjets tax exposure and pretax cost of debt.
Case Exhibit 6 presents a worked-out set of calculations for Scenario A, and leaves the student to
complete the analysis for the other three scenarios. Exhibit TN1 provides a completed table.
(One teaching approach would be to project case Exhibit 6 onto a screen with an overhead
transparency and invite students to fill in the blanks).
The completed work yields a number of insights. The first is how dramatically the leases
attractiveness to a customer can vary depending on the customers tax rate and cost of debt. The
instructor can ask the students to consider three sets of comparisons:
Tax exposure. A comparison of Scenarios A (tax rate of 34%) and C (tax rate of 0%)
shows a sizable increase in the cost of financing as Avantjets tax exposure declineson
average more than $200,000 in NPV cost, or 320 to 450 basis points. This is an object
illustration of the effect of financing tax shields.
Cost of debt. A comparison of Scenarios A (9.5% cost) and B (13% cost) reveals that as
Avantjets cost of debt rises, the lease financing becomes more attractive.
Scenario
A: 34% tax rate
9.5% cost of debt
Lowest Cost-Competitive
Alternative to Primus in
Exhibit TN1
Borrow-and-Buy
6.27%
Faulhaber Gmbh
7.13%
C: 0% tax rate
9.5% cost of debt
Borrow-and-Buy
9.50%
D: 0% tax rate
13% cost of debt
Faulhaber Gmbh
11.42%
Cash flow: Lease payments are usually lower than the payments on conventional loans.
The lessee passes tax savings to the lessor in exchange for a low lease payment. The
lessor receives depreciation and tax savings along with any investment tax credits. This
tax-shield exchange can benefit both parties at the expense of the government if the lessor
is in a higher tax bracket than the lessee. Under an operating lease, the lessee
immediately expenses the lease payment, which results in quick cost realization, thus
decreasing taxable income. Because leases are 100% financing, in contrast to a bank loan
that requires some equity investment in the asset, leasing provides liquidity to a cashconstrained company.
Flexibility: Leases closely match the life of the equipment to the term of the lease, unlike
short-term bank loans. This duration-matching may be achieved through tailoring of
payment periods (annual, monthly, quarterly, etc.), flat versus trended payments (i.e.,
rising or falling over time), tying payments to the assets actual use, omitting payments
during a cyclical downturn, tying payments to floating rates of interest, balloon
payments, advance payments, and six-month trial options with no payments.
Risk: With leasing, the equipment user bears no risk of large changes in value due to
obsolescence (mainly with high-tech equipment). At the end of the lease term, the lessee
can negotiate a new lease, purchase the equipment at fair market value, or merely return
the property to the lessor. In addition, lessees often have the ability to upgrade to
featured, large-capacity, modern equipment during the lease term, thus eliminating the
risk of locking into a particular piece of equipment when technology is rapidly evolving.
Finally, fixed-rate leases eliminate the risk of interest-rate fluctuations. The instructor
might point out that many of these risk-management features are actually real options
the value of which can only enhance the worth of the lease to the lessee.
Recommendation
Many of the considerations that surround making a Discussion question 4:
recommendation have been surveyed above (see Pricing section). What lease terms should
The feasibility test for all suggested lease terms is that they must be Baumann recommend?
lower in cost than proposals from Honshu and Faulhaber and the
cost of the buy-and-borrow alternative, yet they must meet or exceed the risk-adjusted, required
rate of return as seen by Primus (6.27%). In short, Tom Baumann faces a constrained
optimization problem. He must first assess what kind of customer Avantjet is (i.e., in terms of tax
exposure and cost of debt) and then tailor a winning proposal within the constraints.
In essence, this is a problem of financial engineering: One lease proposal does not fit all
scenarios. Specifically, students should see that to win the deal and meet the capital cost hurdle,
Primus should offer the terms in the following four scenarios (Table TN2):
Table TN2. Various leasing options.
Scenario
A
B
C
D
IRR
6.27%
6.27%
8.61%
8.61%
NPV
$469,273
$450,898
$651,863
$616,202
any
1. Is Primuss system exactly the same as those of Honshu and Faulhaber? Are there
differences that might justify slightly more expensive lease terms than Primus is
contemplating? Simply pricing to meet the competition might give away some of the
operating advantages of Primuss system.
2. What precedent does this deal set? If we price this lease to the bare minimum, will other
customers hear about it and switch from buying to leasing? What are the financial
impacts on Primus if many customers start leasing the factory-automation systems?
3. Exactly how should Jim Feldman present this proposal to Avantjet? One must remember
that Avantjets tax exposure and pretax cost of debt are unknown to Primus. If Avantjet
will not tell Feldman its tax and interest-rate expectations, then Feldman must sell the
terms of the lease under all four scenarios. Plainly, this situation calls for sharp
presentation skills and may form the foundation for a group project or written
assignment.
Exhibit TN1
PRIMUS AUTOMATION DIVISION, 2002
Completed Summary Table of the NPV and IRR
For Four Tax and Cost-of-Capital Scenarios