CASE 38

PRIMUS AUTOMATION DIVISION, 2002

Teaching Note

Synopsis and Objectives

In early 2002, analyst Tom Baumann needed to propose terms for leasing one of his
companys advanced factory-automation systems to a major customer. From the lessors
standpoint, the challenge was simply to design an annuity stream that yielded a present value
equal to or greater than the value of the asset being leased. Certain factors, however, served to
complicate the analysis. The tax exposure and debt rating of the customer were uncertain,
leaving the analyst to estimate the impact of alternative lease terms under different tax and
interest-rate assumptions. The customer was also considering the lease of competing systems
from companies in Germany and Japan; these competing proposals limited Primuss flexibility in
tailoring its proposal. In short, the students task is to design lease terms that exploit the lessees
tax and interest-rate exposure within constraints set by competitive terms.

The principal objective of this case is to provide a comprehensive exercise in the

economics of lease financing. First, the case illustrates how a lease in effect sells the
depreciation-tax shield of an asset. Second, the case suggests that leases are an alternative to debt
financing and, thus, are shadow-priced off prevailing interest rates. Finally, the case reveals that
the distribution of economic benefits from leasing is substantially a bargaining outcome and
therefore, is subject to bargaining strategy, tactics, and positioning.

A secondary objective of this case is to underscore important insights about capital

markets, financial innovation, and financial contracting: alternatives to so-called plain-vanilla
financial contracts arise to fulfill special needs of the issuer and investor. A classic concern, for
instance, is why leases exist when they are, in effect, debt. The answer must be that leases exploit
capital-market imperfections, thus making leasing attractive for the lessor and lessee.

The final objective is to provide some institutional background on lease financing, which
includes the dramatic increase in the volume of leasing, accounting considerations, and a general
perspective from the lessors point of view. This is a challenging case in preparation for which

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,
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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: Case_38.xls

For the instructor: none

Suggested Supplemental Readings for Students

If this is the students first exposure to leasing, then some supplemental readings will be
helpful to them (see the list below).

Brealey, Richard A., Stewart C. Myers, and Franklin Allen. Leasing. Chap. 26. Principles of
Corporate Finance. 8th ed. (New York: McGraw-Hill Higher Education, 2006).
Aswath, Damodaran. An Overview of Financing Choices. Chap. 16. Corporate Finance:
Theory and Practice. 2nd ed. (New York: John Wiley and Sons, 2001).
Ross, Stephen, Randolph Westerfield, and Jeffrey Jaffe. Leasing. Chap. 21. Corporate
Finance. 7th ed. (New York: McGraw-Hill Higher Education, 2005).

Hypothetical Teaching Plan

The advance study questions form a useful outline for the class discussion. The needs of
the students will dictate how much time and emphasis to give to the analytical details as opposed
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?
 If it leases the system to Avantjet, Primus is in effect making a credit decision.
Accordingly, Primus assumes various credit-related risks and must decide whether the rate of
return on the lease is sufficient to compensate the firm for the risk. If it does not lease the system,
however, Primus will probably lose the customer. Thus, Baumanns problem is to assess the risks
and determine whether the investment is economically attractive.

If time permits, the instructor can encourage students to think about which division(s)
should bear the lease exposure and in what proportions? The Automation Division (AD) is
pushing to make the lease, but Primus also has an Equipment Finance Division (EFD) that, in
effect, serves as a bank for lease deals. The simple answer must be to house the lease in the EFD,
where manufacturing and marketing managers (e.g., in the AD) would focus on operating policy
and not mingle operating and financing decisions. As long as the EFD invests in only attractive
lease deals, Primus can avoid the temptation to tailor lease terms simply to mask price cuts to
win a sale.

Case Analysis

The case offers an unusual perspectivethat of the lessor who is trying to understand the
viewpoint of the lessee. Many leasing problems are cast from the standpoint of the lessee only,
and thus, amount to estimating the cost of financing. By considering both perspectives, this case
shows that the lessees financing problem is the lessors investment problem. The other key
insight provided by this perspective is that competition among manufacturers to provide lease
financing actually replicates competition in the capital markets. Constrained by the risk-adjusted
costs of capital1 and the pressures of competitors lease terms, the manufacturers proposals tend
to cluster in a narrow range.

Assessment of the various lease terms

Objective measures of the attractiveness of lease Discussion question 1: Why is Primus

terms are net present value and internal rate of return. considering the lease of its factory-
One assesses the benefits of leasing versus buying by automation system to Avantjet?
evaluating the cash flows under each alternative. The
objective is to choose the alternative with the lowest cost, because the use of the asset is the same
whether it is leased or bought. This assessment is a financial decision rather than an investment
decision (where financing costs are excluded), because financing flows determine the investment
1
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.
Interaction of tax exposure and cost of debt. A comparison of Scenarios A and D
shows that with the loss of tax shields and more expensive debt, lease financing generally
dominates the borrow-and-buy alternative.

Pricing

If Avantjet has a 0% tax rate and a 9.5% cost of debt, as in

Scenario C, leasing option 1 saves them only $11,937 (perhaps not Discussion question 2:
How did Tom Baumann
enough to give up asset ownership). Lease payments 2, 3, and 4 are analyze the problem of
all more expensive than debt financing on a present-value basis (in setting the lease-financing
Scenario C) because the discounted value of the loan and lease are terms?
much closer after the tax savings are erased than they were before.
Primus would have to lower the lease payment even more in order to get Avantjet to lease the
system.

If Avantjet is in the same tax bracket as Primus but pays higher rates on its debt, (contrary
to Baumanns assumptions in the case) then leasing is very advantageous. These various
scenarios and lease payments show how the lease-versus-buy decision varies under different
circumstances and how the total cost under either method rises significantly without tax savings.

What about the competition from Faulhaber and Honshu? Discussion question 3:
Students can answer this by comparing the IRR of lease costs of How are Faulhaber and
Primus, Faulhaber, and Honshu. Exhibit TN1 reveals that all of Honshu using their leasing
Primuss leasing options are superior to Honshus lease proposal plans?
under all four scenarios. Primuss lease payment schemes 1, 2, and
3 dominate Faulhaber on an IRR basis under all the scenarios; Baumann might consider tinkering
slightly with the lease terms to dominate this competitor. By trial and error (e.g., using the Goal
Seek tool in Microsoft Excel) the student can solve for the breakeven level of annual lease
payments necessary to just equal the next most attractive financing alternative in terms of IRR
cost (see Table TN1).

Focusing on IRR costs to Avantjet obscures an important competitive advantage: the

comparatively cheaper purchase price of the Primus system. This price advantage could permit
Primus to ask the second lowest annual lease payment ($160,003) yet meet its minimum required
rate of return of 6.27%, assuming a tax rate of 34% and a cost of debt of 9.5%. If Avantjet is truly
cash constrained, and if the Primus system is both cheaper and genuinely comparable to the
others, then Avantjet may accept leasing option 2.
 Table TN1. Comparison of loan versus leasing.

Annual Lease Payments

Lowest Cost-Competitive Necessary for Primus to
Alternative to Primus in Quote in Order to Equal
Scenario Exhibit TN1 Next Best IRR
A: 34% tax rate Borrow-and-Buy $160,003
9.5% cost of debt 6.27% (equal to leasing option #2)
$164,471
B: 34% tax rate Faulhaber Gmbh
(between leasing options #3
13% cost of debt 7.13%
and #4)
C: 0% tax rate Borrow-and-Buy $176,786
9.5% cost of debt 9.50% (above leasing option #4)
$186,534
D: 0% tax rate Faulhaber Gmbh
(between leasing options #3
13% cost of debt 11.42%
and #4)
Capital markets and financial innovation

Exhibit TN1 illustrates the range of present values for a lease and loan, depending on the
tax rate and cost of debt used. Lessees can benefit when they exchange tax savings that they
would not be able to use for a lower lease payment providing a lower total cost than the loan.
The lessor gains by receiving a lease payment that gives a higher return than the cost of
borrowing and administration from some lessee willing to pay more for a lease than one who has
taxable income and low debt costs. As the table suggests, the savings from a lease are not
necessarily a huge amount. Some leases are taken for convenience, flexibility, and obsolescence
protection rather than for explicit cost savings. Chief financial officers must exploit these tax-
and technology-arbitrage opportunities while they exist.

Manufacturers who lease can only depreciate based on the cost basis of the cost of goods
sold. Independent lessors, on the other hand, can depreciate based on the full selling price of the
asset. Thus, a separate lease division within a corporation provides an attractive warehouse for
leases, because the division buys the asset from the manufacturing division and depreciates on
the full price. In addition to the depreciation incentive, leasing intermediaries offer expertise,
possibly a low cost of capital, portfolio diversification, economies of scale in administration, and
potentially fine management of residual values.

Leases may be viewed as nonstandard forms of debt financing. The obvious question is,
What justifies the innovation? Some classic explanations include the following considerations:

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 cash-
constrained 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.
Accounting: If structured as an operating lease, the lessee can obtain off-balance-sheet
financing that shows no liability for the leased property. Thus, leasing can allegedly
improve a companys credit standing. In efficient debt and equity markets, however, this
advantage cannot be sustained. Another cosmetic advantage is an internal one: For many
companies, leasing is a method for managers to avoid capital-budgeting system
constraints because some capital-budgeting processes exclude operating leases (which is
apparently the case with Avantjet). Finally, leasing may be a means of avoiding
Alternative Minimum Tax (AMT) because lease payments do not contribute to the AMT-
book-income adjustment, which shrinks the difference between book and AMT income
and helps the company avoid additional tax.
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.
Convenience: Leasing is a relatively hassle-free method of acquiring the use of an asset.
(The amount of hassle, obviously, depends on the size and sophistication of the asset.)
The lessee often obtains the equipment and the financing simultaneously. Full-service
leases and maintenance contracts remove the typical headaches associated with owning
equipment while providing peace of mind by promising that someone will quickly solve
any problems that occur. Furthermore, leasing brings no expense associated with
disposing of the equipment. When an asset has reached the end of its life or is no longer
needed, the lessee simply returns it to the lessor.
 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 Primus Should Offer IRR NPV

A Leasing Option #2 6.27% $469,273
B Leasing Option #2 6.27% $450,898
C Leasing Option #1 8.61% $651,863
D Leasing Option #1 8.61% $616,202

Students may ignore some important qualitative concerns surrounding any

recommendation they make. Students should then be asked the following questions:

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