The evaluation of a floating-rate sale-leaseback.
Rajagopal, Sanjay
CASE DESCRIPTION
The primary subject matter of this case concerns the evaluation of
a sale-and-leaseback arrangement. Secondary issues examined include
differences in tax ramifications and financial reporting implications of
the leasing arrangement, and simple scenario analysis. The case is
intended for an introductory finance course delivered to juniors and
seniors in a business program. Students should have prior familiarity
with the structure of the balance sheet and the income statement, and
discounted cash flow analysis, including the concept of net present
value. The case will require approximately two hours of preparation
outside of class, after which it can comfortably be discussed in a
one-hour class. It is recommended that the instructor provide a
ten-minute overview of the case in a prior class period.
CASE SYNOPSIS
Rockhill, Inc. is an electric utility operating in mid-western
United States. The process of deregulation in electricity generation has
transformed the utility's competitive landscape, prompting it to
divest much of its generating assets, shift its focus to electricity
transmission and distribution, and revise several of its financial
policies. Among other things, the company has adopted the policy to
lease, rather than purchase, any additions to its fleet of vehicles.
While the vehicles it currently owns represent slightly over 40% of its
entire fleet (with the remainder being leased), over time, its
"lease-only" policy will eliminate owned vehicles altogether,
since vehicles must eventually be replaced. In the meantime, though, it
wishes to evaluate the economic advisability of speeding up the process
of eliminating ownership by converting the owned vehicles into leased
vehicles through a "sale and lease-back" arrangement with
another party.
One of Rockhill's financial analysts has just been assigned
the task of determining whether such a lease will add value to the firm.
She must project the cash flow implications of the switch from ownership
to leasing, and then estimate the present value of those incremental
cash flows. Based upon her analysis, she needs to make a recommendation
to management at the upcoming meeting. The estimation of incremental
cash flows will require a careful consideration of the tax treatment of
the leasing arrangement as well as a forecast of the floating interest
rate that the utility will have to pay on its lease.
COMPANY BACKGROUND
Rockhill, Inc. is a regulated transmission and distribution utility
that serves almost 1.2 million customers over three counties. The
customers are primarily residents, rather than businesses, and, by
national standards, enjoy an above-average per capita income. Over the
past three years, Rockhill's customers have had the option to
choose other suppliers of power, and to date about 10% of them have
switched to alternative providers. While the service area is fairly
stable, it is also mature, and growth is expected to be moderate for the
foreseeable future; estimates of the growth rate range from 1.5% to 2.5%
assuming normal weather conditions.
The utility has divested a large portion of its generating assets
to Altisar Corporation, with whom it has a five-year, fixed-price
contract to purchase the electricity needed to fulfill its standard
service commitment to its customers. Altogether, its power purchase
agreements and its remaining ownership interest in generating assets is
very likely to meet the utility's supply needs for the next six
years.
Rockhill recently acquired a smaller electricity distributor,
Teslar, Inc., which cost approximately $3 billion. While the proceeds
from the sale of generating assets to Altisar Corporation paid for more
than half this amount, almost 45% of the funds needed for the
acquisition of Teslar came from the issue of long-term debt. A favorable
interest rate environment has made this bond issue an attractive source
of financing, but it has also raised significantly the utility's
debt ratio.
Like most utilities, Rockhill, Inc. operates a large fleet of
vehicles, including a variety of trucks, vans, cranes, backhoes, and
tractors. If purchased new, these vehicles would cost anywhere from
$3000 to as much as $200,000. For a few years now, Rockhill's
management has adopted a policy of leasing any additions to its existing
fleet. Currently, the utility owns 200 vehicles, and an additional 250
are leased through the Dalton Leasing and Finance Corporation (DLFC).
THE REQUEST FOR LEASE ANALYSIS
By leasing rather than buying the new vehicles, the utility avoids
large outlays of cash. As a corollary, it avoids booking a large amount
of debt and depreciating vehicles over long periods, often beyond the
original costs (which the rules of the Federal Energy Regulatory
Commission, FERC, can engender). Thus, the utility can maintain its cash
reserves and keep its debt and coverage ratios in a more desirable
range. This is of particular concern in the face of some active credit
downgrades currently occurring in the industry. Indeed, an industry that
has traditionally been characterized by high payout ratios now finds
many of its firms cutting back on their dividends in an effort to
satisfy credit rating agencies and preserve their bond ratings.
In the case of Rockhill, conserving cash and reducing debt is of
particular concern in the light of its recent acquisition of Teslar,
Inc. As noted earlier, this purchase came at a cost of $3 billion, of
which approximately 45% was financed by long-term debt. Not
surprisingly, then, the utility's treasury department recently
received a suggestion from management to evaluate the feasibility of
converting the 200 owned vehicles to leased vehicles. The utility could
consummate such a conversion by first determining the current market
value of the owned vehicles and then establishing an amortization period
and mutually agreeable value with the potential lessor, probably DLFC.
DLFC would then reimburse the utility for the agreed-upon market value,
and the latter would lease the same vehicles from DLFC. Management
expects that such a sale-and-lease-back arrangement will significantly
reduce fleet costs, since the annual amortization on the lease will be
significantly less than the current depreciation on these vehicles. Of
course, the transaction would also result in an upfront inflow of cash
equal to the market value of the vehicles.
THE ANALYST GATHERS INFORMATION
Meg Hawkins, a financial analyst with Rockhill's treasury
department, has been assigned the task of evaluating the
sale-and-leaseback, and must report her recommendation to management
within a week. She begins by contacting the Fleet Management department,
which informs her that none of the vehicles is scheduled to be sold or
salvaged for two years. It also estimates the market value of the 200
owned vehicles to be approximately $3,000,000. For financial reporting
purposes, the vehicles currently have a book value of approximately
$12,000,000, and the firm charges annual depreciation of $1,500,000 on
the vehicles to the transportation clearing account. The depreciation
amount is based on original costs, and continues at the same level as
long as the company owns the vehicles. On the other hand, for tax
purposes, these vehicles are almost fully depreciated at this point, and
have a remaining tax basis of approximately $25,000. Thus, by the time
the lease goes into effect, the owned vehicles would have a negligible
depreciation tax shield.
Ms. Hawkins apprises the potential lessor, DLFC, of Rockhill's
interest in a sale-and-leaseback transaction. DLFC also contacts Fleet
Management at Rockhill, Inc., and obtains information pertaining to the
vehicles involved in the leasing arrangement. DLFC concurs with Fleet
Management's estimate of $3,000,000 for the value of the vehicles,
and quotes Ms. Hawkins a spread of125 basis points over the one-month
LIBOR for a lease involving a 24-month amortization period. The current
level of the one-month LIBOR is 2.5%, and this will determine
Rockhill's initial finance cost. Any change in the LIBOR will be
recognized at the end of the first year of the lease. According to the
lease terms, the residual value of the vehicles will be $0, so the
entire amount of $3,000,000 will be amortized over the 24-month period,
at a rate of $125,000 per month. Payment will be made monthly, and, in
addition to the $125,000 amortization payment, will include an interest
payment calculated on the unamortized value at the beginning of the
month. Rockhill has the option to terminate the lease at the end of the
first year, but provides the lessor a "residual guarantee" of
up to $1,150,000 if the equipment is sold for less than the unamortized
lease balance. This amount can be looked upon as the utility's
"maximum obligation", in addition to the first twelve monthly
payments. Unless Rockhill terminates the lease at the end of the year,
the lease will be remain in effect for another twelve months, with
interest payments being determined at the reset LIBOR rate. At the end
of the two-year period, Rockhill can repurchase the vehicles for the
unamortized value, which is zero. Exhibit 1 shows DLFC's sample
amortization schedule for the lease (some information has deliberately
been hidden, and represented by Xs, since the reader will be asked to
ascertain it). Note that this schedule is based on the assumption that
the currently prevailing LIBOR of 2.5% will continue through the two
years of the lease.
Ms. Hawkins knows that Rockhill's marginal tax rate is 38%,
that its weighted average cost of capital is 9%, and that its cost of
secured debt is 7% on a pre-tax basis. For the lease analysis, she will
use the after-tax cost of secured debt, rather than the firm's
weighted average cost of capital, as the discount rate. This is because
the lease payments by the lessee are akin to debt service cash flows on
secured debt rather than like operating cash flows; the lower discount
rate reflects the lower risk of these incremental cash flows. Before she
can ascertain the economic feasibility of the lease, however, the
analyst needs two more pieces of information: a forecast of the LIBOR
one year from now, and a clear determination of the tax treatment of the
lease. Luckily, the former is readily available, since she just
completed a project in connection with which she forecasted the
following LIBOR rates for the next 4 years (beginning today),
respectively: 2.5%, 2.6%; 2.35%; and 2.31%.
The tax treatment of the sale-and-leaseback, on the other hand, is
a more complicated issue. Being somewhat less familiar with this aspect
of leases, Ms. Hawkins decides to consult some textbooks pertaining to
the accounting and tax classification of leases. In addition, she
requests DLFC to provide its input on the matter.
CLASSIFICATION OF THE LEASE AGREEMENT
The analyst finds that the lease has different implications for
financial reporting and reporting for tax purposes. Of course, she is
interested in both the financial reporting and tax aspects of the
sale-and-leaseback, even though only the tax treatment of the lease has
an impact on cash flow. The results of the analyst's research and
the opinion provided by a Vice President of DLFC on the specific leasing
arrangement proposed by Rockhill can be summarized as follows. For
financial accounting purposes, the sale-and-leaseback is looked upon as
an operating lease. Therefore, the lessee (Rockhill) is not required to
book the lease obligations as a liability and the leased property as an
asset. For tax purposes, on the other hand, the same lease is viewed as
a financing arrangement. The lessee maintains the operating control of
the asset, and retains the tax benefits associated with the debt implied
by the lease.
A few key features of the proposed lease agreement should be noted,
which are relevant to the tax treatment summarized above. First, as
mentioned earlier, under the proposed agreement, the lessee would have
the option to purchase the leased vehicles at the end of the 24-month
period for a fixed price equal to the unamortized lease balance, which
in this case is zero. Thus, Rockhill would retain the right to any
upside equipment value. Second, Rockhill would provide a residual
guarantee in the form of additional rent, should the lease be
terminated, and the equipment sold for less than the unamortized lease
balance. There will be a cap on this guarantee, but the risk to the
lessor (DLFC) would be less than 20% of the original cost. Third, a
portion of each payment made by Rockhill would represent amortization;
since the utility has the option to purchase the equipment at the
expiration of the lease (at the unamortized balance), this portion of
each payment essentially represents a build-up of equity for Rockhill.
Finally, the remaining portion of each payment would represent interest,
which would be computed on the basis of the unamortized value at the
beginning of each month, as noted earlier.
These key features of the proposed lease indicate that all the
benefits, and a substantial part of the risk of ownership are to be
retained by Rockhill. For tax purposes, therefore, the utility can be
treated as the owner of the equipment, and the lease may be treated as a
financing arrangement. Indeed, the analyst obtained a copy of the IRS
Field Service Advice on a similar lease, which deemed the lease to be a
financing arrangement, or a "conditional sale agreement".
Rockhill can thus reduce its taxable income by the amount of the
interest involved in the lease. While it can also claim depreciation
expense on the equipment by virtue of being treated as the owner of the
equipment, the vehicles will have no depreciable basis by the time the
lease is expected to go into effect. The analyst does not, therefore,
need to consider any tax shield from depreciation in her evaluation of
this leasing arrangement.
For financial reporting purposes, Meg Hawkins finds that the
Financial Accounting Standards Board (FASB) Statement No.13 (FASB 13)
sets out the criteria that determine whether a lease might be classified
as an operating lease or a capital lease. Should the lease meet any one
of four criteria specified by FASB 13, it would have to be classified as
a capital lease. These criteria, and Meg Hawkins' assessment of
whether the proposed lease meets any of those criteria, are provided in
Exhibit 2. As reported there, the analyst finds that the proposed lease
fails to meet each of the criteria defined by FASB 13, and concludes
that the lease would in fact be classified as an operating lease rather
than as a capital lease.
The classification of the sale-and-leaseback as an operating lease
for financial reporting purposes implies that the vehicles will not
appear as assets on the utility's balance sheet, nor will the
required payments be reported as a liability. Meg Hawkins notes with
some satisfaction that, should she find the lease to be sound on
economic grounds, its "off-balance-sheet" classification will
lead management to receive the sale-and-leaseback proposal with greater
enthusiasm.
The analyst is curious to find out how the numbers will play out in
the case of this lease. She organizes all the information she has
gathered, starts up her spreadsheet program, and begins the process of
arriving at some hard figures that will help her make a recommendation
to management in the upcoming meeting.
Sanjay Rajagopal, Western Carolina University
Exhibit 1--Sample Amortization Schedule for Rockhill, Inc.
Dalton Leasing and Finance Corporation
Equipment Cost $3,000,000
Payment Frequency Monthly
Amortization Period 24
Expected Residual
Value 0
Spread over LIBOR 1.25%
Indexed to LIBOR Rate 2.50%
Lease Rate 3.75%
PV of 12 payments:
NPV of Total $X,XXX,XX
Payments X
As % of Fair Value XX.XX%
End of Unamortized Amortization Lease Total
Period Value for the Month Rate Payment
0 $3,000,000
1 2,875,000 $125,000 $9,375.00 $134,375.00
2 2,750,000 125,000 8,984.38 133,984.38
3 2,625,000 125,000 8,593.75 133,593.75
4 2,500,000 125,000 8,203.13 133,203.13
5 2,375,000 125,000 7,812.50 132,812.50
6 2,250,000 125,000 7,421.88 132,421.88
7 2,125,000 125,000 7,031.25 132,031.25
8 2,000,000 125,000 6,640.63 131,640.63
9 1,875,000 125,000 6,250.00 131,250.00
10 1,750,000 125,000 5,859.38 130,859.38
11 1,625,000 125,000 5,468.75 130,468.75
12 1,500,000 125,000 5,078.13 130,078.13
13 1,375,000 125,000 4,687.50 129,687.50
14 1,250,000 125,000 4,296.88 129,296.88
15 1,125,000 125,000 3,906.25 128,906.25
16 1,000,000 125,000 3,515.63 128,515.63
17 875,000 125,000 3,125.00 128,125.00
18 750,000 125,000 2,734.38 127,734.38
19 625,000 125,000 2,343.75 127,343.75
20 500,000 125,000 1,953.13 126,953.13
21 375,000 125,000 1,562.50 126,562.50
22 250,000 125,000 1,171.88 126,171.88
23 125,000 125,000 781.25 125,781.25
24 0 125,000 390.63 125,390.63
dEnd of Lessee's Max.
rPeriod Obligation
0
1
2
3
4
5
6
7
8
9
10
11
12 $1,150,000.00
13
14
15
16
17
18
19
20
21
22
23
24
$X,XXX,XX
PV of First Year Payments X
$X,XXX,XX
PV of Residual Guarantee X
Exhibit 2--Classification Criteria for Capital Leases
FASB Criterion Does Lease Meet Criterion?
1 "The lease transfers ownership of No
the property to the lessee by the
end of the lease term."
2 "The lease contains a bargain No
purchase option."
3 "The lease term is equal to 75% or No
more of the estimated economic
life of the leased property."
4 "The present value at the No
beginning of the lease term of the
minimum lease payments equals or
exceeds 90% of the fair value of
the leased property at the inception
of the lease."
Explanation
1 The lease provides a purchase option
but not a predetermined transfer of
ownership.
2 The lease does contain a purchase
option, but the price is not a bargain.
3 The estimated useful economic life of
the property is more than 2.7 years,
and therefore the lease term is less
than 75% of the estimated useful life.
4 The present value of the minimum
lease payments, including the residual
guarantee at the end of the first
twelve-month term, is less than 90%
of the fair value of the leased property
at the inception of the lease.
Source for Criteria: Financial Accounting Standards Board, Statement
13, "Accounting for Leases", Paragraph 7. The criteria are quoted from
the FASB statement.
