Equipment Leasing 913 ■ The options available to the lessee at the end of the lease term are criti- cal in determining the nature of the lease for tax purposes and the clas- sification of the lease for financial accounting purposes. ■ Non-tax-oriented leases or conditional sale leases transfer all incidents of ownership of the leased property to the lessee and usually give the lessee a fixed price bargain purchase option or renewal option not based on fair market value at the time of exercise. For tax purposes, the transaction is treated as a loan. ■ In a tax-oriented true leases, the lessor claims and retains the tax ben- efits of ownership and passes through to the lessee most of such tax benefits in the form of reduced lease payments. The principal advan- tage to a lessee of using a true lease to finance an equipment acquisi- tion is the economic benefit that comes from the indirect realization of tax benefits that might otherwise be lost because the lessee cannot use the tax benefits. ■ True leases are categorized as single-investor leases (or direct leases) and leveraged leases. Single-investor leases are essentially two-party transactions, with the lessor purchasing the leased equipment with its own funds and being at risk for 100% of the funds used to purchase the equipment. Conceptually, a leveraged lease of equipment is similar to a single-investor lease. However, it is more complex in size, docu- mentation, legal involvement, and, most importantly, the number of parties (particularly lenders who provide the major portion of funds to purchase the equipment) involved and the unique advantages that each party gains. ■ Full payout leases are basically financing transactions. In contrast, an operating lease is one for which the lease term is much shorter than the expected life of the equipment. ■ The reasons cited for leasing rather than borrowing to purchase equip- ment are cost savings, conservation of working capital, preservation of credit capacity by avoiding capitalization, elimination of risk of obso- lescence and disposal of equipment, less restrictions on management, and flexibility and convenience. Not all of these claims are valid, par- ticularly cost savings since cost reduction depends on whether the lease is tax-oriented. ■ For financial reporting purposes, a lease is classified as either an operat- ing lease or a capital lease. FAS 13 sets forth the conditions for classify- ing a lease. For a capital lease, the transaction is shown on the lessee’s balance sheet as a liability and the leased property reported as an asset. For an operating lease, the lessee need only disclose certain information regarding lease commitments in a footnote. ■ The value of the lease is found by discounting the direct cash flow from leasing by the adjusted discount rate. A negative value for a lease indi- 27-Equipment Leasing Page 913 Wednesday, June 4, 2003 12:07 PM 914 SELECTED TOPICS IN FINANCIAL MANAGEMENT cates that leasing will not be more economically beneficial than bor- rowing to purchase. A positive value means that leasing will be more economically beneficial. However, leasing will be attractive only if the NPV of the asset assuming normal financing is positive and the value of the lease is positive, or if the sum of the NPV of the asset assuming nor- mal financing and the value of the lease is positive. QUESTIONS 1. Why in a tax-oriented true lease can the lessee benefit from a lower leasing cost? 2. How does a single-investor lease differ from a leveraged lease? 3. Explain how a lessor expects to recover its investment in a full payout lease. 4. How does an operating lease differ from a full payout lease? 5. How is an operating lease treated for tax purposes? 6. How can a corporation that cannot currently use tax benefits associ- ated with equipment ownership because it lacks currently taxable income or net operating loss carryforward benefits from leasing? 7. Why, if it were not for the different tax treatment for owning and leasing equipment, would the costs be identical in an efficient capital market? 8. Explain why the cost of a true lease depends on the size of the transac- tion and whether the lease is tax-oriented or non-tax-oriented. 9. A frequently cited advantage for leasing is that it conserves working capital. The validity of this advantage for financially sound firms dur- ing normal economic conditions is questionable. Explain why. 10. Why do chief financial officers generally prefer that lease agreements be structured as an operating lease for financial accounting purposes? 11. Critically evaluate the claim that by leasing, a corporation can avoid the risk of obsolescence of equipment and the risk of disposal of the equipment. 12. Who are corporate lessors? 13. Explain the role of lease brokers and financial advisers in a lease trans- action. 14. a. What is a master lease? b. What is a sale-and-leaseback transaction? 15. a. For financial reporting purposes, what determines if a lease is treated as an operating lease or capital lease? b. If a lease for equipment that has a 15-year expected economic life has a lease term of two years, how will the lease be treated for financial reporting purposes? 27-Equipment Leasing Page 914 Wednesday, June 4, 2003 12:07 PM Equipment Leasing 915 c. If a lease for equipment allows the lessee to buy the equipment at the end of the lease term for $1, how will the lease be treated for financial reporting purposes? 16. For tax reporting purposes, explain why a purchase option based on fair market value rather than a nominal purchase option is a strong indication of intent to create a lease rather than a conditional sale lease. 17. Explain why when structuring a tax-oriented lease transaction, corpo- rations requiring the use of equipment will seek to have the lease treated as an operating lease for financial reporting purposes but as a true lease for tax purposes. 18. What is a synthetic lease? 19. The Mishthosi Company is considering the acquisition of a machine that costs $50,000 if bought today. The company can buy or lease the machine. If it buys the machine, the machine would be depreci- ated as a 3-year MACRS asset and is expected to have a salvage value of $1,000 at the end of the 5-year useful life. If leased, the lease payments are $12,000 each year for four years, payable at the beginning of each year. The marginal tax rate of Mishthosi is 30% and its cost of capital is 10%. Assume that the lease is a net lease, that any tax benefits are realized in the year of the expense, and that there is no investment tax credit. MACRS rates of depreciation on a 3-year asset are: a. Calculate the depreciation for each year in the case of the pur- chase of this machine. b. Calculate the direct cash flows from leasing initially and for each of the five years. c. Calculate the adjusted discount rate. d. Calculate the value of the lease. 20. The Mietet Company is considering the acquisition of a machine that costs $1 million if bought today. The company can buy or lease the machine. If it buys the machine, the machine would be depreciated as a 3-year MACRS asset and is expected to have a salvage value of $10,000 at the end of the 5-year useful life. If leased, the lease pay- ments are $250,000 each year for four years, payable at the begin- ning of each year. Mietet’s marginal tax rate is 35% and the cost of capital is 12%. Use the MACRS rates as provided in Problem 1. Year Rate 1 33.33% 2 44.45% 3 14.81% 4 7.41% 27-Equipment Leasing Page 915 Wednesday, June 4, 2003 12:07 PM 916 SELECTED TOPICS IN FINANCIAL MANAGEMENT Assume that the lease is a net lease, that any tax benefits are realized in the year of the expense, and that there is no investment tax credit. a. Calculate the depreciation for each year in the case of the purchase of this machine. b. Calculate the direct cash flows from leasing initially and for each of the five years. c. Calculate the adjusted discount rate. d. Calculate the value of the lease. 21. The Rendilegping Company is considering the acquisition of a machine that costs $100,000 if bought today. The company can buy or lease the machine. If it buys the machine, the machine would be depreciated as a 3-year MACRS asset and is expected to have a sal- vage value of $5,000 at the end of the 5-year useful life. If leased, the lease payments are $24,000 each year for four years, payable at the beginning of each year. The marginal tax rate of the Rendileg- ping Company is 30% and the cost of capital is 15%. Use the MACRS rates as provided in Question 19 and assume that the lease is a net lease, that any tax benefits are realized in the year of the expense, and that there is no investment tax credit. a. Calculate the depreciation for each year in the case of the pur- chase of this machine. b. Calculate the direct cash flows from leasing initially and for each of the five years. c. Calculate the adjusted discount rate. d. Calculate the value of the lease. e. Calculate the amortization of the equivalent loan. 22. The Arrende Corporation is considering the acquisition of a machine that costs $73,000 if bought today. The company can buy or lease the machine. If it buys the machine, the machine would be depreciated using the straight-line method, depreciating the full asset cost over five years, and is expected to have a salvage value of $2,000 at the end of the 5-year useful life. If leased, the lease payments are $17,500 each year for four years, payable at the beginning of each year. Arrende’s marginal tax rate is 38% and the appropriate cost of capital is 10%. Assume that the lease is a net lease, that any tax benefits are realized in the year of the expense, and that there is no investment tax credit. a. Calculate the depreciation for each year in the case of the pur- chase of this machine. b. Calculate the direct cash flows from leasing initially and for each of the five years. c. Calculate the adjusted discount rate. d. Calculate the value of the lease. e. Calculate the amortization of the equivalent loan. 27-Equipment Leasing Page 916 Wednesday, June 4, 2003 12:07 PM CHAPTER 28 917 Project Financing tructured financing is a debt obligation that is backed by the value of an asset or credit support provided by a third party. In Chapter 26 we described one form of structured finance transaction—asset securiti- zation. The key in an asset securitization is to remove the assets (i.e., loans and receivables) from the balance sheet of an entity. Recall that the special purpose vehicle (SPV) is the entity that acquires the asset and sells the securities to purchase the assets. 1 Structured finance is also used by corporations to fund major projects so that the lenders look to the cash flow from the project being financed rather than corporation or corporations seeking funding. This financing technique is called project financing (or project finance) and uses the SPV to accomplish its financ- ing objectives. Both project financing and asset securitization use SPVs, yet project financing involves cash flows from operating assets, whereas asset securitization involves cash flows from financial assets, such loans or as receivables. Industries engaged in the production, processing, transportation or use of energy have been particularly attracted to project financing tech- niques because of the needs of such companies for new capital sources. Enterprises located in countries privatizing state-owned companies have made extensive use of project financing. In this chapter we look at the basic features of project financing. Discussions associated with project financing tend to focus on large complex projects. This might lead one to the conclusion that the project financing principles discussed in this chapter have little application to smaller, more ordinary financings. This is not the case. The same princi- ples used to finance a major pipeline, copper mine, or a power plant can be used to finance a cannery, a hotel, a ship, or a processing plant. 1 Another name for the SPV is the special purpose entity, or SPE. S 28-Project financing Page 917 Wednesday, April 30, 2003 12:20 PM 918 SELECTED TOPICS IN FINANCIAL MANAGEMENT The use of project financing, and the use of an SPV to accomplish it, have been under attack by the press and some legislative leaders. This attack is the result of the bankruptcy of Enron in 2002. Enron used project financing in a manner that made little economic sense and purely as a means for avoiding disclosing information to shareholders and creditors. At the end of this chapter, we discuss the impact of Enron’s bankruptcy on the use of project financing by corporations. WHAT IS PROJECT FINANCING? Although the term “project financing” has been used to describe all types of financing of projects, both with and without recourse, the term has evolved in recent years to have a more precise definition: A financing of a particular economic unit in which a lender is satisfied to look initially to the cash flows and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the eco- nomic unit as collateral for the loan. 2 A key word in the definition is “initially.” While a lender may be willing to look initially to the cash flows of a project as the source of funds for repayment of the loan, the lender must also feel comfortable that the loan will in fact be paid on a worst case basis. This may involve undertakings or direct or indirect guarantees by third parties who are motivated in some way to provide such guarantees. Project financing has great appeal when it does not have a substan- tial impact on the balance sheet or the creditworthiness of the sponsor- ing entity. Boards of directors are receptive to proceeding with projects which can be very highly leveraged or financed entirely or substantially on their own merits. The moving party in a project is its promoter or sponsor. A project may have one or several sponsors. The motivation of construction com- panies acting as sponsors is to profit in some way from the construction or operation of the project. The motivation of operating companies for sponsoring a project may be simply to make a profit from selling the product produced by the project. In many instances the motivation for the project is to provide processing or distribution of a basic product of the sponsor or to ensure a source of supply vital to the sponsor’s business. 2 Peter K. Nevitt and Frank J. Fabozzi, Project Financing: Seventh Edition (London: Euromoney, 2001), p. 1. 28-Project financing Page 918 Wednesday, April 30, 2003 12:20 PM Project Financing 919 The ultimate goal in project financing is to arrange a borrowing for a project which will benefit the sponsor and at the same time be com- pletely non-recourse to the sponsor, in no way affecting its credit stand- ing or balance sheet. One way this can be accomplished is by using the credit of a third party to support the transaction. Such a third party then becomes a sponsor. However, projects are rarely financed independently on their own merits without credit support from sponsors who are inter- ested as third parties and who will benefit in some way from the project. There is considerable room for disagreement between lenders and borrowers as to what constitutes a feasible project financing. Borrowers prefer their projects to be financed independently off-balance sheet with appropriate disclosures in financial reports indicating the exposure of the borrower to a project financing. Lenders, on the other hand, are not in the venture capital business. They are not equity risk takers. Lenders want to feel secure that they are going to be repaid either by the project, the sponsor, or an interested third party. Therein lies the challenge of most project financings. The key to a successful project financing is structuring the financing of a project with as little recourse as possible to the sponsor while at the same time providing sufficient credit support through guarantees or undertakings of a sponsor or third party, so that lenders will be satisfied with the credit risk. There is a popular misconception that project financing means off- balance sheet financing to the point that the project is completely self- supporting without guarantees or undertakings by financially responsible parties. This leads to misunderstandings by prospective borrowers who are under the impression that certain kinds of projects may be financed as stand-alone, self-supporting project financings and, therefore, proceed on the assumption that similar projects in which they are interested can be financed without recourse to the sponsor, be off-balance sheet to the sponsor, and be without any additional credit support from a financially responsible third party. It would be a happy circumstance if it were possible simply to arrange a 100% loan for a project (non-recourse to sponsors) which looked as though it would surely be successful on the basis of optimistic financial projections. Unfortunately, this is not the case. There is no magic about project financing. Such a financing can be accomplished by financial engi- neering which combines the undertakings and various kinds of guarantees by parties interested in a project being built in such a way that none of the parties alone has to assume the full credit responsibility for the project, yet when all the undertakings are combined and reviewed together, the equiv- alent of a satisfactory credit risk for lenders has resulted. 28-Project financing Page 919 Wednesday, April 30, 2003 12:20 PM 920 SELECTED TOPICS IN FINANCIAL MANAGEMENT REASONS FOR JOINTLY OWNED OR SPONSORED PROJECTS There has been an increasing trend towards jointly owned or controlled projects. Although most corporations prefer sole ownership and control of a major project, particularly projects involving vital supplies and dis- tribution channels, there are factors that encourage the formation of jointly owned or controlled projects that consist of partners with mutual goals, talents, and resources. These factors include: 3 ■ The undertaking is beyond a single corporation’s financial and/or man- agerial resources. ■ The partners have complementary skills. ■ Economics of a large project lower the cost of the product or service substantially over the possible cost of a smaller project if the partners proceeded individually. ■ The risks of the projects are shared. ■ One or more of the partners can use the tax benefits (i.e., depreciation and any tax credit). ■ Greater debt leverage can be obtained. The joint sponsors will select the legal form of the SPV (corpora- tion, partner, limited partnership, limited liability company, contractual joint venture, or trust) that will be satisfy their tax and legal objectives. CREDIT EXPOSURES IN A PROJECT FINANCING To place a project financing into perspective, it is helpful to review the different credit exposures that occur at different times in the course of a typical project financing. Risk Phases Project financing risks can be divided into three time frames in which the elements of credit exposure assume different characteristics: ■ engineering and construction phase ■ start-up phase ■ operations according to planned specifications 3 Nevitt and Fabozzi, Project Financing, Seventh Edition, p. 265. 28-Project financing Page 920 Wednesday, April 30, 2003 12:20 PM Project Financing 921 Different guarantees and undertakings of different partners may be used in each time frame to provide the credit support necessary for structur- ing a project financing. Engineering and Construction Phase Projects generally begin with a long period of planning and engineering. Equipment is ordered, construction contracts are negotiated, and actual construction begins. After commencement of construction, the amount at risk begins to increase sharply as funds are advanced to purchase material, labor, and equipment. Interest charges on loans to finance con- struction also begin to accumulate. Start-Up Phase Project lenders do not regard a project as completed on conclusion of the construction of the facility. They are concerned that the plant or facility will work at the costs and to the specifications which were planned when arranging the financing. Failure to produce the product or service in the amounts and at the costs originally planned means that the projections and the feasibility study are incorrect and that there may be insufficient cash to service debt and pay expenses. Project lenders regard a project as acceptable only after the plant or facility has been in operation for a sufficient period of time to ensure that the plant will in fact produce the product or service at the price, in the amounts, and to the standards assumed in the financial plan which formed the basis for the financing. This start-up risk period may run from a few months to several years. Operations According to Specification Once the parties are satisfied that the plant is running to specification, the final operating phase begins. During this phase, the project begins to function as a regular operating company. If correct financial planning was done, revenues from the sale of the product produced or service performed should be sufficient to service debt—interest and principal— pay operating costs, and provide a return to sponsors and investors. Different Lenders for Different Risk Periods Some projects are financed from beginning to end with a single lender or single group of lenders. However, most large projects employ different lenders or groups of lenders during different risk phases. This is because of the different risks involved as the project facility progresses through 28-Project financing Page 921 Wednesday, April 30, 2003 12:20 PM 922 SELECTED TOPICS IN FINANCIAL MANAGEMENT construction to operation, and the different ability of lenders to cope with and accept such risks. Some lenders like to lend for longer terms and some prefer short-term lending. Some lenders specialize in construction lending and are equipped to monitor engineering and construction of a project, some are not. Some lenders will accept and rely on guarantees of different sponsors during the construction, start-up or operation phases, and some will not. Some lend- ers will accept the credit risk of a turn-key operating project, but are not interested in the high-risk lending during construction and start-up. Interest rates will also vary during the different risk phases of project financing and with different credit support from sponsors during those time periods. Short-term construction lenders are very concerned about the avail- ability of long-term “take out” financing by other lenders upon comple- tion of the construction or start-up phase. Construction lenders live in fear of providing their own unplanned take out financing. Consequently, from the standpoint of the construction lender, take out financing should be in place at the outset of construction financing. KEY ELEMENTS OF A SUCCESSFUL PROJECT FINANCING There are several elements that both sponsors and lenders to a project financing should review in order to increase the likelihood that a project financing will be successful. The key ones are listed below: 4 ■ A satisfactory feasibility study and financial plan should be prepared with realistic assumptions regarding future inflation rates and interest rates. ■ The cost of product or raw materials to be used by the project is assured. ■ A supply of energy at reasonable cost has been assured. ■ A market exists for the product, commodity, or service to be produced. ■ Transportation is available at a reasonable cost to move the product to the market. ■ Adequate communications are available. ■ Building materials are available at the costs contemplated. ■ The contractor is experienced and reliable. ■ The operator is experienced and reliable. ■ Management personnel are experienced and reliable. ■ Untested technology is not involved. 4 Nevitt and Fabozzi, Project Financing, Seventh Edition, p. 7. 28-Project financing Page 922 Wednesday, April 30, 2003 12:20 PM [...]... IN FINANCIAL MANAGEMENT Management Forecasts In addition to market surveys, the firm’s managers may be able to provide forecasts of future sales The experience of a firm’s management and their familiarity with the firm’s products, customers, and competitors make them reliable forecasters of future sales The firm’s own managers should have the expertise to predict the market for the goods and services and. .. not keep up with demand It was in such demand and inventory so depleted that fights broke out in toy stores, some parents bribed store personnel to get scarce dolls just before Christmas, and fake dolls were being smuggled into the country Coleco missed its mark, significantly underestimating the demand for these dolls While having a popular toy may seem like a dream for a Strategy and Financial Planning... original financing agreements and operating agreements will require patience, forbearing, and understanding Decision making in partnerships and joint ventures is never easy, since the friendliest of partners may have diverse interests, problems, and objectives However, the rewards and advantages of a project financing will often justify the special problems that may arise in structuring and operating the project... capital management (in particular, short-term financing) and the capital structure decision (the mix of longterm sources of financing) enters the picture When managers look at the firm’s investment decisions and consider how to finance them, they are budgeting Budgeting is mapping out the sources and uses of funds for future periods Budgeting requires both economic analysis (including forecasting) and accounting... strategy and a strategic plan: Define comparative and competitive advantages Develop the investment strategy: Identify and evaluate investment opportunities Develop budgets: Coordinate the investment plan needs with the financing plan Evaluate performance: Post-auditing, compare results with plans Develop the financing strategy: Identify the needs for financing and the means of financing Strategy and Financial. .. detailed in George S Day and Liam Fahey in “Putting Strategy into Shareholder Value Analysis, ” Harvard Business Review (March–April 1990), pp 156–162 938 SELECTED TOPICS IN FINANCIAL MANAGEMENT capital, the timing, amount, and type of capital (whether equity or debt) comprise elements of a firm’s financial strategic plan These things must be planned to implement the strategy Financial planning allocates... the firm’s cash flows and its financing needs to changes in sales or some other factor Third, creating a financial plan helps managers understand the tradeoffs inherent in its investment and financing plans For example, by developing a financial plan, the financial manager is better able to understand the tradeoff that exists between having sufficient inventory to satisfy customer demands and the need to finance... among Sears’ marketing, purchasing, and financial management Once Sears has its sales and related forecasts, the next step is a cash budget, detailing the cash inflows and outflows each period Once the cash budget is established, pro forma balance sheet and income statements can be constructed Following this, Sears must verify that its budget is consistent with its objective and its strategies Budgeting generally... services or the product and to pay operating expenses of the project The obligation to make minimum payments is unconditional and must be paid whether or not the service or product is actually furnished or delivered In contrast, a take -and- pay contract is a contact in which payment is contingent upon delivery and the obligation to pay is not unconditional 926 SELECTED TOPICS IN FINANCIAL MANAGEMENT Because... Predicted Sales for 2000 and 2001, Based on Regression of Sales and Capital Expenditures for 1976–1999 Source: IBM Annual Reports, various years Predicted and actual 2000 and 2001 sales are shown in Exhibit 29.3, panel c You’ll notice that we overestimated sales This illustrates a problem with regression analysis: Past trends do not always continue Sales growth slowed in 2000 and 2001 Another way of . SELECTED TOPICS IN FINANCIAL MANAGEMENT construction to operation, and the different ability of lenders to cope with and accept such risks. Some lenders like to lend for longer terms and some prefer. experienced and reliable. ■ The operator is experienced and reliable. ■ Management personnel are experienced and reliable. ■ Untested technology is not involved. 4 Nevitt and Fabozzi,. avoiding capitalization, elimination of risk of obso- lescence and disposal of equipment, less restrictions on management, and flexibility and convenience. Not all of these claims are valid, par- ticularly