In the late 1990s, the National Railroad Passenger Corporation (Amtrak) faced a rude awakening as the U.S. Congress stipulated that Amtrak eliminate its reliance on federal subsidies by 2002. In response, Amtrak drew up a plan for self-sufficiency, the centerpiece of which was a new, high-speed passenger service that it hoped would boost revenue enough to make Amtrak self-sufficient by 2002. To run this new service, Amtrak needed to purchase $750 million worth of new locomotives and train cars in 1999. Three alternatives were available for funding the purchase: debt financing, lease financing, or reliance on federal sources. The case opens in April 1999, with Amtrak’s Chief Financial Officer (CFO) Arlene Friner instructing her staff to review a leveraged-lease proposal that has just been submitted by BNY Capital Funding LLC (BNYCF).
The objectives of the case are to: Introduce students to financial leases as a financing alternative. Explore the lease-versus-buy decision and the conditions under which financial lease arrangements make sense. Exercise skills in the valuation of financial leases.
Suggested Advance Study Questions
What is a financial lease? What advantages or disadvantages does it have over debt? What are the pros and cons of each of the three financing alternatives given in the case? Which alternative did you choose? Why? Provide quantitative support for your answer.Hypothetical Teaching Plan What is the problem in the case?
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The opening question takes the discussion directly to the heart of the matter. Amtrak’s CFO needs to choose among three financing options. This opening allows the instructor to transition smoothly to question 2. Alternatively, the instructor could open the discussion by taking a vote on the three financing alternatives. The instructor could then call on students from each camp to explain their votes. It is advisable, however, that the instructor keep the early part of the class focused on the conceptual issues and deal with the quantitative analysis later. What is a financial lease?
How does it work?
The discussion at this point should focus on the conceptual issues. Students need to understand the basic differences between lease and debt financing before the discussion moves into quantitative analysis. It is helpful to use case Exhibit 4 to illustrate how a lease works. Which alternative did you choose? Provide quantitative support. What does a sensitivity analysis show? What are the key bets in the decision? The quantitative analysis involves both a net present value (NPV) and options analysis. For beginning finance students, instructors may choose to focus on the NPV calculations; however, students must understand that there is an inherent value in the early-buyout option. What, in your view, are the advantages of leasing over debt and vice versa? This discussion allows the instructor to highlight instances in which leasing makes sense. The instructor can tie this section to the discussion in questions 3 and 4. Supporting Spreadsheet Files
The Microsoft Excel spreadsheet file, Case_37.xls, may be handed out to students prior to the case discussion in order to facilitate analysis. The instructor’s file, TN_37.xls, should not be shared with students. Suggested Supplementary Readings
For a background on the topic of leases: Richard A. Brealey, Stewart C. Myers, and Franklin Allen, Principles of Corporate Finance, 8th ed. (New York: McGraw-Hill/Irwin, 2006), 698–717. For a theoretical/mathematical discussion of lease pricing: W. G. Lewellen, M. S. Long, and J. J. McConnell. “Asset Leasing in Competitive Capital Markets.” Journal of Finance 31 (June 1976): 787–798. For a discussion of options embedded in leases: J. J. McConnell and J. S. Schallheim. “Valuation of Asset Leasing Contracts.” Journal of Financial Economics 12 (August 1983): 237–261. Case Analysis and Discussion
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Discussion question 1
00Discussion question 1
Congress has mandated that Amtrak become self-sufficient by 2002. Although the deadline is still three years away, the sense of urgency must not be
lost on the students. Amtrak faces a daunting task, especially in light of the fact that it has never been profitable. If it is to meet Congress’s stipulated deadline, it is imperative that it get the Acela service up and running. Of course, the assumption is that Amtrak’s management has performed a feasibility analysis and concluded that Acela is the key to self-sufficiency. In other words, the investment decision has already been made; the key question now is the financing decision. The choices boil down to debt or lease financing. Although reliance on U.S. government funding sources is an alternative, the case makes it clear that the use of federal monies is neither preferred nor practical.
Discussion question
Before launching into the relative advantages and disadvantages of debt and lease financing, it is helpful at this early stage to define what a financial lease is. A financial lease is a long-term, (often) noncancelable rental agreement that extends over most of an asset’s economic life. The main parties to a financial lease are the lessee and the lessor. The lessee receives the right to use the asset in exchange for rental payments made to the lessor, the legal owner of the asset. Financial leases are not to be confused with operating leases, which are short-term, generally cancelable rental agreements. It is also helpful to point out that operating leases are often used for smaller assets, such as cars and computers, while financial leases are often used for bigger assets like airplanes and land. (See Exhibit TN1 for the Financial Accounting Standards Board’s (FASB) rules on classifying operating and capital leases.)
A common argument students are likely to present in favor of lease financing is that it increases a company’s debt capacity. In fact, the case intentionally steers students in this direction by implying that because the public market is already saturated with Amtrak debt, the debt option is less tenable than leasing. It is folly, however, to think that investors will not recognize a financial-lease liability as also being a form of debt. A lessee has regular payment obligations to a lessor, just as a debtor has to a creditor. Even though the lessee’s payments to the lessor are accounted for as lease payments, those include an interest component, as in a debt obligation. Increasing a company’s debt capacity is perhaps the most common dubious argument given to justify leases. Other dubious arguments include the following: The possibility of increasing book income. When a firm buys an asset and borrows money to finance the acquisition, the firm incurs interest and depreciation expenses.
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When a firm leases an asset, the firm incurs lease expenses only (lease payments).
Sometimes the lease payments may be set up so that, in the early years, they are less than depreciation plus interest expense under the borrow-and-buy scenario. In efficient capital markets, analysts should see that this is merely a form of window dressing. The possibility of evading capital-expenditure controls. Because of the common notion that leasing is not tantamount to buying, lease proposals may not be evaluated as stringently as capital-expenditure proposals in some companies. Thus, some managers may advocate leases in order to avoid capital-approval procedures. Nevertheless, some students will argue against lease financing simply because it does not grant the lessee the title to the asset. This argument is suspect: a lease arrangement allows the lessee full use of the asset, just as if the lessee owned the asset. By this measure then, is there really a difference between formally owning an asset, on the one hand, and being entitled to full use of the asset even without formal ownership, on the other?
In fact, if we assume a world without taxes and a world in which everybody (lessor and lessee included) can acquire and own an asset at the same price, we would always be indifferent to borrowing-and-buying versus leasing. Think about this truism: a lessor will always charge a lessee that amount which is just enough to cover the lessor’s costs of buying and owning the leased asset. The lessor cannot charge more than that amount because if he did, the lessee would just buy the asset; it would make no sense for the lessee to lease it. Thus, any lease amount that is higher or lower than the indifference point would result in value destruction for either the lessor or the lessee. The article, “Asset Leasing in Competitive Capital Markets,” provides excellent mathematical proof for this assertion. This is not a perfect world; however, and there may be—and often are—differences in the circumstances of lessor and lessee that create not only opportunities for leases to be offered at prices other than the indifference point, but also value for both parties. Examples of such circumstances include the following: differences in the tax rates of lessor and lessee
The Essay on Comparing and contrasting lease versus purchase options
It is important to know the difference between lease purchase and lease option. The use of leases can also have an impact on a company’s liquidity profitability ratios (Schroeder, Clark, & Cathey, 2005). First the organization should study the expenses of what it would cost to lease as to what it cost to purchase this can be done with a reduced cash flow evaluation. The study would compare the ...
differences in the way in which depreciation deductions can be realized by lessor and lessee differences in asset acquisition and maintenance costs between lessors and lessees because of scale economies or some other reason differences in the way in which salvage values can be realized by lessor and lessee (for example: through superior or proprietary knowledge) differences in leverage abilities between lessor and lessee, which lead to differences in interest deductibility
A lease decision must be evaluated by comparing the NPVs of cash flows between a lease scenario and a buy (or a borrow-and-buy) scenario. There are two ways of doing this: one way is to value the incremental cash flows, NPV(Lease − Borrow).
The other way is to compare the present value of the leasing cash flows with the present value of the cash flows under the borrow-and-buy alternative, that is, NPVLease − NPVBorrow. This teaching note adopts the latter approach. Exhibit TN2 presents the cash flows associated with the leasing alternative: Lease payments represent an outflow for Amtrak.
There are no tax shields on lease payments because Amtrak pays no taxes. Amtrak is not entitled to the residual value of $40.2 million as it does not own the equipment. A debate is likely to arise over which rate to use for discounting the cash flows. Some students will advocate using the 11.8% WACC suggested in footnote 10 of the case. Sharper students will note, however, that 6.75%—the interest rate at which the debt option is being offered to Amtrak—is the proper rate to use, as it represents Amtrak’s opportunity cost from lease financing. Exhibit TN2 shows that the lease option results in a NPV of −$220.3 million. Cash flows associated with the borrow-and-buy alternative are presented in Exhibit TN3: Debt proceeds represent an inflow for Amtrak.
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The debt proceeds are then used to finance the equipment purchased—hence, the outflow. 3. & 4. Interest and principal repayments represent an outflow for Amtrak. Students should be able to construct the correct schedule of interest and principal repayments with the information in the case. 5.There are no interest tax shields because of the absence of a taxable base for Amtrak. 6.Likewise, Amtrak cannot claim depreciation tax shields.
7.Amtrak is entitled to the residual value of the equipment, as it is the legal owner. The cash flows from the borrow-and-buy option result in an NPV of −$260.26 million. Astute students will recognize that the NPV of the interest- and principal-repayment cash flows, when discounted by the cost of debt, will be equal to the initial debt proceeds. The only reason that the NPV in this case differs from the debt proceeds is because of the residual value that Amtrak claims at the end of 25 years. Comparing the two alternatives, we see that leasing is superior because it is “cheaper” in net present value terms by $40 million. Thus, Amtrak’s shareholders are better off financing the equipment purchases through the BNYCF lease rather than through the debt option. Notice, however, that we have made a key bet in our analysis: we have assumed that Amtrak will continue to be unprofitable and therefore, will not be able to claim any tax shields.
What happens if we assume otherwise? Exhibits TN4 and TN5 show the results of the lease scenario and the borrow-and-buy scenario, assuming a tax rate of 38%. Note in Exhibit TN4 that the tax shields on lease payments (item 2) are no longer zero; similarly, interest and depreciation tax shields in Exhibit TN5 are now positive. In both scenarios, we now also use the after-tax cost of debt (KD) to discount the yearly cash flows. Sure enough, the NPV advantage of leasing is eliminated when taxes are assumed. In fact, the decision now favors the borrow-and-buy alternative. Table TN1 clearly illustrates that leasing makes sense when the lessor can use tax shields more effectively than the lessee. Table TN1. NPV analysis.
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NPV ($ millions) Without Taxes With Taxes
Lease $(220.26) $(173.90)
Borrow-and-buy $(260.26) $(171.51)
Our NPV analysis, however, failed to take one important element into account—the value of Amtrak’s early-buyout option. The case states that Amtrak could acquire the equipment from BNY Capital Funding in 2017 for $126.6 million. In other words, this is a simple European call option that can easily be valued using a Black-Scholes option pricing model. The inputs are as follows: Underlying asset value: $17 million (the strike price of $126.6 million 18 years from now discounted at Amtrak’s WACC of 11.8% [given in footnote 10 of the case]).
We use the WACC rather than the 6.75% rate because of the greater riskiness of this asset. Strike price: $126.6 million, the price at which Amtrak can purchase the equipment. Maturity: The maturity is 18.5 years from June 1999 to December 2017. Instructors can be a little flexible with the maturity, as the case does not provide specific details. Risk-free rate: The case is silent about this, but students can easily assume a risk-free rate of 5% to 6%. This note assumes 6%. Volatility: Footnote 10 of the case provides a volatility estimate of 25% for the prices of locomotives and train cars.
Putting these numbers into the Black-Scholes model yields an option value of $2.97 million. This value is in addition to the cash-flow numbers we calculated earlier. Note that the option value is highly sensitive to the WACC that is used to obtain the underlying asset value. Therefore, a valid question would be, “how realistic is the WACC?” In April 1999, the average yield on the 30-year bond stood at 5.5%. Assuming a beta of 1 for Amtrak and a market risk premium of 6%, its cost of equity would be 11.5%. We do not know the market value of Amtrak’s equity; assuming a 100% equity scenario in the worst case, Amtrak’s WACC would be 11.5%—not far from the 11.8% given in the case. As this number is probably on the high end of possible WACCs for Amtrak, we can consider the $2.97-million option value a minimum (a lower WACC would yield a higher option value).
That is, the option is worth at least $2.97 million. Reproducing Table TN1 to include the option value, we get the following as shown in Table TN2: Table TN2. NPV analysis with option value.
NPV + Option Value ($ millions) Without Taxes With Taxes Lease $(217.29) $(170.93)
Borrow-and-buy $(260.26) $(171.51)
Now the borrow-and-buy alternative does not dominate the lease alternative, even in the with-taxes scenario. Little options often prove of significant value. Earlier we said that when a lessor and a lessee incur equivalent costs to acquire and own an asset, the choice between debt financing and lease financing the purchase of the asset is likely to be irrelevant. In this case, however, it is clear that the lease-financing option is superior. The most obvious explanation is that the lessor can purchase the equipment more cost effectively, because it can claim tax deductions for interest and depreciation expenses, whereas Amtrak cannot. The instructor may also use this opportunity to bring up other instances in which leasing might make sense. Those examples were discussed earlier. Another advantage of leases is that they can often be tailored to meet the lessor’s needs. This advantage is evident in Amtrak’s case—notice the pattern of lease payments in case Exhibit 5. The payments seem to be heavier in December than in June—perhaps Amtrak’s peak revenues occur during the latter half of the year (for example: Thanksgiving, Christmas).
Epilogue
Amtrak did, in fact, accept BNYCF’s leveraged-lease proposal for funding the Acela equipment purchases. The Acela service along the Northeast Corridor was launched not in 1999, as originally planned, but in December 2000. The trains were designed to run as fast as 150 miles an hour but could seldom do so because of the incompatibility of the trains with the existing railroad tracks. To allow the train to achieve its maximum speed, major upgrades would have to be made including laying new track, stations, overhead wiring, tunnels, bridges, and track connections throughout the Northeast Corridor. On the route from Washington, D.C., to Boston, the train could reach 150 miles an hour on only 18 miles of the 452-mile route. The Wall Street Journal called Acela “The Super Engine that Crawled.”
