Primus Automation Division, 2002
In early 2002, Tom Baumann, an analyst in the Marketing and Sales Group of the Factory Automation Division of Primus Corporation, had to recommend to the division sales manager, Jim Feldman, the terms under which Primus would lease one of its advanced systems to Avantjet Corporation, a manufacturer of corporate-jet aircraft. Specifically, Baumann was weighing a choice among four alternative sets of lease terms. The problem of analyzing and setting lease terms was relatively new to Baumann and had arisen only a month earlier, when Avantjet informed Baumann and Feldman that its pending purchase of the factory-automation system had been put on indefinite hold. Avantjet’s CEO had just ordered a moratorium on any capital expenditures that might negatively affect Avantjet’s income statement and balance sheet. Baumann was not completely surprised by Avantjet’s decision. Just recently, the Wall Street Journal had singled out Avantjet’s declining stock price and worsening balance sheet as an example of manufacturers’ deteriorating condition during the economic recession. Only three months earlier, Baumann and Feldman had won an apparent competition for Avantjet’s business over Primus’s leading competitors, Faulhaber Gmbh of Germany and Honshu Heavy Industries of Japan. Baumann feared that Avantjet’s temporizing would give those two competitors an opportunity to renew their selling efforts to Avantjet. Feldman challenged Baumann to find a way to make the sale: “Help me salvage this deal or we won’t make our sales budget for the year. Also, given the steep competition, we might lose the customer altogether on future sales.” Baumann explored a range of creative financing terms, such as leasing, that might remove Avantjet’s reluctance to proceed. He concluded that structuring the transaction as a lease might save the deal. Now, choosing the annual lease payment remained the only detail to be settled before returning to Avantjet with a proposal.
Primus Automation Division Primus Automation, a division of a large, worldwide manufacturing and services firm, was an innovative producer of world-class factory-automation products and services, with operations in the United States, Europe, and Asia. Primus’s products included programmable controllers, numerical controls, industrial computers, manufacturing software, factory-automation systems, and data communication networks. The business environment had changed dramatically over the past year. Slower economic growth, coupled with increased competition for market share, had been forecast for the next few years. Still, a recent resurgence in the U.S. manufacturing base – due to the weakened dollar driving up U.S. exports – was spurring factory automation. Cross-continental industry alliances and an accelerated rate of new product introductions had heightened industry rivalries. Primus Automation’s objectives were to maintain leadership in market share, increase sales by 15 percent a year, and achieve its targets for net income and working capital turnover. Those objectives were to be realized by providing the most responsive customer service, attaining a strong share position in the high volume-growing segments, and offering leading-technology products based on industry standards. Meeting the objectives required stimulating the demand by creating new incentives for purchasing automation equipment. Many of the unsophisticated users of automation equipment in the United States needed to be educated in analyzing capital expenditures, tax incentives, and alternative methods for acquiring the needed equipment. Division executives had discussed various asset-financing approaches as a means of assisting with the placement of their systems.
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Asset-Financing Approaches Baumann discussed with Primus’s division executives the variety of ways a firm might acquire the use of a Primus Automated Factory System. First, the customer could purchase a system with cash or with borrowed funds, either unsecured or collateralized by the equipment. Second, the firm could acquire the equipment through a conditional sale in which the title would pass to the firm upon the receipt of the final payment. Finally, the customer could lease the equipment in one of two ways: (1) via a cancelable operating lease, which could carry a term that was less than the economic life of the property; or (2) via a noncancelable financial capital lease that would span the entire economic life of the property.
Capital versus Operating Leases Baumann reviewed his notes on the rules defining the two types of leases. To be classified as a capital lease under the guidelines of Financial Accounting Standards Board (FASB) Statement No. 13,1 the lease had to meet one or more of the following four criteria: a. Ownership of the asset transferred by the end of the lease term. b. The lease contained a bargain-purchase option, whereby the lessee had to pay the fair market value for the property at the end of the lease. c. The lease term was equal to 75 percent or more of the economic life of the property. d. The present value of the lease payments over the lease term was equal to or greater than 90 percent of the fair market value of the leased property at the beginning of the lease. If the lease qualified as a capital lease, then the lessee would be required to depreciate the equipment by showing it as an asset and a liability on its balance sheet. The lessee could not deduct the lease payment from its income taxes. At the end of the lease, the lessee retained ownership and bore the risk of early changes in the asset’s value. If the lease met none of the foregoing criteria, it would be classified as an operating lease. As an operating lease, the lease payments would be treated as an ordinary expense, deductible from taxable income. The leased property would not appear on the lessee’s balance sheet and, after the lease term, would revert to the lessor. Primus Automation had never before offered leasing and was unfamiliar with the actual workings of leasing arrangements. Fortunately, the Equipment Finance Division of Primus’s parent company had extensive leasing expertise and assisted Baumann in his research. As he dug out some of the information that the division had sent him, Baumann realized that this was the first application of his efforts and he wanted to make sure he understood all the nuances involved with leasing.
Avantjet Baumann had heard that Avantjet’s vice president of operations was determined to get an automation system to cut costs and accelerate his company’s production line. A large backlog of orders for both new jets and the retrofitted older models had put new demands on production. Without such a system, it would be very difficult to meet promised deliveries. In addition, Baumann knew that Avantjet’s capital-budgeting process included all major expenditures – new construction and capital leases – but excluded operating leases. The risk of obsolescence and the ability to upgrade equipment weighed heavily in Avantjet’s decision. Overall, the most important factor was cash flow, because Avantjet wanted
1 Statement of Financial Accounting Standards No. 13: Accounting for Leases, Financial Accounting Standards Board (November 1976), 7-9.
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to avoid any additional unplanned expenditures in 2002. Avantjet was very capital intensive and was only marginally profitable because it was so highly leveraged. (Exhibits 1 and 2 show Avantjet’s income statement and balance sheet) With that in mind, Baumann wondered how he was going to find a way to resolve all the issues. He knew that many companies had turned to leasing to address some of those concerns. Although many of the large firms in the airframe industry were not as cash strapped as the small- and medium-sized shops, it was worthwhile to find out what classes of customers would benefit financially from leasing. Baumann surmised that tax rates and cost-of-capital disparities between the lessor and lessee might be critical drivers in any lease arrangement.