Rachel Gold, a newly recruited financial analyst at Halverton Corporation, had just been asked to analyze a proposal to acquire a new dredger.
She reviewed the capital appropriation request. The dredger would cost $3.5 million and was expected to generate cash flows of $4 70,000 a year for 9 years. After that point, the dredger would almost surely be obsolete and have no significant salvage value. The company's weighted-average cost of capital was 16%.
Rachel proposed a standard DCF analysis, but this suggestion was brushed off by Halverton's top management. They seemed to be convinced of the merits of the investment but were unsure of the best ways to finance it. Halverton could raise the money by issuing a secured 8-year note at an interest rate of 12%. However, Halverton had large tax-loss carry-forwards from a disastrous foray into foreign exchange options. As a result, the company was unlikely to be in a tax-paying position for many years. Halverton's CEO thought it might be better to lease the dredger rather than to buy it.
Rachel's first step was to invite two leasing companies, Mount Zircon Finance and First Cookham Bank, to submit proposals. Both companies were in a tax-paying position and could claim CCA on the dredger. The dredger is a Class 38 asset with a 30% CCA rate.
Rachel received the following letters, the first from Mount Zircon Finance:
March 31, 2010
Dear Rachel,
We appreciated the opportunity to meet you the other day and to discuss the possibility of providing lease finance for your proposed new JLT4 dredger. As you know, Mount Zircon has extensive experience in this field, and because of our large volumes and low borrowing costs, we are able to offer very attractive terms.
We would envisage offering a 9-year lease with 10 annual payments of $550,000, with the initial lease payment due on entering into the lease contract. This is equivalent to a borrowing cost of 11.8 percent per annum (i.e., 10 payments of $550,000 paid at the beginning of each year discounted at 11.8 percent amounts to $3,500,000)
We hope that you agree with us that this is an attractive rate. It is well below your company's overall cost of capital. Our leasing proposal will cover the entire $3.5 million cost of the dredger, thereby preserving Halverton's capital for other uses. Leasing will also allow a very attractive return on equity from your company's acquisition of this new equipment.
This proposal is subject to a routine credit check and review of Halverton's financial statements. We expect no difficulties on that score, but you will understand the need for due diligence.
Thank you for contacting Mount Zircon Finance. We look forward to hearing your response.
Sincerely yours,
Henry Attinger
For and on behalf of Mount Zircon Finance
The next letter was from First Cookham.
March 31, 2010
Dear Rachel,
It was an honour to meet you the other day and to discuss how First Cookham Bank can help your company to finance its new dredger. First Cookham has a small specialized leasing operation. This enables us to tailor our proposals to our clients' needs.
We recommend that Halverton consider leasing the dredger on a 7-year term. Subject to documentation and routine review of Halverton's financial statements, we could offer a 7 -year lease on the basis of eight payments of $619,400 due at the beginning of each year. This is equivalent to a loan at an interest rate of 11.41 percent.
We expect that this lease payment will be higher than quoted by the large, mass-market leasing companies, but our financial analysts have determined that by offering a shorter lease, we can quote a lower interest rate.
We are confident that this is a highly competitive offer, and we look forward to your response.
Yours sincerely,
George Bucknall
First Cookham Bank
Both proposals looked attractive. However, Rachel realized the need to undertake careful calculations before deciding whether leasing made sense and which firm was offering the better deal. She also wondered whether the terms offered were really as attractive as the two lessors claimed. Perhaps she could persuade them to cut their prices.