Case 8 - Lease Financing at Burlington Northern Railroad Company

Memo From: Maxime Gauthier-Grace (260611276); Samuel Hodhod

(260696304); Clement Lai (260665485); Francis Poirier-Cloutier (260690546);
John Poole (260655638); Natali Yerokhina Mazer (260744560)

Subject: Burlington Northern Railroad Company: Equipment Leasing

Problem:

It is 1990 and Paul Weyandt, the director of Equipment Finance at Burlington Northern Railroad
Company (BNRR), must decide on the best way to finance the purchase of bi-level and tri-level
auto racks. Weyandt had already demonstrated that the equipment was a good investment for the
company as the discounted expected-cash flows exceeded the 20% investment hurdle rate

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benchmark for BNRR. Now, Weyandt must determine and prove the best way to finance the

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investment.

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Options:

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1) Lease the equipment through Norwest Equipment Finance (NEF).
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a) Lease under current offered terms.
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b) Lease under newly negotiated terms.
2) Borrow $22 million to purchase the auto racks directly.
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Recommendation:
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It is our recommendation that BNRR lease the equipment through Norwest for two primary
reasons. First, using the NPV method and comparing the cash flows for leasing versus
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borrowing/buy we can conclude that leasing the equipment with Norwest would be the optimal
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financial decision for BNRR. This is mainly driven by the tax benefits of leasing from a
company with a comparatively higher tax-bracket. Secondly, BNRR is currently a highly
leveraged company with long-term debt representing 76% of its total capital in 1988. Taking on
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more debt to purchase the asset directly would significantly increase the company's debt-to-
equity ratio. Leasing through NEF, as it will be shown below, maximizes both financial gains
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and operational efficiency.

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Context
Paul Weyandt must determine the best way to finance the Auto racks valued at $22,067,600. His

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 options are twofold: to lease the equipment through Norwest Equipment Finance (NEF) or to
borrow $22 million and purchase the equipment directly.

Issuing new equity had been ruled out as a viable option for BNRR. The philosophy of BNI
management was that the interest of the shareholders would be of the utmost importance with
every financing decision. Historically, railroad companies rarely went to the equity markets.
Doing so would be interpreted negatively by the marketplace and as a result, BNRR’s stock price
would fall significantly. In terms of internal financing, BNRR’s options are limited. Observing
Exhibit 3 from the case, we can derive BNRR’s current and quick ratio which were 0.87 and 0.07
respectively for the FY 1989. These ratios suggest that BNRR has poor short-term liquidity and
would be unable to finance the purchase of the equipment entirely through cash. Furthermore, we
can rule out financing through retained earnings. Once again, if we observe Exhibit 3 from the
case, we can see that BNRR’s retained earnings were actually running at a deficit of
approximately $20.6 million for the FY 1989.

This leaves BNRR with the option to fund the auto racks through external financing. The spin-

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off of Burlington Resources in May 1988 left Burlington Northern Inc. (BNI) in the position of
being a highly levered company. Long-term debt represented 76% of its total capital in 1988. As

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a result, BNRR had publicly stated their intention to reduce the debt by an ambitious $1 billion
during 1989-94 with the objective of reducing their financial leverage. Borrowing the $22

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million and purchasing the auto racks directly would significantly increase the company’s debt-
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to-equity ratio and thus, would be inconsistent with the company’s objective of significantly
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reducing their debt over the next 5 years. In order to avoid a larger debt burden, BNI should
consider an operating lease with NEF.
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Leasing, as opposed to borrowing the equipment directly, would be beneficial to BNRR for two
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primary reasons. The first of which being BNRR’s current tax situation. Due to its accelerated-
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depreciation expenses and other tax preferences BNI is subject to the 20% Alternative Minimum
Tax (AMT). Consequently, the monetary value of actually owning an asset would be
significantly reduced since the assets in question would have to be depreciated on a straight-line
basis as opposed to on an accelerated basis. Entering into a lease agreement with Norwest, a
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company that finds themselves in a significantly higher tax bracket (34%), would lead to
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significant tax benefits for BNRR. Norwest would be able to fully utilise the depreciation tax
shield benefits that come with ownership of the asset and pass those savings along to BNRR
through leasing said asset.The second benefit of leasing with Norwest, the auto racks would be
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considered an off-balance sheet item as it would be an operational lease. This arrangement would
be consistent with BNRR’s objective of decreasing its financial leverage as its debt-to-equity
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ratio would not be affected.

Assumptions
In order to properly conduct the analysis of whether Weyandt should purchase the equipment
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directly or finance the investment through a lease we were required to make several assumptions.
We assumed that tax laws would not be changed in the interim so that the AMT applied to BNRR
for at least the next 15 years. We also assumed that the auto racks would be depreciated on a
straight-line basis over 14 years (with $0 salvage value) as opposed to on an accelerated basis.

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 Analysis
Cash Flows From Leasing
In calculating the cash flows from both leasing and borrowing/buy we assumed a 22 year
investment horizon as this was determined to be the estimated life of the auto racks. After the 15-
year lease with Norwest was over, we assumed that if BNRR were to lease instead of buy the
equipment at the beginning, they would purchase the 15-year old auto racks at the end of 2005
and depreciate them for the subsequent 7 years (end of 2012).

BNRR would pay Norwest lease payments in two-tiers; $2.3 million for the first seven years
(1991-1997) and $2.8 million for the last eight years (1998-2005). The tax benefits that BNRR
would earn from these respective lease payments would be $460,00 for the first seven years and
$560,000 for the subsequent eight years. The tax benefits were calculated as follows: (lease
payment)*(AMT). Thus, the net undiscounted cash flows for the periods 1991 to 1997 and 1998
to 2005 would be $1,840,000 and $2,240,000 respectively (See Appendix I).

In 2005, BNRR’s lease agreement with Norwest will expire and BNRR will purchase the 15-year

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old auto racks. In order to determine the price that BNRR can expect to pay for he auto racks at
t=15, we needed to make certain assumptions. Due to the large amount of uncertainty

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surrounding the future residual value of the auto racks at t=15, we assumed that the auto racks
will have a market value of either $6,932,049, $9,242,732, or $11,553,415 with equal probability

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(25% market volatility). If the market value of the auto racks were determined to be below the
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predefined purchase price, BNRR would find it optimal to go to the open market and buy the
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asset for $6.9 million as opposed to buying it from Norwest. In the other scenario, if the market
value of the auto racks in 15 years is equal to the predefined purchase price or larger, BNRR will
find it optimal to go ahead with the purchase of the auto racks from Norwest for the predefined
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purchase price of $9.2 million. Keeping in mind BNRR’s optimal behaviour in all three
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scenarios, we defined the probability of the market value being either below $9.2 million or at
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$9.2 million and above as being 50/50. We then calculated the average of the two possible prices
($6.9 million and $9.2 million) with their respective probabilities. Thus, in order to acquire the
15-year old auto racks in 2005, BNRR can expect to pay $8,087,390 (See Appendix II).
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Keeping this purchase price in mind, the asset would be depreciated on a straight-line basis for
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the subsequent 7 years (2006-2012). The tax shield depreciation value was calculated as follows:
(expected purchase price/remaining useful life)*(AMT). For the 2006-2012 period, BNRR will
benefit from a tax shield of $231,068 (See Appendix II).
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Cash Flows from Borrowing/Buying

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The purchase price of the auto racks at t=0 (1990) was $22,067,600 (Exhibit 1). In order to
calculate the tax shield depreciation benefits we used the following formula:
($22,067,600/22)*(20%). The annual tax shield depreciation benefits that BNRR would receive
if it were to buy the equipment would thus be $200,615 for the entire investment horizon (See
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Appendix III).

Leasing Versus Purchasing

In order to determine whether or not BNRR should enter into a lease agreement with Norwest,
we needed to compare the discounted cash flows from leasing to that of the discounted cash

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 flows from the outright purchase of the auto racks.

We found the appropriate discount rate by taking BNRR’s cost of debt, which was determined to
be 9.81% (page 5), and determining its after-tax value which was 7.85% ((0.0981)*(1-0.20) =
0.0785). Subtracting the discounted cash flows of buying the asset from the discounted cash
flows of leasing the asset we obtained a positive NPV value of $703,043. Thus, we can conclude
that the optimal decision for BNRR would be to lease the auto racks from Norwest as opposed to
borrowing money and purchasing them directly.

Lmin and Lmax Analysis

In order to assess the offer made by Norwest we need to first calculate what would be the amount
paid if the lease payment would have stayed constant. Using the PVIFA formula, we derived that
the payments would have been 2,497,115 per year (Appendix IV). Then, we calculated the
minimum lease payment Norwest would accept. The discount rate use have been calculated
using the annual coupon rate of a bond maturing in 2016 (10%). Also, we assume that the lessor
will be taxed at 34%. The tax shield of depreciation assume that Norwest will be using the

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MACRS schedule and depreciate the asset in 7 years. Setting the NPV at 0 we can isolate the
Lmin for the lessor which equals 2,102,353 (Appendix IV). Afterwards, we did the same

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mechanic for the maximum lease payment that the lessee would accept. For this calculation, we
have used the same discount rate and tax rate used previously for the cash flow analysis. We then

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derived from the formula that the maximum lease payment accepted is 2,572,747 (Appendix IV).
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We can see that current offer is under the maximum payment acceptable by BNI, but is well
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above the minimum payment Norwest would accept.

Recommendation
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Based on the calculations of the cash flows, it is clear that BNI should lease the autoracks instead
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of seeking external financing to buy the asset. With that being said, it is important to notice that
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the minimum amount (Lmin) Norwest would accept is well below the offer they are currently
making. Thus, we concluded that BNI still have some room to negotiate a more favorable lease
payment with Norwest. They should ensure at the same time that they will keep their healthy and
long-standing relationship with Norwest in the process.
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Appendix
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Appendix I

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 Appendix II

Appendix III

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Appendix IV
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