PRIMUS AUTOMATION

Robert ClarkRey MendezNate Wills

Katie Young

Primus AutomationInnovative producer of world-class factory-automation products

and services with operations in the United States, Europe, and Asia.

Products:• Programmable controllers• Numerical controllers• Industrial computers• Manufacturing software• Factory-automation systems• Data communication networks

Objectives:• Maintain leadership in market share• Increase sales by 15% a year• Achieve its targets for net income and working capital turnover

Avantjet

Manufacturer of corporate-jet aircraft. Avantjet is trying to acquire an automation system that will cut costs and

accelerate the company’s production line. Some things to note:• Capital Intensive• Highly levered• CEO ordered a moratorium on any capital expenditures that will

negatively affect the income statement and balance sheet

Financial Situation

In order for Avantjet to acquire the automation system they could:1. Acquire funds through borrowed funds2. Acquire the equipment through a conditional sale – title passes to

the firm upon receipt of the final payment3. Lease the equipment in two ways:

I. Capital Lease

II. Operating Lease

Lease Characteristics

A lease is a rental agreement that involves a series of fixed payments that extend over several periods.

Lessor owns the property that is leased. Lessee acquires the asset’s productive value from the

lessor, but relinquishes the residual value.

Residual Value- what the asset is worth at the end of the lease

Lease Evaluation

• By the lessee– Is leasing the asset less costly than buying it?– What company will offer the best leasing terms?

• By the lessor– Will the lease payments provide a satisfactory return on

the capital invested in the leased asset?

Capital Lease

• Spans the entire life of the asset, no cancellation clause• Lessee retains ownership of the equipment and is

exposed to the risk of early changes in the asset’s value

• Lessee is required to depreciate the equipment by showing it as an asset and liability on their balance sheet

• Not able to deduct the lease payment from income taxes

Operating Lease

• Cancellation clause– Technological obsolescence

• Automation system would not appear on Avantjet’s balance sheet and at the end of the lease term, the equipment would revert back to Primus Automation

• Not fully amortized– Lessee discount– Lessor can renew, re-lease, or sell

• Lease payments are treated as an ordinary expense, deductible from taxable income

Balance Sheet

Income Statement

Loan Amortization Schedule Loan Amortization Table A

Year   1 2 3 4 5

Beginning Balance $ 715,000 $ 596,713 $467,189 $325,360 $170,057

Annual Payment $186,212 186,212 186,212 186,212 186,212 186,212

Interest Before Tax @ 9.50% 67,925 56,688 44,383 30,909 16,155

Principal Reduction 118,287 129,524 141,829 155,303 170,057

Ending Balance $ 596,713 $467,189 $325,360 $170,057 $0

Tax Rate 34.00%  

Interest After Tax   $44,831 $37,414 $29,293 $20,400 $10,663

   

Total Interest Paid $142,600

Total Principal Paid   $715,000

                 

PMT(Pretax Annual Rate, Term, -715000)

Calculating Operating Lease NPV(Lessee’s Perspective)

Option 1 A Exhibit 4

Sample Calculation of the Present Value of Cash Outflows1 Tax rate: 34.00%   Equipment cost: $ 715,000        

Pretax interest rate: 9.50%   Lease payment: $ 155,040       Interest Five-Year Residual    Payment MACRS3 Depr. Depr. Cash Flow Loan Lease  after Principal Depr. before Tax after Cash Cash

Year Tax2 Payment2 Rate Tax Savings Tax4 Outflow5 Outflow6

0 $0 $102,326 1 $44,831 $118,287 20.00% $143,000 ($48,620) $114,498 $102,326 2 $37,414 $129,524 32.00% $228,800 ($77,792) $89,146 $102,326 3 $29,293 $141,829 19.20% $137,280 ($46,675) $124,447 $102,326 4 $20,400 $155,303 11.52% $82,368 ($28,005) $147,698 $102,326 5 $10,663 $170,057 11.52% $82,368 ($28,005) ($67,199) $85,515 $0

Sum $142,600 $715,000 94.24% $673,816 ($229,097) ($67,199) $561,303 $511,632 NPV            $469,273 $454,717

Calculating Lease NPV(Lessor’s Perspective)

Option 1Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Tax 40.00%

Net Purchase Price (715,000) Kd 9.50%Depreciation Tax Savings 48,620 77,792 46,675 28,005 28,005 Lease Payment 155,040 155,040 155,040 155,040 155,040 Tax on Lease Payment (52,714) (52,714) (52,714) (52,714) (52,714)Residual Value 67,199 Tax on Residual Value (15,767)Net Cash Flow (612,674) 150,946 180,118 149,001 130,331 79,437

NPV (17,860)IRR 4.52%

Calculating Lease IRROption 1 A

Exhibit 5Sample Calculation of the Internal Rate of Return1

for Lease Financing

          Lease

  Lease Forgone Tax Forgone Initial Payment

  Payment Savings Residual Value Purchase Less

  after Associated with after Price Incremental

Year Tax2 Depreciation2 Tax2 Saved Cash Flow

0 ($108,742) $ 715,000 $606,258 1 ($108,742) ($48,620) ($157,362)2 ($108,742) ($77,792) ($186,534)3 ($108,742) ($46,675) ($155,417)4 ($108,742) ($28,005) ($136,747)5 $0 ($28,005) ($67,199) ($95,204)

Sum ($543,708) ($229,097) ($67,199) $715,000 ($125,005)IRR         7.19%

Leasing Options Offered by Primus’ Equipment Finance Division

NPV for PrimusOptions 1 & 2

Option 1

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Tax 40.00%

Net Purchase Price (715,000) Kd 9.50%

Depreciation Tax Savings 48,620 77,792 46,675 28,005 28,005

Lease Payment 155,040 155,040 155,040 155,040 155,040

Tax on Lease Payment (52,714) (52,714) (52,714) (52,714) (52,714)

Residual Value 67,199

Tax on Residual Value (15,767)

Net Cash Flow (612,674) 150,946 180,118 149,001 130,331 79,437

NPV (17,860)

IRR 4.52%

Option 2

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Net Purchase Price (715,000)

Depreciation Tax Savings 48,620 77,792 46,675 28,005 28,005

Lease Payment 160,002 160,003 160,003 160,003 160,003

Tax on Lease Payment (54,401) (54,401) (54,401) (54,401) (54,401)

Residual Value 67,199

Tax on Residual Value (15,767)

Net Cash Flow (609,399) 154,222 183,394 152,277 133,607 79,437

NPV (3,156)

IRR 5.49%

NPV for Primus Options 3 & 4

Option 3

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Tax 40.00%

Net Purchase Price (715,000) Kd 9.50%

Depreciation Tax Savings 48,620 77,792 46,675 28,005 28,005

Lease Payment 162,349 162,350 162,350 162,350 162,350

Tax on Lease Payment (55,199) (55,199) (55,199) (55,199) (55,199)

Residual Value 67,199

Tax on Residual Value (15,767)

Net Cash Flow (607,850) 155,771 184,943 153,826 135,156 79,437

NPV 3,798

IRR 5.95%

Option 4

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Net Purchase Price (715,000)

Depreciation Tax Savings 48,620 77,792 46,675 28,005 28,005

Lease Payment 164,759 164,760 164,760 164,760 164,760

Tax on Lease Payment (56,018) (56,018) (56,018) (56,018) (56,018)

Residual Value 67,199

Tax on Residual Value (15,767)

Net Cash Flow (606,259) 157,362 186,534 155,417 136,747 79,437

NPV 10,938

IRR 6.43%

SummaryScenario A B C DEffective tax rate 34.0% 34.0% 0.0% 0.0%Pretax cost of debt 9.5% 13.0% 9.5% 13.0%After-tax cost of debt 6.27% 8.58% 9.50% 13.00%         NPV of loan (“borrow-and-buy”) $469,273 $484,546 $663,800 $671,253 IRR of loan (“borrow-and-buy”) 6.27% 8.58% 9.50% 13.00%   Leasing option #1 $155,040 $155,040 $155,040 $155,040 NPV of leasing option #1 $454,717 436,915 651,863 616,202 IRR of lease 5.32% 5.32% 8.61% 8.61%Lease advantage over borrowing $14,556 $47,631 $11,937 $55,050    Leasing option #2 $160,003 $160,003 $160,003 $160,003 NPV of leasing option #2 $469,273 $450,901 $672,730 $635,927 IRR of lease 6.27% 6.27% 10.17% 10.17%Lease advantage over borrowing $0 $33,645 ($8,930) $35,326    Leasing option #3 $162,350 $162,350 $162,350 $162,350 NPV of leasing option #3 $476,156 $457,515 $682,598 $645,255 IRR of lease 6.72% 6.72% 10.91% 10.91%Lease advantage over borrowing ($6,883) $27,031 ($18,797) $25,9978    Leasing option #4 $164,760 $164,760 $164,760 $164,760 NPV of leasing option #4 $483,225 $464,306 $692,730 $654,834 IRR of lease 7.19% 7.19% 11.68% 11.68%Lease advantage over borrowing ($13,952) $20,239 ($28,930) $16,419

SummaryScenario A B C DEffective tax rate 34.0% 34.0% 0.0% 0.0%Pretax cost of debt 9.5% 13.0% 9.5% 13.0%After-tax cost of debt 6.27% 8.58% 9.50% 13.00%         NPV of loan (“borrow-and-buy”) $469,273 $484,546 $663,800 $671,253 IRR of loan (“borrow-and-buy”) 6.27% 8.58% 9.50% 13.00%   Leasing option #3 $162,350 $162,350 $162,350 $162,350 NPV of leasing option #3 $476,156 $457,515 $682,598 $645,255 IRR of lease 6.72% 6.72% 10.91% 10.91%Lease advantage over borrowing ($6,883) $27,031 ($18,797) $25,997 Faulhaber Gmbh 170,000 170,000 170,000 170,000

NPV of loan 484,376 501,993 686,679 697,207 NPV of lease 498,593 479,073 714,762 675,660 IRR of lease 7.13% 7.13% 11.42% 11.42%Lease advantage over borrowing ($14,217) $22,920 ($28,082) $21,546

   Honshu Heavy Industries 163,000 163,000 163,000 163,000

NPV of loan 438,036 458,436 624,641 640,997 NPV of lease 478,063 459,346 685,330 647,839 IRR of lease 8.64% 8.64% 13.48% 13.48%Lease advantage over borrowing ($40,027) ($911) ($60,689) ($6,842)

AvantJet’s Net Advantage of Leasing over Borrowing

Option 1

Option 2

AvantJet’s Net Advantage of Leasing over Borrowing

Option 3

Option 4Net Advantage of Leasing Determined by Cost of Capital and

Tax RateTax Cost of Capital

  9.50%10.00

%10.50

%11.00

%11.50

%12.00

%12.50

%13.00

%

34%(13,95

2) (8,872) (3,858) 1,089 5,971 10,790 15,546 20,240

25%(17,46

4)(11,868

) (6,354) (923) 4,429 9,702 14,899 20,020

15%(21,75

7)(15,628

) (9,601) (3,673) 2,158 7,893 13,535 19,086

0%(28,93

0)(22,074

)(15,349

) (8,752) (2,280) 4,071 10,303 16,419

Primus Vs.

Faulhaber Gmbh

Net Advantage of Leasing Determined by Cost of Capital and Tax Rate (AvantJet)Tax Cost of Capital

  9.50% 10.00% 10.50% 11.00% 11.50% 12.00% 12.50% 13.00%34% 22,437 22,307 22,178 22,051 21,926 21,802 21,679 21,558 25% 25,117 24,954 24,794 24,636 24,479 24,325 24,173 24,023 15% 28,004 27,802 27,604 27,408 27,215 27,026 26,839 26,655 0% 32,164 31,899 31,639 31,384 31,133 30,886 30,643 30,405

Option 3

Option 4Net Advantage of Leasing Determined by Cost of Capital and Tax Rate (Avantjet)

Tax Cost of Capital  9.50% 10.00% 10.50% 11.00% 11.50% 12.00% 12.50% 13.00%

34% 15,368 15,279 15,191 15,104 15,018 14,933 14,850 14,767 25% 17,204 17,093 16,983 16,875 16,768 16,662 16,558 16,455 15% 19,182 19,044 18,907 18,774 18,642 18,512 18,384 18,258 0% 22,031 21,850 21,672 21,497 21,325 21,156 20,990 20,826

Primus Vs.

Honshu Heavy Industries

Option 3

Option 4Net Advantage of Leasing Determined by Cost of Capital and Tax Rate (Avantjet)Tax Cost of Capital

  9.50% 10.00% 10.50% 11.00% 11.50% 12.00% 12.50% 13.00%34% (5,162) (5,132) (5,102) (5,073) (5,044) (5,016) (4,988) (4,960)25% (5,779) (5,741) (5,704) (5,668) (5,632) (5,596) (5,561) (5,527)15% (6,443) (6,396) (6,351) (6,306) (6,261) (6,218) (6,175) (6,132)0% (7,400) (7,339) (7,279) (7,220) (7,163) (7,106) (7,050) (6,995)

Net Advantage of Leasing Determined by Cost of Capital and Tax Rate (AvantJet)Tax Cost of Capital

  9.50% 10.00% 10.50% 11.00% 11.50% 12.00% 12.50% 13.00%34% 1,906 1,895 1,884 1,874 1,863 1,852 1,842 1,832 25% 2,134 2,120 2,107 2,093 2,080 2,067 2,054 2,041 15% 2,379 2,362 2,345 2,329 2,312 2,296 2,280 2,265 0% 2,733 2,710 2,688 2,667 2,645 2,624 2,604 2,583

Decision Summary

• Pick Option 3– Operating lease

• Option 1 and 2 do not give Primus a positive NPV• Option 3 and 4 give Primus a positive NPV – However, with option 4 there would not be a net

advantage to leasing between Primus and Honshu Heavy Industries, so we would risk potentially losing this business.

THIS IS OUR STORY …

AND WE’RE STICKING TO IT!