Sale and Leaseback Transactions: The Case of Electric Utilities

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INTRODUCTION

The use of financial leases in the electric utility industry is a relatively new phenomenon. Although direct lease financing of small portions of nonnuclear power plants and some other utility assets occurred in the 1970s, there was a significant change in the size and type of these transactions during the 1980s. For example, in 1985 the Public Service Company of New Mexico used the first sale and leaseback (SL) financing of a major transmission line. Nuclear and nonnuclear power plants also were refinanced with sale and leaseback transactions during the 1980s. Because of the cost recovery character of public utility regulation, sale and leaseback transactions among utilities may be motivated by factors other than the tax effects identified for industrial firms (Slovin, Sushka, and Polonchek, 1990a).

This paper examines possible rationales for lease financing by utility companies. To provide insight regarding the tax rationale for leasing, we consider the financial condition and comparative tax rates of utility firms that have engaged in lease financing. We also provide evidence of bond rating changes following these transactions. The paper concludes that the use by utilities of sale and leaseback financing reflects the restricted range of financing options available to weaker firms, who often were not able to fully use the tax benefits of ownership that were available in the early to mid-1980s. This result is consistent with the bankruptcy cost theory of leasing advanced by Krishnan and Moyer (1994).

FINANCIAL LEASING: THEORY AND EVIDENCE

The theory of financial leasing traditionally has focused on the tax differential between lessees and lessors as a primary rationale for leasing (Miller and Upton, 1976; Lewellen, Long, and McConnell, 1976; Myers, Dill, and Bautista, 1976; Brealey and Young, 1980; and Brick, Fung, and Subrahmanyam, 1990). Empirical studies of leasing, however, report that lessors typically earn higher returns than do lenders. For example, Sorensen and Johnson (1977), Gudikunst and Roberts (1978), Roenfeldt and Henry (1979), Crawford, Harper, and McConnell (1981), and Schallheim, Johnson, Lease, and McConnell (1987) report high ex ante returns to lessors and, by implication, high lease rates paid by lessees. Lease, McConnell, and Schallheim (1990) document high realized returns to lessors on financial leasing contracts. These high lessor returns suggest factors in addition to tax effects in the lease-buy decision.

Lease financing often is evaluated as an alternative to debt financing. Surprisingly, Bowman (1980) finds a significant positive correlation between financial leverage and the use of lease financing, a result contradicting the assumption that leasing and debt financing are substitutes. Ang and Peterson (1984) also find that debt and lease financing are positively correlated, implying that debt and lease financing are complements, not substitutes. Marston and Harris (1988), Finucane (1988), Smith and Wakeman (1985), and Erickson (1990) develop explanations for these seemingly anomalous findings in terms of financial distress costs and asset characteristics. Krishnan and Moyer (1994) explain the positive relationship between debt and lease financing in terms of bankruptcy costs and asset characteristics.

Additional insight regarding the motivation for financial leasing has been obtained from an examination of the announcement period effects of corporate sale and leaseback transactions. Slovin, Sushka, and Polonchek (1990a) find positive announcement period effects for nonutility, nonbanking firm sale and leaseback transactions. They attribute these results to the market's perception that the transaction will result in a reduction in the present value of expected taxes occasioned by the transaction. In contrast, Slovin, Sushka, and Polonchek (1990b) find that sale and leaseback transactions by commercial banks are associated with significant negative announcement period returns - a result attributed to bank capital regulation. …