The Evaluation of a Floating-Rate Sale-Leaseback

By Rajagopal, Sanjay | Journal of the International Academy for Case Studies, July 1, 2009 | Go to article overview

The Evaluation of a Floating-Rate Sale-Leaseback


Rajagopal, Sanjay, Journal of the International Academy for Case Studies


CASE DESCRIPTION

The primary subject matter of this case concerns the evaluation of a sale-and-leaseback arrangement. Secondary issues examined include differences in tax ramifications and financial reporting implications of the leasing arrangement, and simple scenario analysis. The case is intended for an introductory finance course delivered to juniors and seniors in a business program. Students should have prior familiarity with the structure of the balance sheet and the income statement, and discounted cashflow analysis, including the concept of net present value. The case will require approximately two hours of preparation outside of class, after which it can comfortably be discussed in a one-hour class. It is recommended that the instructor provide a ten-minute overview of the case in a prior class period.

CASE SYNOPSIS

Rockhill, Inc. is an electric utility operating in mid-western United States. The process of deregulation in electricity generation has transformed the utility 's competitive landscape, prompting it to divest much of its generating assets, shift its focus to electricity transmission and distribution, and revise several of its financial policies. Among other things, the company has adopted the policy to lease, rather than purchase, any additions to its fleet of vehicles. While the vehicles it currently owns represent slightly over 40% of its entire fleet (with the remainder being leased), over time, its "lease-only " policy will eliminate owned vehicles altogether, since vehicles must eventually be replaced. In the meantime, though, it wishes to evaluate the economic advisability of speeding up the process of eliminating ownership by converting the owned vehicles into leased vehicles through a "sale and lease-back" arrangement with another party.

One of Rockhill 's financial analysts has just been assigned the task of determining whether such a lease will add value to the firm. She must project the cashflow implications of the switch from ownership to leasing, and then estimate the present value of those incremental cashflows. Based upon her analysis, she needs to make a recommendation to management at the upcoming meeting. The estimation of incremental cashflows will require a careful consideration of the tax treatment of the leasing arrangement as well as a forecast of the floating interest rate that the utility will have to pay on its lease.

COMPANY BACKGROUND

Rockhill, Inc. is a regulated transmission and distribution utility that serves almost 1.2 million customers over three counties. The customers are primarily residents, rather than businesses, and, by national standards, enjoy an above-average per capita income. Over the past three years, Rockhill's customers have had the option to choose other suppliers of power, and to date about 10% of them have switched to alternative providers. While the service area is fairly stable, it is also mature, and growth is expected to be moderate for the foreseeable future; estimates of the growth rate range from 1.5% to 2.5% assuming normal weather conditions.

The utility has divested a large portion of its generating assets to Altisar Corporation, with whom it has a five-year, fixed-price contract to purchase the electricity needed to fulfill its standard service commitment to its customers. Altogether, its power purchase agreements and its remaining ownership interest in generating assets is very likely to meet the utility's supply needs for the next six years.

Rockhill recently acquired a smaller electricity distributor, Teslar, Inc., which cost approximately $3 billion. While the proceeds from the sale of generating assets to Altisar Corporation paid for more than half this amount, almost 45 % of the funds needed for the acquisition of Teslar came from the issue of long-term debt. A favorable interest rate environment has made this bond issue an attractive source of financing, but it has also raised significantly the utility's debt ratio. …

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