CASE STUDY

LEVERAGED LEASE

Please read the case study carefully and answer the questions below

ABC Company of Kuwait is the largest independent owner-operator of large-scale automated self-storage complexes in Kuwait City area. The first self-storage complex was opened in Kuwait in 1997 and now has facilities throughout downtown Kuwait City and nearby residential areas. The business is based on a franchise management company located in Michigan state (USA).

Mr. Sarfaz, CEO of ABC, was considering options for financing $1,000,000 of new forklifts needed for the commercial storage facilities. In Kuwait there was no corporate tax, therefore ABC could not take advantage of the equipment's depreciation tax shield. Mr. Sarfaz was considering a fifteen years lease of the equipment.

The Canadian lessor, DEF Leasing Co., had offered to structure a capital lease for ABC Company, as long as DEF could arrange non-recourse financing for the equipment. DEF wanted to purchase the forklifts with $200,000 of its own cash and $800,000 borrowed from a bank in Dubai at 7.5%. The leasing company's effective tax rate was 30%, and Canadian tax laws permit use of the double-declining balance method for leasing companies. The forklifts had a tax life of seven years.

DEF Leasing Co. estimated that it could sell the equipment for $200,000 (the residual value after fifteen years). ABC, the lessee, had requested an early buyout option (EBO) after ten years. Immediately upon purchase, the lessor would lease the equipment to the lessee for fifteen years. Rents would be paid monthly, on the same day the debt services were due, and the rents always would be sufficient to pay debt service.

When Mr. Sarfaz received a fax summarizing the terms of the lease, he could hardly believe his eyes. The lessor offered ABC a 15-year lease with 180 equal monthly payments of $8,052. This included an effective interest rate of only 6.5% per annum. Not only was the rate very attractive, but ABC Company would also receive 100% financing with no downpayment. He decided to try for the early buyout option and scribbled "Accepted, as long as we get the EBO!" on the term sheet, signed it, and faxed it back to Toronto.

QUESTIONS:

1. Show, with a diagram, the cash flows in this deal, assuming no Early Buyout Option.

2. Would the deal make sense for DEF Leasing, assuming that its shareholders insist on a required return on equity of 15% p.a.?