Burlington Northern Railroad Company: Equipment Leasing Harvard Case Solution & Analysis

INTRODUCTION

Burlington Northern Railroad Company (BNRR) is considering the bid from the lease finance company. BRNN is planning to expand further by investment in the fixed assets and improving the network. Paul Weyandt, the director of Equipment finance at BNRR is a talented personality and has built up a good relation with a leasing company called Norwest Equipment finance, which is offering the leasing arrangement at the attractive agreement. Following is the detailed analysis on the Lease arrangements and the buy arrangement and the evaluation on both the options. 

PROBLEM STATEMENT

In this case analysis, Paul is concerned to the options available for the expansion such that whether to accept the lease offer for the equipment, Auto Rocks, or to buy the equipment. The detailed analysis is required on both of the options. The cash flows relevant to the leasing arrangements and of the buy option are required to be shown and explained. The net present value on lease agreement is required to be calculated and the sensitivity on present value to the residual value of that equipment. Finally, the weighted average cost of capital is required.

ANALYSIS

Evaluation of Lease Option asan Investment ora Financing Decision

In this case, BNRR is considering the option of leasing the equipment because it does not have sufficient amount of cash available to purchase the equipment. Therefore, this will be considered as the financing decision over here. Investment decision is the decision in which a company invests in something like securities or assets then earning some return on that investment, there fore this arrangement is called the investment decision.

However, this is not the case here as BNRR wants to invest in the equipment however; it does not have such amount of cash or reserves. Even if it chooses to purchase the asset then it will issue the corporate bonds to the market to raise sufficient amount of funds, as it cannot issue further equity in the primary market, therefore this can impact upon the market value. The leasing is the financing decision and it can prove good for BNRR.

After-Tax Cfs Relevant To Paul Weyandt If Burlington Purchases the Auto Racks

First of all, if BNRR chooses to purchase the equipment then it does not have enough funds to purchase the equipment. BNRR has to raise funds through some external sources, the company can issue shares however,this will negatively impact the company therefore,they have other option to issue the corporate bonds in the debt market to raise the funds and this is what BNRR is considering.

The relevant after tax cash flows regarding purchase option is the cash flows from the issue of debt, the purchase cost of asset and the tax benefits. BNRR has to issue the debt at a coupon of 9.81% with a principal payment of $ 17.6 million. After that,the equipment will be purchased at a cost of $ 22.1 million, which has a residual value of 25% of the initial purchase price. Finally, the tax benefits that will be awarded regarding the asset are $ 0.29 million per year and for 15 years it is $ 4.42 million. These all figures are shown in the EXHIBIT.

Determining After-tax CFs directly attributable to the leasing decision

There is another option for BNRR to enter into the lease agreement. The lease would be a 15 years, operating lease because BNRR is not meeting the conditions defined by the International Accounting Standard Board. The lease payments offered by the Nor west Equipment Finance are the $ 2.3 million per year for fist of the seven years, then it would be $ 2.8 million per year for rest of the agreement.

In the lease option, BNRR has the option to purchase the equipment from Norwest at the end of the agreement if BNRR wants. The value of this option such that the residual value of the equipment at year 15th is calculated in the EXHIBIT is $ 9.26 million, which would be paid by the BNRR to the Norwest at the end of this agreement.

Burlington Northern Railroad Company Equipment Leasing Case Solution

Discount Rate Used For These Cfs

Finally, the discount rate has been calculated using the ‘Trial and Error’ method. First of all, to calculate the discount rate, the present value of equipment has been taken that is $ 22.1 million, then the average lease payment has been calculated using simple average method, which is $ 2.55 million. After that the factor has been calculated by simply dividing the value of equipment by the average lease payment and it is 8.67, also the time period of lease is 15 years.Lastly,the different discount rates have been used in the annuity formula to see the resulting value equals or close to the value of factor, there fore 7.8% discount rate was the rate at which the annuity factor is closest to the factor...................................

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