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This case was prepared by Robert Hengelbrok, under the supervision of Robert F. Bruner and with the assistance of
Sean D. Carr. It was written as a basis for class discussion rather than to illustrate the effective or ineffective handling
of an administrative situation. Copyright 2005 by the University of Virginia Darden School Foundation,
Charlottesville, VA. All rights reserved.
Primus Automation Division, 2002

In early 2002, Tom Baumann, an analyst in the Marketing and Sales Group of the Factory
Automation Division of Primus Corporation, had to recommend to the division sales manager,
J im Feldman, the terms under which Primus would lease one of its advanced systems to Avantjet
Corporation, a manufacturer of corporate-jet aircraft. Specifically, Baumann was weighing a
choice among four alternative sets of lease terms.
The problem of analyzing and setting lease terms was relatively new to Baumann and had
arisen only a month earlier, when Avantjet informed Baumann and Feldman that its pending
purchase of the factory-automation system had been put on indefinite hold. Avantjets CEO had
just ordered a moratorium on any capital expenditures that might negatively affect Avantjets
income statement and balance sheet. Baumann was not completely surprised by Avantjets
decision. J ust recently, the Wall Street Journal had singled out Avantjets declining stock price
and worsening balance sheet as an example of manufacturers deteriorating condition during the
economic recession.
Only three months earlier, Baumann and Feldman had won an apparent competition for
Avantjets business over Primuss leading competitors, Faulhaber Gmbh of Germany and Honshu
Heavy Industries of J apan. Baumann feared that Avantjets temporizing would give those two
competitors an opportunity to renew their selling efforts to Avantjet.
Feldman challenged Baumann to find a way to make the sale: Help me salvage this deal
or we wont make our sales budget for the year. Also, given the steep competition, we might lose
the customer altogether on future sales. Baumann explored a range of creative financing terms,
such as leasing, that might remove Avantjets reluctance to proceed. He concluded that
structuring the transaction as a lease might save the deal. Now, choosing the annual lease
payment remained the only detail to be settled before returning to Avantjet with a proposal.

Primus Automation Division
Primus Automation, a division of a large, worldwide manufacturing and services firm,
was an innovative producer of world-class factory-automation products and services, with
operations in the United States, Europe, and Asia. Primuss products included programmable
controllers, numerical controls, industrial computers, manufacturing software, factory-automation
systems, and data communication networks.
The business environment had changed dramatically over the past year. Slower
economic growth, coupled with increased competition for market share, had been forecast for the
next few years. Still, a recent resurgence in the U.S. manufacturing base due to the weakened
dollar driving up U.S. exports was spurring factory automation. Cross-continental industry
alliances and an accelerated rate of new product introductions had heightened industry rivalries.
Primus Automations objectives were to maintain leadership in market share, increase
sales by 15 percent a year, and achieve its targets for net income and working capital turnover.
Those objectives were to be realized by providing the most responsive customer service, attaining
a strong share position in the high volume-growing segments, and offering leading-technology
products based on industry standards.
Meeting the objectives required stimulating the demand by creating new incentives for
purchasing automation equipment. Many of the unsophisticated users of automation equipment
in the United States needed to be educated in analyzing capital expenditures, tax incentives, and
alternative methods for acquiring the needed equipment. Division executives had discussed
various asset-financing approaches as a means of assisting with the placement of their systems.
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Asset-Financing Approaches
Baumann discussed with Primuss division executives the variety of ways a firm might
acquire the use of a Primus Automated Factory System. First, the customer could purchase a
system with cash or with borrowed funds, either unsecured or collateralized by the equipment.
Second, the firm could acquire the equipment through a conditional sale in which the title would
pass to the firm upon the receipt of the final payment. Finally, the customer could lease the
equipment in one of two ways: (1) via a cancelable operating lease, which could carry a term that
was less than the economic life of the property; or (2) via a noncancelable financial capital lease
that would span the entire economic life of the property.

Capital versus Operating Leases
Baumann reviewed his notes on the rules defining the two types of leases. To be
classified as a capital lease under the guidelines of Financial Accounting Standards Board
(FASB) Statement No. 13,
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the lease had to meet one or more of the following four criteria:
a. Ownership of the asset transferred by the end of the lease term.
b. The lease contained a bargain-purchase option, whereby the lessee had to pay the fair
market value for the property at the end of the lease.
c. The lease term was equal to 75 percent or more of the economic life of the property.
d. The present value of the lease payments over the lease term was equal to or greater than
90 percent of the fair market value of the leased property at the beginning of the lease.
If the lease qualified as a capital lease, then the lessee would be required to depreciate the
equipment by showing it as an asset and a liability on its balance sheet. The lessee could not
deduct the lease payment from its income taxes. At the end of the lease, the lessee retained
ownership and bore the risk of early changes in the assets value.
If the lease met none of the foregoing criteria, it would be classified as an operating lease.
As an operating lease, the lease payments would be treated as an ordinary expense, deductible
from taxable income. The leased property would not appear on the lessees balance sheet and,
after the lease term, would revert to the lessor.
Primus Automation had never before offered leasing and was unfamiliar with the actual
workings of leasing arrangements. Fortunately, the Equipment Finance Division of Primuss
parent company had extensive leasing expertise and assisted Baumann in his research. As he dug
out some of the information that the division had sent him, Baumann realized that this was the
first application of his efforts and he wanted to make sure he understood all the nuances involved
with leasing.

Avantjet
Baumann had heard that Avantjets vice president of operations was determined to get an
automation system to cut costs and accelerate his companys production line. A large backlog of
orders for both new jets and the retrofitted older models had put new demands on production.
Without such a system, it would be very difficult to meet promised deliveries. In addition,
Baumann knew that Avantjets capital-budgeting process included all major expenditures new
construction and capital leases but excluded operating leases.
The risk of obsolescence and the ability to upgrade equipment weighed heavily in
Avantjets decision. Overall, the most important factor was cash flow, because Avantjet wanted

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Statement of Financial Accounting Standards No. 13: Accounting for Leases, Financial Accounting
Standards Board (November 1976), 7-9.
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to avoid any additional unplanned expenditures in 2002. Avantjet was very capital intensive and
was only marginally profitable because it was so highly leveraged. (Exhibits 1 and 2 show
Avantjets income statement and balance sheet)
With that in mind, Baumann wondered how he was going to find a way to resolve all the
issues. He knew that many companies had turned to leasing to address some of those concerns.
Although many of the large firms in the airframe industry were not as cash strapped as the small-
and medium-sized shops, it was worthwhile to find out what classes of customers would benefit
financially from leasing. Baumann surmised that tax rates and cost-of-capital disparities between
the lessor and lessee might be critical drivers in any lease arrangement.

Primuss Competitors
Several months earlier, when Avantjet was reviewing system proposals from Primus,
Honshu and Faulhaber, Baumann and Feldman learned from Avantjet that all three systems were
roughly equivalent but differed in pricing. Table 1 summarizes the pricing options then
available:
Table 1 | Summary of the available pricing options (in US$)
System Manufacturer Purchase Price of
System if Avantjet
Were to Buy
Quoted Annual Lease Expense and
Guaranteed Residual Value
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for
5-Year Operating Lease
Faulhaber Gmbh $805,000 $160,000; 27% residual value
Honshu Heavy Industries $787,000 $158,000; 25% residual value
Primus Automation Division $745,000 Not previously quoted
Baumann had learned from industry newsletters that foreign manufacturers sometimes
exploited their allegedly lower costs of capital as a competitive weapon in designing financing
terms for their customers. Baumann wondered whether this was apparent in the lease terms
proposed by Faulhaber and Honshu, and planned to estimate the effective lease costs under their
respective proposals.

Primuss Lease Proposal
The particular deal that Feldman had called Baumann about was a proposal for a
$745,000 factory-automation system. This equipment would enable Avantjet to operate a group
of workstations from a central control site while gaining valuable feedback and planning
capabilities. Realizing that he had to find out more about Avantjets motives for delaying the
project, Baumann quizzed Feldman about Avantjets performance and requirements. Feldman
told Baumann that Avantjets last CEO had been replaced by a senior executive from outside the
firm who was more concerned about the bottom line and the balance sheet than he was about
making capital expenditures that had long paybacks.
With that in mind, Baumann began to assess this particular deal. The price of the total
package was $745,000. Baumann assumed that Avantjets primary alternative to leasing was to
borrow the purchase price of the equipment on a non-amortizing five-year loan. The Equipment
Finance Division also quoted Baumann two alternatives for a five-year operating lease with equal
annual payments (due at the beginning of each year) that varied depending on Avantjets actual
tax rate and cost of debt. At the end of the lease term, renewal was subject to negotiation
between the two parties. Factory-automation equipment was classified as technological

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Residual value was the estimated fair value of a leased asset at the end of the lease term. Because future
values were difficult to predict, residual values were often highly subjective. Equipment leases typically
stipulated a guaranteed residual value.
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equipment with a five-year life. Five-year MACRS
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depreciation rates, based on the full value of
the property, were as follows in Table 2:
Table 2 Five-Year MACRS
Income Tax Depreciation Rate Schedule
Year Percentage
1 20.00
2 32.00
3 19.20
4 11.52
5 11.52
In order to structure it as an operating lease, the Equipment Finance Division required an
20.2729 percent residual guarantee from Baumanns division. Baumann did not know how
sensitive to the residual assumption the results would be. Because his division was trying to
move into leasing to bolster sales, he figured that it might be willing to assume some of the risk of
the equipments value declining substantially in five years. Primus Automation might also have
to assist the Equipment Finance Division in remarketing the equipment to another user, if a new
lease were not signed when the original lease expired. (Exhibit 3 lists the various pricing and
leasing terms)
EXHIBIT 1 | Avantjets Statement of Income ($000s)
2001 2000 1999
Sales $576,327 $575,477 $432,522
Other income 9,985 6,976 9,677
Gross income 586,312 582,453 442,199
Cost of good sold 425,076 423,443 325,016
Selling, general & admin. 43,624 36,215 35,632
Research & development 13,773 12,873 9,064
Interest 84,062 87,259 27,002
Total expenses 566,535 559,790 396,714
Income before taxes 19,777 22,662 45,485
Taxes 6,724 7,705 15,465
Net income 13,053 14,957 30,020
Source: Company records.


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MACRS stood for modified accelerated cost recovery system. It was a method of accelerated
depreciation allowed under the U.S. Tax Code. Under MACRS, depreciation deductions were determined
without regard to the assets residual value. The terminal loss or gain will be directly incorporated into firm
profit/loss. To compare with the Canadian tax code, this is identical to the assumption that the asset pool is
terminated at the end of the lease term.
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EXHIBIT 2 Avantject's Balance Sheet ($000)
2001 2000
Assets

Current assets:
Cash and temporary investments $19,918 $27,263
Accounts receivable 37,791 37,307
Inventories 310,180 323,101
Prepaid expenses 13,928 13,362
Total current assets 381,817 401,033

Property, plant, and equipment:
Land 2,245 2,245
Buildings 30,654 30,229
Machinery and equipment 26,932 21,244
Furniture and fixtures 1,683 1,520
Construction in progress 1,668 885
63,182 56,123
Less accumulated depreciation 12,634 8,267
Net property, plant, and equipment 50,548 47,856
Other assets 640,369 648,339
Total assets $1,072,734 $1,097,228

Liabilities and stockholders' equity

Current liabilities:
Long-term debt $592 $563
Accounts payable 42,355 38,760
Notes payable 4,750 5,760
Accrued compensation, interest,
and other liabilites 39,627 43,855
Deposits and progress payments 146,964 160,946
Total currect liabilities 234,288 249,888

Long-term nots payable to banks 646,633 671,255
Deferred income taxes 42,661 41,498
689,294 712,723

Common Stockholders' equity:
Common stock 3,385 3,027
Capital in excess of par value 74,081 69,770
Retained earnings 72,017 62,156
Less common stock in treasury -331 -336
Total stockholders' equity 149,152 134,617
Total Liabilities and stockeholders' equity $1,072,734 $1,097,228
Source: Company records

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EXHIBIT 3 Terms under Hypothetical Leasing and Borrow-and-Buy
Strategies

Loan (" Borrow-and-Buy" )
5-year term loan
Payment in arrears
Equipment cost $745,000
Cash Down Payment $0
Loan amount $745,000
Lease Annual payments
5-year net lease (in advance)
Leasing option #1 $150,003
Leasing option #2 $152,350
Both Methods
Guaranteed residual value: 20.2729%
(required by Primus Equipment Finance Division)
Investment tax credit 0%
Depreciation Five-year MACRS


Issues to be addressed:

Tom Bauman needs to prepare a report to his manager, J im Feldman. In this report, he
will clarify the following issues:

1. Compare the advantages and disadvantages of operating lease for Avantjet relative to
other alternatives including (1) borrow-and-buy, and (2) capital lease.

2. Prepare a projected balance sheet and income statement for Avantjet in year 2002 after
the first lease payment under leasing option #2, assuming that everything else remain the
same as in year 2001. Repeat the same exercise supposing that the lease is structured as a
capital lease by including a bargain purchase option, which requires Avantjet to purchase
the equipment at $60,000 by the end of the fifth year. Assume no taxation and Avantject
had about the same borrowing cost as Primus (about 9.5 percent). Show your calculation
and journal entries in appendix. Persuade J im Feldman that given Avantjets situation,
operating lease is a preferred choice.

3. Assume no taxation, calculate the minimum lease payment acceptable to Primus.
Assume Avantject had about the same borrowing cost as Primus (about 9.5 percent).

4. Estimate the effective tax rate of Avanjet from the past three years' income statements.
Assume Avantjet had about the same borrowing cost as Primus (about 9.5 percent). At
the current point, Primus has a tax rate of 40%. This tax rate is estimated to last in the
next couple of years.

4.1 In exhibit 3, there are two leasing options. Evaluate the economic feasibility of
these two options based on the tax rates and interest rate provided above.
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4.2 Compare Primus leasing option #1 with the competing offers from Faulhaber
Gmbh and Honshu Heavy Industries (See table 1). Comment on the competitiveness of
Primus.

4.3 What is the minimum lease payment acceptable to Primus? Compare the minimum
lease payment in this context with the minimum lease payment you derived from the
above (issue 3). Comment on the taxation effect.

4.4 Whats the maximum lease payment acceptable to Avantjet?

5. Small- and medium-size firms probably paid higher interest rates than Primus and
could save money if Primus financed the equipment and passed on some of the financing
savings to them. Based on Avantjets income statement and balance sheet, Bauman is
able to estimate the interest rate for Avantjet. He noticed that the interest rate for Avantjet
is indeed higher.

5.1 What is the minimum lease payment acceptable to Primus now?
5.2 What is the maximum lease payment acceptable to Avantjet now?
5.3 Since 2005 regulators have been concerned that the all-or-nothing capitalization
method of the current standards on leases results in off-balance sheet financing. They are
specifically critical of its rules- vs. principles-based approach, the 75% economic life and
90% fair value tests, and the complexity of the statement. The regulatory bodies feel that
material operating leases must be capitalized to show a truer picture of the lessee's
financial position. One suggested approach to accounting for leases is the asset and
liability approach which suggests that the lessee capitalize all material leases at the value
of the lessee's rights and obligations under the lease. How would this new approach, if
instituted, impact Baumans recommendation to Avantjet?

5.4 With a variety of options and scenarios to propose to Avantjet, Baumann believed
that Primus had a good chance of resurrecting the deal and meeting its sales goals for
2002. Persuade J im that he is right.

6. Combining your knowledge in both accounting and finance, what factors do you think
determine whether or not a firm should engage in leasing? Apply this knowledge to
Primus and Avantjet.

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Instruction: Prepare a report, according to the expectations of the case.

INTEGRATIVE CASE REPORT EXPECTATIONS

The Goals

The integrative case is a project of the instructors of Managerial Finance II (AFM 371/372) and
Intermediate Financial Accounting II (AFM 391). The case is a multi-subject case that has the
following objectives:

to encourage integration of materials from these two subject areas,
to encourage the development of case analysis skills,
to use a variety of information sources to solve an accounting problem, and
to reinforce the development of report writing skills.

The total mark of the case project includes two components: the report and the peer evaluation
based on the individual contribution for the report. The total mark will count for 10% towards the
final grades in AFM 371/372 and AFM 391 respectively, or equivalently, a combined 20% for
two courses. Out of the combined 20%, the report will receive 17% for which each group member
receives same mark, and the peer evaluation will receive the rest 3%.

Logistics

Do not contact any representative of the company. Only use publicly available information.


Due Date

The final report is due at 5:00 p.m., Thursday, November 20, 2008. It can be placed in the gray
drop box outside HH290. A 10% penalty will be levied for each day that the assignment is late,
no exceptions or excuses.

Report Expectations

Formal Expectations

1. The case is designed to integrate the topics from within, and across, the two courses. Your
analysis and report should demonstrate an integration of these concepts. Your report should
identify key issues and analyze these to arrive at a reasonable, well thought out solution.
State clearly both quantitative and qualitative recommendations that you make.

2. Your report must meet the standards of professional report writing, as taught in your English
class. Your writing must be clear, concise and free of grammatical or spelling errors.

3. Your report should be appropriate to the audience specified in the requirements of the case.

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4. You can work in a group not exceeding four members. You cannot discuss the case with
anyone other than your own group members. You are bound by the ethical standards of the
university, as summarized in the course outlines of the accounting courses.

Technical Requirements

1. The main text of the report should be typed on 8 x 11 paper, double-spaced with 1
margins on all four borders, typed with a Times New Roman font size no smaller than 11
point (i.e. this size). The main text of your report (not including the cover page, executive
summary, the table of contents, and the reference page) will be no more than eight pages.

2. Appendices, spreadsheets, exhibits and tables should not exceed an additional eight pages.

3. The report should also include a title page and a one page executive summary. The summary
should summarize the key points in your analysis and your recommendations. It should not
describe what will be found in the report, but rather summarize the contents of the report.

4. Submit only one copy of the report.


Evaluation Criteria

1. As in prior accounting and finance courses, content is particularly important. In this setting,
thoroughness and thoughtfulness of the analysis are the key components of content. Do not
simply perform a superficial analysis of the issues; rather attempt to understand the issues at a
greater depth. Review course material to determine the relevant knowledge and analyses and
try to think beyond the obvious facts and figures presented in the case materials.

2. Integration of materials will also be rewarded.

3. Recommendations should be clear and supported by the analysis performed.
Style is also important. Take on the role given and write to the audience specified.


Other Guidance and Tips

1. Determine the primary thrust of your report before you begin to write. Compose the report
such that everything contributes to this primary thrust. Plan your structure to achieve your
goals.

2. This is a business report. Be very careful to write to a relatively sophisticated business
reader.

3. Pay close attention to how material is presented in graphs and tables. Each such exhibit
should be completely self-explanatory with clear and accurate labels. Looking only at the
exhibit alone, can its message be clearly understood?

4. If you wish to cite outside materials (other than those provided directly to you), be selective
in how you cite these this is a business report, not an academic essay. The case is designed
such that significant additional outside materials are not necessary to complete the analysis.