CASE STUDY 5

Date: January 13, 2016

Due Date: January 19, 2016

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.?