November 2000

The Grower As Informed Borrower: Financing the Acquisition of Capital Assets By Alan W. Adams

The capital assets the grower finances are what make the grower's operation work and generate cash flow. But should material handling systems, structures and other capital assets be leased or financed through a fixed-rate or floating loan?

The acquisition of land may be the commercial grower's largest purchase (certainly in terms of sheer dollars). However, the grower's most important purchase may be the acquisition of other capital assets such as automation equipment and material handling systems. Land is obviously a prerequisite to producing crops, but capital assets are what make the operation work Ð and generate cash flow.

As is the case with land acquisition (discussed in part one of this series, which appeared in the March 2000 issue of GPN), the grower has access to numerous financing sources, offering a wide array of products for the acquisition of capital assets. Likewise, as with the financing of the purchase of land, some general rules and “tricks of the trade” can help the commercial grower better navigate the financing process.

At the onset, it's important to understand that most financing sources will seek to match the life of the asset with the loan term Ð longer-term loans or financing packages for the acquisition long-term assets (i.e., automation equipment), and shorter-term loans for short term assets or purposes (i.e., inventory expansion). The perceived life of the asset will affect payment terms, interest rates and other aspects of loan structures.

When financing a capital asset, most lenders are willing to offer up to a five-year term loan (sometimes with amortization periods that extend beyond the five years). This is particularly true of commercial banks. While the asset may have a useful life beyond five years, most lenders are reluctant to set a loan term beyond five years. This is primarily because of the interest rate risk implied with longer terms. Commercial loans also are subject to the scrutiny of regulators who, as a rule, do not like longer loan terms. The regulators believe (correctly) that longer loan terms discourage lender/borrower interaction, which means the lender is less likely to uncover or head off potential problems.

One of the less publicized components of commercial lending is the influence of regulatory agencies. A company's success in most business sectors is based on the convergence of talents and resources from customers, employees and shareholders. Commercial banks have a fourth “partner” Ð the regulators. Whether they admit it or not, almost all bankers take into account how the regulators might react when they structure loans.

Many growers have faced this somewhat daunting question: Should a capital asset be financed with a traditional loan or should it be acquired via a lease? There are distinct advantages and disadvantages to both avenues Ð many of which depend largely on the financial performance and position of the grower. Leasing can be an attractive option. As J. Paul Getty once said, “If it appreciates, own it Ð if it depreciates, rent it! ”

Most growers are familiar with the key terms in a typical loan transaction (interest rates, maturity dates, amortization period, etc.). In the leasing world, the terminology is somewhat different, as are the ways in which leases operate.

There are several key issues the informed grower should be aware of when negotiating an equipment lease. Foremost (as with any financing transaction), read the documentation carefully! Leasing contracts can be complicated and are notorious for buried “hidden” costs.

Another key issue is figuring out exactly what type of lease the lessor is proposing. A wide variety of leasing products are available, but they break down into two basic types:

Operating leases are typically short-duration contracts Ð the term will be less than the expected useful life of the equipment being leased, and the aggregate lease payments will be less than the cost of the equipment of the lessor. This type of lease is particularly popular for the acquisition of high-tech equipment because the lease's shorter duration helps mitigate issues of “technological obsolescence.”

Capital leases (also known as “finance leases”) are written for a longer term. The term of the lease will cover the majority of the asset's useful life and payments will approximate the equipment cost (plus a return for the lessor, of course). It is also not unusual for a capital lease to allow for a “bargain purchase” option at the end of the lease. An example would be the ability of the lessee to purchase the leased equipment for some nominal amount such as $1.

While the differences between the two lease types may not appear significant, the accounting treatment for the two types is vastly different. Operating leases are the simplest from an accounting standpoint. Payments made under an operating lease are considered business expenses and consequently are generally tax deductible. In addition, under an operating lease, the value of the asset being leased does not show up on the lessee's balance sheet (an operating lease is an off-balance sheet item). Consequently, there is generally no need to deal with issues such as depreciation. Effectively, the depreciation “belongs” to the lessor.

Under a capital lease the value of the asset will be added to the lessee's balance sheet; the lease is effectively amortized much like depreciation; and the implicit interest in the lease is expensed much like interest on a loan. Capital leases effectively “act” like a traditional loan.

A series of rules are used to determine whether a lease is a “capital” or “operating” lease. I recommend conferring with a qualified accountant or tax attorney prior to entering into a lease agreement to be certain of the type of tax treatment the lease will receive. This may seem like a small matter, but the accounting treatment can have a dramatic effect on the grower's financial statements. As a general rule, the lease is a capital lease if substantially all risks and benefits of ownership are transferred to the lessee by the lease. It's an operating lease if the lessor retains the majority of the risks or benefits of ownership.

Unlike a loan, a lease will not have a stated interest rate. This is not some great act of largesse by the lessor! The rate of return the lessor earns on the transaction is simply stated differently. The implicit interest rate is built into the lease via a lease factor, which is expressed as a constant number rather than a percentage (as with a loan).

While changes in the lease factor will affect the monthly payment amount, several other figures can have far more impact on the monthly payment. First is the residual Ð a concept that applies primarily to operating leases. The residual is what the lessor believes the equipment will be worth at the end of the term of the lease (assuming normal wear and tear on the equipment); the higher the residual value assigned by the lessor, the lower the monthly payments, and vice-versa.

Growers should also be aware that residuals are a potential money maker for lessors. At the end of a lease, the lessee has three options: purchase the equipment at the price previously agreed upon; re-lease the equipment; or return the property to the lessor. Let's say that at the end of a given lease the lessee chooses to return the equipment to the lessor. The lessor calculated the lease based on a residual value of $10,000 but was able to sell the returned equipment on the open market for $15,000. The “extra” $5,000 is additional profit for the lessor; the lessee does not share in the windfall. Conversely, if the lessor can only sell the equipment for $8,000, the $2,000 “hit” is the lessor's alone. Consistent with the concept of an operating lease, the risk of ownership remains with the lessor.

The second number that may significantly affect the payment amount is the value the lessor has assigned to be the “purchase price” for the equipment. This is what the lessor would charge if the equipment was purchased for cash; but the purchase price the lesser assigns when calculating the lease may be different. You must look at the documents carefully to determine what figure the lessor is using to calculate the lease.

Leasing a piece (or pieces) of equipment may or may not be a better deal than financing the same equipment with a standard loan product. Whether a lease is the best option often depends on the grower's particular situation. Generally, leasing may offer some of the following advantages:

• Lower payment amounts (particularly true with operating leases).

• Less money down than with a traditional loan. Most lenders will require 10 to 20 percent of the purchase price of the equipment as a down payment. Leases may only require a down payment of only the first and last months' payments.

• Protection against technological obsolescence. Because an operating lease gives the lessee the option of simply turning the leased equipment back to the lessor at the end of the lease, the lessee effectively shifts the risk that the equipment is no longer “state of the art” to the lessor. At the end of the lease the lessee simply returns the equipment and then leases the latest generation of similar equipment. This is why leasing is particularly popular for equipment that undergoes rapid technological innovation.

• Tax advantages. As mentioned previously, payments made under an operating lease are generally fully tax deductible.

While there may be some advantages to leasing, there can also be some drawbacks, with cost being the principal potential drawback. From a purely economic standpoint, leasing can often be more expensive in terms of the effective interest rate the lessee is paying (versus the rate the lessee would pay on a traditional loan).

When evaluating a loan-versus-lease scenario, you should run a present value analysis to determine which option is better economically. This is done by present-valuing the stream of payments that would have to be made under the lease (down payment amounts, monthly payments, etc.), factoring in any tax benefits derived from expensing the loan interest and depreciation.

The primary difference is that in the loan scenario you must calculate that at the end of the loan the borrower owns the equipment (assuming that the loan is being compared to an operating lease) and that the equipment will have some value that can be realized. Your accountant or tax attorney can help you conduct this analysis and give you guidance on the appropriate discount rate. In addition, many lenders will conduct the analysis for you, comparing their product to other lender products.

In addition, just because leasing typically involves a smaller down payment does not mean that you will not have to come up with some material amount of cash to close the transaction. As mentioned previously, most leases typically require some sort of down payment (first and last months' payments are not uncommon) and may require a security deposit. In addition, the lease may also require some other amount down.

Finally, in most leases, the lessee will be responsible for paying any applicable taxes. In some cases, lessors will consider rolling taxes and other closing costs into the lease payments. The obvious effect of this will be to raise the lease payment amount.

As mentioned previously, most lenders will generally consider term loans for the purchase of capital equipment, offering payment terms of up to five years (and a potentially longer amortization period). Let's suppose a grower has a five-year term loan and a 10-year amortization for the purchase of automation equipment. The loan rate will be fixed for five years, but the payments will be calculated as if the loan was being paid over 10 years. At the end of the five year period, the borrower must refinance the outstanding balance or pay it off.

This type of structure is often referred to as a “bullet loan,” Ð what constitutes the bullet loan is the principal balance at the end of the initial term. Assuming that the grower has made timely payments and that the grower's financial condition has not deteriorated, most lenders will be willing to refinance at the end of the initial term. Effectively, this sort of structure (in which the loan term is shorter than the amortization period) allows the lender to reset the interest rate at the end of the initial period.

Most lenders making equipment loans also will typically consider floating rate structures, or variations thereof, such as fixing the rate annually on a base rate (the prime, for example) plus or minus some spread. (The “spread” will depend on the strength of the borrower and on competitive pressures).

Floating rate structures are often attractive to lenders because they effectively shift the interest rate risk to the borrower. Consequently, the borrower should recognize this and be willing to accept the consequences. Typically, the rate on a floating rate structure will be lower than that of a comparable fixed rate structure. The rate difference is designed to partially compensate for and encourage the borrower to accept the interest rate risk.

A Word On Fixed Rates

What happens when you arrange a five-year fixed rate loan with a financing source for the purchase of a piece of equipment only to see interest rates drop significantly one year later? Your best course of action is to go back to the lender and renegotiate. Not surprisingly, the lender will not be thrilled by the prospect of lowering the rate but he or she may capitulate, particularly if you have been a good customer. The lending business is like most businesses: the cost of replacing a good customer can be significantly greater than the cost of lowering that customer's rate.

Notwithstanding the potential of renegotiating a loan package, the reality of fluctuating economic indicators and changes in the market behooves you to work out the best possible initial loan package with a lender. Be attentive to closing costs, prepayment penalties and lender “fees.”

A prepayment penalty is a clause that simply states that you will pay an additional fee if you pay the loan off faster than the agreed-upon schedule. Prepayment penalties make it much more expensive to renegotiate rates.

Closing costs and lender fees effectively create the same problem. Closing costs are those costs the lender incurs when “closing” the transaction. These may include lien searches, registration fees, title cost (in the case of land purchases) and legal fees. These are costs that the borrower typically pays, so you should be sure that the lender is passing these on to you at his or her cost and is not marking them up.

In the next and final article in this three-part series I will address the issues a borrower faces when financing working capital needs such as inventory or receivable expansion. I also will offer suggestions on when and how to best negotiate working capital financing with a lender.