United States

Department of

Agriculture

Agricultural

Cooperative

Service

ACS Research

Report

Number 83

as an Alternative Method of Financing

for Agricultural Cooperatives
Abstract

Leasing as an Alternative Method of Financing

for Agricultural Cooperatives

Glenn D. Pederson and Eric E. Gill

Department of Agricultural and Applied Economics

University of Minnesota

under a cooperative research agreement with

Agricultural Cooperative Service,

U.S. Department of Agriculture

Washington, D.C.

Economic incentives for agricultural cooperatives to lease capital assets such as

structures, machinery, equipment, and other depreciable items are explored and

illustrated. Selected aspects of lease contracts are reviewed. The lease or purchase

problem is analyzed using capital budgeting (discounted cash flow) and wholefirm financial simulation methods. Results for a case farmer cooperative situation

are compared under pre- and post-1986 Tax Reform Act rules and various interest

rate and lease rate conditions. The analyses suggest that the attractiveness of

facility leasing for cooperatives has declined in the post-1986 period. However,

leasing will likely continue to be used selectively by farmer cooperatives.

Key Words: Agricultural cooperatives, finance, leasing, capital budgeting, simulation,

lease contracts.

ACS Research Report 83

February 1990
Preface

Leasing is an economic alternative to traditional debt financing of capital invcstments. Leasing provides the use of, and usually the option to acquire, capital

assets. For agricultural cooperatives, certain changes in the economy might force

cooperatives to try to selectively improve both cash flow and profit performance

through use of long-term capital leasing arrangements. The economic incentives

for agricultural cooperatives to lease structures, machinery, equipment, and other

depreciable assets are primarily financial and tax-related issues. The advantages

of leasing such capital assets depend on a careful analysis of the options and

terms that are available.

This study had two primary objectives: (1) to identify the economic incentives

for agricultural cooperatives to use finance (capital) leases, and (2) to evaluate the

relative economic advantages and impacts of finance leases at the project and

whole-firm levels using an agricultural cooperative illustration.

This report attempts to provide a background on leasing activities in agriculture,

a discussion of lease contracts and concepts, and a set of illustrations that provide

direction to cooperative managers on what to consider when evaluating a lease.

The authors are indebted to numerous individuals for their assistance during the

development of this report, They are Edward Barchenger, Vicki Knapp, Douglas

Leicht, and Kenneth Reiners at Farm Credit Leasing Services Corporation: Bruce

Hatteberg of Harvest States Cooperatives; Frank Smith at the University of Minncsota; Donald Scott at North Dakota State University; and Charles Kraenzle, Jeffrey

Royer, and Donald Frederick at Agricultural Cooperative Service. Susan Pohlod

provided excellent typing support on earlier drafts and the final report. This

project was completed under cooperative research agreement 58-3J31-4-1010

between North Dakota State University and Agricultural Cooperative Service.
Contents

Highlights . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iii

Introduction ........................................................................................................... 1

Background on Leasing Activity ........................................................................ 3

Study Objectives ............................................................................................... 5

Investment Financing Alternatives........................................................................ 6

Changing Financial Structure of Large Cooperatives ........................................ 6

Small Cooperatives ........................................................................................... 7

Financing Alternatives ....................................................................................... 9

Debt Financing .............................................................................................. 9

Lease Financing ............................................................................................ 11

Agricultural Cooperative Tax Management Alternatives ....................................... 19

Cooperatives and the Investment Tax Credit (ITC) ........................................... 19

Summary of Lease-Related Federal Tax Law ...................................................... 21

Lease Versus Purchase Option.. ....................................................................... 21

Capital Budgeting Model ................................................................................... 22

Description and Analysis of a Cooperative Lease ............................................. 23

Strategy of Analysis .......................................................................................... 24

Results of 1985 Analysis ................................................................................... 25

Results of 1987 Analysis ................................................................................... 29

Whole-Firm Lease Simulation Analysis ................................................................ 32

Description of the Simulation Model .................................................................. 32

Simulation Strategy ........................................................................................... 34

1985 Model ....................................................................................................... 36

1987 Model ....................................................................................................... 41

Simulation of Tax Law Change Effects ............................................................. 41

Bibliography . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43

Appendix A: Glossary of Leasing Terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45

Appendix B: Sample Lease Agreements Representative of Lease Arrangements 48

Appendix C: Summary of Federal Tax Law Related to Leasing . . . . . . . . . . . . . . . . . . . . . . . . . . . 49

ii
Highlights

Leasing Activity

Concern about the financial condition and performance of agricultural cooperatives has increased because of the farm sector recession of the early and mid1980’s. Escalating debt levels and interest expense are contributing factors to the

erosion of cooperative income. Both the decline of internally generated equity

and reliance on debt financing increase the exposure of agricultural cooperatives

to financial risk. Under such conditions, cooperative managers and directors need

to consider the potential for alternative financial arrangements to rebuild and

stabilize cooperatives. Leasing is one such financial option.

The use of leasing by agricultural cooperatives is small and has grown at a slower

pace when compared with that observed in the computer, transportation, and telecommunications industries. The reasons for this slower growth appear to be a

lack of:

l acceptance of leasing by agricultural managers, with a traditional preference for

debt-financed ownership,

l knowledge by small potential agricultural lessees concerning the advantages,

and how to evaluate the financial impacts, of leasing, and

l widespread lessor familiarity with agriculture’s capital needs, and a

corresponding lack of available leasing services in rural areas.

As a result, only large cooperatives tend to be users of financial leases and related

purchase-leaseback arrangements.

Large cooperatives typically negotiate larger lease deals through national leasing

companies and regional commercial banks, where leasing expertise exists. The

leasing needs of large, regional farmer cooperatives tend to be similar to their nonagricultural, corporate counterparts. Therefore, leasing services have tended to be

more easily adapted to large cooperative situations. Financial performance and

documentation of large regional cooperatives also tend to be more acceptable to

large leasing entities, as compared with the financial picture presented by small

farmer cooperatives. Another reason for less use of financial leasing by small

cooperatives is the relative absence of leasing services in rural business communities. Finally, where large cooperative financial managers have sought out leasing

opportunities, small farmer cooperative managers have often lacked management

experience and rejected leasing in favor of traditional debt-financing arrangements.

The lease-financing option is explored in two related ways: First, the incentives

to leasing that represent the basic underlying reasons for leasing an asset (as

opposed to debt financing or a cash purchase). These incentives include improved financial risk control through diversified financing, increased cooperative

profitability, and the cooperative’s own management of cash and working capital.

Second, analysis of the conditions that potentially favor leasing requires the use of

capital budgeting techniques to adequately compare leasing and debt-financed

purchase of capital assets. Alternatively, a simulation analysis can be used to
Capital Budgeting

and Simulation

compute the financial impacts on both future cooperative financial performance

and patron benefits. Systematic analysis of these conditions requires that cash

flows be evaluated in terms of profitability and feasibility of each financing

choice under a variety of assumptions.

Leasing as a financial choice is investigated under two sets of economic conditions-those prevailing in 1985 and those in 1987 (to represent pre- and post1986 Tax Reform Act conditions). Results from capital budgeting confirm similar

analyses that have appeared in the applied leasing literature. Sensitivity analysis

is performed on a case lease using the 1985 capital budgeting model. Results

from the 1985 analysis indicate that while the base lease situation faced by the

cooperative slightly favored debt financing at all tax rate levels, variations in the

interest rate on borrowed funds and potential nonuse of investment tax credit

(ITC) were sufficiently large to support the cooperative’s actual decision to lease.

In this regard, opposing changes in interest rates, tax rates, and lease rates can be

potentially more important than (and different from) single-factor effects. For

example, the availability of a slightly lower interest rate on debt can be completely offset by the inability to use the ITC generated by purchasing, thus making

the lease attractive.

Results from the 1987 capital budgeting model are similar to those obtained with

the 1985 model. However, debt financing for 1987 appears to be more highly

favored given the elimination of the ITC and decline of interest rates. In this

economic environment, a slight reduction in the lease rate makes the lease reasonably competitive with the debt-financing alternative. Capital budgeting

results are shown to provide useful information to cooperative decisionmakers

regarding the most profitable financing choice. Moreover, capital budgeting

allows the cooperative manager to consider which factors are most critical to the

financing choice.

Simulation results indicate that leasing versus debt financing can be evaluated by

their impacts on future cooperative financial performance and the stream of

patron benefits. Patron benefits (especially cash refunds) are shown to be quite

sensitive to the lease rate, patron tax rates, and interest rate levels. A lower

interest rate is highly favorable to patron cash refunds with (or without) the lease.

A lower lease rate provides a similar but smaller effect when the lease-financing

option is selected (the lease is only 10 percent of the modeled capital structure).

Other patron benefits (retirement of member debt and the revolving fund) respond similarly to cash refunds when rate adjustments are made.

Debt financing is found to produce the highest present value of patron benefits in

all situations that are simulated. However, cooperative financial performance

varies depending on the model being used. The 1985 model produces stronger

cooperative financial performance with the lease when interest rates were allowed to rise, business rates of return and business volume were declining, and

iv
Future Cooperative

Leasing

the annual lease rate was held constant. In sharp contrast, the 1987 model indicates that debt financing produces higher cooperative net savings and cash

availability in all situations that are analyzed. This consistent result under a

range of assumptions suggests that the attractiveness of selected leases (such as

the facility lease modeled here) has declined in the post-1986 (Tax Reform Act)

period.

The future use of leasing by agricultural cooperatives remains uncertain. First,

changes in tax and financial market conditions, volatile financial performance,

and the availability of alternative interest rate pricing arrangements through

banks for cooperatives have reduced the incentives for small cooperatives to

engage in facility leases. However, small-to middle-sized farmer cooperatives

continue to successfully use leases to finance vehicles and other “rolling-stock”

capital investments.

Second, farmer cooperatives are recovering from a difficult financial era, and both

reorganization and restructuring are occurring. The scenario of rising interest

rates on loans, falling returns on cooperative assets, constant business volume,

and market-level lease rates (simulated in the 1987 model in this report) result in

a high probability that a business plan for expansion will be financially infeasible

under both debt and lease financing. As cooperatives emerge from the mid1980’s period and experience improved financial conditions, caution needs to be

exercised regarding asset acquisitions. Additional economic analysis of the

financial returns and risk is advisable before assuming new lease and debt obligations.

The “leasing is dead” view expressed by some observers tends not to be generally

correct for large cooperatives. Large cooperatives continue to negotiate leases and

lease-purchase deals. Several cooperatives are in the process of selective financial restructuring, and others are developing joint ventures where lease financing

is playing a role. A financial lease will likely continue to be the higher cost altcrnative for most farmer cooperatives, and better-than-average leases will be required to be competitive with debt-financed purchases, as long as interest rates

remain relatively low and stable. The methods of analysis presented in this study

are important for cooperative decisionmakers to use in identifying profitable

leasing opportunities.

This report does not address the broader issue of combining leases and/or term

debt with nonqualified notices of allocation. Additional research could productively focus on how to develop financing strategies that increase the present value

of future patron benefits under alternative assumptions about the future course of

interest rates, tax rates, tax benefits of ownership, lease rates, and cooperative

earnings. Presumably, a cooperative gains additional financial flexibility and

gcncratcs greater benefits to patrons if all three financing options arc jointly

considered.
Leasing as an Alternative Method

of Financing for Agricultural Cooperatives

Glenn D. Pede’rson, Associate Professor

Eric E. Gill, Research Assistant

Department of Agricultural and Applied Economics

University of Minnesota

Introduction

Public concern about the financial condition of agricultural cooperatives and other agribusiness firms

has increased as a result of the farm sector economic

recession during the early and mid-1980’s. Farmer

cooperatives participated in that recession because

of their reliance on farm sector sales and profitability. Reduced farm earnings have been reflected in

the impaired earnings (net margins) of farmer cooperatives between 1980 and 1984 (Royer, 1985). The

problem has been documented as more critical

among cooperatives that carry relatively heavy debt

loads (Cinder et al., 1985).

Turner (1985) compared the 1984-85 financial audits

of 480 grain and farm supply cooperatives in the

Omaha Farm Credit District. Thirty-five percent (170

firms) reported operating losses, and 65 percent (310

firms) reported net savings. One of the more significant contrasts between these two groups was the

high average term-debt/equity capital ratio reported

by the cooperatives with losses and the low leverage

ratio reported by profitable cooperatives.

The escalation of both debt levels and interest

expense has been one of the major factors contributing to the selective erosion of cooperative profits. In

addition, the recession in agriculture has reduced

the ability of farmers to invest funds in their cooperatives. The combination of these events raises

questions about how cooperatives will be capitalized

in the future.

Boehlje and Pederson (1988) suggest that one of the

major lessons to be learned from financial stress of

the 1980’s is that the financial base of agriculture is

too narrow. Heavy reliance has been placed on

internally generated equity and debt financing. As a

consequence, the exposure to, and consequences of,

financial risk are great for farm and agribusiness

firms. They argue that agricultural managers,

financial institutions, and policy makers need to

consider the potential for new financial arrangements and instruments in the mix of alternatives

used to rebuild and stabilize the financial position of

agricultural businesses. Leasing of production assets

is part of that array of financing options.

This study looks at the past, present, and future role

of leasing in financing agricultural cooperative

investments. This report also investigates the

impacts which selective changes in the federal tax

law during 1986 will have on leasing and its attractiveness to farmer cooperatives.

1
Figure la Types of Equipment Under Financing Lease Arrangements, 1983-1987.

*

---__ --_

~**~--~*~ Telecommunications

- Trucks, Trailers

- Agricultural

__-. Aircraft

-*-*-** Computers

? 1983 1984 1985 1986 1987 1988

Figure 1 b Types of Equipment Under Leveraged Lease Arrangements,1 983-l 987.

30

20

i

i

i

i

i

10

:982 1983 1984 1985 1986 1987 1’98t

_-**-- Telecommunications

- Trucks, Trailers

- Agricultural

-_-_ Aircraft

-*-.-*- Computers
Background on Leasing Activity

Generally, leasing (including agricultural leasing)

has been increasing during the 1980’s. The Department of Commerce estimates that about $90.6 billion

in equipment was purchased for lease in the United

States during 1987. That represents about 29 percent

of all business investment in durable capital equipment (American Association of Equipment Lessors,

1988). Despite the loss of investment tax credit and

the introduction of the alternative minimum tax

(AMT), the outlook for aggregate U.S. leasing volume

is that it would reach $108 billion in 1987 (Berg).

In contrast, agricultural equipment has not been

among the active areas in this growing industry.

Figures la and lb indicate that direct (financing) and

leveraged leases of agricultural equipment have

accounted for a small percentage of total new leasing

business volume during 1983-87 (American Association of Equipment Lessors, 1988). Computers,

aircraft, and telecommunications remained the

dominant forms of leased equipment, through 1987.

Leveraged leasing of computers declined dramatically in 1987 (fig. lb).

Reasons for the lack of past agricultural leasing

activity can be suggested along three lines: (1) lack

of acceptance of this form of financing by agricultural decisionmakers because of traditional preferences for ownership, (2) lack of knowledge of potential agricultural lessees about the advantages of

leasing, and (3) lack of lessor familiarity with agriculture’s capital needs, and the perception that

agricultural firms (farms and cooperatives) are not a

growth market.

Use of capitalized financial leases has occurred

primarily among the largest 100 cooperatives, with

31 using leasing in 1986 to provide 6.8 percent of

their total borrowed capital (Davidson and Kane,

1987, 1988). Although the volume of agricultural

leasing has been small relative to the total industry,

the range of assets leased by agricultural firms is

quite extensive. For example, equipment directly

leased includes automobiles, light-duty trucks,

tractors, fertilizer equipment, trailers, forklifts, plant

equipment, storage tanks, and an array of other

miscellaneous small equipment. Mid-size and larger

scale leased assets include computers, transportation

equipment, processing equipment, office buildings,

warehouses, grain elevators, service facilities,

railroad cars, and storage facilities.

As part of the growth in agricultural leasing activity,

10 of the 12 district banks of the Farm Credit System

(FCS) jointly acquired the Interregional Service

Corporation (ISC) in 1984. Between 1971 and 1984,

ISC had served the leasing needs of Midwest and

Southeast regional cooperatives and their affiliates.

The new leasing entity, Farm Credit Leasing Services

Corporation (FCL), expanded the range of leasing

services beyond what ISC had provided.

FCL provided direct leases through 1986, by which

investment tax credits were “passed through” to

cooperative leases. FCL continues to provide taxoriented leases, but ownership is retained by FCL

and the capital item is leased to the cooperative for

an annual rental fee. FCL provides direct finance

and leveraged lease services and syndicates leases

for the FCS. The majority of FCL’s leasing volume is

in the form of operating leases. Property under operating lease contracts was $86.3 million in 1985,

$74.8 million in 1986, and $87.4 million in 1987

(Farm Credit Leasing Services). Net investment in

direct finance leases increased from about $7.5

million in 1984 to nearly $16 million in 1985, $33.8

million in 1986, and $52.8 million in 1987.

FCL’s equipment lease portfolio in 1986 and 1987

was dominated by autos, trucks, and truck trailers

and bodies (fig. 2a). The geographic distribution of

FCL’s 1987 lease portfolio is illustrated in fig. 2b.

The St. Paul and Columbia Farm Credit Districts

account for the largest shares of FCL’s lease volume.

A majority of FCL’s lease volume was under fixedrate leasing arrangements (68 percent) in 1987.

Variable-rate leases accounted for the remaining 32

percent of lease value.

Prior to 1986, the Farm Credit System’s banks for cooperatives (BC’s) became an active lessor to cooperatives. The St. Paul BC tripled its direct lease and

leveraged lease loan volumes between 1984 and

1985, reflecting the selective growth in tax-oriented

leasing business in the Seventh Farm Credit District.

A significant proportion of the BC’s 1984-85 lease

3
Figure 2a Farm Credit Leasing Services Lease Portfolio by Equipment Type, 1986-87.

Other

Office &

Communications

Equip.

~~;;facturing

Ag.Structures

Material

Handling

Ag. Field and

lrngation Equip.

Trailers and

Truck Bodies

Trucks

Autos and

Light Trucks

0 10 2 0

Percentage of Portfolio

q 1986

q 1987

Figure 2b Farm Credit Leasing Services Lease Portfolio by Farm Credit District, 1986-87.

Springfield

Baltimore

Columbia

Louisville

Jackson

St. Louis

St. Paul

Omaha

Wichita

Texas

Sacramento

Spokane

q 1986

q 1987

10 20 30 40

Percent of Current Portfolio

Source: Farm Credit Leasing Services Corporation

A
volume was generated on a few large lease contracts

with rural electric cooperatives. Leasing activity at

the St. Paul BC declined sharply in 1986 (the bank

generated less taxable income and less incentive to

write tax-oriented leases), and FCL expanded its role

as lessor to BC customers.

Federal tax policy is a major determinant of leasing

industry activity. A favorable tax treatment of

leasing transactions is influential in attracting firms

into leasing and in shaping the terms of lease contracts, making them more competitive with traditional debt financing. Underlying a lease transaction

is the general assumption that it is the productive use

of a depreciable asset, rather than its ownership, that

results in profits necessary to operate a business.

Based on that approach, an investing firm would first

determine which projects are profitable to undertake,

then determine how best to finance those projects.

Tax policies play a role by either enhancing or reducing the underlying profitability of the project on an

after-tax basis.

The 1986 U.S. Congress modified the income tax law

as it applies to depreciable assets. The modifications

that have particular relevance for financial leasing

are: (1) repeal of the investment tax credit on items

purchased after December 31,1985 I, (2) adjustment

of expensing provisions and rules for depreciation,

(3) consolidation of tax brackets and reduction of the

top rate (with elimination of selected business deductions), and 4) application of the alternative minimum tax provision.

These modifications in the tax code have significantly altered the tax incentives for lessors to write

leases and will potentially lead to changes in the

characteristics of lease contracts that will be offered

in the future. Leasing contracts will likely be restructured (with some leasing options discontinued) and

repriced to reflect the loss of selected tax benefits.

Study Objectives

An evaluation of finance and tax developments at both

the National and the agricultural levels is clearly

beyond the scope of this study. The more limited

concern here is to explore capital leasing by agricultural cooperatives as an innovation that may selectively improve cooperative financial performance

within this changing economic environment.

Two general objectives of this study are to:

1. Identify the economic incentives for agricultural

cooperatives to use finance (capital) leases, and

2. Evaluate the impacts of finance leases at the project

and whole-firm levels using an agricultural cooperative illustration.

The economic incentives for farmer cooperatives to

lease structures, machinery, equipment, and other

depreciable items are primarily finance and taxrelated issues. The advantages of leasing such capital

assets depend on a careful analysis of the financing

options and terms that are available. The current and

projected tax situations of the cooperative and its

farmer members are of equivalent importance in the

leasing decision. These factors, and associated incentives are identified in this study through a review of

selected changes in financing terms and lease-related

tax laws.

The financial impacts of capital leases are analyzed by

(1) studying the profitability of the lease or purchase

alternative using capital budgeting, and

(2) simulating the whole-firm financial effects for a

farmer cooperative employing equity, debt, and lease

capital. The results are then evaluated after making

selective adjustments to the tax and financial variables.

’ Farm Finance Leases (as a special category) were allowed the

investment tax credit through December 31, 1987.

5
Investment Financing Alternatives

Financial capital is required in all phases of cooperative management: initial formation, daily operation

and maintenance, asset replacement, and plant

expansion. Capital acquisition and funding of these

activities can occur through the use of equity, debt,

and/or leases. Although use of these sources of

funds by cooperatives has changed in recent years,

balance sheet statistics indicate that those changes

arc not widespread by cooperatives regardless of

size.

Changing Financial Structure

of Large Cooperatives

Table 1 contains a description of the major categories

of financial capital used by the Nation’s 100 largest

farmer cooperatives for selected years between 1970

and 1986. The trend between 1970 and 1980 was

away from equity capital and toward growing dependence on debt and other liabilities. After 1980,

equity formation occurred to reverse the earlier

trend. A dramatic substitution of long-term for

short-term debt occurred between 1980 and 1982,

while total debt declined. The substitution moderated during 1982-85, as the total use of debt continued to decline. Other liabilities increased from 22

percent in 1970 to 29.2 percent in 1980, and declined slightly to 26.8 percent in 1986. As a reflection of reduced debt, the ratio of percentage total

(short- and long-term) borrowed funds to total equity

(based on table 1) fell from 1.46 at the end of 1982 to

1.14 at the end of 1984, and to 1.04 at the end of

1986. These falling leverage ratios reflect the response to higher interest rates on debt and the efforts

by large agricultural cooperatives to strengthen their

financial positions.

Debt financing has traditionally been obtained

through regional BC’s, commercial banks, insurance

companies, the issuance of debt securities, and from

other cooperatives. As indicated in table 2, the longterm trend among the 100 largest agricultural cooperatives has been away from conventional loans by

BC’s and commercial banks and toward the use of

capital leases, industrial development revenue

bonds, and other sources. The decline in traditional

debt and the increased use of other sources is quite

noticeable during 1980-86. BC financing has typically been provided on a variable interest rate basis.

Table l-Financial structure of the 100 largest U.S. farmer cooperatives in selected years, 1970-86

Category 1970 1980 1981 1982 1983 1984 1985 1988

Equity capital 39.1 28.6

Borrowed capital 38.9 42.2

Short term n.a. 21.1

Long term n.a. 21.1

Other liabilities 22.0 29.2

Percent of total capital

29.8 30.0 31.6

42.1 43.7 41.1

18.5 17.9 16.9

23.6 25.8 24.2

28.1 26.3 27.3

33.8 35.9 35.9

38.6 37.0 37.3

15.4 14.1 15.0

23.2 22.9 22.3

27.6 27.1 26.8

n.a. = not available.

Source: Davidson and Street (1984b), and Davidson and Kane (1988).
Consequently, interest expense on BC borrowings

has been rising and less stable in the post-1979

period. Farmer cooperatives have sought opportunities to convert to fixed-rate debt and insulate their

earnings from rate fluctuations.

Financial leases, industrial revenue bonds and other

sources have provided some opportunity to “lockin”

interest rates on these liability items. Capital leases

totaled $368 million in 1983, $377 million in 1984,

$398 million in 1985, and $390 million in 1986

(Davidson and Street, 1984; Davidson and Kane,

1988). Industrial revenue bonds showed a similar

small increase from $394 million in 1983 to $400

million in 1985, and fell to $364 million in 1986. In

1986 the “other sources” category accounted for 16.8

percent of total debt. This included Commodity

Credit Corporation and other Government sources

(5.3 percent), commercial paper (2.2 percent), other

nonfinancial businesses-cooperative and noncooperative (3.6 percent), insurance companies (5.4

percent), and various others (1.6 percent).

Small Cooperatives

Balance sheet data obtained from the St. Paul Bank

for Cooperatives for three major types of farmer

cooperatives (dairy, grain, and farm supply) indicates no consistent pattern of financial restructuring

occurred among smaller farmer cooperatives in the

Seventh Farm Credit District during 1980-85 [table

3). In 1985, these smaller cooperatives varied in

average total investment from nearly $17.5 million

among dairy, $2.7 million among grain, and $2.5

million among farm supply cooperatives. By comparison, the Nation’s largest 100 cooperatives reported an average total investment of about $165

million in 1984.

Table 3 contains percentages of financing by liability

category. Although these data are not available in a

form that is directly comparable with the largest 100

cooperatives, they do suggest that dairy cooperatives

(the largest number of the three categories) have also

moved toward an increased use of industrial revenue

Table 2-Sources of debt capital for the 100 largest U.S. farmer cooperatives in selected years, 1970-85

Source 1970 1976 1980 1981 1982 1983 1984 1985

Banks for

Cooperatives

Debt Certificates l

Commercial Banks

Leasing/Industrial

RevenueBonds

Other

Percent of total liabilities

62.0

23.4

10.7

n.a.

3.92

56.9

22.7

10.0

4.8

5.6

58.4 57.7 51.7 51 .o 54.6 48.2

13.6 15.5 16.0 16.8 16.3 15.9

12.4 5.9 5.9 5.2 5.3 6.7

7.8 9.2 9.7 11.0 12.3 13.8

7.8 11.7 16.7 16.0 11.5 15.4

n.a. = not available.

’ Debt certificates include bonds, notes, and certificates issued by cooperatives.

2 In 1970 other sources included capitalized leases and industrial revenue bonds.

Source: Davidson and Street (1984), and Davidson and Royer (1986). 7
bonds and contracts. Contracts payable (which

includes leases) at dairy cooperatives moved up to

4.9 percent of total liabilities in 1985. Industrial

revenue bonds provided 3.7 percent of total liabilities in 1985. Small-scale grain and general farm

supply cooperatives made increasing (but less

significant) use of contracts and revenue bonds as

sources of funds by 1985.

The relative stability of these balance sheet percentages for smaller cooperatives suggests that financial

leasing by small cooperatives has been quite limited

when compared with the trend among large cooperatives. This may reflect the relatively recent use of

financial leasing as an option for farmer cooperatives

and the absence of leasing services in rural areas.

Table 3-Term liabilities of selected U.S. farmer cooperatives in the Seventh Farm Credit District

by type of cooperative, 1980-85 l

Cooperative Liability

Type Category 1980 1981 1982 1983 1984 1985

Percent of total liabilities

Dairy Bank for Cooperatives loans 18.0 16.2 19.3 18.4 19.2 17.1

Notes payable 0.7 .6 .6 .7 .7 0.4

Patron notes payable 1.9 1.8 1.3 .9 1.0 0.9

Contracts payable * .4 .3 .7 1.8 2.9 4.9

Industrial revenue bonds 2.9 2.3 1.8 1.3 4.5 3.7

Other term liabilities 3 .2 .l .l .l .I 0.1

Total 24.1 21.3 23.8 23.2 28.4 27.1

Grain Bank for Cooperatives loans 16.4 17.9 19.3 15.4 15.2 17.5

Notes payable .6 .5 .7 .6 .7 .l

Patron notes payable 2.3 2.4 2.6 2.0 2.2 2.4

Contracts payable .2 .2 .2 .I .2 .8

Industrial revenue bonds 1.2 1.1 1.6 1.2 1.2 1.6

Other term liabilities 0 0 .2 .I .l .2

Total 20.7 22.1 24.6 19.4 19.6 22.6

General Farm Bank for Cooperatives loans 16.4 19.8 22.4 22.5 21.8 21.8

3UPPfY Notes payable 1.8 1.4 1.4 2.0 1.9 3.2

Patron notes payable 1.6 1.2 1.1 1.2 1.2 1.3

Contracts payable 0.6 0.5 0.7 0.9 0.7 1.3

Industrial revenue bonds 1.2 1.1 1.1 0.5 0.5 1.3

Other term liabilities 0.2 0 0 0 0.1 0.3

Total 21.8 24.0 26.7 27.1 26.2 29.2

I Only cooperatives which were borrowing from the Seventh District BC were included.

z Contracts payable include financial leases and real estate contracts for deed.

3 Other term liabilities include deferred income tax items and deferred compensation for employees.
Additional explanations would be that the financial

costs and benefits of leases have not been widely

known by local cooperative decisionmakers, or that

leasing rates were known but were not sufficiently

competitive to displace the use of term debt. Leasing

may have been more attractive for some cooperatives

(for example, dairy) than for others due to the nature

of the assets most commonly leased.

The preceding balance sheet trends suggest a high

level of financial uniformity and stability among

farmer cooperatives. That uniformity tends to

obscure the variety of financing choices available to

individual cooperatives and for individual investment projects of these cooperatives.

Financing Alternatives

The selection of a mode of financing from alternative

financing sources depends upon economic and

noneconomic factors. For instance, financing at a

lower projected interest expense is an important

economic consideration, but it may be of less importance in some situations than obtaining an ownership position. Similarly, a new financing opportunity may be rejected in favor of a more traditional

method due to a lack of management experience

with the proposed new financing method.

An additional consideration for a farmer cooperative

is the influence of the financing choice on future

patron benefits. If an asset is financed with debt,

current patrons would gain the tax benefits of

ownership, and future patrons would share the

interest costs. The benefits of leasing (lower, stable

lease payments) would be distributed among current

and future patrons. This report does not explicitly

analyze the issue of how financing choice alters the

distribution of patron benefits over time.

Each of the financing methods shown in figure 3 has

different tax, balance sheet, and cash flow characteristics than the other methods of asset control shown.

These various financing choices extend from full

ownership (through an outright purchase using lOOpercent equity capital) to exclusive use rights with

no ownership (through an operating lease arrangement). An outright purchase provides the owner

with tax benefits and the right to collateralize or sell

the asset at any time, in addition to its long-term use.

At the other extreme, an operating lease conveys just

the contractual right to short-term use of the asset.

Between these two extremes the debt-financing

alternatives (unsecured loan, mortgage, credit sale,

and conditional sale) provide for various levels of

ownership and associated rights to claim tax benefits, collateralize, or sell the asset prior to maturity.

Debt Financing Interest expense is typically a

primary concern when negotiating a project loan

because it directly influences the cash flow and the

financial profitability of the investment project and

the cooperative. Both the level and the variability of

interest rates paid on debt are important.

Inflationary pressures in the latter 1970’s, coupled

with gradual deregulation of interest rates, pushed

interest rates up during the post-1979 period.

Through variable-rate lending, this instability

translated into higher interest expense for cooperative borrowers. Variable interest rates on term loans

through the St. Paul Bank for Cooperatives, for

example, escalated from 7.75 percent in 1978 to

13.75 percent in 1982, declined to 11.75 percent in

1985, and fell to 10.25 percent in late 1986. More

recently, the variable rate offered by the St. Paul BC

has fluctuated between 10.25 percent in early 1987

and 9.25 percent in mid-1988 for middle-sized

cooperatives in relatively strong financial positions.

Variable-rate loans allow for the periodic adjustment

of interest rates when market conditions change. By

adjusting the rate, a lender (for example, the bank for

cooperatives) is able to achieve a closer “match”

between the interest rate charged and the cost of

funds acquired for lending. The disadvantage to the

borrower (the farmer cooperative) is that the interest

21 expense is not highly predictable in distant years.

Situations may occur where interest expenses

fluctuate upward at a time when earnings are low,

resulting in cash flow stress. If cash reserves are

depleted, the cooperative may find it difficult to

generate cash to make larger debt payments.

9
Figure 3 Alternative Financing Methods in Agriculture for Acquiring Various Levels of Asset

Ownership and Use.

Financing Method Description

Ownership and Use

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Use

Outright Purchase . . . . . . . . . . . . . . . . . . . . Purchase with own funds

Unsecured Loan . . . . . . . . . . . . . . . . . . . . . . . Purchase with borrowed funds without a

security interest in the asset

Mortgage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchase with borrowed funds with a

security interest in the asset (real estate)

Credit Sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Purchase with financing

provided by the supplier

Conditional Sale . . . . . . . . . . . . . . . . . . . . . . . Purchase with title passing upon

completion of installment payments

Financial Lease . . . . . . . . . . . . . . . . . . . . . . . . Long-term lease with lessor retaining

residual interest (lessee may have an

option to buy)

Operating Lease . . . . . . . . . . . . . . . . . . . . . . . Short-term rental

IO
Variations in liquidity (due to rising interest expense) is partially manageable through the use of

fixed-rate financing. In an effort to provide greater

cooperative flexibility and control in the term debtfinancing decision, some BC’s have initiated lending

programs that allow variable- or fixed-rate contracts.

For example, the St. Paul District BC allows a

cooperative to finance on a l-year, variable rate or fix

the rate for 1, 3, 5, 7, or 10 years with rate spreads

(set according to market interest rate yield curve

relationships) to reflect maturity differences. Availability of this form of rate selection flexibility provides a cooperative with additional options for

reducing the adverse effects of rising interest rates.

It also allows a better choice of debt financing versus

lease financing by comparing effective interest rates.

Lease Financing A direct financial lease (fig. 4)

provides asset control with generally no ownership

rights, except for the opportunity to acquire the asset

at lease termination through a purchase option. This

financing technique has been used by cooperatives

for the past 35 years or so and is typically used to

finance relatively small, short-term asset requirements. Some tax benefits (for example, investment

tax credit under previous tax law provisions) were

occasionally “passed through” by the lessor to the

lessee under direct finance leasing arrangements.

The financial lease is a long-term (typically noncancelable) financial arrangement and, therefore, differs

from an annual operating lease. Financing terms of

an operating lease may be adjusted on an annual

basis in contrast with a financial lease where the

terms remain unchanged for several years.

A leveraged lease (fig. 5) involves a number of

parties-a cooperative lessee, a lessor (or equity

participant), a lender, a contractor (or manufacturer),

an owner trustee (or indenture trustee), and potentially an agent (investment banker). An owner

trustee holds title to the leased asset for the lessor(s)

and issues trust certificates to them as evidence of

ownership, whereas an indenture trustee holds a

security intcrcst in the leased property for the benefit

of debt lenders. This financing arrangement provides an alternative to the direct financial lease

when large capital outlays are required on depreciable real and personal property. A leveraged lease

operates the same for the lessee as would a direct

lease. The lessee contracts to make the periodic

lease payments and is entitled to the use of the asset.

The lessor’s role is altered. The lessor acquires the

asset, financing a minor part of it as an equity

investment, and borrowing to finance the remaining

amount. The loan is usually secured by a mortgage,

as well as by an assignment of the lease and lease

payments. Since the lessor is a borrower, the lease

rate must be set at a level that will cover the interest

expenses incurred under the loan and provide the

lessor with an acceptable after-tax rate of return.

The lessor is entitled to all tax benefits of depreciation and investment credits that apply.

The leasing option can be explored in two related

ways: (1) the lessee’s incentives to lease, and (2)

conditions (factors) that are favorable to lease financing. Incentives to lease include the general underlying reasons that a lessee might have for pursuing a

lease opportunity. Conditions favoring a lease

include specific factors that weigh the advantage of

leasing over a debt-financed purchase.

Incentives to Lease. The primary incentive to lease

is to capture favorable financing terms of the lease

contract. Proponents of leasing cite the “freeing up”

of working capital and the improved cash flow that

result from favorable leasing terms. An increase in

working capital means that the downpayment

required with debt financing exceeds the initial

capital requirements of the lease. Some leases may

require a security deposit that, along with the first

lease payment (usually in advance), would

significantly raise the initial cash outlay of the lease.

This may compare to a situation where a cooperative

can obtain nearly loo-percent debt financing, given a

strong equity position.

Financial leases may be more predictable in terms of

their cash flow impact than credit line or variablcrate debt financing, where the interest rate can be

periodically adjusted. Unanticipated increases in

interest rates and the cash flow requirement to

service the project’s debt may make a project infeasible due to potential cash flow shortages, even

though the project represents a profitable use of

funds over its life. Since the timing of lease and debt

11
Figure 4 Direct (single-investor) Lease Transactions.

Lessor

(owner)

1

Contractor or manufacturer

Leased item(s) (equipment, structure)

b

4

Lease payments (rents)

Lessee

(user)

Ir

Leased Item(s)

(equipment, structure)

12
Figure 5 Leveraged Lease Transactions (adapted from Griffen and Finsterstock, 1974).

Cooperative

Lessee

Owner Lessors

(equity)

Equity Funds to

1 T Lease Payments Less Principal,

Purchase Asset Interest, and Expenses

Lease Payments

(rents)

1

4

Leased Item(s)

(equipment,

structures)

Owner Trustee

and/or

Indenture Trustee

Purchase

+

1

Leased Item(s)

(equipment,

structures)

T 1

Principal

Debt Funds and Interest

to Purchase Asset Payments

Institutional

Lenders

(debt)

Contractor or

Manufacturer

1 3
payments varies, the feasibility of either financing alternative requires that cash inflows and outflows of

the project be listed along with their time of occurrence to develop a clear picture of the net cash flow

stream on at least an annual basis. The cash flow

advantage of leasing over debt financing is strongly

influenced by the repayment period of the loan. A

loan with a term shorter than the lease period will

frequently result in a cash flow advantage to leasing.

In addition, a lease may free the lessee from loan

indenture agreements or other restrictive covenants

that apply to the use of cash.

A secondary incentive to lease is to avoid obsolescence (residual value) risk. Leasing provides the

lessee with protection from risks of ownership losses

when technological advancement reduces the market

(resale) value of capital assets. The lease contract

provides the option for the lessee to purchase the

asset without a legal requirement to do so. The

purchase price may be specified as the asset’s “fair

market value” or as some predetermined, fixed

percentage of the initial value (a “bargain purchase”). If the lessee estimates that the asset is

worth less than the purchase option price due to

obsolescence, the associated loss is borne by the

lessor.2 In anticipation of this risk problem, the

lessor will typically set the lease term appreciably

shorter than the economic life of the asset and

reduce the purchase option price sufficiently to

encourage purchase by the lessee.3

Conditions that Favor Leasing. Major economic

factors that may combine to make leasing the preferred financing option are: anticipated income tax

bracket, interest rate level, residual value versus

purchase option price, pass through of lessor volume

purchase discounts on leased assets to the lessee,

and agreements concerning repairs, insurance, taxes

(sales or use taxes and personal property taxes), and

lease termination. Each of these items influences

lease profitability either directly or indirectly. A

comparison of purchasing (using debt) and leasing

requires that an analysis of the discounted, after-tax

cash flows be completed. Casual observations may

be quite misleading. (A later section of this report

demonstrates some results using capital budgeting.)

A cooperative that projects a low tax bracket (due to

reduced earnings or the method chosen to distribute

earnings) may find that the tax benefits from ownership would have a lower value to the cooperative

and its members. If the cooperative conveys tax

credits and deductions to a lessor, and receives a

lower lease rate in return, both parties may gain

through leasing. The cooperative is still able to

deduct annual lease payments as an expense, and

the lessor would likely be in a position to make full

use of the tax benefits.

The marginal tax rate plays a dual role in profitability analysis. Cash flows are adjusted to an after-tax

basis using the projected tax bracket of the cooperative. A lower tax rate increases the after-tax net cash

flows and profitability of both financing options.

The tax rate is also used when determining the appropriate after-tax discount rate. For a given cost of

capital, a lower tax rate raises the after-tax discount

rate and reduces the profitability of both options, but

it may affect one option more than the other due to

differences in timing of cash flows.

A relatively higher interest rate on debt tends to

favor leasing. The effect of an interest rate increase

(holding the lease percentage rate constant) would

make the lease more profitable than the use of term

debt.’ The advantage of leasing cannot be determined by a simple comparison of the annual percentage rates (APR) of interest paid on debt and the

percentage lease rate because different tax rules

apply. Also, the quoted lease rate would already

reflect tax benefits used by the lessor. Interestingly,

simply having a lease rate lower than the interest

rate on debt may not be sufficient, by itself, to make

* It is entirely possible that an asset is considered obsolete to a

given lessee but is not obsolete to alternative potential purchasers

at the time the purchase option is being negotiated.

3 Adjustments to the tax law in 1981 reduced the “at risk” requirement for lessors. Additionally, more latitude was provided in the

length of lease term and the expected residual value that could be

used when establishing the lease payment amount.

‘The important point to note here is that interest rates on debt and

lease rates do not necessarily move in parallel fashion. Divergence

between these rates results in situations that may favor a given

financing option.

14
the lease more profitable. The size of the spread

between these two rates and their relative stability

over time are likely to be more important considerations. The interest rate on debt also plays the major

role of setting the discount rate to be used in profitability analysis.

The residual (resale) value of a capital asset can

potentially affect lease costs when the lessee has a

fair market value purchase option. Since the capital

item is owned by the lessor, a general increase in

market values may translate into a larger-thanexpected cash outlay by the lessee to purchase the

asset at lease termination. This would tend to make

a lease with a market value purchase option less

attractive to cooperatives in periods when asset

prices are rising due to inflation or other factors.

When asset prices are falling, a market value purchase option would generate a gain for the leasing

cooperative. In response, lessors have increasingly

moved toward low, fixed-price purchase option

leases in agriculture to reduce residual value effects

on profitability. Lessees in agriculture have been

generally quite receptive to these fixed-price purchase contracts because uncertainty about cash flow

is reduced. It is useful to note that while lessees

generally prefer a fixed-price purchase option, the

difference between the purchase price and the

anticipated residual value is irrelevant to the lessee’s

position. It is only the magnitude of the actual lease

rate charged (which theoretically reflects the difference) that has significance for the lessee.

Contractual agreements by which the lessor makes financial concessions on repair, insurance, and/or tax

items reduce the lessee’s expected cash outlay and

favor the lease option. Normal maintenance of

equipment and structures is usually the responsibility of the cooperative lessee. Major repairs expenses

(those not due to negligence by the lessee) may or

may not be covered by a manufacturer’s warranty or

be paid for by the lessor.5 If major repairs can be

anticipated to occur during the lease period, and are

not covered by a warranty, they should be incorporated into the lease profitability analysis. Since

disagreements can arise over what constitutes a

major repair, as opposed to normal maintenance, this

should also be clearly specified in the lease contract.

Insurance expenses are usually borne by the owner

of an asset and are an expense item that the cooperative may seek to avoid through leasing. However,

payment of insurance premiums may (or may not) be

a negotiable item. Whose responsibility it becomes

needs to be specified in the lease. The magnitude of

the cost saving is usually small when compared with

other costs of ownership, but it should be factored

into the analysis of lease profitability.

“Net lease” is a term frequently used in the leasing

industry. Under a net lease agreement the lessee

becomes responsible for all costs of insurance,

maintenance, and taxes (excluding income taxes).

The lessee is required to maintain the asset in good

working condition and appearance, considering

normal wear and tear.

Termination of leases on structures creates a unique

situation for the cooperative lessee. Usually, lessors

will set the purchase price option deliberately low to

provide an incentive for the lessee to purchase the

asset at lease termination. If the lessee elects to not

purchase the structure at the end of the lease term,

however, either the lessor or the lessee will incur an

additional expense associated with disassembly and

removal from the site. It is important that the lease

specify who is responsible for this and the condition

of the site after removal. This is an important

consideration if there are large structures, which

might require concrete footings or other site preparation before installation. If the cooperative lessee is

made responsible for removal, lease profitability will

certainly be reduced for the cooperative.

s Lease contracts frequently contain “warranty disclaimer” clauses

that stipulate since the lessor is not a manufacturer nor engaged in

the sale of the equipment, it is not liable for the failure of the asset

to perform for its intended use. The lessee’s only recourse is to

pursue the manufacturer under the provisions of the warranty if

major repairs occur. See, for example, section 15 of the sample

lease agreement in appendix B.

15
Terms of the Lease. In addition to the conditions

that favor a lease, several financing terms are

important to consider. B These “lease contract” items

may be negotiable and do frequently influence lease

profitability- directly or indirectly. It is expected

that the lessor and the lessee will take opposing

views concerning how leases should be structured

and a compromise must be found.

The following is a partial list of lease contract items

to consider:

I. Timing of lease payments. Since lease payments

are typically made in advance, timing of these

payments (monthly, annually) will alter the

pattern of project cash inflows and outflows

during the year.

2. Security deposit. Although security deposits are

primarily a feature of operating leases, their

presence in a financial lease increases the cost of

the lease. Both the size of the deposit and

whether it bears interest should be considered.

3. Origination or service fees. When the lease

contract is initiated, a service fee may be applied

at a percentage of the value of the leased asset.

Fee charges increase the effective interest costs of

the lease.

4. Duration. Extension of the lease term directly

affects the amount of each lease payment. The

longer the lease, the smaller the lease payment,

other factors being constant. Tax laws place

effective limits on the term of some lease contracts.

5. Purchase option. Under the “fair market value”

purchase option, purchase price determination is

delayed until the lease terminates. In the case of a

vehicle lease, a “Terminal Rental Adjustment

Clause” (TRAC) may provide the lessor with the

option to adjust the lease rental upward to recover the diffcrcnce between the projected and

actual value at the termination of the lease.

8 Additional discussion of lease contract terms can be found in lsom

and Amembal(1982).

6. Penalties. Failure of the lessee to perform under

the terms of the lease contract may trigger a penalty fee, or in extreme cases nullify the lease.

Under a noncancelable lease, a penalty may arise

due to lessor or lessee action to cancel. Additionally, a prepayment penalty would occur when the

lessee attempts to pay off the lease before maturity. Late payment penalties are also likely to be

imposed on the lessee. Clauses that accelerate the

lease payment schedule may be quite severe.

7. Flexible lease options. Several factors that may

add financial flexibility to the lease are trial

periods, provision of nonfinancial services of the

lessor, and sharing of delivery, installation, and

licensing expenses.

8. Lease rate. A fixed-rate lease may be preferred by

the lessee due to the predictability of each payment. In exchange, the lessor may be willing to

accept a variable-term lease arrangement to

compensate for the risk associated with changing

borrowing costs.

Most (if not all) of these financing terms appear on a

lease contract; selected items represent areas for

lessee/lessor negotiation.

Appendix B contains sample lease agreements and

attendant documents, used by Farm Credit Leasing

Services Corporation, which are representative of

documents designed for executing lease arrangements. An application agreement (of the type

shown) is used to initiate the leasing process. In

addition to the lease application agreement, a release

of credit and financial information is typically requested of the lessee. The lessee has the option to

enter into a lease agreement (like the one shown) for

each leased asset, or into a master lease agreement

(not shown) that provides for the current lease and

future lease transactions under a continuing lease

arrangement. A purchase option schedule (shown in

the appendix) may be a part of, or a document that is

supplemental to, the lease agreement. A guaranty

agreement (shown in the appendix) may also be

required by the lessor, depending on the financial

strength of the lessee. Several other lease documents

may be important in lease transactions, depending

on the type of lease and applicable State laws. These

16
include: purchase order, invoice, bill of sale (from

the supplier), acknowledgment of delivery and acceptance, and security agreement.

Lease rates are expressed in various ways depending

on the underlying yield to be generated by the lessor

and several of the lease contract items identified

above. Factors such as the lessor’s pretax yield, the

residual purchase percentage, the number of advance

payments, the frequency of lease payments, the term

of the lease, availability of investment tax credit, and

risk all directly or indirectly enter the lease payment

computation and, therefore, are determinants of the

lease rate.

The “implicit lease rate” is the discount rate that,

when applied to the lease payments (excluding costs

of executing the lease) and any unguaranteed residual, results in a present value sum of the cash inflows equal to the fair market value of the leased

property (less any ITC claimed by the lessor) acquired at the inception of the leasea This discount

rate is commonly referred to as the “internal rate of

return” to the lessor. For example, a leased asset

with an initial fair market value of $100,000, an

$8,000 ITC, monthly advance lease payments of

$2,900 for 47 months, and an expected residual fair

market value of $18,000 at the end of 48 months,

yields an implicit (annual) lease rate of 25.64 percent. Elimination of the ITC drops the implicit rate

to 21.12 percent (assuming the lease payments

remain unchanged).

The lease rate factor (which is used to determine the

size of the periodic lease payment) is related to the

above implicit rate calculation. The periodic lease

payment amount ($2,900) is divided by the initial

lease investment ($100,000) to derive the monthly

lease rate factor (0.029). The corresponding annual

lease rate factor is 0.348 (0.029 x 12). As the term of

the lease is lengthened, the lease rate factor declines,

reflecting the smaller periodic lease payments.

Lease applications and lease agreements will frequently bear the lease rate factor and corresponding

scheduled lease payment amounts. It is important

for the lessee to distinguish between the lease rate

factor and an annual percentage rate (which is often

quoted on a loan). Since lease rates reflect the use of

tax benefits by the lessor, and interest rates on loans

do not reflect tax benefits of ownership, these two

rates cannot be directly compared without significant computational adjustments.

In addition, special purpose clauses may appear on

the lease contract. A “tax indemnification clause”

makes provision for the loss of tax benefits by the

lessor if the lease “unwinds,” that is, does not pass

the tests for a true lease. In this case, the lessee

indemnifies (insures) the lessor for any loss of tax

benefits. Tax indemnification is a clause that the

lessor would want to insert into a tax-oriented lease

agreement in anticipation of any change in the tax

law that would apply retroactively. A “hell-or-highwater clause” reiterates a lessee’s unconditional legal

obligation to make lease payments for the entire term

of the lease, regardless of events that may affect the

leased equipment or structure and its use, or any

change in the lessee’s circumstances. This no-escape

clause provides the lessor with a high level of assurance that the lease payments will be made, barring

bankruptcy of the lessee’s business.

’ The “running rate” is occasionally quoted by lessors. It is the

discount rate that sets the present value of the lease payments

(excluding the residual asset value) equal to the initial fair market

value of the leased asset.

17
Table 4-Monthly lease payments and annual lease rate factors for a $100,000 investment at selected

buyout percentages and lease terms for two alternative lessor implicit yield levels.

Lessorlmplicit Term

Yield Level(%) (months) 18

Buyout(purchaseoption)percentage

20 22

10.5 60 $1,903' $1,878 $1,852

0.22842 0.2254 0.2220

10.5 72 $1,682 $1,662 $1,642

0.2018 0.1994 0.1970

10.5 84 $1,526 $1,510 $1,494

0.1831 0.1812 0.1793

11.5 60 $1,957 $1,932 $1,908

0.2347 0.2318 0.2290

11.5 72 $1,737 $1,718 $1,699

0.2084 0.2062 0.2039

11.5 84 $1,583 $1,567 $1,552

0.1899 0.1880 0.1862

1 The lease payment is expressed as a constant monthly amount.

* The lease rate factor is expressed as an annual rate in decimal form.This is done by dividing

the monthly lease payment by the initial investment ($100,000) and multiplying the result by 12.

Leasing contract terms involve tradeoffs that are

analogous to those in loan arrangements. Table 4

illustrates the relationships between three factors that

influence the lease rate: (1) the lessor’s implicit yield

(internal rate of return), (2) the term of the lease, and

(3) the buyout percentage.

Increases in the lease term (holding other factors

constant) significantly reduce the size of the monthly

lease payment and the corresponding annual lease

rate factor. For example, extension of the lease

contract from 60 to 84 months drops the monthly

lease payment from $1,878 to $1,510 (assuming a 20-

percent buyout and a 10.5-percent lessor yield). The

corresponding decrease in the annual lease rate is

from 0.2254 to 0.1812.

A l-percent increase in the lessor’s implicit yield

from 10.5 percent to 11.5 percent increases the

monthly lease payment from $1,878 to $1,932 (in the

20-percent buyout and 60-month lease situation).

The associated annual lease rate factor increases from

0.2254 to 0.2318 (or by 0.64 percent). One implication is that a cooperative seeking longer lease terms

may find that the lessor requires a higher pretax yield

(to compensate for the longer financing term) and the

lease payment may not be appreciably reduced.

A comparison of monthly payments and annual lease

rates in table 4 also shows that increases in the

buyout percentage are as influential as increases in

the length of lease term. When the lessor’s yield is

10.5 percent and the purchase option is 18 percent,

monthly lease payments fall from $1,903 to $1,526

when the lease term is increased form 60 to 84

months. This represents a 20-percent decrease in the

monthly payment when the lease term increases 40

percent. However, an increase of just 4 percent in the

purchase option (from 18 to 22 percent) decreases the

monthly payment by about 2.5 percent (from $1,903

to $1,852). Leasing cooperatives should evaluate all

aspects of leasing and, especially, consider the cash

flow impacts of changes in the lease term and the

buyout percentage. This is an important consideration when making lease comparisons to identify the

most favorable lease contract.

18
Agricultural Cooperative Tax

Management Alternatives

Cooperatives, like other corporations, pay Federal

income taxes. But because of unique cooperative

operating methods, special rules were established to

regulate cooperative and patron taxation. The basic

concept is a single tax on net margins at either the

cooperative or patron level. Subchapter T of the

Internal Revenue Code regulates cooperative taxation.8 It applies to any corporation, with a few exceptions, operating on a cooperative basis. This

section reviews some of the tax management alternatives available to farmer cooperatives. Special

attention is given to past provisions regarding the

use of the investment tax credit.

A cooperative’s tax management decisions depend

on many factors, and each cooperative may find

itself in a unique situation. According to Subchapter

T, cooperatives are able to manage taxation on net

margins from patronage business at the cooperative

level. To accomplish this, margins must be distributed on a patronage basis, and special rules must be

met. Cooperatives meeting the rules can deduct

certain allocations from gross taxable income.

Cooperatives and the Investment Tax Credit (ITC)

Repeal of the ITC allowance under the 1986 Tax

Reform Act (effective January 1, 1986) eliminated the

tax credit as a financing incentive.Q However, cooperative use of the ITC has been a problem area in the past

due partly to the unique position of cooperatives as

representatives for their member/patrons. Prior to

1978, a cooperative that met Subchapter T requirements was limited in the amount of qualified investment property that was eligible for the ITC. The available ITC was based on the amount of taxable income

retained by the cooperative. In most situations, a sizable amount of taxable income was distributed to

patrons, resulting in little or no ITC available to the

cooperative.

Provisions of the Revenue Act of 1978 altered the

methods of determining available ITC, making it

available to cooperatives in the same manner as other

corporations. It was required that any part of the

currently-generated ITC not usable at the cooperative

B Consisting of sections 1381, 1382, 1383, 1385, and 1388. 9 The effect of eliminating the ITC on the purchase versus lease

decision is analyzed in a later section of this report.

Table 54llustration of the computation and use of the investment tax credit (ITC) under pre-1986 tax rules.

Taxable net savings (annual total)

Income tax before ITC

Qualified investment

ITC (optional) rate

ITC earned

First $25,000 of tax liability

85% over $25,000 (0.85 times $1750)

ITC allowed in the current year

Income tax after ITC ($26,750 - $26,488)

ITC allocated to patrons ($50,000 - $26,488)

$100,000

$26,750

$500,000

X .I0

= $50,000

- $25,000

+ $ 1,488

= $26,488 $26,488

$ 262

$23,512

1 9
level was to be passed through to patrons. ITC recapture remained the responsibility of the cooperative.

Past use of the investment tax credit is illustrated in

table 5. Assume the cooperative made a qualified

investment of $500,000 with an 8-year useful life in

the 1985 tax year. The available ITC was $100,000 in

taxable net savings and a $26,750 tax liability. The

ITC could be used to offset the $25,000 in taxes plus

85 percent of the taxes over $25,000. A tax liability of

$262 remained and $23,512 of ITC was passed

through to the cooperative’s patrons. If the cooperative sustained a net operating loss, the

entire ITC was passed through to the cooperative’s patrons that year. The ITC could not be

carried back or forward at the cooperative

level, but patrons could carry unused credits back or

forward.

A potential tradeoff existed between the cooperative

and its member/patrons concerning how to maximize

the benefit of ITC use. If the cooperative projected

sufficiently high tax liability, patrons would benefit if

the cooperative fully utilized the credit. This would

raise after-tax net savings and either increase the

distribution of cooperative earnings to the patrons or

stimulate cooperative growth (if retained). Alternatively, if patrons were expected to face a higher tax

bracket than that of the cooperative, an allocation of

ITC to the patron level would be a more desirable

arrangement. A significant obstacle to implementing

this strategy was the lack of information about the tax

situation of patrons.

20
Summary of Lease-Related

Federal Tax Law

The Federal income tax law related to leasing has

been altered through a series of court cases, Internal

Revenue Service rulings and procedures, and

changes in the tax law itself. Most of these developments apply to lessees in general and are not specific

to agricultural cooperatives. Appendix C contains a

more detailed review of past tax legislation related to

leasing.

Two major investment incentives altered the leasing

strategies of many firms: accelerated depreciation

deductions (1954), and the investment tax credit

(1962). Tax guidelines were later liberalized with

passage of the Economic Recovery Tax Act (ERTA) of

1981. ERTA established “safe harbor” leases as an

investment incentive for firms unable to take advantage of the ITC and accelerated depreciation rules.

While safe harbor lease rules stimulated leasing

activity, the result was significant tax revenue losses

to the Federal Government. Provisions of the Tax

Equity and Fiscal Responsibility Act (TEFRA) of

1982 curbed the problem by gradually eliminating

the safe harbor lease guidelines. Beginning with

1984, TEFRA created “finance leases” to replace safe

harbor leases. The new finance lease provisions

served as transitional rules by placing limits on

leasing volume and reducing the tax benefits available to lessors. At the same time, liberalization of

the rules related to limited-use property and fixedprice purchase options served as incentives to

lessees.

The Tax Reform Act of 1984 instituted revised

finance lease guidelines and postponed, until 1988,

rules on finance leases for leases entered into after

March 6,1984. Most leases continue to fall under

the pre-safe harbor (pm-ERTA) lease guidelines. The

intent of the pre-ERTA guidelines was to ensure that

the lessor retained some of the benefits, costs, and

risks of ownership without providing the lessee an

equity (ownership) interest in the leased item.

At this time, cooperative leasing transactions are

covered under provisions of the Tax Reform Act of

1986 (TRA). The 1986 act generally repealed the

statutes that imposed finance lease rules (those used

to determine whether a transaction is a lease or a

purchase, that is, conditional sales contract, for tax

purposes) on contracts entered into after December

31,1986. Under the 1984 act, these rules had been

postponed until after 1987. Under the nonstatutory

lease rules (which applied beginning in 1987) the

courts and the IRS determine property ownership for

tax purposes based on the “economic substance” of

the transaction. Transitional rules enacted in 1984

continue to apply for selected contracts (Commerce

Clearing House 1986). A major change in the 1986

Tax Reform Act was the repeal of the investment tax

credit for property placed in service after December

31,1985.

Lease Versus Purchase Decision

A financing alternative should be shown to be economically profitable and financially feasible to be

clearly preferred. The profitability test suggests that

the preferred financing option would be that minimizing the present cost (discounted, after-tax cash

outflows) to the firm. Discounting the after-tax, net

cash outflows associated with the lease and purchase

alternatives using a common, after-tax discount rate

places the two financing options on the same basis

for direct comparison. It is argued here, and elsewhere (Van Horne 1983), that the appropriate

discount rate to use is the cooperative’s after-tax cost

of debt because the firm is analyzing a financing

alternative-whether to purchase or lease the asset.

The financial feasibility test involves the comparison

of the two undiscounted, after-tax net cash outflow

streams associated with the project financing alternatives be compared with the common cash inflow

(revenue) stream of the project. The objective is to

identify if and when cash flow deficits occur. In addition, the magnitude of the annual net cash flow

surplus (deficit) is estimated. With this information,

the investor may elect to accept or reject the project

under either/or both financing arrangements. Financial feasibility becomes an important consideration

whenever outside funds (debt or lease) are involved

in a project.

The analysis of the lease or loan/purchase decision

that follows concentrates on the profitability test

aspect. A computerized capital budgeting model

developed for this purpose is used to evaluate the

sensitivity of the lease or purchase decision to

changes in key financial variables. The model is

briefly described, along with an actual cooperative

leasing situation. Analysis of the case lease provides

insight into the importance of conditions and terms

that are favorable to leasing.

21
Capital Budgeting Model

Capital budgeting analysis involves a comparison of

the net present cost (discounted, after-tax net cash

expenses) of purchasing versus leasing. These

alternatives are compared over a common holding

period to incorporate all of the tax benefits generated

by each financing option.‘O

The net present cost (NPC) of the purchase alternative is most compactly expressed by the accounting

equation,

NPC (purchase) = D, +X

M Am+ fm C4

~~---------

m=l (l+r)m (l+r)q >

The accounting equation states that the net present

cost of purchasing is equal to the initial cash

downpayment (Do), plus the discounted sum of endof-period (principal and interest) payments (D,),

minus the tax savings associated with the discounted

sum of annual depreciation allowance (A,) and

interest expense (I,) in each period m, minus the

investment tax credit (C ) if any, which is taken in

period q (presumably p&fod zero). By discounting

each of these after-tax net cash flow items at the

after-tax interest rate (r) on debt, and summing, the

resulting NPC can be compared to other acquistion

alternatives expressed on an after-tax present value

basis with identical lengths of contract.

Similarly, the net present cost of the lease is

N ‘P” BN

NPC(lease) =x ---+----t

N LP” M A,

+I -

n=O (l+r)” (l+r)N n=O (l+r)’ m=N+l (l+r)” >

The net present cost of leasing is equal to the discounted sum of the periodic advance lease payments

(LP,), plus the cash purchase outlay at the end of the

lease term (B,), minus the tax savings associated

with deductibility of the periodic lease payments

(expressed as the tax rate times the sum of the discounted lease payments) and the sum of the discounted tax deductions associated with annual

depreciation allowance (A,) after purchasing the

asset at lease termination (in period N). Under the

lease alternative, the ITC (if available) is assumed to

be retained by the lessor. Downpayments, rebates,

and other cash expenses are not considered in the

lease cash flow estimates.

Results of the capital budgeting computations are

summarized in a set of estimates of the net advantage

to leasing (NAL). The NAL is computed as the

difference between the net present costs of the two

financing alternatives.

NAL = NPC (purchase) - NPC (lease)

When the NAL estimate is positive, the lease will

result in the lowest financing cost to the cooperative

over the life of the lease.” When the NAL is negative, the cooperative should purchase the asset,

based on comparison of costs. The NAL tells nothing about the size of the alternative net costs, only

the magnitude of the difference in those costs. As

the NAL approaches zero, the dollar consequence

(gain or loss) from choosing one financing alternative

over another becomes smaller, and other factors

become relatively more important considerations in

the decision.

An alternative way of expressing the net advantage

to leasing is by “annualizing” the NAL. This is done

by amortizing the net present cost of each financing

alternative and then subtracting the annualized net

present cost of the lease from the annualized net

present cost of the loan:

NPC (purchase) NPC (lease)

NALA =

PVIFA (r,m) PVIFA (r,n)

Where NALA is the annualized net advantage to

leasing, PVIFA is the present value interest factor for

a discount rate of r, associated with either an m-year

loan or an n-year lease. By annualizing the NPCs,

loans and leases with different contract lengths can

be directly compared.

The lease-versus-purchase model is used to generate

the discounted cash flow of these two financing

options under various terms to determine their

lo Under the assumption that the leased asset is purchased at the

end of the lease contract at a fair market price, there would be no

differential in the after-tax cash flows at the end of the common

holding period.

22

” It is important to remember that these NAL estimates pertain only

to the cooperative and do not reflect the net value of ITC passed

through to patrons.
separate present value costs. A 15-year plan is

allowed, which makes the model applicable for

machinery, equipment, and single-purpose structures (that is, 5-year property). Income tax liability

is determined, and taxes are assumed to be paid

quarterly. If leased, the capital item is assumed to be

purchased when the lease expires under either a

fixed-price purchase or a fair market value option

(provided by the model user). Sales tax is assumed

paid at the time of purchase, or in the case of a lease,

the tax is capitalized into the periodic lease payments. In addition to information on the terms of

the lease and loan, some financial information on the

cooperative is required.

Loan repayment options in the model allow for

various amortization schedules (fixed or declining

total payments) on annual, semiannual, quarterly, or

monthly terms. Interest rate charges may be computed on a fixed- or variable-rate basis. Purchased 3-

or 5year property is depreciated using either pre1987 ACRS classlife percentages or the optional

straight-line method. The election to expense in the

first year is also available with reduction of ITC

(when the ITC is assumed to exist). The choice of

constant or declining periodic lease payments is an

option within the model. Periodic lease payments

can be scheduled in advance or in arrears. Finally,

the model provides for sensitivity analysis on the

after-tax cost of capital and the marginal ordinary

income tax rate. Each cost of capital and tax rate

combination is assumed to be constant over time.

Description and Analysis of a Cooperative Lease

A grain-handling cooperative located in a prime

cash-grain-producing region of the Seventh Farm

Credit District was selected for illustration of the

lease versus purchase analysis. The cooperative

elevator handles spring and winter wheat, durum

wheat, flax, rye, barley, oats, corn, and sunflower

seed. In addition, it supplies feed, dry and liquid

fertilizers, seed, and other farm supplies. In 1984,80

percent of total sales were generated through commodity handling. Total grain volume in 1984 was

6.7 million bushels, which represented a 114-percent

net increase over 1980.

In 1985, the cooperative initiated a major expansion

of its facilities with the construction of a 52-car unit

train, grain storage and loading facility. The majority of the project was financed with debt in the form

of a term loan through the St. Paul BC. But a significant amount was financed with a direct lease, also

with the BC. The total cost of the unit train facility

was about $2.75 million, of which $780,679 was

leased. The equipment included in the lease contract is described in table 6. The lease was a 5-

year contract with monthly payments due in

advance. Monthly payments (including sales tax)

Table 6-Description of case lease expense items.

Item

Equipment Sales

Cost and Setup Tax

Total

cost

Truck scales

Legs, distributor, and spouts

Draw-off and loading systems

Manlift

Rail receiving conveyor and

grain sampler

Bulk weight system

Dust control system

$142,516 $3,465 $145,981

328,718 6,911 335,629

101,429 2,293 103,722

22,585 $594 23,179

28,195 804 28,999

62,962 1,792 64,754

77,029 1,386 78,415

Total $763,434 $17,245 $780,679

23
were $14,304. A fixed-price purchase option of 20

percent of the original cost was available at the end

of the 5 years.

The alternative to the lease was to purchase the

capital items with additional term debt. The loan

was scheduled for repayment using a constant

principal and declining interest scheme. A 20-

percent downpayment was required. The loan was

for 5 years (60 monthly payments) at an 11.75 annual

percentage rate of interest. If the cooperative were to

purchase the machinery and equipment, 100 percent

of the purchase price would serve as the tax basis

and a 10 percent ITC option would be elected.

Initially, the cooperative was assumed to be able to

use just 50 percent of the ITC generated. Accelerated

depreciation was assumed with no first-year expensing.

Strategy of Analysis

Sensitivity analysis is performed on (1) the cooperative’s marginal tax rate, (2) the annual loan interest

rate, (3) the cooperative’s use of ITC, and (4) the

annual lease rate. The analysis is performed for the

1985 situation (when the case lease was written) and

a representative 1987 situation for the case lease.

Results from these computations illustrate how the

effects of adjustments in the initial values for these

factors in a given situation (year) and the effects of

adjustments between situations (years) alter the annualized net advantage to leasing. Table 7 summarizes the parameter adjustments that were made.

The 1985 base situation parameters describe the

actual lease with two additional assumptions: a

marginal tax rate of 25 percent, and an ITC use of 50

percent (with the other 50 percent of ITC passed

through to member patrons). Alternatives were

sequentially analyzed for projected high-tax-rate and

low-tax-rate positions (alternatives 1 and 21, projected high-interest-rate and low-interest-rate conditions (alternatives 3 and 4) low and high lease rates

(alternatives 5 and 6), and zero versus total use of

available ITC (alternatives 7 and 8). In alternative 1,

the 50-percent marginal tax rate is set to illustrate

the top bracket and its effects on profitability. Prior

to the 1986 Tax Reform Act, the top marginal rate

was actually 46 percent plus a 5-percent surcharge

for incomes of $l,OOO,OOO to $1,405,000. The

annual lease rate was set at a level consistent with

the actual monthly lease payments and terms incurred by the cooperative under the case lease

contract.

The 2987 base situation was developed to be consistent with the 1985 lease contract. I2 However,

adjustments were made to reflect (1) the general

decline in the level of interest rates on loans between

1985 and 1987, (2) changes in tax rates, and (3) the

elimination of the ITC allowance. The base interest

rate of 10.25 percent reflects the level of rates at the

St. Paul Bank for Cooperatives in early 1987. The

annual lease rate of 23.4 percent makes the additionai assumption that the lessor derives an implicit

yield of about 10 percent. The increase in the

annual lease rate from 22 percent to 23.4 percent is

an estimate of the net increase in the lease rate that

would occur from elimination of the ITC tax benefit

to the lessor and slightly lower market interest rates

in 1987 (compared with 1985). Since the capital

budgeting results are sensitive to the yield level (and

the corresponding lease rate), sensitivity analysis is

performed at lease rates varying between 0.18 and

0.28.

I2 Revision of the accelerated depreciation percentages (to reflect

changes made in the 1986 tax law) was not done in the 1987

analysis. As a result, the net present cost of purchasing in 1987 is

slightly underestimated, but the difference is quite small.

2 4
Results of 1985 Analysis

Tax Rates (Alternatives 1 and 2). Capital budgeting

results for various marginal tax rate lcvcls projected

in 1985 are shown in figure 6. The base line results

indicate that the annualized net advantage to leasing

was slightly negative (-$1,100 to -$3,918 per year) for

all marginal tax rates analyzed. As the tax rate is

increased, the annualized net advantage of the lease

alternative becomes more negative, and leasing

becomes less attractive (holding all other factors

constant at 1985 baseline levels). This result reflects

the increasing opportunity cost of forgone tax

benefits of ownership, if the lease option is pursued.

A higher marginal tax rate also reduces the after-tax

discount rate in the analysis. A lower discount rate

increases the present value of distant future cash

outflows. This penalizes the lease due to the buyout

payment at the end of the lease term.

Adjustments to the interest rate (from 11.75 percent

to 8.75 and 13.75 percent) shift the baseline. A

lower interest rate on the loan (holding the lease rate

fixed) shifts the baseline down and favors the loan.

As a result, the annualized net advantage to leasing

becomes more negative at all tax rate levels. A rise

in the loan interest rate, conversely, favors the fixcdrate lease and the base line shifts up. Interestingly,

Table 7-Situations and ranges of factors for sensitivity analysis.

Year and

situation

Annual Cooperative Annual

lease marginal interest

rate l tax rate rate

ITC

use1

1985

Base situation 0.22 0.25 0.1175 50

Alternative situation:

0.22 0.50 0.1175 50

0.22 0.15 0.1175 50

0.22 0.25 0.1575 50

0.22 0.25 0.0875 50

0.18 0.25 0.1175 50

0.28 0.25 0.1175 50

0.22 0.25 0.1175 0

0.22 0.25 0.1175 100

1987

Base situation 0.234 0.25 0.1025 0

Alternativesituation:

1 0.234 0.34 0.1025 0

2 0.234 0.15 0.1025 0

3 0.234 0.25 0.1375 0

4 0.234 0.25 0.0875 0

1 In each instance, the fixed residual (buyout) price is $156,000 (or 20 percent of the purchase price).

2 ITC use is expressed as a percentage of available ITC. In 1985 the 1 O-percent ITC option was used

in each case to estimate the amount of ITC available. In 1987 the ITC was not available.

25
Figure 6 Annualized Net Present Values of the Advantage to Leasing at Alternative

Levels of Marginal Tax Rates, 1985 Model.

---_

-...

---

-.._ ------

-.._

---_

.N._ ---_

*.._ -w

*-._

*1._

a-._

--._

--..._

--._

__--

__-*

--*-* . . . . . . . . . . . . . ..__ _

---*- -......__ __--

__--

_______--------

_ ,“u-~...........................__........

20 30 40

Marginal Tax Rate (%)

50 60

- Base

-.-*-*’ IFi = 13.75%

----- IR = 8.75%

--- u ITC = 0%

. . . . . . . . . . . . . ,TC = 100%

Figure 7 Annualized Net Present Values of the Advantage to Leasing at Alternative

Levels of Iinterest Rates, 1985 Model.

- Base

__._m_. MTR = 0.50

----- MTR = 0.15

__-. ITC = 0%

. . . . . . . . . . . . . ITC = 100%

12

Interest Rate (%)

14 16

26
the low- and high-interest rate lines move toward the

base line as the projected marginal tax rate is raised.

This is a reflection of the effects of raising tax rates,

thereby decreasing the after-tax discount rate, and

the role of discounting in computing relative profitability.

Changes in the percentage of ITC also shift the

baseline. As ITC use increases from zero to 100

percent, the loan is favored and the net advantage to

leasing becomes negative. For example, when the

tax rate is 15 percent and ITC use is zero percent, the

annualized net advantage to leasing is positive

(between $5,000 and $10,000) and favors the lease

option. An increase to lOO-percent ITC shifts the

line down between -$lO,OOO and -$15,000, and the

loan is the more profitable choice. Intermediate

levels of ITC use (between zero and 100 percent) at

higher marginal tax rates have similar effects on the

financing choice. Low levels of ITC tend to favor the

lease financing alternative. The result is apparently

quite sensitive to the ITC use assumption and could

be considered a major factor in the purchase/lease

decision of the cooperative in the 1985 model.

Given the combination of factors that prevailed in

1985, the cooperative’s decision to lease the facilities

appears to be supportable. The cooperative was, and

continues to be, in a low tax bracket. A combination

of low ITC use and relatively high projected interest

rates, with the tax position that existed in 1985

yields a result that would appear to be close to (or

above) the zero (horizontal) line.

Interest Rates (Alternatives 3 and 4). A similar

sensitivity analysis of the interest rate variable is

illustrated in figure 7. Generally, as the interest rate

is increased, the leasing option is favored as the

upward sloping lines indicate. The baseline situation crosses the interest rate axis between 11.75 and

12.75 percent. This indicates that when all other

factors are projected at their 1985 base levels, the

lease option will yield a lower cost financing result

when the interest rate on debt is projected at levels

exceeding 12 percent. When the ITC use level is

increased to 100 percent, the interest rate at which

the lease contract becomes competitive shifts up to

about 15 percent (assuming a tax rate of 25 percent).

This higher interest rate level is comparable to other

published results, where the standard assumption

has been loo-percent, immediate ITC use by the

decisionmaker. I3

Adjustments in the tax rate (in combination with

interest rate level changes) result in modest shifts in

the baseline. A higher tax rate (50 percent) rotates

the line downward at high interest rates (those above

10 percent), and upward at low interest rates to the

point where it crosses the horizontal (zero) line

between 12.75 and 13.75 percent. The reduction of

slope indicates that the tax deductibility of interest

at high interest rates is an advantage to the purchase

option and, therefore, the annualized net advantage

to leasing is reduced. The small reduction in tax rate

to 15 percent is not a significant adjustment to the

base situation. Changes in the level of ITC use lead

to roughly parallel shifts in the base line similar to

those illustrated in figure 6.

I3 See, for example LaDue (1977, 1979) and Wickham and Boehtje

(1986).

27
Figure 8 Annualized Net Present Values of the Advantage to Leasing at Alternative Levels of

Annual Lease Rate Factors, 1985 Model.

40

-60

0.16 0.18 0.20 0.22 0.24 0.26 0.28 0.30

Annual Lease Rate Factor

Lease Rates (Alternatives 5 and 6). Annual lease

rates were adjusted from 18 to 28 percent, as

illustrated in figure 8. As the lease rate is increased,

the net advantage to leasing decreases. The baseline

crosses over the horizontal (zero) line slightly under

the 22-percent annual lease rate level. At lease rates

below that level the lease generates an advantage to

the cooperative.

Tax rate adjustments shift the baseline in a nonparallel fashion in figure 8. A higher tax rate rotates the

baseline to a flatter position, and a lower tax rate

rotates it to a slightly steeper position. The higher

tax rate (at lease rates under 22 percent) reduces the

net advantage to leasing for two reasons. The tax

benefits of ownership take on additional value to the

cooperative when it is in a high tax bracket. The

second factor operating here is the reduction in the

after-tax discount rate. A reduction in the discount

rate increases the present value of the cash outflow

at the end of the lease (the buyout) and makes the

- Base

------. MTRz0.50

-----1 MTR= 0.15

-.-*-.- IR= 13.75%

-____. IR = 8.75%

---. ITC= 0%

. . . . . . . . . . . . . ,TC = 100%

lease more expensive. When the lease rate is increased (in combination with the high tax rate), the

advantage to leasing remains negative, but less

negative than in the base situation. At high lease

rates, the cooperative is able to claim a larger lease

payment tax expense, so the cost of the lease is

reduced slightly. Analogous explanations can be

made for the observed shift to a flatter line when the

tax rate is reduced to 15 percent.

Interest rate increases (decreases) result in upward

(downward) shifts in the baseline in figure 8.

Clearly, the higher the interest rate paid on a loan

(while holding the lease rate constant), the greater is

the present value advantage of the lease. To say it

another way, as interest rates rise, lease rates can

also be raised without affecting competitiveness.

This is illustrated in figure 8 by the adjustment in

the lease rates at which the low- and high-interestrate lines cross over the horizontal (zero) line relative to the baseline.

28
Figure 9 Annualized Net Present Values of the Advantage to Leasing at Alternative Levels of

Tax Investment, 1985 Model

- Base

------- MTR = 0.50

------ MTR=0.15

---*-*- IR =13.75%

------ IR=8.75%

40 60 80 100 120

ITC Utilization (%)

Parallel shifts of the baseline occur when the ITC pcrcentage is adjusted. The important point to note is

that when the ITC is reduced from 50 percent to zero,

the “crossover lease rate” shifts from just under 22

percent to about 23 pcrccnt. Similarly, a shift to lOOpercent ITC results in a 2Wpercent lease rate at the

point where the NAL is zero. This suggests that

inability to use any of the ITC gcneratcd by a purchase

would have an effect which is equivalent to a lease

rate increase of about 3 percent (under the conditions

assumed in this analysis).

investment Tax Credit (Alternatives 7 and 8). Figure

9 reflects the impact of changes in the level of ITC

UC in combination with tax rates and interest rites.

The baseline situation indicates that leasing retained

an advantage up to the level of 4C percent ITC use

(ignoring benefits passed through to members). I4

Above that lcvcl of use, the cooperative would have

found purchasing to bc the lower cost alternative.

Increases in the tax rate will shift the baseline downward, making the lease less attractive and more costly

at ITC use rates above 30 percent. A reduction in the

tax rate has just the opposite effect.

I4 The passthrough of tax benefits to patron members would tend to

improve the overall profitability of the purchase option due to

greater after-tax earnings when the cooperative and members are

jointly considered. This issue is explored in greater detail in the

whole-firm simulation in the next section of this report.

IJnlike tax rate effects, interest rate increases (decreases) shift the baseline up (down) in a parallel

fashion. As the projected interest rate is raised, the

use of debt to finance the acquisition becomes

relatively more expensive due to higher debt service.

The interest rate increase illustrated in figure 9 shifts

the crossover ITC level to nearly 80 percent when

other factors are held constant.

Results of 1987 Analysis

Analysis of the 1987 purchase versus lease decision

is reported here for comparison with the 1985

results. Sensitivity analysis is performed on the

interest rate and lease rate variables in combination

with 1986 changes in the tax law.

Interest Rates. The baseline interest rate

assumption for 1987 is 10.25 percent. Results for the

baseline and two alternative marginal tax rates (0.15

and 0.34) in combination with interest rates from

8.75 percent to 15.75 percent are illustrated in figure

10. This sensitivity analysis assumes that factors

other than the interest rate on debt and the marginal

tax rate are known at the time the lease-financing

decision is made.

29
The 1987 baseline has about the same positive slope

but is shifted upward slightly when compared to the

1985 baseline (shown in fig. 7). Two underlying

factors cause the baseline to shift in favor of the lease

alternative. First, elimination of the ITC allowance

in the 1987 analysis increases the after-tax present

cost of the purchase option, making the leasefinancing option relatively less costly. Second, the

annual lease rate factor is increased from 22 to 23.4

percent to reflect the loss of ITC benefits to the lessor

and a lower lessor yield.

The lease rate factor is adjusted upward by an

amount that is smaller than the change in the lessor’s

yield due to the loss of ITC alone. Loss of ITC (by

itself) implies a 5-6-percent reduction in the lessor’s

yield. The small lease rate factor increase reflects an

assumption that the lessor was willing to accept a

slightly lower yield of 11.5 percent in 1987 (since all

market rates had fallen). I5 The 1987 baseline crosses

the horizontal (zero) line at about 12 percent, where

the 1985 baseline crossed at a slightly higher rate.

Expected interest rates below 12 percent in the

baseline situation make debt financing the preferred

financing option.

The 1986 tax law collapsed the marginal tax rate

schedule from 0.15-0.46 to 0.15-0.34. As a result, the

case lease becomes competitive in the 12-12.25-

percent interest rate range in 1987 (fig. 10) compared

I5 In the 1985 analysis the lessor was assumed to generate a 12.5

percent yield based on advance monthly lease payments and full

use of the ITC allowance.

Figure 10 Annualized Net Present Values of the Advantage to Leasing at Alternative

Interest rates, 1987 Model.

20

10

0

-10

- Base

---- MTR=0.34

-*-.-.- MTR = 0.15

8 10 12

Interest Rate (%)

14 16

30
to the 12-13.5-percent range in 1985 (fig. 7). The

general result of comparing 1985 and 1987 sensitivity with interest rate changes is that the financial

lease option is still relatively more expensive than

debt financing at typical borrowing rates faced by

financially stronger cooperatives,

Lease Rates. Sensitivity of the purchase/lease

decision to changes in the annual lease rate (in

combination with different tax rates and interest

rates) is illustrated in figure 11. A comparison of the

1987 baseline with the 1985 baseline (fig. 8) indicates that an upward shift occurs due to reductions

in the underlying tax benefits of ownership and the

intcrcst rate on debt. The baseline lease rate at

which the lease and purchase options yield equivalent levels of profitability shifts from under 0.22 in

the 1985 model (fig. 8) to just over 0.22 in the 1987

model (fig. 11).

Sensitivity to interest rate changes indicates that

interest rates of 13.75 percent are competitive with

annual lease rates over 24 percent in 1987. Lease

rates below that range favor the lease option when

interest rates are held high. The corresponding lease

rate is about 23 percent in 1985 (fig. 8). At the low

end of the interest rate spectrum, an interest rate of

8.75 percent is competitive with a lease rate of about

21 percent in the 1987 analysis. The corresponding

lease rate in the 1985 analysis is 20 percent.

Figure 11 Annualized Net Present Values of the Advantage to Leasing at Alternative

Levels of Annual Lease Factors, 1987 Model.

60

40

r 20

m=

00

‘i5

%

0

:

5

F -20

-40

.

\

.

-..

Base

----- MTR =34%

-.-*-*-.- MTR = 15%

---------’ IR = 13,75y0

. . . . . . . . . . . . . . . . . . . ,R = 8.75%

0.18 0.20 0.22 0.24 0.26

Annual Lease Rate Factor

0.28 0.30

31
Whole-Firm Lease Simulation Analysis

The preceding capital budgeting analysis is adequate

as the basis for making a financing decision if the

investing firm is the only entity involved. In a

cooperative setting, there are multiple taxable

entities-the cooperative and the patrons of the

cooperative. In this situation, capital budgeting

needs to be supplemented by additional analysis

that considers the broader tax situation of the patrons. Secondly, capital budgeting is “project

specific,” since it considers the cash flows and

profitability of the individual project in isolation.

Comparison of the financing impacts of purchasing

versus leasing on the cooperative can be supplemcnted through a whole-firm analysis that considers

the alteration of cash and capital flows over time for

the cooperative and its patrons.

This section employs a computer-simulation model

of a cooperative firm (Beierlein and Schrader, 1978)

to analyze the impact of lease financing. Simulation

models are typically “learning” models in the sense

that they rcquirc (1) a number of assumptions, and

(2) an interpretation of the sensitivity of results to

changes in those assumptions. The model used here

is briefly described and then applied to the leasing

situation. The simulation exercise looks at changes

in the financial structure of the cooperative, interest

rates, lease rates, tax rates, and selected aspects of

cooperative financial management,

Description of the Simulation Model

The simulation model is illustrated in figure 12.

The model is designed to compute cooperative cash

flows and the after-tax present value of patron

benefits associated with the use of alternative

financing strategies. The cooperative and patron

groups (members and nonmembers in various tax

brackets) interact over a preset planning horizon.16

The financing strategy is input to the simulator in

terms of the initial mix of equity capital, term debt,

and financial leasing.

The model initially computes the annual amount of

replacement capital required to retire capital (stock

and revolving-fund equities), member-held debt, and

nonmember-held debt. The model also computes

new investment required due to growth in patron

business. Total capital requirements are met according to the financing strategy through external financing (debt or lease) and internal financing (generated

earnings). A comparison of patron funds available

for investment with the required level of internal

investment is used to determine if the plan is financially feasible. Here, patron funds available for

investment is equal to the amount of patron funds

after payment of taxes and interest, required cash

payments, and allowances for dividends, retained

savings, and nonqualified patronage refunds.17

Assuming that the plan is feasible, the after-tax

present value of patron cash refunds and patron

investment in the cooperative are computed. The

values of the cooperative’s cash and capital accounts

and the present value of patron benefits serve as the

measures by which alternative fin.ancing strategies

are compared.

Two versions of the simulator are used. One version

corresponds to the 1985 tax environment (1985

model). The second version incorporates changes in

the tax law made during 1986 (1987 model).

I6 Patrons are separated into two groups. The two patron groups

differ according to growth of cooperative patronage, after-tax

opportunity cost of capital, and marginal personal income tax rates.

I7 An investment plan is defined as financially infeasible if earnings

(after payments of interest and taxes) net of the required cash refund

to patrons is not sufficient to meet the internal financing requirements.

32
Figure 12 Schematic Representation of the Cooperative Financial Simulator

(adapted from Beierlein and Schrader).

Eegin 0

Read in Variables

and Parameters

Adjust Capital

Accounts

Set

Financing

Strategy

Set Group Capital

Investment and

Patron Group

Compute after Tax

Present Value of

Patron Cash Refund

Determine Replacement .

Capital Requirement

No Investment

Determine Required

Investment b Type

and Patron 6roup

External and Internal

Financing

Requirements

Comparison of Patron Funds

Available for Investment with

Needed Internal Investment

Patron Sales, Payment Required

Payment of Taxes as Cash Refund

on Non-Qualified -r

Retains and

Dividends

Net Savings Available for

- Distribution (from patron

and non-patron sales)

Nonpatron Sales,

- Payment of Taxes -1

33
Simulation Strategy

The case lease (examined earlier using capital

budgeting) is initially simulated in a baseline

situation that incorporates several assumptions

about the cooperative and its patrons. Table 8

contains assumptions of the 1985 model for the

baseline situation with the lease and without the

lease. The baseline model without the lease assumes that the asset is acquired with commercial

debt financing. The buyout under the lease agreement is member-debt financed at the end of the fifth

year.

Variables that are sequentially changed from their

baseline model values are identified in table 9 for the

1985 and 1987 models. Those variables include the

interest rate on member debt, marginal tax rates for

patron groups, the lease rate percentage, the rate of

Table 8-l 985 baseline model assumptions.

Varlable

Base model Base model

with lease without lease

Number of patron groups

Planning horizon

Total invested capital

Rate of return on total invested capital

Sales from: Patron sources

Nonpatron sources

Interest rate on member debt 1

Length of: Debt instrument

Revolving fund

Nonqualified refund

Dividend

New investment:

Stock

Revolving fund

Nonqualified revolving fund

Unqualified retained savings

Member debt

Nonmember debt

Lease: Amount

Rate (annual)

Buyout

Patron group 1:

Annual growth in sales

Proportion of total patronage

Marginal tax rate

Patron group 2:

Annual growth in sales

Proportion of total patronage

Marginal tax rate

2 2

8 yr 8 yr

$7,800,000 $7,800,000

11% 1 1%

80% 80%

20% 20%

1 1% 11%

5 yr 5 yr

10 yr 10yr

IOyr 10yr

0.5% 0.5%

0 %

40%

0%

5%

10%

35%

$780,000

22%

20%

1%

50%

0.15

1%

50%

0.15

0 %

40%

0%

5%

10%

45%

$ 0

0%

0%

1%

50%

0.15

1%

50%

0.15

’ The average interest rate on member debt serves as the before-tax discount rate for computing the present value of patron benefits. The

before-tax cost of member debt is adjusted downward by the simulation model according to each patron group’s assumed marginal tax rate to

arrive at the appropriate after-tax discount rate for use in computing the present value of patron benefits.

34
return on assets, and the rate of growth in sales.

Both the 1985 baseline model and all variations

assume full use of the IO-percent investment tax

credit.

The case lease is also simulated under 1987 conditions. Several variables carry the same values

assumed in the 1985 baseline model. However,

interest rates, lease rates, and the range of tax rates

are systematically lower in the 1987 model. The

1987 baseline model and all variations assume the

repeal of the investment tax credit.

Simulations are performed along two lines

Sensitivitv analysis involves systematic

adjustment of a single variable. Comparisons are

made of the model results with those derived in the

baseline situation and with results from previous

simulations assuming other values of that single

variable. Scenario analysis allows for a single

variable, or sets of variables, to be sequentially

adjusted over the 6 years of simulated time to reflect

alternative patterns of change. Scenario analysis is

in recognition that change variables under analysis

tend to be interrelated and should be analyzed

jointly. Results from scenario simulations are also

compared with baseline model results and with

other simulated scenarios.

Table g--Change variables for the 1985 and 1987 simulation models.

Change Variable

1985 model 1987 model

Baseline Range Baseline Range

Percent

Interest Rate on Member Debt 11 9-14 9 8-13

Patron Marginal Tax Rate 15 15-50 15 15-34

Annual Lease Rate Factor I 20 18-22 22 21-24

Rate of Return on Assets 11 8.5-l 1 9 6.5-9

Growth in Business Volume 1 -1-I 1 -1-I

1 Baseline lease rate factors were computed based on annual lease payments made in advance and were set at levels about equivalent (on a

pretax yield basis) to baseline interest rates on member debt. Due to annual payments in the simulation model (as opposed to monthly payments in the earlier capital budgeting analysis) the annual lease rate is 22 percent in the 1987 base simulation model (compared to the 23.4

percent rate in the 1987 base capital budgeting model).

35
1985 Model

Baseline simulation results reported in table 10

indicate that, generally, the cooperative’s plan is

financially feasible and profitable over the 6-year

horizon either with the lease (Panel A) or without

the lease (Panel B). A comparison of the two base

models indicates that total patron benefits are greater

without the lease ($1,382,500) than with the lease

($1,195,3OO). One difference between the two

financing choices is that more member debt

(S120,400) is retired and greater revolving fund

disbursements ($160,800) are made under the lease

situation.

The most significant difference is that more cash

($1,168,700) is paid out and $51,200 in ITC is passed

through to patrons when the cooperative does not

finance with the lease. Although the lease and debt

alternatives both represent 5-year financing (this was

done to eliminate maturity effects), cash refunds to

patrons are quite evenly distributed during all 6

years when only debt financing is used. When

leasing is employed, a sharp increase in both the

total cash available for patron refunds and the

distribution of cash occurs in the sixth year (the year

after the asset is purchased from the lessor). Therefore, later timing of cash flows to patrons explains a

major part of the lower present value of cash benefits

in the lease financing situation.

A review of the base model undiscounted annual

cash available amounts under the two financing

options indicates that both alternatives result in cash

flows sufficient to consider the additional investment financially feasible (that is, cooperative net

cash flows are sufficient to meet the annual debt

payments or lease payments). Although not reported

in table 10, the lease option generates slightly higher

cash available in the first three years. Conversely,

the debt-financing option tends to generate somewhat higher levels of cash available in the fourth and

fifth years.

Cooperative performance at the end of the fifth year

(EOY5) reveals that greater cash is available without

the lease ($426,100) than with the lease ($419,600)

and net savings are higher by $13,800 ($384,000

versus $370,200). The higher fixed-expense coverI8 The fixed-coverage ratio equals the gross margin on sales before

taxes, interest, lease payments, and dividends by the value of fixed

obligations (interests, dividends, and lease payments).

3 6

age ratio without the lease (1.91) is consistent with

the higher available cash position at EOY5. I8 Cash

available with the lease at EOY6 (not reported in

table 11) rises sharply to $578,500 (versus $434,000

without the lease) and the fixed-coverage ratio at

BOY6 rises to 2.43 (versus 1.93 without the lease).

The cooperative’s leverage position (debt/equity

ratio) adjusts from 1.13 (at EOYl) to 0.86 (at EOY6)

with the lease. The debt/equity ratio falls from 1.22

(EOYl) to 1.08 (EOY6) without the lease. Even

though the lease obligation is included as a “debt”

item in the leverage ratio, the cooperative makes al

lease payments in advance. Therefore, the end-ofyear leverage position is stronger with the lease.

1

Sensitivity Results. A reduction of the interest rat.e

from 11 percent to 9 percent on member and nonmember debt improves financial performance

measures for both the lease and debt alternatives (see

Model A in table 10). In present value terms, dollar

increases in member debt and revolving fund patron

benefits are greater in the leasing situation. Increases in cash refunds are greater in the all-debt

situation. As expected, the largest present value of

total benefits accrues to patrons under the all-debt

financing strategy. The percentage increases in

present values are equivalent across financing

choices.

Significant increases in available cash and net

savings at EOY5 occurred under both financing

situations. The largest dollar increases in these

items occurred without the lease. The larger increase in the fixed expense coverage ratio without

the lease is consistent with the observed larger

earnings in the fifth year.

An increase in the interest rate on debt from 11 to 13

percent reduces financial performance (see Model B

in table 10). The all-debt financing situation was

more severely affected, as reflected by the $355,600

($1,382,500 - $1,026,900) decrease in patron benefits

from the baseline simulation result. The leasing

situation generated a $309,000 ($1,195,300 -

$886,300) decrease in total patron benefits when

compared with the baseline simulation. Similarly,

cooperative liquidity and profitability were reduced

by larger dollar amounts under the all-debt situation,

as evidenced by the cash available and net savings at

EOY5. This is an initial demonstration that the

impact of an interest rate increase (holding the lease
Table lo-1985 model simulation results.

Model ’

Item Units Base A B C D E F

Patron beneflts:

Member debt $000

Revolving fund $000

Cash refunds $000

Total $000

Cooperative performance: *

Cash avail. @ EOY5 $000 419.6 489.5 349.4 419.6 437.1 365.6 180.5

Net savings @ EOY5 $000 370.2 434.5 312.7 370.2 387.2 328.8 163.6

Fixed coverage @ EOY5 ratio 1.76 2.01 1.56 1.76 1.82 1.60 1.31

Debt/equity @ EOY6 ratio 0.86 0.86 0.86 0.86 0.86 0.86 0.86

Patron benefits

Member debt $000 66.8 68.6

Revolving fund $000 95.8 125.4

Cash refunds $000 1 ,I 68.7 1,543.7

ITC $000 51.2 44.3

Total $000 1,382.5 1,782.O

Cooperative performance: 2

Cash avail. @ EOY5 $000 426.1 510.9 341.2 426.1 426.1 341.2 172.1

Net savings @ EOY5 $000 384.0 455.9 312.7 384.0 384.0 312.7 162.4

Fixed coverage @ EOY5 ratio 1.91 2.34 1.62 1.91 1.91 1.62 1.33

Debt/equity @ EOY6 ratio 1.08 1.08 1.08 1.08 1.08 1.08 1.08

120.4 123.9 116.9 75.6

160.8 210.4 120.7 56.9

914.1 1,219.3 648.7 595.2

1,195.3 1,553.6 886.3 727.7

Panel B (without lease):

65.0 41.9

72.0 34.0

889.9 750.3

63.0 51.2

1.026.9 877.4

114.4

153.4

993.5

1,261.3

Panel A (with lease):

66.7 64.3 42.0

95.8 89.4 49.6

1,168.8 1,134.5 963.3

51.2 44.3 43.0

1,382.5 1,332.5 1,097.g

110.5 87.8

143.1 103.6

959.8 762.3

1,213.4 953.7

’ A: lower interest rate

B: higher interest rate

C: higher patron tax rate

D: lower lease rate

E: rising interest rate combined with a lower lease rate

F: rising interest rate and falling returns combined with a lower lease rate and no growth.

* Cash available, net savings, and fixed expense coverage measures are all at the end of the fifth year (EOY5). The debt/equity ratio is at end of

the sixth year (EOY6).

37
Table 1 l-1987 Model Simulation results.

Model I

Item Units Base A B C D E F G

Patron benefits:

Member debt $000

Revolving fund $000

Cash refunds $000

Total $000

Cooperative performance:3

130.2 132.2 12 104.1 127.1 I4

220.1 250.7 I 153.3 215.3 I

486.6 639.4 I 398.9 529.8 I

836.9 1,022.3 I 656.3 872.22 I

Cash avail. @ EOY5 $000 295.4 330.8

Net savings @ EOY5 $000 263.9 297.4

Fixed coverage @ EOY5 ratio 1.59 1.71

Debt/equity @ EOY6 ratio .86 .86

Patron benefits:

Member debt $000

Revolving fund $000

Cash refunds $000

Total $000

Cooperative performance: 3

68.6 69.6 12 54.8 68.6 65.2

125.4 142.7 I 87.4 125.4 102.6

927.2 1 ,I 03.3 I 750.0 927.2 695.1

1,121.2 1,315.6 I 892.2 1,121.2 862.9 I 1,051.2

Cash avail. @ EOY5 $000 348.6 391.0

Net savings @ EOY5 $000 323.2 356.4

Fixed coverage @ EOY5 ratio 1.91 2.15

Debt/equity @ EOY6 ratio 1.08 1.08

Panel A (with lease)

12 295.4 304.1 14

I 263.9 272.6 I

I 1.59 1.62 I

I .86 .86 I

Panel B (without lease)

2 348.6 348.6 221.3

323.2 323.2 206.6

I 1.91 1 .Ql 1.44

I 1.08 1.08 1.08

14

I

I

I

I4

I

I

I

I4

I

I

I4

I

I

I

75.5

87.6

649.8

812.9

178.1

165.3

1.31

.86

20.8

15.8

1,014.6

204.6

199.1

1.44

1.08

’ A: lower interest rate

B: higher interest rate

C: higher patron tax rate

0: lower lease rate

E: rising interest rate combined with a lower lease rate

F: rising interest rate and falling returns combined with a lower lease rate and no growth

in business volume

G: rising interest rate and constant returns combined with a lower lease rate and declining business volume.

2 Infeasible in period 1 (needed internal investment funds exceed patron funds available for investment).

3 Cash available, net savings, and fixed expense coverage measures are all at the end of the fifth year (EOY5). The debt/equity ratio is at end of

the sixth year (EOY6).

4 Infeasible in period 5 (needed internal investment funds exceed patron funds available for investment).

38
rate fixed) results in benefits to the cooperative and

its patrons when leasing is selected. I9

The fixed expense coverage ratio decreases for both

situations when the interest rate is increased, due to

the higher annual interest expense. The decrease in

the fixed coverage ratio is greater in the all-debt

situation because of the higher level of debt involved.

An increase in patron marginal tax rates from 15 to

50 percent sharply reduces the present value of total

patron benefits under both financing alternatives

(see Model C in table 10). Tax rate increases produce two opposing effects-the higher tax rate results

in a lower discount rate (and higher present values)

and lower after-tax cash flows (and lower present

values). Total patron benefits declined by $467,600

(39.1 percent) ($1,195,300 - $7~7,700) under the

leasing option. Comparable total benefits decline by

$505,100 ($1,382,500 - $877,400) (36.5 percent) in

the all-debt situation. Cash refunds is the largest

single patron benefit item to decline. The reduction

in cash accounts for 82 percent of the decrease in

total benefits in the all-debt situation and 68 percent

in the lease situation. Cooperative financial performance measures are not directly affected by the

increase in patron marginal tax rates.

An alternative specification of Model C was done to

analyze the impact of placing patron group 1 in the

15-percent marginal tax bracket and patron group 2

in the 34-percent marginal tax bracket. The financial

impacts (not reported in table 10) are that present

values of total patron benefits are decreased from

$1,195,300 (baseline simulation) to SI,O~I,OOO with

the lcasc, and from $1,382,500 (baseline) to

$1,249,100 with the all-debt strategy. This result

suggests that differential (as opposed to uniform) tax

rates can be analyzed in a similar fashion. A dooperativc could identify the “losers” and the “gainers”

from selection of a leasing or debt-financing strategy.

The lease-financing option becomes more competitive with the debt-financing option when the annual

I9 The present value of patron benefits is influenced by an interest

rate change in two ways-the effect on interest payments on debt

and the effect of a higher discount rate. Both effects tend to reduce

the present values of benefits, but the all-debt situation is influenced

to a greater extent because of the larger debt on which interest must

be paid.

lease rate is reduced from the initial 22 percent to 18

percent (see Model D in table 10). The present value

of total patron benefits with the lease increases by

nearly 12 percent (over the baseline result) to

$1,261,300. Patron benefits in the all-debt situation

are unchanged. The increase in benefits with the

lease are attributable to an increase in cash refunds

(from $834,300 in the base model to $993,500),

which more than offsets the decrease in member debt

and revolving fund benefits. Total patron benefits

with the lease remain $121,200 less than total

benefits without the lease when the lease rate is

reduced. Cooperative performance (cash available

and net savings) with the lease exceeds that without

the lease when the lease rate is reduced. This simulation demonstrates that a competitive lease rate is a

major factor in the determination of patron and cooperative financial incentives to lease.

Scenario Results. The first of two scenarios illustrates the impact of a rising interest rate (from 9 to 14

percent) and a constant annual lease rate of 18

percent. Results in Model E (table 10) indicate that

the total patron benefits increased by about 8 percent

(to $1,213,400) with the lease, and decreased by

about 4 percent (to $1,332,500) without the lease.

Member debt and revolving fund benefits fell

slightly, and cash refunds increased significantly in

the leasing situation when compared to the past

simulation. All three categories of patron benefits

declined when all debt was used. Results are qualitatively similar to those derived from the previous

sensitivity analysis (Model B). However, with the

leasing strategy, the combination of a rising interest

rate and a constant lease rate improves total patron

benefits and reduces the negative impacts of a rising

interest rate on cooperative financial performance

(cash available and net savings). Financial results

for both the patrons and the cooperative deteriorate

to a greater extent in the all-debt situation in this

scenario.

The second scenario reflects a financially stressing

combination of rising interest rates (from 9 to 14

percent) and a gradually declining rate of return on

assets (from 11 percent in the first year to 8.5 percent

in the sixth year). When combined with an 18-

percent annual lease rate, this situation is expected

to be favorable to the leasing option. Results rcported in table 10 (Model F) confirm that the all-debt

financing option deteriorated to a greater extent.

39
LVhcn compared with the base simulation, total

patron benefits with the lease fell by about 15 percent

(a decrease of $174,900 in present value) versus a 21-

percent decline in total patron benefits (a $284,600

decrease) in the all-debt situation. Cash refunds,

member debt, and revolving fund distribution to

members all declined by larger dollar and percentage

amounts when all-debt is used to finance the cooperative.

Cooperative financial performance is also more stable

with the lease, as reflected by a comparison of cash

available and net savings generated in the fifth year

with those items in the baseline simulation. Cash

available, net savings, and the fixed-expense coverage

ratio at EOY5 are all nearly equal in the debt and lease

situations. These results tend to slightly favor the

leasing option.

Table 12-Simulation of financial effects due to 1986 changes in the tax law.

item Units

Patron tax rate = 0.15

1985 1987

Patron tax rate = 0.34

1985 1987

Panel A (with lease)

Patron benefits:

Member debt $000 120.3 126.3

Revolving fund $000 160.8 168.1

Cash refunds $000 914.2 828.8

Total $000

Cooperative performance:

Cash avail. @ EOY5 $000 420.6 402.1 I’ 402.1

Net savings @ EOY5 $000 370.2 358.0 I 358.0

Fixed coverage @ EOY5 ratio 1.76 1.70 I 1.70

Debt/equity @ EOY6 ratio 0.86 0.86 I 0.86

1 ,I 95.3 1,123.2

Panel B (without lease)

Patron benefits:

Member debt

Revolving fund

Cash refunds

ITC

$000 66.7 66.7 53.6 53.6

$000 95.8 95.8 60.0 60.0

$000 1,168.8 1 ,152.8 950.9 938.8

$000 51.2 0 51.2 0

Total $000

Cooperative performance:

Cash avail. @ EOY5 $000 426.1 426.1 426,l 426.1

Net savings @ EOY5 $000 384.0 389.1 384.0 389.1

Fixed coverage @ EOY5 ratio 1.91 1.91 1.91 1.91

Debt/equity @ EOY6 ratio 1.08 1.08 1.08 1.08

1,382.5 1,315.3

I’ 101.6

I 105.2

I 680.5

I 887.3

1,115.7 1,052.4

’ Infeasible in period 6 (needed internal investment funds exceed patron funds available for investment).

40
1987 Model

Simulation results for post-1986 conditions (1987

model) are reported in table 11. A lower interest rate

(9 percent), a lower return on assets (9 percent), and a

lease rate of 22 percent are assumed in the 1987 base

model. 2o These changes reflect reductions in market

rates and cooperative net margins that occurred

between 1985 and 1987. In contrast to the 1985

simulation results, some of the simulations performed

with the 1987 model were not financially feasible and

could not be compared with the baseline model.

Results of the 1987 baseline simulation are qualitatively similar to those found with the 1985 base

model. The all-debt financing alternative generates

greater total patron benefits ($1,121,2OO versus

$836,900 with leasing). Cash refunds to patrons is

again larger in present value dollars with the use of

debt only. Cooperative financial performance is also

stronger without the lease.

Sensitivity Results. An interest rate increase (from 9

to 10 percent) results in an infeasible financial plan.

Required internal investment funds (after applying

funds from external debt sources) exceed investment

funds available from patron sources. A l-percent

increase in the interest rate on debt (holding the

cooperative’s rate of return on assets at 9 percent)

causes the plan to become infeasible in the first year.

An increase in the patron marginal tax rate (Model C

in table 11) from 15 to 34 percent (the highest marginal rate under the 1986 tax law) yields results

which are qualitatively similar to those in the 1985

simulation. Patron benefits are reduced from baseline

levels in both the all-debt (20.4 percent decrease) and

lease (21.6 percent decrease) situations.

A reduction of the annual lease rate from 22 to 21

percent (Model D in table 11) makes the lease slightly

more competitive. This is reflected by the higher

levels of total patron benefits, cooperative cash

available, and net savings. The availability of a lower

lease rate in the post-1986 situation would be possible if it were the net result of a lower lessor yield

objective.

*O The base model lease rate reflects an annual lease payment in

advance. Due to the use of annual rates in the simulation model, as

opposed to monthly payments in the capital budgeting model, the

annual lease rate is initially 22 percent in the 1987 simulation.

Scenario Results. The combination of a rising

interest rate (from 8 percent in the first year to 13

percent in the sixth year) and a constant lease rate of

21 percent results in an infeasible financial plan in

period 5 with the lease. The debt-financing strategy

is feasible, however, even though interest rates on

debt are allowed to increase.

A scenario of rising interest rates (from 8 to 13

percent), a falling return on assets (from 9 to 6.5

percent), constant business volume, and an annual

lease rate of 21 percent results in a financially

infeasible plan for both financing alternatives (Model

F). The cooperative’s financial plan becomes infeasible in the fifth year of the simulation. The

erosion of earnings becomes too great by EOY5 to

fund the required investment in assets and meet

other cash requirements (debt service and retirement, dividends, etc.).

A revision of the pessimistic scenario in model F is

feasible, Model G maintains a constant g-percent

return on assets, but allows patron and nonpatron

business volume to decrease by 1 percent per year.

This scenario results in lower total patron benefits

with the lease strategy ($812,900) and lower patron

benefits with the all-debt strategy ($1,051,200) when

compared with the base simulation. Although

member debt and revolving fund distributions fall

sharply with the lease, patron cash refunds dramatically increase to $649,800 (nearly a 34-percent

increase over the base result). The 6-percent decrease in patron benefits with the all-debt strategy is

primarily due to the sharp decrease in member debt

and revolving fund benefits. Cooperative financial

performance is stronger with the lease. Cash available at EOY5 is $178,100 with the lease and

$204,600 without the lease. Net savings with the

lease ($165,300) are lower than net savings generated

with the all-debt strategy ($199,100).

Simulation of Tax Law Change Effects

The significance of changes in the Federal tax code

that were made in 1986 (as they relate to the lease

versus debt financing decision) can be directly

considered with the aid of the simulation model.

Table 12 contains results for the case cooperative

using the 1985 and 1987 models and inputs identical

to the 1985 base model. The two tax aspects under

41
investigation are the revision of the corporate tax

rate schedule and the elimination of the investment

tax credit. The marginal tax rate of patrons is set at

15 percent, then at 34 percent, to identify the magnitude of the effects on patron benefits.

The three financial measures influenced by the

change in tax law are: (1) cash refunds to patrons, (2)

investment tax credit passed through to patrons, and

(3) cooperative net savings (after tax).

The impact on cash refunds to patrons is the most

complex. Cash refunds to patrons equals the sum of

required cash distributions and additional cash (cash

patronage refunds in excess of the required cash

refund). Required cash refunds is equal to 20

percent of net savings available for distribution from

patron business (after deduction of taxes and payment of dividends and unallocated retained savings).

The additional cash refund is equal to the difference

between patron funds available for investment (after

payment of taxes, investment, required cash refunds,

dividends, and retained savings) and the amount of

needed internal investment in the period.

Invcstmcnt tax credit has direct and indirect component effects. The indirect component arises through

cooperative utilization of ITC generated in a given

year. Utilization of the ITC increases patron funds

available for investment and net savings available for

distribution to patrons. The direct impact is attributable to the passthrough of ITC to patrons. A

“passthrough” occurs when the ITC generated by the

cooperative in a single year exceeds its tax liability.

The excess ITC is assumed to be allocated to patrons

on the basis of patronage.

The net financial impacts of the tax change items are

reported in table 12. When the patron marginal tax

rate is 15 percent, total patron benefits decline by

about 6 percent with the leasing strategy (from

$1,195,300 in the 1985 model to S1,123,200 in the

1987 model). The decline in patron benefits with

the lease is primarily due to lower present value of

cash refunds. Cooperative net savings at EOY5 with

the lease decrcascs slightly (from $370,200 to

$358,000). A larger increase in net savings occurs at

ECY6 (from $517,300 in 1985 to $528,900 in 1987)

with the lease. The increase in net savings is primarily due to the revised cooperative tax rate schedule.

The impacts on the cooperative and patrons are

qualitatively similar in the all-debt situation. Total

patron benefits decrease by 4.9 percent (from

$1,382,500 to $1,315,300). The decrease in benefits

is caused by (I) a reduction in present value of cash

refunds (from $1,168,800 to $1,152,800), and (2) the

elimination of the ITC and reduction of the

passthrough from $51,200 (which occurred during

the first year in the 1985 model) to zero (in the 1987

model). The larger decrease in patron cash refunds

with all-debt financing is attributable to the combined effect of higher cooperative earnings and

greater utilization of ITC in the 1985 model. The

increase in after-tax net savings at EOY5 with alldebt financing is nearly identical to the savings

generated with the lease. The EOY6 net savings

improvement with debt financing is smaller (it rose

from $391,800 to $397,000) than the $11,600 increase with lease financing.

The cooperative’s financial plan becomes infeasible

in period 6 with the lease when the marginal tax rate

of patrons is raised to 34 percent throughout the

simulation period (table 12).21 The debt-financing

strategy is feasible, however, and total patron benefits decrease from $1,115,700 to $1,052,400.

This analysis of the financial impacts of tax law

changes on the lease versus debt-financing alternatives is only a partial analysis. Obviously, factors

such as interest rates, lease rates, and cooperative

assets and debt management strategies were changing at the time the 1986 tax law was being formulated. Several of those corresponding changes could

be evaluated by establishing additional scenarios

similar to those reported in tables 10 and 11.

*I Patron business earnings that are taxable include the proportion of

dividends not charged to nonpatronage business and unallocated

retained savings not paid from patronage earnings, and the amount

of nonqualified patronage refund retained. Since these are after-tax

values, the model requires the cooperative to retain more than a

dollar out of gross margin to meet both the tax liability and the

amount of dollar capital needs. The higher patron tax rate pushes

the required level of cooperative earning to be retained above

feasible level in period 6.

42
Bibliography

Abrahamsen, M.A. Coonerative Business Enter-

-. New York: McGraw-Hill, Inc., 1976.

Adair, A.L., J.B. Penson, Jr., and M. Duncan.

“Monitoring Lease-Financing in Agriculture.”

Economic Review, Federal Reserve of Kansas City,

1981.

American Association of Equipment Lessors.

Eauinment Leasing 1988. Arlington, Virginia.

September 1988.

. Survey of Industrv Activitv

for 1985. Arlington, Virginia, 1986.

. Survev of Jndustrv Activitv

for 1984. Arlington, Virginia, 1985.

American Bankers Association. The Essentials of

Bank Leasing. Washington, DC: American Bankers

Association, 1981.

Bcierlein, J.G. and L.F. Schrader. Program Documentation of a Cash Flow Simulator for Coonerative Patrons. Station Bulletin No. 119, Department

of Agricultural Economics, Purdue University, West

Lafayette, Indiana, 1978.

Berg, I. “Equipment Leasing: Prospects 1988 - Four

Viewpoints.” Eauinment FinancinP Tournal. Vol.

X1(6), November/December 1987.

Bochljc, M. and G. Pederson. “Farm Finance: The

New Issues.” Choices. Third Quarter, 1988.

Cobia, D.W., J.S. Royer, R.A. Wissman, D.P. Smith,

D.R. Davidson, SD. Lurya, J.W. Mather, P.F.

Brown, and K.P. Krueger. Eauitv Redemution:

Issues and Alternatives for Farmer Cooneratives.

US. Department of Agriculture, Agricultural

Cooperative Service, ACS Research Report No. 23,

1982.

Commerce Clearing House. Exulanation of Tax

Reform Act of 1986. Chicago, Illinois, 1986.

Davcy, P.J. Leasing: Exoeriences and Exuectau. A Research Report from the Conference

Board, Conference Board Report No. 791. New

York: The Conference Board, Inc., 1980.

Davidson, D.R. and M.D. Kane. Top 100 Cooneratives, 1986 Financial Profile. US. Department of

Agriculture, Agricultural Cooperative Service, ACS

Report No. 71, 1988.

, “Restructurings Accelerate

As Co-op Struggle to Adapt to Sagging Economy.”

Farmer Cooneratives. U.S. Department of Agriculture, Agricultural Cooperative Service, 1987.

Davidson, D.R. and J.S. Royer. “Top 100 Cooperatives Cut Refunds 20 Percent in 1985.” Farmer

Cooneratives. U.S. Department of Agriculture,

Agricultural Cooperative Service, 1986.

Davidson, D.R. and D.W. Street. “Top 100 Raise

Cash Refunds, Retains; Reduce Borrowing From Coop Banks.” Farmer Cooneratives. US. Department

of Agriculture, Agricultural Cooperative Service,

1984a.

Davidson, D.R. and D.W. Street. “Ag Decline

Prompts Top 100 to Cut Debt, Prune Assets.”

Farmer Coooeratives. U.S. Department of Agriculture, Agricultural Cooperative Service, 1984b.

Elgers, P.T., and J.J. Clark. The Lease/Buv Decision, A Simplified Guide to Maximizing Financial

and Tax Advantages in the 1980s. New York: The

Free Press, 1980.

Farm Credit Leasing Services. Annual Reports

(1985-1987). Minneapolis.

Frederick, D.A. Tax Treatment of Coonerativcs.

U.S. Department of Agriculture, Agricultural

Cooperative Service, Cooperative Information

Report No. 23, 1984.

Ginder, R., K.E. Stone, and Daniel Otto. “Impact of

the Farm Financial Crisis on Agribusiness Firms

and Rural Communities.” American lournal of Anricultural Economics. 67(5):1985, 1184-1130.

Griffin, N., D. Volkin, and D. Davidson. Coonerative Financing and Taxation. Cooperative Information Report 1 Section 9, Agricultural Cooperative

Service, USDA, 1981.

43
Griffin, N. and L.S. Finstcrstock. “Leveraged Lease

Financing for Agricultural Cooperatives,” Farmer

Cooperative Service, U.S. Dept. of Agriculture,

LVashington, December 1974, pp. 10-13.

Isom, T.A. and S.P. Amcmbal. The Handbook of

Leasing: Tcchniaues and Analvsis. New York:

Pctrocelli Books, Inc., 1982.

Johnson, J.M. and C.B. McGowan. “Alternative

Minimum Tax Implications for Lease/Buy

Analysis.” The Journal of Eauioment Lease Financing. Vol. 6(Z), 1988, pp. 23-32.

LaDue, E.L. Economic Evaluation of an Eouioment

Lease Program. Extension Bulletin No. 79-35,

Department of Agricultural Economics, Cornell

University, 1979.

. “Equipment Leasing and

Renting as Alternative Sources of Investment

Capital for Northcast Farmers.” New York’s Food

and Life Sciences Bulletin, Social Sciences, Aaricultural Economics. Vol. 67, 1977, pp. 1-15.

LaDue, E., R. Durst, G. Pederson, J. Plaxico, and A.

McDonley. Financial Leasing in Agriculture: An

Economic Analvsis. North Central Regional Research Publication 303, North Dakota Agricultural

Experiment Station, Fargo, 1985.

Roycr, J.S. “Strategies for Capitalizing Farmer Cooperatives,” in Farmer Coooeratives for the Future.

NCR-140 Workshop Papers, Department of Agricultural Economics, Purdue University. WcstLafaycttc, Indiana, 1985, pp. 83-90

Schmclzer, J.R. I_Jse of Investment Tax Credits by

Selected Farmer Cooncratives. U.S. Department of

Agriculture, Agricultural Cooperative Service, Staff

Paper, 1984.

Van Home, J.C. Financial Management and Policv.

6th Edition, Englewood Cliffs, New Jersey: Prentice-Hall, Inc., 1983.

Wickham, A.B. and M. Boehlje. The Resuonsiveness of the Lease Versus Buv FinancinP Decision to

Various Parameters. Staff Paper P86-16. Department of Agricultural and Applied Economics,

University of Minnesota, St. Paul, 1986.

Turner, M.S. “Cooperative Acquisitions and Other

Forms of Restructuring” in Farmer Coooeratives for

the Future. NCR-140 Workshop Papers, Department of Agricultural Economics, Purdue University.

\Vcst Lafayette, Indiana, 1985, pp. 118-124.

44
Appendix A: Glossary of Leasing Terms

Annual Pcrccntage Rate:

Broker:

Certificate of Acceptance:

Closed End Lease:

Conditional Sale Lease:

Debt-Financing:

Economic Life:

Fair Market Value:

Finance Lease

(Direct Lease,

Capital Lease):

Financing Statement:

Full-Payout Lease:

Hell-or-High-1’Vater Clause:

An interest rate that expresses the “true cost” of credit as an annual rate.

A company or person arranging lease transactions between lessees and

lessors for a fee.

A document whereby the lessee acknowledges that the equipment to be

leased has been delivered, is acceptable, and has been manufactured or

constructed in accordance with specifications.

A category of lease under which the lessee does not participate in gain or

loss on sale at the end of the lease term; a “walkaway lease.” The full risk of

residual value loss rests with the lessor.

A lease in form but a conditional sale in substance. A conditional sale is a

transaction where the holder of an asset, the lessee, is treated as the owner of

the asset for tax purposes. The lessee or user treats the property as owned,

depreciates the property for the purposes, claims ITC, and deducts the

interest portion of rent for tax purposes. The lessor treats the transaction as a

loan and will not offer the lower lease rate associated with a true lease since

tax benefits of ownership are not retained.

Acquisition of an asset through use of borrowed capital.

The time period over which an asset is expected to be usable, with normal

repairs and maintenance.

A form of residual asset value determined in an open, competitive market

transaction between a willing buyer and a willing seller at the end of the

lease term.

A long-term noncancelable contract giving the lessee use of an asset in

exchange for a series of lease payments to the lessor. The lessee acquires the

right to use the asset while the lessor retains ownership of the asset. The

term of a financial lease usually covers a major portion of the economic life

of the asset. The lease is a substitute for purchase.

A notice of a security interest in an asset filed untip the Uniform

Commercial Code.

A lease in which the sum of the lease rental payments alone (excluding

purchase at the end of the lease term) pay the lessor sufficiently to cover the

full costs of the leased asset (including the lessor’s cost of financing and

overhead) and provide a satisfactory rate of return to the lessor.

A lease clause that reiterates the lessee’s unconditional obligation to make

lease payments for the entire term of the lease, regardless of any event

affecting the equipment or any change in the circumstance of a lessee.

45
Implicit Lease Rate:

Lease Rate Factor:

Lease:

Lessee:

Lessor:

Leveraged Lease:

The “implicit rate” is a frequently quoted rate of return earned by the lessor.

It is calculated based on lessor returns from the scheduled lease payments

and the unguaranteed residual amount. It is the rate that equates the present

value of these inflows to the fair market value of the lease at its inception.

The decimal rate applied to the leased equipment initial

cost to arrive at the periodic lease payment.

A contractual agreement that conveys the right to use an asset for a

predetermined length of time in return for a fee.

A person or company acquiring the use of an asset through a lease agreement.

The actual owner of an asset: the person or company with an asset to lease.

A contract involving at least three parties: the lessee, the lessor, and the

long-term lender. From the lessee’s standpoint, there is no difference

between a leveraged lease and any other type of lease. The lessor holds title

to the asset, but its acquisition is financed partly by the lessor and partly by

the lender. The lessor provides a percentage (usually 20-40 percent) of

necessary capital, with the lender providing the remainder as nonrecourse

debt financing. The lessor, rather than the lessee, is the borrower.

Master Lease Agreement: The basic documentation that allows the addition of equipment under the

same basic terms and conditions without negotiating a new lease contract.

Net Lease: A lease under which the lessee is obligated to pay several cost items

(e.g., sales tax, property tax, insurance premiums, maintenance and repair,

licenses, registration, etc.) in addition to the basic lease payments.

Nonrccoursc Lender: The lender in a leveraged lease. If the lessee defaults on the lease, the lender

in a nonrecourse loan has no recourse against the borrower (i.e., the lessor).

The lender looks solely to the lessee and the strength of the lessee’s credit in

making the loan decision.

Open-End Lease:

Operating Lease:

Purchase Option:

A net lease, where title to the asset passes to the lessee after exercising a

purchase option or payment of a guaranteed residual price. Frequently, these

leases are structured on a full-payout basis (lessor recovers all costs plus

anacceptable rate of return). Part of the residual value risk is passed to the

lessee. Ownership potential is “open” to the lessee.

A short-term contract giving the lessee use of an asset for a period of time

substantially less than its economic life. Operating leases are used to meet

seasonal or cyclical needs of the lessee when purchase of the asset is not a

viable alternative.

A written agreement in the lease contract stating that at the end of the lease

term, the lessee has the option of buying the leased asset. A bargain purchase

option is one that allows the lessee to purchase the asset at the end of the

lease period for a price that is significantly below the expected fair market

value.

46
Renewal Option:

Residual Value:

Sale-Leaseback:

Severance Agreement:

Sublease:

Tax Indemnification

Clause:

Tax-Oriented Lease:

Terminal Rental

Adjustment Clause:

True Lease:

Wash Lease:

An option to renew the lease at the end of the initial lease term.

The remaining value of leased equipment or machinery when the lease

expires. The actual residual value is the price the lessor could obtain by

disposing of the equipment when the lease expires.

A arrangement through which the owner of an asset (usually a structure or

expensive machinery or equipment item) sells it to a second party and

simultaneously agrees to lease it back from the purchaser.

An agreement whereby landowners, land contract holders, or mortgage

holders release any rights of claim against, or possession to, the leased

property, and agree that the leased property shall remain severed from the

land on which it is located.

A transaction in which leased property is released by the original lessee to a

third party. The lease agreement between the two original parties remains

in effect.

A lease contract clause whereby the lessee indemnifies (insures) the lessor

from loss of tax benefits, if the lease unwinds.

A transaction where the lessor takes into account the investment tax credit

and depreciation when determining the lease rate.

A provision in a motor vehicle rental agreement that permits the lessor to

make an upward (or downward) adjtistment of the rental payment at the end

of the lease to make up the difference between the projected value and the

actual value of the vehicle at the termination of the agreement. This results

in an open-end lease.

An agreement qualifying as a lease for tax purposes by Internal Revenue

Service standards. A true lease qualifies for such tax benefits as deductible

lease payments, depreciation, and investment tax credit. The lessor holds the

title and assumes the risks of ownership.

A lease under which transfer of tax benefits from the owner-user to an

investor is arranged. This is a “hybrid” leveraged lease, sale-leaseback

arrangement through which the lessor (investor) is considered the owner for

tax purposes, but the lessee (user) is the legal owner. The owner-user

provides his own financing by extending nonre course debt (leverage) to the

lessor (investor). The lessor acts as if he had purchased the asset from the

lcsscc (sale-leascback). Lease payments to the lessor exactly equal (wash out)

loan payments to the lessee.

47
Appendix B: Sample Lease Agreements Representative of Lease Arrangements

%=t

Farm Credit Leasing Services Corporation 10 Second Street N.E.

Minneapolis. Minnesota 55413

(6121 376-1733

LESSEE: Name and Billing Address VENDOR: Name and Billing Address

48

IIi r

-1 L

ESTIMATED IN SERVICE DATE:

Clusntity Model No. Equipment Description Unit Cost

EQUIP. COST

FREIGHT

LABOR

TAX

TOTAL COST

TOTAL COST TO LESSOR

1

-I

INSTALLATION ADDRESS:

Street end Number City County stste

APPLICATION AGREEMENT

1. This Application is made bv the above named Lessee I”lessea”l to enter into (I lease with Farm Credit Leasing Sewlces Corporetlon f”Lessor”1

of the equipment described ebove l”Equipment”l. LESSEE CONFIRMS THAT THE EOUIPMENT AND THE ABOVE NAMED VENDOR (“VENDOA”) HAVE BEEN SELECTED BY LESSEE. LESSOR DOES NOT HAVE ANY RESPONSIBILITY FOR THE ECIUIPMENT AND MAKES NO

REPRESENTATIONS OR WARRANTIES AS TO THE EQUIPMENT’S CONDITION. MERCHANTABILITY OR FITNESS FOR PARTICULAR PURPOSE OR THAT IT IS SUITABLE FOR LESSEE. NONE OF THE PROVISIONS OF THIS APPLICATION AGREEMENT OR OF ANY LEASE AGREEMENT CAN BE CHANGED BY THE VENDOR OR MANUFACTURER OR THEIR REPRESENTATIONS. ANY ORAL REPRESENTATIVES OR PROMISES BY ANYONE ARE NOT ENFORCEABLE AGAINST LESSOR. LESSEE WAIVES ALL CLAIMS AGAINST LESSOR ARISING OUT OF THE

DESIGN. MANUFACTURE. ACQUISITION. USE, POSSESSION. CONDITION OR DISPOSITION OF THE EOUIPMENT. INCLUDING CLAIMS

THAT THE EQUIPMENT IS NOT SUITABLE FOR LESSEE’S PURPOSES, IS NOT MERCHANTABLE. OR IS IN ANY WAY DEFECTIVE. INAOEQUATE, UNSAFE OR UNUSABLE.

2. THE LEASE WILL BE A NET LEASE. Lessee will be required to pay ell costs of maintaining end repairmg the Equipment and all costs. fees and

taxes relatino to the use OI oossess~on of the Eouimnsnt. THE LEASE AGREEMENT WILL BE NON-CANCELLABLE. All rent will be pavabfs to

Lessor whet&or not the Equipment is destroybd’or fails to perform as expected. Any claims of any kind relating to Equipment must be made

against the Vendor or manufacturer of such Equipment.

3. LESSEE REPRESENTS AND AGREES THAT:

Ial Lessee he8 not relied upon Lessor to select the Equipment or the Vendor of the Equipment end will use the Equipment solely for business or

farming purposes.

lbl Lessee will indemnify Lessor egeinst soy claims by third parties sgainst Lessor arising out of the design, menutacture. purchase. lease. use.

possession. operation or condition of the Equipment.

ICI The Vendor, ats salesmen and agents. we not authorized to mske soy promises. claims, or representetions for or on behalf of Lessor or to

waive or change soy terms or provisions of this Application, the Lease Agreement or eny schedule or ettachment thereto.

Idl Unless otherwise stated on the reverse side of this Application. Lessee’s principsl place of business is the “Billing Address” specified

above. Tfm Equipment will be kept at the “lnatelletion Address” specltied above and will not be moved without Lessor’s prior written spproval.

le) Lessee has reviewed and hereby accept8 the terms of the Lease Agremmsnt.

4. This Applicabon does not obligate Lessor. Lessor mey reject this Application for soy or no reason without obligation to Lessee. Upon acceptsnce of this Applicabon by Lessor and the execution of a Lease Agreement by Lessor end Lessee, the Lease Agreement shall become the entorcseble sgreemsnt between Lessor and Lessee. Notwithstsnding Lessor’s acceptence of this Application, Lessor may terminate such acceptance end have no further obligation to lease the Equipment to Lessee it any of the following events occur:

lal The Equipment is not available for service within 30 days of the “Estimated In Service Date” noted above.

Ibl If Lessee tails to accept the Equipment meeting specifketions conteined in sny purchase agreement between Lessee and Vendor.

ICI Acceptencslor deposit by Lessor of any sdvsnce paymentr. deposits or other funds provided by or on behalf of Lessee does not constitutll

acc.qHanc~ of the Lease Agreement by Lessor.

6. Lessee grents permission to Lessor to obtain from any source eny lnformetion relst!ng to Lessee’s credit standing. includmg but not limited to

the Ls~ee’a operating lender, trade suppliers, real estete lenders, instellment creditors. end others with whom the Lessee does business. The

Lessee expressly authorizes these sources to dwulge any information that the Lessor may ressonably require including exact ligures and dates.

Lessee agrees to supply to Lessor (without charge1 such financial statements and other information as may reasonably be requested and wetrants the accurecy of the information on the reverse side of this Appllcetion and the intormetion submitted to Lessor bv Lessee in connection

with this Application.

FOR LESSOR INTERNAL USE ONLY

DATE RECEIVED

REVIEWED BY:

DATE

ACTION TAKEN:

LESSEE CONTACTED:

Phone/Letter DATE

VENDOR CONTACTED:

Phone/Letter DATE

PRINT LESSEE’S FULL NAME

Title Date

Title oets

Title Dste

Title Date
3% Farm Credit Leasing Services Corporation

I” bU‘“ll” alleel 19 t.

Minneapolis. Mmnesola 55413

(612) 376-1733

LESSEE: Name and B~llmg Address VENDOR: Name and Blllmg Address

1

LESSOR UNIT NUMBER

umt coat TOTAL COSTTO LESSOR

EOUlPMENr COST

FREIGHT

LABOR

TAX

TOTAL COST

LEASE AGREEMENT

THIS LEASE is made as of this day of , 19- between FARM CREDIT LEASING

SERVICES CORPORATION, a corporation organized under the Farm Credit Act of 1971. as amended (“Lessor”) and the above named

lessee (‘Lessee”).

1. Leasing. Lessor hereby rents and leases to Lessee and Lessee hereby rents and leases from Lessor the equlpment described

above subject to terms and conditions contained herein.

2. Equipment. The equipment leased hereunder (hereinafter referred to as “Equipment”) is described above and/or shall be described in schedules attached hereto and incorporated herein.

3. Term, Rental and Deposit. The Lease term shall be as se1 forth above and shall commence on the Commencement Date above

described. All renlal amounts described above shall be due and payable to Lessor in accordance with the Rental Payment Periods

noted above at Lessor’s address designated herein or at such other place(s) as Lessor may direct in writing. Upon lhe wntlen request

of Lessor, Lessee agrees lo make a security deposit in an amount equal lo the Security Deposit specified above The Security Deposal.

if any, may be used at the Lessor’s election to cure any default of Lessee. Lessee shall promptly restore Ihe Secunly Deposal lo lull

amount specified. If Lessee has lulfilled all terms and conditions herein, Ihe Security Deposit shall be returned wtthout interest or il may

be applied lo any purchase oplion exercised by Lessee.

4. Location end Use of Equipment.

4.1 The Equipment leased hereunder shall at all limes be located at the address indicated above. The Equipment shall nol be

removed from such location without the prior written consent of Lessor.

4.2 Lessee will not use, operate, maintain or keep any Equipment leased hereunder improperly, carelessly or in violalIon of any

laws or regulattons relating to the possession, use or maintenance thereof. or in a manner or lor a use olher than contemplated by Ihe

manufacturer thereof as indicated by the instruclions furnished therewith. Lessee at its own expense WIII keep and maintam the

Equipment in good condition and working order, paying when due all costs and expenses of every characler occasioned by or ansting

out of the use and maintenance of the Equlpmenl. Insignia. tags, decals or other identification furnished by Lessor will be mainlamed

on the Equipment and will not be removed by Lessee. Lessor may Inspect any Equipment at any reasonable time.

5. Indemnity, Insurance.

5.1 Lessee assumes all responsibility for the maintenance, repair, testing, use and operation of the Equipment and assumes all

risk 01 loss or damage to Ihe Equipment lrom whatsoever cause during the lease term. Lessee agrees lo indemnify, reimburse and hold

Lessor harmless from any and all claims, losses, liabilities, demands, suits, judgmenls or causes of action, and all legal proceedings,

and all costs associated therewilh, including attorney’s fees and expenses which may result from or anse in any manner out 01 Ihe

condition, use or operalion of the Equipment, or any defect in the Equipment regardless of when such defect shall be discovered. Ail

the indemnities contained herein shall continue in full force and effect notwilhstanding the expiration or termination of the Lease.

5.2 During the term of this Lease, Lessee will maintain fire insurance, including standard extended coverage, for the full value

of the Equipment. Lessee also will maintam public Ilability and property damage insurance wilh respecl to the Equipment I” such

amounts and with such insurers as approved by Lessor. Such insurance shall name Lessor as an additional insured and loss payee

and shall provide that such insurance may be altered or cancelled only after thirty (30) days pnor written notice to Lessor. Such

insurance shall further provide lhat losses shall be adjusted only with, and paid lo, Lessor. If any such loss shall be paid by check or

draft payable to Lessor and Lessee joinlly, Lessor may endorse Lessee’s name thereon as Lessee’s agent. Lessee shall deliver lo

Lessor, prior lo the beginning of the lease term or prior to the effective date of any cancellation or expiration of such insurance, the

insurance policy or a certificate or other evidence, satisfactory to Lessor, of the maintenance of such insurance.

6. Loss or Damage to Equipment. All risks of loss, theft, deslruction and damage lo the Equipment, lrom whalsoever cause, are

assumed by Lessee. Should the Equipment be damaged or destroyed and the applicable insurance proceeds not be adequale to

repair the same, Lessee shall either repair or replace the same at ils expense or Lessee shall pay lo Lessor an amount equal to the

Slipulated Loss Value, it any, applicable lo such Equipment at the date of such damaqe or deslruclion or Lessee shall otherwise pay lo

Lessor an amount which will cause Lessor lo realize the same yield Lessor would have realized if Ihe Lease 01 the Equiprrlelll would

have been in efiecl for Ihe enlire lease term.

----------___------ ________--__________-----

SEE REVERSE SIDE AND ANY LEASE AGREEMENT SCHEDULES FOR ADDITIONALTERMS AND CONDITIONS

THE UNDERSIGNED AGREES TO ALL THE TERMS AND CONDITIONS STATED ABOVE AND ON THE REVERSE SIDE OF THIS

PAGE AND IN ANY LEASE AGREEMENT SCHEDULES INCORPORATED HEREIN.

LESSOR: Farm Credit Leasing

Services Corporation

By:

TITLE

MK017 (03187)

LESSEE:

BY:

Print Full Name

Tulle

Tilfe

Title

Title

Date

Dale

Date

Dale

49
7. Expenses, Fees, Taxes. Lessee shall pay all cost$. expenses, fees and charges mcurred in connection with the use and

operation 01 the Equipment dunng Ihe term of this Lease. Lessee shall pay any and all taxes whatsoever paid, payable or required lo

be collected by lessor (except income taxes based upon Lessor’s net income) on or relating lo the Equipmenl leased hereunder and

the rental. use or operation thereof.

8. Delivery, Inslallalion, Acceptance and Return of Equlpmenl. Upon delivery of the Eqllipmenl lo Lessee and the insIallalion

of such Equipment. 11 any, Lessee shall execule and deliver lo Lessor a dated receipt identifying Ihe Equipment and acknowledgrog

accepfance thereof. By such acceptance, Lessee agrees that such Equlpment is in good operating order, repair, condllion and appearance and in all respects satislactory lo Lessee. After the exprralion or other termination of the lease term pertaining lo the Equipment,

or any renewal thereol; Lessee, upon nollce by Lessor, will promptly return the Equipment,to Lessor in the same operating order, repair.

condltlon and appearance as when received. excepting only lor reasonable wear and tear. Lessee will load the Equipment al Lessee’s

expense on board such carrier as Lessor, may specify and ship the same lo lhe deslination spcciflod by l.essor.

9. Renewal Option. II no Event of Default has occurred or is continuing, Lessee shall be enlttled lo renew thls Lease with rcspocl

lo the Equipment. If Lessee intends to exercise this renewal option, Lessesshall qive notice lo Lessor al least nmely (90) da s prior lo

the exoiralion of thr term of IIlls Lease. The duration 01 any such renewal lernr. the rental ralo nr~d the Slil,ul.llnrJ Los% Value . &-~l~cdule,

il any. for any such rerlewal lorrn shall be dclcrn!cned by Lessor. All other terms and cund~ltons 01 1111:; l.nasc. including Ill<? lerrns

contained III this Secllon 9. shall apply during such renewal term

lO.Tille. Tttle lo the Cqulpmenl shall al all limes remain in Lessor and al no llrne during term of 1111s Lease stlall Illlc: b~?cf~rnc \‘cr,le?rJ

in Lessee.

11. Assignment and Subleasing. Lessee shall not delegate. sublet, Iransler. or encumhnr ltre Equl(ment or irrly of I& rryhls or

obliyahons hereunder wlthoul thr prju# wnllen cor~senl 01 Lessor. Lessor mny, at Lrssor’s sulr! d~s(.tr~Oun ;III~ :v~thout I~UIII:(’ II I LI:;SCC.

assign this Lease and all of Lessor’s nqhl. tillo. ;%II~ interesl III and lo lhe Equlpment and all rirrlls ;tnd olhor nr~~ounls due 01 lo brcomc

rlue to Lessor under thls Lease lo any other party

IZTax, Benefits and Indemnification. Lessor shall retarrr Ihe benelrt of the Investnienl l:rx Crsdrl. cloprecrntlurr deductrons nnd

other lax benellts as are prowdad by lederal. stale and local law applicable lo each unit of Equipment (“Tax Beneltts”). Iiowcv~r. upon

written request by Lessee lo Lessor, Lessor may elocl lo pass through cnrtain fax benehts lo Lcss~c ut~l~r~nq lnrms to be furnl5llcd by

Lessor or by 111mg the inlormat8on and forms requlrnd by the reyulalinns governmy Ihe pass throuqh 01 the Tax HenellIs. II Lessor shall

not have or shall lose the rrghl lo claim, or if all or any portion of IIre l&x Benefrls as arc prow&d lo an ownr!r of (xop?rly wllh respect

lo any Equlpment shall be disallowed or rccaplured with [espect lo Lessor (hercinaltcr catlod “Tax B~nr~f~l LOSS”) then on the naxt

succeeding renlal payment date alter wrltlen notice lo Lessee by Lessor that a Tax Ren~.~l~l Loss has occurred (or if there he no such

date..thirty (30) days following such notice). Lessee shall pay Lessor an amount which. alter dcrluct~on 01 HII taxes requlretl to be paid

by Le’ssor’@h respect to Ihe receipt of such amouRI, wrll cause IIre LessorS net after-lax yleid over Ihe lerm ol Ihc Lease in respect of

such Equipment lo equal the net after-tax yield Ihat would have been realized by Lessor if Lessor had been entitled lo the utillzallon 01

all the Tax BenellIs.

13.Events of Default. The following shall consl~tule events 01 default:

a) Lessee shall fail lo pay ‘all or any part of a rental paymenl or any other payment when due and payable;

b) Lessee shall fall lo porlorm or shall breach any 01 the other covenants herein and shall conlinue lo fail lo observe or perform

the same tor’a period 01 ten (1Oj days alter written tlolice thereof by Lessor;

c) If Lessee becomes insolvent. makes an assignment lor the benefit or credrlors. ceases or suspends 11s business or bankruptcy reotganizallon or other proceedings for Ihe rellel of debtors or benefit of creditors shall be insliluted by or against Lessee;

d) Any ropresenlalion or warranty made by Lessee herein or in any document or certificate furnished Lessor may prove lo be

incorrect in any material respect;

e) ‘If Lessee is a btisincss entity, the dissolution, merger or reorganization of Lessee.

14.Remedles Upon Default. Upon the occurrence of any event of defaull. Lessor may exerctse any one or more of the following:

a) Demand immediate payment 01 entlre amount of Lease paymenls and residual due hereunder;

b) Take immediate possesslon of any and all Equlpment wilhout notice:

c) Sell or Lease any Equipment or otherwlse clispose, hold or use such Equipmenl al Lessor’s sole’discretion;

d) Demand payment in an amount equal to the Stipulated Loss Value, il any, applicable lo the Equipment;

e) Demand payment of all addltlonal costs incurred by Lessor in the course of correcting any default;

1) Proceed against any or all security given in cor,,.cction herewith which Includes but is not limited lo co-signers, chattel kens

and real estate.

g) Exercise any other right or remedy available lo Lessor under applicable law.

Lessor’s rights and remedies provided hereunder or by law shall be cumulative and shall bo in addllion lo all other nghls and remedies

available lo Lessor. Lessor’s failure lo slnclly enforce any provisions of this Lease shall not be construed as a waiver thereof or as

excusing Lessee from fullrrc perlorrnance.

15.Warrantles.

15.1 Assignment of Manufacturer’s Warranties. Lessor hereby assigns lo Lessee, lor and during the Lease lerm wrth respect lo

the Equipmenf, any warranty of the manufaclurer. express or implred, issued on the Equipment and hereby authorizes Lessee lo obtain

the service furnished by the manufacturer in connection therewith al Lessee’s expense. Lessee acknowledges and agrees that the

Equipment ii a size, design, capacity and manufacture selected solely by Lessee and suitable for IIS purposes.

15.2 D IS CLAIMER OF WARRANTIES. LESSOR is NOT A MANUFACTURER NOR IS LESSOR ENG AG ED IN Tt tE SALE OR

DlSTRlBUTloN8F~~~~LESSOR MAKES NO REPRESENTATIONS. PROMISES. STATEMENTS OR WARRAN IES.

EXPRESSED OR IMPLIED, WITH RESPECTTO THE’CONDITION, MERCHANTABILITY, SUITABILITY OR FITNESS FOR A PARTICULAR PURPOSE OF THE EQUIPMENT OR ANY OTHER MATTER CONCERNING THE EQUIPMENT. LESSEE AGREES THAT

CE&SOR’SkALL NOT BE LIABLE TO LESSEE FOR ANY LOSS, CLAIM. OEMAtiO. LIABILITY. COST. DAMAGE OR EXPEFISES OF

ANY KIND, CAUSED, OR ALLEGED TO BE CAUSED. DIRECTLY OR INDIRECTLY, BYTHE EOUIPMENT OR BY ANY INADEQUACY

THEREOF FOR ANY PURPOSE, OR BY’ANY DEFECTS THEREIN, OR IN THE USE OR MAINTENANCE THEREOF, OR ANY

REPAIRS, SERVICING OR ADJUSTMENTS THERETO;: OR ANY DELAY IN PROVIDING, OR FAILURE TO PROVIDE THE SAME.

OR ANY INTERRUPTION OR’LOSS OF SERVICE’OR USE THEREOF, OR ANY LOSS OF BUSINESS OR ANY DAMAGE WHATSOEVER AND ti0WsOEvER CAUSED. LESSEE AGREES THAT ITS OBLIGATIONS HEREUNDER TO PAY THE RENTALS HEREIN

PROVIDED FOR SHALL NOT, IN ANY WAY, BE AFFECTED BY ANY DEFECT OR FAILURE OF THE EOUIPMENT.

i6;Miscallanecrw k..

16.1 This agreement is and is intended lo be a Lease. and Lessee does nol holeby ocqrr;io ally right. Ii:!? rr !n!?‘r?~t in ?nf! to Ihe

Equipment except the right lo use the same under the terms hereof.

162The relationship between Lessor and Lessee shall always and only be that of Lessor nnd Lessee. Lcssce shall not hereby

become the agent of Lessor a@ .Lessor shall not be responsible lor the acts or omissions of Lessee.

16.3This Lease shall be governed in all respects by the laws 01 the State of Minnesota.

16.4 Lessee hereby irrevocably appoints and constllutes Lessor and each of Lessor’s ofhcers. employees or nyenls as Lessee’s

true and lawful agent and attorney-in-fact lor the purpose of filing financing slatemenls. including amendments tllerelo. pursuanl lo the

Unitorm Commercial Code as adopted in the state or slates where the Equipment is located or for filing simtlar documents or mslruments in locations which have not adopted the Uniform Commercial Code; Lessor being hereby authorized and empowered to s~yn

Lessee’s Name on one or more of such linancmg statements. documents ofiinstrumenls.

17.0plion lo Purchase llpon the expiration of the Lease term as indicated herein, Lessee may al 11s sole option purchase the

Equipment in accordance with Ihe terms specllled in the applicable schedule attached hereto.

50
Farm Credit Leasing Services Corporation Minneapolis. Mmnesota 55413

(612) 376-1733

LESSEE: Name and Billii Mdress VENDOR: Name and Billing Address

r 7 r

%OUN

!te!!l

,NIT NUMB

unil cosl

1

_I

1:

TOTAL COST TO LESSOR

EWIPMEM COST

FREIGHT

LABOR

TAX

TOTAL COST

INSTALLATION ADDRESS:

streel mnd - cI* -v ?.I.,#

PURCHASE OPTION SCHEDULE

This Purchase Oplion Schedule is hereby made a par! 01 that certain Lease Agreement dated

between the parties hereto (“Lease”) and is applicable to Ihe Equipment described above. The terms hereof apply only to the lease of

the Equipment described herein and shall be deemed to be a part of the Lease.

1.0 PURCHASE OPTION.

Unless a Default or event ol Dataull shall have occurred and is continuing, Lessee may purchase the Equipment described

above at the expiration of the term of this Lease at a cash price equal to the ‘Option Price” as defined below. Lessee shall notify Lessor

no later than sixty (60) days prior lo the expiralion of the Lease term.

‘OPTION PRICE” shall be one of the following (check one):

0 “Fair Market Value” (FMV) of Equipment at the end of the lease term. FMV is defined as the price negotiated between an

informed and willing purchaser and an informed and willing seller. If the parties cannot agree as lo what constitutes Fair Market Value,

an appraiser shall be selected by the parties whose determinalion ol Fair Market Value shall be binding on Lessor and Lessee.

OS Which ispercent (%) of the Total Cost as listed above. Both parties agree that this is a reasonable estimate of the anticipated market value of the Equipment at the expiration of the Lease.

2.0 WARRANTY OF FARM FINANCE LEASE ELIGIBILITY

0 By checking this box Lessee hereby warrants that the above referenced Equipment is eligible lor farm finance lease treatment.

Lessee warrants that Ihe above Equipment has not been placed in service more than three (3) months prior lo the commencement of

the Lease and that all Equipmen! is NEW and qualities as Section 36 Property under the Internal Revenue Code of 1966. The -

Equipment will be used solely for agricultural purposes and if the Equipment is a lixture. it is used for a single purpose in the production

or storage of an agricultural commodity, Lessee also warrants that the total cost of all property leased pursuant to finance leases of

farm properly, as provided for under Section 209 (d)(l)(B) ol the Tax Equity and Fiscal Responsibility Act of 1962, (“TEFRA”) as

amended by the Tax Reform Acf of 1964. during Ihe current calendar year will not exceed $15O,OOO. The parties hereby: a) agree lo

characterize transactions hereunder as farm finance leases under Section 209 (d)(l)(B) of TEFRA for federal tax purposes; and b)

agree lo have the provisions of Section 209 (d)(l)(B) ot TEFRA apply to the transactions hereunder. If this Section 2.0 is made

apgdMabE;z the Lease of Equipment described herein, any staled purchase option shall be al least 10% of the Total Cost of Equipment

___-_---_-_----___-_---------- --------_--_--

THE UNDERSIGNED AGREES TO ALL THE TERMS AND CONDITIONS STATED ABOVE AND IN ANY OTHER LEASE AGREEMENT SCHEDULES. EACH PERSON SIGNING FOR A LESSEE REPRESENTS THAT SUCH PERSON IS AUTHORIZED TO ACT

FOR SUCH LESSEE.

LESSOR: Farnl Credit Leasi.lg

Services Corporation

BY:

TITLE

MKOl6 (03167)

LESSEE: _ __ _ ---

Print Full Name

By: Title Dale

Title Date

Title Dale

Title Dale

51
%

% Farm Credit Leasing Services Corporation

10 Second Street N.E.

Minneapolis, Minnesota 55413

(612) 378-1733

LESSEE: Name and Billing Address VENDOR: Name and Billing Address

r 7 r 1

LACCOUNTNUMBER:

aumwy Modal No.

-I L J LESSOR UNITNUMBER:

Equipment Deacrlp~icm Unll Coal TOTAL COSTTO LESSOR

EOUIPMENT COST

FREIGHT

LASOA

TAX

TOTAL COST

1

INSTALLATION ADDRESS:

“:“z@

RentSI

AmlXln(

GUARANTY

In order to induce and in consideration of FARM CREDIT LEASING SERVICES CORPORATION (hereinafter “FCL”). a federally

chartered corporation organized under the Farm Credit Act of 1971, es amended, entering into a Lease Agreement, daled

, for the lease of equipment described in certain Purchase Option Schedules signed and

acknowledged by the UNDERSIGNED GUARANTOR and appended hereto (such Lease Agreement and Purchase Option Schedues

hereinafter referred to as the ‘Lease Agreement”) with the Lessee whose name and address appears above (hereinafter the “Lessee”)

the UNDERSIGNED GUARANTOR hereby uncondttionally guarantees to FCL, its successors and assigns, the prompt and full pay

ment when due of all sums due from Lessee to FCL under the Lease Agreement and the prompt full performance by Lessee of each

and every provision and warranty of Lessee set forth In the Lease Agreement.

The UNDERSIGNED GUARANTOR hereby expressly waives (I) notice of acceptance of the Guaranty by FCL; (ii) presentment,

demand for payment, protest and notice of protest, default, non-payment or partial payment by Lessee: (iii) all other notices and

formalities to which Lessee and/or the UNDERSIGNED GUARANTOR might be entitled, by statute or otherwise; and (iv) any other

circumstance whatsoever which might constitute a defense to enforcement of this Guaranty. The UNDERSJGNED GUARANTOR

further agrees that no renewal, modification, amendment or supplement of or lo the Lease Agreement or any extension or compromise

of Lessees obligations arising under the said Lease Agreement shall affect the Ilability of the UNDERSIGNED GUARANTOR hereunder and the UNDERSIGNED GUARANTOR hereby consents to and waives notice of any of the foregoing.

The UNDERSIGNED GUARANTOR further waives any right of set-off or counterclaim against Lessor with respect to any claim or

demand the UNDERSIGNED GUARANTOR may have against the Lessee. As further security to Lessor, any and all debts or liabilities

now or hereinafter owing to the UNDERSIGNED GUARANTOR by Lessee, and any lien, security or collateral given to the UNDERSIGNED GUARANTOR in connection therewith are hereby subordinated to the claims and liens of. and assigned to, Lessor.

The obligations of the UNDERSIGNED GUARANTOR hereunder are and shall at all times be the original, direct and primary

obligations of the UNDERSIGNED GUARANTOR and Lessor shall not be obligated to pursue or exhaust any rights or remedies

against the Lessee as a prerequisite to enforcing this Guaranty against the UNDERSIGNED GUARANTOR.

No modification or waiver of any of the provisions of this Guaranty shall be effective unless in writing and signed by the UNDERSIGNED GUARANTOR and an officer of Lessor. If any provision of this Guarenty or the application thereof is hereafter held invalid or

unenforceable, the remainder of this Guaranty shall not be affected Ihereby, and to this end the provisions of this Guaranty are

declared severable.

If the UNDERSIGNED GUARANTOR is a corporation, each signatory on behalf of each such corporation warrants that (s)he has

authority to sign on behall of such corporation and by so signing. to bind said corporation hereunder. This Guaranty is absolute,

unconditional and continuing and shall remain in effect until all of Lessee’s obligations under the Lease Agreement shall have been

paid. performed and discharged.

This Guaranty and every part hereof shall be binding upon the UNDERSIGNED GUARANTOR and upon the successors and

assigns of the UNDERSIGNED GUARANTOR, and shall inure to the benefit of FCL, its successors and assigns. The provisions of this

Guaranty shall be construed and enforced In accordance with the laws of the State of Minnesota.

IN WITNESS WHERZO: ti;is. Guaranty has ken du!y executed by the UNDERSIGNED GUARANTOR this

, w-.

day of

52

GUARANTOR:

Print Full Name

MK022 (03IS7) c
Appendix C:

Summary of Federal Tax Law

Related to Leasing

This appendix provides a brief review of the tax laws

and codes that contains major lease provisions. It is

not intended to be an exhaustive treatment of the

subject.

lessee to purchase the asset being leased for an

estimated residual value of at least 20 percent of

the asset’s original cost. The asset was required to

have a remaining economic life which exceeded

the lease term by more than 1 year or 20 percent

1954 internal Revenue Code of the estimated depreciation life.

The 1954 Internal Revenue Code distinguished

between a true lease and a conditional sale. According to section 167, a lessor could deduct any ordinary expenses incurred in the taxable year that were

attributable to the lessor’s earnings. The lessor was

allowed to depreciate the leased assets and, beginning in 1962, to also claim the investment tax credit

(ITC). If the transaction was a true lease, the lessor

retained the ITC and depreciation deductions.

The introduction of accelerated depreciation and ITC

altered the leasing strategy of many firms. The ITC

had the effect of reducing an asset’s purchase price

by reducing the firm’s tax liability on a dollar-fordollar basis. As a result of these incentives, deductions available to a purchaser in the early years were

greater than those available to a lessee. Firms with

higher marginal tax rates began leasing property to

firms with little or no income tax liability (lower

marginal tax rates). The lessor could take advantage

of the accelerated depreciation deductions and ITC

allowance to offset income tax liability. The lessee

would have little use for these benefits. To compensate the lessee, a lessor could afford to offer a lower

lease rate and still realize an acceptable rate of return

on an after-tax basis.

Revenue Procedure 75-21

A set of lease structuring guidelines was established

in 1975 as a result of Revenue Procedure 75-21. The

guidelines applied specifically to the structure of

leveraged leases. If the following conditions were

met, an agreement would be considered an operating

(true) lease by the IRS for tax purposes:

. The lessor was required to maintain a minimum

“at-risk” investment of 20 percent through the

lease term. The lessor must have required the

l The lease term included all renewals or exten

sions, except those at the lessee’s option.

l The lessee must have paid fair market value for

the leased asset. The fair market value paid for

the leased asset at lease termination must repre

sent at least 20 percent of the asset’s original cost.

No bargain purchase options were allowed. The

lessor could not abandon the asset at the end of

the lease term. There could be no written contrac

tual statement requiring the lessee to purchase the

leased asset.

l The lessee could not provide to the lessor any part

of the cost of the leased item at the time of asset

acquisition.

l The lessee could not lend any funds necessary to

purchase the asset by the lessor at the time of

asset acquisition.

l The lessor must have shown profit beyond the

benefits derived from the ITC and depreciation tax

shield. The lease must have resulted in a pro

jetted positive cash flow.

l Limited use property (that is, readily usable only

by the lessee) was not eligible for lease treatment.

The intent of these guidelines was to ensure that the

lessor retained some of the benefits, costs, and risks

of ownership while a lessee did not obtain an equity

interest. Although these guidelines were set up

specifically for leveraged leases, they were adopted

as guidelines for most leases. They were considered

by most lessors as minimum requirements for a true

lease for tax purposes.

53
Economic Recovery Tax Act of 1981

Tax guidelines were liberalized by tax law changes

in provisions of the Economic Recovery Tax Act of

1981 (ERTA). Just as the concepts of ITC and accelerated depreciation had substantial effects on leasing, so did the provisions of ERTA. ERTA established a “safe harbor” lease transaction. The purpose

behind the safe harbor lease was to generate investment incentives for firms unable to take advantage of

the ITC and accelerated cost recovery allowances.

The safe harbor provisions nearly guaranteed the

parties of a lease transaction that the agreement

would be considered a true lease for income tax

purposes if the six safe harbor guidelines were met.

The following conditions had to be met according to

section 168(8)8 of the Internal Revenue Code for a

lease to be considered a safe harbor lease transaction.

l The lessor had to have been a regular corporation.

Others qualifying included partnerships (where

all partners were corporations) and grantor trusts

(where the grantor and beneficiaries were corporations).

l The lessor must have maintained a minimum “atrisk” investment of at least 10 percent of the cost

of the leased asset.

l The maximum lease term could not exceed the

greater of 90 percent of the useful life of the asset

or 150 percent of the asset depreciation range

(ADR) class life of the property. The lease term

must have equaled or exceeded the ACRS life of

the asset (i.e., for 5-year property the lease term

must be at least 5 years).

l Only certain property was qualified for safe

harbor treatment:

--Property must have been placed in service after

January 1, 1981.

--It must have been recovery property eligible for

ACRS (i.e., qualify for tax depreciation).

-It must have been new section 38 property

(property eligible for ITC).

-Limited use property (i.e., readily usable only

by the lessee) did not qualify.

l The lessor and lessee must have agreed in writing

that the transaction was to be characterized as a

lease for IRS tax treatment.

l The lessor and lessee must have agreed in writing

that they elected to have safe harbor provisions

apply to the lease transaction.

The lease could still be classified as a true lease by

the IRS even though it included a bargain purchase

option, fixed-price purchase option, or fair market

value purchase option. With the safe harbor lease

provisions, those firms unable to use their income

tax benefits could trade them to a lessor in need of

tax benefits in exchange for a more favorable lease

payment. For those leases not meeting the safe

harbor requirements, previously established guidelines would have to be followed. This includes

those guidelines established through Revenue

Procedure 75-21, IRS rulings and procedures, and

tax court rulings.

Tax Equity and Fiscal Responsibility Act of 1982

The safe harbor lease provisions of ERTA were very

successful, but at a great expense to the Federal Government in lost tax revenue. Provisions of the Tax

Equity and Fiscal Responsibility Act of 1982

(TEFRA) curbed the problem by placing restrictions

on safe harbor leases.

TEFRA gradually repealed the safe harbor lease

guidelines. Any safe harbor lease arranged after July

1, 1982, and before January 1,1984, under ERTA,

became subject to several restrictions:

l Depreciation was determined using the 150

percent declining-balance method in the early

years, switching to straight-line in later years.

The lease term could not exceed the greater of the

specially designated recovery period or 120

percent of the property’s class life. The recovery

periods were established at 5 years for 3-year

property, 8 years for 5-year property, and 15 years

for lo-year property. The ITC were required to be

rated over a 5-year period (20 percent of the ITC

54
allowance in each of the first 5 years), The in

come tax basis adjustment was made in year one.

l The lease term could not exceed the upper asset

depreciation range (ADR) limit for the property as

of January 1, 1981.

l Only 40 percent of a lessee’s “qualified base

property” placed in service during a year qualified

for safe harbor treatment. Qualified base property

included:

-all property under a safe harbor lease election,

-all other new ITC property, and

-new property eligible for the ITC under non-safe

harbor lease rules,

l The lessor could not apply cost recovery deductions or ITC’s to reduce income tax liability by

more than 50 percent. Deductions that could not

be used in the current year could be carried for

ward, but not backward. Cooperatives were an

exception to this rule. Any deductions not

usable by the cooperative in the current year

must have been passed through to its patrons.

ERTA repealed the safe harbor provisions for leases

entered into after December 31,1983. Safe harbor

leasing was completely eliminated after 1983.

TEFRA created “finance leases” to replace safe

harbor leases starting in 1984. Finance leases failed

to retain many of the benefits of safe harbor leases.

As a result, leases lost some of their previous attractiveness. Finance lease guidelines included the

following provisions:

l They must generally have met the non-safe harbor

lease guidelines.

l Purchase of the leased property by the lessee must

have been permitted for a price. The price was set

at the start of the lease at 10 percent or greater of

the original property cost. This option was

exercisable by the lessee at the end of the lease

term.

l The asset must have been new Section 38 property (eligible for ITC) to qualify.

l The transaction must have contained economic

substance in addition to any guaranteed tax

benefit.

. The lessor must have expected to show a profit

from the lease transaction aside from any expected tax benefits (the “profit test”).

l The lease arrangement could not be a financing

arrangement or conditional sale.

Transitional rules were scheduled to be in effect

during 1984 and 1985.

The new finance lease provisions were expected to

put some limits on leasing volume and reduce the

tax benefits available to the lessor. Liberalization of

the rules relating to limited-use property and fixedprice purchase options were expected to be quite

attractive to many potential lessees.

TEFRA included some specific changes for ACRS

and the ITC. TEFRA eliminated the accelerated

depreciation rates scheduled to go into effect in 1985

and the faster rates for years after 1985. For 1982,

the ITC could be used to offset up to $25,000 of

income tax liability, plus 90 percent of income tax

liability above $25,000. Starting in 1983, TEFRA

reduced the maximum ITC allowance from 90

percent to 85 percent of the income tax liability over

$25,000.

Tax Reform Act of 1984

Revised leasing rules incorporated in TEFRA (1982)

were replaced by new finance lease guidelines in

1984. Provisions of the Tax Reform Act of 1984

(TRA) postponed until 1988 provisions on finance

leases entered into after March 6, 1984. During 1984

and 1985, most leases fell under the pre-safe harbor

(pre-ERTA) lease guidelines.

The introduction of finance leases was to be phased

in with transitional rules scheduled to apply during

1984 and 1985. The TRA of 1984 delayed these

transitional rules until 1988 and 1989. The transitional rules are as follows:

55
l No more than 40 percent of a lessee’s property

qualifies for finance lease treatment if placed in

service during any year before 1990.

l A lessor cannot use finance lease rules to reduce

tax liability by more than 50 percent in any year

except for property placed in service after Septembcr 3,1989, in taxable years starting after that

date

l The ITC for finance lease property will only be

allowed ratably over 5 years, except for property

placed in service after September 30, 1989.

Tax Reform Act of 1986

The statutes that imposed finance lease rules,

determining whether a transaction is a lease or a

purchase for tax purposes, are generally repealed for

contracts entered into after December 31, 1986.

Under the 1984 act, these rules had been generally

postponed until after 1987. Under the nonstatutory

lease rules that apply beginning in 1987, the courts

and the IRS will determine property ownership for

tax purposes based on the “economic substance” of

the transaction.

Transitional rules enacted in 1984 continue to apply

for (1) property used for farming purposes (Section

38 property), (2) certain auto manufacturing property, and (3) contracts which were binding before

March 7, 1984.

Repeal of the lo-percent investment tax credit for

property placed in service after December 31,1985,

affects both purchase and leasing of new property.

The ITC carryover rules continue to apply for property placed in service before 1986. In addition, the

ACRS depreciation method is modified to reclassify

certain 3-year property (cars and light-duty trucks) as

s-year property, and to establish a new 7-year

property classification (railroad track and singlepurpose agricultural and horticultural structures).

56
Agricultural Cooperative Service (ACS) provides research, management, and

U.S. Department of Agriculture

Agricultural Cooperative Service

P.O. Box 96576

Washington, D.C. 20090-6576

educational assistance to cooperatives to strengthen the economic position of farmers

and other rural residents. It works directly with cooperative leaders and Federal and

State agencies to improve organization, leadership, and operation of cooperatives and

to give guidance to further development.

The agency (1) helps farmers and other rural residents develop cooperatives to obtain

supplies and services at lower cost and to get better prices for products they sell; (2)

advises rural residents on developing existing resources through cooperative action to

enhance rural living; (3) helps cooperatives improve services and operating efficiency;

(4) informs members, directors, employees, and the public on how cooperatives work

and benefit their members and their communities; and (5) encourages international

cooperative programs.

ACS publishes research and educational materials and issues Farmer Cooperatives

magazine. All programs and activities are conducted on a nondiscriminatory basis,

without regard to race, creed, color, sex, age, marital status, handicap, or national

origin.