PRODUCTION SYSTEMS                                PIH-115


       Financial Leasing of Capital Assets in Pork Production

Chris Hurt, Purdue University
Allan E. Lines, Ohio State University
Gerry Schwab, Michigan State University

Danny Klinefelter, Texas A&M University
Matt Parsons, Hadley, Massachusetts
James S. Plaxico, Oklahoma State University
Tommy Reff, North Dakota State University

     The U.S. pork production industry continues to move  rapidly
towards  fewer  farms  producing  an  increasing  amount  of  the
nation's hogs. This movement toward fewer, but larger,  producers
has  been  made possible by added capital investments for facili-
ties,  equipment,  and  various  production  inputs  which   have
replaced,  or  have  been  substituted  for, manual labor on many

     Traditionally, producers needing funds for growth used their
own  capital  (equity) or borrowed capital (debt) to purchase the
assets needed. But, with the  increased  capital  needs  and  the
changes  in financial markets, producers are exploring leasing as
an alternative method to acquire assets.  Increased use  of  debt
capital  and  interest rate variability have increased the finan-
cial risk-exposure for some  producers.  And,  leasing  may  help
reduce  some financial uncertainties. Another important reason to
consider leasing is that, in  some  cases,  it  may  provide  the
lowest cost method to acquire certain assets.

     Leasing consists of paying a  set  fee  for  the  use  of  a
durable  asset owned by a party other than the user. The owner of
the asset is termed the lessor, and the user termed  the  lessee.
Since  this  arrangement  can  be viewed as an alternative way to
finance the use of an asset, it is called financial leasing.

The Financial Lease

     Nearly any kind of asset used  in  pork  production  can  be
leased.  Common examples of leased assets include breeding stock,
production equipment, and buildings.

     A financial lease is a contractual commitment  that  enables
the  lessee  to  acquire  the  use  of an asset in exchange for a
stipulated fixed payment to the  asset  owner,  the  lessor.  The
lease  is  the  contractual  agreement  to which both parties are
legally obligated during the lease period.

     To clarify the positions of both the lessor and  lessee  and
to  help  avoid misunderstandings, the lease should be written. A
written lease should include:

1.   description of the  property  by  location  and  a  list  of
     exactly what is included;

2.   the expected and permitted use of the property;

3.   provisions for termination of the lease;

4.   timing and amount (or calculation method) of lease payments;

5.   initial maintenance condition of the property;

6.   rights and obligations of the lessor; for  example,  permis-
     sion  to  enter the leased property premises and maintenance

7.   operating obligations of the lessee. Examples  include,  who
     is responsible for repairs, insurance and property taxes;

8.   terms of a buy-out option at end of the lease period or  any
     early buyout agreements; and

9.   an arbitration procedure to settle  disagreements  that  are
     not resolved by mutual agreement.

Advantages and Disadvantages

     Some advantages to the lessee are listed. They  may  not  be
valid  in all cases, but have the potential to be advantageous in
other cases:

1.   Leasing may require fewer dollars up front  than  ownership.
     Capital  assets  may be placed in service at an initial cost
     that may be less than even the minimum 10% down payment com-
     monly associated with ownership.

2.   When credit limits are imposed by a producer's lender, leas-
     ing may be a way to acquire additional assets. However, pro-
     ducers should realize that  financial  leasing  will  affect
     cash  flow  requirements  and  thus may affect credit limits
     imposed by the primary lender.  In  any  case,  the  primary
     lender should be made aware when a producer is considering a
     financial lease.

3.   The lease payment schedule is often a  fixed  dollar  amount
     per time period. When this occurs, cash flow planning on the
     outflow side may  be  more  certain  than  with  a  variable
     interest rate loan under the ownership alternative.

4.   The entire lease payment is  a  tax-deductible  expense  for
     federal income tax purposes for qualifying leases.

5.   Leasing may provide more flexibility to  match  the  payment
     terms  to  the  actual expected useful life of an asset. For
     example, a lender may want  a  three-year-term  note  on  an
     asset  which  could  have  lease  payments extended over its
     five-year-useful life.

6.   Leasing provides clear alternatives  for  disposing  of  the
     capital  asset  at the completion date of the lease contract
     since the asset can be returned to the lessor, or  purchased
     if there is a buy-out option.

7.   Leasing may be less risky to the lessee than  debt  financed
     ownership.   With  leasing,  the only collateral required is
     the actual capital asset being leased. With debt  financing,
     additional collateral may be required to obtain financing.

8.   Leasing can be a lower cost method  of  obtaining  an  asset
     than  debt  financing  when  the  lessor  is in a higher tax
     bracket, and/or has a lower cost of capital, and is  willing
     to pass a portion of this advantage to the lessee.

     Some disadvantages of leasing from the lessee's  perspective
relative to ownership are:

1.   Depreciation and interest expense cannot be claimed  by  the
     lessee for tax deductions.

2.   If the lease period is equal to, or shorter than,  the  time
     period  for  financing the asset using the ownership option,
     the before-tax cash flow  requirement  will  most  often  be
     higher for leasing.

3.   The total cost associated with leasing will often be  higher
     than  the  total cost associated with debt-financing for the
     ownership option.

4.   The fixed dollar lease payment is often inflexible over  the
     life  of  the  lease  with few options to refinance or delay
     lease payments.

5.   If the primary lender is not consulted about the  additional
     cash  flow requirements of a lease, this may erode the work-
     ing relationship with the lender.

6.   The lessee may make cash flow commitments that  are  greater
     than the ability to make payments.

     When considering expenses such as repairs,  property  taxes,
and  insurance, there is generally little difference between own-
ership or leasing since these items are usually paid by the  user
directly, under the ownership option, or indirectly with a higher
lease payment.

Income Tax Implications

     Since the financial lease is similar to  ownership  under  a
debt-purchase arrangement, questions have arisen about income tax
treatment. The tax laws on lease arrangements continue to evolve.
Congress specifically defined a qualifying financial lease in the
Tax Equity and Fiscal Responsibility Act of 1982. A detailed  set
of  guidelines had to be met by both the lessor and the lessee in
order to qualify as a financial lease.  However,  farm  financial
leases  for the first $150,000 cost basis of leased property dur-
ing a year were not subject to these guidelines and  did  qualify
as a farm financial lease. The category known as ``farm financial
leases'' expired at the end of 1987. Accordingly,  farm  property
leased  after  1987  falls under the guidelines of regular leases
for tax treatment.

     For qualified capital assets, the lessor (owner) is  allowed
to  take  interest  expense and depreciation as business expenses
and thereby reduce income tax liability. Pork producers who lease
the  capital  assets  are  able  to  take the lease payments as a
deductible business expense.

     Since tax laws are subject to change,  it  is  advisable  to
check  income  tax  guidelines  before  entering into a financial
lease. Sources of information on  the  income  tax  treatment  of
financial  leases  include  the  Farmer's Tax Guide (IRS publica-
tion), CPA's, attorneys, and tax practitioners.

Comparison of Debt-Purchase with Financial Leasing

     It is important to note that the evaluation of the  type  of
financing  has  little  to  do  with  whether the asset should be
acquired. Before analyzing the type of financing,  an  evaluation
of potential profitability should be made. If the asset cannot be
used profitably, the best financing decision will  only  moderate
total  losses. Therefore, the first analysis should be a profita-
bility analysis. This is then followed by the financial  analysis
which is shown here.

     To understand the economic differences between using debt to
purchase an asset or financial leasing, check the following exam-
ple. The analysis involves computing the  net  cash  outflow,  or
cost,  each year. The net cash outflow is simply the cash outflow
less the tax savings in that year. Tax savings become a  critical
factor  since  the amount of tax savings will likely vary between
the two alternatives. Cash outflows occur over a series of years,
therefore  it  becomes  necessary to make some adjustment for the
timing of cash outflows.  We know for example, that when purchas-
ing  an  asset worth $1, it is generally preferable to pay the $1
next year rather than today. How much  better  depends  upon  the
cost  of  (borrowed)  money, or upon the earning power of (saved)
money. At a 12% interest rate, 89.3 cents today is equal to $1 in
a  year (see discount factors in Table 1). Because of this ``time
value'' of money, it  is  necessary  to  adjust  (discount)  each
year's  cash  outflow by the appropriate discount factor. By sum-
ming the annual discounted cash  outflows  over  the  years,  the
net-present  value  of the cash outflows for each alternative can
be calculated. The net-present value of  the  cash  outflows  for
leasing is then compared with the debt-purchase alternative.

Debt-Purchase Financing Example

     Assume a producer has made a decision to purchase $30,000 of
feedmill equipment under the following financial arrangements:
o    Down payment is $6,000.

o    Amount financed is $24,000 at a 12% interest rate.

o    Payments are to be made in 5 equal yearly amounts of $6,658.

o    Marginal income tax rate is 31%.

o    Equipment is considered 7 year property, for  tax  purposes,
     and is depreciated using the double-declining balance method
     with a half-year convention under the  Modified  Accelerated
     Cost  Recovery  System as specified by the Tax Reform Act of

o    Equipment is sold after  7  years  for  the  $3,000  salvage
     value,  which is considered ordinary income for tax purposes
     because the asset was fully depreciated.

     The financial analysis for  this  debt-purchase  example  is
shown  in Table 2.  Annual payments of $6,658 are divided between
the portion of  the  payment  allocated  to  principal  repayment
(column  A) and to interest (column B).  Depreciation is shown in
Column C.  Column E and F compute the amount of annual income tax
savings,  while Column G shows the annual cash outflows after tax
savings are subtracted. Finally the annual after tax outflows are
multiplied  by  the  appropriate  tax adjusted discount factor in
Column H to provide the annual discounted cash outflow  shown  in
Column I. The net-present value of the cash outflows is then com-
puted by adding the numbers in Column I.  For  the  debt-purchase
financing alternative, the net-present value of the cash outflows
is $21,590 for this example.

     Table 1 provides discount factors for various discount rates
and  years. The discount rate should be the interest rate on bor-
rowed capital if debt is used or the rate of  return  that  could
have  been  earned if equity capital is used. Commonly, producers
do not finance with 100% debt, or with 100%  equity,  but  rather
with a combination of the two. In this case, it is appropriate to
use a discount rate which is  a  combination  of  the  rates  for
interest cost and expected return on equity. In this example, the
feedmill equipment was financed with $6,000 of equity and $24,000
of  debt,  or 20% equity and 80% debt. The discount factor to use
for the debt is the 12% interest rate, and let's assume the  pro-
ducer  required  a  return  of 17% on the equity. Given these two
rates, a weighted cost of capital could be calculated  by  multi-
plying  the  rates  by the respective amounts of capital used. In
this example, the weighted cost of capital is 13% and  is  calcu-
lated as (.20 x 17%) + (.80 x 12%) = 13%.

     The weighted costs of capital should then  be  adjusted  for
tax  implications.  This  can be done by multiplying the weighted
cost of capital x (1 - tax rate). In the example used here,  this
would  be  13% (1 - .31) = 13% x .69 or about 9%. The 9% discount
factor is then used as the tax adjusted discount  factor  in  the

Financial Lease Alternative

     This analysis assumes the pork producer  acquires  the  same
$30,000  of  feedmill  equipment, but leases the equipment rather
than using debt to purchase.  Leasing assumptions are:

1.   The lease payment rate is 24% per year for  five  years,  or
     $7200 annually.

2.   The first payment is due when the equipment is acquired with
     subsequent annual payments.

3.   31% marginal tax rate,

4.   Equipment is returned to lessor after 5 years.

     The lease analysis is illustrated in Table 3.  Annual  lease
payments  of  $7,200  are  tax  deductible  with  the tax savings
assumed to be received in the year after the payment. Tax savings
each  year  is $2,232. This is the $7,200 lease payment times the
31% marginal tax rate and is shown in Column B.  Column  C  shows
the  tax  adjusted  cash outflow. These numbers are multiplied by
the appropriate tax adjusted discount factor in Column D  so  the
net-present  value  of  the  cash  outflows  can be calculated in
Column E.

     The lease alternative, under the assumptions given,  has  an
adjusted  cash  outflow, or cost, of $21,840. This number is com-
pared with the purchase alternative with an adjusted cash outflow
of  $21,590.  Thus, from an economic viewpoint, the debt-purchase
alternative has a lower cost in this example.

Factors That Affect The Analysis

     It is possible for leasing to be the lowest cost  method  to
acquire  assets.  While  this  is  not  always the case, the most
likely conditions under which leasing could be more  economically
attractive in relation to purchasing could occur if: (1) the les-
see has a lower marginal tax rate than the lessor; (2) the lessor
can obtain capital at a lower cost than the lessee or has a rela-
tively low return on their own capital, such  as  Certificate  of
Deposit  rates;  (3)  the  lease  payments can be extended over a
longer period than the allowable depreciable  life;  or  (4)  the
lessee  has a very limited amount of equity but has the opportun-
ity to earn a high rate of return on the equity.

Other Factors to Consider

     The economic comparison of the financial lease versus owner-
ship  with debt is an important analysis in decision making. How-
ever, other factors should also be considered. (1) Pride of  own-
ership may be an important reason for owning rather than leasing.
(2) Ownership may allow more flexibility if one wants to sell the
asset  due  to going out of business or has the need to trade the
asset for a larger or more technologically advanced  replacement.
(3)  Leasing is sometimes considered a way to secure 100% financ-
ing without making a down payment out of equity  funds.  However,
the first lease payment, which is generally due when the asset is
acquired, may be near the size of a down payment. (4) Leasing may
require the pork producer to justify as much credit worthiness as
a lending institution would require for a purchase. (5) The deci-
sion  to acquire an asset may change the marginal tax rate versus
not acquiring the asset. (6) When  comparing  lease  or  purchase
alternatives, the pork producer should realize that the variables
used in the analysis may be different than expected. For example,
the  results  may  vary  substantially if the producer expected a
marginal tax rate of 20% and it was actually 40% or  if  interest
rates  were expected to be 10% but were actually 14%. Some recog-
nition of future uncertainty probably means the producer needs to
consider  the  impacts  of  a broader range of values for the key

Additional Information

     Only one  leasing  situation  has  been  evaluated  in  this
worksheet.   Each  potential leasing situation will be unique and
will need to be evaluated with the producer's own  variables.  To
help  analyze  these  individual leasing situations, the attached
worksheet, identified as Tables 4  and  5,  can  be  used.   This
worksheet  follows  the  format of the examples previously cited.
Another alternative is to evaluate financial leasing versus  debt
purchase  with the use of a microcomputer. Many leasing companies
will provide this analysis as part of their service. In addition,
the  Cooperative Extension Service, in many states, has the capa-
city to provide this computer analysis. Having access to a micro-
computer program will also allow you to evaluate financing alter-
natives under different sets of assumptions. But before  entering
any  lease, read the provisions of the lease carefully and have a
clear understanding of your obligations.


     Leasing is an alternative way for a pork producer to control
the use of an asset without owning the asset. The financial lease
allows a producer to use assets generally over a period of  years
for  a  fixed  fee. The cost of leasing assets can be compared to
the use of debt to purchase the  assets  by  examination  of  the
alternative  impacts upon annual cash flows. Financial leasing is
often not as economically attractive as ownership,  but  this  is
not  always  the  case. Pork producers who are most likely to use
leasing will tend to be in one or more of  the  following  situa-
tions:  they have low marginal tax rates; they have high interest
cost; they have the opportunity to earn high rates of  return  on
their  equity;  or  they do not wish to borrow additional amounts
against limited equity.

NEW 6/88 (5M)
Table 1. Annual Discount Factors
No. of
Years 6%   7%  8%   9% 10%  11% 12%  13% 14%  15%
1    .943 .935.926 .917.909 .901.893 .885.877 .870
2    .890 .873.857 .842.826 .812.797 .783.769 .756
3    .840 .816.794 .772.751 .731.712 .693.675 .658
4    .792 .763.735 .708.683 .659.636 .613.592 .572
5    .747 .713.681 .650.621 .593.567 .543.519 .497
6    .705 .666.630 .596.564 .535.507 .480.456 .432
7    .665 .623.583 .547.513 .482.452 .425.400 .376
8    .627 .582.540 .502.467 .434.404 .376.351 .327
9    .592 .544.500 .460.424 .391.361 .333.308 .284
10   .558 .508.463 .422.386 .352.322 .295.270 .247
11   .527 .475.429 .388.351 .317.288 .261.237 .215
12   .497 .444.397 .356.319 .286.257 .213.208 .187

Table 2.  Debt-Purchase Analysis1
        (A)        (B)        (C)           (D)    
      Principal  Interest2  Depreciation3  Salvage4
      Payments   Payments                  Value   
 0    6,000                                 
 1    3,778      2,880       4,287             
 2    4,231      2,427       7,347             
 3    4,739      1,919       5,247             
 4    5,308      1,350       3,747             
 5    5,944        713       2,679             
 6                           2,676             
 7                           2,679             
 8                           1,338         3,000   

Table 2. (Continue...)
   (E)        (F)        (G)            (H)            (I)      
   $Tax       Tax    Tax Adjusted   Tax Adjusted     Discounted  
Deductible  Savings  Cash outflow  Discount Factor  Cash outflow
 (B+C-D)   (E x .31)  (A+B-D-F)        (9%)           (GxH)     
                       6,000          1.0             6,000    
   7,167     2,222     4,436           .917           4,068    
   9,774     3,030     3,628           .842           3,055    
   7,166     2,221     4,437           .772           3,425    
   5,097     1,580     5,078           .708           3,595    
   3,392     1,052     5,605           .650           3,643    
   2,676       830      -830           .596            -495    
   2,679       830      -830           .547            -454    
  -1,662      -515    -2,485           .502          -1,247    
      Net Present Value of Cash Outflows            $21,590    

1Based upon  $30,000  purchase  price  with  $6,000  down  payment,
financed  at  12%  interest  with 5 equal annual payments of $6,658
each, salvage value is $3,000. Numbers are rounded to  the  nearest
whole dollar amount.
2It is assumed that  interest  payments  are  made  on  the  annual
anniversary  of the loan and that the tax savings from the interest
occur in the same year. This  assumption  may  vary  in  individual
3Depreciation is based upon the  double  declining  balance  method
with  a  half-year  convention  under the Modified Accelerated Cost
Recovery System as specified by the Tax Reform Act of 1986.
4Salvage value is assumed to be ordinary income since the asset was
fully depreciated.

Table 3. Lease Analysis1
       (A)        (B)         (C)           (D)                (E)
                  Tax2     Tax Adjusted   Tax Adjusted     Discounted
       Lease     Savings   Cash Outflow  Discount Factor  Cash Outflow
Year  Payments  (A x .31)     (A-B)          (9%)           (C x D)
0      7,200                 7,200           1.0              7,200
1      7,200    2,232        4,968            .9l7            4,556
2      7,200    2,232        4,968            .842            4,183
3      7,200    2,232        4,968            .772            3,835
4      7,200    2,232        4,968            .708            3,517
5               2,232       -2,232            .650           -1,451
Net Present Value of Cash Outflows
1Based upon annual lease payments of $7,200 for  5
years on $30,000 worth of equipment.
2Marginal income tax rate.

              Debt-Purchase Versus Lease Worksheet

Table 4. Debt-Purchase Analysis
        (A)      (B)         (C)        (D)      (E)        (F)    
     Principal Interest  Depreciation Salvage   $Tax       Tax1    
Year Payments  Payments               Value    Deductible  Savings  
                                               (B+C-D)     (E x .__)

Table 4: (Continue...)
      (G)            (H)              (I)      
  Tax Adjusted   Tax Adjusted      Discounted  
  Cash Outflow  Discount Factor2  Cash Outflow
   (A+B-D-F)        (__%)            (GxH)     
Net Present Value of Cash Outflows
1Marginal income tax rate.
2Adjust discount rate by the marginal tax rate and use factors in
Table 1


Table 5. Lease Analysis
       (A)       (B)        (C)            (D)           (E)
                Tax1    Tax Adjusted  Tax Adjusted2   Discounted
      Lease    Savings  Cash Outflow Discount Factor Cash Outflow
Year Payments (A x.___)    (A-B)         (___%)        (C x D)
Net Present Value of Cash Outflows
1Marginal income tax rate
2Adjust discount rate by the marginal tax rate and use factors in
Table 1

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