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800,000

800,000

200,000

68,000

132,000

Net Present Value at 18%: $412,787

Net Present Value at 18%: $412,787

Notes: ESCO purchases/operates equipment. Host pays ESCO 80% of the savings = $800,000.

The contract could also be designed so that PizzaCo can buy the equipment at the end of year 5.

Table 25.12 Host's Tax Benefits for each Arrangement.

Depreciation Interest Payments are Total Payments are

ARRANGEMENT Benefits Tax-Deductible Tax-Deductible

Retained Earnings X

Loan X X

Bond X X

Sell Stock X

Capital Lease X X

True Lease X

Performance Contract X

25.5 "PROS" & "CONS" OF EACH FINANCIAL ARRANGEMENT

This section presents a brief summary of the "Pros" and "Cons" of each financial arrangement from the host's perspective.

Loan

"Pros":

• host keeps all savings,

• depreciation & interest payments are tax-deductible,

• host owns the equipment, and

• the arrangement is good for long-term use of equipment

Use Retained Earnings

Has the same Pros/Cons as loan, and "Pro":

• host pays no external interest charges. However retained earnings do carry an opportunity cost, because such funds could be invested somewhere at the MARR.

"Cons":

host takes all the risk, and must install and manage project

Bond

Has the same Pros/ Cons as loan, and "Pro":

• good for government facilities, because they can offer a tax-free rate (that is lower, but considered favorable by investors)

Sell Stock

Has the same Pros/ Cons as loan, and "Pro":

• selling stock could help the host achieve its target capital structure

• dividend payments (unlike interest payments) are not tax-deductible, and

• dilutes company control

• host loses tax-deductible benefits of interest charges

Capital Lease

Has the same Pros/ Cons as loan, and "Pro":

• Greater flexibility in financing, possible lower cost of capital with third-party participation

True Lease

"Pros":

• allows use of equipment, without ownership risks,

• reduced risk of poor performance, service, equipment obsolescence, etc.,

• good for short-term use of equipment, an

• entire lease payment is tax-deductible

"Cons":

• no ownership at end of lease contract, and

• no depreciation tax benefits

Performance Contract

"Pros":

• allows use of equipment, with reduced installment/operational risks, and

• reduced risk of poor performance, service, equipment obsolescence, etc., and

• allows host to focus on its core business objectives

"Cons":

• potentially binding contracts, legal expenses, and increased administrative costs, and

• host must share project savings

25.5.1 Rules of Thumb

When investigating financing options, consider the following generalities:

Loans, bonds and other host-managed arrangements should be used when a customer has the resources (experience, financial support, and time) to handle the risks. Performance contracting (ESCO assumes most of the risk) is usually best when a customer doesn't have the resources to properly manage the project. Remember that with any arrangement where the host delegates risk to another firm, the host must also share the savings.

Leases are the "middle ground" between owning and delegating risks. Leases are very popular due to their tax benefits.

True leases tend to be preferred when:

• the equipment is needed on a short-term basis;

• the equipment has unusual service problems that cannot be handled by the host;

• technological advances cause equipment to become obsolete quickly; or

• depreciation benefits are not useful to the lessee.

Capital Leases are preferred when:

• the installation and removal of equipment is costly;

• the equipment is needed for a long time; or

• the equipment user desires to secure a "bargain purchase option."

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