The Evaluation of Leveraged Leases

This article discusses and critiques yield‐based capital budgeting techniques that have arisen over the past 30 years. Some have theoretical inconsistencies, while some work well only for certain kinds of problems. A new method, the marginal return on invested capital, is presented. The method's application is general; it gives accept/reject signals and rankings consistent with the net present value method.

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“…Athanasopoulos and Bacon [2] imply that these problems are avoided if the reinvestment rate is the MCC of the lessee.…”

Section: Explicit Reinvestment Rate Methodsmentioning

confidence: 99%

Discounted Cash Flow With Explicit Reinvestment Rates–tutorial and Extension

McDaniel

McCarty

Jessell

1986

The Financial Review

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“…Risk equivalence is not considered, as mentioned above, and there is no prescribed frame of comparison. [2] imply that these problems are avoided if the reinvestment rate is the MCC of the lessee.…”

Section: Critics Of Fmrr Include Young [26]mentioning

confidence: 99%

Discounted Cash Flow With Explicit Reinvestment Rates: Tutorial and Extension

McDaniel

McCarty

Jessell

1988

The Financial Review

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Academicians have demonstrated the superiority of the Net Present Value (NPV) method for capital budgeting decisions for the value maximizer. Unfortunately, practitioners do not exhibit the same fervor for theoretical purity that academics do. Specifically, numerous surveys of capital budgeting practices show that the most commonly used discounted cashflow (DCF) method among practitioners is the Internal Rate of Return (IRR). Theorists have shown that the IRR is an accurate method for typical capital budgeting cases, giving proper accept or reject solutions; nevertheless, in some cases the IRR solution is inferior to the NPV solution. Thus, theorists favor the NPV in research and class endeavors. Yet, decision makers tend to ignore the plea of NPV's higher level o f "rigor" in favor of the IRR's "more intuitive appeal."Because o f the exceptional cases and perhaps to bring academicians and practitioners closer, many have undertaken to improve the IRR by creating various DCF methods that give answers in the form of yields. Not all of these creations have met the demands of logical consistency; not all have had clear focus on what one must do to make a rational capital budgeting decision; and most have too much of an ad hoc flair to be considered legitimate pedagogically. Many of these new methods are not in the finance literature and thus may have escaped notice; therefore, a critical review of some of these methods is the second section of the paper.The criticisms of existing yield-based methods are based on a theoretical framework for NPV, set up in the paper's first section as a standard for comparison of other models presented. Then assumptions are relaxed to accommodate pragmatic decision-making. This is done to demonstrate how NPV and yield-based methods deal with the changed environment. The third section is the paper's primary purpose. It sets forth eight criteria essential for a yield-based DCF methods to be a valid substitute for NPV. These criteria require that the yield-based method: . 4. 5. 6.7. 8.gives the same accept/reject decision as NPV for every project; maintains risk-equivalence with the firm's typical operations so that it may be compared to the marginal cost of capital; is consistent with the idea that in the long run the marginal return on projects approaches equilibrium with the marginal cost of capital; includes the idea that capital funds are different from operational cashfl ows ; gives a unique solution for every project; ranks projects of unequal size in the same order as NPV; ranks projects having time disparity in the same order as NPV; and ranks projects having unequal lives in the same order as NPV.Finally, the paper defines a yield-based method that meets seven of these criteria. Formal proofs demonstrating the consistency with each criterion are given where necessary. The paper demonstrates the logical inconsistency and conceptual impossibility of any yield-based method discriminating among projects of different sizes.

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“…In particular, NPN cash flow patterns can arise in environmentally regulated industries, such as mining, where a firm must incur significant phase-out costs in the final periods of the project's life. Either a NPN or a NPNP cash flow will arise in the lessor's evaluation of a leveraged lease (see for example, Anthanasopoulos and Bacon (1980), Childs and Gridley (1973), Myers, et al (1976), Regan (1976), Vanderwicken (1973), and Wiar (1973)). These practical oriented NPN and NPNP cash flow patterns are the subject of the present paper.…”

Section: Two Additional Examples Of Practical Concernmentioning

confidence: 99%

Sign Tests for Actual Investments With Latter Period Net Cash Outflows

Grimlund

Capettini

1983

Business Fin & Account

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IntroductionIn a recent JBFA article Wilkes (1980) presented some analytical results on the occurence of multiple rates of return in projects with mutiple sign changes. This work was prompted by an earlier JBFA article by Longbottom and Wiper (1978). Wilkes presented a procedure for detecting n real, distinct and positive internal rates of return (IRR) in a project with n periods. He then went on to observe the analytical difficulties in using his methodology for studying the possibility of less than n of these multiple rates of return in the n period project. Finally, he discussed two situations in which multiple rates of return may be of practical importance: Incremental investment analysis and combined interrelated projects. In both cases projects with mutiple sign changes can arise.The purpose of this paper is to introduce and analyze two other situations of practical importance where multiple sign changes and the real possibility of multiple IRRs can arise. The paper provides a more general sign test procedure for these situations than is possible with Wilkes' procedure. In addition, the sign tests will, at times, be useful with incremental investment analysis or with combined interrelated projects such as discussed by Wilkes. The sign tests can be used to determine in most cases the number of IRRs of an investment and the nature of its net present value (NPV) function.

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The Evaluation of Leveraged Leases

Cited by 11 publications

References 8 publications

Discounted Cash Flow With Explicit Reinvestment Rates–tutorial and Extension

Discounted Cash Flow With Explicit Reinvestment Rates–tutorial and Extension

Discounted Cash Flow With Explicit Reinvestment Rates: Tutorial and Extension

Sign Tests for Actual Investments With Latter Period Net Cash Outflows

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