Burlington Northern Railroad Company

UV0245
BURLINGTON NORTHERN RAILROAD COMPANY:

EQUIPMENT LEASING
On July 9, 1990, Paul Weyandt, the director of Equipment Finance at Burlington

Northern Railroad Company (BNRR), was leafing through the bids he had received for the lease-
financing deal being proposed by his office. Included in the $150 million of equipment to be
leased were new and remanufactured diesel electric locomotives, bi-level and tri-level auto racks,
box cars, coal gondola cars, and covered hopper cars (see Exhibit 1 for equipment descriptions).
Weyandt had decided that the bid submitted by Phyllis Grossman, vice president, Norwest
Equipment Finance, had the most attractive attributes for the auto racks. In addition to a
reasonable annual lease payment, Grossman’s proposal also granted BNRR an option to
purchase the auto racks at the end of the 15-year period.
Because of BNRR’s good working relationship with Norwest over the years, Weyandt
was confident that Rob McKenney, vice president and treasurer of BNRR, would support the
choice of Norwest. Before accepting the bid, however, Weyandt needed to demonstrate to
McKenney that leasing through Norwest would be better for BNRR than borrowing $22 million
to purchase the auto racks directly. Weyandt had already demonstrated to McKenney that the
equipment was a good investment by showing that the discounted expected-cash flows exceeded
BNRR’s 20% investment hurdle rate; now he had to determine the best way to finance the
investment.
Burlington Northern Railroad Company
In 1990, Burlington Northern Railroad Company was the primary subsidiary of

Burlington Northern, Inc. (BNI), a holding company. With over 25,000 miles of track in the
system, BNRR operated one of the largest railroads in the United States. When the railroad
industry was essentially deregulated in l980, BNRR’s revenues became subject to the
competition of the market place. Revenues were generated by transporting bulk freight across
the country. Coal, the most important, accounted for approximately one-third of the company’s
total revenues. Other major products transported included those from the agricultural, forest, and
automotive industries.
This case was written by Kenneth Eades for the purposes of classroom discussion with the support of the Foundation
for Leasing Education, the education foundation of the Equipment Leasing Association of America. Some figures
have been altered at the request of the participating companies. Copyright © 1991 by the University of Virginia
Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to
sales@dardenpublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a
spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or
otherwise—without the permission of the Darden School Foundation. Rev. 4/01.
This document is authorized for use only in Prof. N. Sivasankaran's Financial Management - II, (FM2B19-3), Term - III, BM 2019-21 at Xavier Labour Relations Institute (XLRI) from Dec 2019
to Mar 2020.
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In May 1988, Burlington Resources, another subsidiary of BNI, was spun off as an
independent corporation, and certain aspects of this spin-off were still having an effect on BNRR’s
financing decisions in 1990. Burlington Resources had contained the natural-resource operations of
BNI, including the exploration, development, and production of oil, gas, coal, and other minerals. It
also included the transportation and sale of natural gas, the sale of timber and logs, the manufacture
and sale of forest products, and the management and development of real estate.
In the Burlington Resources spin-off, BNI stockholders were distributed shares of

Burlington Resources, Inc., proportionate to their ownership of BNI.1 After the spin-off, BNI
stockholders held both their old BNI shares plus new Burlington Resources shares. Because the
BNI shares no longer represented a claim on the assets of Burlington Resources, the price of BNI
shares dropped in value as soon as the Burlington Resources shares were distributed. The total
wealth of BNI shareholders increased, however, because the loss in value of the BNI shares was
more than offset by the market value of the new Burlington Resources shares distributed.
The spin-off had a significant effect on BNI’s capital structure, because virtually no long-
term debt was transferred along with Burlington Resources’ assets. The act of removing
Burlington Resources’ assets and yet retaining the debt associated with those assets left BNI in
the position of being a highly levered company with long-term debt representing 76% of its total
capital in 1988. The company had publicly stated its intent of reducing the debt by $1 billion
during 1989-94 to keep its financial leverage within manageable limits. The combination of
heavy capital needs and a recent fall in BNRR’s revenue (see Exhibits 2 and 3 for financial data
on BNI) made the reduction of debt an ambitious undertaking.
Capital expenditures were projected at $550 million in 1990 and had been $465 million in
1989. For 1990, $325 million was being invested in roadwork (railway track, track bedding, and
track equipment), and the remaining $225 million was being spent on equipment (locomotives, rail
cars, auto racks, etc.). Despite these heavy investments, BNRR had managed to fund most of its
needs internally. The choices of external financing, however, were limited by the philosophy of
BNI management that the interest of BNI shareholders should be the overriding consideration with
every decision. Issuing new equity, for example, had been ruled out because railroads rarely went
to the equity markets and doing so might be interpreted negatively by the market place. Rather than
risk a fall in the stock price, management had decided that if new investments could not be funded
internally, they would either have to be funded with debt or be in the form of leases.
Norwest Equipment Finance
On December 31, 1989, Norwest Corporation, with $24.3 billion in assets, was one of the
largest regional bank holding companies in the United States. Despite the difficult times facing
1
A spin-off is a form of corporate divestiture in which a holding company distributes shares of one of its
subsidiaries to the holding company’s shareholders. Thus, a spin-off creates a new company by slicing off part of
the holding company.
to Mar 2020.
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many members of the banking industry, Norwest maintained a strong return on common equity
of 19.6% and, on December 1, 1990, had increased its quarterly dividend to $0.205 from $0.185,
the second increase for the year. The strong return on equity and increased dividends resulted in
a record-high stock price of $24.13 on a book value of $13.67/share. The premium over book
value reflected Norwest’s relatively low number of highly levered transactions and the
depressing effect that real estate loans were having on the market values of many other banks.
The proportion of nonperforming assets in Norwest was less than half that of the average
regional bank-holding company.
Norwest Equipment Finance, which specialized in leasing to corporations, was a wholly

owned subsidiary of Norwest Corporation. For more than 20 years, Norwest Equipment Finance
had leased equipment ranging from trucks to machine tools, computers, and railroad equipment
to some of the largest companies in the United States. BNRR had been leasing equipment
through Norwest for more than 15 years.
Leasing at BNRR
Leasing played an important role at BNRR because of the company’s tax status in 1990.
The 1986 Tax Reform Act required that corporations not only compute their taxes as they had in
the past, but also compute an alternative minimum tax (AMT). The AMT amount had to be paid
if it exceeded the tax liability computed by the regular method. The 20% tax rate for AMT was
much lower than the normal rate of 34%, but taxable income for AMT was computed much
differently and could be much higher than the regular taxable income.2
A likely candidate for AMT was a company that reported large amounts of tax-
preference items, which included depletion allowances, intangible drilling costs, and accelerated
depreciation of assets placed in service after 1986. Tax-preference items were deductible under
the regular tax method but were not allowable deductions when taxable income was computed
for AMT. The heavy demands for capital equipment in a railroad meant that BNRR carried a
great deal of equipment on its books, and as a result, the company incurred large accelerated-
depreciation expenses. The accelerated-depreciation expenses combined with other tax-
preference items had been sufficient to make BNI subject to the AMT in the past and into the
foreseeable future.
As long as BNI was subject to the AMT, the value of owning an asset would be reduced
because assets would have to be depreciated on a straight-line basis rather than on an accelerated
basis. As a lessee, however, the lease payments made by BNRR were deductible regardless of
whether the company was subject to AMT or not. Regarding BNRR’s use of leases, Weyandt
had recently stated:
2
For a more complete discussion of the AMT for corporations, see Handbook of Equipment Leasing by Richard
Contino, New York, AMACOM, 1989.
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For the most part, leasing is either credit motivated or tax motivated. Sometimes a
company will lease because it’s a relatively weak credit and wants to use the
lessor’s ability to borrow money at a lower rate. Burlington, however, is a good
credit. Our equipment-backed securities are rated Aa3 by Moody’s and A+ by
Standard & Poor’s, so even a AAA-rated lessor could not realize enough
advantage in the markets to make it worthwhile for us to lease through them.
Because of our current tax situation, on the other hand, we are in a position of
benefiting by leasing from a company that is not subject to AMT like we are. If a
company is paying the 34% tax rate, it can fully utilize the depreciation expenses
of an asset and then pass the depreciation benefits along to Burlington by leasing
us the asset. So right now, leasing is basically a tax play for Burlington Northern.3
The leasing terms proposed by Norwest for the auto racks had the added advantage for
BNRR of being an off-balance-sheet item. According to accounting principles, a lease had to be
classified as either an operating or a capital lease (see Exhibit 4). If a lease were capitalized, the
lessee had to report the value of the leased equipment as an asset and the value of the lease as a
liability. Assuming that the asset value and lease value were identical, capitalizing a lease was
equivalent to adding a 100%-debt-financed asset to the books, which would increase BNRR’s
debt-to-equity ratio. Operating leases, on the other hand, were reported in the footnotes of the
company’s annual reports but were not required to be reported on the company’s balance sheets.
To achieve the objective of decreasing its financial leverage, therefore, BNRR was careful to
make sure that all its new leases were classified as operating leases.
Two of the four criteria necessary to qualify as an operating lease were critical—the
economic-life test and the value test. The estimated life of the auto racks was approximately 22
years; thus, the 15-year lease was shorter than required by the economic-life test—75% of the
asset’s life. For purposes of the value test, Weyandt had computed the present value of the lease
payments by discounting them at BNRR’s cost of equipment-secured debt. His preliminary
calculations indicated that the value test was also satisfied, as the present value of the lease
payments was less than 90% of the auto racks’ current value.
Leasing the Auto Racks
Exhibit 5 illustrates the various methods of structuring a lease. In a direct lease, the
manufacturer either leased directly to the lessee or sold the asset to an intermediary who acted as
the lessor. In a sale-and-lease-back arrangement, the owner of an asset sold the asset to a lessor
and then leased it back. Like most large leasing deals, however, BNRR’s equipment lease would
be structured as a leveraged lease.
Typical of most leveraged leases, the auto-rack deal involved three parties: a lessee, an
equity-participant lessor, and a debt participant. The auto racks would be purchased from the
3
Casewriter interview, March 25, 1991.
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manufacturer by Norwest, who would act as the lessor and realize all the tax benefits of
ownership. The leverage aspect of the lease arose because Norwest would contribute only 20%
of the purchase price, with the remaining 80% being borrowed with either a public or private
debt offering. Because of the large amount of debt required and the relatively attractive rates in
the public market, it had been decided to issue public debt. To limit Norwest’s exposure in the
deal, however, the debt would be structured as a nonrecourse loan. Under such a loan, the
debtholders had a first lien on the auto racks and, in the event of default, could repossess the auto
racks directly from BNRR. The debtholders would not, however, have recourse to any other
assets held by either BNRR or Norwest. The debt would provide leverage for Norwest, therefore,
without being a general liability to the firm. From the debtholders’ perspective, the nonrecourse
debt would be virtually identical to an equipment-secured loan issued directly by BNRR.
The bankruptcy laws treated default on equipment-secured loans for railroads and airlines
differently from the way it treated default on identical loans in other industries. If a railroad was
forced into bankruptcy, the equipment-secured creditors had the right to repossess the pledged
asset directly without waiting more than 60 days for a judgment from the bankruptcy court. In
the case of a company in another industry, bankruptcy meant that the secured creditors would
receive the proceeds of the sale of their collateral, but only if the courts deemed liquidation to be
the appropriate action and only after protracted and costly legal proceedings. Thus, the special
treatment by the bankruptcy laws made equipment-secured loans less risky for railroads than for
other companies, and allowed railroads to pay much lower interest rates for secured borrowing
than for general credit. The nonrecourse loan arranged by BNRR for the auto racks gave the
lenders virtually the same rights they would have had if the bonds had been issued by BNRR as a
loan secured directly by the auto racks.
Morgan Stanley, an investment-banking firm retained by BNRR for the deal, had advised
that the $17.6 million, 15-year bond issue would be rated by the rating agencies as Aa3/A+ and
carry a rate of 9.81% with annual coupon payments and principal due at maturity. The notes
would be serviced by BNRR’s lease payments made to a trustee who would be obligated to make
the interest and principal payments on the debt before any excess rent, renewal, or purchase-
option payments could be distributed to Norwest. In the event that BNRR missed a lease
payment, Norwest could take one of several actions: keep the lease alive by making the missed
payment for BNRR, pay off the debtholders and keep the auto racks, or cut its losses by allowing
the debtholders to repossess the racks.
As part of the bidding process, Weyandt had informed the bidders what the terms of each
lease should be for each class of equipment. For example, the new locomotives were to be bid as
a 23-year lease and the auto racks were to be bid as a 15-year lease. The leases were to have
annual payments and allow BNRR to purchase the assets at a predefined price at the end of each
lease. According to FASB 13, an operating lease could not give the lessee the right to purchase
the asset at a bargain price (i.e., at substantially below its residual value, the fair market value of
the asset at the end of the lease [see the alternative-ownership test in Exhibit 4]). Typically,
industry practice was for the lessor to hire an independent appraiser and offer a purchase price to
the lessee of no less than the inflation-adjusted appraised residual value. Currently, the industry
to Mar 2020.
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was using a rate of 3.5% per annum to inflate the purchase price to future dollars. Thus, if an
asset worth $1 million were to be leased for 15 years and the appraised residual value equaled
25% of its current value, the lowest purchase price Norwest would offer was $0.42 million [0.25
× $1 million × (1+.035)15].
The estimate of the auto racks’ residual value played a significant role in how Norwest
and BNRR valued the lease. The lease gave BNRR the right to buy the auto racks at a predefined
purchase price, but neither Grossman nor Weyandt knew with any certainty what the market for
used auto racks would be in 15 years. The major determinants of the residual value would be
inflation and supply-and-demand forces. If inflation turned out to be higher than anticipated
during the term of the lease, the value of the auto racks would also be high (and vice versa). If
another railroad happened to go out of business close to the termination of the lease, a glut of
used auto racks on the market would keep the market price of auto racks low. New auto racks
being produced at significantly reduced prices or significantly higher quality would also exert
downward pressure on the price of used auto racks.
Grossman realized that the purchase price was a critical part of the lease. If the purchase
price ended up being higher than the market value of the auto racks at the end of the lease,
BNRR would simply decline to buy from Norwest unless the auto racks were offered at the
prevailing market price. On the other hand, if Grossman offered BNRR a purchase-option price
that was too low, BNRR would almost certainly end up buying the racks and Norwest’s yield on
the lease would suffer. The trick was to offer Weyandt an attractive purchase price that satisfied
the IRS’s interpretation of the alternative-ownership test and also kept enough of the upside
value of the asset to give Norwest a reasonable return on the lease.
For the auto racks, Norwest had bid a two-tier lease payment of $2.3 million for the first
seven years and $2.8 million for the last eight years. The 15 lease payments were to be made
annually beginning at the end of the first year. At the end of the lease, BNRR had the right to
purchase the auto racks for $9.2 million, 25% of $22.1 million inflated at 3.5% per year for 15 years.
Analyzing the Lease
The lease-versus-buy analysis required several assumptions. In particular, BNRR’s tax

status was critical to how it assessed the value of the lease. BNRR’s tax department had told
Weyandt that the company would, assuming that the tax laws were not changed in the interim, be
subject to AMT for at least the next 15 years. The auto racks would be depreciated on a straight-
line basis over 14 years (to a $0 salvage value) rather than an accelerated basis (Modified
Accelerated Cost Recovery System [MACRS] for 7-year property). See Exhibit 6 for MACRS
depreciation schedule. Leasing meant, of course, that BNRR would forfeit the right to depreciate
the asset altogether.
Another assumption critical to the analysis was the residual value of the auto racks.
Because of the fixed purchase price, a high residual value in 2005 increased the value of the lease
to Mar 2020.
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significantly. A low residual value in 2005 meant that the fixed purchase price would have no
value to BNRR. Because of the uncertainty associated with its estimation and its potential impact
on the overall decision, Weyandt had decided to compute the present value of the residual value
separately. If the overall value of the lease depended too much on his estimate of residual value, he
would have to reconsider whether he should recommend that BNRR lease the auto racks.
to Mar 2020.
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Exhibit 1
EQUIPMENT LEASING
Equipment Description
Equipment Type Market Value Description
New locomotives $19,600,000 Built by Electro-Motive Division, General Motors

Corporation - 3800 HP diesel electric locomotive.
Remanufactured
locomotives 47,740,000 Remanufactured by Morrison-Knudsen Company,
Inc., Electro-Motive Division, General Motors
Corporation, and VMV Enterprises, Inc.
Remanufactured locomotives met or exceeded the
performance standards and requirements for new
locomotives.
Auto racks 22,067,600 Bi-level and tri-level auto racks built by Trinity
Industries, Inc., and Thrall Car Manufacturing
Company. Completely enclosed structures used to
haul automobiles.
Box cars 7,680,000 Built by Gunderson Inc. 50.5-foot hi-cube box cars
with 8-foot double plug doors.
Gondolas 12,288,000 Built by Bethlehem Steel Corp. Aluminum-bodied

rotary coal gondolas, 4,400-cubic-foot capacity with
a maximum load of 120 tons of coal.
Covered hoppers 43,500,000 Built by Trinity Industries, Inc. Trough hatch-

covered hoppers designed for 4,750 cubic foot of
grain up to a maximum of 110 tons.
$152,875,600
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Exhibit 2
EQUIPMENT LEASING
BNI Income Statements, Bond, and Equity Data
Consolidated Income Statements, as of December 31 ($000)
1989 1988
Revenue $4,606,286 $4,699,517

Costs & expenses 3,949,750 4,020,617
Operating income 656,536 678,900
Interest expense on long-term debt (270,272) (292,050)

Other income (expense), net 4,397 (207,655)1
Income from continuing operations
before taxes 390,661 179,195
Provision for income taxes 147,670 80,493

Income from continuing operations 242,991 98,702
Income from discontinued operations

net of income taxes ------ 57,048
Net income $ 242,991 $ 155,750
_______________________
1
Includes litigation settlement of $175,000.
Bond Data as of July 9, 1990
Annual Maturity 52-Week

Rating Coupon Date High Low Current
Baa1 9 1996 102 97 100

Baa1 9 2016 95 88 90
Baa1 8 1996 98 95 97
Equity Data as of July 9, 1990
Shares common stock outstanding: 75,678,974

Share price: $37
Beta: Not a meaningful figure because of recent spin-off; 0.9 prior to spin-off.
to Mar 2020.
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Exhibit 3
EQUIPMENT LEASING
Consolidated Balance Sheets, as of Dec. 31 ($000)
Assets 1989 1988
Cash and equivalents $83,620 $ 82,627

Accounts receivable, net 685,018 430,355
Materials and supplies 157,954 133,286
Current portion of deferred income taxes 98,339 119,589
Other current assets 39,740 31,137
Total current assets $1,064,671 $ 796,994
Property and equipment
Road, roadway, and real estate $6,362,153 $6,566,015
Equipment 1,766,458 1,777,927
Total PP&E 8,128,611 8,343,942
Accumulated depreciation and amortization 3,050,349 3,189,410
Property and equipment, net 5,078,262 5,154,532
Other assets 187,401 196,254
Total assets $6,330,334 $6,147,780
Liabilities
Accounts payable $ 628,008 $ 645,077

Compensation and benefits payable 178,957 222,218
Accrued interest on long-term debt 96,972 77,375
Taxes payable 117,684 135,564
Other current liabilities 85,053 94,242
Current portion of long-term debt 112,083 113,490
Total current liabilities $1,218,757 $1,287,966
Long-term debt $2,722,625 $2,219,619
Other liabilities 270,702 268,721
Deferred income taxes 1,186,124 1,277,715
Total liabilities $5,398,208 $5,054,021
Preferred stock $ 14,101 $ 13,512

Common stock 992,405 967,528
Retained earnings (deficit) (20,624) 131,544
Cost of treasury stock (53,756) (18,825)
Net worth $ 932,126 $1,093,759
Total liabilities and net worth $6,330,334 $6,147,780
to Mar 2020.
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Exhibit 4
EQUIPMENT LEASING
Rules for Determining Operating vs. Capital Lease
According to the Financial Accounting Standards Board in Financial Accounting Standard No.
13, a lease must be capitalized if it meets any one of the following criteria:
1. Ownership test
The lessee automatically is transferred ownership of the asset by the end of the lease.
2. Alternative-ownership test
The lessee has the right to buy the asset at a price substantially below the fair market price.
3. Economic-life test
The lease term is greater than or equal to 75% of the estimated economic life of the asset.
4. Value test
The present value of the minimum lease payments is greater than or equal to 90% of the fair
market value of the asset at the time of the lease.
to Mar 2020.
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Exhibit 5
EQUIPMENT LEASING
Lease Structures
1. Direct Lease
Sale of
Lease Asset
Lessee Lessor Manufacturer
2. Sale and Lease Back
Sale of Asset
Lessee Lessor
Lease
3. Leveraged Lease
Manufacturer
(Trinity Industries and
Thrall Car Manufacturing)
Sale of Asset
Lease Lessor Lien on Asset

Lessee
Equity Investor Lender
BNRR Nonrecourse Debt
(Norwest)
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Exhibit 6
EQUIPMENT LEASING
MACRS Seven-Year Property-Depreciation Schedule1
Tax MACRS Beginning

Year Schedule Tax Basis
1 0.1429 1.0000
2 0.2449 0.8571
3 0.1749 0.6122
4 0.1249 0.4373
5 0.0893 0.3124
6 0.0892 0.2231
7 0.0893 0.1339
8 0.0446 0.0446
________________
1
Because of the half-year convention, seven-year MACRS involves eight years of depreciation expenses.
to Mar 2020.

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UV0245

BURLINGTON NORTHERN RAILROAD COMPANY:

On July 9, 1990, Paul Weyandt, the director of Equipment Finance at Burlington

Burlington Northern Railroad Company

In 1990, Burlington Northern Railroad Company was the primary subsidiary of

In the Burlington Resources spin-off, BNI stockholders were distributed shares of

Norwest Equipment Finance

Norwest Equipment Finance, which specialized in leasing to corporations, was a wholly

Leasing the Auto Racks

Analyzing the Lease

The lease-versus-buy analysis required several assumptions. In particular, BNRR’s tax

Equipment Type Market Value Description

New locomotives $19,600,000 Built by Electro-Motive Division, General Motors

Gondolas 12,288,000 Built by Bethlehem Steel Corp. Aluminum-bodied

Covered hoppers 43,500,000 Built by Trinity Industries, Inc. Trough hatch-

Revenue $4,606,286 $4,699,517

Interest expense on long-term debt (270,272) (292,050)

Provision for income taxes 147,670 80,493

Income from discontinued operations

Bond Data as of July 9, 1990

Annual Maturity 52-Week

Baa1 9 1996 102 97 100

Equity Data as of July 9, 1990

Shares common stock outstanding: 75,678,974

Assets 1989 1988

Cash and equivalents $83,620 $ 82,627

Accounts payable $ 628,008 $ 645,077

Preferred stock $ 14,101 $ 13,512

2. Sale and Lease Back

Lease Lessor Lien on Asset

Tax MACRS Beginning

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