This Study Resource Was: Eastside Communications, Inc

Eastside Communications, Inc.
Page 1 of 6
Eastside Communications, Inc.

In June, 1984, the management of Eastside Communications, Inc. decided to acquire $10 million in new
broadcasting equipment for one of its television stations. Various means of financing this acquisition had
been considered during the past several months. Mr. Jonathan Stone, vice president of finance of
Eastside had narrowed the financing decision to two alternatives: (1) a seven-year lease proposed by the
manufacturer of the equipment to be acquired, Audionics Corporation, or (2) a seven-year term loan for
$10 million from a major insurance company. Mr. Stone knew that a final choice, between these two
alternatives would have to be made within a matter of days.
Eastside Communications and the broadcasting industry
Prior to 1970, Eastside Communications was a privately-held business engaged in magazine publishing
and distribution. The corporation raised external equity capital in 1970 with an initial public issue of
common stock. In 1971, Eastside purchased its first radio station and embarked on a program of
investment in the broadcasting industry. A second radio station was acquired in 1973, and in the period
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1973-76 both stations produced operating losses.
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As a result of management changes and significant promotional work, the two radio stations were
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profitable in every year of the period 1977-73. Several additional radio and television stations were
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purchased in the late 1970's and early 1980's, and by 1983 operating revenues from broadcasting had
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grown to $90.7 million, representing 28 % of Eastside's total operating revenues of $340.6 million. A five-
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year summary of income statements is shown in Exhibit 1, and balance sheets for 1981-83 are
summarized in Exhibit 2.
Eastside ranked in the "second tier" of the broadcasting industry in terms of total broadcasting revenues,
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as the company was significantly smaller than the ten major broadcasters in the United States. The
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largest independent companies in the radio and television broadcasting industry were Columbia
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Broadcasting Systems, Inc. (sales revenues of $1.5 billion) and American Broadcasting Companies, Inc.
($880 million).
Early in 1984, observers of the broadcasting industry noted widespread Wall Street pessimism about
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rising operating costs (reflecting an 8% increase in costs reported for 1983) with only modest increases in
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total advertising revenues. One prominent New York Stock Exchange member firm anticipated that
advertising revenues to broadcasters would grow at only 3% to 5% in 1984, down from a 9% increase in
1983. Under these industry conditions the price of the common stock of most major broadcasters had
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dropped 50% from the market highs of 1983, and Eastside's stock price had declined from its 1983 peak
of $31 a share to around $10 by mid-1984. In the light of this development the management of Eastside
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had ruled out a new issue of common stock as a source of financing capital expenditures so long as the
price of the company's common stock remained depressed.
The lease proposal

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The seven-year lease under consideration had been proposed by the manufacturer of the new
equipment to be acquired, Audionics Corporation, Audionics Corporation was a leading manufacturer of
audio and video broadcasting equipment with total sales of several hundred million dollars. Audionics
had recently organized a new financial subsidiary, Audionics Finance Corporation (AFC), whose purpose
was to extend lease financing to customers interested in acquiring Audionics equipment. AFC
customarily retained new leases in its portfolio, but it reserved the right to place some of its leases with
The information in this case is disguised. However, the financial data of this company / industry represents an accurate approximation. December 29, 2019
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Eastside Communications, Inc. Page 2 of 6
third-party institutions.
The principal terms of the seven-year lease proposed to Eastside, by Audionics to cover the acquisition
of the $10 million of Audionics equipment were as follows:
1. Annual lease payment for duration of lease. Eastside would be obligated to pay AFC seven equal
annual lease payments of $1,666,084 a year, payments to be made at the end of each year. 1
2. Maintenance, taxes, and insurance. All payments for maintenance of the equipment and any
taxes and assessments thereon would be the responsibility of Eastside and they would also be
obligated to carry a specified level of insurance on the equipment. (Mr. Stone estimated that
Eastside's outlays for these purposes would be the same whether the equipment was leased or
purchased.)
The annual lease payments quoted by AFC were, computed so as to amortize the full $10 million sales
price of the equipment over the seven-year period at an implicit interest rate of 4%. At the end of the
seven-year period ownership of the equipment would, of course, reside in the hands of AFC. If Eastside
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desired to continue to use the equipment beyond the expiration of the lease, it would have to negotiate
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renewal of the lease or a purchase of the equipment from AFC as of the expiration of the lease in 1991.
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The loan proposal
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The only practical alternative to the lease proposal was for Eastside to buy the new equipment outright
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from Audionics and to finance it from available funds or by new borrowing. Since all of Eastside's internal
funds were fully committed to projects previously undertaken, a decision to purchase the $10 million of
equipment from Audionics would necessitate a new loan of $10 million. After investigating a number of
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loan possibilities Mr. Stone had decided that a seven-year term loan from a major insurance company
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was the most attractive source of additional debt available to Eastside.

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The provisions of this loan were straightforward. Interest on the loan would be set at a rate of 12% on
the outstanding balance of the loan for the duration of the loan. Repayments of principal would be made
in equal annual, installments at the rate of $??????? a year, the payments to be made on each
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anniversary date of the loan. The loan proposal contained standard covenants on the usual subjects such
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as the maintenance of a required minimum level of working capital, incurrence of additional

indebtedness, and repurchases of stock. All such provisions were regarded as reasonable by Mr. Stone.
Additional considerations relevant to lease versus buy-borrow decision

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One of the considerations important in the decision as to whether to lease, or buy the Audionic
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equipment was the tax consequences of the two transactions. Mr. Stone had been advised by his tax
counsel that under the lease proposal "the full amount of the annual lease payments would be
deductible for income tax purposes as rental payments. In the event the asset was purchased the tax
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consequences would be as follows: (1) the full $10 million purchase price could be depreciated on an
accelerated basis over an eight-year life. Under the sum of the year’s digits method the depreciation
allowances to which Eastside would be entitled would be:
1 1
Actually, most leases? Provide for monthly or quarterly rental payments, with pay ments due at the
beginning of the period. The terms as here stated have been modified to simplify the analysis of t h e case.
Year Allowable Depreciation

1 $ 2,222,220
2 1,944,440
3 1,666,670
4 1,388,890
5 1,111,110
6 833,330
7 555,560
8 277,780
In addition, under the purchase alternative the interest payments on the term loan obtained to finance
the purchase would be deductible.
A second consideration involved in the decision was whether the equipment would have continued
usefulness to Eastside at the end of the seven-year lease period, either for use within the company or for
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resale purposes. Mr. Stone estimated that under normal conditions the Audionics equipment package
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would be worth $2,000,000 or 20% of its initial value, at the end of seven years, even though the
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equipment would be fully depreciated by the end of the eighth year. Mr. Stone recognized, however, that
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technological developments might render the equipment obsolete sooner than he anticipated. On the
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other hand, a sustained rapid rate of inflation over the next seven years might mean that the dollar value
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of the equipment at the end of seven years would substantially exceed Mr. Stone's estimate of
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$2,000,000.
A third consideration that troubled Mr. Stone was the appropriate discount rate or discount rates to use
in comparing the cash flows involved in the lease versus the buy-borrow alternatives. Mr. Stone had
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asked his assistant, Mr. Young, a recent MBA graduate, to prepare a memorandum for him discussing this
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issue. Mr. Young's memorandum, which is reproduced as Exhibit 3, did not fully resolve Mr. Stone's
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uncertainty on this point.
The decision
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In order to obtain a better feel for the merits of the two alternatives Mr. Stone gave Mr. Young another
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assignment. First, he requested Mr. Young to lay out precisely the cash flows involved under the two
alternatives. Where uncertainties were involved, such as the residual value of the equipment at the end
of the seven years, Mr. Stone asked Mr. Young to prepare multiple estimates that would bracket the
reasonable range of probable outcomes. Finally, Mr. Stone asked Mr. Young to compute the present
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value of the lease versus the buy-borrow alternative over the range of discount rates that might
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conceivably be justified on the basis of his memorandum (Exhibit 3). Mr. Stone hoped that this additional
information would resolve the uncertainty regarding the relative attractiveness of the two alternatives.
In any event, he knew that he had to make a firm decision on the appropriate method of financing within
the next two or three days.
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Exhibit 1
EASTSIDE COMMUNICATIONS, INC
Income Statements for Years ending December 31, 1979-83
(In million except for per share data)
1979 1980 1981 1982 1983

Newspaper operating revenues.................. $106 $ 171 $182 $197 $221
Broadcasting operating revenues................ 68 71 74 78 97
Other operating revenues........................... 2 15 23 26 28
Total operating revenues............................. 176 257 $279 301 $346
Operating expenses.................................... 123 178 195 209 239
Depreciation............................................... 7 11 11 12 14
Interest expense.......................................... - 13 12 5 3
Other income.............................................. 1 3 1 1 -
Net income before tax................................ $47 59 $62 76 90
Provision for income taxes.......................... 26 32 32 37 43
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Net income after tax................................... 21 27 30 $39 $47
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Earnings per share (in dollars) $ 57 $ 67 $ 73 $ 89 $ 106
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Note: Figures may not add because of
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rounding
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Exhibit 2
EASTSIDE COMMUNICATIONS, INC.
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BALANCE SHEETS AS OF DECEMBER 31, 1981-83

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(In millions)
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............................................................................... 1981 1982 1983

ASSETS
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Cash and marketable securities.............................. $ 27 $ 21 $ 20

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Accounts receivable............................................... 27 28 36
Inventories.............................................................. 5 5 04
Other current assets............................................... 5 4 06
Total current assets................................................ $ 63 $ 58 $ 67
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Land and land improvements................................. 11 11 18

Buildings................................................................. 67 70 89
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Equipment and fixtures.......................................... 129 137 175

$ 207 $ 218 $ 282
Less: Accumulated depreciation............................. 94 101 111
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Net fixed assets...................................................... $113 $117 $171

Intangible assets..................................................... 166 166 187
Other assets........................................................... 10 10 13
Total assets............................................................. $353 $350 $438
LIABILITIES
Long-term debt due within one year...................... $ 12 $ 12 $ 13

Accounts payable................................................... 7 9 8
Dividends payable on common stock..................... -- -- 3
Accrued income taxes............................................ 9 10 5
Film contracts, payments due in one year.............. 1 2 4
Accrued expenses and other current liabilities...... 0.9 10 11
Total current liabilities............................................ $ 39 $ 43 $44
Long-term debt...................................................... 110 35 78
Film contracts, payments due after one year......... 0.1 1 6
Deferred income taxes........................................... 5 5 8
Total liabilities-....................................................... $154 $84 $135
Convertible cumulative preferred stock................. 91 85 --
Net common equity............................................... 108 181 302
Total liabilities and net worth................................. $353 $350 $438
Note: Figures may not add because of rounding.
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Exhibit 3
EASTSIDE COMMUNICATIONS, INC.
MEMORANDUM June 15, 1984
TO: Mr. Stone
FROM: Mr. Young
SUBJECT: Discount Rate to Use in Computing Present Values in Lease versus Buy-Borrow Decisions
There seems to be a big difference of opinion these days about the right discount rate to use in
computing present values in lease versus buy-borrow decisions. As you know, we have always used
Eastside's (weighted average} cost of capital in all discounted cash flow calculations, in the interests of
consistency. Our target debt ratio is 0.30 (long-term debt to total long-term capital), and in 1983 we
were comfortably below that figure (0.23).
Under the term-loan alternative, with a 12% interest rate, the cost of debt to us currently would be
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about 6% on an after-tax basis. The cost of equity capital represents one number on which we have
never had total agreement. The fundamental point is that this figure should reflect the basic business
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and financial risk of the company. Nearly everyone would agree that the broadcasting industry is subject
to above-average risk—a look at our current stock price versus the high of last year will confirm that
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assessment. We assume the average public corporation in this country has a cost of equity of about 12%.
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Adding a 3% margin for additional risk would place our cost of equity in the area of 15%. Under current
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conditions in the capital markets even these figures may be too low.
At a level of abstraction commonly found in academic finance journals, it seems to make sense to
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discount each item of cash flow in a project at a rate commensurate with its risk. The problem, is that
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any one project has many individual components of cash How, all more or less risky, so that some degree
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of aggregation must be used in practice. The traditional approach has been to apply a single rate to the
whole company as a "risk class" as well. At a practical level, we have to decide whether to apply one rate,
our (weighted average) cost of capital, in all discounted cash flow calculations, or to use a higher or
lower rate depending on some judgment of the risk of future cash flows in each, specific instance in
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Eastside.
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A case can be made for discounting lease payments at a rate lower than our cost of capital, on grounds
that the payments are legal commitments that we certainly intend to honor. In this sense a lease
payment is very similar to a loan payment. Both are legal obligations which can be treated as virtually
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certain over the term of the lease or loan. On the other hand, our estimates of residual equipment
values are subject to all the obvious uncertainties concerning the state of new technology, new
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competing products, and demand for used audio/video broadcasting equipment. The argument for
discounting everything at our cost of capital is based on simplicity. It has the great virtue of being
workable and understandable, although it seems to be less elegant from a conceptual standpoint than
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applying different rates to different cash flows of different risk.
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Eastside Communications, Inc.

Eastside Communications, Inc.

Eastside Communications and the broadcasting industry

The lease proposal

was the most attractive source of additional debt available to Eastside.

as the maintenance of a required minimum level of working capital, incurrence of additional

Additional considerations relevant to lease versus buy-borrow decision

Year Allowable Depreciation

uncertainty on this point.

1979 1980 1981 1982 1983

BALANCE SHEETS AS OF DECEMBER 31, 1981-83

............................................................................... 1981 1982 1983

Cash and marketable securities.............................. $ 27 $ 21 $ 20

Land and land improvements................................. 11 11 18

Equipment and fixtures.......................................... 129 137 175

Net fixed assets...................................................... $113 $117 $171

Long-term debt due within one year...................... $ 12 $ 12 $ 13

Note: Figures may not add because of rounding.

TO: Mr. Stone

FROM: Mr. Young

applying different rates to different cash flows of different risk.

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