Lease or Buy Before a Covenant Test
Midori Seiki is a third-generation precision-parts maker with revenue of ¥2.4 billion, EBITDA of ¥240 million, and net debt of ¥660 million. Its main bank covenant requires net debt/EBITDA no higher than 3.0x, tested annually. The firm needs a ¥300 million five-axis machining center to retain a Tier-1 automotive contract. The bank offers a five-year debt facility at 4.5%, principal repaid straight-line, or a five-year lease with annual payments of ¥72 million at the end of each year. The CFO prefers the lease because “it keeps debt off the balance sheet and protects the covenant.” Under the applicable lease standard, the lease liability would be recognized at ¥310 million, and annual lease expense would be replaced by depreciation and interest. The EBITDA impact is a ¥72 million increase because rent is added back; depreciation would be ¥62 million and interest about ¥15 million in year one. The company also has ¥80 million of cash, of which ¥50 million is needed for working capital.
1. Calculate the covenant ratio under lease capitalization and under debt purchase. Explain why the CFO’s reasoning is partly wrong and which structure is financially preferable.
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Lease case. The lease is capitalized, so net debt = ¥660m existing net debt + ¥310m lease liability = ¥970m. EBITDA = ¥240m + ¥72m rent add-back = ¥312m. Net debt/EBITDA = 970 ÷ 312 = 3.11x, a breach of the 3.0x covenant. Using the ¥30m of excess cash would reduce net debt to ¥940m and the ratio to 3.01x-still effectively at the limit.
Purchase case. New debt is ¥300m, so net debt = ¥660m + ¥300m = ¥960m. EBITDA remains ¥240m because interest and depreciation are below EBITDA. Ratio = 960 ÷ 240 = 4.00x, a clear breach.
CFO error. The lease does not stay off the balance sheet; the lease liability is recognized. The CFO is accidentally right that the lease produces a better covenant ratio, but for the wrong reason: the improvement comes from the EBITDA add-back of rent, not from non-recognition of debt. The lease also preserves cash and flexibility, while purchase gives ownership and potential residual value.
Preference. The lease is preferable, but it still breaches the covenant. Midori needs about ¥35m of equity or subordinated debt: (970 − 35) ÷ 312 = 3.00x. Alternatively, it must obtain a covenant reset before signing.
2. Recommend a financing and negotiation plan. Include the order of actions, the minimum covenant headroom you would accept, and what to do if the bank refuses a waiver.
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Order of actions. First, do not draw the lease or debt until the covenant position is agreed in writing. Second, prepare a 13-week cash flow and a downside case showing EBITDA at ¥280m rather than ¥312m. Third, ask the bank for a 12-month covenant reset to 3.25x with a step-down to 3.0x, plus a waiver for the current test date. Fourth, inject ¥35m–¥50m of equity or subordinated shareholder debt to create headroom. Fifth, sign the lease only after the waiver and the customer contract are effective.
Minimum headroom. I would accept no less than 0.15x–0.20x headroom against the reset covenant, because the EBITDA add-back depends on the lease being classified as a lease and on the machine running at planned hours. A ratio exactly at 3.00x leaves no room for a demand dip.
If the bank refuses. Reduce the machine specification or phase the investment; seek vendor financing or a sale-and-leaseback of unencumbered property; bring in a co-investor; or renegotiate the customer contract for progress payments. Replacing the bank is a last resort because it signals distress and may accelerate other covenants.
3. What qualitative factors could make outright purchase preferable despite the covenant math?
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Purchase may be preferable if the machine is core to process know-how and Midori needs unrestricted rights to modify it; if residual value is likely to be strong and the company can sell it without lessor consent; if the lease contains restrictive maintenance, insurance, or return conditions; if tax depreciation and interest deductibility produce a better after-tax result; or if the company expects to refinance at a lower rate within two years. Purchase also avoids lease-disclosure complexity and gives cleaner collateral for future secured borrowing. These factors should be weighed against the higher covenant breach risk and the cash outflow.