Our analysis of the costs of chartering and purchasing the TAKX ships is based on the prices, structures and tax effects reflected in the proposals selected by the Navy. Each such offer (as well as all of the offers not selected) proposed to charter the vessels to the Navy under a leveraged lease arrangement. This method is used commercially in many industries to finance large assets without capital investment by the user, at rates that are, because of the tax benefits of ownership accruing to the lessor, attractive by comparison with conventional financing rates.

The cost to the Navy of a lease, or charter, of a vessel will be the stream of rental payments made over the 25-year charter term; the cost of purchase is simply the acquisition price that would be payable for the vessel on its delivery date. To provide a means of comparing these two costs, a present value analysis was used to discount the rentals back to a single value as of the delivery date. The 10% discount rate stipulated by the Office of Management and Budget was used initially for this purpose, but the analysis was also performed using a range of discount rates.

This present value analysis was applied, employing a computer model, to a base case representing capital costs, rental payment rates, interest rate on debt, rate of return on equity and other factors derived from the selected offers and considered commercially reasonable under present economic conditions and tax laws.

The Base Case analysis (using the 10% discount rate) demonstrates that the cost to the Navy of chartering would be $140.56 million per vessel, compared to a purchase cost of $184.01 million. This advantage increases as the discount rate increases, and declines at lower discount rates.

The analysis was then expanded to examine the total cost of the charter program to the Government as a whole. While the cost to the Navy, as stated above, is the aggregate rental payments under the charter, the total cost to the Government can be viewed as the sum of those payments and the net effect on Treasury tax revenues resulting from the tax outflows and inflows generated by the lease transaction. Using the same Base Case assumptions (and the 10% discount rate), but taking into account the net Treasury revenue effect, the cost of chartering is $157.33 million, compared again to a purchase cost of $184.01 million.

Such an analysis, of course, assumes that the taxes payable by the potential investors in a TAKX charter would not otherwise be sheltered, which is a doubtful proposition. It can fairly be expected that the private sector lease financing sources would find alternative transactions producing tax benefits. Given that likelihood, the Treasury tax revenue effects cannot reasonably be considered as a cost of the TAKX program.

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Nevertheless, even on the hypothetical Total Government cost basis, chartering the vessels represents a significant savings over purchase. The advantage to the Government, just as in the Navy only case, varies with the discount rate.

Table 1, on the following page, summarizes the present value analysis described above.

2. METHOD OF ANALYSIS

Leveraged Lease. Each of the TAKX offers submitted to the Navy proposed a charter of the vessels under a lever-. aged lease structure. A typical commercial leveraged lease ship financing involves three basic parties -- the lessee, the lessor and the lender. The lessee, or charterer, is the user of the vessel, e.g., a ship operating company. The lessor, frequently a bank or finance company, is the passive owner of the vessel, who typically invests 20-50% of the capital cost as equity. The lender provides loans for the remaining 50-80% of the vessel cost.**

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In the TAKX program (as in similar commercial transactions), the Navy, as charterer, desires to obtain the services to be performed by the vessel and to contract with a third party for its operation. The operator becomes an intermediate lessee in the leveraged lease structure. The vessel is "bareboat chartered from the owner-lessor the operator who in turn "time" charters the vessel to the Navy. The rent payable by the Navy is divided into two components: capital hire, which repays (with interest or a return) the equity and debt financing provided by the lessor and the lender, and operating hire, which compensates the operator for the services rendered.***

The lessor's return on a leveraged lease investment is derived both from a portion of the rental payments and from the tax benefits available to it as owner: depreciation, investment credit, and interest deductions, A lessor can thus offer low-cost financing by passing through the effect of most of these tax benefits, in the form of reduced rental payments, to a lessee who might not be (as the Navy is not) itself in a position to take advantage of the tax

These leases would be guideline leveraged leases, governed by IRS regulations entirely separate from the safe harbor leases created by the Economic Recovery Tax Act of 1981.

In a large transaction there may be multiple lessors and lenders, in each case represented by a trustee.

For purposes of this analysis, only the cash flows associated with the financing of the vessels are relevant; thus operating hire, which would be payable by the Navy in either the charter or the purchase alternative, is not addressed further.

benefits. The lease arrangement can be viewed as a loan that bears an effective interest rate significantly lower than the rate which would be charged in a conventional, non-tax-oriented financing. In fact, in the Base Case analysis that follows, the effective interest rate of the Navy capital hire payments is 7.00% per annum -below the 13% assumed long term debt rate.

6.00%

Leasing also provides a hedge against inflation because, in an inflationary economy, future rents for assets acquired through a lease based on today's prices will be paid in inflated dollars. (This benefit, of course, is available in any long-term, fixed rate financing.) Leases also provide flexibility, within certain parameters, with respect to rental payment schedules. This flexibility can be used to maximize the value of a lease in an inflationary economy by scheduling payments so that more of the rentals are paid later in inflated dollars.

Basic Assumptions. In order to perform the charter versus purchase comparison, three basic financial parameters were required: the capitalized cost of the vessel (i.e., the amount to be financed by the lessor's equity and the lender's debt investments); the capital hire (or rental) rates; and the cost to purchase the vessel.

Each of the proposals considered by the Navy specified the amount of capitalized costs for each vessel offered. The capitalized cost of the vessel used in this analysis represents the average of the amounts⭑ set forth in the proposals for the 13 selected vessels; this average is $184.01 million per vessel.

In the RFP, the Navy also requested the offerors to submit firm capital hire rate commitments from equity financing sources. Given the current tax legislation uncertainty and the long lead time until delivery of the vessels, the RFP anticipated that firm commitments at this time were unlikely and provided alternate mechanisms for subsequent competitive equity placement. As expected, none of the proposals contained fully acceptable firm commitments for the equity financing; in each case one of the alternate mechanisms will be used.

Consequently, for purposes of this analysis, a capital hire rate schedule was constructed, based on current market rates for near-term deliveries and supported by the estimated rates quoted in the selected proposals. The rates are a function of the lessor's rate of return and the interest rate on the long-term debt, among other items. The analysis uses an equity rate of return of 23%, which is reflected in the proposals and represents a competitive current market level for such transactions. The long-term debt rate was assumed to be 138, which is likewise realistic, given the Government credit underlying the

Adjusted to reflect the 14.5% prime interest rate prevailing on the date of award rather than the 16.5% rate specified by the Navy in the RFP for computation of construction period interest.