Term Loans and Leases

1
Chapter 21

• Term Loans and Leases

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After Studying Chapter 21, you should be able to

1. Describe various types of term loans and discuss
   the costs and benefits of each.
2. Discuss the nature and the content of loan
   agreements, including protective (restrictive)
   covenants.
3. Discuss the sources and types of equipment
   financing.
4. Understand and explain lease financing in its
   various forms.
5. Compare lease financing with debt financing via a
   numerical evaluation of the present value of cash
   outflows.

3
Term Loans and Leases

• Term Loans
• Provisions of Loan Agreements
• Equipment Financing
• Lease Financing
• Evaluating Lease Financing in Relation to Debt
  Financing

4
Term Loans
Term Loan Debt originally scheduled for
repayment in more than 1 year, but generally in
less than 10 years.

• Credit is extended under a formal loan
  arrangement.
• Usually payments that cover both interest and
  principal are made quarterly, semiannually, or
  annually.
• The repayment schedule is geared to the
  borrowers cash-flow ability and may be amortized
  or have a balloon payment.

5
Costs of a Term Loan

• The interest rate is higher than on a short-term
  loan to the same borrower (25 to 50 basis points
  on a low risk borrower).
• Interest rates are either (1) fixed or (2)
  variable depending on changing market conditions
  possibly with a floor or ceiling.
• Borrower is also required to pay legal expenses
  (loan agreement) and a commitment fee (25 to 75
  basis points) may be imposed on the unused
  portion.

6
Benefits of a Term Loan

• The borrower can tailor a loan to their specific
  needs through direct negotiation with the lender.
• Flexibility in terms of changing needs allows the
  borrower to revise the loan more quickly and more
  easily.
• Term loan financing is more readily available
  over time making it a more dependable source of
  financing than, say, the capital markets.

7
Revolving Credit Agreements
Revolving Credit Agreement A formal, legal
commitment to extend credit up to some maximum
amount over a stated period of time.

• Agreements are frequently for three years.
• The actual notes are usually 90 days, but the
  company can renew them per the agreement.
• Most useful when funding needs are uncertain.
• Many are set up so at maturity the borrower has
  the option of converting into a term loan.

8
Insurance Company Term Loans

• These term loans usually have final maturities in
  excess of seven years.
• These companies do not have compensating balances
  to generate additional revenue and usually have a
  prepayment penalty.
• Loans must yield a return commensurate with the
  risks and costs involved in making the loan.
• As such, the rate is typically higher than what a
  bank would charge, but the term is longer.

9
Medium-Term Note
Medium-Term Note (MTN) A corporate or
government debt instrument that is offered to
investors on a continuous basis.

• Maturities range from 9 months to 30 years (or
  more).
• Shelf registration makes it practical for
  corporate issuers to offer small amounts of MTNs
  to the public.
• Issuers include finance companies, banks or bank
  holding companies, and industrial companies.

Euro MTN An MTN issue sold internationally
outside the country in whose currency the MTN is
denominated.
10
Provisions of Loan Agreements
Loan Agreement A legal agreement specifying the
terms of a loan and the obligations of the
borrower.

• Covenant A restriction on a borrower imposed by
  a lender for example, the borrower must maintain
  a minimum amount of working capital.
• This allows the lender to act (or be warned
  early) when adverse developments are occurring
  that will affect the borrowing firm.

11
Formulation of Provisions
The important protective covenants fall into
three different categories.

• General provisions are used in most loan
  agreements, which are usually variable to fit the
  situation.
• Routine provisions used in most loan agreements,
  which are usually not variable.
• Specific provisions that are used according to
  the situation.

Restrictions are negotiated between the
borrower and lender
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Frequent General Provisions

• Working capital requirement
• Cash dividend and repurchase of common stock
  restriction
• Capital expenditures limitation
• Limitation on other indebtedness

13
Frequent Routine Provisions

• Furnish financial statements and maintain
  adequate insurance to the lender
• Must not sell a significant portion of its assets
  and pay all liabilities as required
• Negative pledge clause
• Cannot sell or discount accounts receivable
• Prohibited from entering into any leasing
  arrangement of property
• Restrictions on other contingent liabilities

14
Equipment Financing

• Loans are usually extended for more than 1 year.
• The lender evaluates the marketability and
  quality of equipment to determine the loanable
  percentage.
• Repayment schedules are designed by the lender so
  that the market value is expected to exceed the
  loan balance by a given safety margin.
• Trucking equipment is highly marketable, and the
  lender may advance as much as 80 of market
  value, while a limited use lathe might provide
  only a 40 advance or a specific use item cannot
  be used as collateral.

15
Sources and Types of Equipment Financing
Sources of financing are commercial banks,
finance companies, and sellers of
equipment. Types of financing

• 1. Chattel Mortgage A lien on specifically
  identified personal property (assets other than
  real estate) backing a loan.
• To perfect (make legally valid) the lien, the
  lender files a copy of the security agreement or
  a financing statement with a public office of the
  state in which the equipment is located.

16
Sources and Types of Equipment Financing
2. Conditional Sales Contract A means of
financing provided by the seller of equipment,
who holds title to it until the financing is paid
off.

• The buyer signs a conditional sales contract
  security agreement to make installment payments
  (usually monthly or quarterly) over time.
• The seller has the authority to repossess the
  equipment if the buyer does not meet all of the
  terms of the contract.
• The seller can sell the contract without the
  buyers consent usually to a finance company or
  bank.

17
Lease Financing
Lease A contract under which one party, the
lessor (owner) of an asset, agrees to grant the
use of that asset to another, the lessee, in
exchange for periodic rental payments.

• Examples of familiar leases
• Apartments Houses
• Offices Automobiles

18
Issues in Lease Financing

• Advantage Use of an asset without purchasing the
  asset
• Obligation Make periodic lease payments
• Contract specifies who maintains the asset
• Full-service lease lessor pays maintenance
• Net lease lessee pays maintenance costs
• Cancelable or noncancelable lease?
• Operating lease (short-term, cancellable) vs.
  financial lease (longer-term, noncancelable)
• Options at expiration to lessee

19
Types of Leasing
Sale and Leaseback The sale of an asset with
the agreement to immediately lease it back for an
extended period of time.

• The lessor realizes any residual value.
• There may be a tax advantage as land is not
  depreciable, but the entire lease payment is a
  deductible expense.
• Lessors insurance companies, institutional
  investors, finance companies, and independent
  companies.

20
Types of Leasing
Direct Leasing Under direct leasing a firm
acquires the use of an asset it did not
previously own.

• The firm often leases an asset directly from a
  manufacturer (e.g., IBM leases computers and
  Xerox leases copiers).
• Lessors manufacturers, finance companies, banks,
  independent leasing companies, special-purpose
  leasing companies, and partnerships.

21
Types of Leasing
Leverage Leasing A lease arrangement in which
the lessor provides an equity portion (usually 20
to 40 percent) of the leased assets cost and
third-party lenders provide the balance of the
financing.

• Popular for big-ticket assets such as aircraft,
  oil rigs, and railway equipment.
• The role of the lessor changes as the lessor is
  borrowing funds itself to finance the lease for
  the lessee (hence, leveraged lease).
• Any residual value belongs to the lessor as well
  as any net cash inflows during the lease.

22
Accounting and Tax Treatment of Leases

• In the past, leases were off-balance-sheet
  items and hid the true obligations of some firms.
• The lessee can deduct the full lease payment in a
  properly structured lease. To be a true lease
  the IRS requires
• Lessor must have a minimum at-risk (inception
  and throughout lease) of 20 or more of the
  acquisition cost.
• The remaining life of the asset at the end of the
  lease period must be the longer of 1 year or 20
  of original estimated asset life.
• An expected profit to the lessor from the lease
  contract apart from any tax benefits.

23
Economic Rationale for Leasing

• Leasing allows higher-income taxable companies to
  own equipment (lessor) and take accelerated
  depreciation, while a marginally profitable
  company (lessee) would prefer the advantages
  afforded by leases.
• Thus, leases provide a means of shifting tax
  benefits to companies that can fully utilize
  those benefits.
• Other non-tax issues economies of scale in the
  purchase of assets different estimates of asset
  life, salvage value, or the opportunity cost of
  funds and the lessors expertise in equipment
  selection and maintenance.

24
Should I Lease or Should I Buy?
Analyze cash flows and determine which
alternative has the lowest (present value) cost
to the firm. Example

• Basket Wonders (BW) is deciding between leasing a
  new machine or purchasing the machine outright.
• The equipment, which manufactures Easter baskets,
  costs 74,000 and can be leased over seven years
  with payments being made at the beginning of each
  year.

25
Should I Lease or Should I Buy?

• The lessor calculates the lease payments based on
  an expected return of 11 over the seven years.
  (Ignore possible residual value of equipment to
  lessor.)
• The lease is a net lease.
• The firm is in the 40 marginal tax bracket.
• If bought, the equipment is expected to have a
  final salvage value of 7,500.

26
Should I Lease or Should I Buy?

• The purchase of the equipment will result in a
  depreciation schedule of 20, 32, 19.2, 11.52,
  11.52, and 5.76 for the first six years (5-year
  property class) based on a 74,000 depreciable
  base.
• Loan payments are based on a 12 loan with
  payments occurring at the beginning of each
  period.

27
Determining the PV of Cash Outflows for the Lease
0 1 2 3
4 5 6
11
L L L L
L L L
This is an annuity due that equals 74,000 today.
74,000.00 L (PVIFA 11, 7) (1.11) 66,666.67
L (4.712) 14,148.27 L

• The lessor will charge BW 14,148.27, beginning
  today, for seven years until expiration of the
  lease contract.

28
Solving for the Payment
Inputs
7 11 74,000 0
N
I/Y
PV
PMT
FV

14147.68
Compute
The result indicates that a 74,000 lease that
costs 11 annually for 7 years will require
14,147.68 annual payments. Note that this is
an annuity due, so set your calculator to BGN
and the answer is the actual amount versus
rounding with the tables.
29
Determining the PV of Cash Outflows for the Lease
0 1 2 3
4 5 6 7
L L L L
L L L
B B B B
B B B
B Tax-shield benefit (Inflow)
5,659.31 L Lease payment (Outflow)
14,148.27

• Net cash outflows at t 0 14,148.27
• Net cash outflows at t 1 to 6 8,488.96
• Net cash outflows at t 7 5,659.31

30
Determining the PV of Cash Outflows for the Lease
Comments for the previous slide

• Since the lease payments are prepaid, the company
  is not able to deduct the expenses until the end
  of each year.
• The lessee, BW, can deduct the entire 14,148.27
  as an expense each year. Thus, the net cash
  outflows are given as the difference between
  lease payments (outflow) and tax-shield benefits
  (inflow).
• The difference in risk between the lease and the
  purchase (using debt) is negligible and the
  appropriate before-tax cost is the same as debt,
  12.

31
Determining the PV of Cash Outflows for the Lease
Calculating the Present Value of Cash Outflows
for the Lease

• The after-tax cost of financing the lease should
  be equivalent to the after-tax cost of debt
  financing.
• After-tax cost 12 ( 1 0.4 ) 7.2.
• The discounted present value of cash
  outflows 14,148.27 x (PVIF 7.2, 0)
  14,148.27 8,488.96 x (PVIFA 7.2, 6)
  40,214.34 -5,659.31 x (PVIF 7.2, 7)
  3,478.56 Present Value 50,884.05

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Determining the PV of Cash Outflows for the Term
Loan
0 1 2 3
4 5 6
12
TL TL TL TL TL
TL TL
This is an annuity due that equals 74,000 today.
74,000.00 TL (PVIFA 12, 7) (1.12) 66,071.43
TL (4.564) 14,477.42 TL

• BW will make loan payments of 14,477.42,
  beginning today, for seven years until full
  payment of the loan.

33
Solving for the Payment
Inputs
7 12 74,000 0
N
I/Y
PV
PMT
FV

-14477.42
Compute
The result indicates that a 74,000 term loan
that costs 12 annually for 7 years will require
14,477.42 annual payments. Note that this is
an annuity due, so set your calculator to BGN
34
Determining the PV of Cash Outflows for the Term
Loan

• End of Loan Loan Annual
• Year Payment Balance Interest
• 0 14,477.42 59,522.58 ---
• 1 14,477.42 52,187.87 7,142.71
• 2 14,477.42 43,972.99 6,262.54
• 3 14,477.42 34,772.33 5,276.76
• 4 14,477.42 24,467.59 4,172.68
• 5 14,477.42 12,926.28 2,936.11
• 6 14,477.43 0 1,551.15

Loan balance is the principal amount owed at the
end of each year.
35
Remember Amortization Functions of the
Calculator

• Press
• 2nd Amort
• 2 ENTER
• 2 ENTER

Results BAL 52,187.87 ? PRN
7,334.71 ? INT 7,142.71
?
Second payment only shown here
Source Courtesy of Texas Instruments
36
Determining the PV of Cash Outflows for the Term
Loan

• End of Annual Annual Tax-Shield
• Year Interest Depreciation Benefits
• 0 0
• 1 7,142.71 14,800.00 8,777.08
• 2 6,262.54 23,680.00 11,977.02
• 3 5,276.76 14,208.00 7,793.90
• 4 4,172.68 8,524.80 5,078.99
• 5 2,936.11 8,524.80 4,584.36
• 6 1,551.15 4,262.40 2,325.42
• 7 0 0 3,000.00

Based on schedule given on Slide 21.26.
0.4 (annual interest annual
depreciation). Tax due to recover salvage
value, 7,500 x 0.4.
37
Determining the PV of Cash Outflows for the Term
Loan

• End of Loan Tax-Shield Cash
  Present
• Year Payment Benefit Outflow
  Value
• 0 14,477.42 14,477.42
  14,477.42
• 1 14,477.42 8,777.08 5,700.34
  5,317.48
• 2 14,477.42 11,977.02 2,500.40
  2,175.80
• 3 14,477.42 7,793.90 6,683.52
  5,425.26
• 4 14,477.42 5,078.99 9,398.43
  7,116.66
• 5 14,477.42 4,584.36 9,893.06
  6,988.06
• 6 14,477.43 2,325.42 12,152.01
  8,007.18
• 7 7,500.00 3,000.00 4,500.00
  2,765.98

Loan payment - tax-shield benefit.
Present value of the cash outflow discounted at
7.2. Salvage value that is recovered when
owned.
38
Determining the PV of Cash Outflows for the Term
Loan

• The present value of costs for the term loan is
  46,741.88. The present value of the lease
  program is 50,884.059.
• The least costly alternative is the term loan.
  Basket Wonders should proceed with the term loan
  rather than the lease.
• Other considerations The tax rate of the
  potential lessee, timing and magnitude of the
  cash flows, discount rate employed, and
  uncertainty of the salvage value and their
  impacts on the analysis.