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Term Loans and Leases

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Title: Term Loans and Leases


1
Chapter 21
  • Term Loans and Leases

2
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
12
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

32
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.
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