1. finance

Chapter 21
Term Loans
and Leases
21-1
© Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
After studying Chapter 21,
you should be able to:

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21-2
Describe various types of term loans and
discuss the costs and benefits of each.
Discuss the nature and the content of loan
agreements including protective (restrictive)
covenants.
Discuss the sources and types of equipment
financing.
Understand and explain lease financing in its
various forms.
Compare lease financing with debt financing
via a numerical evaluation of the present
value of cash outflows.
Term Loans and Leases
Term Loans
 Provisions of Loan Agreements
 Equipment Financing
 Lease Financing
 Evaluating Lease Financing in
Relation to Debt Financing

21-3
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 borrower’s
cash-flow ability and may be amortized or have a
balloon payment.
21-4
Costs of a Term Loan
 The
interest rate is higher than on a shortterm 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.
21-5
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.
21-6
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.
21-7
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.
21-8
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.
21-9
Provisions of
Loan Agreements
Loan Agreement -- A legal agreement
specifying the terms of a loan and the
obligations of the borrower.
21-10

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.
Formulation of Provisions
The important protective covenants* fall into
three different categories.
21-11

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
Frequent
General Provisions
21-12

Working capital requirement

Cash dividend and repurchase of
common stock restriction

Capital expenditures limitation

Limitation on other indebtedness
Frequent
Routine Provisions

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
21-13
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
Equipment Financing




21-14
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.
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.

21-15
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.
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.



21-16
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 buyer’s
consent -- usually to a finance company or bank.
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
21-17
Apartments
Houses
Offices
Automobiles
Issues in Lease Financing



Advantage: Use of an asset without
purchasing the asset
Obligation: Make periodic lease payments
Contract specifies who maintains the asset



Cancelable or noncancelable lease?


21-18
Full-service lease -- lessor pays maintenance
Net lease -- lessee pays maintenance costs
Operating lease (short-term, cancelable) vs.
financial lease (longer-term, noncancelable)
Options at expiration to lessee
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.
21-19
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, specialpurpose leasing companies, and partnerships.
21-20
Types of Leasing
Leverage Leasing -- A lease arrangement in which the
lessor provides an equity portion (usually 20 to 40
percent) of the leased asset’s cost and third-party
lenders provide the balance of the financing.



21-21
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.
Accounting and Tax
Treatment of Leases


21-22
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:
1.
Lessor must have a minimum “at-risk”
(inception and throughout lease) of 20% or
more of the acquisition cost.
2.
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.
3.
An expected profit to the lessor from the lease
contract apart from any tax benefits.
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 lessor’s expertise in equipment selection and
maintenance.
21-23
“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.
21-24
“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.
21-25
“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.
21-26
Determining the PV of Cash
Outflows for the Lease
0
11%
1
2
3
4
5
6
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

21-27
The lessor will charge BW $14,148.27,
beginning today, for seven years until
expiration of the lease contract.
Solving for the Payment
Inputs
Compute
7
11
74,000
N
I/Y
PV
0
PMT
FV
-14147.68
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”
21-28
Determining the PV of Cash
Outflows for the Lease
0
1
2
3
4
5
6
7
L
L
B
L
B
L
B
L
B
L
B
L
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:
21-29
$ -5,659.31
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%.
21-30
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 - .4 ) = 7.2%.

The discounted present value of cash outflows:
$14,148.27 x (PVIF 7.2%, 1)
= $13,198.01
$ 8,488.96 x (PVIFA 7.2%, 6)
= 40,214.34
$ -5,659.31 x (PVIF 7.2%, 7)
= -3,478.56
Present Value
$ 49,933.79
21-31
Determining the PV of Cash
Outflows for the Term Loan
0
12%
1
2
3
4
5
6
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

21-32
BW will make loan payments of
$14,477.42, beginning today, for seven
years until full payment of the loan.
Solving for the Payment
Inputs
Compute
7
12
74,000
N
I/Y
PV
0
PMT
FV
-14477.42
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”
21-33
Determining the PV of Cash
Outflows for the Term Loan
End of
Year
Loan
Payment
Loan
Balance*
Annual
Interest
0
1
2
3
4
5
6
$14,477.42
14,477.42
14,477.42
14,477.42
14,477.42
14,477.42
14,477.43
$59,522.58
52,187.87
43,972.99
34,772.33
24,467.59
12,926.28
0
--$7,142.71
6,262.54
5,276.76
4,172.68
2,936.11
1,551.15
Loan balance is the principal amount
owed at the end of each year.
21-34
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
21-35
Determining the PV of Cash
Outflows for the Term Loan
End of
Year
Annual
Interest
Annual
Depreciation*
0
1
2
3
4
5
6
7
--$7,142.71
6,262.54
5,276.76
4,172.68
2,936.11
1,551.15
0
$
0
14,800.00
23,680.00
14,208.00
8,524.80
8,524.80
4,262.40
0
21-36
Tax-Shield
Benefits**
--$ 8,777.08
11,977.02
7,793.90
5,078.99
4,584.36
2,325.42
-3,000.00***
*
Based on schedule given on Slide 21-26.
** .4 x (annual interest + annual depreciation).
*** Tax due to recover salvage value, $7,500 x .4.
Determining the PV of Cash
Outflows for the Term Loan
End of
Loan
Year Payment
0
1
2
3
4
5
6
7
21-37
Tax-Shield
Benefit
Cash
Outflow*
Present
Value**
$14,477.42
--$14,477.42 $14,477.42
14,477.42 $ 8,777.08
5,700.34
5,317.48
14,477.42
11,977.02
2,500.40
2,175.80
14,477.42
7,793.90
6,683.52
5,425.26
14,477.42
5,078.99
9,398.43
7,116.66
14,477.42
4,584.36
9,893.06
6,988.06
14,477.43
2,325.42 12,152.01
8,007.18
- 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.
Determining the PV of Cash
Outflows for the Term Loan



21-38
The present value of costs for the term loan is
$46,741.88. The present value of the lease
program is $49,933.79.
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.