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:

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 borrowers 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 Shelf

range from 9 months to 30 years (or more).

registration makes it practical for corporate issuers to offer small amounts of MTNs to the public.
include finance companies, banks or bank holding companies, and industrial companies.

Issuers

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.

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.

21-10

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

21-11

Frequent General Provisions

Working capital requirement

Cash dividend and repurchase of common stock restriction Capital expenditures limitation Limitation on other indebtedness

21-12

Frequent Routine Provisions

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

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.

21-14

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.

21-15

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 buyers 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 Apartments Houses

Offices
21-17

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

Full-service lease -- lessor pays maintenance Net lease -- lessee pays maintenance costs Operating lease (short-term, cancelable) vs. financial lease (longer-term, noncancelable)

Cancelable or noncancelable lease?

21-18

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 assets 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

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.

21-22

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.
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.

Other

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. 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.

The

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%

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.

21-27

Solving for the Payment

Inputs 7 11 74,000 0

N
Compute

I/Y

PV

PMT
-14147.68

FV

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
L

1
L B

2
L B

3
L B

4
L B

5
L B

6
L B

B = Tax-shield benefit (Inflow) = $ 5,659.31 L = Lease payment (Outflow) = $ 14,148.27

Net cash outflows at t = 0: Net cash outflows at t = 7:

21-29

$ 14,148.27 $ -5,659.31

Net cash outflows at t = 1 to 6: $ 8,488.96

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%

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.

21-32

Solving for the Payment

Inputs 7 12 74,000 0

N
Compute

I/Y

PV

PMT
-14477.42

FV

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 0 1 2 3 4 5 6 Loan Payment $14,477.42 14,477.42 14,477.42 14,477.42 14,477.42 14,477.42 14,477.43 Loan Balance* $59,522.58 52,187.87 43,972.99 34,772.33 24,467.59 12,926.28 0 Annual Interest --$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 2 Amort ENTER

2
Results*:

ENTER

BAL = 52,187.87

PRN = -7,334.71
INT =
21-35

-7,142.71

Second payment only shown here

Determining the PV of Cash Outflows for the Term Loan

End of Year 0 1 2 3 4 5 6 7
21-36

Annual Interest --$7,142.71 6,262.54 5,276.76 4,172.68 2,936.11 1,551.15 0

Annual Depreciation* $ 0 14,800.00 23,680.00 14,208.00 8,524.80 8,524.80 4,262.40 0

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 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.

21-37

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 $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.

21-38