Chapter 21

1. Chapter 21 Term Loans and Leases © 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI

2. Term Loans and Leases • Term Loans • Provisions of Loan Agreements • Equipment Financing • Lease Financing • Evaluating Lease Financing in Relation to Debt Financing

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.

4. 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.

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.

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.

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.

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.

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.

10. Formulation of Provisions The important protective covenants* fall into threedifferent categories. • General provisionsare used in most loan agreements, which are usually variable to fit the situation. • Routine provisionsused in most loan agreements, which are usually not variable. • Specific provisionsthat are used according to the situation. * Restrictions are negotiated between the borrower and lender

11. Frequent General Provisions • Working capital requirement • Cash dividend and repurchase of common stock restriction • Capital expenditures limitation • Limitation on other indebtedness

12. 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

13. 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.

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.

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. • 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.

16. 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

17. 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

18. 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.

19. Types of Leasing Direct Leasing -- Under direct leasinga 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.

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. • 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 valuebelongs to the lessor as well as any net cash inflows during the lease.

21. 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.

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. • 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.

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.

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.

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.

26. Determining the PV of Cash Outflows for the Lease 0 1 2 3 4 5 6 • The lessor will charge BW$14,148.27, beginning today, for seven years until expiration of the lease contract. 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

27. Solving for the Payment Inputs 711 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”

28. Determining the PV of Cash Outflows for the Lease 01 2 3 4 5 6 7 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 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

29. Determining the PV of Cash Outflows for the Lease Comments for Slide 21-28: • 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%.

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)= -3,478.56Present Value$49,933.79

31. Determining the PV of Cash Outflows for the Term Loan 0 1 2 3 4 5 6 • BW will make loan payments of $14,477.42, beginning today, for seven years until full payment of the loan. 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

32. Solving for the Payment Inputs 712 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”

33. 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.

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

35. 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 21-25. ** .4 x (annual interest + annual depreciation). *** Tax due to recover salvage value, $7,500 x .4.

36. 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.

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.