9780273713654_pp21.ppt

21.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Chapter 21
Term Loans
and Leases

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.

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

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

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.

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.

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

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.

Medium-Term Note
• 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.
Medium-Term Note (MTN) – A corporate or government
debt instrument that is offered to investors on a
continuous basis.
Euro MTN – An MTN issue sold internationally outside
the country in whose currency the MTN is denominated.

Provisions of
Loan Agreements
• 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.
Loan Agreement – A legal agreement
specifying the terms of a loan and the
obligations of the borrower.

Formulation of Provisions
• 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.
The important protective covenants* fall into
three different categories.
* Restrictions are negotiated between
the borrower and lender

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

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

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.

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

Sources and Types of
Equipment Financing
• 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.
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.

Lease Financing
Examples of familiar leases
Apartments Houses
Offices Automobiles
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.

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

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

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

Types of Leasing
• 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.
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.

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.

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.

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

“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.

“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.

Determining the PV of Cash
Outflows for the Lease
• The lessor will charge BW $14,148.27,
beginning today, for seven years until
expiration of the lease contract.
L L L L L L L
0 1 2 3 4 5 6
11%
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 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.
Solving for the Payment
N I/Y PV PMT FV
Inputs
Compute
7 11 74,000 0
–14147.68

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
0 1 2 3 4 5 6 7
B = Tax-shield benefit (Inflow) = $ 5,659.31
L = Lease payment (Outflow) = $ 14,148.27
B B B B B B B

• 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%.
Comments for the previous slide:

• 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
Calculating the Present Value of
Cash Outflows for the Lease

Outflows for the Term Loan
• BW will make loan payments of
$14,477.42, beginning today, for seven
years until full payment of the loan.
TL TL TL TL TL TL TL
0 1 2 3 4 5 6
12%
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

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”
Solving for the Payment
N I/Y PV PMT FV
Inputs
Compute
7 12 74,000 0
-14477.42

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.

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

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.

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.

• 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.

9780273713654_pp21.ppt

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