1-1
Chapter 21Chapter 21
Term LoansTerm Loans
and Leasesand Leases
© Pearson Education Limited 2004
Fundamentals of Financ...
1-2
After studying Chapter 21,After studying Chapter 21,
you should be able to:you should be able to:
Describe various typ...
1-3
Term Loans and LeasesTerm Loans and Leases
Term Loans
Provisions of Loan Agreements
Equipment Financing
Lease Financin...
1-4
Term LoanTerm Loan -- Debt originally scheduled
for repayment in more than 1 year, but
generally in less than 10 years...
1-5
Costs of a Term LoanCosts of a Term Loan
The interest rate is higher than on a short-
term loan to the same borrower (...
1-6
Benefits of a Term LoanBenefits of a Term Loan
The borrower can tailor a loan to their
specific needs through direct n...
1-7
Revolving CreditRevolving Credit
AgreementsAgreements
Agreements are frequently for three years.
The actual notes are ...
1-8
Medium-Term NoteMedium-Term Note
Maturities range from 9 months to 30 years (or more).
Issuers include finance compani...
1-9
Provisions ofProvisions of
Loan AgreementsLoan Agreements
CovenantCovenant -- A restriction on a borrower
imposed by a...
1-10
Formulation of ProvisionsFormulation of Provisions
General provisionsGeneral provisions are used in most loan
agreeme...
1-11
FrequentFrequent
General ProvisionsGeneral Provisions
Working capital requirement
Cash dividend and repurchase of
com...
1-12
FrequentFrequent
Routine ProvisionsRoutine Provisions
Furnish financial statements and maintain
adequate insurance to...
1-13
Equipment FinancingEquipment Financing
Loans are usually extended for more than 1 year.
The lender evaluates the mark...
1-14
Sources and Types ofSources and Types of
Equipment FinancingEquipment Financing
1.1. Chattel MortgageChattel Mortgage...
1-15
Sources and Types ofSources and Types of
Equipment FinancingEquipment Financing
The buyer signs a conditional sales c...
1-16
Lease FinancingLease Financing
Examples of familiar leasesExamples of familiar leases
Apartments Houses
Offices Autom...
1-17
Issues in Lease FinancingIssues in Lease Financing
AdvantageAdvantage: Use of an asset without
purchasing the asset
O...
1-18
Types of LeasingTypes of Leasing
The lessor realizes any residual value.
LessorsLessors: insurance companies, institu...
1-19
Types of LeasingTypes of Leasing
The firm often leases an asset directly from a
manufacturer (e.g., IBM leases comput...
1-20
Types of LeasingTypes of Leasing
Popular for big-ticket assets such as aircraft, oil
rigs, and railway equipment.
The...
1-21
Accounting and TaxAccounting and Tax
Treatment of LeasesTreatment of Leases
In the past, leases were “off-balance-she...
1-22
Economic RationaleEconomic Rationale
for Leasingfor Leasing
Leasing allows higher-income taxable companies to
own equ...
1-23
““Should I LeaseShould I Lease
or Should I Buy?”or Should I Buy?”
Basket Wonders (BW) is deciding between leasing
a n...
1-24
““Should I LeaseShould I Lease
or Should I Buy?”or Should I Buy?”
The lessor calculates the lease payments
based on a...
1-25
““Should I LeaseShould I Lease
or Should I Buy?”or Should I Buy?”
The purchase value of the equipment will
result in ...
1-26
Determining the PV of CashDetermining the PV of Cash
Outflows for the LeaseOutflows for the Lease
The lessor will cha...
1-27
The result indicates that a $74,000 lease
that costs 11% annually for 7 years will
require $14,147.68* annual payment...
1-28
Determining the PV of CashDetermining the PV of Cash
Outflows for the LeaseOutflows for the Lease
Net cash outflows a...
1-29
Determining the PV of CashDetermining the PV of Cash
Outflows for the LeaseOutflows for the Lease
Since the lease pay...
1-30
Determining the PV of CashDetermining the PV of Cash
Outflows for the LeaseOutflows for the Lease
The after-tax cost ...
1-31
Determining the PV of CashDetermining the PV of Cash
Outflows for the Term LoanOutflows for the Term Loan
BWBW will m...
1-32
The result indicates that a $74,000 term
loan that costs 12% annually for 7 years
will require $14,477.42* annual
pay...
1-33
Determining the PV of CashDetermining the PV of Cash
Outflows for the Term LoanOutflows for the Term Loan
End ofEnd o...
1-34
Remember -- AmortizationRemember -- Amortization
Functions of the CalculatorFunctions of the Calculator
Press:
2nd
Am...
1-35
Determining the PV of CashDetermining the PV of Cash
Outflows for the Term LoanOutflows for the Term Loan
End ofEnd o...
1-36
Determining the PV of CashDetermining the PV of Cash
Outflows for the Term LoanOutflows for the Term Loan
End of Loan...
1-37
Determining the PV of CashDetermining the PV of Cash
Outflows for the Term LoanOutflows for the Term Loan
The present...
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Term loan and leasing

  1. 1. 1-1 Chapter 21Chapter 21 Term LoansTerm Loans and Leasesand Leases © Pearson Education Limited 2004 Fundamentals of Financial Management, 12/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI
  2. 2. 1-2 After studying Chapter 21,After studying Chapter 21, you should be able to:you should be able to: 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.
  3. 3. 1-3 Term Loans and LeasesTerm Loans and Leases Term Loans Provisions of Loan Agreements Equipment Financing Lease Financing Evaluating Lease Financing in Relation to Debt Financing
  4. 4. 1-4 Term LoanTerm Loan -- Debt originally scheduled for repayment in more than 1 year, but generally in less than 10 years. Term LoansTerm 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.
  5. 5. 1-5 Costs of a Term LoanCosts 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. 6. 1-6 Benefits of a Term LoanBenefits 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. 7. 1-7 Revolving CreditRevolving Credit AgreementsAgreements 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 AgreementRevolving Credit Agreement -- A formal, legal commitment to extend credit up to some maximum amount over a stated period of time.
  8. 8. 1-8 Medium-Term NoteMedium-Term Note Maturities range from 9 months to 30 years (or more). Issuers include finance companies, banks or bank holding companies, and industrial companies. Medium-Term Note (MTN)Medium-Term Note (MTN) -- A corporate or government debt instrument that is offered to investors on a continuous basis. Euro MTNEuro MTN -- An MTN issue sold internationally outside the country in whose currency the MTN is denominated.
  9. 9. 1-9 Provisions ofProvisions of Loan AgreementsLoan Agreements CovenantCovenant -- 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 AgreementLoan Agreement -- A legal agreement specifying the terms of a loan and the obligations of the borrower.
  10. 10. 1-10 Formulation of ProvisionsFormulation of Provisions General provisionsGeneral provisions are used in most loan agreements, which are usually variable to fit the situation. Routine provisionsRoutine provisions used in most loan agreements, which are usually notnot variable. Specific provisionsSpecific provisions that are used according to the situation. The important protective covenantsThe important protective covenants* fall intofall into threethree differentdifferent categories.categories. * Restrictions are negotiated between the borrower and lender
  11. 11. 1-11 FrequentFrequent General ProvisionsGeneral Provisions Working capital requirement Cash dividend and repurchase of common stock restriction Capital expenditures limitation Limitation on other indebtedness
  12. 12. 1-12 FrequentFrequent Routine ProvisionsRoutine 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. 13. 1-13 Equipment FinancingEquipment 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. 14. 1-14 Sources and Types ofSources and Types of Equipment FinancingEquipment Financing 1.1. Chattel MortgageChattel 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,Sources of financing are commercial banks, finance companies, and sellers of equipment.finance companies, and sellers of equipment. Types of financingTypes of financing
  15. 15. 1-15 Sources and Types ofSources and Types of Equipment FinancingEquipment 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. 2.2. Conditional Sales ContractConditional Sales Contract -- A means of financing provided by the seller of equipment, who holds title to it until the financing is paid off.
  16. 16. 1-16 Lease FinancingLease Financing Examples of familiar leasesExamples of familiar leases Apartments Houses Offices Automobiles LeaseLease -- 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.
  17. 17. 1-17 Issues in Lease FinancingIssues in Lease Financing AdvantageAdvantage: Use of an asset without purchasing the asset ObligationObligation: Make periodic lease payments Contract specifies who maintains the asset Full-service leaseFull-service lease -- lessor pays maintenance Net leaseNet lease -- lessee pays maintenance costs Cancelable or noncancelable lease?Cancelable or noncancelable lease? Operating lease (short-term, cancelable) vs. financial lease (longer-term, noncancelable) Options at expiration to lessee
  18. 18. 1-18 Types of LeasingTypes of Leasing The lessor realizes any residual value. LessorsLessors: insurance companies, institutional investors, finance companies, and independent companies. Sale and LeasebackSale and Leaseback -- The sale of an asset with the agreement to immediately lease it back for an extended period of time.
  19. 19. 1-19 Types of LeasingTypes of Leasing The firm often leases an asset directly from a manufacturer (e.g., IBM leases computers and Xerox leases copiers). LessorsLessors: manufacturers, finance companies, banks, independent leasing companies, special- purpose leasing companies, and partnerships. Direct LeasingDirect Leasing -- Under direct leasingdirect leasing a firm acquires the use of an asset it did not previously own.
  20. 20. 1-20 Types of LeasingTypes 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 leasehence, leveraged lease). Any residual valueresidual value belongs to the lessor as well as any net cash inflows during the lease. Leverage LeasingLeverage 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. 1-21 Accounting and TaxAccounting and Tax Treatment of LeasesTreatment 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.
  22. 22. 1-22 Economic RationaleEconomic Rationale for Leasingfor 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 issuesOther 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. 23. 1-23 ““Should I LeaseShould I Lease or Should I Buy?”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 whichAnalyze cash flows and determine which alternative has the lowest (present value) costalternative has the lowest (present value) cost to the firm.to the firm. ExampleExample::
  24. 24. 1-24 ““Should I LeaseShould I Lease or Should I Buy?”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 Financial leaseFinancial 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. 25. 1-25 ““Should I LeaseShould I Lease or Should I Buy?”or Should I Buy?” The purchase value of the equipment will result in a depreciation schedule of 20%,20%, (declining balance method) 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. 26. 1-26 Determining the PV of CashDetermining the PV of Cash Outflows for the LeaseOutflows for the Lease The lessor will charge BWBW $14,148.27$14,148.27, beginning today, for seven years until expiration of the lease contract. L L L L L L LL L L L L L L 0 1 2 3 4 5 6 11%11% This is an annuity due that equals $74,000$74,000 today. $74,000.00$74,000.00 = LL (PVIFA 11%11%, 7) (1.1111) $66,666.67 = LL (4.712) $14,148.27$14,148.27 = LL
  27. 27. 1-27 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” Solving for the PaymentSolving for the Payment N I/Y PV PMT FV Inputs Compute 7 11 74,000 0 -14147.68
  28. 28. 1-28 Determining the PV of CashDetermining the PV of Cash Outflows for the LeaseOutflows for the Lease 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 LL L L L L L L 0 1 2 3 4 5 6 7 BB = Tax-shield benefit (Inflow) = $ 5,659.31$ 5,659.31 LL = Lease payment (Outflow) = $ 14,148.27$ 14,148.27 B B B B B B BB B B B B B B
  29. 29. 1-29 Determining the PV of CashDetermining the PV of Cash Outflows for the LeaseOutflows for the Lease Since the lease payments are prepaid, the company is not able to deduct the expenses until the end of each year. The lessee, BWBW, can deduct the entire $14,148.27$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 slideComments for the previous slide:
  30. 30. 1-30 Determining the PV of CashDetermining the PV of Cash Outflows for the LeaseOutflows 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%7.2%. The discounteddiscounted present value of cash outflows: $14,148.27 x (PVIF 7.2%, 1) = $13,198.01$13,198.01 $ 8,488.96 x (PVIFA 7.2%, 6) = 40,214.3440,214.34 $ -5,659.31 x (PVIF 7.2%, 7) = -3,478.56-3,478.56 Present ValuePresent Value $$ 49,933.7949,933.79 Calculating the Present Value ofCalculating the Present Value of Cash Outflows for the LeaseCash Outflows for the Lease
  31. 31. 1-31 Determining the PV of CashDetermining the PV of Cash Outflows for the Term LoanOutflows for the Term Loan BWBW will make loan payments of $14,477.42$14,477.42, beginning today, for seven years until full payment of the loan. TL TL TL TL TL TL TLTL TL TL TL TL TL TL 0 1 2 3 4 5 6 12%12% This is an annuity due that equals $74,000$74,000 today. $74,000.00$74,000.00 = TLTL (PVIFA 12%12%, 7) (1.1212) $66,071.43 = TLTL (4.564) $14,477.42$14,477.42 = TLTL
  32. 32. 1-32 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 PaymentSolving for the Payment N I/Y PV PMT FV Inputs Compute 7 12 74,000 0 -14477.42
  33. 33. 1-33 Determining the PV of CashDetermining the PV of Cash Outflows for the Term LoanOutflows for the Term Loan End ofEnd of LoanLoan LoanLoan AnnualAnnual YearYear PaymentPayment BalanceBalance* InterestInterest 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. 34. 1-34 Remember -- AmortizationRemember -- Amortization Functions of the CalculatorFunctions 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. 35. 1-35 Determining the PV of CashDetermining the PV of Cash Outflows for the Term LoanOutflows for the Term Loan End ofEnd of AnnualAnnual AnnualAnnual Tax-ShieldTax-Shield YearYear InterestInterest DepreciationDepreciation* BenefitsBenefits** 0 --- $ 0 --- 1 $7,142.71 14,800.00 8,777.00 2 6,262.54 11,840.00 7240.80 3 5,276.76 9,472.00 5900.00 4 4,172.68 7,577.00 4700.00 5 2,936.11 6062.00 3600.00 6 1,551.15 4850.00 2560.00 7 0 2380 952.00*** * Based on 20% declining balance method.. ** .4 x (annual interest + annual depreciation). *** Tax due to recover salvage value, $7,500 x .4.
  36. 36. 1-36 Determining the PV of CashDetermining the PV of Cash Outflows for the Term LoanOutflows for the Term Loan End of LoanEnd of Loan Tax-ShieldTax-Shield CashCash PresentPresent YearYear PaymentPayment BenefitBenefit OutflowOutflow* ValueValue** 0 $14,477.42 --- $14,477.42 $14,477.42 1 14,477.42 $ 8,777.08 5,700.34 5,327.00 2 14,477.42 7,240.00 7,237.42 6321.00 3 14,477.42 5900.00 8577.42 7002 4 14,477.42 4,700.00 9777.42 7460 5 14,477.42 3,600 10877.42 7755 6 14,477.43 2,560.00 11917.42 7941 7 - 7,500.00*** 952.00 - 8452.00 - 5263 * Loan payment - tax-shield benefit. ** Present value of the cash outflow discounted at 7.2%.- 7% Table *** Salvage value that is recovered when owned.
  37. 37. 1-37 Determining the PV of CashDetermining the PV of Cash Outflows for the Term LoanOutflows for the Term Loan The present value of costs for the term loan is $51,020$51,020. The present value of the lease program is $49,933.79$49,933.79. The least costlyleast costly alternative is the lease programlease program. Basket Wonders should proceed with the lease program rather than the term loan.

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