chapter 24 - term loans and leases 2005, pearson prentice hall

Chapter 24 - Chapter 24 - Term Loans Term Loans and Leasesand Leases

2005, Pearson Prentice Hall

Term LoansTerm Loans

Characteristics of Term LoansCharacteristics of Term Loans Secured loansSecured loans 1- to 10-year maturity1- to 10-year maturity Repaid in periodic installmentsRepaid in periodic installments


Collateral for shorter loansCollateral for shorter loans Chattel mortgage (mortgage Chattel mortgage (mortgage

on machinery and on machinery and equipment)equipment)

Collateral for longer loansCollateral for longer loans Mortgages on real estateMortgages on real estate


Restrictive Covenants on BorrowersRestrictive Covenants on Borrowers Working capitalWorking capital - borrower may be - borrower may be

required to set a minimum current ratio.required to set a minimum current ratio. Restrictions on Restrictions on additional borrowingadditional borrowing.. Borrower provides periodic Borrower provides periodic financial financial

statements.statements. Restrictions on Restrictions on management changes.management changes.


Eurodollar LoansEurodollar Loans Loans by major international Loans by major international

banks based on foreign deposits banks based on foreign deposits denominated in dollars.denominated in dollars.

Adjustable interest rates based Adjustable interest rates based on the London Interbank on the London Interbank Offered Rate (LIBOR).Offered Rate (LIBOR).

LeasesLeases

LesseeLessee Acquires the services of a leased Acquires the services of a leased

asset, by making a series of asset, by making a series of payments to the owner of the payments to the owner of the asset.asset.

LessorLessor The owner of the asset that is The owner of the asset that is

being leased to the lessee.being leased to the lessee.

LeasingLeasingTypes of LeasesTypes of Leases

Direct LeaseDirect Lease - a firm acquires the services - a firm acquires the services of an asset that it didn’t previously own.of an asset that it didn’t previously own.

Sale and LeasebackSale and Leaseback - Asset’s owner sells - Asset’s owner sells the asset to a buyer and then leases the the asset to a buyer and then leases the asset from the buyer.asset from the buyer.

Leveraged LeaseLeveraged Lease - Lessor borrows from a - Lessor borrows from a lender to buy the asset that will be leased lender to buy the asset that will be leased to the lessee.to the lessee.

Lease vs. PurchaseLease vs. Purchase

IssueIssue: Should a firm…: Should a firm…

Purchase an asset using the firm’s Purchase an asset using the firm’s optional financing mix? optional financing mix? oror

Finance the asset using a financial Finance the asset using a financial lease?lease?

Lease vs. PurchaseLease vs. PurchaseProcedure:Procedure:

1)1) Compute NPV to determine if the Compute NPV to determine if the asset should be purchased.asset should be purchased.

Lease vs. PurchaseLease vs. PurchaseProcedure:Procedure:

1)1) Compute NPV to determine if the Compute NPV to determine if the asset should be purchased.asset should be purchased.

NPV = - IO ACFt(1 + k) t

n

t=1


Procedure:Procedure:

2)2) Compute NAL (net advantage to Compute NAL (net advantage to leasing) to determine if leasing the asset leasing) to determine if leasing the asset is better for the firm than purchasing.is better for the firm than purchasing.

O =O = operating cash flows if purchased operating cash flows if purchased R =R = annual rental cost annual rental costT =T = marginal tax rate marginal tax rateI =I = interest expense forfeited if leased interest expense forfeited if leased D =D = depreciation expense depreciation expenseVVnn = = after-tax salvage value after-tax salvage valuek =k = discount rate discount rate IO =IO = purchase price purchase pricerrbb = = after-tax interest rate on borrowed funds. after-tax interest rate on borrowed funds.

nn

t=1t=1

OOtt (1-T) - R (1-T) - Rtt (1-T) - T(I (1-T) - T(Itt) - T(D) - T(Dtt) ) (1 + r(1 + rbb))tt

VnVn (1+k(1+kss))nn

NAL =NAL =

-- + IO + IO


Leasing vs. Debt Financing:Leasing vs. Debt Financing:Potential BenefitsPotential Benefits

1) Flexibility and Convenience1) Flexibility and Convenience Leases are easier, quicker, and require less Leases are easier, quicker, and require less

documentation.documentation. Leases are easier to have approved than Leases are easier to have approved than

capital budgeting projects.capital budgeting projects. Leasing simplifies bookkeeping for tax Leasing simplifies bookkeeping for tax

purposes.purposes. Leasing allows synchronization of lease Leasing allows synchronization of lease

payments with the firm’s cash cycle.payments with the firm’s cash cycle. Leasing avoids the problems of ownership.Leasing avoids the problems of ownership.


2) Lack of Restrictions2) Lack of RestrictionsLeases usually do not have protective Leases usually do not have protective restrictions.restrictions.

3) Avoiding Risk of Obsolescence?3) Avoiding Risk of Obsolescence?Not really - only in cancelable operating Not really - only in cancelable operating leases.leases.

4) Conservation of Working Capital4) Conservation of Working CapitalLeases usually have a lower initial outlay Leases usually have a lower initial outlay than a purchase.than a purchase.


5) 100% Financing?5) 100% Financing?Leases usually do not require a down payment.Leases usually do not require a down payment.

6) Tax Savings6) Tax SavingsLeases may provide a larger tax shield than Leases may provide a larger tax shield than that provided by depreciation.that provided by depreciation.

7) Ease of Obtaining Credit7) Ease of Obtaining CreditIt is often easier for riskier firms to obtain a It is often easier for riskier firms to obtain a lease than to obtain debt financing.lease than to obtain debt financing.

chapter 24 - term loans and leases 2005, pearson prentice hall

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