Lecture 25Chapter 18Leases

FinancingLeases

Financing

Term Loan -- Debt originally scheduledfor 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 andprincipal are made quarterly, semiannually, orannually.

The repayment schedule is geared to the borrowerscash-flow ability and may be amortized or have aballoon payment.

Costs of a Term Loan The interest rate is higher than on a short-term loan to the same borrower (25 to 50basis points on a low risk borrower).

Interest rates are either (1) fixed or (2)variable depending on changing marketconditions -- possibly with a floor or ceiling.

Borrower is also required to pay legalexpenses (loan agreement) and acommitment fee (25 to 75 basis points) maybe imposed on the unused portion.

Benefits of a Term Loan The borrower can tailor a loan to theirspecific needs through direct negotiationwith the lender.

Flexibility in terms of changing needs allowsthe borrower to revise the loan more quicklyand more easily.

Term loan financing is more readily availableover time making it a more dependablesource of financing than, say, the capitalmarkets.

Revolving CreditAgreements

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, legalcommitment to extend credit up to some

maximum amount over a stated period of time.

InsuranceCompany Term Loans

These term loans usually have final maturities inexcess of seven years.

These companies do not have compensatingbalances to generate additional revenue andusually have a prepayment penalty.

Loans must yield a return matching with therisks and costs involved in making the loan.

As such, the rate is typically higher than what abank would charge, but the term is longer.

Provisions ofLoan Agreements

Covenant -- A restriction on a borrowerimposed by a lender; for example, theborrower must maintain a minimum amount ofworking capital.

This allows the lender to act (or be warnedearly) when adverse developments areoccurring that will affect the borrowing firm.

Loan Agreement -- A legal agreementspecifying the terms of a loan and the

obligations of the borrower.

Formulation of Provisions

General provisions are used in most loanagreements, which are usually variable to fit thesituation.

Routine provisions used in most loanagreements, which are usually not variable.

Specific provisions that are used according to thesituation.

The important protective covenants* fall intothree different categories.

* Restrictions are negotiated betweenthe borrower and lender

FrequentGeneral Provisions

Working capital requirement Cash dividend and repurchase ofcommon stock restriction

Capital expenditures limitation Limitation on other indebtedness(obligation)

FrequentRoutine Provisions

Furnish financial statements and maintainadequate insurance to the lender

Must not sell a significant portion of itsassets 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 loanbalance by a given safety margin. truck

Trucking equipment is highly marketable, and thelender may advance as much as 80% of marketvalue, while a limited use lathe might provide only a40% advance or a specific use item cannot be usedas collateral.

Sources and Types ofEquipment Financing

Chattel any article of tangible property other than land,buildings, and other things annexed to land.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 copyof the security: agreement or a financing statement with apublic 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 ofEquipment Financing

The buyer signs a conditional sales contractsecurity agreement to make installment payments(usually monthly or quarterly) over time.

The seller has the authority to repossess theequipment if the buyer does not meet all of the termsof the contract.

The seller can sell the contract without the buyersconsent -- usually to a finance company or bank.

2. Conditional Sales Contract -- A means of financingprovided by the seller of equipment, who holds titleto it until the financing is paid off.

Lease Financing

Examples of familiar leasesApartments HousesOffices Automobiles

Lease -- A contract under which one party, thelessor (owner) of an asset, agrees to grant theuse of that asset to another, the lessee, inexchange 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, cancelable) vs.financial lease (longer-term, noncancelable)

Options at expiration to lessee

Live today pay later

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Operating Versus Financial LeasesOperating lease

Relative short-term< assets usefullife

Cancellable withproper notice

Financial leaseLonger term

Assets usefullife

Noncancellable

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Capital Lease ConditionsTitle transfers to lesseeOption to purchaseLease period 75% of economiclife

Present value (PV) of leasepayments 90% of the fair valueof the leased property

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Recording the Value of aCapital Lease

Value appears on the balance sheet Amount reflected

PV of the minimum lease payments overthe lease period

Discount rate employedLessees incremental borrowing rateLessors implicit interest rate

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Accounting and TaxTreatment of Leases

FASB No. 13

Asset

LiabilityValue shown on the balance sheet

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Disclosure of OperatingLeases

Total future minimum lease payments Schedule by year for next five years Total sublease rentals to be received Basis for contingent rental payments Existence and terms of purchase Renewal options and escalation clauses Lease agreement restrictions

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 adeductible expense.

Lessors: insurance companies, institutionalinvestors, finance companies, and independentcompanies.

Sale and Leaseback -- The sale of an asset withthe agreement to immediately lease it back for

an extended period of time.

Types of Leasing

The firm often leases an asset directly from amanufacturer (e.g., IBM leases computers andXerox leases copiers).

Lessors: manufacturers, finance companies,banks, independent leasing companies, special-purpose leasing companies, and partnerships.

Direct Leasing -- Under direct leasing a firmacquires the use of an asset it did not

previously own.

Types of Leasing

Popular for big-ticket assets such as aircraft, oilrigs, and railway equipment.

The role of the lessor changes as the lessor isborrowing funds itself to finance the lease for thelessee (hence, leveraged lease).

Any residual value belongs to the lessor as well asany net cash inflows during the lease.

Leverage Leasing -- A lease arrangement in which thelessor provides an equity portion (usually 20 to 40percent) of the leased assets cost and third-party

lenders provide the balance of the financing.

Accounting and TaxTreatment of Leases

In the past, leases were off-balance-sheet itemsand hid the true obligations of some firms.

The lessee can deduct the full lease payment in aproperly structured lease. To be a true lease theIRS requires:1. Lessor must have a minimum at-risk

(inception and throughout lease) of 20% ormore of the acquisition cost.

2. The remaining life of the asset at the end of thelease period must be the longer of 1 year or20% of original estimated asset life.

3. An expected profit to the lessor from the leasecontract apart from any tax benefits.

Economic Rationalefor Leasing

Leasing allows higher-income taxable companies toown equipment (lessor) and take accelerateddepreciation, while a marginally profitable company(lessee) would prefer the advantages afforded byleases.

Thus, leases provide a means of shifting taxbenefits to companies that can fully utilize thosebenefits.

Other non-tax issues: economies of scale in thepurchase of assets; different estimates of asset life,salvage value, or the opportunity cost of funds; andthe lessors expertise in equipment selection andmaintenance.

Refresh your memoryPVA = R (PVIFA i%, n)WhereAnnuity Due (installment amount at thebeg.)

PVAd = R (PVIFA i%, n) (1+i)If there is any residual value of an asset:PVAd = R (PVIFA i%, n) (1+i) +RV(PVIFi%, n)R = TL = L = P , RV= residual valuePVAd = loan amount, asset amount,purchase price

i

iRPVAn )1(1

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Calculating the LeasePayment

n = length of the lease in yearsm = number of times a year periodic leasepayments are made

R = implicit interest rate for which wesolve

RV = assumed residual value at the end ofthe lease term

1-mn

0t 11paymentleaseassetofValue mnt

mRRV

mR

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Analysis of Lease VersusBuy/Borrow

After tax Discounted cash flows Financial decision

The investment decision is to acquire anasset

Then a company decides how to finance it

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Methods of Analysis Present value method (PV)

Compare PVs of alternativesLowest PV is the most desirable

Internal rate of return (IRR)Compare costs of lease/borrowing

After-taxSelect alternative with lowest rate

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Favorable Factors forBuy/Borrow Alternative

Use of accelerated cost recoverydepreciation

Residual value at the end of theproject

Greater residual valueTax deductibility of interest paymentsHigh tax brackets

31

Residual ValueUsually subject to considerableuncertaintyCould require higher discountrateHigher rate favors leasefinancing

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Sensitivity Analysis ofUncertain BorrowingCosts

Interest rate change

Speed of rate change

Change financingdecision

How probable is the interest ratechange?

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Sources of Value in Leasing Perfect capital markets

Firm indifferent Bankruptcy costs

Lessors position somewhat superior to lender Effect of differing taxes

Low tax-bracket firms lease more and borrowless

Market equilibration processCompetition encourages sharing of tax benefits

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Alleged Lessors Benefits Economies of scale Different estimate

Life of the assetResidual valueDiscount rate

Face different borrowing costs Provide expertise to customers

Equipment selectionEquipment maintenance

Problem 1a. Cost of Asset = 260,000, i=13%, n=5PVAd = L (PVIFA i%, n) (1+i) + 0260,000 = L (PVIFA 13%, 5) (1.13)260,000 = L (3.5172) (1.13)260,000 = L (3.974436)L= 260,000 / 3.974436 = 65418

b. 138,000 = L (PVIFA 6%, 9) (1.06)+ (PVIF 6%, 9) (20,000)L = 17499c. 773,000 = L(PVIFA 9%, 10) (1.10)L = 773000 / 6.51952 = 110,504

Problem 18.3 Co wishes to acquire a $100,000 machine. useful life 08-years no expected salvage value If lease financing: annual lease payments of$16,000 in advance OR Co. can borrow $100,000 at 12% interestrate Assets fall 5-year property class tc = 35%, use after cost of debt as an discountrateWhat is PV of Cash outflow of thesealternatives

Problem 3Cost of an Asset 100,000n= 8RV 0L 16000

Loani 0.12

5-year property class20%, 32%, 19.2%, 11.52%,11.52%, and 5.76%

t 0.35k = Discount rate After Tax cost of debtk = ki = i * (1-t) = .12 (1-.35) 0.078

Valuation of Loan optionAssume that the first installmentis due at the end of period.

100,000 = TL(PVIFA 12%,8)TL = 100,000 / 4.9676 = 20,130

Valuation of Loan optionYear Installment Interest Principal O/S amount

0 0 0 0 100,0001 20130 12000 8130 91,8702 20130 11024 9106 82,7643 20130 9932 10198 72,5664 20130 8708 11422 61,1445 20130 7337 12793 48,3516 20130 5802 14328 34,0237 20130 4083 16047 17,9768 20130 2154 17976 0

161040 61040 100000

Purchase asset for $100,000

Depreciation on AssetY Depr. Rate (%) Depr. amt0 01 20 200002 32 320003 19.2 192004 11.52 115205 11.52 115206 5.76 57607 0 08 0 0

100 100000

Present Value for loan payments

Y inst depr iDepr +

itax

saving CF-AT DF @7.8 PV

0 0 0 0 0 0 0 1 01 20130 20000 12000 32000 11200 8930 0.9276 82832 20130 32000 11024 43024 15058 5072 0.8605 43643 20130 19200 9932 29132 10196 9934 0.7983 79304 20130 11520 8708 20228 7080 13050 0.7405 96645 20130 11520 7337 18857 6600 13530 0.6869 92946 20130 5760 5802 11562 4047 16083 0.6372 102487 20130 0 4083 4083 1429 18701 0.5911 110548 20130 0 2154 2154 754 19376 0.5483 10624

161040 100000 61040 56364 104676 71461

OR Dpr Tax-saving DF@7.8% PV of Tax-Saving-100000 0 020000 7000 0.9276 6,49332000 11200 0.8605 9,63819200 6720 0.7983 5,36511520 4032 0.7405 2,98611520 4032 0.6869 2,7705760 2016 0.6372 1,285

0 0 0.5911 - -100000

0 0 0.5483 - 28,535

100000 28,535 (71,465)

Present Value for lease paymentsy inst

taxsaving CF-AT DF@7.8 PV

0 16000 0 16000 1 160001 16000 5600 10400 0.9276 96472 16000 5600 10400 0.8605 89493 16000 5600 10400 0.7983 83024 16000 5600 10400 0.7405 77015 16000 5600 10400 0.6869 71446 16000 5600 10400 0.6372 66277 16000 5600 10400 0.5911 61478 0 5600 -5600 0.5483 -3070

128000 44800 67447

OR

y inst tax saving CF-AT DF@7.8 PV0 16000 0 16000 1 16000

1-7 16000 5600 10400 5.2422 545198 0 5600 -5600 0.5483 -3070

67449

Analysis: Lease vs. Borrow-and-buy: Example 2

Data: New computer costs $1,200,000. 3-year MACRS class life; 4-year economic life. Tax rate = 40%. kd = 10%. Maintenance of $25,000/year, payable atbeginning of each year.

Residual value in Year 4 of $125,000. 4-year lease includes maintenance. Lease payment is $340,000/year, payable atbeginning of each year.

Depreciationschedule

Depreciable basis = $1,200,000

MACRS Depreciation End-of-YearYear Rate Expense Book Value1 0.33 $ 396,000 $804,0002 0.45 540,000 264,0003 0.15 180,000 84,0004 0.07 84,000 0

1.00 $1,200,000

Year MACRS Depr exp Tax Saving1 0.33 $396,000 $158,400.02 0.45 540,000 $216,000.03 0.15 180,000 $72,000.04 0.07 84,000 $33,600.0

In a lease analysis, at what discountrate should cash flows be discounted? Since cash flows in a lease analysis areevaluated on an after-tax basis, we shoulduse the after-tax cost of borrowing.

Previously, we were told the cost of debt,kd, was 10%. Therefore, we shoulddiscount cash flows at 6%.A-T kd = 10%(1 T) = 10%(1 0.4) = 6%.

0 1 2 3 4

Cost of Owning Analysis

Cost of asset (1,200.0)Dep. tax savings1 158.4 216.0 72.0 33.6Maint. (AT)2 (15.0) (15.0) (15.0) (15.0)Res. value (AT)3 ______ _____ _____ _____ 75.0Net cash flow (1,215.0) 143.4 201.0 57.0 108.6

PV cost of owning (@ 6%) = $-766.948.

Analysis in thousands:

Notes on Cost of OwningAnalysis

1. Depreciation is a tax deductibleexpense, so it produces a tax savingsof T(Depreciation). Year 1 = 0.4($396)= $158.4.

2. Each maintenance payment of $25 isdeductible so the after-tax cost is(1 T)($25) = $15.

3. The ending book value is $0 so thefull $125 salvage (residual) value istaxed, (1 - T)($125) = $75.0.

Cost of Leasing Analysis

Each lease payment of $340 isdeductible, so the after-tax cost of thelease is(1-T)($340) = -$204.

PV cost of leasing (@6%) = $-749.294.

0 1 2 3 4A-T Lease pmt -204 -204 -204 -204Analysis in thousands:

Assume tax benefits are assumed in beg.

Net advantage of leasing NAL = PV cost of owning PV cost ofleasing

NAL = $766.948 - $749.294= $17.654

Since the cost of owning outweighs thecost of leasing, the firm should lease.

Lecture 25 Chapter 18Term LoansCosts of a Term LoanBenefits of a Term LoanRevolving Credit AgreementsInsurance Company Term LoansProvisions of Loan AgreementsFormulation of ProvisionsFrequent General ProvisionsFrequent Routine ProvisionsEquipment FinancingSources and Types of Equipment FinancingSources and Types of Equipment FinancingLease FinancingIssues in Lease FinancingOperating Versus Financial LeasesCapital Lease ConditionsRecording the Value of a Capital LeaseAccounting and Tax Treatment of LeasesDisclosure of Operating LeasesTypes of LeasingTypes of LeasingTypes of LeasingAccounting and Tax Treatment of LeasesEconomic Rationale for LeasingRefresh your memoryCalculating the Lease PaymentAnalysis of Lease Versus Buy/BorrowMethods of AnalysisFavorable Factors for Buy/Borrow AlternativeResidual ValueSensitivity Analysis of Uncertain Borrowing CostsSources of Value in LeasingAlleged Lessors BenefitsProblem 1Slide38Problem 18.3Problem 3Valuation of Loan optionValuation of Loan optionDepreciation on AssetPresent Value for loan paymentsORPresent Value for lease paymentsORAnalysis: Lease vs. Borrow-and-buy: Example 2Depreciation scheduleIn a lease analysis, at what discount rate should cash flows be discounted?Cost of Owning AnalysisNotes on Cost of Owning AnalysisCost of Leasing AnalysisNet advantage of leasing