Term Loans and Leases

2002, Prentice Hall, Inc.

Term Loans

Characteristics of Term Loans

• Secured loans

• 1- to 10-year maturity

• Repaid in periodic installments

Term Loans

Collateral for shorter loans

• Chattel mortgage (mortgage on machinery and equipment)

Collateral for longer loans

• mortgages on real estate

Term LoansRestrictive Covenants on Borrowers

• Working capital - borrower may be required to set a minimum current ratio.

• Restrictions on additional borrowing.

• Borrower provides periodic financial statements.

• Restrictions on management changes.

Term Loans

Eurodollar Loans

• Loans by major international banks based on foreign deposits denominated in dollars.

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

Leases

Lessee

• Acquires the services of a leased asset, by making a series of payments to the owner of the asset.

Lessor

• The owner of the asset that is being leased to the lessee.

Leasing

Types of Leases

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

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

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

Lease vs. Purchase

Issue: Should a firm

• Purchase an asset using the firm’s optional financing mix, or

• Finance the asset using a financial lease.

Lease vs. PurchaseProcedure:

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

Lease vs. PurchaseProcedure:

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

NPV = - IO ACFt

(1 + k) t

n

t=1

Lease vs. Purchase

Procedure:

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

O = operating cash flows if purchased

R = annual rental cost T = marginal tax rate

I = interest expense forfeited if leased

D = depreciation expense Vn = after-tax salvage value

k = discount rate

IO = purchase price

rb = after-tax interest rate on borrowed funds.

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

nn

t=1t=1

Leasing vs. Debt Financing:Potential Benefits

1) Flexibility and Convenience

• Leases are easier, quicker and require less documentation.

• Leases are easier to have approved than capital budgeting projects.

• Leasing simplifies bookkeeping for tax purposes.

• Leasing allows synchronization of lease payments with the firm’s cash cycle.

• Leasing avoids the problems of ownership.

Leasing vs. Debt Financing:Potential Benefits

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

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

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

Leasing vs. Debt Financing:Potential Benefits

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

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

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