Chapter 24 - Term Loans and Leases  2005, Pearson Prentice Hall

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 Loans Restrictive 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. Purchase Procedure: 1) Compute NPV to determine if the asset should be purchased.

Lease vs. Purchase Procedure: 1) Compute NPV to determine if the asset should be purchased. NPV = - IO ACF t (1 + k) t n t=1 

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

O = operating cash flows if purchasedR = annual rental cost T = marginal tax rate I = interest expense forfeited if leasedD = depreciation expense V n = after-tax salvage value k = discount rateIO = purchase price r b = after-tax interest rate on borrowed funds. nt=1 O t (1-T) - R t (1-T) - T(I t ) - T(D t ) (1 + r b ) t (1 + r b ) t Vn Vn (1+k s ) n (1+k s ) n NAL = NAL = - + IO - + IO Lease vs. Purchase

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 Restrictions Leases usually do not have protective restrictions. 3) Avoiding Risk of Obsolescence? Not really - only in cancelable operating leases. 4) Conservation of Working Capital Leases 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 Savings Leases may provide a larger tax shield than that provided by depreciation. 7) Ease of Obtaining Credit It is often easier for riskier firms to obtain a lease than to obtain debt financing.