1. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 1 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter 10 Medium- to Longer-term Debt

2. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 2 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Learning Objectives Identify the types of medium- to long-term debt instruments in the market Understand the securitisation process Pricing of longer-term debt instruments

3. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 3 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 10.1 Introduction 10.2 Term Loans or Fully-drawn Advances 10.3 Mortgage Finance 10.4 Debentures, Unsecured Notes and Subordinated Debt

4. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 4 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation (cont.) 10.5 Calculations: Fixed Interest Securities 10.6 Leasing 10.7 Direct Credit Substitutes 10.8 Summary

5. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 5 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.1 Introduction Matching principle – Firms should match the maturity structure of their assets with the maturity structure of their sources of funds (liabilities and shareholder funds)  Therefore, longer-term assets should be funded with longer-term liabilities and equity – The repayment schedule of debt financing for long-term projects should align with the project’s expected future cash flows

6. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 6 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.1 Introduction (cont.) Repayment may be – Interest only during term of loan and principal repayment on maturity – Amortised loan (credit foncier loan)  periodic loan instalments consisting of interest due and reduction of principal – Deferred repayment loan  loan instalments commence after a specified period related to project cash flows, and the debt is amortised over the remaining term of the loan

7. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 7 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 10.1 Introduction 10.2 Term Loans or Fully-drawn Advances 10.3 Mortgage Finance 10.4 Debentures, Unsecured Notes and Subordinated Debt

8. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 8 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.2 Term Loans or Fully- drawn Advances Fixed-term loan periods generally range from 3 to 15 years Typically used to finance capital expenditure e.g. building, equipment Repayment can be amortised or deferred

9. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 9 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.2 Term Loans or Fully- drawn Advances (cont.) Interest may be fixed or variable, is linked to an indicator rate e.g. BBSW or bank’s prime rate, and is influenced by – Credit risk of borrower (risk premium) – Term of the loan – Repayment schedule

10. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 10 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.2 Term Loans or Fully- drawn Advances (cont.) Other fees include – Establishment fee – Service fee – Commitment fee – Line fee – Bill option clause fee

11. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 11 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.2 Term Loans or Fully- drawn Advances (cont.) Loan covenants – Restrict the business and financial activities of the borrowing firm  Positive covenant requires borrower to take prescribed actions e.g. maintain a minimum level of working capital  Negative covenant restricts the activities and financial structure of borrower e.g. amount of dividend, maximum debt to equity ratio

12. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 12 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.2 Term Loans or Fully- drawn Advances (cont.) Loan covenants (cont.) – Breach of covenant results in default of the loan contract entitling lender to act

13. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 13 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.2 Term Loans or Fully- drawn Advances (cont.) Calculating the loan instalment— ordinary annuity (10.1)

14. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 14 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.2 Term Loans or Fully- drawn Advances (cont.) Calculating the loan instalment— ordinary annuity (cont.) – Example 1: Floppy Software Limited has approached Mega Bank to obtain a term loan to finance the purchase of a new high- speed CD burner. The bank offers a $150,000 loan, amortised over five years at 8 per cent per annum, payable monthly. Calculate the monthly loan instalments.

15. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 15 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.2 Term Loans or Fully- drawn Advances (cont.) Calculating the loan instalment— ordinary annuity (cont.) – Example 1 (cont.)

16. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 16 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.2 Term Loans or Fully- drawn Advances (cont.) Calculating the loan instalment—annuity due (10.2)

17. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 17 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.2 Term Loans or Fully- drawn Advances (cont.) Calculating the loan instalment—annuity due (cont.) – Example 2: A business proprietor is purchasing a computer system for the business at a cost of $21,500. a finance company has offered a term loan over seven years at a rate of 12 per cent per annum. The loan will be repaid by equal monthly instalments at the beginning of each month. Calculate the amount of the loan instalments.

18. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 18 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.2 Term Loans or Fully- drawn Advances (cont.) – Example 2 (cont.)

19. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 19 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 10.1 Introduction 10.2 Term Loans or Fully-drawn Advances 10.3 Mortgage Finance 10.4 Debentures, Unsecured Notes and Subordinated Debt

20. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 20 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.3 Mortgage Finance A mortgage is a form of security for a loan The borrower (mortgagor) conveys an interest in the land to the lender (mortgagee) The mortgage is registered on the land title

21. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 21 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.3 Mortgage Finance (cont.) The mortgage is discharged when the loan is repaid If the mortgagor defaults on the loan, the mortgagee is entitled to foreclose on the property Mortgage loans can be either residential or commercial

22. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 22 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.3 Mortgage Finance (cont.) Residential loans are typically granted for periods of up to 20 years, while commercial loans are for periods of 5 to 10 years, typically Variable interest rate loans dominate, but fixed rates are available for loans with terms of up to 2 years

23. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 23 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.3 Mortgage Finance (cont.) Mortgagee (lender) may reduce their risk exposure to borrower default by – Requiring mortgagor to take out mortgage insurance – Mortgagee buying a put option on the mortgage or property – Securitisation i.e. the sale of mortgage loans  The conversion of non-liquid assets into new asset-backed securities that are serviced with cash flows from the original assets

24. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 24 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.3 Mortgage Finance (cont.) Calculating the instalment on a mortgage loan (10.3)

25. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 25 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.3 Mortgage Finance (cont.) Calculating the instalment on a mortgage loan (cont.) – Example 3: A company is seeking a fully-amortised commercial mortgage loan of $650,000 from its bank. The conditions attached to the loan include an interest rate of 8 per cent per annum, payable over five years by equal end-of-quarter instalments. The company treasurer needs to ascertain the quarterly instalment amount.

26. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 26 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.3 Mortgage Finance (cont.) Calculating the instalment on a mortgage loan (cont.) – Example 3 (cont.):

27. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 27 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation 10.1 Introduction 10.2 Term Loans or Fully-drawn Advances 10.3 Mortgage Finance 10.4 Debentures, Unsecured Notes and Subordinated Debt

28. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 28 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.4 Debentures, Unsecured Notes and Subordinated Debt These securities are issued in the corporate bond market – Markets for the direct issue of longer-term debt securities – Lenders face higher  Risk compared to lending indirectly through intermediaries  Yield due to sharing in the profit margin usually taken by intermediaries

29. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 29 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.4 Debentures, Unsecured Notes and Subordinated Debt (cont.) Debentures and unsecured notes – Are both described as a corporate bond – Specify that the lender will receive regular interest payments (coupon) during the term of the bond and receive repayment of the face value at maturity – Debentures are secured by either a fixed or floating charge over the issuer’s unpledged assets

30. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 30 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.4 Debentures, Unsecured Notes and Subordinated Debt (cont.) Debentures and unsecured notes (cont.) – Unsecured notes are bonds with no underlying security attached – Debentures are listed and traded on the stock exchange – Debentures have a higher claim over a company’s assets (e.g. on liquidation) than unsecured note holders

31. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 31 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.4 Debentures, Unsecured Notes and Subordinated Debt (cont.) Issuing debentures and notes – There are three principal issue methods  Public issue—issued to the public at large, by prospectus  Family issue—issued to existing shareholders and investors by prospectus  Private placement—issued to institutional investors, prospectus not required – Usually issued at face value, but may be issued at a discount, or with deferred or zero interest

32. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 32 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.4 Debentures, Unsecured Notes and Subordinated Debt (cont.) Subordinated debt – More like equity than debt i.e. quasi-equity – Claims of debt holders are ‘subordinated’ behind all other company liabilities – Agreement may specify that the debt is not presented for redemption until after a certain period has elapsed – May be regarded as equity in the balance sheet and treated as Tier 2 capital

33. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 33 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation (cont.) 10.5 Calculations: Fixed Interest Securities 10.6 Leasing 10.7 Direct Credit Substitutes 10.8 Summary

34. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 34 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.5 Calculations: Fixed Interest Securities Price of a fixed interest bond at coupon date – The price of a fixed interest security is the sum of the present value of the face value and the present value of the coupon stream (10.4)

35. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 35 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.5 Calculations: Fixed Interest Securities (cont.) Price of a fixed interest bond at coupon date (cont.) – Example 4: Current corporate bond yields in the market are 8 per cent per annum. An existing corporate bond with a face value of $100,000, paying 10 per cent per annum half-yearly coupons, and exactly six years to maturity, would be sold at a price of:

36. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 36 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.5 Calculations: Fixed Interest Securities (cont.) – Example 4 (cont.): a b

37. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 37 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.5 Calculations: Fixed Interest Securities (cont.) Price of a fixed interest bond between coupon dates (10.7)

38. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 38 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.5 Calculations: Fixed Interest Securities (cont.) Price of a fixed interest bond between coupon dates (cont.) – Example 5: Current corporate bond yields in the market are 8 per cent per annum. An existing corporate bond with a face value of $100,000, paying 10 per cent per annum half-yearly coupons, maturing 31 December 2009, would be sold on 20 May 2004 at a price of:

39. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 39 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.5 Calculations: Fixed Interest Securities (cont.) – Example 5 (cont.): a b

40. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 40 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.5 Calculations: Fixed Interest Securities (cont.) – Example 5 (cont.): c

41. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 41 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation (cont.) 10.5 Calculations: Fixed Interest Securities 10.6 Leasing 10.7 Direct Credit Substitutes 10.8Summary

42. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 42 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.6 Leasing A lease is a contract where the owner of an asset (lessor) grants another party (lessee) the right to use the asset for an agreed period of time in return for periodic rental payments Leasing is the borrowing (renting) of an asset, instead of borrowing the funds to purchase the asset

43. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 43 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.6 Leasing (cont.) Advantages of leasing – Conserves capital – Provides 100% financing – Matches cash flows (i.e. rental payments with income generated by the asset) – Less likely to breach any existing loan covenants – Rental payments are tax deductible

44. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 44 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.6 Leasing (cont.) Types of leases – Operating lease  Lessor may lease the asset to successive lessees (e.g. short-term use of equipment)  Maintenance and insurance of the asset is provided by the lessor  Lessee makes rental payments for the period of use of the assets

45. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 45 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.6 Leasing (cont.) Types of leases (cont.) – Finance lease  Longer-term financing  Lessor finances the asset  Lessor earns return from a single lease contract  Lessee pays for insurance and maintenance  Residual amount due at end of lease period  Ownership of the asset passes to lessee on payment of the residual amount

46. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 46 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.6 Leasing (cont.) Types of leases (cont.) – Sale and lease-back  Existing assets owned by a company or government are sold to raise cash  The assets are then leased back from the new owner – Cross-border lease  A lessor in one country leases an asset to a lessee in another country

47. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 47 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.6 Leasing (cont.) Lease structures – Direct  Involves two parties (lessor and lessee)  Lessor purchases equipment with own funds and leases asset to lessee  Direct leases generally run from between 3 and 5 years  Leased asset price is, generally, less than $100,000

48. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 48 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.6 Leasing (cont.) Lease structures (cont.) – Leveraged leasing  Lessors contribute limited equity, and borrow the majority of funds required to purchase the asset  Asset then leased to lessee  Lessors gain tax advantages of depreciation and interest expense claims  Leased asset price is, usually, large (upwards of $2 million)

49. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 49 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.6 Leasing (cont.) Lease structures (cont.) – Equity leasing  Leased asset cost usually between direct and leveraged range ($100,000 to $2 million)  Similar structure to leveraged lease, but lose the leverage advantage due to the smaller amount of debt financing required

50. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 50 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation (cont.) 10.5 Calculations: Fixed Interest Securities 10.6 Leasing 10.7 Direct Credit Substitutes 10.8 Summary

51. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 51 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.7 Direct Credit Substitutes These are OBS arrangements that allow a corporation or government to substitute or replace an actual borrowing of funds with an undertaking from a financial institution such as a bank

52. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 52 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.7 Direct Credit Substitutes (cont.) Three categories of direct credit substitutes – Letter of credit—an irrevocable undertaking to meet a financial commitment in the event of default by a named party – Letter of comfort—advice given by a parent company provided reassurance that its subsidiary can meet its obligations

53. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 53 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.7 Direct Credit Substitutes (cont.) Three categories of direct credit substitutes (cont.) – Guarantee—a guarantor agrees to assume the liabilities of a third party in the event of default

54. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 54 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson Chapter Organisation (cont.) 10.5 Calculations: Fixed Interest Securities 10.6 Leasing 10.7 Direct Credit Substitutes 10.8 Summary

55. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 55 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.8 Summary When choosing the most appropriate source of medium- to longer-term debt, a borrower should consider the following factors – Matching the maturity and repayment schedule of debt with cash flows generated by assets financed by debt – Fixed or variable interest rate – Term of the financing arrangement – Repayment schedule – Loan covenants

56. Copyright  2003 McGraw-Hill Australia Pty Ltd PPT Slides t/a Financial Institutions, Instruments and Markets 4/e by Christopher Viney Slides prepared by Anthony Stanger 56 Copyright  2003 McGraw-Hill Australia Pty Ltd PPTs t/a Financial Accounting by Willis Slides prepared by Kaye Watson 10.8 Summary (cont.) When choosing the most appropriate source of medium- to longer-term debt, a borrower should consider the following factors (cont.) – Whether secured by fixed or floating charge, or unsecured – Impact on capital adequacy requirements of borrowing corporation – Impact of direct credit substitutes on the availability and cost of funds – Leasing an asset as opposed to buying an asset