Term loan and leasing

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Chapter 21Chapter 21
Term LoansTerm Loans
and Leasesand Leases
© Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI

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After studying Chapter 21,After studying Chapter 21,
you should be able to:you should be able to:
Describe various types of term loans and
discuss the costs and benefits of each.
Discuss the nature and the content of loan
agreements including protective (restrictive)
covenants.
Discuss the sources and types of equipment
financing.
Understand and explain lease financing in its
various forms.
Compare lease financing with debt financing
via a numerical evaluation of the present
value of cash outflows.

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Term Loans and LeasesTerm Loans and Leases
Term Loans
Provisions of Loan Agreements
Equipment Financing
Lease Financing
Evaluating Lease Financing in
Relation to Debt Financing

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Term LoanTerm Loan -- Debt originally scheduled
for repayment in more than 1 year, but
generally in less than 10 years.
Term LoansTerm Loans
Credit is extended under a formal loan arrangement.
Usually payments that cover both interest and
principal are made quarterly, semiannually, or
annually.
The repayment schedule is geared to the borrower’s
cash-flow ability and may be amortized or have a
balloon payment.

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Costs of a Term LoanCosts of a Term Loan
The interest rate is higher than on a short-
term loan to the same borrower (25 to 50
basis points on a low risk borrower).
Interest rates are either (1) fixed or (2)
variable depending on changing market
conditions -- possibly with a floor or ceiling.
Borrower is also required to pay legal
expenses (loan agreement) and a
commitment fee (25 to 75 basis points) may
be imposed on the unused portion.

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Benefits of a Term LoanBenefits of a Term Loan
The borrower can tailor a loan to their
specific needs through direct negotiation
with the lender.
Flexibility in terms of changing needs allows
the borrower to revise the loan more quickly
and more easily.
Term loan financing is more readily available
over time making it a more dependable
source of financing than, say, the capital
markets.

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Revolving CreditRevolving Credit
AgreementsAgreements
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 AgreementRevolving Credit Agreement -- A formal, legal
commitment to extend credit up to some
maximum amount over a stated period of time.

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Medium-Term NoteMedium-Term Note
Maturities range from 9 months to 30 years (or more).
Issuers include finance companies, banks or bank
holding companies, and industrial companies.
Medium-Term Note (MTN)Medium-Term Note (MTN) -- A corporate or government
debt instrument that is offered to investors on a
continuous basis.
Euro MTNEuro MTN -- An MTN issue sold internationally outside
the country in whose currency the MTN is denominated.

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Provisions ofProvisions of
Loan AgreementsLoan Agreements
CovenantCovenant -- A restriction on a borrower
imposed by a lender; for example, the
borrower must maintain a minimum amount of
working capital.
This allows the lender to act (or be “warned”
early) when adverse developments are
occurring that will affect the borrowing firm.
Loan AgreementLoan Agreement -- A legal agreement
specifying the terms of a loan and the
obligations of the borrower.

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Formulation of ProvisionsFormulation of Provisions
General provisionsGeneral provisions are used in most loan
agreements, which are usually variable to fit the
situation.
Routine provisionsRoutine provisions used in most loan
agreements, which are usually notnot variable.
Specific provisionsSpecific provisions that are used according to the
situation.
The important protective covenantsThe important protective covenants* fall intofall into
threethree differentdifferent categories.categories.
* Restrictions are negotiated between
the borrower and lender

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FrequentFrequent
General ProvisionsGeneral Provisions
Working capital requirement
Cash dividend and repurchase of
common stock restriction
Capital expenditures limitation
Limitation on other indebtedness

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FrequentFrequent
Routine ProvisionsRoutine Provisions
Furnish financial statements and maintain
adequate insurance to the lender
Must not sell a significant portion of its
assets 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

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Equipment FinancingEquipment 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 loan
balance by a given safety margin.
Trucking equipment is highly marketable, and the
lender may advance as much as 80% of market
value, while a limited use lathe might provide only a
40% advance or a specific use item cannot be used
as collateral.

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Sources and Types ofSources and Types of
1.1. Chattel MortgageChattel 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 copy of the security agreement or a financing
statement with a public office of the state in which
the equipment is located.
Sources of financing are commercial banks,Sources of financing are commercial banks,
finance companies, and sellers of equipment.finance companies, and sellers of equipment.
Types of financingTypes of financing

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Sources and Types ofSources and Types of
The buyer signs a conditional sales contract
security agreement to make installment payments
(usually monthly or quarterly) over time.
The seller has the authority to repossess the
equipment if the buyer does not meet all of the
terms of the contract.
The seller can sell the contract without the buyer’s
consent -- usually to a finance company or bank.
2.2. Conditional Sales ContractConditional Sales Contract -- A means of financing
provided by the seller of equipment, who holds title
to it until the financing is paid off.

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Lease FinancingLease Financing
Examples of familiar leasesExamples of familiar leases
Apartments Houses
Offices Automobiles
LeaseLease -- A contract under which one party, the
lessor (owner) of an asset, agrees to grant the
use of that asset to another, the lessee, in
exchange for periodic rental payments.

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Issues in Lease FinancingIssues in Lease Financing
AdvantageAdvantage: Use of an asset without
purchasing the asset
ObligationObligation: Make periodic lease payments
Contract specifies who maintains the asset
Full-service leaseFull-service lease -- lessor pays maintenance
Net leaseNet lease -- lessee pays maintenance costs
Cancelable or noncancelable lease?Cancelable or noncancelable lease?
Operating lease (short-term, cancelable) vs.
financial lease (longer-term, noncancelable)
Options at expiration to lessee

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Types of LeasingTypes of Leasing
The lessor realizes any residual value.
LessorsLessors: insurance companies, institutional
investors, finance companies, and independent
companies.
Sale and LeasebackSale and Leaseback -- The sale of an asset with
the agreement to immediately lease it back for
an extended period of time.

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The firm often leases an asset directly from a
manufacturer (e.g., IBM leases computers and
Xerox leases copiers).
LessorsLessors: manufacturers, finance companies,
banks, independent leasing companies, special-
purpose leasing companies, and partnerships.
Direct LeasingDirect Leasing -- Under direct leasingdirect leasing a firm
acquires the use of an asset it did not
previously own.

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Popular for big-ticket assets such as aircraft, oil
rigs, and railway equipment.
The role of the lessor changes as the lessor is
borrowing funds itself to finance the lease for the
lessee (hence, leveraged leasehence, leveraged lease).
Any residual valueresidual value belongs to the lessor as well as
any net cash inflows during the lease.
Leverage LeasingLeverage Leasing -- A lease arrangement in which the
lessor provides an equity portion (usually 20 to 40
percent) of the leased asset’s cost and third-party
lenders provide the balance of the financing.

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Accounting and TaxAccounting and Tax
Treatment of LeasesTreatment of Leases
In the past, leases were “off-balance-sheet” items
and hid the true obligations of some firms.
The lessee can deduct the full lease payment in a
properly structured lease. To be a “true lease” the
IRS requires:
1. Lessor must have a minimum “at-risk”
(inception and throughout lease) of 20% or
more of the acquisition cost.
2. The remaining life of the asset at the end of the
lease period must be the longer of 1 year or
20% of original estimated asset life.
3. An expected profit to the lessor from the lease
contract apart from any tax benefits.

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Economic RationaleEconomic Rationale
for Leasingfor Leasing
Leasing allows higher-income taxable companies to
own equipment (lessor) and take accelerated
depreciation, while a marginally profitable company
(lessee) would prefer the advantages afforded by
leases.
Thus, leases provide a means of shifting tax
benefits to companies that can fully utilize those
benefits.
Other non-tax issuesOther non-tax issues: economies of scale in the
purchase of assets; different estimates of asset life,
salvage value, or the opportunity cost of funds; and
the lessor’s expertise in equipment selection and
maintenance.

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““Should I LeaseShould I Lease
or Should I Buy?”or Should I Buy?”
Basket Wonders (BW) is deciding between leasing
a new machine or purchasing the machine outright.
The equipment, which manufactures Easter
baskets, costs $74,000 and can be leased over
seven years with payments being made at the
beginning of each year.
Analyze cash flows and determine whichAnalyze cash flows and determine which
alternative has the lowest (present value) costalternative has the lowest (present value) cost
to the firm.to the firm.
ExampleExample::

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The lessor calculates the lease payments
based on an expected return of 11% over the
seven years. (Ignore possible residual value
of equipment to lessor.)
The lease is a Financial leaseFinancial lease.
The firm is in the 40% marginal tax bracket.
If bought, the equipment is expected to have
a final salvage value of $7,500.

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The purchase value of the equipment will
result in a depreciation schedule of 20%,20%,
(declining balance method) based on a
$74,000 depreciable base.
Loan payments are based on a 12% loan
with payments occurring at the beginning
of each period.

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Determining the PV of CashDetermining the PV of Cash
Outflows for the LeaseOutflows for the Lease
The lessor will charge BWBW $14,148.27$14,148.27,
beginning today, for seven years until
expiration of the lease contract.
L L L L L L LL L L L L L L
0 1 2 3 4 5 6
11%11%
This is an annuity due that equals $74,000$74,000 today.
$74,000.00$74,000.00 = LL (PVIFA 11%11%, 7) (1.1111)
$66,666.67 = LL (4.712)
$14,148.27$14,148.27 = LL

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The result indicates that a $74,000 lease
that costs 11% annually for 7 years will
require $14,147.68* annual payments.
* Note that this is an annuity due, so set your calculator to “BGN”
Solving for the PaymentSolving for the Payment
N I/Y PV PMT FV
Inputs
Compute
7 11 74,000 0
-14147.68

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Net cash outflows at t = 0: $ 14,148.27
Net cash outflows at t = 1 to 6: $ 8,488.96
Net cash outflows at t = 7: $ -5,659.31
L L L L L L LL L L L L L L
0 1 2 3 4 5 6 7
BB = Tax-shield benefit (Inflow) = $ 5,659.31$ 5,659.31
LL = Lease payment (Outflow) = $ 14,148.27$ 14,148.27
B B B B B B BB B B B B B B

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Since the lease payments are prepaid, the company
is not able to deduct the expenses until the end of
each year.
The lessee, BWBW, can deduct the entire $14,148.27$14,148.27 as
an expense each year. Thus, the net cash outflows
are given as the difference between lease payments
(outflow) and tax-shield benefits (inflow).
The difference in risk between the lease and the
purchase (using debt) is negligible and the
appropriate before-tax cost is the same as debt, 12%.
Comments for the previous slideComments for the previous slide:

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The after-tax cost of financing the lease should be
equivalent to the after-tax cost of debt financing.
After-tax cost = 12% ( 1 - .4 ) = 7.2%7.2%.
The discounteddiscounted present value of cash outflows:
$14,148.27 x (PVIF 7.2%, 1) = $13,198.01$13,198.01
$ 8,488.96 x (PVIFA 7.2%, 6) = 40,214.3440,214.34
$ -5,659.31 x (PVIF 7.2%, 7) = -3,478.56-3,478.56
Present ValuePresent Value $$ 49,933.7949,933.79
Calculating the Present Value ofCalculating the Present Value of
Cash Outflows for the LeaseCash Outflows for the Lease

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Outflows for the Term LoanOutflows for the Term Loan
BWBW will make loan payments of
$14,477.42$14,477.42, beginning today, for seven
years until full payment of the loan.
TL TL TL TL TL TL TLTL TL TL TL TL TL TL
0 1 2 3 4 5 6
12%12%
This is an annuity due that equals $74,000$74,000 today.
$74,000.00$74,000.00 = TLTL (PVIFA 12%12%, 7) (1.1212)
$66,071.43 = TLTL (4.564)
$14,477.42$14,477.42 = TLTL

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The result indicates that a $74,000 term
loan that costs 12% annually for 7 years
will require $14,477.42* annual
payments.
* Note that this is an annuity due, so set your calculator to “BGN”
Solving for the PaymentSolving for the Payment
N I/Y PV PMT FV
Inputs
Compute
7 12 74,000 0
-14477.42

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End ofEnd of LoanLoan LoanLoan AnnualAnnual
YearYear PaymentPayment BalanceBalance* InterestInterest
0 $14,477.42 $59,522.58 ---
1 14,477.42 52,187.87 $7,142.71
2 14,477.42 43,972.99 6,262.54
3 14,477.42 34,772.33 5,276.76
4 14,477.42 24,467.59 4,172.68
5 14,477.42 12,926.28 2,936.11
6 14,477.43 0 1,551.15
Loan balance is the principal amount
owed at the end of each year.

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Remember -- AmortizationRemember -- Amortization
Functions of the CalculatorFunctions of the Calculator
Press:
2nd
Amort
2 ENTER
2 ENTER
Results*:
BAL = 52,187.87 ↓
PRN = -7,334.71 ↓
INT = -7,142.71 ↓
Second payment only shown here

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End ofEnd of AnnualAnnual AnnualAnnual Tax-ShieldTax-Shield
YearYear InterestInterest DepreciationDepreciation* BenefitsBenefits**
0 --- $ 0 ---
1 $7,142.71 14,800.00 8,777.00
2 6,262.54 11,840.00 7240.80
3 5,276.76 9,472.00 5900.00
4 4,172.68 7,577.00 4700.00
5 2,936.11 6062.00 3600.00
6 1,551.15 4850.00 2560.00
7 0 2380 952.00***
* Based on 20% declining balance method..
** .4 x (annual interest + annual depreciation).
*** Tax due to recover salvage value, $7,500 x .4.

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End of LoanEnd of Loan Tax-ShieldTax-Shield CashCash PresentPresent
YearYear PaymentPayment BenefitBenefit OutflowOutflow* ValueValue**
0 $14,477.42 --- $14,477.42 $14,477.42
1 14,477.42 $ 8,777.08 5,700.34 5,327.00
2 14,477.42 7,240.00 7,237.42 6321.00
3 14,477.42 5900.00 8577.42 7002
4 14,477.42 4,700.00 9777.42 7460
5 14,477.42 3,600 10877.42 7755
6 14,477.43 2,560.00 11917.42 7941
7 - 7,500.00*** 952.00 - 8452.00 - 5263
* Loan payment - tax-shield benefit.
** Present value of the cash outflow discounted at 7.2%.- 7% Table
*** Salvage value that is recovered when owned.

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The present value of costs for the term loan is
$51,020$51,020. The present value of the lease program
is $49,933.79$49,933.79.
The least costlyleast costly alternative is the lease programlease program.
Basket Wonders should proceed with the lease
program rather than the term loan.

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