ppt of term loan

21-1

Chapter 21Chapter 21

Term Loans Term Loans and Leasesand LeasesTerm Loans Term Loans and Leasesand Leases

© Pearson Education Limited 2004Fundamentals of Financial Management, 12/e

Created by: Gregory A. Kuhlemeyer, Ph.D.Carroll College, Waukesha, WI

21-2

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.

21-3

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

21-4

Term Loan Term 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.

21-5

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.

21-6

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.

21-7

Revolving Credit Revolving 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.

21-8

Insurance Insurance Company Term LoansCompany Term Loans

These term loans usually have final maturities in excess of seven years.

These companies do not have compensating balances to generate additional revenue and usually have a prepayment penalty.

Loans must yield a return commensurate with the risks and costs involved in making the loan.

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

21-9

Medium-Term NoteMedium-Term Note

Maturities range from 9 months to 30 years (or more).

Shelf registration makes it practical for corporate issuers to offer small amounts of MTNs to the public.

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 MTN Euro MTN -- An MTN issue sold internationally outside the country in whose currency the MTN is denominated.

21-10

Provisions of Provisions of Loan AgreementsLoan Agreements

Covenant Covenant -- 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 Agreement Loan Agreement -- A legal agreement specifying the terms of a loan and the

obligations of the borrower.

21-11

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 into fall into threethree differentdifferent categories. categories.

* Restrictions are negotiated between the borrower and lender

21-12

FrequentFrequentGeneral ProvisionsGeneral Provisions

Working capital requirement

Cash dividend and repurchase of common stock restriction

Capital expenditures limitation

Limitation on other indebtedness

21-13

FrequentFrequentRoutine 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

21-14

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.

21-15

Sources and Types of Sources and Types of Equipment FinancingEquipment Financing

1.1. Chattel Mortgage 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 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

21-16

Sources and Types of Sources and Types of Equipment FinancingEquipment Financing

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 Contract Conditional Sales Contract -- A means of financing provided by the seller of equipment, who holds title to it until the financing is paid off.

21-17

Lease FinancingLease Financing

Examples of familiar leasesExamples of familiar leases

Apartments Houses

Offices Automobiles

Lease Lease -- 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.

21-18

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 lease Full-service lease -- lessor pays maintenance Net lease Net 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

21-19

Types of LeasingTypes 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 a deductible expense.

LessorsLessors: insurance companies, institutional investors, finance companies, and independent companies.

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

an extended period of time.

21-20


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 Leasing Direct Leasing -- Under direct leasingdirect leasing a firm acquires the use of an asset it did not

previously own.

21-21


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 Leasing Leverage 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.

21-22

Accounting and Tax Accounting 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.

21-23

Economic Rationale Economic 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.

21-24

““Should I Lease Should 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 which Analyze cash flows and determine which alternative has the lowest (present value) cost alternative has the lowest (present value) cost

to the firm.to the firm.

ExampleExample::

21-25


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 net leasenet 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.

21-26


The purchase of the equipment will result in a depreciation schedule of 20%, 32%, 20%, 32%, 19.2%, 11.52%, 11.52%, and 5.76% 19.2%, 11.52%, 11.52%, and 5.76% for the first six years (5-year property class) based on a $74,000 depreciable base.

Loan payments are based on a 12% loan with payments occurring at the beginning of each period.

21-27

Determining the PV of Cash Determining 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 5 611%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

21-28

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 PaymentSolving for the PaymentSolving for the Payment

N I/Y PV PMT FV

Inputs

Compute

7 11 74,000 0

-14147.68

21-29


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$ 5,659.31LL = Lease payment (Outflow) = $ 14,148.27$ 14,148.27

B B B B B B BB B B B B B B

21-30


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:

21-31


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) =

40,214.34 40,214.34 $ -5,659.31 x (PVIF 7.2%, 7) = - -

3,478.563,478.56 Present ValuePresent Value $$

49,933.7949,933.79

Calculating the Present Value of Calculating the Present Value of Cash Outflows for the LeaseCash Outflows for the Lease

21-32

Determining the PV of Cash Determining the PV of Cash 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 5 612%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

21-33

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 PaymentSolving for the PaymentSolving for the Payment

N I/Y PV PMT FV

Inputs

Compute

7 12 74,000 0

-14477.42

21-34


End ofEnd of Loan Loan Loan Loan Annual Annual YearYear Payment Payment Balance Balance* Interest Interest

0 $14,477.42 $59,522.58 ---1 14,477.42 52,187.87 $7,142.712 14,477.42 43,972.99 6,262.543 14,477.42 34,772.33 5,276.764 14,477.42 24,467.59 4,172.685 14,477.42 12,926.28 2,936.116 14,477.43 0 1,551.15

Loan balance is the principal amount owed at the end of each year.

21-35

Remember -- Amortization Remember -- Amortization Functions of the CalculatorFunctions of the Calculator

Press:

2nd Amort

2 ENTER

2 ENTERResults*:

BAL = 52,187.87

PRN = -7,334.71

INT = -7,142.71

Second payment only shown here

21-36


End ofEnd of Annual Annual Annual Annual Tax-Shield Tax-Shield YearYear Interest Interest Depreciation Depreciation* Benefits Benefits**

0 --- $ 0 ---1 $7,142.71 14,800.00 $ 8,777.082 6,262.54 23,680.00 11,977.023 5,276.76 14,208.00 7,793.904 4,172.68 8,524.80 5,078.995 2,936.11 8,524.80 4,584.366 1,551.15 4,262.40 2,325.427 0 0 -3,000.00***

* Based on schedule given on Slide 21-26.** .4 x (annual interest + annual depreciation).*** Tax due to recover salvage value, $7,500 x .4.

21-37


End of LoanEnd of Loan Tax-Shield Tax-Shield Cash Cash Present Present YearYear Payment Payment Benefit Benefit Outflow Outflow* Value Value**

0 $14,477.42 --- $14,477.42 $14,477.421 14,477.42 $ 8,777.08 5,700.34 5,317.482 14,477.42 11,977.02 2,500.40 2,175.803 14,477.42 7,793.90 6,683.52 5,425.264 14,477.42 5,078.99 9,398.43 7,116.665 14,477.42 4,584.36 9,893.06 6,988.066 14,477.43 2,325.42 12,152.01 8,007.187 - 7,500.00*** -3,000.00 - 4,500.00 - 2,765.98

* Loan payment - tax-shield benefit.** Present value of the cash outflow discounted at 7.2%.*** Salvage value that is recovered when owned.

21-38


The present value of costs for the term loan is $46,741.88$46,741.88. The present value of the lease program is $49,933.79$49,933.79.

The least costly least costly alternative is the term loanterm loan. Basket Wonders should proceed with the term loan rather than the lease.

Other considerationsOther considerations: The tax rate of the tax rate of the potential lessee, potential lessee, timing and magnitude of the cash flows, discount rate employed, and uncertainty of the salvage value and their impacts on the analysis.

ppt of term loan

Documents

cash outflows

direct leasing

term loans

term loanend

basket wonders

tax cost

annuity due

shield benefit