Chapter 24 IM 10th Ed

8/13/2019 Chapter 24 IM 10th Ed

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CHAPTER 24

Term Loans and Leases

CHAPTER ORIENTATION

The first section of this chapter provides an overview of the major sources of term loans andtheir characteristics. The second section of the chapter provides an overview of leasefinancing, including a discussion of leasing arrangements, the accounting treatment offinancial leases, the lease versus purchase decision, and the potential benefits from leasing.

CHAPTER OUTLINE

I. Term loans

A. In general, term loans have maturities from one to 10 years and are repaid inperiodic installments over the life of the loan. Term loans are usually securedby a chattel mortgage on equipment or a mortgage on real property. Theprincipal suppliers of term credit include commercial bans, insurancecompanies and, to a lesser e!tent, pension funds.

". The common attributes of term loans include the following#1. The maturities of term loans are usually as follows#

a. $ommercial bans# 1 to % years.


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*. In addition to collateral, the lender on a term loan agreement will oftenrequire restrictive covenants that are designed to maintain theborrower+s financial condition on a par with that which e!isted at the

time the loan was made.

a. oring capital restrictions involve maintaining a minimumcurrent ratio that reflects the norm for the borrower+s industry,as well as the lender+s desires.

b. Additional borrowing restrictions prevent the borrower fromincreasing the amount of debt financing outstanding withoutthe lender+s approval.

c. A third covenant that is very popular requires that theborrower supply periodic financial statements to the lender.

d. Term loan agreements often include a ey-man provision thatthe borrower requires that the lender approve major personnelchanges and insure the lives of ey personnel with the lendernamed as the beneficiary.

/. Term loans are generally repaid in periodic installments in accordancewith repayment schedules established by the lender. ach installmentincludes both an interest and a principal component.

%. requently a ban will have demand for loans that e!ceeds its lendingcapacity. In order to satisfy the demand, the ban will share the loandemand with other participating bans. The participating bansreceive a certificate of participation and a commitment from the leadban to pay a portion of the loan cash flows as they are received.

2. urodollar loans are intermediate term loans made by majorinternational bans to businesses based on foreign depositsdenominated in dollars. The rate of the loan is an amount greater thanth ) d I t b 3ff d 4 t Th d ll l t i


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cash in the amount of the sales price of the asset sold and the use ofthe asset over the term of the lease. In return, the firm must maeperiodic rental payments throughout the term of the lease to the lessor.

*. In a leveraged lease a third participant is added who finances theacquisition of the asset to be leased for the lessor. rom the lessee+sstandpoint, this lease is no different from the two lease arrangementsdiscussed above. "ut with a leveraged lease, specific consideration isgiven to the financing arrangement used by the lessor in acquiring theasset to be leased.

". The accounting profession through inancial Accounting (tatement 6o. 1*

requires the capitali7ation of any lease that meets one or more of the followingcriteria#

1. The lease transfers ownership of the property to the lessee by the endof the lease term.

'. The lease contains a bargain repurchase option.

*. The lease term is equal to 8% percent or more of the estimatedeconomic life of the leased property.

/. The present value of the minimum lease payments equals or e!ceeds90: of the e!cess of the fair value of the property over any relatedinvestment ta! credit retained by the lessor.

$. The lease;versus-purchase decision requires a standard capital budgeting typeof analysis, as well as an analysis of two alternative pacages of financing.Two models are used to evaluate the lease versus purchase decision.

1. The first model computes the net present value of the purchase optionwhich can be defined as follows#

6&< =&> n

tA$I3


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'. In the second model a net advantage to lease =6A)> over purchaseequation is used that indicates the more favorable =least e!pensive>method of financing. The equation used to arrive at 6A) is as follows#

6A) ? = +

n

tt

b

tttt

1 >r=1

T5-TI-T>-=14-T>-=13

- ns

n

>@=1

isgreat enough to offset the negative 6&. In effect, if apositive 6A) were to more than offset a negative 6&,then the net present value through lease would be positive.

5. 3ver the years a number of potential benefits have been offered for leasefinancing. (ome of the more frequently cited advantages are enumerated andcommented upon here.

1. le!ibility and convenience. It is often argued that lease financing ismore convenient than other forms of financing because smalleramounts of funds can be raised at lower cost. In addition, it is oftenargued that lease payment schedules can be made to coincide withcash flows generated by the asset. These may or may not be realadvantages. It depends on the actual circumstances faced by the lesseefirm.

'. )ac of restrictions. It has been argued that leases require fewer

restrictions on the lessee than do debt agreements.

*. Avoiding the ris of obsolescence. This argument is generallyconceded to be fallacious because the lessor includes his or herestimated cost of obsolescence in the lease terms.

/. $onservation of woring capital. Dere it is argued that leasing involvesno down payment. Dowever, the borrower could obtain the sameeffect by borrowing the down payment.

%. 100-percent financing. The lease involves 100: financing butpurchasing the asset would surely involve some equity. As we notedabove, the down payment could be borrowed to produce 100:fi i i l I ddi i i i l h 100: l


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ANSWERS TOEND-OF-CHAPTER QUESTIONS

'/-1. Intermediate-term financing includes all those financing arrangements with finalmaturities longer than one year and with a ma!imum of ten years. (hort-termfinancing is for a period of less than one year and long-term financing generallyinvolves a period of more than ten years.

'/-'. The major types of restrictions usually found in the covenants of term loanagreements include#

=1> oring capital requirement. This restriction involves maintaining a minimumamount of woring capital. Additional borrowing. Generally, this type of restriction will require theapproval of the lender before any additional debt is issued. The restriction isoften e!tended to long-term lease agreements.

=*> &eriodic financial statements. A standard covenant in most term-loanagreements involves supplying the lender with periodic financial statements.These usually include annual or quarterly-income statements and balancesheets.

=/> Canagement. Term-loan agreements will sometimes include a provisionrequiring prior approval by the lender of major personnel changes. Inaddition, the borrower may be required to insure the lives of certain eypersonnel with the lender named as beneficiary.

'/-*. =1> In a direct leasing agreement the firm acquires the services of an asset it didnot previously own. The lease basically involves purchase of the asset by thelessor from a vendor and leasing it to the lessee.


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'/-/. &rior to Hanuary, 1988, most financial leases were not included in the balance sheetsof lessee firms. They were instead reported in the footnotes to the balance sheet inaccordance with A&" 3pinions % and *1. In 6ovember, 1982, the accounting

profession reversed its long standing position with (tatement of inancial Account(tandards 6o. 1* entitled Accounting for )eases. (pecifically, (tatement 1*requires that any lease which meets one or more of the following criteria be includedin the body of the balance sheet of the lessee#

=1> The lease transfers ownership of the property to the lessee by the end of thelease term.

='> The lease contains a bargain repurchase option.

=*> The lease term is equal to 8% percent or more of the estimated economic lifeof the leased property.

=/> The present value of the minimum lease payments equals or e!ceeds 90percent of the e!cess of the fair value of the property over any relatedinvestment ta! credit retained by the lessor.

'/-%. The potential benefits from lease financing include#

=1> le!ibility and convenience. irst, it is argued that leasing provides the firmwith fle!ibility because it allows for piece-meal financing of relatively smallasset acquisitions.

(econd, leasing may allow a division or subsidiary manager to acquireequipment without the approval of the corporate capital budgeting committee.

Third, some lease payment schedules may be structured to coincide with therevenues generated by the asset, or they may be timed to match seasonal

fluctuations in a given industry.Arguments for the greater convenience of leasing may tae many forms. It issometimes stated that leasing simplifies booeeping for ta! purposes becauseit eliminates the need to prepare time consuming depreciation tables and


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=%> 100 percent financing. Another alleged benefit of leasing is embodied in theargument that a lease provides the firm with 100 percent financing. It ispointed out that the borrow-and-buy alternative generally involves a down

payment, whereas leasing does not.=2> Ta! savings. It is also argued that leasing offers an economic advantage in

that the ta! shield generated by the lease payments usually e!ceeds the ta!shield from depreciation that would be available if the asset were purchased.

=8> ase of obtaining credit. This alleged advantage of leasing concerns assertionthat firms with poor credit ratings are able to obtain assets through leaseswhen they are unable to finance the acquisitions with debt capital.

SOLUTIONS TOEND-OF-CHAPTER PROBLEMS

(olutions to &roblem (et A

'/-1A.Interest 4ate 10.0:ace Amount F*'%,000.00

ear Pa!men" In"eres" Pr#n$#%a& Ba&an$e0 *'%,000.001 %0,000.00 *',%00.00 18,%00.00 *08,%00.00' %0,000.00 *0,8%0.00 19,'%0.00 ','%0.00

* %0,000.00 ','%.00 '1,18%.00 '28,08%.00/ %0,000.00 '2,808.%0 '*,'9'.%0 '/*,8'.%0% '2,120.8% '/,*8.'% '/*,8'.%0 0


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&ayment ?1'8.*

000,100F ? F*1,989.%*

'/-/A.4emaining

Jear &ayment Interest &rincipal "alance1 F*1,989.%* F1,000.00 F1*,989.%* F2,0'0./8' *1,989.%* 1%,/*.2 12,/9%.% 29,%'/.2'* *1,989.%* 1',%1/./* 19,/2%.10 %0,0%9.%'/ *1,989.%* 9,010.81 '',92.' '8,090.80% *1,989.%* /,82.** '8,10*.'0 =1'.%0>

4ounding errors produced a F1'.%0 difference in the remaining balance and principalportion of the fifth year payment.

'/-%A. =a> F'00,000 ? F%9,22* = +

%

1ttr>=1

1

where r ? the effective annual rate on the computer sales firm loan.

= +

%

1ttr>=1

1 ?

22*,%9

000,'00F? *.*%'

)ooing in the annuity present value table we find that an r of 1%: for a fiveyear loan is *.*%'. Thus, the effective rate on the loan is 1%:.

=b > F'%0,000 ? &ayment =

%

1tt>12.1=

1

&ayment ?'8/*

000,'%0F? F82,*%9.19


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e now that the following relationship holds for any equal paymentinstallment loan#

)oan Amount ? &ayment = +

n

1t t>1=

1

where n is the term of the loan and is the rate of interest charged on theremaining loan balance.

Ksing this relationship we can define

F/00,000 ? F1/0,102 = +

/

1tt>=1

1

Therefore, = +

/

1tt>=1

1 ?

102,1/0F

000,/00F? '.%%

e now now the present value of an annuity factor that corresponds to afour-year period and the rate of interest on the loan =>. )ooing up thisfactor in the annuity present value table, we find that ? 1% percent.

Therefore, the ban loan alternative is preferred.

'/-8A.=a> valuating the purchase alternative#

I3 ? F'0,000

Annual net cash flows#"oo profits $ash flows

Annual cash savings F2,000 F2,000)ess# depreciation =/,000 >

6et revenues before ta!es ',000 2,000)ess# ta!es =%0:> =1,000 > =1,000 >

F%,000&l l l / 000


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Annual payment ? F'0,000 E =

/

1tt=1.10>

1 ? F2,*09.1%

Jear &ayment Interest &rincipal 4emaining "alance0 F'0,000.001 F2,*09.1% F',000.00 F/,*09.1% 1%,290.%' 2,*09.1% 1,%29.09 /,8/0.02 10,9%0.89* 2,*09.1% 1,09%.0 %,'1/.08 %,8*2.8'/ 2,*09.1% %8*.28 %,8*%./ 1.'/

4ounding errors produced a F1.'/ difference in the remaining balance and principal portionof the fourth year payment.

=1> (olving for = +

/

1tt

b

ttt

>r=1

T5TIT>=14T>=13 t =Term one>

5iscount &resent

Jear 3t=1-T> - 4=1-T> - ItT - 5tT ? (KC actor ? -F1,**1

='> (olving for - ns

n

>=1

? -',%//


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'/-A.=a> The basic analytical relationship needed to solve for installment payments isfound below#

)oan Amount ? &ayment = +

n

1tt>=1

1

Thus, for the first part of this e!ercise

F100,000 ? &ayment =

10

1t

t=1.1%>

1

or

&ayment ? F100,000 L ==

10

1tt=1.1%>

1 >

e recogni7e the summation term =

10

1tt=1.1%>

1 as a present

value annuity factor which is found in Appendi! . Thus,

&ayment ? F100,000 L %.019

? F19,9'/.'9

=b> In this problem we must recall the procedure for quarterly compounding. Ingeneral, the payment relationship in =a> becomes

mn 1


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=c> This problem requires that we first solve for the annual installment paymentsfor each of the ne!t five years based upon a *0-year installment period, i.e.,

&ayment ? )oan amount L =

+

*0

1t

t.1%>=11

or

&ayment ? F100,000 L 2.%22

? F1%,''9.98

6e!t, we have to calculate the outstanding or remaining balance of the loan atthe end of the fifth year where five annual installments of F1%,''9.98 havebeen made. To do this, we must go through the calculations outlined in Table'/-1.

4emaining

Jear )oan &ayment Interest &rincipal "alance0 F100,000.001 F1%,''9.98 F1%,000.00 F ''9.98 99,880.0*' 1%,''9.98 1/,92%.%0 '2/./8 99,%0%.%2* 1%,''9.98 1/,9'%.* *0/.1/ 99,'01./'/ 1%,''9.98 1/,0.'1 */9.82 9,%1.22% 11*,289./1 1/,'8.8% 9,%1.22 0

Thus, the fifth year balloon payment will equal the principal remaining at the

end of that year of F9,%1.22 plus interest for the year of F1/,'8.8% for atotal of F11*,289./1.

This type of loan agreement is frequently used by homeowners who givebuyers a second loan on a home purchase The loan will usually be amorti7ed


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SOLUTION TO INTE'RATI(E PROBLEM

=a> Initial outlay =I3> ? F20,000

$omputing annual net cash flows

"oo profits $ash flowsAnnual cash savings F'8,000 F'8,000)ess# depreciation =1',%00 >

6et revenues before ta!es 1/,%00 '8,000)ess# ta!es =%0:> =8,'%0 > =8,'%0 >

JearsAnnual after-ta! cash flows =1-*> F19,8%0 1-*&lus# salvage value 10,000

JearAnnual after-ta! cash flow =/> F'9,8%0 /

$alculating 6&< =&>#

6& ? F19,8%0 =

/

1tt=1.1'>

1 B F10,000 - F20,000

? F19,8%0=*.0*8> B F10,000=0.2*2> - F20,000

? F%9,90.8% B F2,*20 - F20,000

? F2,*/0.8%

Thus, the computer should be acquired via normal purchase financing, as ithas a positive 6& of F2 */0 8%


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=1> (olving for = +

/

1tt

b

tttt

>r=1

T5TIT>=14T>=13 =Term one>

After-ta! After-ta! Ta! (helter on 5iscountoperating e!penses rental loan =interest 5epreciation actor &resent

Jear paid by lessor e!penses lost by leasing> Ta! (helter Total /: - 4 t=1-T> - ItT - T5t ? (KC ! 5 ? & (olving for# - ns

n

>=1

1'.1=

000,10? =Term two> ? - 2,*20

=*> Adding# I3# =Term three> ? 20,000

=/> 6et Advantage of )easing =6A)> F =*,20 >

=c> The 6A) is negative, indicating that lease financing is not preferred to normal purchase financing.That is, the net present value of the asset, if leased, is equal to 6& B 6A) or F2,*/0 - F*,20 ?F',/0. The asset should not be leased.

59

1


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(olutions to &roblem (et "

'/-1".Interest 4ate 1'.0:ace Amount F*00,000.00

ear Pa!men" In"eres" Pr#n$#%a& Ba&an$e0 *00,000.001 20,000.00 *2,000.00 '/,000.00 '82,000.00' 20,000.00 **,1'0.00 '2,0.00 '/9,1'0.00

* 20,000.00 '9,9/./0 *0,10%.20 '19,01/./0/ 20,000.00 '2,'1.8* **,81.'8 1%,'92.1*% '08,%*1.28 '','*%.%/ 1%,'92.1* 0

Thus, the fifth year balloon payment will equal the principal remaining at the end of thatyear of F1%,'92.1* plus interest for the year of F'','*%.%/ for a total of F'08,%*1.28.

'/-'".

Interest 4ate 1%.0:quipment &rice '%0,000.006umber of &ayments 104ental &ayment /*,*1%.28

&resent


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'/-%".

=a> F'%0,000 ? F29,000 = +

%

1ttr>=1

1

where r ? the effective annual rate on the loan.

= +

%

1ttr>=1

1 ?

000,29

000,'%0F ? *.2'*

)ooing in the annuity present value table we find that an r of 1': for a five-yearloan is *.20%. Thus, the effective rate on the loan is appro!imately 1':.

Actually, it is 11.89: =found using the 4ate function in a financial spreadsheet>.

=b > F*00,000 ? &ayment =

%

1tt=1.12>

1

&ayment ? F91,2*1.0*

=c> F*00,000 ? F/'%,000 %r>=1

1

+

%r>=1

1

+?

000,/'%F

000,*00F ? .80%9

Thus, r ? 8.'1:.

=d> The effective rate of interest is lowest on the insurance loan


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Ksing this relationship we can define

F%00,000 ? F18%,000 = +

/

1ttr>=1

1

Therefore, = +

/

1ttr>=1

1 ?

000,18%F

000,%00F ? '.%8

e now now the present value of an annuity factor that corresponds to a four-year period and the rate of interest on the loan =r>. )ooing up this factor in theannuity present value table, we find that r ? 1% percent.

Therefore, ban loan alternative is preferred.

'/-8".=a> I3 ? F'%,000

Annual net cash flows# "oo profits $ash flowsAnnual cash savings F8,000 F8,000)ess# depreciation =%,000 >

6et revenues before ta!es ',000 8,000)ess# ta!es =%0:> =1,000 > =1,000 >

Annual after-ta! Jears

$ash flows F2,000 1-*&lus# salvage value %,000Jear

Annual after-ta! cash flow =/> F11,000 /


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=b> $alculating principal and interest on a loan of F'%,000 at 10:.

Annual payment ? F'%,000E =

/

1tt=1.11>

1 ? F,0%.12

Jear &ayment Interest &rincipal 4emaining "alance0 F'%,000.001 F,0%.12 F',8%0.00 F%,*0.12 19,291./' ,0%.12 ',122.10 %,9'.02 1*,899.8

* ,0%.12 1,%18.9 2,%/0.1 8,'%9.20/ ,0%.12 89.%2 8,'%9.20 0.00

=1> (olving for>tr=1

T5-TI-T>-4=1-T>-=13

b

ttt/

1t +=

Jear 3t=1-T> - 4=1-T> - ItT - 5tT ? (KC &< actor &

1

=

or

&ayment ? F1'%,000 L t

1'

1t =1.1*>

1

=

e recogni7e the summation term t

1'

1t =1.1*>

1

=as a present

value annuity factor which is found in Appendi! . Thus,

&ayment ? F1'%,000 L %.91

? F'1,1''.00

=b> In this problem we must recall the procedure for quarterly compounding. Ingeneral, the payment relationship in =a> becomes

)oan Amount ? &ayment t

mn

1t Em>=1

1

+=

where m is the number of compounding periods in a year =e.g., m ? / forquarterly compounding>. Thus,


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=c> This problem requires that we first solve for the annual installment payments for

each of the ne!t five years based upon a *0-year installment period, i.e.,

&ayment ? )oan amount L t

*0

1t .1*>=1

1

+=

or

&ayment ? F1'%,000 L 8./92

? F12,28%.%2

6e!t, we have to calculate the outstanding or remaining balance of the loan at theend of the fifth year where five annual installments of F12,28%.%2 have been made.To do this, we must go through the calculations outlined in Table '/-1.

4emainingJear )oan &ayment Interest &rincipal "alance

F1'%,000.00

0 F12,28%.%2 F12,'%0.00 F /'%.%2 1'/,%8/.//

1 12,28%.%2 12,19/.2 /0. 1'/,09*.%2

* 12,28%.%2 12,1*'.12 %/*./0 1'*,%%0.12

/ 12,28%.%2 12,021.%' 21/.0/ 1'',9*2.1'

% 1*,918.' 1%,91.80 1'',9*2.1' 0.00

6ote that the fifth year balloon payment will equal the principal remaining at theend of that year of F1'' 9*2 1' plus interest for the year of F1% 91 80 for a total


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'/-9".=a> Initial outlay =I3> ? F2%,000

$omputing annual net cash flows

"oo profits $ash flowsAnnual cash savings F'9,000 F'9,000

)ess# depreciation =1/,'%0 >

6et revenues before ta!es 1/,8%0 '9,000

)ess# ta!es =%0:> =8,*8% > =8,*8% >

JearsAnnual after-ta! cash flows =1-*> F'1,2'% 1-*

&lus# salvage value ,000Jear

Annual after-ta! cash flow =/> F'9,2'% /

$alculating 6&< =&>#

6& ? F'1,2'% t

/

1t =1.1/>

1

= B F,000 />1/.1=

1 - F2%,000

? F'1,2'% ='.91/> B F,000 =0.%9'> - F2%,000

? F',8%1.'%

Thus, the computer should be acquired via normal purchase financing, as it has a


23/23

=1> (olving for tb

tttt/

1t >r=1

T5TIT>=14T>=13

+

=

After-ta! After-ta! Ta! (helter 5iscountoperating e!penses rental on loan =interest 5epreciation actor &resent

Jear paid by lessor e!penses lost by leasing> Ta! (helter Total /: - 4 t=1-T> - ItT - T5t ? (KC ! 5 ? & (olving for - ? - />1/.1=

000,I? =Term two> ? - /,8*2

=*> Adding# I3# =Term three> ? 2%,000

=/> 6et Advantage of )easing =6A)> F =/,029>

=c> The 6A) is negative, indicating that lease financing is not preferred to normal purchase financing.

599

Documents

Chapter 24 IM 10th Ed