LEARN ING OB JECT IVES After reading this chapter, you should be able to

1. Describe the basic characteristics ofa term loan.

2. Calculate the principal and interestcomponents of an installment loan.

3. List and define the basic types oflease arrangements.

4. Calculate the net advantage ofleasing versus purchasing an asset.

5. Describe the potential sources ofeconomic benefit derived fromleasing versus purchasing.

Term Loans and Leases

24-2

Virtually everyone has rented something at one time oranother. With renting, just like owning, you get to use theasset. What distinguishes renting or leasing from owning isthat when you rent, you dont actually obtain ownership ofthe thing being rented and must return it to the owner at theend of the agreement.

Firms lease all types of capital equipment as an alternative to purchasing it. For example, they lease computers, trucks, and railroad cars. The U.S. Navy has even leased minesweepers.The Equipment Leasing AssociationELA(www.elaonline.com/industryData/overview.cfm) reports that more com-panies, particularly small companies, acquire new productiveequipment through leases than through loans. Of the $697 bil-lion spent by businesses on productive assets in 2001, $216 bil-

lion, or 31 percent, was acquired by American businessesthrough leasing. In 2002, expenditures on leases were estimatedto be $204 billion and for 2003 the total was projected to be$208 billion. Furthermore, virtually every company uses leasefinancing. The ELA estimates that over 80 percent of U.S. compa-nies lease all or some of their equipment.

Why leasewhy not purchase? Some companies leasebecause they think they can avoid investing in equipmentthat faces the risk of rapid obsolescence, whereas othersthink that they are conserving their cash. As we learn in thischapter, these and many other reasons for leasing are sub-ject to quantitative analysis, which reduces the decisiondown to an analysis of the net present value of leasing ver-sus owning.

CHAPTER PREV IEW Chapter 24 contains a discussion of two sources ofintermediate term financing: term loans and leases.Intermediate term financing consists of all thosesources of financing with maturities longer than oneyear and shorter than 10 years. This maturity rangeis bracketed by short-term sources of financing suchas bank notes, trade credit, and commercial paper(discussed in Chapter 18) and long-term sources offinancing such as bonds and stock (discussed inChapters 7, 8, and 14).

Our discussion of term loans, an importantsource of financing for machinery and equipment,will focus on the various sources of term financingand their basic characteristics as well as thecalculation of installment payments (including thedecomposition of those payments into their princi-pal and interest components). We then categorize

leases as operating or financial leases and focus on thelatter, because operating leases are short-term innature. We evaluate the merits of leasing versus pur-chasing by first evaluating the viability of purchas-ing via the projects net present value and then ana-lyzing the incremental benefits of leasing bycalculating the net advantage of leasing.

This chapter will emphasize these principles:Principle 1: The Risk-Return Trade-OffWewont take on additional risk unless we expect tobe compensated with additional return; Principle2: The Time Value of MoneyA dollar receivedtoday is worth more than a dollar received in thefuture; Principle 3: CashNot ProfitsIs King;Principle 4: Incremental Cash FlowsIts onlywhat changes that counts; and Principle 8: TaxesBias Business Decisions.

C H A P T E R 2 4

24-3 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

O b j e c t i v e 1 T E R M L O A N STerm loans generally share three common characteristics: They (1) have maturities of 1to 10 years; (2) are repaid in periodic installments (such as quarterly, semiannual, orannual payments) over the life of the loan; and (3) are usually secured by a chattel mort-gage on equipment or a mortgage on real property. The principal suppliers of term creditare commercial banks, insurance companies, and (to a lesser extent) pension funds.

We will consider briefly some of the more common characteristics of term loanagreements.

M A T U R I T I E SCommercial banks generally restrict their term lending to one- to five-year maturities.Insurance companies and pension funds with their longer-term liabilities generally makeloans with 5- to 15-year maturities. Thus, the term lending activities of commercial banksactually complement rather than compete with those of insurance companies and pensionfunds. In fact, commercial banks very often cooperate with both insurance companies andpension funds in providing term financing for very large loans.

C O L L A T E R A LTerm loans are generally backed by some form of collateral. Shorter-maturity loans arefrequently secured with a chattel mortgage (a mortgage on machinery and equipment) orwith securities such as stocks and bonds. Longer-maturity loans are frequently secured bymortgages on real estate.

There is also a form of term credit that requires no collateral that can be used by onlythe largest blue-chip companies. These unsecured medium-term notes (MTNs) were cre-ated as a result of the introduction of shelf registration by the Securities and ExchangeCommission in 1982. Shelf registration permits companies to file a single registrationstatement for a series of similar issues. Once registered, the MTNs can be sold as fundsare required, giving the issuer a ready source of term financing. The key thing to recog-nize here is that unsecured term financing, like similar forms of unsecured short-termfinancing (e.g., commercial paper), is available to only the most creditworthy borrowers.

R E S T R I C T I V E C O V E N A N T SIn addition to requiring collateral, the lender in a term loan agreement often placesrestrictions on the borrower that, when violated, make the loan immediately due andpayable. These restrictive covenants are designed to prohibit the borrower from engag-ing in any activities that would increase the likelihood of loss on the loan. There are somecommon restrictions:

1. Working-capital requirement. This restriction takes the form of a minimum cur-rent ratio, such as 2 to 1 or 312 to 1, or a minimum dollar amount of net working cap-ital. The actual requirement would reflect the norm for the borrowers industry, aswell as the lenders desires.

2. Additional borrowing. This type of restriction requires the lenders approval beforeany additional debt can be issued. Furthermore, a restriction on additional borrowingis often extended to long-term lease agreements, which are discussed later in thischapter.

3. Periodic financial statements. A standard covenant in most term loan agreementsincludes a requirement that the borrower supply the lender with financial statements

Term loansLoans that have maturities of 1 to 10 years and are repaid inperiodic installments over thelife of the loan; usually securedby a chattel mortgage onequipment or a mortgage onreal property.

C H A P T E R 2 4 T E R M L O A N S A N D L E A S E S 24-4

on a regular basis. These generally include annual or quarterly income statementsand balance sheets.

4. Management. Term loan agreements sometimes include a provision that requiresprior approval by the lender of major personnel changes. In addition, the borrowermay be required to insure the lives of certain key personnel, naming the lender asbeneficiary.

We have presented only a partial listing of restrictions commonly found in term loanagreements. The number and form of such provisions are limited only by the scope of thelaw and the imagination of the parties involved. It should be noted, however, that restric-tive covenants are subject to negotiation. The specific agreement that results reflects therelative bargaining strengths of the borrower and lender. Marginal borrowers are morelikely to find their loan agreements burdened with restrictive covenants than more cred-itworthy borrowers.

Term loan agreements can be very technical and are generally tailored to the situa-tion. Therefore, it is difficult to generalize about their content. However, many banksrely on standardized worksheets or checksheets to aid in the preparation of the document.

L O A N PA R T I C I P A T I O N S A M O N G B A N K SThe demand for loans is not evenly dispersed across banks; heavier demand is placed onlarge money center banks and banks in regions of the country that are experiencingstrong economic growth. This frequently means that these banks cannot provide all thenecessary funds, so they share the loan demand with one or more participating banks.This shared lending has grown rapidly in recent years and has served to promote the flowof funds from banks with excess lending capacity to those with excess loan demand. Theparticipating banks work out an agreement and receive a certificate of participation,which states that the lead bank will pay a portion of the loan cash flows as they arereceived.

E U R O D O L L A R L O A N SEurodollar loans are intermediate-term loans made by major international banks tobusinesses based on foreign deposits that are denominated in dollars. These loans aregenerally made in amounts ranging from $1 million to $1.5 billion with the rate based ona certain amount above the London Interbank Offered Rate (LIBOR). The rate on these

B A C K T O T H E P R I N C I P L E S

When we determine the loan payments for an installment loan, we are solving for a series ofannuity payments (installment or loan payments) whose present value equals the face value ofthe loan when discounted using the borrowing rate on the loan. Thus, we are valuing a series offuture cash flows. The valuation process utilizes a number of our Principles: Principle 1: TheRisk-Return Trade-OffWe wont take on additional risk unless we expect to be compen-sated with additional return comes into play in determining the rate of interest for the loan.Principle 2: The Time Value of MoneyA dollar received today is worth more than a dollarreceived in the future provides the basis for finding the present value of future payments.Finally, Principle 3: CashNot ProfitsIs King tells us that what matters to both the lenderand borrower is the cash received and cash paid.

Eurodollar loansIntermediate-term loans madeby major international banks tobusinesses based on foreigndeposits that are denominatedin dollars.

24-5 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

loans is adjusted periodically (generally every six months), and there is a wide range ofmaturities. Eurodollar lending has become a major source of commercial lending withthe total volume of lending being measured in trillions of dollars.

The attraction of the Eurodollar market relates to the fact that this market is subjectto very limited official regulation. It has been suggested, in fact, that some investors usethe market to avoid home country taxes. For example, Eurobonds (which are long-termbonds sold outside the country in whose currency the bond is denominated) are sold inbearer rather than registered form. This means that there is no record of who owns thebonds and receives the interest payments.

L O A N P A Y M E N T C A L C U L A T I O N

R E P AY M E N T S C H E D U L E STerm loans are generally repaid with periodic installments, which include both an inter-est and a principal component. Thus, the loan is repaid over its life with equal annual,semiannual, or quarterly payments.

To illustrate how the repayment procedure works, let us assume that a firm borrows$15,000, which is to be repaid in five annual installments. The loan will carry an 8 percentrate of interest, and payments will be made at the end of each of the next five years. Thefollowing diagram shows the cash flows to the lender:

O b j e c t i v e 2

C O N C E P T C H E C K1. How is a term loan distinguished from other forms of financing?2. What are the common types of restrictions placed on borrowers when using

term loans?

The $15,000 cash flow at period zero is placed in parentheses to indicate an outflow ofcash by the lender, whereas the annual installments, A1 through A5, represent cashinflows (of course, the opposite is true for the borrower). The lender must determine theannual installments that will give an 8 percent return on the outstanding balance over thelife of the loan. This problem is very similar to the internal rate of return problemencountered in Chapter 9, where we discussed capital-budgeting decisions and had todetermine the rate of interest that would make the present value of a stream of future cashflows equal to some present sum. Here we want to determine the future cash flows whosepresent value, when discounted at 8 percent, is equal to the $15,000 loan amount. Thus,we must solve for those values of A1 through A5 whose present value when discounted at8 percent is $15,000. In equation form,

(24-1)$ ,( . )

15 0001 081

5

=+=

At tt

Year0 1 2 3 4 5

$(15,000) A1 A2 A3 A4 A5

C H A P T E R 2 4 T E R M L O A N S A N D L E A S E S 24-6

Where we assume equal annual installments, A, for all five years, we can solve for A as follows:

or

The term that is divided into that $15,000 loan amount is the present value factor for afive-year annuity carrying an 8 percent rate of interest. Thus,

Therefore, if the borrower makes payments of $3,756.57 each year, then the lender willreceive an 8 percent return on the outstanding loan balance. To verify this assertion,check Table 24-1, which contains the principal and interest components of the annualloan payments. We see that the $3,756.57 installments truly provide the lender with an 8 percent return on the outstanding balance of a $15,000 loan.

A = =$ ,.

$ , .15 0003 993

3 756 57

APVIF

tt

=

+

=

=

$ ,

( . )

$ ,

%,

15 000

11 08

15 000

1

58 5 yrs

$ ,( . )

15 0001

1 081

5

=+=

A tt

C O N C E P T C H E C K1. What factors does a lender use to calculate the installment payments for a loan?2. How is loan payment calculation similar to the internal rate of return

calculation for a capital-budgeting project?

TA B L E 2 4 - 1 Term Loan Amortization Schedule

E N D O F I N S TA L L M E N T P R I N C I PA L R E M A I N I N G Y E A R PAY M E N T a I N T E R E S T b R E PAY M E N T c B A L A N C E d

t A I t P t R B t

0 $15,000.001 $3,756.57 $1,200.00 $2,556.57 12,443.432 3,756.57 995.47 2,761.10 9,682.333 3,756.57 774.59 2,981.98 6,700.354 3,756.57 536.03 3,220.54 3,479.815 3,756.57 278.38 3,478.19 1.62e

aThe annual installment payment, A, is found as follows:

bAnnual interest expense is equal to 8 percent of the outstanding loan balance. Thus, for year 1, the interest expense, It , is found asfollows:

It = .08 ($15,000) = $1,200cPrincipal repayment for year t, Pt , is the difference in the loan payment, A, and interest for the year. Thus, for year 1, we compute

Pt = A I1 = $3,756.57 $1,200 = $2,556.57dThe remaining balance of the end of year 1, RB1 is the difference in the remaining balance for the previous year, RB0, and theprincipal payment in year 1, P1. Thus, at the end of year 1,

RB1 = RB0 P1 = $15,000 $2,556.57 = $12,443.43eThe $1.62 difference in RB4 and P5 is due to rounding error.

A

t

t

=

+

=

=

$ ,

( . )

$ , .15 000

1

1 08

3 756 57

1

5

(24-2)

24-7 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

O b j e c t i v e 3

LeaseA contract between a lessee,who acquires the services of aleased asset by making a seriesof rental payments to thelessor, who is the owner of theasset.

Lessee and lessorThe user of the leased asset,who agrees to make periodiclease or rental payments to thelessor, who owns the asset.

Financial leaseA noncancelable contractualcommitment on the part of thefirm leasing the asset (thelessee) to make a series ofpayments to the firm thatactually owns the asset (thelessor) for use of the asset.

Operating leaseA lease agreement (see financiallease) in which the lessee cancancel the agreement at anytime by giving proper notice tothe lessor.

Net and net-net leasesIn a net lease agreement, thelessee assumes the risk andburden of ownership over theterm of the lease. This meansthat the lessee must payinsurance and taxes on the assetas well as maintain theoperating condition of theasset. In a net-net lease, thelessee must, in addition to therequirements of a net lease,return the asset to the lessor atthe end of the lease while stillworth a preestablished value.

1 Many leasing companies specialize in the leasing of a single type of asset. For example, several firms lease computersexclusively, and others lease only automobiles.

L E A S E S

Leasing provides an alternative to buying an asset to acquire its services. Although someleases involve maturities of more than 10 years, most do not. Thus, lease financing is clas-sified as a source of intermediate-term credit. Today, virtually any type of asset can beacquired through a lease agreement. The recent growth in lease financing has been phe-nomenal, with more than $200 billion in assets (based on original cost) now under leasein the United States.

A lease is simply a contract between a lessee, who acquires the services of a leasedasset by making a series of payments to the lessor, who is the owner of the asset. Thecontract provides the lessee with the right to use the asset for the term of the lease agree-ment; at the end of the term of the lease, the lessee must return the asset to the lessor.However, leases frequently contain an option for the lessee to purchase the asset at thetermination of the lease agreement. Lessees can be just about anyone (an individual, abusiness, or a government agency). Lessors are generally the manufacturer of the leasedasset or an independent leasing company.

The primary difference between leasing and buying an asset relates to the rights thattransfer to the lessee versus the owner. The lessee obtains the right to use the asset upuntil the term of the agreement. The owner, in contrast, receives both the right to use theasset and the title to the asset so that, when he or she decides to sell, the owner can dis-pose of the asset and realize the proceeds from its sale.

T Y P E S O F L E A S E A R R A N G E M E N T SThere are three major types of lease agreements: direct leasing, sale and leaseback, andleveraged leasing. Most lease agreements fall into one of these categories. However, theparticular lease agreement can take one of two forms: (1) The financial lease constitutesa noncancelable contractual commitment on the part of the firm leasing the asset (thelessee) to make a series of payments to the firm that actually owns the asset (the lessor) foruse of the asset and (2) The operating lease differs from the financial lease only withrespect to its cancelability. An operating lease can be canceled after giving proper noticeto the lessor any time during its term. Thus, operating leases are by their very naturesources of short-term financing. The balance of this chapter is concerned with the finan-cial lease, which provides the firm with a form of intermediate-term financing most com-parable with debt financing.

In the jargon of the leasing industry, a financial lease can take one of two basic forms:a net lease or a net-net lease. In a net lease agreement, the lessee firm assumes the riskand burden of ownership over the term of the lease. That is, the lessee must maintain theasset, as well as pay insurance and taxes on the asset. A net-net lease requires that thelessee meet all the requirements of the net lease as well as return the asset, still worth apreestablished value, to the lessor at the end of the lease term.

D I R E C T L E A S I N GIn a direct lease, the firm acquires the services of an asset it did not previously own. Directleasing is available through several financial institutions, including manufacturers, banks,finance companies, independent leasing companies, and special-purpose leasing compa-nies.1 In the lease arrangement, the lessor purchases the asset and leases it to the lessee. Inthe case of a manufacturer lessor, however, the lessor has already produced the asset.

C H A P T E R 2 4 T E R M L O A N S A N D L E A S E S 24-8

S A L E A N D L E A S E B A C KA sale and leaseback arrangement arises when a firm sells land, buildings, or equip-ment that it already owns to a lessor and simultaneously enters into an agreement to leasethe property back for a specified period under specific terms. The lessor involved in thesale and leaseback varies with the nature of the property involved and the lease period.When land is involved and the corresponding lease is long term, the lessor is generally alife insurance company. If the property consists of machinery and equipment, then thematurity of the lease will probably be intermediate term, and the lessor could be an insur-ance company, commercial bank, or leasing company.

The lessee firm receives cash in the amount of the sales price of the assets sold andthe use of the asset over the term of the lease. In return, the lessee must make periodicrental payments through the term of the lease and give up any salvage or residual value tothe lessor.

L E V E R A G E D L E A S I N GIn the leasing arrangements discussed thus far, only two participants have been identified:the lessor and lessee. In leveraged leasing, a third participant is added: the lender, whohelps finance the acquisition of the asset to be leased. From the viewpoint of the lessee,there is no difference in a leveraged lease, direct lease, or sale and leaseback arrangement.However, with a leveraged lease, the method of financing used by the lessor in acquiringthe asset receives specific consideration. The lessor generally supplies equity funds up to20 to 30 percent of the purchase price and borrows the remainder from a third-partylender, which may be a commercial bank or an insurance company. In some arrange-ments, the lessor firm sells bonds, which are guaranteed by the lessee. This guaranteeserves to reduce the risk and thus the cost of the debt. The majority of financial leases areleveraged leases.

L E A S E S A N D F I N A N C I A L R E P O R T I N GAny lease that meets one or more of the following criteria is a capital lease and must beincluded in the body of the balance sheet of the lessee according to the FinancialAccounting Standards Board (FASB). All other lease agreements are classified as operatingleases for accounting purposes. In a capital lease:

1. The lease transfers ownership of the property to the lessee by the end of the leaseterm.

2. The lease contains a bargain repurchase option.3. The lease term is equal to 75 percent or more of the estimated economic life of the

leased property.4. The present value of the minimum lease payments equals or exceeds 90 percent of

the excess of the fair value of the property over any related investment tax creditretained by the lessor.

The last two requirements are the most stringent elements in the boards statement.The first two have been applicable to most leases for many years because of the InternalRevenue Services true lease requirements. However, the last two apply to most finan-cial leases written in the United States. As a result, the board now requires capitalizationof all leases meeting one or more of these criteria.

Table 24-2 is a sample balance sheet for the Alpha Manufacturing Company. Alphahas entered into capital leases whose payments have a present value of $4 million.

Sale and leasebackarrangementAn arrangement arising when afirm sells land, buildings, orequipment that it already ownsand simultaneously enters intoan agreement to lease theproperty back for a specifiedperiod under specific terms.

24-9 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

Note that the asset leased property is matched by a liability, capital lease obliga-tions. The specific entries recorded for the lease obligations equal the present value ofminimum lease payments the firm must pay over the term of the lease. The discount rateused is the lower of either the lessees incremental borrowing rate or the lessors implicitinterest rate (where that rate can be determined).

Operating leases are not disclosed in the body of the balance sheet. Instead, theselease obligations must be reported in a footnote to the balance sheet.

T H E L E A S E - V E R S U S - P U R C H A S E D E C I S I O NThe lease-versus-purchase decision is a hybrid capital-budgeting problem that forces theanalyst to consider the consequences of alternative forms of financing on the investmentdecision. When we discussed capital budgeting in Chapter 9 and the cost of capital inChapter 12, we assumed that all new financing would be undertaken in accordance withthe firms optimal capital structure. When analyzing an asset that is to be leased, theanalysis must be altered to consider financing through leasing as opposed to the use of themore traditional debt and equity sources of funds. Thus, the lease-versus-purchase deci-sion requires a standard capital-budgeting type of analysis, as well as an analysis of twoalternative financing packages. The lease-purchase decision involves the analysis of twobasic issues:

1. Should the asset be purchased using the firms optimal financing mix?2. Should the asset be financed using a financial lease?

The answer to the first question can be obtained through an analysis of the projectsNPV, following the method laid out in Chapter 9. There are times when it might beadvantageous to lease an asset, even when the NPV for its purchase is negative. The costsavings of a lease may more than offset the negative NPV of purchase. For example, theAlpha Manufacturing Co. is considering the acquisition of a new computer-based inven-tory and payroll system. The computed net present value of the new system based onnormal purchase financing is $40, indicating that acquisition of the system through pur-chasing or ownership is not warranted. However, an analysis of the cost savings resultingfrom leasing the system (referred to here as the net advantage of leasing, or NAL) indicatesthat the lease alternative will produce a present value cost savings of $60 over normal pur-chase financing. Therefore, the net present value of the system if leased is $20 (the net

TA B L E 2 4 - 2 Alpha Manufacturing Company Balance Sheet, December 31, 2003 (Millions of Dollars)

A S S E T S 2 0 0 3

Current assets $14Plant and equipment 20Leased property (capital leases) 4___

Total $38______

L I A B I L I T I E S A N D S T O C K H O L D E R S E Q U I T Y

Current liabilities $ 8Long-term debt 9Capital lease obligations 4Stockholders equity 17___

Total $38______

C H A P T E R 2 4 T E R M L O A N S A N D L E A S E S 24-10

B A C K T O T H E P R I N C I P L E S

A primary motivating factor behind leasing is the opportunity to transfer the tax consequences ofownership (i.e., interest and depreciation expense) from a firm that is either not currently payingtaxes because of prior year losses or is paying them at a very low rate to another firm (the lessor),who is paying taxes at a much higher rate. This is a direct application of Principle 8: Taxes BiasBusiness Decisions.

C O N C E P T C H E C K1. Define a lease and identify the participants. What are the principal

differences between asset ownership and asset leasing?2. How does an operating lease differ from a financial lease?3. Describe the three major types of lease agreements.4. What requirements has FASB established for reporting leases on a firms

financial statements?

2 That is, NAL = NPV(L) NPV(P), where NPV(L) is the net present value of the asset if leased. Thus, the sum ofNPV(P) and NAL is the net present value of the asset if leased.

T H E L E A S E - P U R C H A S E A L G O R I T H MFigure 24-1 contains a flow chart that can be used in performing lease-purchase analyses.The analyst first calculates the net present value of purchasing, NPV(P ). If the projectsnet present value is positive, then the left branch of Figure 24-1 should be followed.Tracing through the left branch, we now compute NAL. If NAL is positive, the leasealternative offers a positive present-value cost advantage over normal purchase financing,and the asset should be leased. Should NAL be negative, then the purchase alternativeshould be selected. If NPV(P) is negative, then return to the top of Figure 24-1 and go tothe right side of the flow chart. The only hope for the projects acceptance at this point isa favorable set of lease terms. In this circumstance, the project would be acceptable andthus leased only if NAL were large enough to offset the negative NPV(P) [that is, whereNAL was greater than the absolute value of NPV(P) or, equivalently, where NAL +NPV(P) 0].2

The lease-versus-purchase problem is analyzed using the equations 24-3 and 24-4found in Table 24-3. The first equation is simply the net present value of purchasing theproposed project, discussed in Chapter 9. The second equation calculates the net presentvalue advantage of leasing, or NAL. NAL represents an accumulation of the cash flows(both inflows and outflows) associated with leasing as opposed to purchasing the asset.Specifically, through leasing, the firm avoids certain operating expenses, Ot, but incursthe after-tax rental expense, Rt(1 T). By leasing, furthermore, the firm loses the tax-deductible expense associated with interest, T It, and depreciation, T Dt. Finally, thefirm does not receive the salvage value from the asset, Vn, if it is leased, but it does nothave to make the initial cash outlay to purchase the asset, IO. Thus, NAL reflects the costsavings associated with leasing, net of the opportunity costs of not purchasing.

present value if leased equals the NPV of a purchase plus the net advantage of leasing, or $40 + $60). Thus, the systems services should be acquired via the lease agreement.

24-11 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

Lease

Lease

Compute NPV(P)

Compute NAL Compute NAL

Is NPV(P) 0?

Is NAL > 0?

Yes

Yes

Lease the asset

Lease the asset

Purchase the asset

No

No

Is NAL > 0?

Is NAL + (t) 0?

Reject

Yes No

Yes No

Reject

F I G U R E 2 4 - 1 Lease-Purchase Analysis

Note that the after-tax cost of new debt is used to discount the NAL cash flows otherthan the salvage value, Vn. This is justified because the affected cash flows are very nearlyriskless and certainly no more risky than the interest and principal accruing to the firmscreditors (which underlie the rate of interest charged to the firm for its debt).3 Because Vnis not a risk-free cash flow but depends on the market price for the leased asset in year n,a rate higher than r is appropriate. Because the salvage value of the leased asset was dis-counted using the cost of capital when determining NPV(P), we use this rate here whencalculating NAL.

3 The argument for using the firms borrowing rate to discount these tax shelters goes as follows: The tax shields arerelatively free of risk in that their source (depreciation, interest, rental payments) can be estimated with a high degreeof certainty. There are, however, two sources of uncertainty regarding these tax shelters: (1) the possibility of achange in the firms tax rate or the tax benefits of leasing, and (2) the possibility that the firm might become bankruptat some future date. If we attach a very low probability to the likelihood of a reduction in the tax rate, then the primerisk associated with these tax shelters is the possibility of bankruptcy wherein they would be lost forever (certainly, alltax shelters after the date of bankruptcy would be lost). We now note that the firms creditors also faced the risk ofthe firms bankruptcy when they lent the firm funds at the rate r. If this rate r reflects the markets assessment of thefirms bankruptcy potential as well as the time value of money, then it offers an appropriate rate for discounting theinterest shelters generated by the firm. Note also that the Ot cash flows are generally estimated with a high degree ofcertainty (in the case in which they represent insurance premiums they may be contractually set) such that r is appro-priate as a discount rate here also. Of course, r is adjusted for taxes to discount the after-tax cash flows.

C H A P T E R 2 4 T E R M L O A N S A N D L E A S E S 24-12

4 The problem example is a modification of the example from R. W. Johnson and W. G. Lewellen, Analysis of theLease-or-Buy Decision, Journal of Finance 27 (September 1972): 81523.

C A S E P R O B L E M I N L E A S E - P U R C H A S E A N A LY S I SThe Waynesboro Plastic Molding Company (WPM) is now deciding whether to purchasean automatic casting machine. The machine will cost $15,000 and for tax purposes will bedepreciated toward a zero salvage value over a five-year period. However, at the end of fiveyears, the machine actually has an expected salvage value of $2,100. Because the machine isdepreciated toward a zero book value at the end of five years, the salvage value is fully tax-able at the firms marginal tax rate of 50 percent. Hence the after-tax salvage value of themachine is only $1,050.4 The firm uses the simple straight-line depreciation method todepreciate the $15,000 asset toward a zero salvage value. Furthermore, the project isexpected to generate annual cash revenues of $5,000 per year over the next five years (net ofcash operating expenses but before depreciation and taxes). For projects of this type, WPMhas a target debt ratio of 40 percent that is impounded in its after-tax cost-of-capital esti-mate of 12 percent. Finally, WPM can borrow funds at a before-tax rate of 8 percent.

TA B L E 2 4 - 3 Lease-Purchase Model

Equation OneNet present value of purchase [NPV (P )]:

(24-3)

where ACFt = the annual after-tax cash flow in period t resulting from the assets purchase (note that ACFnalso includes any after-tax salvage value expected from the project).

K = the firms cost of capital applicable to the project being analyzed and the particular mix offinancing used to acquire the project.

IO = the initial cash outlay required to purchase the asset in period zero (now).n = the productive life of the project.

Equation TwoNet advantage of leasing (NAL):

(24-4)

where Ot = any operating cash flows incurred in period t that are incurred only when the asset is purchased.Most often this consists of maintenance expenses and insurance that would be paid by thelessor.

Rt = the annual rental for period t.T = the marginal tax rate on corporate income.It = the tax-deductible interest expense forfeited in period t if the lease option is adopted. This

represents the interest expense on a loan equal to the full purchase price of the asset beingacquired.a

Dt = depreciation expense in period t for the asset.Vn = the after-tax salvage value of the asset expected in year n.Ks = the discount rate used to find the present value of Vn. This rate should reflect the risk inherent

in the estimated Vn. For simplicity the after-tax cost of capital (K) is often used as a proxy forthis rate. Also, note that this rate is the same one used to discount the salvage value in NPV (P ).

IO = the purchase price of the asset, which is not paid by the firm in the event the asset is leased.rb = the after-tax rate of interest on borrowed funds (i.e., rb = r (1 T ) where r is the before-tax

borrowing rate for the firm). This rate is used to discount the relatively certain after-tax cashflow savings that accrue through the leasing of the asset.

aThis analysis makes the implicit assumption that a dollar of lease financing is equivalent to a dollar of loan. This form ofequivalence is only one of several that might be used.

NALO T R T T I T D

r

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bt

n

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NPV PACF

KIOt

tt

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11

24-13 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

TA B L E 2 4 - 4 Computing Project Annual After-Tax Cash Flows (ACFt ) Associated with Asset Purchase

Y E A R1 2

B O O K C A S H B O O K C A S HP R O F I T S F L O W P R O F I T S F L O W

Annual cash revenues $ 5,000 $ 5,000 $ 5,000 $ 5,000Less: depreciation (3,000) (3,000) ______ ______ ______ ______Net revenues before taxes $ 2,000 $ 5,000 $ 2,000 $ 5,000Less: taxes (50%) (1,000) (1,000) (1,000) (1,000)______ ______ ______ ______Annual after-tax cash flow $ 4,000 $ 4,000______ ____________ ______

S T E P 1 : C O M P U T I N G N P V ( P ) S H O U L D T H E A S S E T B E P U R C H A S E D ?The first step in analyzing the lease-purchase problem involves computing the net pre-sent value under the purchase alternative. The relevant cash flow computations are pre-sented in Table 24-4.

The NPV(P) is found by discounting the annual cash flows (ACFt) in Table 24-3 backto the present at the firms after-tax cost of capital of 12 percent, adding this sum to thepresent value of the salvage value, and subtracting the initial cash outlay. These calcula-tions are shown in Table 24-5. The projects NPV(P) is a positive $15.35, indicating thatthe asset should be acquired.

The second question concerns whether the asset should be leased. This can beanswered by considering the net advantage to leasing (NAL).

S T E P 2 : C O M P U T I N G N A L S H O U L D T H E A S S E T B E L E A S E D ? The com-putation of NAL is shown in Table 24-6. The resulting NAL is a negative $1,121, whichindicates that leasing is not preferred to the normal debt-equity method of financing. Infact, WPM will be $1,121 worse off, in present value terms, if it chooses to lease ratherthan purchase the asset.

Calculating NAL involves solving equation 24-4 presented earlier in Table 24-3. Todo this, we first estimate all those cash flows that are to be discounted at the firms after-tax cost of debt, rb. These include Ot(1 T ), Rt(1 T ), It T, and T Dt.

The operating expenses associated with the asset that will be paid by the lessor if weleasethat is, the Otgenerally consist of certain maintenance expenses and insurance.WPM estimates them to be $1,000 per year over the life of the project. The annual rentalor lease payments, Rt, are given and equal $4,200.

The interest tax shelter lost because the asset is leased and not purchased must nowbe estimated. This tax shelter is lost because the firm does not borrow any money if itenters into the lease agreement. Table 24-1 contains the principal and interest compo-nents for a five-year $15,000 loan. Note that the interest column supplies the neededinformation for the interest tax shelter that is lost if the asset is leased, It .

5

5 Technically the firm does not lose the interest tax shelter on a $15,000 loan if it leases. In fact, the firm would losethe tax shelter on only that portion of the $15,000 purchase price that it would have financed by borrowing, forexample, 40 percent of the $15,000 investment, or $6,000. However, if the firm leases the $15,000 asset, it has effec-tively used 100 percent levered (nonowner) financing. This means that the leasing of this project uses not only its 40 percent allotment of levered (debt) financing, but an additional 60 percent as well. Thus, by leasing the $15,000asset the lessee forfeits the interest tax shelter on a 40 percent or $6,000 loan plus an additional 60 percent of the$15,000 purchase price, or an additional $9,000 loan. In total, leasing has caused the firm to forgo the interest taxsavings on a loan equal to 100 percent of the leased assets purchase price. Once again, we note that this analysis presumes $1 of lease financing is equivalent to $1 of loan financing.

C H A P T E R 2 4 T E R M L O A N S A N D L E A S E S 24-14

TA B L E 2 4 - 5 Calculating NPV (P )

A N N U A L C A S H F L O W D I S C O U N T FA C T O R P R E S E N T Y E A R t A C F t F O R 1 2 P E R C E N T VA L U E

1 $4,000 .893 $ 3,5722 4,000 .797 3,1883 4,000 .712 2,8484 4,000 .636 2,5445 4,000 .567 2,2685 (Salvage = Vn) 1,050 .567 595.35_________

Present value of ACFs and Vn = $15,015.35_________NPV (P ) = $15,015.35 $15,000 = $ 15.35_________

Earlier when we computed NPV(P), we found this to equal $15.35. Because NPV(P)is positive, the purchase would increase shareholder wealth. Now, substituting the resultsof our calculations into equation 24-4 produces the NAL of $1,121. Because NAL isnegative, the asset should not be leased.

Note that the lease payments used in this example were made at the end of eachyear. In practice, lease payments are generally made at the beginning of each year (thatis, they constitute an annuity due rather than an ordinary annuity, as used here). TheNAL for the example used here is even more negative if we assume beginning of yearlease payments; that is, with beginning-of-year payments NAL = $1,495. You can eas-ily verify this result as follows: Note first that changing from a regular annuity to anannuity due affects only the first and last annuity payments. In this example, thismeans that the first lease payment of $2,100 (after tax) is paid immediately such thatits present value is $2,100. However, the final lease payment is now made at the begin-ning of year 5 (or at the end of year 4). The present value of the fifth-year after-taxlease payment is therefore $2,100 .822 = $1,726. To summarize, by changing from aregular annuity set of lease payments to an annuity due, we must include a $2,100immediate cash flow at time t = 0, and we exchange this for the fifth-year present-value after-tax lease payment of $1,726. Therefore, the NAL with annuity due leasepayments is NAL (annuity due) = (1,121) + 1,726 2,100 = (1,495). Hence, if the leasepayments are an annuity due, the asset should be purchased [because NPV(P) =$15.35] and not leased (because NAL = $1,495).

Lets recap the lease-purchase analysis: First the projects net present value wascomputed. This analysis produced a positive NPV(P) equal to $15.35, which indi-cated that the asset should be acquired. On computing the net advantage to leasing,we found that the financial lease was not the preferred method of financing the

Y E A R3 4 5

B O O K C A S H B O O K C A S H B O O K C A S HP R O F I T S F L O W P R O F I T S F L O W P R O F I T S F L O W

$ 5,000 $ 5,000 $ 5,000 $ 5,000 $ 5,000 $ 5,000(3,000) (3,000) (3,000) ______ ______ ______ ______ ______ ______

$ 2,000 $ 5,000 $ 2,000 $ 5,000 $ 2,000 $ 5,000(1,000) (1,000) (1,000) (1,000) (1,000) (1,000)______ ______ ______

$ 4,000 $ 4,000 $ 4,000______ ______ ____________ ______ ______

24-15 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

acquisition of the assets services. Thus, the assets services should be purchasedusing the firms normal financing mix.

Our analysis of the lease-purchase choice found in Tables 24-4, 24-5, and 24-6 illus-trates the application of a number of basic principles of finance. In Table 24-4, we arecareful to identify the cash-flow consequences of asset ownership even though thisrequires that we evaluate profits for purposes of determining tax liabilities. This illus-trates the use of Principle 3: CashNot ProfitsIs King. We then discount the cashflows associated with both purchasing and leasing which reflects Principle 2: The TimeValue of MoneyA dollar received today is worth more than a dollar received inthe future. In Table 24-5, we see two principles at work. First, we are careful to properlyadjust all expenses for their tax consequences, which reflects Principle 8: Taxes BiasBusiness Decisions. Finally, we discount the after-tax expenses associated with leasingversus purchasing, using the firms borrowing rate, and discount the salvage value usingthe firms weighted average cost of capital. Using a higher rate to discount the riskier sal-vage value reflects Principle 1: The Risk-Return Trade-OffWe wont take onadditional risk unless we expect to be compensated with additional return.

TA B L E 2 4 - 6 Computing NAL

Overview: To solve for NAL, we use equation 24-4, which was discussed in Table 24-3. This equation contains three terms and is repeated belowfor convenience.

Term 1 Term 2 Term 3

Step 1: Solving for term 1

A F T E R - TA X O P E R AT I N G TA X E X P E N S E S A F T E R - TA X TA X S H E LT E R S H E LT E R O N PA I D B Y R E N TA L O N L O A N D E P R E C I A - D I S C O U N T P R E S E N T

Y E A R L E S S O R a E X P E N S E b I N T E R E S T c T I O N d FA C T O R e VA L U Et O t ( 1 T ) R t ( 1 T ) I t T D t T = S U M D F = P V

1 $500 $2,100 $600 $1,500 $3,700 .9615 $ 3,5582 500 2,100 498 1,500 3,598 .9246 3,3263 500 2,100 387 1,500 3,487 .8890 3,1004 500 2,100 268 1,500 3,368 .8548 2,8795 500 2,100 140 1,500 3,240 .8219 2,662

15,525

Step 2: Solving for term 2 = $ 596

Step 3: Term 3 = IO $15,000Step 4: Calculate NAL = $15,525 $596 + $15,000 = $ 1,121________________

aAfter-tax lessor-paid operating expenses are found by Ot(1 T ) $1,000 (1 .5) = $500.bAfter-tax rent expense for year 1 is computed as follows: Rt(1 T ) = $4,200 (1 .5) = $2,100.cInterest expense figures were calculated in Table 24-1 for a $15,000 loan. For year 1 the interest tax shelter is 0.5 $1,200 $600.dThe tax shelter from depreciation is found as follows: DtT = $3,000 0.5 = $1,500.eBased on the after-tax borrowing rate, i.e., .08 (1 .5) = .04fKs was estimated to be the same as the firms after-tax cost of capital, 12 percent.

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C H A P T E R 2 4 T E R M L O A N S A N D L E A S E S 24-16

Purchaser LesseeLessor (retainssalvage value)

Lease agreement(use value of asset)

Leasepayments

Securities (e.g.,stocks, bonds,or notes)

$ Net proceedsfrom sale

of securities

1. Use value2. Salvage value

Purchasing

$ Purchaseprice ofequipment

Securities (e.g.,stocks, bonds,

or notes)

$$ Purchase

price ofequipment

Title1. Use value2. Salvage value

Title

$ Net proceedsfrom saleof securities

Leasing

Capital markets(e.g., a commercial bankor life insurance company)

Equipmentdealer

F I G U R E 2 4 - 2 Comparison of Purchasing with Simple Financial Lease Agreement

T H E E C O N O M I C S O F L E A S I N G V E R S U S P U R C H A S I N G

Lets now review briefly the economic attributes of leasing and purchasing. Figure 24-2summarizes the participants and transactions involved in leasing (the right side of the fig-ure) and purchasing (the left side). In purchasing, the asset is financed via the sale of secu-rities and the purchaser acquires title to the asset (including both the use and salvagevalue of the asset). In leasing, the lessee acquires the use value of the asset but uses thelessor as an intermediary to finance and purchase the asset. The key feature of leasing asopposed to purchasing is the interjection of a financial intermediary (the lessor) into thescheme used to acquire the assets services. Thus, the basic question that arises in lease-purchase analysis is one of Why does adding another financial intermediary (the lessor)save the lessee money? Some of the traditional answers to this question are discussedsubsequently. As you read through each, simply remember that the lessee is hiring thelessor to perform the functions associated with ownership that he or she would perform ifthe asset were purchased. Thus, for the lease to be cheaper than owning, the lessormust be able to perform these functions of ownership at a lower cost than the lessee couldperform them and be willing to pass a portion of these savings along to the lessee in theform of lower rental rates.

O b j e c t i v e 4

C O N C E P T C H E C K1. Describe the process used when evaluating the lease-versus-purchase

decision.2. Why are the NAL cash flows discounted using the firms after-tax cost of

borrowing rather than the firms cost of capital?

24-17 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

6 The contributions of Paul P. Anderson in the preparation of this discussion are gratefully acknowledged.

P O T E N T I A L B E N E F I T S F R O M L E A S I N G 6

Several purported advantages have been associated with leasing as opposed to debtfinancing. These benefits include flexibility and convenience, lack of restrictions, avoid-ing the risk of obsolescence, conservation of working capital, 100 percent financing, taxsavings, and availability of credit.

F L E X I B I L I T Y A N D C O N V E N I E N C EA variety of potential benefits are often included under the rubric of flexibility and con-venience. It is argued, for example, that leasing provides the firm with flexibility becauseit allows for piecemeal financing of relatively small asset acquisitions. Debt financing ofsuch acquisitions can be costly and difficult to arrange. Leases, conversely, may bearranged more quickly and with less documentation.

Another flexibility argument notes that leasing may allow a division or subsidiary man-ager to acquire equipment without the approval of the corporate capital-budgeting com-mittee. Depending on the firm, the manager may be able to avoid the time-consumingprocess of preparing and presenting a formal acquisition proposal.

A third flexibility advantage relates to the fact that some lease payment schedules maybe structured to coincide with the revenues generated by the asset, or they may be timedto match seasonal fluctuations in a given industry. Thus, the firm is able to synchronize itslease payments with its cash cyclean option rarely available with debt financing.

Arguments for the greater convenience of leasing take many forms. It is sometimesstated that leasing simplifies bookkeeping for tax purposes because it eliminates the needto prepare time-consuming depreciation tables and subsidiary fixed asset schedules.Finally, leasing allows the firm to avoid the problems and headaches associated withownership. Executives often note that leasing keeps the company out of the real estatebusiness. Implicit in this argument is the assumption that the firms human and materialresources may be more profitably allocated to its primary line of business and that it isbetter to allow the lessor to deal with the obligations associated with ownership.

It is difficult to generalize about the validity of the various arguments for greater flex-ibility and convenience in leasing. Some companies, under specific conditions, may findleasing advantageous for some of the reasons listed earlier. In practice, the trade-offs arelikely to be different for every firm. The relevant issue is often that of shifting functions.By leasing a piece of capital equipment, the firm may effectively shift bookkeeping, dis-posal of used equipment, and other functions to the lessor. The lessee will benefit in thesesituations if the lessor is able to perform the functions at a lower cost than the lessee andis willing to pass on a portion of the savings in a lower lease rate.

The arguments that follow should be viewed in a similar vein. In many cases, the ben-efits the firm is able to attain are not worth the cost. Compounding the problem is thefact that it is often difficult for a lessee firm to quantify such cost-benefit trade-offs.

L A C K O F R E S T R I C T I O N SAnother suggested advantage of leasing relates to the lack of restrictions associated with alease. Unlike term loan agreements or bond indentures, lease contracts generally do notcontain protective covenant restrictions. Furthermore, in calculating financial ratiosunder existing covenants, it is sometimes possible to exclude lease payments from the

C H A P T E R 2 4 T E R M L O A N S A N D L E A S E S 24-18

firms debt commitments. Once again, the extent to which lack of restrictions benefits alessee will depend on the price it must pay. If a lessor views its security position to besuperior to that of a lender, it may not require a higher return on the lease to compensatefor the lack of restrictions on the lessee. Conversely, if the prospective lessee is viewed asa marginal credit risk, a higher rate may be charged.

A V O I D A N C E O F R I S K O F O B S O L E S C E N C ESimilar reasoning applies to another popular argument for leasing. This argument statesthat a lease is advantageous because it allows the firm to avoid the risk that the equipmentwill become obsolete. In actuality, the risk of obsolescence is passed on to the lessee in anyfinancial lease. Because the original cost of the asset is fully amortized over the basic leaseterm, all of the risk is borne by the lessee. Only in a cancelable operating lease is it some-times possible to avoid the risk of obsolescence.

A related argument in favor of leasing states that a lessor will generally provide thefirm with better and more reliable service to maintain the resale value of the asset. Theextent to which this is true depends on the lessors own cost-benefit trade-off. If the lessoris a manufacturing or a leasing company that specializes in a particular type of equipment,it may be profitable to maintain the equipments resale value by ensuring that it is prop-erly repaired and maintained. Because of their technical and marketing expertise, thesetypes of lessors may be able to operate successfully in the secondary market for the equip-ment. Conversely, bank lessors or independent financial leasing companies would proba-bly find it too expensive to follow this approach.

C O N S E R V A T I O N O F W O R K I N G C A P I T A LOne of the oldest and most widely used arguments in favor of leasing is the assertion thata lease conserves the firms working capital. The conservation argument runs as follows:Because a lease does not require an immediate outflow of cash to cover the full purchaseprice of the asset, funds are retained in the business.

It is clear that a lease does require a lower initial outlay than does a cash purchase.However, the cash outlay associated with the purchase option can be reduced or elimi-nated by borrowing the down payment from another source. This argument leads usdirectly into the next purported advantage of lease financing.

O N E H U N D R E D P E R C E N T F I N A N C I N GAnother alleged benefit of leasing is embodied in the argument that a lease provides thefirm with 100 percent financing. It is pointed out that the borrow-and-buy alternativegenerally involves a down payment, whereas leasing does not. Given that investors andcreditors are reasonably intelligent, however, it is sensible to conclude that they considersimilar amounts of lease and debt financing to add equivalent amounts of risk to the firm.Thus, a firm uses up less of its capacity to raise nonequity funds with debt than with leas-ing. In theory, it could issue a second debt instrument to make up the differencethat is,the down payment.

TA X S A V I N G SIt is also argued that leasing offers an economic advantage in that the tax shield generatedby the lease payments usually exceeds the tax shield from depreciation that would be

24-19 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

7 W. L. Ferrara, J. B. Thies, and M. W. Dirsmith, The Lease-Purchase Decision, National Association of Accountants,1980, Cited in LeasingA Review of the Empirical Studies, Managerial Finance 15, 1 and 2 (1989): 1320.8 Anderson and Bird also investigated the reasons why lessees lease. They used a survey in which the respondentswere asked to indicate both the extent to which they agreed or disagreed with the advantages attributed to leasing andthe extent to which a particular advantage was important to their lease decisions. One of the purported advantages toleasing was the following: All things considered, leasing is less expensive than debt as a means of acquiring equip-ment. The respondents accorded the lowest agreement rating to this statement (that is, they disagreed that this wastrue), yet they ranked this same statement third in overall importance in terms of their decision to lease. The authorsinterpret this finding as evidence that lessees believe that it is important that the cost of leasing be less than the costof debt financing, but they do not expect to find this to be so in practice.

available if the asset were purchased. The extent to which leasing provides a tax-shieldbenefit is a function of many factors. The NAL equation (24-4), discussed earlier, is thebasis for weighing these differences in tax shields.

E A S E O F O B T A I N I N G C R E D I TAnother purported advantage of leasing is that firms with poor credit ratings are able toobtain assets through leases when they are unable to finance the acquisitions with debtcapital. The counterargument is that the firm will certainly face a high lease interest rateto compensate the lessor for bearing this higher risk of default.

W H Y D O F I R M S L E A S E ?Several researchers have asked firms why they use financial leases as opposed to purchas-ing. For example, in a study by Ferrara, Thies, and Dirsmith,7 the following factors werefound to affect the leasing decision:

FA C T O R R A N K P E R C E N T O F R E S P O N D E N T S

Implied interest rate 1 52Threat of obsolescence 2 37Income taxes 3 33Maintain flexibility 4 12Conserve working capital 5 12Less restrictive financing 6 6Off balance sheet finance 7 7

Interestingly, the factor most often mentioned was the implied cost of financing.That is, 52 percent of the lessees considered the cost of lease financing to be an importantfactor in determining their decision to use lease financing. This factor was followed byconcern over the risk of obsolescence, followed by tax considerations. In light of the the-oretical significance given to tax considerations in the theoretical literature on leasefinancing, it is interesting to note that only 33 percent of the respondents felt that taxconsiderations were a factor in their decision to lease.

Ferrara, Thies, and Dirsmith also provide evidence concerning the motives under-lying a firms decision to use lease financing and its financial characteristics.8Specifically, they observed that smaller and financially weaker firms tended to justifythe use of lease financing based on qualitative benefits. These included flexibility, theconservation of working capital, financing restrictions, off balance sheet financing, andtransference of the risk of obsolescence. Conversely, larger and financially strongerfirms tended to base their leasing decisions on more quantitative considerations. Thatis, this latter group tended to use more formal comparisons of the cost of leasing versusother forms of intermediate-term financing.

C H A P T E R 2 4 T E R M L O A N S A N D L E A S E S 24-20

O b j e c t i v e 1

C O N C E P T C H E C K1. How is the net advantage of leasing related to the net present value of

purchasing an asset?2. What are some of the potential benefits to the use of lease financing?3. What are the most important reasons firms give for using lease financing?

H O W F I N A N C I A L M A N A G E R S U S E T H I S M A T E R I A L

Firms can and do lease just about everything. So, how do they decide when to lease? Theanswer is that for big-ticket items, a formal analysis is used, along the lines of the netadvantage of leasing model discussed in this chapter. However, for smaller expenditures,often no formal model is used.

When you discuss the decision to lease with a financial analyst, he or she will oftencite the types of points we made in our discussion of the potential benefits from leasing.That is, leasing is simply easier than purchasing because of internal controls within thefirm regarding asset purchases. In addition, it is commonplace to hear analysts suggestingthat, by leasing, the firm can avoid the risk of obsolescence. As we learned earlier, how-ever, the firm simply transfers the risk of obsolescence to the lessor (presumably for a fee).Analysts also point out that, by leasing, the firm has to invest less of its own money asthere is no associated down payment (or at least a minimal one). Once again, we knowthat this ignores the fact that the firm receives only the use value and not the salvage valueof the asset through the lease and often uses more financial leverage (nonowner financ-ing) than it would if it purchased the asset. The point is that many of the potential advan-tages of leasing fail to make the leasing alternative truly comparable to purchasing theasset. So, when analyzing a lease financing alternative, be careful to compare apples toapples and not be fooled by the claims of an overly zealous lessor.

Intermediate financing is any source of financing with a final maturity greater than one year butless than 10. The two major sources of intermediate financing are term loans and financial leases.

Term loans are available from commercial banks, life insurance companies, and pensionfunds. Although the specifics of each agreement vary, they share a common set of general char-acteristics. These include:

1. A final maturity of 1 to 10 years2. A requirement of some form of collateral3. A body of restrictive covenants designed to protect the security interests of the lender4. A loan amortization schedule whereby periodic loan payments, comprised of both principal

and interest components, are made over the life of the loan.

Term loans generally require the borrower to repay them by making level monthly, quar-terly, or annual payments or installments. These payments include two components: (1) theinterest owed on the loan balance outstanding at the time of the last loan payment, and (2) thedifference in the installment payment and the interest component. This difference goes towardreducing the principal amount of the loan.

Installment payments are calculated using present value analysis. They constitute the peri-odic (monthly, quarterly, annual, and so on) payment whose present value, when discounted backto the present using the loan rate of interest, equals the face amount of the loan.

S U M M A R YS U M M A R Y

24-21 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

Go To:www.prenhall.com/keownfor downloads and currentevents associated with thischapter

O b j e c t i v e 2

There are three basic types of lease arrangements:

1. Direct lease2. Sale and leaseback3. Leveraged lease

The lease agreement can further be classified as a financial or an operating lease; we focusedon the financial lease. Current reporting requirements of the FASB virtually ensure the inclusionof all financial leases in the body of the lessee firms balance sheet.

The lease-versus-purchase decision is a hybrid capital-budgeting problem wherein the analystmust consider both the investment and financing aspects of the decision. The method we recom-mend for analyzing the lease-versus-purchase choice involves first calculating the net present valueof the asset if it were purchased. Next we calculate the net advantage of leasing over purchasing.

Many and varied factors are often claimed to be advantages of leasing versus the firms usualdebt-equity financing mix. However, a complete lease-purchase analysis using a model similar tothe one discussed here is needed to provide a rational basis for uncovering the true advantages oflease financing.

K E Y T E R M SK E Y T E R M S

Eurodollar loans, 24-4Financial lease, 24-7Lease, 24-7

Lessee and lesser, 24-7Net and net-net leases, 24-7Operating lease, 24-7

Sale and leasebackarrangement, 24-8

Term loans, 24-3

24-1. What characteristics distinguish intermediate-term debt from other forms of debt instru-ments?24-2. List and discuss the major types of restrictions generally found in the covenants of termloan agreements.24-3. Define each of the following:

a. Direct leaseb. Sale and leaseback arrangementc. Net-net leased. Operating lease

24-4. How are financial leases handled in the financial statements of the lessee firm?24-5. List and discuss each of the potential benefits from lease financing.

ST-1. (Analyzing a term loan) Calculate the annual installment payment and the principal and inter-est components of a five-year loan carrying a 10 percent rate of interest. The loan amount is$50,000.ST-2. (Analyzing an installment loan) The S. P. Sargent Sales Company is contemplating thepurchase of a new machine. The total cost of the machine is $120,000 and the firm plans to makea $20,000 cash down payment. The firms bank has offered to finance the remaining $100,000 ata rate of 14 percent. The bank has offered two possible loan repayment plans. Plan A involves

S E L F - T E S T P R O B L E M SS E L F - T E S T P R O B L E M S

S T U D Y Q U E S T I O N SS T U D Y Q U E S T I O N S

C H A P T E R 2 4 T E R M L O A N S A N D L E A S E S 24-22

O b j e c t i v e 3

O b j e c t i v e 4

O b j e c t i v e 5

equal annual installments payable at the end of each of the next five years. Plan B requires fiveequal annual payments plus a balloon payment of $20,000 at the end of year 5.

a. Calculate the annual payment on the loan in plan A.b. Calculate the principal and interest components of the plan A installment loan.c. Calculate the annual installments for plan B where the loan carries a 14 percent rate.

ST-3. (Lease versus purchase analysis) Jensen Trucking, Inc., is considering the possibility of leas-ing a $100,000 truck-servicing facility. This newly developed piece of equipment facilitates thecleaning and servicing of diesel tractors used on long-haul runs. The firm has evaluated the pos-sible purchase of the equipment and found it to have an $8,000 net present value. However, anequipment leasing company has approached Jensen with an offer to lease the equipment for anannual rental charge of $24,000 payable at the beginning of each of the next five years. In addi-tion, should Jensen lease the equipment, it would receive insurance and maintenance valued at$4,000 per year (assume that this amount would be payable at the beginning of each year if pur-chased separately from the lease agreement). Also, for simplicity you may assume that tax savingsare realized immediately. Additional information pertaining to the lease and purchase alterna-tives is found in the following table:

Acquisition price $100,000Useful life (used in analysis) 5 yearsSalvage value (estimated) $0Depreciation method Straight-lineBorrowing rate 12%Marginal tax rate 40%Cost of capital (based on a target debt/total 16%

asset ratio of 30%)

a. Calculate the net advantage of leasing (NAL) the equipment.b. Should Jensen lease the equipment?

24-1A. (Calculation of balloon payment for a term loan) The First State Bank has offered to lend$325,000 to Jamie Tulia to help him purchase a group home for handicapped persons. The bankloan officer (Chris Turner) has structured the loan to include four installments of $50,000 each,followed in year 5 by a balloon payment. The loan is to carry a 10 percent rate of interest withannual compounding. What is the fifth-year balloon payment?24-2A. (Calculating lease payments) Apple Leasing, Inc., calculates its lease payments such thatthey provide the firm with a 12 percent pre-tax return. The firm has been asked to quote rentalpayments on a $100,000 piece of equipment which is to include 10 payments spread over thenext nine years (the first payment is made immediately upon signing of the agreement with theremaining payments coming at the end of each of the next nine years). What amount shouldApple quote on the lease?24-3A. (Installment payments) Compute the annual payments for an installment loan carrying an18 percent rate of interest, a five-year maturity, and a face amount of $100,000.24-4A. (Principal and interest components of an installment loan) Compute the annual principal andinterest components of the loan in problem 24-3A.24-5A. (Cost of an intermediate-term loan) The J. B. Marcum Company needs $250,000 tofinance a new minicomputer. The computer sales firm has offered to finance the purchase with a$50,000 down payment followed by five annual installments of $59,663 each. Alternatively, thefirms bank has offered to lend the firm $250,000 to be repaid in five annual installments based onan annual rate of interest of 16 percent. Finally, the firm has arranged to finance the needed$250,000 through a loan from an insurance company requiring a lump-sum payment of$385,080 in five years.

S T U D Y P R O B L E M S ( S E T A )S T U D Y P R O B L E M S ( S E T A )

24-23 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

a. What is the effective annual rate of interest on the loan from the computer sales firm?b. What will the annual payments on the bank loan be?c. What is the annual rate of interest for the insurance company term loan?d. Based on cost considerations only, which source of financing should Marcum select?

24-6A. (Cost of intermediate-term credit) Charter Electronics is planning to purchase a $400,000burglar alarm system for its southwestern Illinois plant. Charters bank has offered to lend thefirm the full $400,000. The note would be paid in one payment at the end of four years andwould require payment of interest at a rate of 14 percent compounded annually. The manufac-turer of the alarm system has offered to finance the $400,000 purchase with an installment loan.The loan would require four annual installments of $140,106 each. Which method of financingshould Charter select?24-7A. (Lease-versus-purchase analysis) S. S. Johnson Enterprises (SSJE) is evaluating the acquisi-tion of a heavy-duty forklift with 20,000- to 24,000-pound lift capacity. SSJE can purchase theforklift through the use of its normal financing mix (30 percent debt and 70 percent commonequity) or lease it. Pertinent details follow:

Acquisition price of the forklift $20,000Useful life 4 yearsSalvage value (estimated) $4,000Depreciation method Straight-lineAnnual cash savings before tax and depreciation from $6,000

the forkliftRate of interest on a four-year installment loan 10 percentMarginal tax rate 50 percentAnnual rentals (four-year lease) $6,000Annual operating expenses included in the lease $1,000Cost of capital 12 percent

a. Evaluate whether the forklift acquisition is justified through normal purchase financing.b. Should SSJE lease the asset?

24-8A. (Installment loan payment) Calculate the annual installment payments for the followingloans:

a. A $100,000 loan carrying a 15 percent annual rate of interest and requiring 10 annualpayments.

b. A $100,000 loan carrying a 15 percent annual rate of interest with quarterly paymentsover the next five years. (Hint: Refer to Chapter 5 for discussion of semiannual com-pounding and discounting.)

c. A $100,000 loan requiring annual installments for each of the next five years at a 15 per-cent rate of interest. However, the annual installments are based on a 30-year loanperiod. In year 5, the balance of the loan is due in a single (balloon) payment. (Hint:Calculate the installment payments using n = 30 years. Next use the procedure given inTable 24-1 to determine the remaining balance of the loan at the end of the fifth year.)

Early in the spring of 2003, the Jonesboro Steel Corporation (JSC) decided to purchase a smallcomputer. The computer is designed to handle the inventory, payroll, shipping, and general cler-ical functions for small manufacturers like JSC. The firm estimates that the computer will cost$60,000 to purchase and will last four years, at which time it can be salvaged for $10,000. Thefirms marginal tax rate is 50 percent, and its cost of capital for projects of this type is estimatedto be 12 percent. Over the next four years, the management of JSC thinks the computer willreduce operating expenses by $27,000 a year before depreciation and taxes. JSC uses straight-linedepreciation.

I N T E G R A T I V E P R O B L E MI N T E G R A T I V E P R O B L E M

C H A P T E R 2 4 T E R M L O A N S A N D L E A S E S 24-24

JSC is also considering the possibility of leasing the computer. The computer sales firm hasoffered JSC a four-year lease contract with annual payments of $18,000. In addition, if JSC leasesthe computer, the lessor will absorb insurance and maintenance expenses valued at $2,000 peryear. Thus JSC will save $2,000 per year if it leases the asset (on a before-tax basis).1. Evaluate the net present value of the computer purchase. Should the computer be acquired

via purchase? (Hint: Refer to Tables 24-3 and 24-4.)2. If JSC uses a 40 percent target debt to total assets ratio, evaluate the net present value advan-

tage of leasing. JSC can borrow at a rate of 8 percent with annual installments paid over thenext four years. (Hint: Recall that the interest tax shelter lost through leasing is based on aloan equal to the full purchase price of the asset, or $60,000.)

3. Should JSC lease the asset?

24-1B. (Calculation of balloon payment for a term loan) In March, the Cross National Bank agreedto finance the purchase of a new building for Harris Tweeds mens wear shop. The loan is for$300,000 and will carry a 12 percent annual rate of interest with annual compounding. The loanwill require that Harris make four annual installments of $60,000 at the end of years 1 through 4.In year 5, Harris must make a large balloon payment which will fully retire the outstanding loanbalance. What is the fifth-year balloon payment?24-2B. (Calculating lease payments) Raucher Leasing, Inc., calculates its lease payments with a 15 percent pre-tax return. The firm has been asked to quote rental payments on a $250,000 pieceof equipment which is to include 10 payments spread over nine years (the first payment is madeimmediately upon signing of the agreement with the remaining payments coming at the end ofeach of the next nine years). What amount should Raucher quote on the lease?24-3B. (Installment payments) Compute the annual payments for an installment loan carrying a16 percent rate of interest, a seven-year maturity, and a face amount of $100,000.24-4B. (Principal and interest components of an installment loan) Compute the annual principal andinterest components of the loan in problem 24-3B.24-5B. (Cost of an intermediate loan) Azteca Freight Forwarding Company of Laredo, Texas,needs $300,000 to complete the construction of several prefabricated metal warehouses. Thefirm that produces the warehouses has offered to finance the purchase with a $50,000 downpayment followed by five annual installments of $69,000 each. Alternatively, Aztecas bankhas offered to lend the firm $300,000 to be repaid in five annual installments based on anannual rate of interest of 16 percent. Finally, the firm could finance the needed $300,000through a loan from an insurance company requiring a lump-sum payment of $425,000 infive years.

a. What is the effective annual rate of interest on the loan from the warehouse producer?b. What will the annual payments on the bank loan be?c. What is the annual rate of interest for the insurance company term loan?d. Based on cost considerations only, which source of financing should Azteca select?

24-6B. (Intermediate-term credit) Powder Meadows, a western ski resort, is planning to purchasea $500,000 ski lift. Powder Meadows bank has offered to lend it the full $500,000. The notewould be paid in one payment at the end of four years and would require payment of interest ata rate of 14 percent compounded annually. The manufacturer of the ski lift has offered to financethe $500,000 purchase with an installment loan. The loan would require four annual installmentsof $175,000 each. Which method of financing should Powder Meadows select?24-7B. (Lease-versus-purchase analysis) KKR Live, Inc., a carnival operating firm based inLaramie, Wyoming, is considering the acquisition of a new German-made carousel, with a pas-senger capacity of 30. KKR can purchase the carousel through the use of its normal financingmix (30 percent debt and 70 percent common equity) or lease it. Pertinent details follow:

S T U D Y P R O B L E M S ( S E T B )S T U D Y P R O B L E M S ( S E T B )

24-25 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

Acquisition price of the carousel $25,000Useful life 4 yearsSalvage value $5,000Depreciation method Straight-lineAnnual cash savings before tax and depreciation from the $7,000

carouselRate of interest on a four-year installment loan 11 percentMarginal tax rate 50 percentAnnual rentals (four-year lease) $7,000Annual operating expenses included in the lease $1,250Cost of capital 13 percent

a. Evaluate whether the carousel acquisition is justified through normal purchase financing.b. Should KKR lease the asset?

24-8B. (Installment loan payment) Calculate the annual installment payments for the followingloans:

a. A $125,000 loan carrying a 13 percent annual rate of interest and requiring 12 annualpayments.

b. A $125,000 loan carrying a 13 percent annual rate of interest with quarterly paymentsover the next six years. (Hint: Refer to Chapter 5 for a discussion of semiannual com-pounding and discounting.)

c. A $125,000 loan requiring annual installments for each of the next five years at a 13 per-cent rate of interest. However, the annual installments are based on a 30-year loanperiod. In year 5, the balance of the loan is due in a single (balloon) payment. (Hint:Calculate the installment payments using n = 30 years. Next use the procedure given inTable 24-1 to determine the remaining balance of the loan at the end of the fifth year.)

24-9B. (Lease-versus-purchase analysis) Lubin Landscaping, Inc., has decided to purchase a truck-mounted lawn fertilizer tank and spray unit. The truck would replace its hand-held fertilizertanks, providing substantial reductions in labor expense. The firm estimates that the truck willcost $65,000 to purchase and will last four years, at which time it can be salvaged for $8,000. Thefirms tax rate is 50 percent, and its cost of capital for projects of this type is estimated to be 14 percent. Over the next four years, the management of Lubin estimates that the truck willreduce operating expenses by $29,000 a year before depreciation and taxes. Lubin uses straight-line depreciation.Lubin is also considering the possibility of leasing the truck. The truck sales firm has offeredLubin a four-year lease contract with annual payments of $20,000. In addition, if Lubin leasesthe truck, the lessor will absorb insurance and maintenance expenses valued at $2,250 per year.Thus, Lubin will save $2,250 per year if it leases the asset (on a before-tax basis).

a. Evaluate the net present value of the truck purchase. Should the truck be acquired viapurchase? (Hint: Refer to Tables 24-3 and 24-4.)

b. If Lubin uses a 40 percent target debt to total assets ratio, evaluate the net present valueadvantage of leasing. Lubin can borrow at a rate of 8 percent with annual installmentspaid over the next four years. (Hint: Recall that the interest tax shelter lost through leas-ing is based on a loan equal to the full purchase price of the asset or $65,000.)

c. Should Lubin lease the asset?

C H A P T E R 2 4 T E R M L O A N S A N D L E A S E S 24-26

ST-1.

T I M E PAY M E N T P R I N C I PA L I N T E R E S T R E M A I N I N G B A L A N C E

0 $50,000.001 $13,189.83 $ 8,189.83 $5,000.00 41,810.172 13,189.83 9,008.81 4,181.02 32,801.363 13,189.83 9,909.69 3,280.14 22,891.674 13,189.83 10,900.66 2,289.17 11,991.015 13,189.83 11,990.73 1,199.10 0.28a

aRounding error.

ST-2. a.

b.

T I M E PAY M E N T P R I N C I PA L I N T E R E S T R E M A I N I N G B A L A N C E

0 $100,000.001 $29,128.35 $15,128.35 $14,000.00 84,871.652 29,128.35 17,246.32 11,882.03 67,625.333 29,128.35 19,660.80 9,467.55 47,964.534 29,128.35 22,413.32 6,715.03 25,551.215 29,128.35 25,551.18 3,577.17 .03a

aRounding error.

c. Because the plan B loan includes a $20,000 balloon payment, the five annual install-ments have a present value of only:

$89,613 = $100,000 $20,000/(1.14)5

Therefore, the annual installments can be calculated as follows:

ST-3. a. NAL = $1,772.69. (Calculations are found in the following table.)b. The NAL is positive, indicating that the lease would offer cost savings over a purchase

and therefore should be used.

Payment =

==

$ , ( . )$ , .

89 6131

1 14

26 102 791

5

tt

Payment =

==

$ , ( . )$ , .

100 0001

1 14

29 128 351

5

tt

S E L F - T E S T S O L U T I O N SS E L F - T E S T S O L U T I O N S

24-27 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

A F T E R - TA X O P E R AT I N G TA X S H E LT E R D I S C O U N T E X P E N S E S A F T E R - TA X O N TA X S H E LT E R FA C T O R AT PA I D B Y R E N TA L D E P R E C I - O N L O A N B O R R O W I N G P R E S E N T

Y E A R L E S S O R a E X P E N S E S b AT I O N c I N T E R E S T d R AT E e VA L U E

t O t ( 1 T ) R t ( 1 T ) D t T I t T = S U M D F = P V

0 $2,400 $14,400.00 $12,000.00 1.000 $ 12,000.001 2,400 14,400.00 $8,000.00 4,800.00 24,800.00 0.9328 $ 23,134.332 2,400 14,400.00 8,000.00 4,044.43 24,044.43 0.8702 $ 20,923.053 2,400 14,400.00 8,000.00 3,198.20 23,198.20 0.8117 $ 18,830.854 2,400 14,400.00 8,000.00 2,250.42 22,250.41 0.7572 $ 16,848.415 8,000.00 1,188.90 9,188.90 0.7064 $ 6,490.67

Total $ 98,227.31Plus: initial outlay 100,000.00NAL =$ 1,772.69

a$4,000 (1 .4) = $2,400. For simplicity we assume that the tax shields on expenses paid at the beginning of the year are realized immediately. b$14,400 = $24,000 (1 .4).cThe machine has a zero salvage value. Thus, its annual depreciation expense is $100,000/5 = $20,000. dBased on a $100,000 loan with four end-of-year installments and a 12 percent rate of interest. The loan payments equal $27,740.97.erb = 12% (1 .40) = 7.20%