goodwriter as agreed

The previous chapter covered various short-term sources of finance, commercial bank loans, trade credit, commercial paper, secured loans, and factoring. Chapters 12 through 15 covered a variety of long-term, fixed-income securities ranging from straight bonds to convertible bonds and preferred stock. Between these extremes are intermediate-term bonds and leasing. Intermediate-term debt ranges from 5 to 10 years and is obtained through commercial banks and insurance companies. Term notes may also be sold to the general public.

Some firms own properties in order to lease the properties to others. Washington Real Estate Trust owns office buildings, industrial centers, apartments, and shopping centers in the Washington, D.C., area and rents the space to stores such as Williams-Sonoma, Laura Ashley, and Giant Food. These retail establishments want the use of the asset but not ownership. They prefer to lease the space instead of buying and operating the buildings.

The term of a lease may range from a short period such as a year or two to many years. Since leases create legal obligations (the lease payments), they are an alternative to short-, intermediate-, and long-term debt as a source of funds. This chapter describes the terms of a lease and illustrates the basic analysis of leasing versus borrowing and buying the asset. Since leases are an alternative to debt financing, this section also covers when lease obligations must be capitalized and placed on the firm’s balance sheet as a debt obligation.

While accountants classify all liabilities as either short-term (due in less than one year) or long-term (due in more than one year), debt can also be classified as short-term, intermediate-term, or long-term. Intermediate-term debt is outstanding for more than a year (and hence appears as long-term debt on the firm’s balance sheet), but it matures quicker than long-term debt. While long-term bonds may mature 20, 25, or 30 years after being issued, most intermediate-term debt will mature in 5 to 10 years.

Intermediate-term debt issued by corporations and sold to the general public may be referred to as “notes” to differentiate it from the bonds of the corporation, which are long-term debt. For example, in July 2008, H. J. Heinz issued $500 million of 5.35 percent notes due in 2013 (5 years to maturity). Different terminology may be used when intermediate-term debt is obtained from a commercial bank or an insurance company. Such debt is often referred to as a term loan.

Term loans are usually secured by equipment or real estate. Commercial banks, which make term loans of 1 to 5 years’ duration, generally require that the loan be secured by equipment. Insurance companies, which tend to make term loans of from 5 to 15 years, generally use real estate as collateral for the loan.

In addition to the collateral, term loans have restrictive covenants that are negotiated between the debtor and the creditor. Common restrictions include a minimum current ratio such as 2.0:1, or a minimum amount of net working capital (that is, the difference between current assets and current liabilities must exceed some specified dollar amount). The creditors also require periodic financial statements from the borrower and may require prior approval before the debtor can issue additional debt. While these restrictive covenants are common in term loan agreements, they do not exhaust all the possibilities, as each loan is individually negotiated. Conditions in the credit markets and the relative strengths of the parties also affect the terms.

Term loans are generally retired in periodic payments and hence are like mortgage loans. The repayment schedules call for the payment of interest and the retirement of the principal. For example, a firm buys equipment that costs $12,000 and has an expected life of 5 years. The firm arranges a term loan with a commercial bank. The following conditions apply:

1. a down payment of 20 percent of the cost of the equipment

2. five equal annual payments to pay the interest and retire the loan

3. a 9 percent interest rate on the declining balance

4. the loan to be secured by the equipment

The first condition establishes the amount that the bank is willing to loan. Notice that the bank does not lend the entire amount; the borrower must put up $2,400 (0.20 × $12,000) and the bank finances the balance, $9,600. Terms 2 and 3 establish the rate of interest and the payment schedule. The fourth term designates the equipment as collateral against the loan and gives the bank the right to take the equipment and sell it should the debtor default.

The repayment schedule is determined as follows. The borrower must make equal payments so that the bank earns 9 percent annually and the loan is retired in 5 years. This is another illustration of the time value of money. The equation necessary to solve this problem (that is, to determine the annual payments) is

Calculator Solution

This is an example of an annuity, so the problem collapses to:

Thus, $2,467.87 is the annual payment that retires this loan and pays 9 percent of the declining balance.

The actual payment schedule and the division of the payment into interest payment and principal reduction are given in Exhibit 27.1. This table is essentially the same as the mortgage loan amortization schedule illustrated in Exhibit 7.2 (page 124) in Chapter 7. In both examples, the amount of the interest declines with each payment as the outstanding balance on the loan is reduced. Conversely, the amount of the principal repayment rises with each payment as the interest payment is reduced.

Generally, the depreciation of the equipment and the resulting cash flow cover the required loan payments. In this case, the annual straight-line depreciation expense would be $2,400 ($12,000/5). The cash flow generated by this $2,400 noncash depreciation expense is approximately equal to the $2,467.87 payment required by the loan. (In many cases accelerated depreciation is used so that the initial depreciation expense is increased.) By matching the repayment schedule with the cash flow, the firm enhances its capacity to service the debt.

*The $1.29 results from rounding off in using the interest tables. The $2,468.09 payment determined by the financial calculator avoids this error.

Since each loan is individually negotiated between the borrower and the lender, a variety of possible terms exist. One possibility is for the lender to require equal principal repayments with interest being computed on the remaining balance for each period. The repayment schedule under these terms for the $9,600 term loan is presented in Exhibit 27.2. In this case, the principal is retired in five equal installments of $1,920 ($9,600/5 = $1,920 in the second column). The amount of interest (column 3) depends on the balance owed (column 4). Thus, the payment in the second year is the sum of the principal repayment ($1,920) plus the interest on the balance owed at the end of the first year ($691.20), for a total payment of $2,611.20 (column 5).

Other possible terms include no principal repayment until the loan is due at the end of the fifth year. In this case, the firm would annually remit the $864 interest payment, and at the end of the fifth year make the last interest payment plus the principal repayment ($864 + $9,600 = $10,464). The lender could combine the two previous illustrations and annually require a partial principal repayment (for example, $1,000 annually) with the balance of $4,600 ($9,600 – $5,000) paid at the end of the term of the loan. Such a lump repayment at the end of a loan is referred to as a balloon payment.

Although firms obtain intermediate-term credit from banks and insurance companies, intermediate-term securities may be sold to the general public. Notes sold to the general public are not collateralized, while term loans usually are, and generally the notes do not have a compulsory repayment schedule. Such notes are really more similar to long-term bonds than to term loans. However, these notes may have specific features that make them attractive to investors. The intermediate term (for example, 7 years) may make these notes attractive to investors who do not want to make investments for a longer term (such as 20 years). In addition, intermediate-term notes frequently cannot be called and refunded before maturity. Since the notes lack a call feature, the investor knows that the firm cannot force the buyer to give up the security should interest rates fall. Many long-term bonds are called and refunded when long-term interest rates fall, so this noncallability of intermediate-term notes assures investors of their interest income (if no default) for the term of the notes.

Leasing is essentially renting, and the two terms are often interchanged. Since lease contracts may cover any time period, lease financing may be an alternative to short- or long-term debt.

A lease contract is for the use of an asset such as plant or equipment. Firms want the use of the asset. They use the capital budgeting techniques (net present value and internal rate of return) to determine which investments are profitable. After deciding which investments to make, they must decide how to finance the asset. Notice that it is the use of the asset that the firm desires and not necessarily title to the asset. Leasing permits the firm (lessee) to use the asset without acquiring title, which is retained by the owner (the lessor). In return, the lessee enters into a contract (thelease) to make specified payments for the use of the asset.

Leases take one of two forms. An operating lease provides the lessee with the use of the asset and may include a maintenance contract. The cost of servicing the equipment is built into the lease. The contract may be canceled after proper notice if the lessee wants to change equipment. This type of lease is primarily used for renting equipment, cars, and trucks. The length of the lease is less than the expected life of the asset but the lease may be renewed. Since the lease is not for the life of the asset, the lessor anticipates either having the lease renewed or selling the asset at the lease’s expiration.

A financial lease, which may also be referred to as a capital lease, differs from an operating lease in several significant ways. These contracts are not cancelable and do not include a service clause. The duration of a financial lease is the expected life of the asset. The lease payments cover the cost of the asset and earn a set return for the lessor. Thus, a financial lease is similar to debt financing. If the firm had issued bonds to obtain the funds to acquire the asset, the payments to the bondholders would cover the cost of the equipment plus their return (the rate of interest). Of course, if debt had been used, the firm would own the asset, while with leasing it does not acquire title. This difference is important if at the end of the asset’s life there is residual value that accrues to the asset’s owner.

While there are two classes of leases, there are three types of lease agreements. From the viewpoint of the lessee, the type of lease agreement is immaterial; the firm still acquires the use of the asset. The type of lease has an impact only on the lessor. The first type of lease agreement is thedirect lease. The lessor owns the asset and directly leases it to the lessee. Direct leases are offered by manufacturers who build the asset, such as IBM, as well as by finance companies and leasing companies that acquire assets with the intent to lease them to prospective users.

The second type of lease is a sale and leaseback. Under this type of agreement, the firm that owns the asset sells it to the lessor and then leases it back. The selling firm receives cash from the sale to the lessor that can be put to other uses but still retains the use of the asset. The lessee, however, relinquishes title to the asset and thus loses any residual value that the asset might have. And, of course, the firm must now make the lease payments.

The third type of lease is a leveraged lease. Since the lessor owns the asset, that firm must have the funds to acquire it. In a leveraged lease the lessor borrows part of the funds necessary to acquire the asset. For example, a finance company may borrow from a commercial bank so that it may acquire an asset that it in turn leases to the ultimate users. If financial leverage is favorable, the lessor will increase the return on its funds invested in the asset.

The question of whether it is better to buy or to lease depends on several crucial variables. These include the firm’s tax bracket, the terms of the lease, the asset’s anticipated residual value, and the cost of obtaining funds to buy the asset. While this introductory text cannot develop this topic, the following example will provide some of the essential information necessary to make the choice.

A firm decides to acquire equipment that costs $5,000. The equipment has an expected life of five years, after which the equipment will be sold for an expected salvage value of $500. Depreciation will be straight-line. (The firm would use accelerated depreciation if possible, and the depreciation expense would start after six months have elapsed. These normal conditions are ignored to simplify the illustration.) Maintenance is expected to be $200 annually, and the firm’s tax rate is 40 percent. The purchase is financed entirely with a $5,000 loan that is retired through an annual $1,285 payment covering interest and principal (that is, the payments are a mortgage schedule). The annual cash outflows and inflows are shown in Exhibit 27.3.

Initially, there is an immediate cash $5,000 outflow to pay for the equipment but that is covered by the loan, so there is no immediate cash outflow. At the end of the first year, there is a $200 cash outflow for maintenance, $450 for interest, and $835 for principal repayment, for a total of $1,485. Notice that the $1,000 depreciation is not a cash outflow because it is a noncash expense.

The outflows are partially offset by the tax savings that result from tax-deductible expenses. These expenses are the $200 maintenance, the $450 interest, and the $1,000 depreciation. Notice the principal repayment is not tax deductible. The sum of the tax deductible expense is $1,650, and since the tax rate is 40 percent, these expenses reduce income taxes by $660 so the net cash outflow is $825 ($1,485 – 660). Notice that the net cash outflow grows each year because the principal repayment increases and it is not a tax-deductible expense.

At the end of the fifth year, the equipment is sold for $500. The sale is a cash inflow, but if an asset is sold for more than its book value, the cash inflow is reduced by the taxes generated by the sale. (If the asset were sold for less than its book value, the sale would reduce taxes.) In this illustration, the asset is completely depreciated, so its book value is $0. All of the sale is taxable income, so the firm nets only $300 after paying taxes of $200 on the $500 sale.

Alternatively, the firm could lease the equipment from a lessor who wants a 10 percent return. To determine the annual lease payments, the lessor answers the following question: How much must I charge each year so that my $5,000 invested in the equipment yields 10 percent? (There is no reason to assume the interest rate lessee pays to borrow is the same rate the lessor wants to earn on the lease.) That is,

The interest factor is 3.791, so the equation becomes

For the lessor to earn 10 percent, the annual lease payment should be $1,319.

Calculator Solution

If the lessor charges $1,319 annually, the lessee’s annual cash outflows are

As may be seen by comparing the two projections, the cash flows differ under leasing and owning. Leasing produces a constant $791.40 outflow each year, while owning results in varying cash inflows and outflows.

Which alternative is better? That depends on the time value of money. Which alternative produces the lower present value of the cash outflows? If the financial manager can borrow the funds for 9 percent, the two cash outflows are discounted back at 9 percent. The present value of the cost of owning (that is, the present value of the cash outflows associated with owning) is

The present value of the cost of leasing (that is, the present value of the cash outflows associated with leasing) is

Calculator Solution

Since the present value of the cash outflows associated with leasing is less than the present value of the cash outflows associated with borrowing and owning, leasing is preferred.

While this illustration argues for leasing, there are several critical variables in the illustration. The first is the expected residual or salvage value. If the anticipated residual value were higher, that would argue against leasing. The owner of the equipment receives the residual, and this present value is lost if the firm leases. The smaller the expected residual, the stronger is the argument for leasing. Second, the owner pays the maintenance and the lessee does not. However, if the lease contract does not include maintenance, the lessee will also have to pay that expense, and maintenance is a cash outflow.

The present value of the cash outflows also depends on their timing. In this illustration all the cash outflows occur at the end of each year. Lease payments, however, may be made at the beginning of the time period. (You make rent payments at the beginning of the month and not at the end.) If the lease payments were made at the beginning, the present value of the cash outflows would be $3,355.31. Now borrowing and buying would be preferred, since the present value of the cost of leasing is greater than the present value of the cost of borrowing and buying.

Prior to changes in accounting standards, one reason for using leasing was that the lease would not appear on the firm’s balance sheet. While the lease would be mentioned in the footnotes, the fact that it did not appear on the balance sheet understated the firm’s use of financial leverage. This important distinction between the use of debt, which must appear on the balance sheet, and leasing, which would not appear on the balance sheet, is illustrated by the following example. Both firms initially have the same assets, liabilities, and equity:

Both firms acquire equipment worth $5,000. Firm A purchases the equipment and sells bonds to acquire the funds to pay for it. Firm B leases the equipment. After these transactions, their respective balance sheets become:

Both firms have use of equipment, but firm A has more debt outstanding. Firm A appears to be riskier because its debt ratio is now higher. In reality, however, it is no riskier than firm B, which also has a contractual obligation: the lease payment. Since the lease does not appear on the balance sheet, firm B appears to be less risky.

The use of leases to obtain such “off the balance sheet” financing may no longer be possible. The Financial Accounting Standards Board ruled that if the lease gives the lessee substantially all the benefits and risks of ownership, the lease must be “capitalized” and included on the firm’s balance sheet. This means that the present value of the asset is listed as an asset, and the present value of the lease payments is listed as a liability. The value of the asset then diminishes over time as it is depreciated, and the liability is reduced as the lease payments are made.

The lease must be included on the balance sheet if it meets any of the following four conditions:

1. The lease transfers ownership of the asset at the end of the lease.

2. The lease permits the lessee to buy the asset below its value at the expiration of the lease.

3. The length of the lease is more than 75 percent of the asset’s estimated life.

4. The present value of the lease payments exceeds 90 percent of the fair market value of the property to the lessor.

The first two conditions obviously give the lessee the benefits and risks of ownership. In the first condition, ownership is transferred, and in the second condition, the lessee has the option to buy the asset at a bargain price. While the lessee does not have to exercise the option and buy the asset, the important consideration is the existence of the option.

The third and fourth conditions require some explanation. Consider the illustration presented earlier in which the financial manager had to choose between either the lease or borrowing and buying. In the illustration, the analysis indicated that leasing is the better alternative. Will the lease have to be capitalized? The answer is “yes” because it meets the third condition. The life of the asset is five years and the lease is for five years, so the length of the lease exceeds 75 percent of the estimated life of the asset.

The fourth condition requires calculating the present value of the lease payments. In the illustration, that is the present value of the $1,319 lease payments. Of course, the present value of the lease payments depends upon the discount rate. This rate has to be the lower of (1) the rate used by the lessor to establish the lease payments or (2) the interest rate the lessee would pay to borrow the funds to purchase the assets. In the illustration, the lessor used 10 percent and the lessee used 9 percent, so 9 percent must be the discount rate. When the lease payments are discounted at 9 percent, the present value is

$1,319(3.890) = $5,131.

The present value of the lease payment is greater than 90 percent of the cost of the investment; hence, the lease must be capitalized.

Many leases do not meet any of the preceding criteria for capitalizing a lease. If an employee rents a car for a week, that is certainly an operating lease, and it will not be capitalized. But if the car is rented for several years, the terms of the lease may meet one of the criteria and hence must be capitalized. If management wants to avoid having to capitalize the lease, then the terms must be structured in such a way as to avoid all the criteria.

The inclusion of the lease would have the following impact on the balance sheet of firm B if the lease were capitalized:

This revised balance sheet for firm B brings to the foreground the fact that a financial lease is an alternative to debt financing. Both firms A and B have $15,000 in assets and $5,000 in equity. The remaining sources of funds are either debt or the capitalized lease. The debt ratio for both firms then is $10,000/$15,000 = 67 percent. Now the balance sheets indicate that firm A and firm B are equally leveraged financially.

While financial leases must be capitalized, leases often avoid being capitalized. For example, many firms lease equipment and rent space. These agreements are usually operating leases that are not capitalized and do not appear on the balance sheet. The firm, however, must report future lease payments. Payments for the next four years and for all subsequent years are provided in a footnote to the balance sheet, so the information is not hidden. In some cases, these lease payments are substantial. For example, Limited Brands leases space in malls and shopping centers but has no capitalized leases on its balance sheet. Limited Brands stated in its 2009 10-K report that the company had the following minimum rent commitments under noncancelable leases:

These rental payments are obviously a sizable commitment!

Intermediate-term debt and leasing are alternatives to short- and long-term debt financing. Intermediate-term debt is generally outstanding for 5 to 10 years. While the features are similar to other debt instruments, the shorter maturity and the use of collateral differentiate intermediate-term debt from long-term bonds. The repayment schedule for intermediate-term debt is generally paired with the asset’s anticipated cash inflows.

Leasing is essentially renting. The firm (the lessee) acquires the use of the asset but not the title. The lessee makes periodic lease payments to the owner (the lessor) for the use of the asset. Leases may be classified as operating leases or financial leases. The latter type is similar to purchasing the asset with debt financing. The present value of the lease payments must be capitalized and included on the lessee’s balance sheet as a liability.

The cash inflows and outflows generated by leasing may differ from the cash flows generated through borrowing and purchasing. The financial manager needs to determine the present value of the cost of leasing and the present value of the cost of owning to determine which is cheaper. Depreciation, taxation, the timing of lease payments, the timing of interest and principal repayments, and the residual or salvage value of the asset affect the present value of the cash outflows and thus affect the decision to lease or to borrow and purchase.

Now that you have completed this chapter, you should be able to

1. List the features of intermediate-term debt (pp. 585–586).

2. Construct a repayment schedule (pp. 586–587).

3. Define a balloon payment and explain when it applies (p. 587).

4. Contrast operating and financial leases (p. 588).

5. Determine if a firm should lease or buy equipment (pp. 589–590).

6. Isolate the importance of an asset’s residual value to the lease-versus-buy decision (p. 591).

7. Describe the impact of capitalizing a lease on a firm’s balance sheet, its financial ratios, and the use of financial leverage (pp. 591–594).

Basic Finance. An Introduction to Financial Institutions, Investments, and Management, Tenth Edition

Chapter 27: Intermediate-Term Debt and Leasing

ISBN: 9781111820633 Author: Herbert B. Mayo

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