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Intermediate-Term Debt and Leasing

T he previous chapter covered various short-term sources of finance, com-

mercial 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 pre-

ferred 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, apart-

ments, 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 anal-

ysis of leasing versus borrowing and buying the asset. Since leases are an alter-

native 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.

C H A P T E R

9781133689454, Basic Finance: An Introduction to Institutions, Investments, and Management, Herbert B. Mayo - © Cengage Learning. All rights reserved. No distribution allowed without express authorizationjoka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka joka

CHAPTER 27 Intermediate-Term Debt and Leasing 585

Intermediate-Term Debt 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 classi- fied 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 intermedi- ate-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 work- ing 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 be- fore 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. No- tice that the bank does not lend the entire amount; the borrower must put up $2,400 10.20 3 $12,0002 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.

Intermediate-term debt

Debt instrument with 5 to 10 years to maturity

Term loan

Loan obtained from a bank or insurance com- pany for a period of 5 to 10 years

586 PART 4 Corporate Finance

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

$9,600 5 PMT

11 1 0.0921 1 PMT

11 1 0.0922 1 PMT

11 1 0.0923 1 PMT

11 1 0.0924

1 PMT

11 1 0.0925.

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

PMT 1PVAIF 9I, 5N2 5 $9,600 PMT13.8902 5 $9,600

PMT 5 $9,600/3.890 5 $2,467.87.

Thus, $2,467.87 is the annual payment that retires this loan and pays 9 per- cent 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 essen- tially the same as the mortgage loan amortization schedule illustrated in Ex- hibit 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 de- preciation expense would be $2,400 1$12,000/52. The cash flow generated by this $2,400 noncash depreciation expense is approximately equal to the

CALCULATOR SOLUTION

Function Key Data Input

PV 5 29,600

FV 5 0

I 5 9

N 5 5

PMT 5 ?

Function Key Answer

PMT 5 2468.09

E X H I B I T 27.1 Repayment Schedule for a $9,600 Term Loan at 9 Percent for Five Years

Year Payment Interest Principal Retirement

Balance Owed on Loan

1 $2,467.87 $864.00 $1,603.87 $7,996.13

2 2,467.87 719.65 1,748.22 6,247.91

3 2,467.87 562.31 1,905.56 4,342.35

4 2,467.87 390.81 2,077.06 2,265.29

5 2,467.87 203.87 2,264.00 1.29*

*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.

CHAPTER 27 Intermediate-Term Debt and Leasing 587

$2,467.87 payment required by the loan. (In many cases accelerated deprecia- tion 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.

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 re- quire equal principal repayments with interest being computed on the remain- ing 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 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 inter- est payment plus the principal repayment ($864 1 $9,600 5 $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 2 $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.

Balloon payment

Large, single payment to retire a debt obligation at maturity

E X H I B I T 27.2 Repayment Schedule for a $9,600 Term Loan at 9 Percent with Equal Principal Repayments

Year Principal Repayment Interest

Balance of Loan

Total Payment

1 $1,920 $864.00 $7,680 $2,784.00

2 1,920 691.20 5,760 2,611.20

3 1,920 518.40 3,840 2,438.40

4 1,920 345.60 1,920 2,265.60

5 1,920 172.80 0 2,092.80

588 PART 4 Corporate Finance

Leasing Leasing is essentially renting, and the two terms are often interchanged. Since lease contracts may cover any time period, lease financing may be an alterna- tive 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 (the lease) 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 ser- vicing 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 dif- ference 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 agree- ments. From the viewpoint of the lessee, the type of lease agreement is im- material; 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 the direct 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 fi- nance 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 agree- ment, 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.

Lessee

Firm that rents (leases) property or equipment for its own use

Lessor

Firm that owns property or equipment and rents it (leases the equipment) to other firms or individuals (the lessees)

Lease

Renting (as opposed to owning) property or equipment; the contract between the lessee and the lessor

Operating lease

Lease for the use and maintenance of equip- ment in which the term is less than the expected life of the asset

Financial (capital) lease

Lease in which the term is equal to the expected life of the asset

Direct lease

Lease agreement in which the owner (the lessor) directly leases the asset to the user (the lessee)

Sale and leaseback

Financial agreement in which a firm sells an asset such as a building for cash and subsequently rents (leases) that asset

CHAPTER 27 Intermediate-Term Debt and Leasing 589

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 bor- rows 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.

Lease or Purchase 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 ex- pense 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 en- tirely 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 equip- ment 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.

Leveraged lease

Lease agreement in which the lessor acquires an asset (which it subse- quently leases) through the use of debt financing

Year 0 1 2 3 4 5

Purchase price $5,000

Amount of the loan $5,000

Maintenance $ 200 200 200 200 200

Depreciation $1,000 1,000 1,000 1,000 1,000

Interest payment $450 375 293 204 106

Principal repayment $835 911 993 1,082 1,179

Tax-deductible expenses $1,650 1,575 1,493 1,404 1,306

Tax savings $660 630 597 562 522

Sale of asset after tax 300

Cash outflows before tax $0 1,485 1,486 1,486 1,486 1,485

Cash outflows after tax $0 825 856 889 924 663

E X H I B I T 27.3 Determination of Cash Outflows from Owning

590 PART 4 Corporate Finance

The outflows are partially offset by the tax savings that result from tax- deductible expenses. These expenses are the $200 maintenance, the $450 in- terest, 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 2 660). 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 in- come, 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 an- swers 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,

PMT

11 1 0.121 1 . . . 1 PMT

11 1 0.0925 5 $5,000 PMT1PVAIF 10I, 5N2 5 $5,000.

The interest factor is 3.791, so the equation becomes

PMT13.7912 5 $1,319 PMT 5 $5,000/3.791 5 $1,319.

For the lessor to earn 10 percent, the annual lease payment should be $1,319. If the lessor charges $1,319 annually, the lessee’s annual cash outflows are

Year 1 2 3 4 5

Lease payment $1,319.00 1,319.00 1,319.00 1,319.00 1,319.00

Tax savings ($527.60) (527.60) (527.60) (527.60) (527.60)

Cash outflow $791.40 791.40 791.40 791.40 791.40

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

CALCULATOR SOLUTION

Function Key Data Input

PV 5 25,000

FV 5 0

I 5 10

N 5 5

PMT 5 ?

Function Key Answer

PMT 5 1,318.99

CHAPTER 27 Intermediate-Term Debt and Leasing 591

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

Present value of cost of owning

5 $825

11 1 0.092 1 856

11 1 0.0922 1 889

11 1 0.0923 1

924 11 1 0.0924 1

663 11 1 0.0925 5 $3,249.

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

Present value of cost of leasing

5 $791.40 11 1 0.0921 1 . . . 1

$791.40 11 1 0.0925

5 $791.4013.8902 5 $3,078.55.

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 vari- ables 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 argu- ment 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 pay- ments, 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.

Accounting for Leases 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,

CALCULATOR SOLUTION

Function Key Data Input

FV 5 0

PMT 5 2791.40

I 5 9

N 5 5

PV 5 ?

Function Key Answer

PV 5 3,078.27

592 PART 4 Corporate Finance

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:

Firm A Balance Sheet As Of 12/31/X0

Firm B Balance Sheet As Of 12/31/X0

Assets $10,000 Debt $5,000 Assets $10,000 Debt $5,000

Equity 5,000 Equity 5,000

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:

Firm A Balance Sheet As Of 12/31/X1

Firm B Balance Sheet As Of 12/31/X1

Assets $10,000 Debt $5,000 Assets $10,000 Debt $5,000

Equipment 5,000 Bends 5,000 Equity 5,000

Equity 5,000

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 pay- ment. 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 fol- lowing 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 expira- tion 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.

CHAPTER 27 Intermediate-Term Debt and Leasing 593

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 be- tween either the lease or borrowing and buying. In the illustration, the analy- sis 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 pay- ments. 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

$1,31913.8902 5 $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:

Firm B Balance Sheet As Of 1/31/X1

Assets $10,000 Debt $5,000

Assets under capital lease 5,000 Capital lease 5,000

Equity 5,000

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

594 PART 4 Corporate Finance

Summary 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 operat- ing 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 capital- ized 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 man- ager needs to determine the present value of the cost of leasing and the pres- ent 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.

either debt or the capitalized lease. The debt ratio for both firms then is $10,000/$15,000 5 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 capital- ized. For example, many firms lease equipment and rent space. These agree- ments 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 bal- ance sheet. Limited Brands stated in its 2009 10-K report that the company had the following minimum rent commitments under noncancelable leases:

2010 $478,000,000

2011 444,000,000

2012 396,000,000

2013 362,000,000

Thereafter 1,452,000,000

These rental payments are obviously a sizable commitment!

CHAPTER 27 Intermediate-Term Debt and Leasing 595

Review Objectives

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).

Problems 1. A five-year $100,000 term loan has an interest rate of 7 percent on the declining balance. What are the equal annual payments required to pay interest and principal on the loan? Construct a table showing the declin- ing balance owed after each payment.

2. What are the repayment schedules for each of the following five-year, 10 percent $10,000 term loans?

a. equal annual payments that amortize (retire) the principal and pay the interest owed on the declining balance

b. equal annual principal repayment, with interest calculated on the re- maining balance owned

c. no principal repayment until after five years, with interest paid annu- ally on the balance owned

d. $1,000 annual principal repayment, with the balance paid at the end of five years and annual interest paid on the balance owed

3. Corgi, Inc. plans to update its equipment at a total cost of $90,000. Man- agement anticipates making a $15,000 down payment and borrowing the remainder from a local commercial bank at 12 percent interest. The first option provides for five equal, annual payments to be made at the end of the year. The second option requires five equal, annual payments plus a balloon payment of $15,000 at the end of the fifth year. What are the an- nual payments required by each option?

4. Northwest Bank has been asked to purchase and lease to Fafner Con- struction equipment that costs $1,200,000. The lease will run for six years. If Northwest seeks a minimum return of 12 percent, what will be the required lease payment?

5. A lessor acquired equipment for $83,250 and plans to lease it for a period of five years. If the equipment has no estimated residual value, what must be the annual lease charge for the lessor to earn 12 percent on the invest- ment? What would be the annual lease charge if the lessor sought to earn 8 percent? If the equipment will have a residual value of $10,000, what lease payment will earn the lessor 12 percent?

596 PART 4 Corporate Finance

6. A firm wants the use of a machine that costs $100,000. If the firm pur- chases the equipment, it will depreciate the equipment at the rate of $20,000 a year for four years, at which time the equipment will have a residual value of $20,000. Maintenance will be $2,500 a year. The firm could lease the equipment for four years for an annual lease payment of $26,342. Currently, the firm is in the 40 percent income tax bracket.

a. Determine the firm’s cash inflows and outflows from purchasing the equipment and from leasing.

b. If the firm uses a 14 percent cost of funds to analyze decisions that involve payments over more than a year, should management lease the equipment or purchase it?

c. Would your answer differ if the cost of funds were 8 percent?

Additional Problem

with Answer

Management has decided to acquire a new asset that costs $200,000. The estimated economic life of the asset is five years, but the firm wants the use of the asset only for three years. If the firm purchases the asset, it anticipates selling it at the end of three years for $50,000.

The firm may lease the asset for $55,000 a year paid at the end of each year. The lease does not include maintenance. It is estimated that annual maintenance initially will be $5,000 (paid at the end of the year), but that cost will increase by $1,000 each year as the asset ages.

The firm could purchase the asset with a five-year loan of $200,000. The loan will be retired in five payments of $40,000 unless the equip- ment is sold, in which case the loan must be paid off at closing of the sale. The interest rate is 10 percent and is paid at the end of each year on the balance owed. The annual interest payment is provided below.

If the firm does purchase the asset, it will enter into a maintenance agreement with the manufacturer that costs $5,000 a year. The annual de- preciation expense is provided below. The firm’s tax bracket is 40 percent.

Based on the above information, should the firm borrow and pur- chase or should the firm lease?

To help answer the question, fill in the following tables. (It is not necessary to have an entry in every blank.)

Cash Outflows/Inflows Associated with Leasing

Year 1 2 3 4 5

Lease payments

Maintenance

Total tax-deductible expenses

Tax savings

After-tax net cash outflow from leasing

CHAPTER 27 Intermediate-Term Debt and Leasing 597

Cash Outflows/Inflows Associated with Owning

Year 1 2 3 4 5

Maintenance

Depreciation 40,000 60,000 40,000 30,000 20,000

Interest 20,000 16,000 12,000 8,000 4,000

Principal Repayment

Total tax-deductible expences

Tax savings

Sale of equipment

After-tax inflow from sale of equipment

After-tax net cash outflow from owning

Answer Since the present value of the cash outflows from owning exceed the present value of the cash outflows from leasing, leasing is preferred.

Cash Outflows/Inflows Associated with Leasing

Year 1 2 3

Lease payments $55,000 55,000 55,000

Maintenance 5,000 6,000 7,000

Total tax-deductible expenses 60,000 61,000 62,000

Tax savings 24,000 24,400 24,800

After-tax net cash outflow from leasing 36,000 36,600 37,200

Present value of the cost of leasing (using the 10 percent interest rate):

$36,00010.9092 1 $36,60010.8262 1 $37,20010.7512 5 $90,892

598 PART 4 Corporate Finance

Cash Outflows/Inflows Associated with Owning

Year 1 2 3 4 5

Maintenance $ 5,000 5,000 5,000

Depreciation 40,000 60,000 40,000 Not applicable

Interest 20,000 16,000 12,000 Not applicable

Principal Repayment

40,000 40,000 40,000 1 80,000 balance repaid 5 120,000

Total tax-deductible expenses

65,000 81,000 67,000

Tax savings 26,000 32,400 26,800

Sale of equipment 50,000

After-tax inflow from sale of equipment

54,000

After-tax net cash outflow from owning

39,000 28,600 56,200

Present value of the cost of leasing (using the 10 percent interest rate):

$39,00010.9092 1 28,60010.8262 1 56,20010.7512 5 $101,281 Since the asset is sold at the end of the third year, there are no entries for

years 4 and 5 even though the expected life of the asset is five years. The $80,000 balance of the loan must be repaid when the asset is

sold. The asset is sold for $50,000 but its book value is $60,000. The

book value is the $200,000 cost minus the sum of the amount of de- preciation during the first three years 1$40,000 1 $60,000 1 $40,0002. Since the asset is sold for $50,000, the firm has a $10,000 loss 1$50,000 2 $60,0002. The $10,000 loss produces a $4,000 tax sav- ings 1$10,000 3 0.42. The net cash inflow from the sale is $50,000 1 $4,000 5 $54,000.

The cash outflow at the end of the third year is maintenance ($5,000) plus interest ($12,000) plus principal repayment ($120,000) minus the tax savings ($26,800) plus the after-tax proceeds from the sale ($54,000). That is $5,000 1 $12,000 1 $120,000 2 $26,800 2 $54,000 5 $56,200.

CHAPTER 27 Intermediate-Term Debt and Leasing 599

Relationships 1. An increase in interest rates the value of an intermediate-term loan.

2. Intermediate-term loans and traditional mortgage loans are con- structed so that principal repayments with time.

3. An increase in depreciation expense the cost of a lease.

4. An increase in the residual value of the property the attrac- tiveness of leasing.

5. An increase in lease payments cash outflows.

6. If a lease is capitalized, the firm’s assets and the firm’s equity .

7. Leasing the firm’s use of financial leverage.

Answers 1. decreases 2. increase

3. does not affect (no change) The owner and not the lessee gets the ben- efit of the depreciation expense.

4. decreases

5. increases

6. increase; is not affected (no change)

7. increases

Chapter 27: Intermediate-Term Debt and Leasing

Intermediate-Term Debt
Leasing
Accounting for Leases
Summary
Review Objectives
Problems
Additional Problem with Answer
Answer
Relationships
Answers

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