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Term Loans and Leases
Rough winds do shake the darling buds of May. And
summer’s lease hath all too short a date…
WILLIAM SHAKESPEARE, SONNET XVIII
Chapter 21: Term Loans and Leases
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ANSWERS TO QUESTIONS
1. The demand for intermediate-term loans arises from the needs of many firms to finance
assets with relatively short and uncertain life expectancies.
a. These assets are financed with intermediate debt rather than long-term funds because
the firm is uncertain that the assets represent a permanent funds requirement, because it
b. The use of short-term debt is also undesirable if the firm is unable to generate cash
2. Because of the long-term nature and stability of their liabilities, insurance companies prefer
to invest in assets of like maturity. This reduces the problem of reinvestment of income cash
3. Protective covenants are designed to safeguard the borrower’s ability to repay the loan with
4. A
revolving credit agreement is a legal agreement whereby the lender must loan the
company money upon proper notice. An upper limit is set and the number of years for
5. The lender wishes to preserve the liquidity of a borrower but at the same time does not want
to be so restrictive as to seriously affect the borrower’s profitability. The two restrictions
6. The borrower will wish to negotiate hard on those covenants that may be binding and not so
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7. Commercial banks are perhaps the most important source of intermediate-term financing.
8. A
chattel mortgage is a lien against a borrower’s equipment. With a conditional sales
9. If the investment decision and the financing decision cannot be separated, decisions may be
made that are not optimal. By coupling the decision to use leasing with a highly profitable
10. A financial lease is longer term than an operating lease. The financial lease is also
noncancellable with lease payments being required until the lease’s expiration. The
11. In a sale-and-leaseback, the asset is sold and leased back by the company. The company
12. The capitalized value of a financial lease is shown on the balance sheet as an asset and the
associated liability is shown on the right-hand side of the balance sheet. The amortization of
13. a. Higher liquidity ratios.
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14. This argument is illogical. On financial leases, for example, the lessor will receive the
15. a. The tax rate increase would be neutral in the sense that each tax deductible dollar under
b. Faster accelerated depreciation should favor borrowing as a larger tax shield would
c. This would tend to favor borrowing, especially if the market value of the asset financed
e. If the interest rate rise affected both lessor and lender equally, the effect would tend to
SOLUTIONS TO PROBLEMS
Schedule of debt payments
(a) (b) (c)
End of
Year
Loan
Payment
Principal Amount
Owing At End of
Year (b)t–1 – (a) + (c)
Annual Interest
(b)t–1 × (0.14)
0 $ 0 $600,000 $ 0
* Difference due to rounding and the fact that the discount factor is only four places to the right
of the decimal point.
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2. Balance Sheet Under Growth Assumptions (000s omitted)
Years in Future (at December 31)
Now
(after financing) 1 2 3 4
Current assets* $10,000 $12,400 $15,376 $19,066 $23,642
Fixed assets* 10,000 12,400 15,376 19,066 23,642
* Will show a 24 percent growth rate starting in year 1.
** The current liabilities row is a residual and is found by subtracting long-term debt and
shareholders equity from total assets. In the 4th year, the term loan becomes a current
liability.
*** Increased by the amount of expected profits.
Years in Future (at December 31)
Protective Covenant
Now (after
financing) 1 2 3 4
* In violation of covenant.
Long-term debt does not increase. All growth is financed with short-term liabilities and retained
earnings.
Years in Future (at December 31)
1 2 3 4
Net addition to fixed assets $2,400 $2,976 $3,690 $ 4,576
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The company will breach the total-liabilities-to-total-assets ratio restriction in the second,
third, and fourth year, the capital expenditures restriction in the third and fourth year, and
4. a. $18,600 = X + (PVIFA12%,7)X = X + (4.564)X
5. Schedule of cash flows for the leasing alternative
(a) (b) (c) (d)
End of Year
Lease
Payment
Tax-Shield
Benefits
(a)t–1 × (0.35)
Cash Outflow
After Taxes
(a) – (b)
Present Value
of Cash
Outflows
(at 7.8%)
0 $16,000 $ 0 $16,000 $16,000
* Total for years 1–7.
The discount rate of 7.8 percent is the product of the cost of borrowing of 12 percent times
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Annual debt payments are found using a generalized version of Eq. (21.2):
Schedule of debt payments
(a) (b) (c)
End of Year
Loan
Payment
Principal Amount
Owing At End of
Year (b)t–1 – (a) + (c)
Annual Interest
(b)t–1 × (0.12)
0 $17,973 $82,027 $ 0
1 17,973 73,897 9,843
The principal amount of $100,000 is reduced by the initial debt payment of $17,973 to get
the principal amount owing at time 0 of $82,027. Interest on this amount in year 1 is found
by multiplying it by 12 percent. The debt payment in the last year is slightly larger due to
previous rounding.
Schedule of cash flows for the debt alternative
(a) (b) (c) (d) (e) (f)
End of
Year
Debt
Payment
Annual
Interest
Annual
Depreciation
Tax-Shield
Benefits
(b+c)0.35
After-Tax
Cash Flow
(a)–(d)
PV of
Cash Flows
(at 7.8%)
0 $17,973 $ 0 $ 0 $ 0 $17,973 $17,973
1 17,973 9,843 20,000 10,445 7,528 6,983
* Salvage value.
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Because the present value of debt payments, $64,336, is less than the present value of lease
payments, $67,448, the debt alternative is preferred. However, some would argue that we
6. Schedule of cash flows for the leasing alternative
(a) (b) (c) (d)
End of
Year
Lease
Payment
Tax-Shield
Benefits
(a)t–1 × (0.30)
Cash Outflow
After Taxes
(a) – (b)
Present Value
of Cash
Outflows
(at 7%)
0 $17,000 — $17,000 $17,000
* Total for years 1–4.
The discount rate of 7 percent is the product of the cost of borrowing (10%) times one
minus the tax rate of 30 percent. The present value of cash outflows is $53,672.
Annual debt payments are found using a generalized version of Eq. (21.2):
Schedule of debt payments
(a) (b) (c)
End of Year Loan Payment
Principal Amount
Owing At End of
Year (b)t–1 – (a) + (c)
Annual Interest
(b)t–1 × (0.10)
0 $19,185 $60,815 $ 0
1 In order for the present value of cash outflows for the leasing alternative ($67,448) to be less
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Schedule of cash flows for the debt alternative
(a) (b) (c) (d) (e) (f)
End of
Year
Debt
payment
Annual
Interest
Annual
Depreciation
Tax-Shield
Benefits
(b + c) .30
After-Tax
Cash Flow
(a)–(d)
PV of
Cash
Flows
(at 7%)
0 $19,185 $ 0 $ 0 $ 0 $19,185 $ 19,185
* Residual value.
Solution to Appendix Problem:
7. a. After the initial lease payment, there are five remaining payments. The lower cost
b. Principal amount during the first year for accounting purposes = $110,877
1 In order for the present value of cash outflows for the leasing alternative ($53,672) to be less
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SOLUTIONS TO SELF-CORRECTION PROBLEMS
1. a. b. (in thousands)
YEAR
Revolving Credit Term Loan
1 2 3 4 5 6
Amount borrowed during year $ 1,400 $ 3,000 $ 3,000 $ 3,000 $ 2,000 $ 1,000
2. A generalized version of Eq. (21.2) as the formula is used throughout.
a. $46,000 = X + X(PVIFA11%,5)
b. $210,000 = $47,030 / (1 + PVIFAX,5)
Subtracting 1 from this gives 5.759. Looking in Table IV in the 10% column, we find
that 5.759 corresponds to the 9-period row. Therefore, the lease period is 9 + 1, or 10
years.
3. Schedule of cash flows for the leasing alternative
(a) (b) (c) (d)
End of Year Lease Payment
Tax-Shield
Benefits
(a)t–1 × (0.40)
Cash Outflow
After Taxes
(a) – (b)
Present Value of
Cash Outflows
(at 8.4%)
0 $16,000 – – $16,000 $16,000
* Total for years 1–7.
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The discount rate is the before-tax cost of borrowing times 1 minus the tax rate, or
(14 percent) (1 – 0.40) = 8.4%.
Annual debt payment:
Schedule of debt payments
(a) (b) (c)
End of
Year
Loan
Payment
Principal Amount Owing At
End of Year (b)t–1 – (a) + (c)
Annual Interest
(b)t–1 × (0.14)
0 $18,910 $81,090 $ 0
1 18,910 73,533 11,353
* The last payment is slightly lower due to rounding throughout.
Schedule of cash flows for the debt alternative
(a) (b) (c) (d) (e) (f)
End of
Year
Debt
Payment
Annual
Interest
Annual
Depreciation
Tax-Shield
Benefits
(b+c).40
After-Tax
Cash Flow
(a)–(d)
PV of Cash
Flows
(at 8.4%)
0 $18,910 $ 0 $ 0 $ 0 $18,910 $18,910
1 18,910 11,353 20,000 12,541 6,369 5,875
* Salvage value.
** Tax due to recapture of depreciation, ($24,000)(0.40) = $9,600.
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As the debt alternative has the lower present value of cash outflows, it is preferred.
However, some would argue that we should apply a discount rate higher than the lessee’s
1 In order for the present value of cash outflows for the leasing alternative ($61,948) to be less
than the present value of cash outflows for the debt alternative ([$60,309 + $7,553] –
[$14,400 / (1 + X)8]), the discount rate (X) must be roughly 11.8 percent or more.