Business

Financial Finance
Analysis and Control

Prepared By:
Dr. H. M. Mosarof Hossain
Professor
Department of Finance
University of Dhaka
mosarof@du.ac.bd

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Chapter 10: Lease Financing and Term Loans

Definition of lease:
A contract between two parties where one party provides the
right to another party to use an asset without being owner for
a lump sum or periodic receipts and that another party agrees
to use that asset in exchange of making lump sum or periodic
payments is called lease. The party presently owns the asset
and provides the using right to another party is called lessor
and the party uses the asset is called lessee.

Types of leases:
1. Operating lease: The short-term and cancelable lease
contract where the owner/lessor assumes all repairs and
maintenance expenses is called operating lease.
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 Chapter 10: Lease Financing and Term Loans
2. Capital or financial lease: The long-term and non-cancelable
lease contract where the user/lessee assumes all repairs and
maintenance expenses is called capital lease. This capital lease is
categorized into the followings:
(a) Direct financing lease: The long-term lease agreement where after
participating the contract the lessor places an order to the supplier or
manufacturer of the asset for making delivery directly to the lessee is called
direct financing lease.
(b) Sale and lease back: The long-term lease agreement where after selling an
asset to the buyer, the seller i.e. previous owner takes back the asset under
lease for using as lessee is called sale and lease back.
(c) Leveraged lease: The long-term lease agreement where after participating
the contract the lessor borrows the deficit fund from the lender for buying the
asset from the supplier or manufacturer and then delivers the asset to the
lessee is called leveraged lease.

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Chapter 10: Lease Financing and Term Loans
Criteria for capital lease:
If any of the under mentioned criteria is fulfilled by any lease
agreement, then this is considered as capital lease, otherwise
the contract is operating lease.
1. The lessee should have bargain purchase option at the end
of the lease period.
2. The lessee should have renewal option of the lease.
3. The ownership of the leased asset should be automatically
transferred from the lessor to the lessee.
4. The present value of all rental payments should be equal or
more than 90% of the market value of the leased asset.
5. The lease period should be equal or more than 75% of the
asset’s economic life.

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Chapter 10: Lease Financing and Term Loans
Rational for leasing:
1. Shifting equipment disposal problem.
2. Shifting equipment’s obsolescence risk.
3. Preserving credit capacity.
4. Conserving working capital.
5. Maintaining liquidity.
6. Enjoying tax benefit on rental payments.
7. Improving financial position of the statement i.e. balance
sheet.
8. Accelerating the acquisition of required asset.
9. Facilitating the using opportunity of an asset without owning
and buying.

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Chapter 10: Lease Financing and Term Loans

Annual revenue Tk.4000000

Expected useful life 4 years
Tax rate 40%
If the asset is bought If the asset is leased
Purchase price Tk.6000000 Annual lease payment Tk.2800000
Class life 3 years Annual operating expense
Estimated salvage value is zero Tk.1000000
Straight-line depreciation method Incremental borrowing rate of
with half-year convention the lessor is 10%
Annul operating expenses
Tk.1000000
Required rate of return is 12%

Which option will be chosen?

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Chapter 10: Lease Financing and Term Loans
Calculation of NPV under buy alternative:
Year CFBT Depre Taxable Tax CFAT PV @ 12%
ciation income payment

0 - - - - -6000000 -6000000
1 3000000 1000000 2000000 800000 2200000 1965000
2 3000000 2000000 1000000 400000 2600000 2072000
3 3000000 2000000 1000000 400000 2600000 1851000
4 3000000 1000000 2000000 800000 2200000 1399000

Net present value (NPV) 1287000

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Chapter 10: Lease Financing and Term Loans
Calculation of NPV under lease alternative:

Year Initial savings Lost Net Total PV @ 6%

tax Lease payment
shield payment

1 400000 1680000 2080000 1962000

2 800000 1680000 2480000 2207000
3 800000 1680000 2480000 2082000
4 400000 1680000 2080000 1648000
Net present value (NPV) -1899000
Since NPV of buy alternative is positive and NPV of lease alternative is
negative buy alternative will be chosen.
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Chapter 10: Lease Financing and Term Loans

Problem: The buy alternative of a company has NPV= -80000.

The cost of asset is Tk.2500000 and will be depreciated under
straight-line method for 4 years period. By leasing initially
Tk.2500000 can be saved. An annual lease payment is
Tk.800000, tax rate is 45% and borrowing rate is 10%.
Comment about the financing decision.

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Chapter 10: Lease Financing and Term Loans
Effects of leasing on the firm:
(i) The financing effects – lease is one kind of borrowing that may
influence into bankruptcy.
Lease reduces borrowing capacity that increase implicit cost of
leasing through debt displacement.
(ii) Tax effects – tax shield
(iii) The reporting effects–leased asset and lease liability/obligation

Term loans:
Term loans are loans with a maturity of more than one year. They are
obtained by private placement rather than public subscription.
Commercial banks are the primary term lenders. Because banks
receive much of their loanable funds from demand depositors that
can be drawn down quickly by depositors, banks prefer to make term
loans for relatively short periods of time, usually no longer than three
to five years.

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Chapter 10: Lease Financing and Term Loans
Features of term loans:
i. Maturity: 1-15 years (common practice 3-5 years)
ii. Direct negotiation: firm/borrower negotiate directly
iii. Collateral: generally collateral is required (specially for small and
weak firms)
iv. Restrictive provisions: the lender may attempt to add restrictive
provisions on the firm/borrower such as: asset control provisions,
liability control provisions, cash flow control provisions and
management control provisions
v. Repayment schedule: it specifies when interest payments and
principal repayment are due where a common practice is to amortize
the loan by making periodic payments to reduce the loan balance.

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 Repayment schedule

ABC company took loan Tk.1100000 @10% incremental rate

for 5 years period January 01 20X0. The loan repayments were
made under annuity due situation. Calculate the amount of
periodic loan repayment and prepare the loan amortization
schedule.
 
Solution :
Calculation of annual loan repayment (CF):
CF = Loan principal / PVIFA r,n
= 1100000/4.169865 = 263797.51

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 Loan amortization schedule
Year Beginning Loan Incremental Principal Ending
balance payments payments payments balance

20X0 1100000 263797.51 0 263797.51 836202.49

20X1 836202.49 263797.51 83620.24 180177.27 656025.22
20X2 656025.22 263797.51 65602.52 198194.99 457830.23
20X3 457830.23 263797.51 45783.02 218014.49 239815.74
20X4 239815.74 263797.51 23981.57 239815.74 0

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Chapter 10: Lease Financing and Term Loans
Cost of term loans:
i. Interest expense
ii. Origination fee
iii. Commitment fee
iv. Compensating balance
v. Tax impact
Advantages of term loans:
i. Usually it can be placed faster than bond/debenture issue.
ii. Its floatation costs are less
iii. It helps the borrower to negotiate more readily with the
lender
iv. It facilitates the investment-financing match up
v. It provides long term debt capital for small firms that find
is difficult to raise money through the market
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Chapter 10: Lease Financing and Term Loans

Disadvantages of term loans:

i. Usually it increases level of financial risk
ii. It carries the bankruptcy risk
iii. It usually has fairly stringent restrictions
iv. In periods of tight money, term lenders frequently
demand equity sweeteners i.e. more equity contribution
by the borrower.

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