Intermediate Financing

Term Loan and Lease Financing

Chapter Outline
1. Term Loan
2. Lease Financing
3. Lease-Buy Analysis: Lessee’s Perspective
4. Evaluation of Lease by Lessor
5. Sources of Value in Leasing
1. Term Loan

• A loan in which a borrower agrees to make a series of interest

and principal payments in an interval of specific period
• Original Maturity – more than one year
• Used to finance permanent working capital and fixed assets, or
to discharge other loans
• Primary source – banks and financial institutions
Term Loan …

Characteristics of term loan

• Principal amount
• Fixed maturity
• Interest rate
• Direct negotiation with the lenders
• Tied up with collateral
• Fixed repayment schedule
• Restrictive covenants
Term Loan …

Suppliers of term loan (in Nepal)

• Banks and finance companies
• Life insurance companies
• Dealers/ suppliers of fixed assets
• Employees’ Provident Fund
• Citizen Investment Trust
• Saving and credit co-operatives
Term Loan …

Amortized loan
• A term loan which is scheduled to be repaid in equal periodic
payment
• The payment comprises interest and principal repayment
• The loan amortization process involves:
• Finding periodic equal payment/ Installment
• Preparing loan amortization schedule
• Annual Payment can be calculated using following equation:
Amount of Loan
Annual Payment = (4.1)
PVIFAi‚ n
Term Loan …
Example 4.1 Loan Amortization Schedule
Loan amount = Rs 50,000 Interest rate =10 % and loan period = 5 yrs
a. Calculate annual payment and prepare loan amortization schedule if
installment is payable at the end of the year.
b. Calculate annual payment prepare loan amortization schedule if installment
is payable at the beginning of the year.
Annual Payment can be calculated using following equation:

Amount of Loan
Annual Payment = PVIFA (4.1)
i‚ n

Rs 50‚000 Rs 50‚000
= PVIFA = 3.7908 = Rs 13,189.83
10%‚ 5
Example 4.1 …

Loan amortization schedule

TABLE 4.1 Year Beginning Payment Interest Repayment of Ending

Loan Amortization (1) Amount Principal Balance
Schedule (2) (3) (4) = (2) x 0.10 (5) = (3) – (4) (6) = (2) – (5)
1 Rs 50,000.00 Rs 13,189.83 Rs 5,000.00 Rs 8,189.83 Rs 41,810.17
2 41,810.17 13,189.83 4,181.02 9,008.81 32,801.36
3 32,801.36 13,189.83 3,280.14 9,909.69 22,891.67
4 22,891.67 13,189.83 2,289.17 10,900.66 11,991.01
5 11,991.01 13,189.83 1,198.82* 11,991.01 –
* Interest paym ent in the fifth year has been rounded to m ake sum of principal plus interest equal to the annual paym ent of
Rs 13,189.83
Example 4.1 …

b. If installment is payable at the beginning of the period annual payment is calculated using Equation 4.2
Amount of Loan Rs 50‚000
Annual payment = 1 + PVIFA (4.2) = 1 + PVIFA
i‚ n - 1 10%‚ 4

= Rs 11,991.2

Loan amortization schedule:

TABLE 4.2 Year Beginning Payment Interest Repayment of Ending
Loan Amortization Amount Principal Balance
Schedule (1) (2) (3) (4) (5) = (3) – (4) (6) = (2) – (5)
0 Rs 50,000 Rs 11,991.27 – Rs 11,991.27 Rs 38,008.73
1 38,008.73 11,991.27 Rs 3,800.87 8,190.4 29,818.33
2 29,818.33 11,991.27 2,981.83 9,009.44 20,808.89
3 20,808.89 11,991.27 2,080.89 9,910.38 10,898.51
4 10,898.51 11,991.27 1,092.76* 10,898.51 –
* Interest payment in the 4th year has been rounded to make the sum of principal plus interest equal to the annual payment of
Rs 11,991.27.
Term Loan …
Security Provisions and Protective Covenants
– Term loan agreement specifies the security provisions and protective
covenants
Security provisions
• An assignment of a portion of the receivables or inventories
• The use of a floating lien on inventories and receivables
• A pledge of marketable securities held by the borrower
• A mortgage on property, plant, or equipment held by the borrower
• An assignment of the cash surrender value of a life insurance policy
held by the borrower for its key executives
• An assignment of payments due under a specific contract
Term Loan …

Affirmative covenants: The borrower agrees to

• furnish periodic (monthly quarterly or annually) financial
statements to the lender
• carry sufficient insurance to cover insurable business risk
• maintain a minimum amount of net working capital
• maintain management personnel who are acceptable to the
financing institution
Term Loan …

Negative covenants
• The borrower agrees not to pledge any of its assets as security to
other lenders
• The borrower is prohibited from making mergers or
consolidations without the lender's approval
• The borrower is prohibited from making or guaranteeing loans to
others that would impair the lender's security
Term Loan …

Default provisions
• The borrower fails to pay interest, principal, or both as specified
by the terms of the loan
• The borrower materially misrepresents any information on the
financial statements required under the loan's affirmative
covenants
• The borrower fails to observe any of the affirmative, negative, or
restrictive covenants specified within the loan
Term Loan …

Advantages and Disadvantages of Term Loan

Advantages
• Less costly source of long-term financing
• Provides sufficient flexibility in the financial/capital structure of the
company
• Lenders have no interference in business operations because they are not
entitled to vote
• Quick Service
• No dilution in control power
• The company can enjoy tax saving on interest expense
Term Loan …

Disadvantages
• Burden of fixed repayment to the company
• Risky source of long-term financing
• Restrictive covenants – may limit the company's operating
flexibility
• Requirement of collateral
• Limited use of fund
2. Lease Financing

Lease
• A contract whereby the owner of an asset (lessor) grants to user of the asset
(lessee) the right to use the asset for an agreed period of time
• Lease contract primarily specifies
• the assets which is leased
• the lessor and lessee
• the period of lease
• lease rent
Leasing
• The method of financing under which assets can be used without obtaining their
ownership or title
• Widely used source of intermediate and long-term financing
Lease …

Lessors in lease financing

• Commercial banks
• Savings and loan institutions
• Finance companies
• Insurance companies
• Manufacturing companies (often through captive leasing
subsidiaries)
• Independent leasing companies
Lease …

Types of leases
• Operating lease
• Financial lease
• Sale and leaseback
• Direct lease
• Leveraged lease
Types of Leases …

Operating lease ( Service lease)

• Lessor is responsible to bear maintenance cost
• Considerably shorter period than the expected life of the leased
equipment
• Contains a cancellation clause
• Suitable for the assets in which technology changes quickly
Types of Leases …

Financial lease ( Capital lease)

• Lessor does not provide maintenance service
• Longer period ( may be fully amortized)
• Non-cancellable
• The lessee may have a right to renew the lease on expiration
Types of Lease …

Sale and leaseback

• Under a sale and leaseback arrangement, a firm sells an asset to
another party (prospective lessor) and this party immediately
leases it back to the firm.
• Insurance companies, finance companies, and independent
leasing companies etc. are involved as lessor in sale and
leaseback arrangement.
Types of Lease …

Direct lease
• A direct lease results when a lessor owns or acquires the assets
that are leased to a given lessee.
• Direct leases are obtained from manufacturers, the leasing
divisions of major financial institutions, independent leasing
companies.
Types of Lease …

Leveraged lease
• A lease under which the lessor acts as on equity participant,
supplying only some portion of the cost of asset, while a lender
suppliers the balance.
• Three parties ‒ the lessee, lessor and the lender (or financier) are
involved
Advantages and Disadvantages of Leasing (lessee’s
Perspective)

Advantages
• Tax saving on lease rent
• Avoids huge initial investment
• Less restrictive
• Hundred percent financing
• Risk of obsolescence can be transferred to lessor
• Increase liquidity
• Quick service
• No dilution in further borrowing capacity
Advantages and …

Disadvantages
• Generally, leasing is more expensive than owning alternative
• Lessee cannot entertain benefit of salvage value
• Loss of tax saving on depreciation
• Loss of benefit of investment tax credit
• Difficulty in getting approval to make property improvements
3. Lease-Buy Analysis

Methods of evaluating lease versus purchase decision

• Present value of after-tax cash outflow method
• Net advantage of leasing (NAL) method
• Internal rate of return (IRR) method
Lease-Buy …

Present value of after-tax cash outflow method

• Calculate present value of after-tax lease rent (Cost of leasing)
Cost of Leasing = Lt (1 – T) × PVIFAkdt, n (4.3)
• Calculate present value of after-tax cash flow under purchasing alternative (Cost
of owning)
Cost of Owning = Cost of asset – PV of ownership benefit
= Cost of asset – [ITC + Dep. (T) PVIFA kdt, n + SVn PVIF kdt , n ]
• Compare cost of leasing and cost of owning
• Lease the asset if cost of leasing < Cost of owning
• Purchase the asset if cost of leasing > Cost of owning
Lease-Buy …

Example: 4.2
Annual lease payments = Rs 15,000, Lease period = 3 years (end of each year),
Cost of the equipment = Rs 40,000, Depreciation = straight-line, Salvage value
at the end of the third year = Rs 4,000, The firm's cost of capital = 12%, Before
tax cost of debt = 10%, Tax rate = 40 percent
Would you lease or purchase the asset?

Cost of Leasing = Lt (1 – T) × PVIFAkdt, n

= Rs 15,000 (1 – 0.40) × PVIFA6%,3
= Rs 6,000 × 2.6730
= Rs 24,057
Example: 4.2 …

Cost of owning
= Cost of assets – PV of ownership benefit
= Cost of assets – [ITC + PV of tax saving on depreciation + PV of SV n]
= Rs 40,000 – [0 + Rs. 12,000 × 0.40 × PVIFA6%, 3 + Rs 4,000 × PVIF6%,3]
= Rs 40,000 – [0 + 4,800 × 2.673 + Rs 4,000 × 0.8396]
= Rs 23,811.20
Since cost of purchasing is less than cost of leasing, assets should be
purchased.
Try Yourself 3.1

XYZ Company can lease equipment for five years, making annual payments of
Rs 4,095 per year at the end of each year or they can buy the equipment for
Rs 12,500. At the end of five years, the equipment will have no salvage value. The
firm's cost of capital is 12% and before tax cost of debt is 10%. The company uses
straight-line depreciation and has a 40 percent tax rate.
Using schedules, suggest the appropriate alternative to the company. Use after-tax
cost of debt as the discount factor.
Cost of leasing = Rs 10,350
Cost of owning = Rs 8,288
Lease-Buy …

Net advantage to leasing (NAL) method

• Net advantage to leasing is the difference between the cost of
owning and cost of leasing

Condition Result Decision

Cost of owning > cost of leasing NAL is positive Lease the asset
Cost of owning < cost of leasing NAL is negative Buy the asset
Lease-Buy …

Example: 4.3
Cost of leasing is Rs 24,057 and cost of borrow and buy is
Rs 23,810.6. Calculate net advantage of leasing (NAL) should
equipment be leased or purchased?

Net advantage of leasing = Cost of owning – Cost of leasing

= Rs 23,810.60 – Rs 24,057
= – Rs 246.40
Since net advantage of leasing (NAL) is negative, the company
should purchase the assets.
Lease-Buy …

Internal rate of return (IRR) method

• IRR is the required return that equates the PV of lease payments and residual
value with the asset's beginning value
• Percentage cost of leasing
• IRR can be computed by using following Equation:

I0 – ITC – D(T) PVIFAIRR, n – SVn × PVIFIRR, n – Lt (1 – T) PVIFAIRR, n = 0 (4.6)

Situation Decision
IRR <kdT Lease the asset
IRR >kdT Buy the asset
Lease-Buy …

Factors affecting lease versus purchase decision

• Different required rate of return of lessee and lessor
• Maintenance cost
• Expected salvage value
• Obsolescence cost
• Tax rate
• Methods of depreciation
4. Evaluation of Lease by Lessor

• From lessor’s perspective leasing an asset is similar to capital

budgeting decision
• If net present value by leasing the asset is positive, lessor should lease
the asset
NPV of lessor (NPVLOR) can be computed using Equation.
NPVLOR =  I0 + PV of ownership benefit + PV of lease rent after tax
NPVLOR =  I0 + [ITC + Dep.  T  PVIFA k, n + SVn PVIF k,n] + Lt (1 –T) PVIFA k, n
Where
NPVLOR = net present value of lessor I0 = initial investment
(cost of assets)
ITC = investment tax credit T = tax rate
Evaluation …

Example 4.4
Cost of asset = Rs 700,000 Lease Period = 5 yrs Dep. = SLM Salvage Value = Rs
100,000 Lease rent = Rs 200,000 Tax rate = 40% Lessor’s required rate of return
( cost of capital) = 10%
NPV of lessor (NPVLOR)?
NPVLOR =  I0 + [ITC + Dep.  T  PVIFA k, n + SVn PVIF k,n] + Lt (1 –T) PVIFA k, n
= – Rs 700,000 + [0 + Rs 120,000 × 0.40 × PVIFA10%,5 + Rs. 100,000 ×
PVIF10%,5] + Rs 200,000 (1 – 0.4) PVIFA10%, 5
= – Rs 700,000 + [Rs 48,000 × 3.7908 + Rs. 100,000 × 0.6209] + Rs 120,000 ×
3.7908
= – Rs 1,044
Evaluation …

Competitive lease rent

• The lessor must set the lease rates that will provide a satisfactory
rate of return
• The competitive lease rent is the lease rent at which net present
value of lessor (NPVLOR) equals to zero
• Competitive lease rent can be computed by solving following
equation
0 =  I0 + [ITC + Dep.  T  PVIFA k, n + SVn PVIF k,n] + Lt (1 –T) PVIFA k, n
Evaluation …
Example 4.5
Cost of assets = Rs 120,000, Lessor’s cost of capital = 10%, Depreciation = straight-line
depreciation, Salvage Value = Zero, life = 5yrs, Corporate tax rate = 50%, Competitive
lease rent = ?
NPVLOR =  I0 + [ITC + Dep. T  PVIFA k, n + SVn PVIF k,n] + Lt (1 –T) PVIFA k, n
Competitive lease rent is the lease rent at which NPV of lessor (NPV LOR) equals to zero
So, 0 = Rs 120,000 + Rs 24,000  0.50  PVIFA10%,5 +Lt (1 – 0.50) PVIFA10%,5
or Rs 120,000 = Rs 12,000  3.7908 + Lt 0.50  3.7908
or Rs 120,000 = Rs 45,489.6 + Lt 1.8954
 Lt = = Rs 39,311.17
Therefore, the company's competitive lease rent is Rs 39,311.17.
Try Yourself 4.2
TATA Company produces industrial machines, which have five-year life. TATA
is willing to either sell the machines for Rs 3,200,000 or to lease them at a rental
that yields an after tax return to TATA of 6 percent –its cost of capital. What is
the company's competitive lease rental rate? Assume straight-line depreciation,
Rs 200,000 salvage value, and an effective corporate tax rate of 40 percent.

Competitive lease rent = Rs 806,981

5. Sources of Value in Leasing

Why is leasing being a thing of value in capital markets in recent years?

• Leasing can be beneficial to both lessee and lessor
• The lessor's position is somewhat superior to that of a lender when a
lessee or borrower liquidates
• Lessor can retrieve the asset when the lessee defaults
• Tax benefits
• Lessor may enjoy economies of scale in the purchase of the assets
• Lower maintenance cost