Unit 3

Intermediate term debt financing

NOU
1
 Course Contents

 Unit 4: Intermediate term debt financing

4.5 hrs
– Concept and implications
– Forms of intermediate-term financing
– Protective covenants & loan agreement
– Lease financing: Forms of leasing
– Lease versus purchase decisions.
– Intermediate term financing practices in Nepali firms

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 Intermediate Term Financing

 Intermediate term financing refers to

borrowings with repayment schedules of more
than one year but less than ten years.
 In contrast, short-term financing has a repayment
schedule of less than one year, while long-term
financing matures in ten years or longer.

3
 Advantages of Intermediate Term Financing

 It provides a useful alternative when the firm is

unable to continue expanding assets with internal
or short-term funds;
 It provides a source of funding for small
businesses which do not have ready access to
capital markets;
 It provides an alternative which at times may be
less costly and more convenient than the raising
of funds through the flotation of bonds or stocks
4 in capital markets;
 Advantages of Intermediate Term Financing

 Tax advantages are sometimes derived from the

exercise. Interest on term loans is tax deductible; and
 Intermediate term financing allows the firm to
borrow funds with only the amounts needed at each
stage of financing as required. In effect, the cost of
borrowing is minimized as interest will have to be
paid only on the actual amount borrowed.

5
Protective Covenants
 Agreements to protect lender.
 Negative covenant: Thou shalt not:
– Pay dividends beyond specified amount.
– Sell more senior debt & amount of new debt is limited.
– Refund existing bond issue with new bonds paying lower interest rate.
– Buy another company’s bonds.
 Positive covenant: Thou shall:
– Use proceeds from sale of assets for other assets.
– Allow redemption in event of merger or spinoff.
– Maintain good condition of assets.
– Provide audited financial information.
– Segregate and maintain specific assets as security for debt.
 Suppliers of Term Loans

 Intermediate term financing is provided by

private commercial banks, finance companies,
factors, insurance, and pre-need companies.

7
Types of Leases

 The Basics
– A lease is a contractual agreement between a
lessee and lessor.
– The agreement establishes that the lessee has
the right to use an asset and in return must make
periodic payments to the lessor.
– The lessor is either the asset’s manufacturer or
an independent leasing company.
Operating Leases

 Usually not fully amortized. This means that

the payments required under the terms of the
lease are not enough to recover the full cost
of the asset for the lessor.
 Usually require the lessor to maintain and
insure the asset.
 Lessee enjoys a cancellation option. This
option gives the lessee the right to cancel the
lease contract before the expiration date.
Financial Leases

The exact opposite of an operating lease.

1. Do not provide for maintenance or service by the
lessor.
2. Financial leases are fully amortized.
3. The lessee usually has a right to renew the lease at
expiry.
4. Generally, financial leases cannot be cancelled, i.e.,
the lessee must make all payments or face the risk
of bankruptcy.
Sale and Lease-Back

 A particular type of financial lease.

 Occurs when a company sells an asset it
already owns to another firm and
immediately leases it from them.
 Two sets of cash flows occur:
– The lessee receives cash today from the sale.
– The lessee agrees to make periodic lease
payments, thereby retaining the use of the asset.
Leveraged Leases

 A leveraged lease is another type of financial

lease.
 A three-sided arrangement between the
lessee, the lessor, and lenders.
– The lessor owns the asset and for a fee allows
the lessee to use the asset.
– The lessor borrows to partially finance the asset.
– The lenders typically use a nonrecourse loan.
This means that the lessor is not obligated to the
lender in case of a default by the lessee.
Accounting and Leasing

 In the old days, leases led to off-balance-

sheet financing.
 In 1979, the Canadian Institute of Chartered
Accountants implemented new rules for
lease accounting according to which financial
leases must be “capitalized.”
 Capital leases appear on the balance sheet
—the present value of the lease payments
appears on both sides.
Accounting and Leasing

Balance Sheet
Truck is purchased with debt
Truck $100,000 Debt $100,000
Land $100,000 Equity $100,000
Total Assets $200,000 Total Debt & Equity $200,000
Operating Lease
Truck Debt
Land $100,000 Equity $100,000
Total Assets $100,000 Total Debt & Equity $100,000
Capital Lease
Assets leased $100,000 Obligations (capital lease) $100,000
Land $100,000 Equity $100,000
Total Assets $200,000 Total Debt & Equity $200,000
Capital Lease

 A lease must be capitalized if any one of the

following is met:
– The present value of the lease payments is at
least 90-percent of the fair market value of the
asset at the start of the lease.
– The lease transfers ownership of the property to
the lessee by the end of the term of the lease.
– The lease term is 75-percent or more of the
estimated economic life of the asset.
– The lessee can buy the asset at a bargain price at
expiry.
Taxes and Leases
 The principal benefit of long-term leasing is tax
reduction.
 Leasing allows the transfer of tax benefits from those
who need equipment but cannot take full advantage of
the tax benefits of ownership to a party who can.
The Cash Flows of Leasing
Consider a firm, ClumZee Movers, that wishes to acquire a
delivery truck.
The truck is expected to reduce costs by $4,500 per year.
The truck costs $25,000 and has a useful life of five years.
If the firm buys the truck, they will depreciate it straight-line
to zero.
They can lease it for five years from Tiger Leasing with an
annual lease payment of $6,250.
The Cash Flows of Leasing
 Cash Flows: Buy
Year 0 Years 1-5
Cost of truck –$25,000
After-tax savings 4,500×(1-.34) = $2,970
Depreciation Tax Shield 5,000×(.34) = $1,700
–$25,000 $4,670
 Cash Flows: Lease
Year 0 Years 1-5
Lease Payments –6,250×(1-.34) = –$4,125
After-tax savings 4,500×(1-.34) = $2,970
–$1,155
• Cash Flows: Leasing Instead of Buying
Year 0 Years 1-5
$25,000 –$1,155 – $4,670 = –$5,825
The Cash Flows of Leasing
 Cash Flows: Leasing Instead of Buying
Year 0 Years 1-5
$25,000 –$1,155 – $4,670 = –$5,825
 Cash Flows: Buying Instead of Leasing
Year 0 Years 1-5
–$25,000 $4,670 –$1,155 = $5,825
 However we wish to conceptualize this, we need to have
an interest rate at which to discount the future cash
flows.
 That rate is the after-tax rate on the firm’s secured debt.
NPV Analysis of the Lease-vs.-Buy
Decision
 A lease payment is like the debt service on a
secured bond issued by the lessee.
 In the real world, many companies discount both the
depreciation tax shields and the lease payments at
the after-tax interest rate on secured debt issued by
the lessee.
NPV Analysis of the Lease-vs.-Buy
Decision
• There is a simple method for evaluating leases: discount
all cash flows at the after-tax interest rate on secured debt
issued by the lessee. Suppose that rate is 5-percent.
NPV Leasing Instead of Buying
Year 0 Years 1-5
$25,000 –$1,155 – $4,670 = -$5,825
5
$5,825
NPV  $25,000   t
 $219.20
NPV Buying Instead of Leasing t 1 (1.05)
Year 0 Years 1-5
-$25,000 $4,670 – $1,155 = $5,825
$5,825
5
NPV  $25,000   t
 $219.20
t 1 (1.05)
 A simple example
 A firm wants to acquire equipment that costs Rs 5,000.
 The equipment’s expected life of five years, after which it
will be sold for an expected salvage value of Rs 400.
 The firm can borrow the funds for 15 percent.
 Depreciation will be straight line.
 Maintenance is expected to be Rs 20 annually,
 The firm’s marginal tax rate is 40 percent.
 The firm could lease the equipment at the lease payment of
Rs 1,319.
 Lessor’s required rate of return is 10 percent.
22  To evaluate this lease, we can use three steps as follows:
 Solution
 Step 1: Calculate the PV of leasing
PV(L) = Lt (1 – T) × PVIFAkdt, n
= Rs 1,319 (1 – 0.40) × PVIFA9,5
= Rs 791.4 × 3.8897 = Rs 3,078.31

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 Solution…..
 Step 2: Calculate the PV of purchasing
PV (P) = I0 – [ITC + D × T × PVIFAkdt, n + SVn × PVIFkdt,n]
+ Ot (1 – T) × PVIFAkdt,n
= 5,000 – [0 + 1,000 × 0.40 × PVIFA9, 5 + 240 × PVIF9,5] + 20 (1 –
0.4) × PVIFA9,5
= 5,000 – [0 + 400 × 3.8897 + 240 × 0.6499] +12 × 3.8897
= 5,000 – 1,711.86 + 46.68 = Rs 3,241.46
Step 3: Choose the lease alternative because it has
the lower present value of cash outflows.

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 The Financing Decision:
Lease Vs. Sell

 Lessor’s point of view:

NPVLOR =  I0 + [ITC + Dep.  T  PVIFA k, n + SVn  PVIF k,n] + Lt (1
–T) PVIFA k, n
Decision Rule: Give assets in Lease if NPV LOR is positive otherwise sell.
Alternatively, to find competitive lease rent
I 0  SVn  PVIFk ,n  ICT
 Dep  T
PVIFA k ,n
Lt 
1 T
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 The Financing Decision:
Lease Vs. Borrow

 Lessee’s point of view:

NAL= I0 –[ITC + Dt(T) PVIFAkdt, n + SVn × PVIFkdt, n ] +
Ot (1 – T) PVIFAkdt, n  Lt (1 – T) PVIFAkdt,n

 Decision Rule: Lease if NAL is positive otherwise borrow.

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 Additional influences on the
leasing versus owning decision
 Different costs of capital for the lessor versus the user
firm.
 Financing costs higher in leasing.
 Differences in maintenance costs.
 The benefits of residual values to the owner of the assets.
 The possibility of reducing obsolescence costs by leasing
firms.
 The possibility of increased credit availability under
leasing.
 More favorable tax treatment, such as more rapid write-
off.
 Possible differences in the ability to utilize tax reduction
27 opportunities.
 Example 1

 Consider a company produces industrial

machines, which have five- year lives.
Company is willing to either sell the machines
for Rs 120,000 or to lease them at a rental
that, because of competitive factors, yields an
after-tax return to company of 10 percent – its
cost of capital. Assume straight-line
depreciation, zero salvage value, and
corporate tax rate of 40 percent. What is the
28 Company's competitive lease-rental rate?
 Solution

NPVLOR =  I0 +[ITC + Dep. T  PVIFA k, n + SVn 

PVIF k,n] + Lt (1 –T) PVIFA k, n
 Competitive Lt is that lease rent at which net present
value of lessor (NPVLOR) equals to zero.
So, 0 =  Rs 120,000 + Rs 24,000  0.40  PVIFA10,5
+Lt (1 – 0.40) PVIFA10,5
Or, Rs 120,000 = Rs 9600  3.7908 + Lt  0.50 
3.7908
Or, Rs 120,000 = Rs 45,489.6 + Lt  1.8954
29  Lt = Rs 39,311.17
 Example 2
 A company seeks to acquire the use of a machine at the
lowest possible cost. The choice is either to lease one at
Rs 6,600 annually or to purchase one for Rs 15,000. The
lease payment payable at the end of the year. The
company's cost of debt is 10 percent, and its tax rate is
40 percent. The machine has an economic life of three
years. The depreciation is Rs 3,000 per year. The firm
estimates that, without the maintenance contract, the
annual maintenance expenses related to the machine
would be Rs 600 per year. After-tax salvage value of the
machine at the end of third year is estimated to be Rs
30 6,000 if the purchase alternative is chosen.
 Step 1
 Find the present value of the cash outflows associated
with lease alternative. The present value of the cash
outflows associated with lease alternative is calculated as
follows:
If the lease payments made at the end of the period then these
payments are an expense, they are deductible for tax
purposes, but only in the year for which the payment applies.
PV (L) = Lt (1 – T) × PVIFAkdt, n
= Rs 6,600 (1 – 0.40) × PVIFA6,3
= Rs 3,960 × 2.6730
= Rs 10,585.08

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 Step 2: Find the present value of the cash outflows
associated with purchase alternative

 Calculate the after-tax cash flow from the purchase

alternative is a bit more difficult to find.
 First, determine the annual loan payment and
interest component of each annual loan payment.
 (i) Calculate the annual loan payment

We have,
PVA = PMT × PVIFAkd,n
or, Rs 15,000 = PMT × PVIFA10,3
or,Rs 15,000 = PMT × 2.4869
32 or,PMT = Rs 6,031.61
 (ii) Preparing the Loan Amortization Schedule

Year Installment Interest Principal Loan

balance
0 – – – 15,000
1 6,031.61 1,500 4,531.61 10,468.39
2 6,031.61 1,046.84 4,984.77 5,483.62
3 6,031.61 548.36 5,483.62 * –

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 (iii) Calculate the after-tax cash flow
Tax After-tax Salva After-tax cash
Install
Year Dep. Int. shield (5) maintena ge outflows (8) =
ment
(1) (3) (4) = [(3) + nce cost value (2) + (6)– (5) –
(2)
(4)] × T (6) (7) (7)
1 6,031.61 3,000 1,500 1,800 360 4,591.61
2 6,031.61 3,000 1,046.84 1,618.74 360 4,772.87
3 6,031.61 3,000 548.36 1,419.34 360 6,000 (1,027.73)

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 (iv) Calculate the present value of after-tax
cash flow

Year (1) After-tax cash PVIF @ 6 (3) PV (4) = (2) × (3)

flow (2)
1 4,591.61 0.9434 4,331.72
2 4,772.87 0.8900 4,247.85
3 (1,027.73) 0.8396 (862.88)
Present value of cash outflows 7,716.69

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Problem 1
A. The CL Company (CLCO) produces industrial machines, which have
five- year lives. CLCO is willing to either sell the machines for Rs
60,000 or to lease them at a rental that, because of competitive
factors, yields an after-tax return to CLCO of 9 percent – its cost of
capital. What is the Company's competitive lease-rental rate?
(Assume straight-line depreciation, zero salvage value, and an
effective corporate tax rate of 40 percent.)
B. The ST Company (STCO) is contemplating the purchase of a
machine exactly like those rented by CLCO. The machine will
produce net benefits of Rs 20,000 per year. STCO can buy the
machine for Rs 60,000 or rent it from CLCO at the competitive
lease-rental rate. STCO's cost of capital is 16 percent, its cost of
debt 15 percent, and tax rate = 40 percent. Which alternative is
better for STCO? Note that the discount rate applied by the
company is its after-tax cost of debt.
C. If CLCO's cost of capital is 12 percent and competition exists among
lessors, solve for the new equilibrium rental rate. Will STCO's
decision be altered? 36
• Solution to question 1. a)
• Step 1: PV of ownership benefits ( ITC + D X t X PVIFA + SV X PVIF)
= 0 + 12,000 (0.40)  PVIFA 9,5 + 0
= 4,800  3.8897 = Rs 18,670.56
• Step 2: Net amount to be recovered = (Price – PV of ownership benefit)
= 60,000 – 18,670.56 = Rs 41,329.44
• Step 3: After Tax Lease (ATL) = Net amt to be recovered/ PVIFAk, n
= Rs 41,329.44 / 3.8897 = Rs 10,625.35
• Step 4: Before tax Lease (Lt) = ATL / (1- t)
= 10,625.35 / ( 1 – 0.4) = Rs 17,708.92
• Solution to question 1. b)
• Step 1: Calculation of PV of cash outflows of leasing
PV (L) = Lt ( 1 –T) PVIFA kdt, n
= 17,708.92 (1 – 0.40) PVIFA 9, 5
= 10,625.35  3.8897 = Rs 41,329.42
• Step 2: Calculation of PV of cash outflows of purchasing
= I0 – [ITC + Depreciation (T) PVIFA kdt, n + SVn  PVIF kdt , n ]
= 60,000 – 0 – 12,000 (0.40)  PVIFA 9, 5 – 0
= Rs 60,000 – Rs 0 – Rs 4,800  3.8897 – Rs 0
= Rs 60,000 – Rs 4,800  3.8897 = Rs 41,329.44
Present value of leasing equal with present value of purchasing. So, if cost is considered lessee
will be indifferent between two alternatives. 37
• Solution to question 1. C)
• For Lessor
• Repeat step 1 to 4 using k = 12%
• Before tax Lease (Lt) = Rs 19,740.78

• For Lessee
• Step 1: Calculation of PV of cash outflows of leasing
PV (L) = Lt (1 –T) PVIFA kdT,n
= Rs 19,740.78 (1 – 0.40) PVIFA 9, 5
= Rs 11,844.47  3.8897 = Rs 46,071.43
Step 2: Calculation of PV of cash outflows of purchasing
• PV (P) = Rs 41,329.44 (No change

STCO's decision will be altered. The present value of the cost of leasing is
higher than the present value of buying. So, the buying alternative is
preferable.
38
Problem 2
• The PSC has decided to acquire a new cutting machine. One alternative is to
lease the machine on a 4-year guideline contract for a lease payment or Rs 9,500
per year, with payments to be made at the beginning of each year. Alternatively,
PSC could purchase the machine outright for Rs 38,000, financing the purchase
by a bank loan for the net purchase price and amortizing the loan over a 4-year
period at an interest rate of 10 percent per year installments are paid at
beginning of the year. The machine falls into the MACRS 3-year class. It has a
residual value of Rs 9,000, which is the expected market value after 4 years,
when PSC plans to replace the machine irrespective of whether it leases or buys.
PSC has a marginal tax rate of 40 percent.
a. What is PSC’s PV of cost of leasing?
b. What is PSC’s PV of cost of purchasing?
c. Should the machine be leased or purchased?
d. The appropriate discount rate for cash flows used in the analysis is the firm’s
after-tax cost of debt. Why?
e. The residual value is the least certain cash flow in the analysis. How might PSC
incorporate differential riskiness of this cash flow into the analysis?
• (a) Calculation of PV of cost of leasing i.e. PV (L)
PV (L) = Lt + Lt (1 – T) × PVIFAkdt, n–1 – Lt (T) PVIFkdt, n
= 9,500 + 9,500 (1 – 0.40) × PVIFA6, 4–1 – 9,500 (0.40) PVIF6,, 4
= 9,500 + 5,700 × 2.6730 – 3,800 × 0.7921
= 24,736.10 – 3,009.98 = Rs 21,726.12
• b) Calculation of PV of purchasing i.e. PV(P)
• Step 1: Calculate the PMT
PVA = PMT × PVIFAkd,n × (1 + kd)
38,000 = PMT × PVIFA10,4 × (1 + 0.10)
38,000 = PMT × 3.1699 × 1.10
PMT = Rs 10,897.93
Step 2: Prepare
Year
amortization
Payment
schedule
Interest Principal Loan balance
0 10,897.93 – Rs 10,897.93 Rs 27,102.07
1 10,897.93 2,710.21 8,187.72 18,914.35
2 10,897.93 1,891.44 9,006.49 9,907.86
3 10,897.93 990.79 9,907.14 0 40
• Step 3: Calculate the after-tax cash flows
After-tax After-tax
Year Payment Interest Dep. Tax save
SV cash flow
0 10,897.93 – – –   10,897.93
1 10,897.93 2,710.21 12,665.4 6,150.24   4,747.69
2 10,897.93 1,891.44 16,891 7,512.98   3,384.95
3 10,897.93 990.79 5,627.8 2,647.44   8,250.49
4     2,815.8 1,126.32 5,400 (6,526.32)

• Step 5: Calculate the PV of after-tax cash flows

Year After-tax cash flow PVIF@ 6% PV
0 Rs 10,897.93 1 Rs 10,897.93
1 4,747.69 0.9434 4,478.97
2 3,384.95 0.8900 3,012.61
3 8,250.49 0.8396 6,927.11
4 (6,526.32) 0.7921 (5,169.50)
PV (P) Rs 20,147.12

• Because the present value of the purchase is less than the present value of
leasing, the borrow purchase is preferred. Borrow purchase rather than
leasing the cutting machine should result in an incremental savings of Rs
1,579 (Rs 21,726.12 – Rs 20,147.12) 41
Example 3

• PF Industry wishes to acquire a merchandised feed spreader that

costs Rs 80,000. The Feed Company intends to operate the
equipment for 5 years, at which time it will need to be replaced. The
equipment is depreciated using straight line method to zero book
value. However, it is expected to have a salvage value of Rs 10,000 at
the end of the fifth year. Public Feed is in a 30 percent tax bracket.
Two means for financing the feed spreader are available. The assets
can be leased at annual lease payment of Rs 19,000 which is to be
paid at the beginning of the year. Alternatively the assets can be
purchased by financing it with debt. A debt alternative carries an
interest cost of 10 percent. Debt payments will be at the start of each
of the 5 years using mortgage type of debt amortization.

42
 • Solution 3
• Calculation of PV of cost of leasing i.e. PV (L)
PV (L) = Lt + Lt (1 – T) × PVIFAkdt, n–1 – Lt (T) PVIFkdt, n = Rs 59,986
• Calculate the loan installment
= Rs 19,185
• Develop amortization schedule
Year Installments Interest Principal paid Balance
0 19,185  Rs 19,185 Rs 60,815
1 19,185 6,082 13,103 47,712
2 19,185 4,771 14,414 33,298
3 19,185 3,330 15,855 17,443
4 19,185 1,742 17,443 
• Calculate the present value of purchasing
Tax
Year Install Interest Dep. SVn CFAT PV factor PV at 7%
shield
0 19,185      19,185 1 19,185
1 19,185 Rs 6,082 16,000 6,625   12,560 0.9346 11,738
2 19,185 4,771 16,000 6,231   12,954 0.8734 11,314
3 19,185 3,330 16,000 5,799   13,386 0.8163 10,927
4 19,185 1,742 16,000 5,323   13,862 0.7629 10,575
5     16,000 4,800 7,000 (11,800) 0.7130 (8,413)
43
    PV of after-tax cash outflow under purchasing 55,326
Problem 4
• Star Leasing Company will lease a piece of equipment that has market
price of Rs 80,000 today. The equipment could be leased for 5 years of
its economic life and provide 5000 tax credit to the owner of the
equipment. At the end of the lease, Star estimates the asset will have a
residual value of Rs 20,000. Under the lease term the company has to
bear the maintenance cost of Rs. 2000 per year. The assets is
depreciated on straight line basis to zero book value. The company’s
marginal tax rate is 40%. What would be the competitive lease rent for
the company if it wants to earn 15% return on investment?

44
Solution to question 4
• Step 1: PV of ownership benefits ( ITC + D X t X PVIFA + SV X PVIF)
= 5000 + 16,000 (0.40)  PVIFA 15,5 + 20000(1 - .4) PVIF 15,5
= 5000 + 6400 X 3.3522 + 12000 X .4972 =32420
• Step 2: Net amount to be recovered = (Price – PV of ownership
benefit + PV of after tax Maintenance cost)
= 800,000 – 32420 + 2000 (1 – 0.4) PVIFA 15,5
= 47580 + 1200 X 3.3522 = Rs 51602.67
• Step 3: After Tax Lease (ATL) = Net amt to be recovered/ PVIFAk, n
= Rs 51602.67 / 3.3522 = Rs 15393.88
• Step 4: Before tax Lease (Lt) = ATL / (1- t)
= 15393.88 / ( 1 – 0.4) = Rs 25,656. 47

45
Problem 5
• ABC Company wishes to acquire an equipment that costs Rs 100,000.
The Company intends to operate the equipment for 5 years, at which
time it will need to be replaced. The equipment fall under MACRS 5-
year class for depreciation purpose . However, it is expected to have a
salvage value of Rs 10,000 at the end of the fifth year. ABC is in a 40
percent tax bracket. Two means for financing the equipment are
available. The assets can be leased at annual lease payment of Rs
25,000 which is to be paid at the beginning of the year. Alternatively
the assets can be purchased by financing it with debt. ABC company
will receive Rs. 5000 investment tax credit and has to bear Rs. 1500
annual maintained cost if purchase alternative is chosen. A debt
alternative carries an interest cost of 15 percent. Debt payments will
be at the start of each of the 5 years using mortgage type of debt
amortization.

46
47