19 Lease Financing Short- and Intermediate-Term Funding Alternatives

19 Lease Financing Short- and Intermediate-Term Funding Alternatives © 2006 Thomson/South-Western

Introduction n The first half of this chapter deals with lease financing from the perspective of both the owner and the user of an asset It examines the type of analysis that should go into a lease versus borrow-andpurchase decision to maximize shareholder wealth. The second half of the chapter discusses other intermediate-term sources of funding available to a company, such as term loans and equipment loans. 2

Glossary of Leasing Terms n This Web site has a glossary of leasing terms for researching the right alternative between leasing or borrowing and purchasing assets: http: //www. ge. com/capital/vendor/glosterm. htm 3

Lease Contract n Leases q q n Alternative to term financing Arrangements to transfer tax benefits Lessee q q Obtains use of an asset Specific period of time Ownership to lessor Agrees to make a series of payments to lessor 4

Types of Leases n Operating lease Service lease • Maintenance lease q n Maintenance and insurance included Financial lease q q Noncancelable Lessee responsible for · q q n Maintenance • Insurance • Property taxes Direct lease Sale and leaseback Leveraged lease Three-party financial lease q Lessee • Lessor • Lender 5

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Sale and Leaseback Transaction n Investigate the sale and leaseback transaction at this Web site: http: //www. amcity. com/southflorida/stories/0127 97/focus 5. html 7

Advantages to Leasing n n n n Flexible Convenient Lower payments Avoid some risk of obsolescence Smoother earnings and EPS 100% financing Liquidity 8

Disadvantages to Leasing n More expensive n Salvage value foregone n Difficult approval for modifications n May not be canceled 9

Tax Considerations n n A lease must have economic benefits separate from tax considerations. Recognized by IRS as a lease (Rules) q q q q Remaining useful life < 30 years Reasonable ROI Renewal options Purchase options Level schedule of lease payments 20% equity Property valuable only to the lessee 10

Leases and Accounting Practices n Types of Leases q q n n FASB requires that leases be capitalized. Value of lease q q n Financial leases Operating leases Equal to the PV of the lease payments Discounted at the firm’s borrowing rate for a secured loan with similar maturity Disclosure of details in footnotes 11

Footnotes: Financial Leases n As of the date of the balance sheet q Gross amount of assets by major classes q Amount of accumulated lease amortization q Future minimum lease payments n In total for each of the next five fiscal years 12

Footnotes: Operating Leases n As of the date of the latest balance sheet q Future minimum rental payments required n q In total for each of the following five fiscal years An income statement is presented for rental expense in each period 13

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Lease Payments: Lessor’s perspective n Lessor’s required payment three-step process Step 1: Compute the lessor’s amount to be amortized Initial outlay Less: PV of after-tax salvage Less: PV of depreciation tax shelter Equals: Amount to be amortized 15

Lease Payments (continued) Step 2: Compute after-tax lease income required Amount to be amortized = PV of after-tax lease payment Step 3: Compute before-tax lease payment Lease Payment After-tax lease income required = 1 – lessor’s marginal tax rate 16

Lease vs. Borrowing to Buy n Compute the NAL (net advantage to leasing) n If NAL is positive, it is cheaper to lease. If NAL is negative, it is cheaper to own. n 17

Factors affecting the NAL n Considerations q q q Installed costs PV of after-tax lease payments PV of depreciation tax shield PV of after-tax operating costs if owned AND n PV of after-tax salvage value at the lessee’s weighted cost of capital 18

Small Firms n Reasons for leasing q q n Less cash required upfront Better protection against obsolescence Quicker approvals Fewer restrictive covenants Expensive reasons q q High interest cost Loss of tax benefits 19

Term Loan n Maturity n Amortization n Sources n Interest costs n Less expensive n Loan agreements n Better suited n Warrants n Working capital n Security provisions n Default provisions n Covenants 20

Computing the annual payment PVAN 0 = PMT (PVIFAi, n) PMT = PVAN 0 PVIFAi, n 21

Sources of Term Loans n Banks n Insurance companies n Pension funds n Government agencies n Equipment suppliers q Conditional sales contracts q Chattel mortgages 22

Government Agencies n SBA q http: //www. sba. gov/ n Participation loans n SBICs n IDAs q Municipal bonds 23

Security Provisions n n Dependent on the borrower’s credit standing Provisions q q q Assignment of payments due from a particular contract Assignment or pledging of inventories, A/R or securities Floating lean Mortgage Life insurance Pledge of marketable securities 24

Covenants n Affirmative n Negative n Restrictive 25