WELCOME TO Chapter 3: Intermediate term debt financing

1. WELCOME TO Chapter 3:Intermediate term debt financing

2. Intermediate term debt financing • ITD financing resembles short-term financing as it isself-liquidatingin nature. • It can also satisfy more permanent fund requirements - can serve as aninterim substitutefor long-term financing. • If a firm wishes to float long-term debt or common stock,market conditionsmay not be favorable. • It gives the firmflexibility in timing of long term financing. • It can provide flexibility when the firm is uncertain about thenature & size of its future funds requirement. • As uncertainty is resolved, intermediate term debt financing can bereplacedby a more appropriate means of financing.

3. Forms of Intermediate Term Debt Financing • 1. Bank term loans • 2. Insurance company term loans • 3. Revolving credit agreement • 4. Equipment financing • 5. Lease financing

4. 1. Bank term loans • An ordinary term loan is a business loan with amaturityof more than 1 year, repayable according to some specified schedule. • Repayable inperiodic installments - half-yearly, quarterly etc. • Most bank term loans have a maturity period of 3-7 years. • These loans can berenewedbut the bank will evaluate a fresh. • Interest rate ishigherthan that of short-term loans. • Interest rate may be a fixed, variable or ceiling rate. • Commitment fees • Compensating balance requirement

5. 2. Insurance company term loans • Insurance companies & similar other institutional lenders also extend term loans. • Their protective covenants are similar to banks except for maturity period & interest rate. • Life insurance companies provide loans for more than 10 years. • Interest rate ishigherbecause they do not have opportunity to do business with the client, & demand compensating balance requirement. • To the insurance companies, loans represent investment & must yield greater than cost. • Prepayment penalty. • Sometimes banks & insurance companiesparticipate in the same loan: bank taking early maturities & insurance companies taking late maturities. • Serves both, mid-term & long term loans.

6. 3. Revolving credit agreement • It is a formal commitment by a bank to lend up to a certain amount of money. • If agreement is made for more than a year, it comes under intermediate term financing. • Interest rate is higher than that of short-term loans. • The borrower is required to pay commitment fee on unused funds. • If agreement is made for $5m & $2m is the total borrowing, then commitment fee to be paid @ 0.5 percent would be $15,000. • Useful when the firm is uncertain about funds requirement.

7. 4. Equipment financing • If the firm has equipment, the same can be pledged as collateral & loan can be obtained. • As with other secured loans, the lender will determine how much to lend against collateral. • Repayment schedule is important. • Margin of safety: Lender makes sure that market value of equipment is more than loan amount. • Important factors are: quality of equipment (marketability), life, & risk or market price stability. • Sources of eqpt financing: Com. Banks, finance companies & seller of equipment. 5. Lease financing

8. Protective covenants of loan agreement • Lender provides loan for an extended period of time. • Much can happen to the financial position of the company during the period. Lender has a cause to worry. • Lender wants firm to maintain that fin. position which was there at the time of borrowing. • How to safeguard the loan? • No one single provision is enough. Loan agreement contains different provisions: • 1. General provisions • 2. Routine provisions, & • 3. Special provisions.

9. 1. General provisions a) Working capital requirement: • Force the company to preserve its current position. • Generally straight rupee amount (NWC) is specified. • May specify in terms of current ratio, and/or quick ratio too. b) Cash dividend & repurchase of stock • Limit cash going outside. • Limited to a certain percentage of net profits. c) Capital expenditure limitation • A fixed rupee amount or a certain % of dep. d) Limitation on other indebtness • Prohibiting a company from incurring any other debt with no prior claim on the borrower's assets.

10. 2) Routine provisions • Borrower to furnish financial statements. • Must not sell significant portion of its assets. • Must not pledge or mortgage assets. • Must not discount or sell receivables. • Must not enter into leasing. • Must not enter into merger & acquisitions. 3) Special provisions • Provide a total protection to the loan. • Contains a definite understanding regarding the use of the loan. • Limitation on investments. • Carry life insurance on key personnel. • Management clause: Must employ key executives if so required. • Limit aggregate executive salaries & bonuses.

11. Advantages & Disadvantages of Intermediate term financing: Advantages: • 1. Borrower avoids danger of non-renewal of loan. • 2. Borrower avoids Securities Exchange Center’s registration & investment bankers’ costs. • 3. Shorter lead time. • 4. Easy to negotiate as only one lender is involved. • 5. Beneficial for smaller companies as they do not have access to capital markets. • 6. Market conditions need not be favorable.

12. Disadvantages: • 1. Higher interest rate. • 2. Cash drain is large & continuous. • 3. High credit standard. • 4. Restrictive provisions. • 5. High cost of investigation.

13. Lease Financing • A lease is a contract whereby the owner of an asset(the lessor)grants another party(the lessee)the exclusive right to make use of the asset, usually for an agreed period of time, in return for the payment of rent. • Recent decades have shown an enormous growth in leasing of business assets. • Financial lease– a noncancellable usually multiyear contract in which a lessee agrees to make a series of payments to a lessor for the use of an asset. • Lessee acquires almost all the economic values of the asset.

14. At the end of the lease term, the lessor is entitled to anyresidual valueit might have. • Lease paymentsmay be made on periodic basis such as monthly, quarterly, or annual basis. • In a financial lease, the obligations of the lessor & the lessee are specified in the lease contract. 1.Thebasic lease periodduring which the lease is noncancellable. 2. Thetiming & amounts of periodicrental paymentsduring the basic lease period. 3. Anyoption to renew the lease or to purchase the asset at the end of the basic lease period. 4. Provision for payment of the costs ofmaintenance & repairs, taxes, insurance, & other expenses.

15. Forms of lease financing 1.Sale and lease back: • Here the firm first sells the asset & then takes back the same asset on lease. • Seller receives the price in cash but gives up title to the asset. • Seller exploits almost all the economic values of the asset. • Seller agrees to make a series of periodic lease payments to the buyer. • Used by insurance companies, finance companies, & independent leasing companies.

16. 2. Direct leasing: • A firm may lease an asset directly from the manufacturer. • IBM leases computers; Xerox leases copiers. • Major types of lessors: manufacturers, finance companies, banks, independent leasing companies, special-purpose leasing companies etc. • Vendor generally sells the asset to the lessor, who, in turn, leases it to the lessee. • Lessor may achieve economies of scale which it passes them on to the lessee.

17. 3. Leverage leasing: • In contrast to two parties involved in other forms of leasing, there are three parties involved in leverage leasing: (a)the lessee, (2)the lessor, or equity participant, & (3)the lender. • Here the role of lessor is changed greatly. The lessor acquires the asset by contributing equity investment to finance a part of acquisition cost, say 20 percent. The remaining 80 percent is provided by a lender. • As owner of the asset, the lessor is entitled to deduct alldepreciation charges associated with the asset as well as as utilize the entireinvestment tax credit.

18. 4. Operating or service lease: • Ashort-termlease. Here, themaintenanceis included in lease cost. • Equipment may not be fully amortized. • Lease contract is written for less than the expected life of the leased equipment. • It also containscancellation clause. 5. Financial lease: • This is a long-term lease on fixed assets that may not be cancelled by either party. • It does not provide for maintenance services. • It isnon-cancellableand fully amortized. • The sum of all lease payments is greater than original cost of the asset. The difference representsprofitto the lessor.

19. Accounting treatment of leases • The accounting treatment of leases has undergone sweeping changes over the past two decades or so. • Where once leases were not disclosed, disclosure was gradually required in the form of footnotesto the financial statement. • With only minimal disclosure, leasing was attractive to certain firms as an ‘off balance sheet’method of financing. • Capital lease: If the lessee acquires almost all the economic benefits & risk of the leased property, then the value of the asset along with the corresponding lease liability must be shown in the balance sheet.

20. Capital leases • A lease is a capital lease if it meets any one of the following conditions: • 1. Lease transfers title to the asset to the lessee by the end of the lease period. • 2. Lease contains an option to purchase the asset. • 3. Lease period is equal to, or greater than, 75 percent of the estimated economic life of the asset. • 4. At the beginning of the lease, PV of the minimum lease payments equals or exceeds 90 percent of the fair value of the leased property to the lessor. • If any of these conditions is met, the lessee is said to have acquired most of the economic benefits.

21. With a capital lease, the lessee must report the value of the leased property on the asset side of the balance sheet. • The amount reflected is the present value of the minimum lease payments over the lease period. • The associated lease obligation would be shown on the liability side of the balance sheet. • The PV of lease payments due within one year is being reflected as current liabilities. • The present value of lease payments due after one year being shown as non-current liabilities.

22. Assets • Gross fixed assets* $3,000,000 • Less accum. dep. & amtz. $1,000,000 • Net fixed assets $2,000,000 ______________________ • *Gross fixed assets include leased property of $500,000. • Accumulated dep. & amtz. includes $140,000 in amortization associated with such property. • Liabilities • Current: • Obligations under capital leases $90,000 • Non-Current: • Obligations under capital leases $270,000 • $360,000

23. Lease versus purchase decisions • Framework for analyzing leasing vs. purchase decisions. • Assume a financial lease- fully amortized,& non-cancellable. • First screening test in the selection of project is whether the project passes through hurdle rate. • Once the project passes through hurdle rate, next question is whether leasing or owning is to be preferred. Lessor’s viewpoint:Lease rental charge, Lt? • Io: cost of the asset = $20,000. • N: economic life of asset = 5 years. • Dep: annual straight line depreciation • Kb: before tax cost of debt = 10%, Kd=? • T: Lessor’s corporate tax rate = 40% • NPV LOR = NPV to the lessor.

24. n NPVLOR = -Io +ΣLt(1-T) + T.Dept t=1 (1+k)t NPVLOR=- Io+PVIFA(6%,5 yrs.)[Lt(1-T) +T.Dept] NPVLOR=- Io+PVIFA(6%,5 yrs.)Lt(1-T) + PVIFA(6%,5 yrs.)T.Dept Set NPVLOR = 0. 0=-20,000 + (4.2124)Lt(1-0.4) + (4.2124) 0.4(4000) Lt= $5246 Lessee’s viewpoint: Cost of owning= Io- PVIFA(6%,5yrs.)T.Dept =$20,000-4.2124(.4)$4000 = 20,000 - 6,740=13,260. Cost of leasing= PVIFA(6%,5 yrs.)Lt(1-T) =4.2124 ($5246)0.6 =13,260.

25. NPV (Lease) or Net Advantage to Leasing (NAL) = Cost of owning - cost of leasing. NPVLeaseOR NAL: = Io-PVIFA(6%,5yrs.)T.Dept-PVIFA(6%,5yrs.)Lt(1-T) =20,000 - 4.2124(0.4)(4000) - 4.2124(5246)(1-0.4) =20,000 -13260 - 6740 = 0 Decision rule: If positive, leasing is preferred. If negative, owning is preferred. Alternative computation procedure • Prepare repayment schedule. PV of Annuity Annual payment =------------------------- PVIFA(10%,5 yrs) = $20,000/ 3.7908 = $5,276.

26. Repayment scheduleYearP+Int Int. Prin. Bal Prin1 5,276 2,000 3,276 16,7242 5,276 1,672 3,604 13,1203 5,276 1,312 3,964 9,1564 5,276 916 4,360 4,7965 5,276 480 4,796 -Total 26,380 6,380 20,000Cost of owning YrP+I Int. Dep. Tax shld CF PVIF(6%) PV of costs1 5,276 2,000 4,000 2,400 2,876 0.9434 2,713 2 5,276 1,672 4,000 2,269 3,007 0.8900 2,6763 5,276 1,312 4,000 2,125 3,151 0.8396 2,646 4 5,276 916 4,000 1,966 3,310 0.7921 2,62255,276 4804,000 1,7923,484 0.7473 2,603Σ 26,380 6,380 20,000 10,552 15,828 13,260Note: Tax shield = (Int + Dep)T, CF = (P+I) - Tax shield.

27. Cost of leasingYr Lt CF PVIF(6%) PV of Costs1 5,246 3,147.6 0.9434 2,9702 5,246 3,147.6 0.8900 2,8023 5,246 3,147.6 0.8396 2,6434 5,246 3,147.6 0.7921 2,4935 5,2463,147.6 0.7473 2,352Total 26,230 15,738 4,2124 13,260Or PVIFA(6%,5 yrs.)Lt(1-T) =4.2124 ($5246)0.6 =13,260.Note: CF = Lt (1-T)If operating lease, WACC should be used instead of after cost of debt.

28. Factors affecting lease versus purchase decisions • 1. Differences in cost of capital • 2. Financing cost higher in leasing • 3. Differences in maintenance cost • 4. Residual value • 5. Obsolescence costs • 6. Increased credit availability • 7. Differences in tax rates

29. Internal rate of return method • IRR can be used to make lease versus purchase decision. • Managers prefer IRR as it is convenient to work with. • Decision rule: • IRR > Kd: Choose owning. • IRR < Kd: Choose leasing. n-1 Lt n[Lt-1 - Dept]TRV(1-T) Io - Lt - ITC - Σ ------- + Σ----------------- - ---------- =0 t=1 (1+r)tt=1 (1+r)t (1+r)n Lost benefit Lost benefit Leasing vs owning differential Saved Outflow Advance (Outflow)

30. 148,000 Cost of the asset,$ Kb 0.12 Life 7 years 5 year property class Tax 0.40 Residual value, $ 30000 Kd = 0.072 25,000 in advance Lt = $ IRR= ? • MACRS depreciation: Same as before

31. PV of LR - Investment • IRR = LR + ------------------------------- (Diff. in rates) PV of LR - PV of HR • LR= Lower rate, HR= Higher rate, PV=Present value 125,706 - 123,000 • IRR = 7 + -------------------------- (8% - 7%) = 0.0774 125,706 - 122,039 • IRR= 7.74%. • IRR > Kd. Choose owning. _____________________________________ • Can we find approximate try rate? 148,000 - 30,000 • PVIFAr,6yrs=--------------------------- =4.72 (Try 7% & 8%) 25,000

32. Suppose now that Investment tax credit for $10,000 is also available. IRR? • By interpolation, IRR = 0.1069 • IRR > Kd, choose owning. Try rate? 148,000 - 30,000 -10,000 PVIFAr,6yrs=--------------------------------- =4.32 (Try 10% & 11%) 25,000

33. Solve problems Chapter 3: Intermediate Term Financing • Study self-test & other questions. Self-test Problems: SP 1, 2, & 3. Also SP10&11 (Solve for IRR only). • Problems: P6. • Home assignment: P5 (Page 111). PVIF at 9.24% are 0.8772, 0.7695, & 0.6750 thru years 1 to 3. • Quiz Thanking you