TERM LOANS AND LEASES

Term Loans
Generally, bank loans are short-term in nature, while bonds are very long-term. An
intermediate type of loan exists that is referred to as a term loan. Term loans are particularly
important to medium-sized firms; those that have become too big to obtain all of their financing
from their commercial bank, but are not large enough to issue publicly-traded bonds. The
typical term loan is also of medium duration, typically between five and fifteen years.
While banks will make term loans of up to five years, they generally prefer to make only
short-term loans. This is due to the nature of the source of financing of banks. Banks financing
generally comes from deposits, which are short-term, so they do not want to make long-term
loans. However, some of their funds (equity and long-term certificates of deposit) are long-term
in nature and provide the means by which longer term loans can be made.
The typical term loan is one that is said to be self-amortizing. That is, it is made up of a
series of equal payments, with each payment being comprised of both interest and principal
(just like a fixed rate mortgage on a home). For tax purposes, we need to be able to break
down each payment into the portion that is interest and that which is principal since the interest
portion is tax-deductible. Suppose, for instance, that we take out a $5,000 loan at a 12% rate of
interest payable in four equal annual installments. The first thing we need to calculate is the
annual payment. If we think in terms of a banker, we will ask ourselves What annual payment
over four years will give me a present value equal to the $5,000 amount of the loan if it is
discounted at a 12% rate of interest? Then, solving for that payment, we obtain

Payment =

$5,000
PVIFA 12%,4

$5, 000
= $1,646.20
3.0373

The payment that will be due at the end of each of the next four years will be $1,646.20 and will
pay 12% interest on the outstanding balance as well as paying the $5,000 in principal back. An
amortization table would appear as follows:
Year
0
1
2
3
4

Payment
-0$1,646.20
$1,646.20
$1,646.20
$1,646.20

Interest
-0$ 600.00
$ 474.46
$ 333.85
$ 176.36

Principal
-0$1,046.20
$1,171.74
$1,312.35
$1,469.84

Balance
$ 5,000.00
$ 3,953.80
$ 2,782.06
$ 1,469.71
$(
.13)

Note that thirteen cents too much was paid back. This is due to rounding error and in practice
the last payment would be for only $1,646.07 so that everything worked out even.
Typically, a term loan will be secured by the general assets of the firm. Oftentimes, the
company will agree to maintain certain financial ratios (current/quick ratio and times interest

earned) as well as agreeing to negative covenants regarding additional debt and dividend
payments.
Term loans are available from numerous sources:

Insurance companies
Banks
Venture capital companies
Small Business Administration (SBA)

Leasing
Leasing is an alternative to term loans and, again, generally covers an intermediate (510 years) length of time. Two types of leases exist; an operating lease is one where the lease
period is short in comparison to the life of the equipment and maintenance is generally provided
(although oftentimes a separate maintenance contract is required). A financial lease is where
the lease period exceeds 75% of the life of the equipment and generally has a purchase option
at the end of the lease period.
The IRS is quite concerned with the distinction between the two types of leases. A
financial (or capital) lease is essentially a term loan packaged together with the purchase of an
asset. The reason the IRS wants to distinguish between the two is because it does not want to
see a company both depreciate the asset (expense the cost) as well as deduct the entire lease
payment (expense the cost again). The entire lease payment of an operating lease is taxdeductible. With a financial lease, the lease payment must be broken down into the interest
portion and the principal portion, just like a term loan, and only the interest portion is deductible.
IRS requirements for a lease to be an operating lease are that
1. The lease term is less than 80% of the economic life of the asset
2. The estimated residual value of the asset at the end of the lease term is at least 20% of
its value at the beginning of the lease term
3. Cannot be a purchase option at the end for a fixed price (must be fair market value)
4. Asset cannot be limited use (i.e., usable only by the lessee)
Characteristics of an operating lease include the following:
a)
b)
c)
d)
e)

f)

Lease is cancelable without substantial penalty.

Lessor provides maintenance, taxes and insurance
Contract life is less than the economic life of the asset
Lessor to receive his investment and return from multiple lessees.
Lease payments are expensed by the lessee. Since the asset and the lease are not
recorded on the balance sheet, no depreciation is taken and the lease payments are
shown as an operating expense. Called off balance sheet financing since lessee has use
of the asset, can generate income off the asset without recording the asset on the
balance sheet, leading to a misleading ROA calculation. Shows up as operating leverage
rather than financial leverage.
Asset is depreciated by the lessor, sheltering the rental payment. At the end of the lease,
the lessor retain title (no purchase option). The lessor can, release the asset, sell the

asset, scrap the asset or use the asset himself. Since this is not financing, no truth in
lending is required and typical required rates of return are 18% to 28%. Operating leases
also cause the lessee to lose the asset at the end of the lease and may require
replacement at a higher cost, loss of equity accumulation may affect future financing,
loss of residual value, and may lead to inadequate valuation due to habitual leasing.
Characteristics of a financial (or capital) lease include the following:
a) Asset is fully amortized to one lessee. The lessor plans to recoup his/her investment and
required return from one lessee.
b) Not cancelable without substantial penalty, usually acceleration of the remaining lease
payments.
c) Lessee is responsible for taxes, maintenance and insurance and Lessor determines
liability limits.
d) Contract life approximates the useful economic life of the asset.
e) Lease contains a purchase option at the end of the lease.
f) Lease does not expense the lease payments but rather records the asset on the balance
sheet and the lease as a liability. The interest portion of each lease payment is deducted
and then the asset is depreciated.
For purposes of our discussion, only an operating lease is considered (one where the
entire lease payment is tax-deductible).
The advantages of leasing include the following:

Permits the lessee to obtain the use of equipment that otherwise they couldnt get
Provides equipment that is only temporarily needed
Permits the disposal of obsolete equipment (although higher lease charges generally cover
this)
Lessee doesnt have to worry about maintenance service
Provides an additional source of financing
Lease payment is tax-deductible

Although long-term leases are supposed to be capitalized as both an asset and a liability (FASB
13), few companies actually do so. Leasing is often referred to as off-balance sheet financing
as a consequence.
The disadvantages of leasing include:

High cost the lease payment covers the cost of the equipment as well as a profit for the
lessor.
The lessor gets to take the depreciation expense and receives any residual value that exists
at the end of the lease period.

In general, if equipment is needed for its entire useful life, it is more economic to purchase
the equipment rather than leasing it. On the other hand, a company that is in the business of
leasing equipment may have access to secondary markets that the individual firm does not. For
example, the leasing company may be able to use older equipment as a source of parts, have
customers that buy used equipment, etc., that the leasing firm does not have access to.

Sources of leasing funds include:

Independent leasing companies

Banks
Insurance companies
Pension funds
Industrial development agencies

A Sale and Lease-back is where a company sells an asset to a financial institution but
leases it back over a period of time. The fixed amount of the lease payments over the lease
period are equivalent to the full purchase price plus interest. Why would anyone want to do
this? Because it provides a source of cash to a firm that cannot obtain financing in any other
manner.
The following chart outlines the relevant cash flows in a Lease versus Borrow/Buy
decision. Is this format starting to look familiar? Again, it is a capital budgeting decision. The
objective in this case is to determine the least cost alternative (since the benefits of the
equipment are the same in either case).

CASHFLOWANALYSIS
LEASEVS.BORROW/BUYDECISION
Today
InterveningYears
LastYear

A.Cashinflowfromtheloan
D.<Interestexpensefromloan>
I.Salvageofnewasset
B.<Costofpurchasingasset> E.Less:Depreciationdeduction
J.Taxeffectofgainor
lossondisposalof
C.<Additionalworkingcapital> F.Less:RepairandMaintenance
asset

Changeintaxableincome
K.Recoveryofworking
capital

Less:Taxes

Changeinnetincome
Plus:Depreciationdeduction

Changeinoperatingcashflow
G.<Principalpaymentonloan>
H.<additionalworkingcapital>
Theoccurrencesonthetimelineaboverefertothecostsofpurchasingtheassetassumingthata
termloanmustbetakenouttofinancetheasset'spurchase.Thesecostsaregenerallydiscounted
intopresentvaluetermsattheaftertaxcostofthetermloan. Forexample,ifthenewdebt
carriesacouponrateof10%andtheapplicabletaxrateis40%,thediscountrateemployedwould
be10%*(1.4)=6%.
Thegrossleasecostoftheassetisreducedby(1t)sincetheleasepaymentsaretaxdeductible.
Thecostofleasingisalsogenerallydiscountedintopresentvaluetermsattheaftertaxcostof
borrowed money since a longterm lease is considered debt for accounting purposes. Hence, the
discountratefortheleasingalternativewouldbe6%aswell.Sinceleasepaymentsaregenerally
dueatthebeginningoftheleaseperiod,theleasealternativerepresentsanannuitydue.
NetLeaseCost=GrossLeaseCost*(1t)+GrossLeaseCost*(1t)*PVIFAx%,n1

<>indicatesthatthecashflowisanoutflow.t=applicabletaxrate