Chapter 21

Term
Term Loans
Loans
and
and Leases
Leases
© Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
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 After studying Chapter 21,
you should be able to:
 Describe various types of term loans and
discuss the costs and benefits of each.
 Discuss the nature and the content of loan
agreements including protective (restrictive)
covenants.
 Discuss the sources and types of equipment
financing.
 Understand and explain lease financing in its
various forms.
 Compare lease financing with debt financing
via a numerical evaluation of the present
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 Term Loans and Leases
 Term Loans
 Provisions of Loan Agreements
 Equipment Financing
 Lease Financing
 Evaluating Lease Financing in
Relation to Debt Financing

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 Term Loans
Term Loan -- Debt originally scheduled
for repayment in more than 1 year, but
generally in less than 10 years.
 Credit is extended under a formal loan arrangement.
 Usually payments that cover both interest and
principal are made quarterly, semiannually, or
annually.
 The repayment schedule is geared to the borrower’s
cash-flow ability and may be amortized or have a
balloon payment.
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 Costs of a Term Loan
 The interest rate is higher than on a short-
term loan to the same borrower (25 to 50
basis points on a low risk borrower).
 Interest rates are either (1) fixed or (2)
variable depending on changing market
conditions -- possibly with a floor or ceiling.
 Borrower is also required to pay legal
expenses (loan agreement) and a
commitment fee (25 to 75 basis points) may
be imposed on the unused portion.
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 Benefits of a Term Loan
 The borrower can tailor a loan to their
specific needs through direct negotiation
with the lender.
 Flexibility in terms of changing needs allows
the borrower to revise the loan more quickly
and more easily.
 Term loan financing is more readily available
over time making it a more dependable
source of financing than, say, the capital
markets.
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 Revolving Credit
Agreements
Revolving Credit Agreement -- A formal, legal
commitment to extend credit up to some
maximum amount over a stated period of time.
 Agreements are frequently for three years.
 The actual notes are usually 90 days, but the
company can renew them per the agreement.
 Most useful when funding needs are uncertain.
 Many are set up so at maturity the borrower has
the option of converting into a term loan.
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 Insurance
Company Term Loans
 These term loans usually have final maturities in
excess of seven years.
 These companies do not have compensating
balances to generate additional revenue and
usually have a prepayment penalty.
 Loans must yield a return commensurate with
the risks and costs involved in making the loan.
 As such, the rate is typically higher than what a
bank would charge, but the term is longer.

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 Medium-Term Note
Medium-Term Note (MTN) -- A corporate or government
debt instrument that is offered to investors on a
continuous basis.
 Maturities range from 9 months to 30 years (or more).
 Shelf registration makes it practical for corporate
issuers to offer small amounts of MTNs to the public.
 Issuers include finance companies, banks or bank
holding companies, and industrial companies.
Euro MTN -- An MTN issue sold internationally outside
the country in whose currency the MTN is denominated.
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 Provisions of
Loan Agreements
Loan Agreement -- A legal agreement
specifying the terms of a loan and the
obligations of the borrower.
 Covenant -- A restriction on a borrower
imposed by a lender; for example, the
borrower must maintain a minimum amount of
working capital.
 This allows the lender to act (or be “warned”
early) when adverse developments are
occurring that will affect the borrowing firm.
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 Formulation of Provisions
The important protective covenants*
covenants fall into
three different categories.
 General provisions are used in most loan
agreements, which are usually variable to fit the
situation.
 Routine provisions used in most loan
agreements, which are usually not variable.
 Specific provisions that are used according to the
situation.
* Restrictions are negotiated between
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 Frequent
General Provisions
 Working capital requirement
 Cash dividend and repurchase of
common stock restriction
 Capital expenditures limitation
 Limitation on other indebtedness

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 Frequent
Routine Provisions
 Furnish financial statements and maintain
adequate insurance to the lender
 Must not sell a significant portion of its
assets and pay all liabilities as required
 Negative pledge clause
 Cannot sell or discount accounts receivable
 Prohibited from entering into any leasing
arrangement of property
 Restrictions on other contingent liabilities
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 Equipment Financing
 Loans are usually extended for more than 1 year.
 The lender evaluates the marketability and quality of
equipment to determine the loanable percentage.
 Repayment schedules are designed by the lender so
that the market value is expected to exceed the loan
balance by a given safety margin.
 Trucking equipment is highly marketable, and the
lender may advance as much as 80% of market
value, while a limited use lathe might provide only a
40% advance or a specific use item cannot be used
as collateral.
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 Sources and Types of
Equipment Financing
Sources of financing are commercial banks,
finance companies, and sellers of equipment.
Types of financing
1. Chattel Mortgage -- A lien on specifically
identified personal property (assets other
than real estate) backing a loan.
 To perfect (make legally valid) the lien, the lender
files a copy of the security agreement or a financing
statement with a public office of the state in which
the equipment is located.
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 Sources and Types of
Equipment Financing
2. Conditional Sales Contract -- A means of financing
provided by the seller of equipment, who holds title
to it until the financing is paid off.
 The buyer signs a conditional sales contract
security agreement to make installment payments
(usually monthly or quarterly) over time.
 The seller has the authority to repossess the
equipment if the buyer does not meet all of the
terms of the contract.
 The seller can sell the contract without the buyer’s
consent -- usually to a finance company or bank.
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 Lease Financing
Lease -- A contract under which one party, the
lessor (owner) of an asset, agrees to grant the
use of that asset to another, the lessee, in
exchange for periodic rental payments.
Examples of familiar leases

Apartments Houses
Offices Automobiles

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 Issues in Lease Financing
 Advantage:
Advantage Use of an asset without
purchasing the asset
 Obligation:
Obligation Make periodic lease payments
 Contract specifies who maintains the asset
 Full-service lease -- lessor pays maintenance
 Net lease -- lessee pays maintenance costs
 Cancelable or noncancelable lease?
 Operating lease (short-term, cancelable) vs.
financial lease (longer-term, noncancelable)
 Options at expiration to lessee
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 Types of Leasing
Sale and Leaseback -- The sale of an asset with
the agreement to immediately lease it back for
an extended period of time.
 The lessor realizes any residual value.
 There may be a tax advantage as land is not
depreciable, but the entire lease payment is a
deductible expense.
 Lessors:
Lessors insurance companies, institutional
investors, finance companies, and independent
companies.
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 Types of Leasing
Direct Leasing -- Under direct leasing a firm
acquires the use of an asset it did not
previously own.
 The firm often leases an asset directly from a
manufacturer (e.g., IBM leases computers and
Xerox leases copiers).
 Lessors:
Lessors manufacturers, finance companies,
banks, independent leasing companies, special-
purpose leasing companies, and partnerships.
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 Types of Leasing
Leverage Leasing -- A lease arrangement in which the
lessor provides an equity portion (usually 20 to 40
percent) of the leased asset’s cost and third-party
lenders provide the balance of the financing.
 Popular for big-ticket assets such as aircraft, oil
rigs, and railway equipment.
 The role of the lessor changes as the lessor is
borrowing funds itself to finance the lease for the
lessee (hence, leveraged lease).
lease
 Any residual value belongs to the lessor as well as
any net cash inflows during the lease.
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 Accounting and Tax
Treatment of Leases
 In the past, leases were “off-balance-sheet” items
and hid the true obligations of some firms.
 The lessee can deduct the full lease payment in a
properly structured lease. To be a “true lease” the
IRS requires:
1. Lessor must have a minimum “at-risk”
(inception and throughout lease) of 20% or
more of the acquisition cost.
2. The remaining life of the asset at the end of the
lease period must be the longer of 1 year or
20% of original estimated asset life.
3. An expected profit to the lessor from the lease
contract apart from any tax benefits.
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 Economic Rationale
for Leasing
 Leasing allows higher-income taxable companies to
own equipment (lessor) and take accelerated
depreciation, while a marginally profitable company
(lessee) would prefer the advantages afforded by
leases.
 Thus, leases provide a means of shifting tax benefits
to companies that can fully utilize those benefits.
 Other non-tax issues:
issues economies of scale in the
purchase of assets; different estimates of asset life,
salvage value, or the opportunity cost of funds; and
the lessor’s expertise in equipment selection and
maintenance.

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