Foundations of Financial Management: An Analysis (part 64)

It's how you deal with failure that determines how you achieve success. 

David Feherty

Long-Term Debt and Lease Financing

(Part C)

by

Charles Lamson

Lease versus Purchase Decision

If you will remember from last post, the Statement of Financial Accounting Standards (SFAS) No. 13, issued by the Financial Accounting Standards Board (FASB) in November 1976, says certain types of leases must be shown as long-term obligations on the financial statements of the firm. Before SFAS No. 13, lease obligations could merely be divulged in footnotes to financial statements, and large lease obligations did not have to be included in the debt structure (except for the upcoming payment).

Again, note (from last post) that a capital lease is a contract entitling the renter to the temporary use of an asset, and such a lease has the economic characteristics of asset ownership for accounting purposes. The classic lease versus purchase decision does not fit a capital leasing decision given the existence of SFAS No. 13 and the similar financial accounting and tax treatment accorded to a capital lease and borrowing to purchase. Nevertheless, the classic lease versus purchase decision is still appropriate for the short-term operating lease.

As shown in Table 8 from Part 48 of this analysis and reintroduced below, assets are classified according to nine categories that determine the allowable rate of depreciation write-off. Each class is referred to as a "MACRS" category. MACRS stands for modified accelerated cost recovery system.

Again, remember from last post that an operating lease is usually short-term and is often cancelable at the option of the lessee. Furthermore, the lessor (the owner of the asset) may provide for the maintenance and upkeep of the asset, since he or she is likely to get it back. An operating lease does not require the capitalization, or presentation, of the full obligation on the balance sheet. Operating leases are used most frequently with such assets as automobiles and office equipment, while capital leases are used with oil drilling equipment, airplanes and rail equipment, certain forms of real estate, and other long-term assets. The greatest volume of leasing obligations is represented by capital leases.

Bearing all this in mind, assume a firm is considering the purchase of a $6,000 asset in the 3-year MACRS category (with a four-year write-off) or entering into two sequential operating leases, for two years each. Under the operating leases, the annual payments would be $1,400 on the first lease and $2,600 on the second least. If a firm purchased the asset, it would pay $1,893 annually to amortize (write off) a $6,000 loan over 4 years at 10 percent interest. This is based on the use of Table 1 for the present value of an annuity from Part 41 of this analysis (and reintroduced below).

The firm is in a 30 percent tax bracket. In doing our analysis we look first at the aftertax costs of the operating lease arrangements in Table 1. The tax shield in column (2) indicates the amount the lease payments will save us in taxes. In column (3) we see the net aftertax cost of the lease arrangement.

Table 1 Aftertax cost of operating leases

For the borrowing and purchasing decision, we must consider not only the amount of the payment but also separate out those items that are tax-deductible. First we consider interest and then depreciation.

In Table 2, we show an amortization table to pay off a $6,000 loan over 4 years at 10 percent interest with $1,893 annual payments. In column (1) we show the beginning balance for each year. This is followed by the annual payment in column (2). We then show the amount of interest we will pay on the beginning balance at a 10 percent rate in column (3). In column (4) we subtract the interest payment from the annual payment to determine how much is applied directly to the repayment of principle. In column (5) we subtract the repayment of principal from the beginning balance to get the year-end balance.

Table 2 Amortization table

After determining our interest payment schedule, we look at the depreciation schedule that would apply to the borrow purchase-decision. Using the 3-year MACRS depreciation category (with the associated 4-year write-off), the asset is depreciated at the rates indicated in Table 3. 

Table 3 Depreciation schedule

We now bring our interest and depreciation schedules together in Table 4 to determine the after-tax cost, or cash outflow, associated with the borrow-purchase decision.

The interest and depreciation charges are tax-deductible expenses and provide a tax shield against other income. The total deductions in column (4) are multiplied by the tax rate of 30 percent to show the tax shield benefits in column (5). In column (6), we subtract the tax shield from the payments to get the net after-tax cost, or cash outflow.

Finally, we compare the cash outflows from leasing to the cash outflows from borrowing and purchasing. To consider the time value of money, we discount the annual values at an interest rate of 7 percent. This is the aftertax cost of debt to the firm, and it is computed by multiplying the interest rate of 10 percent by (1 - Tax rate). Because the costs associated with both leasing and borrowing are contractual and certain, we use the aftertax cost of debt as the discount rate, rather than the normal cost of capital. The overall analysis is presented in Table 5.

Table 5 Net present value comparison

The borrow purchase alternative has a lower present value of after-tax costs ($4,422 versus $4,646), which would appear to make it the more desirable alternative. However, many of the previously discussed qualitative factors that support leasing must also be considered in the decision-making process. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 502-504*

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Foundations of Financial Management: An Analysis (part 63)

Being rich is having money; being wealthy is having time.

— Margaret Bonanno

Long-Term Debt and Lease Financing

(Part B)

by

Charles Lamson

Leasing as a Form of Debt

When a corporation contracts to lease an oil tanker or a computer and signs a non-cancelable, long-term agreement, the transaction has all the characteristics of a debt obligation. Long-term leasing was not recognized as a debt obligation in the early post-world War II period, but since the mid-sixties there has been a strong movement by the accounting profession to force companies to fully divulge all information about leasing obligations and to indicate the equivalent debt characteristics.

This position was made official for financial reporting purposes as a result of Statement of Financial Accounting Standards (SFAS) No. 13, issued by the Financial Accounting Standards Board (FASB) in November 1976. This statement said certain types of leases must be shown as long-term obligations on the financial statements of the firm. Before SFAS No. 13, lease obligations could merely be divulged in footnotes to financial statements, and large lease obligations did not have to be included in the debt structure (except for the upcoming payment). Consider the case of firm ABC, whose balance sheet is shown in Table 7.

Table 7 Balance sheet ($ millions)

Before the issuance of SFAS No. 13, a footnote to the financial statements might have indicated a lease obligation of $12 million a year for the next 15 years, with a present value of $100 million. With the issuance of SFAS No. 13, this information was moved directly to the balance sheet, as indicated in Table 8.

Table 8 Revised balance sheet ($ millions)

We see that both a new asset and a new liability have been created, as indicated by the asterisks. The essence of this treatment is that a long-term, noncancelable lease is tantamount to purchasing the asset with borrowed funds, and this should be reflected on the balance sheet. Between the original balance sheet (Table 7) and the revised balance sheet (Table 8), the total-debt-to-total-assets ratio has gone from 50 percent to 66.7 percent.

Though this represents a substantial increase in the ratio, the impact on the firm's credit rating or stock price may be minimal. To the extent that the financial markets are efficient, the information was already known by analysts who took the data from footnotes or other sources and made their own adjustments. Nevertheless, corporate financial officers fought long, hard, and unsuccessfully to keep the lease obligation off the balance sheet. They tend to be much less convinced about the efficiency of the marketplace.

Capital Lease versus Operating Lease

Not all leases must be capitalized (present-valued) and placed on the balance sheet. This treatment is necessary only when substantially all the benefits and risks of ownership are transferred in a lease. Under these circumstances, we have a capital lease (also referred to as a financing lease). Identification as a capital lease and the attendant financial treatment are required whenever any one of the four following conditions is present:

1. The arrangement transfers ownership of the property to the lessee (the leasing party) by the end of the lease term.

2.  The lease contains a bargain purchase price at the end of the lease. The option price will have to be sufficiently low so exercise of the option appears reasonably certain.

3.  The lease term is equal to 75 percent or more of the estimated life of the leased property.

4.  The present value of the minimum lease payments equals 90 percent or more of the fair value of the leased property at the inception of the lease.

A lease that does not meet any of these four criteria is not regarded as a capital lease but as an operating lease. An operating lease is usually short-term and is often cancelable at the option of the lessee. Furthermore, the lessor (the owner of the asset) may provide for the maintenance and upkeep of the asset, since he or she is likely to get it back. An operating lease does not require the capitalization, or presentation, of the full obligation on the balance sheet. Operating leases are used most frequently with such assets as automobiles and office equipment, while capital leases are used with oil drilling equipment, airplanes and rail equipment, certain forms of real estate, and other long-term assets. The greatest volume of leasing obligations is represented by capital leases.

Income Statement Effect

The capital lease calls not only for present-valuing the lease obligation on the balance sheet but also for treating the arrangement for income statement purposes as if it were somewhat similar to a purchase-borrowing arrangement. Thus, under a capital lease, the intangible asset account previously shown in Table 8 as "Leased property under capital lease"is amortized, or written off, over the life of the lease with an annual expense deduction. Also, the liability account shown in Table 8 as "Obligation under capital lease" is written off through regular amortization, with an implied interest expense on the remaining balance. Thus, for financial reporting purposes the annual deductions are amortization of the asset, plus the implied interest expense on the remaining present value of the liability. Though the actual development of these values and accounting rules is best deferred to an accounting course, the finance student should understand the close similarity between a capital lease and borrowing to purchase an asset, for financial reporting purposes. 

An operating lease, on the other hand, usually calls for an annual expense deduction equal to the lease payment, with no specific amortization, as is indicated in the next post, "Lease versus Purchase Decision."

Advantages of Leasing

Why is leasing so popular? It has emerged as a trillion dollar industry. Major reasons for the popularity of leasing include the following:

1. The lessee may lack sufficient funds or the credit capability to purchase the asset from a manufacturer, who is willing, however, to accept a lease arrangement or to arrange a lease obligation with a third party.

2.  The provisions of the lease obligation may be substantially less restrictive than those of a bond indenture.

3.  There may be no down payment requirement, as would generally be the case in the purchase of an asset (leasing allows for a larger indirect loan).

4.  The lessor may possess particular expertise in a given industry allowing for expert product selection, maintenance, and eventual resale. Through this process, the negative effects of obsolescence may be reduced.

5.  Creditor claims on certain types of leases, such as real estate, are restricted in bankruptcy and reorganization proceedings. Leases on chattels (non-real estate items) have no such limitation.

There are also some tax factors to be considered. Where one party to a lease is in a higher tax bracket than the other party, certain tax advantages, such as depreciation write-off or research related tax credits, may be better utilized. For example, a wealthy party may purchase an asset for tax purposes, then lease the asset to another party in a lower tax bracket for actual use. Also, lease payments on the use of land are tax-deductible, whereas land ownership does not allow a similar deduction for depreciation. It should be pointed out that tax advantages related to leasing were reduced somewhat with the passage of the Tax Reform Act of 1986.

Finally, a firm may wish to engage in a sale-leaseback arrangement, in which assets already owned by the lessee are sold to the lessor and then leased back. This process provides the lessee with an infusion of capital, while allowing the lessee to continue to use the asset. Even though the dollar costs of a leasing arrangement are often higher than the dollar costs of owning an asset, the advantages cited above may outweigh the direct cost factors. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 483-486*

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Foundations of Financial Management: An Analysis (part 62)

Everyday is a bank account, and time is our currency. No one is rich, no one is poor, we've got 24 hours each. 

Christopher Rice

Long-Term Debt and Lease Financing

by

Charles Lamson

Other Forms of Bond Financing

This post examines the zero-coupon rate bond and the floating rate bond.

The zero-coupon rate bond, as the name implies, does not pay interest. It is, however, sold at a deep discount from face value. The return to the investor is the difference between the investor's cost and the face value received at the end of the life of the bond. For example, in early 1982, Bank of America Corporation offered $1,000 zero-coupon rate bonds with maturities of 5, 8, and 10 years. The five-year bonds were sold for $500, the 8-year bonds for $333.33, and the 10-year bonds for $250. All three provided an initial yield to maturity (through gain in value) of approximately 14.75 percent. A dramatic case of a zero-coupon bond was an issue offered by PepsiCo, Inc., in 1982, in which the maturities ranged from 6 to 30 years. The 30-year $1,000 par value issue could be purchased for $26.43, providing a yield of approximately 12.75%. The purchase price per bond of $26.43 represented only 2.643 percent of the par value. A million dollars worth of these 30-year bonds could be initially purchased for a mere $26,430.

The advantage to the corporation is that there is immediate cash inflow to the corporation, without any outflow until the bonds mature. Furthermore, the difference between the initial bond price and the maturity value may be amortized for tax purposes by the corporation over the life of the bond. This means the corporation will be taking annual deductions without current cash outflow.

From the investor's viewpoint, the zero-coupon bonds allow him or her to lock in a multiplier of the initial investment. For example, investors may know they will get three times their investment after a specified number of years. The major drawback is that the annual increase in the value of bonds is taxable as ordinary income as it accrues, even though the bondholder does not get any cash flow until maturity. For this reason most investors in zero-coupon rate bonds have tax-exempt or tax-deferred status (pension funds, foundations, charitable organizations, individual retirement accounts, and the like).

A second type of innovative bond issue is the floating rate bond (long popular in European capital markets). In this case, instead of a change in the price of the bond, the interest rate paid on the bond changes with market conditions (usually monthly or quarterly). Thus, a bond that was initially issued to pay 9 percent may lower the interest payments to 6 percent during some years and raise them to 12 percent in others. The interest rate is usually tied to some overall market rate, such as the yield on Treasury bonds (perhaps 120 percent of the going yield on long-term treasury bonds).

The advantages to investors in floating rate ponds is that they have a constant (or almost constant) market value for the security, even though interest rates vary. An exception is that floating-rate bonds often have broad limits that interest payments cannot exceed. For example, the interest rate on a 9 percent initial offering may not be allowed to go over 16 percent or below 4 percent. If long-term interest rates dictate an interest payment of 20 percent, the payment would still remain at 16 percent. This could cause some short-term loss in market value. To date, floating-rate bonds have been relatively free of this problem.

Zero-coupon rate bonds and floating-rate bonds still represent a relatively small percentage of the total market of new debt offerings. Nevertheless, they should be part of a basic understanding of long-term debt instruments. 

Advantages and Disadvantages of Debt

The financial manager must consider whether debt will contribute to or detract from the firm's operations. In certain industries, such as airlines, very heavy debt utilization is a way of life, whereas in other industries (drugs, photographic equipment) reliance is placed on other forms of capital.

Benefits of Debt

The advantages of debt may be enumerated as:

1. Interest payments are tax-deductible.

2.  The financial obligation is clearly specified and of a fixed nature (with the exception of floating rate bonds). Contrast this with selling an ownership interest in which stockholders have open-ended participation and profits; however, the amount of profits is unknown.

3.  In an inflationary economy, debt may be paid back with cheaper dollars. A $1,000 bond obligation may be repaid in 10 or 20 years with dollars that have shrunk in volume by 50 or 60 percent. In terms of "real dollars," or purchasing power equivalents, one might argue that the corporation should be asked to repay something in excess of $2,000. Presumably, high interest rates and inflationary periods compensate the lender for low loss in purchasing power, but this is not always the case.

4.  The use of debt, up to a prudent point, may lower the cost of capital to the firm. To the extent that debt does not strain the risk position of the firm, its low aftertax cost may aid in reducing the weighted overall cost of financing to the firm.

Drawbacks of Debt

Finally, we must consider the disadvantages of debt:

1. Interest and principal payment obligations are set by contract and must be met, regardless of the economic position of the firm.

2.  Indenture agreements may place burdensome restrictions on the firm, such as maintenance of working capital at a given level, limits on future debt offerings, and guidelines for dividend policy. Although bondholders generally do not have the right to vote, they may take virtual control of the firm if important indenture provisions are not met.

3.  Utilized beyond a given point, debt may depress outstanding common stock values.

Eurobond Market

A market with an increasing presence in world capital markets is that in Eurobonds. A Eurobond may be defined as a bond payable in the borrower's currency but sold outside the borrower's country. The Eurobond is usually sold by an international syndicate of investment bankers and includes bonds sold by companies in Switzerland, Japan, the Netherlands, Germany, the United States, and Britain, to name the most popular countries. An example might be a bond of a U.S. company, payable in dollars and sold in London, Paris, Tokyo, or Frankfurt. Disclosure agreements in the Eurobond market are less demanding than those of the Securities and Exchange Commission or other domestic regulatory agencies. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 480-483*

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Foundations of Financial Management: An Analysis (part 61)

Money often costs too much. 

--Ralph Waldo Emerson

Investment Banking (part E)

by

Charles Lamson

The Refunding Decision 

Assume you are the financial vice-president for a corporation that has issued bonds at 11.75 percent, only to witness a drop in interest rates to 9.5 percent. If you believe interest rates will rise rather than sink further, you may wish to redeem the expensive 11.75 percent bonds and issue new debt at the prevailing 9.5 percent rate. This process is labeled a refunding operation. It is made feasible by the call provisions that enable a corporation to buy back bonds at close to par, rather than at high market values, when interest rates are declining.

A Capital Budgeting Problem

The refunding decision involves outflows in the form of financing costs related to redeeming and reissuing securities, and inflows represented by savings in annual interest costs and tax savings. In the present case, we shall assume the corporation issued $10 million worth of 11.75 percent debt with a 25-year maturity and the debt has been on the books for 5 years. The corporation now has the opportunity to buy back the old debt at 10 percent above par (the call premium) and to issue new debt at 9.5 percent interest with a 20-year life. The underwriting cost for the old issue was $125,000, and the underwriting cost for the new issue is $200,000. We also assume the corporation is in the 35 percent tax bracket and uses a 6 percent discount rate for refunding decisions. Since the savings from a refunding decision are certain---unlike savings from most other capital budgeting decisions---we use the aftertax cost of new debt as the discount rate, rather than the more generalized cost of capital. Actually, in this case, the aftertax cost of new debt is 9.5 percent (1 - tax rate), or 9.5% X 0.65 = 6.18%. We round to 6 percent. The facts in this example are restated as follows.

Restatement of facts

Let's go through the capital budgeting process of defining our outflows and inflows and determining the net present value.

Step A---Outflow Considerations

1. Payment of call premium---The first outflow is the 10 percent call premium on $10 million, or $1 million. This prepayment penalty is necessary to call in the original issue. Being an out-of-pocket tax deductible expense, the $1 million cash expenditure will cost us only $650,000 on an aftertax basis. We multiply the expense by (1 - tax rate) to get the aftertax cost.

$1,000,000 (1 - T) = $1,000,000 (1 - 0.35) = $650,000

Net cost of call premium = $650,000

2. Underwriting cost on new issue---The second outflow is the $200,000 underwriting cost on the new issue. The actual cost is somewhat less because the payment is tax deductible, though the write-off must be spread over the life of the bond. While the actual $200,000 is being spent now, equal tax deductions of $10,000 a year will occur over the next 20 years (in a manner similar to depreciation).

The tax savings from a noncash write-off are equal to the amount times the tax rate. For a company in the 35 percent tax bracket, $10,000 of annual tax deductions will provide $3,500 of tax savings each year for the next 20 years. The present value of these savings is the present value of a $3,500 annuity for 20 years at 6 percent interest:

$3,500 X 11.470 (n = 20, i = 6%) equals $40,145

The cost of underwriting the new issue is the actual expenditure now, minus the present value of future tax savings as indicated below.

Step B---Inflow Considerations

The major inflows in the refunding decision are related to the reduction of annual interest expense and the immediate write-off of the underwriting cost on the old issue.

3. Cost savings and lower interest rates---The corporation will enjoy a 2.25 percentage point drop in interest rates, from 11.75 percent to 9.50 percent, on $10 million of bonds.

Since we are in the 35 percent tax bracket, this is equivalent to $146,250 of aftertax benefits per year for 20 years. We have taken the savings and multiplied by one minus the tax rate to get the annual after-tax benefits.

Applying a 6 percent discount rate for a 20-year annuity:

$146,250 X 11.470 (n = 20, i = 6%) = $1,677,488

 Cost savings in lower interest rates . . . $1,677,488

4. Underwriting cost on old issue---There is a further cost savings related to immediately writing off the remaining underwriting costs on the old bonds. Note that the initial amount of $125,000 was spent five years ago and was to be written off for tax purposes over 25 years at $5,000 per year. Since 5 years have passed, $100,000 of old underwriting costs have not been amortized as indicated in the following: 

A tax benefit is associated with the immediate write-off of old underwriting costs, which we shall consider shortly.

Note, however, that this is not a total gain. We would have gotten the $100,000 additional write-off eventually if we had not called in the old bonds. By calling them in now, we simply take the write-off sooner. If we extended the write-off over the remaining life of the bonds, we would have taken $5,000 a year for 20 years. Discounting this value, we show:

$5,000 X 11.470 (n = 20, i equals 6%) = $57,350

Thus, we are getting a write-off of $100,000 now, rather than a present value of future write-offs of $57,350. The gain in immediate tax write-offs is $42,650. The tax savings from a noncash tax write-off equal the amount times the tax rate. Since we are in the 35 percent tax bracket, our savings from this write-off are $14,928. The following calculations, which were discussed above, are necessary to arrive at $14,928.

Net gain from the underwriting on the old issue ......................   $14,928

Step C---Net Present Value

We now compare our outflows and our inflows.

The refunding decision has a positive net present value, suggesting that interest rates have dropped to a sufficiently low level to indicate refunding is in order. The only question is, will interest rates go lower indicating an even better time for refunding? There is no easy answer: conditions in the financial markets must be carefully considered.

A number of other factors could be plugged into the problem. For example, there could be overlapping time periods in the refunding procedure when both issues are outstanding and the firm is paying double interest (hopefully for less than a month). A dollar amount in these cases, however, tends to be small and is not included in the analysis.

And working problems, you should have minimum difficulty if you follow the four suggested calculations. In each of the four calculations we had the following tax implications:

1. Payment of call premium---the cost equals the amount times (1 - Tax rate) for this cash tax-deductible expense.

2.  Underwriting costs on new issue---we pay an amount now and then amortize it over the life of the bond for tax purposes. The subsequent amortization is similar to depreciation and represents a noncash write-off of a tax-deductible expense. The tax saving from the amortization is equal to the amount times the tax rate.

3.  Cost savings in lower interest rates---cost savings are like any form of income, and will retain the cost of savings times (1 - Tax rate).

4.  Underwriting cost on old issue---once again, the writing off of underwriting costs represents a non-cash write-off of a tax-deductible expense. The tax savings from the amortization are equal to the amount times the tax rate. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 476-480*

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