LEARNING OBJECTIVES 

After reading this chapter, you should be able to

1. Describe the basic characteristics of 3. List and define the basic types of 5. Describe the potential sources of
a term loan. lease arrangements. economic benefit derived from
leasing versus purchasing.
2. Calculate the principal and interest 4. Calculate the net advantage of
components of an installment loan. leasing versus purchasing an asset.
 CHAPTER 24

Term Loans and Leases

Virtually everyone has rented something at one time or lion, or 31 percent, was acquired by American businesses
another. With renting, just like owning, you get to use the through leasing. In 2002, expenditures on leases were estimated
asset. What distinguishes renting or leasing from owning is to be $204 billion and for 2003 the total was projected to be
that when you rent, you don’t actually obtain ownership of $208 billion. Furthermore, virtually every company uses lease
the thing being rented and must return it to the owner at the financing. The ELA estimates that over 80 percent of U.S. compa-
end of the agreement. nies lease all or some of their equipment.
Firms lease all types of capital equipment as an alternative Why lease—why not purchase? Some companies lease
to purchasing it. For example, they lease computers, trucks, because they think they can avoid investing in equipment
and railroad cars. The U.S. Navy has even leased minesweepers. that faces the risk of rapid obsolescence, whereas others
The Equipment Leasing Association—ELA—(www.elaonline. think that they are conserving their cash. As we learn in this
com/industryData/overview.cfm) reports that more com- chapter, these and many other reasons for leasing are sub-
panies, particularly small companies, acquire new productive ject to quantitative analysis, which reduces the decision
equipment through leases than through loans. Of the $697 bil- down to an analysis of the net present value of leasing ver-
lion spent by businesses on productive assets in 2001, $216 bil- sus owning.

CHAPTER PREVIEW 
Chapter 24 contains a discussion of two sources of leases as operating or financial leases and focus on the
intermediate term financing: term loans and leases. latter, because operating leases are short-term in
Intermediate term financing consists of all those nature. We evaluate the merits of leasing versus pur-
sources of financing with maturities longer than one chasing by first evaluating the viability of purchas-
year and shorter than 10 years. This maturity range ing via the project’s net present value and then ana-
is bracketed by short-term sources of financing such lyzing the incremental benefits of leasing by
as bank notes, trade credit, and commercial paper calculating the net advantage of leasing.
(discussed in Chapter 18) and long-term sources of This chapter will emphasize these principles:
financing such as bonds and stock (discussed in Principle 1: The Risk-Return Trade-Off—We
Chapters 7, 8, and 14). won’t take on additional risk unless we expect to
Our discussion of term loans, an important be compensated with additional return; Principle
source of financing for machinery and equipment, 2: The Time Value of Money—A dollar received
will focus on the various sources of term financing today is worth more than a dollar received in the
and their basic characteristics as well as the future; Principle 3: Cash—Not Profits—Is King;
calculation of installment payments (including the Principle 4: Incremental Cash Flows—It’s only
decomposition of those payments into their princi- what changes that counts; and Principle 8: Taxes
pal and interest components). We then categorize Bias Business Decisions.

24-2
24-3 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

Objective
1 TERM LOANS
Term loans Term loans generally share three common characteristics: They (1) have maturities of 1
Loans that have maturities of to 10 years; (2) are repaid in periodic installments (such as quarterly, semiannual, or
1 to 10 years and are repaid in annual payments) over the life of the loan; and (3) are usually secured by a chattel mort-
periodic installments over the
life of the loan; usually secured gage on equipment or a mortgage on real property. The principal suppliers of term credit
by a chattel mortgage on are commercial banks, insurance companies, and (to a lesser extent) pension funds.
equipment or a mortgage on We will consider briefly some of the more common characteristics of term loan
real property. agreements.

M AT U R I T I E S
Commercial banks generally restrict their term lending to one- to five-year maturities.
Insurance companies and pension funds with their longer-term liabilities generally make
loans with 5- to 15-year maturities. Thus, the term lending activities of commercial banks
actually complement rather than compete with those of insurance companies and pension
funds. In fact, commercial banks very often cooperate with both insurance companies and
pension funds in providing term financing for very large loans.

C O L L AT E R A L
Term loans are generally backed by some form of collateral. Shorter-maturity loans are
frequently secured with a chattel mortgage (a mortgage on machinery and equipment) or
with securities such as stocks and bonds. Longer-maturity loans are frequently secured by
mortgages on real estate.
There is also a form of term credit that requires no collateral that can be used by only
the largest blue-chip companies. These unsecured medium-term notes (MTNs) were cre-
ated as a result of the introduction of shelf registration by the Securities and Exchange
Commission in 1982. Shelf registration permits companies to file a single registration
statement for a series of similar issues. Once registered, the MTNs can be sold as funds
are required, giving the issuer a ready source of term financing. The key thing to recog-
nize here is that unsecured term financing, like similar forms of unsecured short-term
financing (e.g., commercial paper), is available to only the most creditworthy borrowers.

RESTRICTIVE COVENANTS
In addition to requiring collateral, the lender in a term loan agreement often places
restrictions on the borrower that, when violated, make the loan immediately due and
payable. These restrictive covenants are designed to prohibit the borrower from engag-
ing in any activities that would increase the likelihood of loss on the loan. There are some
common restrictions:
1. Working-capital requirement. This restriction takes the form of a minimum cur-
rent ratio, such as 2 to 1 or 31⁄2 to 1, or a minimum dollar amount of net working cap-
ital. The actual requirement would reflect the norm for the borrower’s industry, as
well as the lender’s desires.
2. Additional borrowing. This type of restriction requires the lender’s approval before
any additional debt can be issued. Furthermore, a restriction on additional borrowing
is often extended to long-term lease agreements, which are discussed later in this
chapter.
3. Periodic financial statements. A standard covenant in most term loan agreements
includes a requirement that the borrower supply the lender with financial statements
 CHAPTER 24 TERM LOANS AND LEASES 24-4

on a regular basis. These generally include annual or quarterly income statements

and balance sheets.
4. Management. Term loan agreements sometimes include a provision that requires
prior approval by the lender of major personnel changes. In addition, the borrower
may be required to insure the lives of certain key personnel, naming the lender as
beneficiary.

We have presented only a partial listing of restrictions commonly found in term loan
agreements. The number and form of such provisions are limited only by the scope of the
law and the imagination of the parties involved. It should be noted, however, that restric-
tive covenants are subject to negotiation. The specific agreement that results reflects the
relative bargaining strengths of the borrower and lender. Marginal borrowers are more
likely to find their loan agreements burdened with restrictive covenants than more cred-
itworthy borrowers.
Term loan agreements can be very technical and are generally tailored to the situa-
tion. Therefore, it is difficult to generalize about their content. However, many banks
rely on standardized worksheets or checksheets to aid in the preparation of the document.

BACK TO THE PRINCIPLES

When we determine the loan payments for an installment loan, we are solving for a series of
annuity payments (installment or loan payments) whose present value equals the face value of
the loan when discounted using the borrowing rate on the loan. Thus, we are valuing a series of
future cash flows. The valuation process utilizes a number of our Principles: Principle 1: The
Risk-Return Trade-Off—We won’t take on additional risk unless we expect to be compen-
sated with additional return comes into play in determining the rate of interest for the loan.
Principle 2: The Time Value of Money—A dollar received today is worth more than a dollar
received in the future provides the basis for finding the present value of future payments.
Finally, Principle 3: Cash—Not Profits—Is King tells us that what matters to both the lender
and borrower is the cash received and cash paid.

L OA N PA RT I C I PAT I O N S AMONG BANKS

The demand for loans is not evenly dispersed across banks; heavier demand is placed on
large money center banks and banks in regions of the country that are experiencing
strong economic growth. This frequently means that these banks cannot provide all the
necessary funds, so they share the loan demand with one or more participating banks.
This shared lending has grown rapidly in recent years and has served to promote the flow
of funds from banks with excess lending capacity to those with excess loan demand. The
participating banks work out an agreement and receive a certificate of participation,
which states that the lead bank will pay a portion of the loan cash flows as they are
received.

EURODOLLAR LOANS Eurodollar loans

Eurodollar loans are intermediate-term loans made by major international banks to Intermediate-term loans made
by major international banks to
businesses based on foreign deposits that are denominated in dollars. These loans are businesses based on foreign
generally made in amounts ranging from $1 million to $1.5 billion with the rate based on deposits that are denominated
a certain amount above the London Interbank Offered Rate (LIBOR). The rate on these in dollars.
24-5 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

loans is adjusted periodically (generally every six months), and there is a wide range of
maturities. Eurodollar lending has become a major source of commercial lending with
the total volume of lending being measured in trillions of dollars.
The attraction of the Eurodollar market relates to the fact that this market is subject
to very limited official regulation. It has been suggested, in fact, that some investors use
the market to avoid home country taxes. For example, Eurobonds (which are long-term
bonds sold outside the country in whose currency the bond is denominated) are sold in
bearer rather than registered form. This means that there is no record of who owns the
bonds and receives the interest payments.

CONCEPT CHECK
1. How is a term loan distinguished from other forms of financing?
2. What are the common types of restrictions placed on borrowers when using
term loans?

Objective
2 LOAN PAYMENT CALCULATION

R E P AY M E N T S C H E D U L E S
Term loans are generally repaid with periodic installments, which include both an inter-
est and a principal component. Thus, the loan is repaid over its life with equal annual,
semiannual, or quarterly payments.
To illustrate how the repayment procedure works, let us assume that a firm borrows
$15,000, which is to be repaid in five annual installments. The loan will carry an 8 percent
rate of interest, and payments will be made at the end of each of the next five years. The
following diagram shows the cash flows to the lender:

Year
0 1 2 3 4 5

$(15,000) A1 A2 A3 A4 A5

The $15,000 cash flow at period zero is placed in parentheses to indicate an outflow of
cash by the lender, whereas the annual installments, A1 through A5, represent cash
inflows (of course, the opposite is true for the borrower). The lender must determine the
annual installments that will give an 8 percent return on the outstanding balance over the
life of the loan. This problem is very similar to the internal rate of return problem
encountered in Chapter 9, where we discussed capital-budgeting decisions and had to
determine the rate of interest that would make the present value of a stream of future cash
flows equal to some present sum. Here we want to determine the future cash flows whose
present value, when discounted at 8 percent, is equal to the $15,000 loan amount. Thus,
we must solve for those values of A1 through A5 whose present value when discounted at
8 percent is $15,000. In equation form,

∑ (1 + .t08)t
A
$15,000 = (24-1)
t =1
 CHAPTER 24 TERM LOANS AND LEASES 24-6

TA B L E 2 4 - 1 Term Loan Amortization Schedule

END OF I N S TA L L M E N T P R I N C I PA L REMAINING
YEAR PAY M E N T a INTERESTb R E PAY M E N T c BALANCEd
t A It Pt RBt

0 — — — $15,000.00
1 $3,756.57 $1,200.00 $2,556.57 12,443.43
2 3,756.57 995.47 2,761.10 9,682.33
3 3,756.57 774.59 2,981.98 6,700.35
4 3,756.57 536.03 3,220.54 3,479.81
5 3,756.57 278.38 3,478.19 1.62e

aThe annual installment payment, A, is found as follows:

$15,000
A = = $3, 756.57
5

∑
1
( 1 + .08) t
t =1
bAnnual interest expense is equal to 8 percent of the outstanding loan balance. Thus, for year 1, the interest expense, It , is found as
follows:
It = .08 ($15,000) = $1,200
cPrincipal repayment for year t, Pt , is the difference in the loan payment, A, and interest for the year. Thus, for year 1, we compute
Pt = A − I1 = $3,756.57 − $1,200 = $2,556.57
dThe remaining balance of the end of year 1, RB1 is the difference in the remaining balance for the previous year, RB0 , and the
principal payment in year 1, P1. Thus, at the end of year 1,
RB1 = RB0 − P1 = $15,000 − $2,556.57 = $12,443.43
eThe $1.62 difference in RB and P is due to rounding error.
4 5

Where we assume equal annual installments, A, for all five years, we can solve for A as follows:
5

∑ (1 + .08)t
1
$15,000 = A
t =1

or
$15,000 $15,000
A = 5
= (24-2)
PVIF8%, 5 yrs
∑ (1 + .08)t
1
t =1

The term that is divided into that $15,000 loan amount is the present value factor for a
five-year annuity carrying an 8 percent rate of interest. Thus,
$15,000
A = = $3,756.57
3.993
Therefore, if the borrower makes payments of $3,756.57 each year, then the lender will
receive an 8 percent return on the outstanding loan balance. To verify this assertion,
check Table 24-1, which contains the principal and interest components of the annual
loan payments. We see that the $3,756.57 installments truly provide the lender with an
8 percent return on the outstanding balance of a $15,000 loan.

CONCEPT CHECK
1. What factors does a lender use to calculate the installment payments for a loan?
2. How is loan payment calculation similar to the internal rate of return
calculation for a capital-budgeting project?
24-7 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

Objective
3 LEASES

Leasing provides an alternative to buying an asset to acquire its services. Although some
leases involve maturities of more than 10 years, most do not. Thus, lease financing is clas-
sified as a source of intermediate-term credit. Today, virtually any type of asset can be
acquired through a lease agreement. The recent growth in lease financing has been phe-
nomenal, with more than $200 billion in assets (based on original cost) now under lease
in the United States.
Lease A lease is simply a contract between a lessee, who acquires the services of a leased
A contract between a lessee, asset by making a series of payments to the lessor, who is the owner of the asset. The
who acquires the services of a contract provides the lessee with the right to use the asset for the term of the lease agree-
leased asset by making a series
of rental payments to the ment; at the end of the term of the lease, the lessee must return the asset to the lessor.
lessor, who is the owner of the However, leases frequently contain an option for the lessee to purchase the asset at the
asset. termination of the lease agreement. Lessees can be just about anyone (an individual, a
Lessee and lessor business, or a government agency). Lessors are generally the manufacturer of the leased
The user of the leased asset, asset or an independent leasing company.
who agrees to make periodic The primary difference between leasing and buying an asset relates to the rights that
lease or rental payments to the transfer to the lessee versus the owner. The lessee obtains the right to use the asset up
lessor, who owns the asset.
until the term of the agreement. The owner, in contrast, receives both the right to use the
asset and the title to the asset so that, when he or she decides to sell, the owner can dis-
pose of the asset and realize the proceeds from its sale.

TYPES OF LEASE ARRANGEMENTS

There are three major types of lease agreements: direct leasing, sale and leaseback, and
leveraged leasing. Most lease agreements fall into one of these categories. However, the
Financial lease particular lease agreement can take one of two forms: (1) The financial lease constitutes
A noncancelable contractual a noncancelable contractual commitment on the part of the firm leasing the asset (the
commitment on the part of the lessee) to make a series of payments to the firm that actually owns the asset (the lessor) for
firm leasing the asset (the
lessee) to make a series of
use of the asset and (2) The operating lease differs from the financial lease only with
payments to the firm that respect to its cancelability. An operating lease can be canceled after giving proper notice
actually owns the asset (the to the lessor any time during its term. Thus, operating leases are by their very nature
lessor) for use of the asset. sources of short-term financing. The balance of this chapter is concerned with the finan-
Operating lease cial lease, which provides the firm with a form of intermediate-term financing most com-
A lease agreement (see financial parable with debt financing.
lease) in which the lessee can In the jargon of the leasing industry, a financial lease can take one of two basic forms:
cancel the agreement at any a net lease or a net-net lease. In a net lease agreement, the lessee firm assumes the risk
time by giving proper notice to
the lessor.
and burden of ownership over the term of the lease. That is, the lessee must maintain the
asset, as well as pay insurance and taxes on the asset. A net-net lease requires that the
Net and net-net leases lessee meet all the requirements of the net lease as well as return the asset, still worth a
In a net lease agreement, the
lessee assumes the risk and
preestablished value, to the lessor at the end of the lease term.
burden of ownership over the
term of the lease. This means
that the lessee must pay DIRECT LEASING
insurance and taxes on the asset
as well as maintain the In a direct lease, the firm acquires the services of an asset it did not previously own. Direct
operating condition of the leasing is available through several financial institutions, including manufacturers, banks,
asset. In a net-net lease, the finance companies, independent leasing companies, and special-purpose leasing compa-
lessee must, in addition to the nies.1 In the lease arrangement, the lessor purchases the asset and leases it to the lessee. In
requirements of a net lease, the case of a manufacturer lessor, however, the lessor has already produced the asset.
return the asset to the lessor at
the end of the lease while still
1 Many leasing companies specialize in the leasing of a single type of asset. For example, several firms lease computers
worth a preestablished value.
exclusively, and others lease only automobiles.
 CHAPTER 24 TERM LOANS AND LEASES 24-8

SALE AND LEASEBACK

A sale and leaseback arrangement arises when a firm sells land, buildings, or equip- Sale and leaseback
ment that it already owns to a lessor and simultaneously enters into an agreement to lease arrangement
the property back for a specified period under specific terms. The lessor involved in the An arrangement arising when a
firm sells land, buildings, or
sale and leaseback varies with the nature of the property involved and the lease period.
equipment that it already owns
When land is involved and the corresponding lease is long term, the lessor is generally a and simultaneously enters into
life insurance company. If the property consists of machinery and equipment, then the an agreement to lease the
maturity of the lease will probably be intermediate term, and the lessor could be an insur- property back for a specified
ance company, commercial bank, or leasing company. period under specific terms.
The lessee firm receives cash in the amount of the sales price of the assets sold and
the use of the asset over the term of the lease. In return, the lessee must make periodic
rental payments through the term of the lease and give up any salvage or residual value to
the lessor.

LEVERAGED LEASING
In the leasing arrangements discussed thus far, only two participants have been identified:
the lessor and lessee. In leveraged leasing, a third participant is added: the lender, who
helps finance the acquisition of the asset to be leased. From the viewpoint of the lessee,
there is no difference in a leveraged lease, direct lease, or sale and leaseback arrangement.
However, with a leveraged lease, the method of financing used by the lessor in acquiring
the asset receives specific consideration. The lessor generally supplies equity funds up to
20 to 30 percent of the purchase price and borrows the remainder from a third-party
lender, which may be a commercial bank or an insurance company. In some arrange-
ments, the lessor firm sells bonds, which are guaranteed by the lessee. This guarantee
serves to reduce the risk and thus the cost of the debt. The majority of financial leases are
leveraged leases.

LEASES AND FINANCIAL REPORTING

Any lease that meets one or more of the following criteria is a capital lease and must be
included in the body of the balance sheet of the lessee according to the Financial
Accounting Standards Board (FASB). All other lease agreements are classified as operating
leases for accounting purposes. In a capital lease:

1. The lease transfers ownership of the property to the lessee by the end of the lease
term.
2. The lease contains a bargain repurchase option.
3. The lease term is equal to 75 percent or more of the estimated economic life of the
leased property.
4. The present value of the minimum lease payments equals or exceeds 90 percent of
the excess of the fair value of the property over any related investment tax credit
retained by the lessor.

The last two requirements are the most stringent elements in the board’s statement.
The first two have been applicable to most leases for many years because of the Internal
Revenue Service’s “true” lease requirements. However, the last two apply to most finan-
cial leases written in the United States. As a result, the board now requires capitalization
of all leases meeting one or more of these criteria.
Table 24-2 is a sample balance sheet for the Alpha Manufacturing Company. Alpha
has entered into capital leases whose payments have a present value of $4 million.
24-9 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

TA B L E 2 4 - 2 Alpha Manufacturing Company Balance Sheet, December 31, 2003

(Millions of Dollars)

ASSETS 2003

Current assets $14

Plant and equipment 20
Leased property (capital leases) ___4
Total $38
___
___

LIABILITIES AND STOCKHOLDERS’ EQUITY

Current liabilities $ 8
Long-term debt 9
Capital lease obligations 4
Stockholders’ equity 17
___
Total $38
___
___

Note that the asset “leased property” is matched by a liability, “capital lease obliga-
tions.” The specific entries recorded for the lease obligations equal the present value of
minimum lease payments the firm must pay over the term of the lease. The discount rate
used is the lower of either the lessee’s incremental borrowing rate or the lessor’s implicit
interest rate (where that rate can be determined).
Operating leases are not disclosed in the body of the balance sheet. Instead, these
lease obligations must be reported in a footnote to the balance sheet.

THE LEASE-VERSUS-PURCHASE DECISION

The lease-versus-purchase decision is a hybrid capital-budgeting problem that forces the
analyst to consider the consequences of alternative forms of financing on the investment
decision. When we discussed capital budgeting in Chapter 9 and the cost of capital in
Chapter 12, we assumed that all new financing would be undertaken in accordance with
the firm’s optimal capital structure. When analyzing an asset that is to be leased, the
analysis must be altered to consider financing through leasing as opposed to the use of the
more traditional debt and equity sources of funds. Thus, the lease-versus-purchase deci-
sion requires a standard capital-budgeting type of analysis, as well as an analysis of two
alternative financing packages. The lease-purchase decision involves the analysis of two
basic issues:

1. Should the asset be purchased using the firm’s optimal financing mix?
2. Should the asset be financed using a financial lease?

The answer to the first question can be obtained through an analysis of the project’s
NPV, following the method laid out in Chapter 9. There are times when it might be
advantageous to lease an asset, even when the NPV for its purchase is negative. The cost
savings of a lease may more than offset the negative NPV of purchase. For example, the
Alpha Manufacturing Co. is considering the acquisition of a new computer-based inven-
tory and payroll system. The computed net present value of the new system based on
normal purchase financing is −$40, indicating that acquisition of the system through pur-
chasing or ownership is not warranted. However, an analysis of the cost savings resulting
from leasing the system (referred to here as the net advantage of leasing, or NAL) indicates
that the lease alternative will produce a present value cost savings of $60 over normal pur-
chase financing. Therefore, the net present value of the system if leased is $20 (the net
 CHAPTER 24 TERM LOANS AND LEASES 24-10

present value if leased equals the NPV of a purchase plus the net advantage of leasing, or
− $40 + $60). Thus, the system’s services should be acquired via the lease agreement.

BACK TO THE PRINCIPLES

A primary motivating factor behind leasing is the opportunity to transfer the tax consequences of
ownership (i.e., interest and depreciation expense) from a firm that is either not currently paying
taxes because of prior year losses or is paying them at a very low rate to another firm (the lessor),
who is paying taxes at a much higher rate. This is a direct application of Principle 8: Taxes Bias
Business Decisions.

CONCEPT CHECK
1. Define a lease and identify the participants. What are the principal
differences between asset ownership and asset leasing?
2. How does an operating lease differ from a financial lease?
3. Describe the three major types of lease agreements.
4. What requirements has FASB established for reporting leases on a firm’s
financial statements?

THE LEASE-PURCHASE ALGORITHM

Figure 24-1 contains a flow chart that can be used in performing lease-purchase analyses.
The analyst first calculates the net present value of purchasing, NPV(P). If the project’s
net present value is positive, then the left branch of Figure 24-1 should be followed.
Tracing through the left branch, we now compute NAL. If NAL is positive, the lease
alternative offers a positive present-value cost advantage over normal purchase financing,
and the asset should be leased. Should NAL be negative, then the purchase alternative
should be selected. If NPV(P) is negative, then return to the top of Figure 24-1 and go to
the right side of the flow chart. The only hope for the project’s acceptance at this point is
a favorable set of lease terms. In this circumstance, the project would be acceptable and
thus leased only if NAL were large enough to offset the negative NPV(P) [that is, where
NAL was greater than the absolute value of NPV(P) or, equivalently, where NAL +
NPV(P) ≥ 0].2
The lease-versus-purchase problem is analyzed using the equations 24-3 and 24-4
found in Table 24-3. The first equation is simply the net present value of purchasing the
proposed project, discussed in Chapter 9. The second equation calculates the net present
value advantage of leasing, or NAL. NAL represents an accumulation of the cash flows
(both inflows and outflows) associated with leasing as opposed to purchasing the asset.
Specifically, through leasing, the firm avoids certain operating expenses, Ot , but incurs
the after-tax rental expense, Rt(1 − T). By leasing, furthermore, the firm loses the tax-
deductible expense associated with interest, T × It, and depreciation, T × Dt . Finally, the
firm does not receive the salvage value from the asset, Vn, if it is leased, but it does not
have to make the initial cash outlay to purchase the asset, IO. Thus, NAL reflects the cost
savings associated with leasing, net of the opportunity costs of not purchasing.

2 That is, NAL = NPV(L) − NPV(P), where NPV(L) is the net present value of the asset if leased. Thus, the sum of

NPV(P) and NAL is the net present value of the asset if leased.
24-11 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

FIGURE 24-1 Lease-Purchase Analysis

Compute NPV(P)

Yes No
Is NPV(P) ≥ 0?

Compute NAL Compute NAL

Is NAL > 0? Is NAL > 0?

Yes No Yes No

se
Lea

Is NAL + (t) ≥ 0?

Yes No Reject
Lease the asset Purchase the asset
se
Lea

Reject
Lease the asset

Note that the after-tax cost of new debt is used to discount the NAL cash flows other
than the salvage value, Vn. This is justified because the affected cash flows are very nearly
riskless and certainly no more risky than the interest and principal accruing to the firm’s
creditors (which underlie the rate of interest charged to the firm for its debt).3 Because Vn
is not a risk-free cash flow but depends on the market price for the leased asset in year n,
a rate higher than r is appropriate. Because the salvage value of the leased asset was dis-
counted using the cost of capital when determining NPV(P), we use this rate here when
calculating NAL.

3 The argument for using the firm’s borrowing rate to discount these tax shelters goes as follows: The tax shields are

relatively free of risk in that their source (depreciation, interest, rental payments) can be estimated with a high degree
of certainty. There are, however, two sources of uncertainty regarding these tax shelters: (1) the possibility of a
change in the firm’s tax rate or the tax benefits of leasing, and (2) the possibility that the firm might become bankrupt
at some future date. If we attach a very low probability to the likelihood of a reduction in the tax rate, then the prime
risk associated with these tax shelters is the possibility of bankruptcy wherein they would be lost forever (certainly, all
tax shelters after the date of bankruptcy would be lost). We now note that the firm’s creditors also faced the risk of
the firm’s bankruptcy when they lent the firm funds at the rate r. If this rate r reflects the market’s assessment of the
firm’s bankruptcy potential as well as the time value of money, then it offers an appropriate rate for discounting the
interest shelters generated by the firm. Note also that the Ot cash flows are generally estimated with a high degree of
certainty (in the case in which they represent insurance premiums they may be contractually set) such that r is appro-
priate as a discount rate here also. Of course, r is adjusted for taxes to discount the after-tax cash flows.
 CHAPTER 24 TERM LOANS AND LEASES 24-12

TA B L E 2 4 - 3 Lease-Purchase Model

Equation One—Net present value of purchase [NPV(P)]:

n

∑ (1 + K )
ACFt
NPV (P ) = t
− IO (24-3)
t=1

where ACFt = the annual after-tax cash flow in period t resulting from the asset’s purchase (note that ACFn
also includes any after-tax salvage value expected from the project).
K = the firm’s cost of capital applicable to the project being analyzed and the particular mix of
financing used to acquire the project.
IO = the initial cash outlay required to purchase the asset in period zero (now).
n = the productive life of the project.
Equation Two—Net advantage of leasing (NAL):
n
Ot (1 − T ) − R t (1 − T ) − T × I t − T × D t
∑
Vn
NAL = − + IO (24-4)
(1 + r b )t (1 + K s )n
t=1

where Ot = any operating cash flows incurred in period t that are incurred only when the asset is purchased.
Most often this consists of maintenance expenses and insurance that would be paid by the
lessor.
Rt = the annual rental for period t.
T = the marginal tax rate on corporate income.
It = the tax-deductible interest expense forfeited in period t if the lease option is adopted. This
represents the interest expense on a loan equal to the full purchase price of the asset being
acquired.a
Dt = depreciation expense in period t for the asset.
Vn = the after-tax salvage value of the asset expected in year n.
Ks = the discount rate used to find the present value of Vn. This rate should reflect the risk inherent
in the estimated Vn. For simplicity the after-tax cost of capital (K) is often used as a proxy for
this rate. Also, note that this rate is the same one used to discount the salvage value in NPV(P).
IO = the purchase price of the asset, which is not paid by the firm in the event the asset is leased.
rb = the after-tax rate of interest on borrowed funds (i.e., rb = r(1 − T) where r is the before-tax
borrowing rate for the firm). This rate is used to discount the relatively certain after-tax cash
flow savings that accrue through the leasing of the asset.

aThis analysis makes the implicit assumption that a dollar of lease financing is equivalent to a dollar of loan. This form of
equivalence is only one of several that might be used.

CASE PROBLEM IN L E A S E - P U R C H A S E A N A LY S I S
The Waynesboro Plastic Molding Company (WPM) is now deciding whether to purchase
an automatic casting machine. The machine will cost $15,000 and for tax purposes will be
depreciated toward a zero salvage value over a five-year period. However, at the end of five
years, the machine actually has an expected salvage value of $2,100. Because the machine is
depreciated toward a zero book value at the end of five years, the salvage value is fully tax-
able at the firm’s marginal tax rate of 50 percent. Hence the after-tax salvage value of the
machine is only $1,050.4 The firm uses the simple straight-line depreciation method to
depreciate the $15,000 asset toward a zero salvage value. Furthermore, the project is
expected to generate annual cash revenues of $5,000 per year over the next five years (net of
cash operating expenses but before depreciation and taxes). For projects of this type, WPM
has a target debt ratio of 40 percent that is impounded in its after-tax cost-of-capital esti-
mate of 12 percent. Finally, WPM can borrow funds at a before-tax rate of 8 percent.

4 The problem example is a modification of the example from R. W. Johnson and W. G. Lewellen, “Analysis of the

Lease-or-Buy Decision,” Journal of Finance 27 (September 1972): 815–23.

24-13 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

TA B L E 2 4 - 4 Computing Project Annual After-Tax Cash Flows (ACFt ) Associated

with Asset Purchase

YEAR
1 2
BOOK CASH BOOK CASH
PROFITS FLOW PROFITS FLOW

Annual cash revenues $ 5,000 $ 5,000 $ 5,000 $ 5,000

Less: depreciation (3,000)
______ ______— (3,000)
______ ______—
Net revenues before taxes $ 2,000 $ 5,000 $ 2,000 $ 5,000
Less: taxes (50%) (1,000)→
______ (1,000)
______ (1,000)→
______ (1,000)
______
Annual after-tax cash flow $ 4,000
______
______ $ 4,000
______
______

STEP 1: COMPUTING NPV(P)—SHOULD THE ASSET BE PURCHASED?

The first step in analyzing the lease-purchase problem involves computing the net pre-
sent value under the purchase alternative. The relevant cash flow computations are pre-
sented in Table 24-4.
The NPV(P) is found by discounting the annual cash flows (ACFt) in Table 24-3 back
to the present at the firm’s after-tax cost of capital of 12 percent, adding this sum to the
present value of the salvage value, and subtracting the initial cash outlay. These calcula-
tions are shown in Table 24-5. The project’s NPV(P) is a positive $15.35, indicating that
the asset should be acquired.
The second question concerns whether the asset should be leased. This can be
answered by considering the net advantage to leasing (NAL).

S T E P 2 : C O M P U T I N G N A L — S H O U L D T H E A S S E T B E L E A S E D ? The com-
putation of NAL is shown in Table 24-6. The resulting NAL is a negative −$1,121, which
indicates that leasing is not preferred to the normal debt-equity method of financing. In
fact, WPM will be −$1,121 worse off, in present value terms, if it chooses to lease rather
than purchase the asset.
Calculating NAL involves solving equation 24-4 presented earlier in Table 24-3. To
do this, we first estimate all those cash flows that are to be discounted at the firm’s after-
tax cost of debt, rb. These include Ot(1 − T), Rt(1 − T), It × T, and T × Dt .
The operating expenses associated with the asset that will be paid by the lessor if we
lease—that is, the Ot—generally consist of certain maintenance expenses and insurance.
WPM estimates them to be $1,000 per year over the life of the project. The annual rental
or lease payments, Rt , are given and equal $4,200.
The interest tax shelter lost because the asset is leased and not purchased must now
be estimated. This tax shelter is lost because the firm does not borrow any money if it
enters into the lease agreement. Table 24-1 contains the principal and interest compo-
nents for a five-year $15,000 loan. Note that the interest column supplies the needed
information for the interest tax shelter that is lost if the asset is leased, It .5

5 Technically the firm does not lose the interest tax shelter on a $15,000 loan if it leases. In fact, the firm would lose
the tax shelter on only that portion of the $15,000 purchase price that it would have financed by borrowing, for
example, 40 percent of the $15,000 investment, or $6,000. However, if the firm leases the $15,000 asset, it has effec-
tively used 100 percent levered (nonowner) financing. This means that the leasing of this project uses not only its
40 percent allotment of levered (debt) financing, but an additional 60 percent as well. Thus, by leasing the $15,000
asset the lessee forfeits the interest tax shelter on a 40 percent or $6,000 loan plus an additional 60 percent of the
$15,000 purchase price, or an additional $9,000 loan. In total, leasing has caused the firm to forgo the interest tax
savings on a loan equal to 100 percent of the leased asset’s purchase price. Once again, we note that this analysis
presumes $1 of lease financing is equivalent to $1 of loan financing.
 CHAPTER 24 TERM LOANS AND LEASES 24-14

YEAR
3 4 5
BOOK CASH BOOK CASH BOOK CASH
PROFITS FLOW PROFITS FLOW PROFITS FLOW

$ 5,000 $ 5,000 $ 5,000 $ 5,000 $ 5,000 $ 5,000

(3,000)
______ ______— (3,000)
______ ______— (3,000)
______ ______—
$ 2,000 $ 5,000 $ 2,000 $ 5,000 $ 2,000 $ 5,000
(1,000)→
______ (1,000) (1,000)→
______ (1,000) (1,000)→
______ (1,000)
$ 4,000
______
______ $ 4,000
______
______ $ 4,000
______
______

Earlier when we computed NPV(P), we found this to equal $15.35. Because NPV(P)
is positive, the purchase would increase shareholder wealth. Now, substituting the results
of our calculations into equation 24-4 produces the NAL of −$1,121. Because NAL is
negative, the asset should not be leased.
Note that the lease payments used in this example were made at the end of each
year. In practice, lease payments are generally made at the beginning of each year (that
is, they constitute an annuity due rather than an ordinary annuity, as used here). The
NAL for the example used here is even more negative if we assume beginning of year
lease payments; that is, with beginning-of-year payments NAL = −$1,495. You can eas-
ily verify this result as follows: Note first that changing from a regular annuity to an
annuity due affects only the first and last annuity payments. In this example, this
means that the first lease payment of $2,100 (after tax) is paid immediately such that
its present value is $2,100. However, the final lease payment is now made at the begin-
ning of year 5 (or at the end of year 4). The present value of the fifth-year after-tax
lease payment is therefore $2,100 × .822 = $1,726. To summarize, by changing from a
regular annuity set of lease payments to an annuity due, we must include a −$2,100
immediate cash flow at time t = 0, and we exchange this for the fifth-year present-
value after-tax lease payment of $1,726. Therefore, the NAL with annuity due lease
payments is NAL (annuity due) = (1,121) + 1,726 − 2,100 = (1,495). Hence, if the lease
payments are an annuity due, the asset should be purchased [because NPV(P) =
$15.35] and not leased (because NAL = −$1,495).
Let’s recap the lease-purchase analysis: First the project’s net present value was
computed. This analysis produced a positive NPV(P) equal to $15.35, which indi-
cated that the asset should be acquired. On computing the net advantage to leasing,
we found that the financial lease was not the preferred method of financing the

TA B L E 2 4 - 5 Calculating NPV(P)

ANNUAL CASH FLOW D I S C O U N T FAC TO R PRESENT

YEAR t ACFt FOR 12 PERCENT VA L U E

1 $4,000 .893 $ 3,572

2 4,000 .797 3,188
3 4,000 .712 2,848
4 4,000 .636 2,544
5 4,000 .567 2,268
5 (Salvage = Vn) 1,050 .567 595.35
_________
Present value of ACFs and Vn = _________
$15,015.35
NPV(P ) = $15,015.35 − $15,000 = _________
$ 15.35
24-15 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

TA B L E 2 4 - 6 Computing NAL

Overview: To solve for NAL, we use equation 24-4, which was discussed in Table 24-3. This equation contains three terms and is repeated below
for convenience.
n
Ot (1 − T ) − R t (1 − T ) − I t × T − D t × T
∑
Vn
NAL = + IO
(1 + r b )t (1 + K s )n
t=1

Term 1 Term 2 Term 3

n
Ot (1 − T ) − R t (1 − T ) − I t × T − D t × T
Step 1: Solving for term 1 = ∑t=1
(1 + r b )t

A F T E R - TA X
O P E R AT I N G TA X
EXPENSES A F T E R - TA X TA X S H E LT E R S H E LT E R O N
PA I D B Y R E N TA L ON LOAN DEPRECIA- DISCOUNT PRESENT
YEAR LESSORa EXPENSEb INTERESTc TIONd FAC TO R e VA L U E
t Ot(1 − T) − Rt(1 − T) − ItT − DtT = SUM × DF = PV

1 $500 $2,100 $600 $1,500 −$3,700 .9615 −$ 3,558

2 500 2,100 498 1,500 − 3,598 .9246 − 3,326
3 500 2,100 387 1,500 − 3,487 .8890 − 3,100
4 500 2,100 268 1,500 − 3,368 .8548 − 2,879
5 500 2,100 140 1,500 − 3,240 .8219 − 2,662
− 15,525
 Vn  $1050
,
Step 2: Solving for term 2 = −   = = $1050
, × .567f = $ 596
 (1 + K s )  (1 + .12)5
n

Step 3: Term 3 = IO $15,000

Step 4: Calculate NAL = $15,525 − $596 + $15,000 = −________
$ 1,121
________

aAfter-tax lessor-paid operating expenses are found by Ot(1 − T ) − $1,000 (1 − .5) = $500.
bAfter-tax rent expense for year 1 is computed as follows: Rt(1 − T ) = $4,200 (1 − .5) = $2,100.
cInterest expense figures were calculated in Table 24-1 for a $15,000 loan. For year 1 the interest tax shelter is 0.5 × $1,200 − $600.
dThe tax shelter from depreciation is found as follows: DtT = $3,000 × 0.5 = $1,500.
eBased on the after-tax borrowing rate, i.e., .08 (1 − .5) = .04
fK was estimated to be the same as the firm’s after-tax cost of capital, 12 percent.
s

acquisition of the asset’s services. Thus, the asset’s services should be purchased
using the firm’s normal financing mix.
Our analysis of the lease-purchase choice found in Tables 24-4, 24-5, and 24-6 illus-
trates the application of a number of basic principles of finance. In Table 24-4, we are
careful to identify the cash-flow consequences of asset ownership even though this
requires that we evaluate profits for purposes of determining tax liabilities. This illus-
trates the use of Principle 3: Cash—Not Profits—Is King. We then discount the cash
flows associated with both purchasing and leasing which reflects Principle 2: The Time
Value of Money—A dollar received today is worth more than a dollar received in
the future. In Table 24-5, we see two principles at work. First, we are careful to properly
adjust all expenses for their tax consequences, which reflects Principle 8: Taxes Bias
Business Decisions. Finally, we discount the after-tax expenses associated with leasing
versus purchasing, using the firm’s borrowing rate, and discount the salvage value using
the firm’s weighted average cost of capital. Using a higher rate to discount the riskier sal-
vage value reflects Principle 1: The Risk-Return Trade-Off—We won’t take on
additional risk unless we expect to be compensated with additional return.
 CHAPTER 24 TERM LOANS AND LEASES 24-16

CONCEPT CHECK
1. Describe the process used when evaluating the lease-versus-purchase
decision.
2. Why are the NAL cash flows discounted using the firm’s after-tax cost of
borrowing rather than the firm’s cost of capital?

Objective
THE ECONOMICS OF LEASING VERSUS PURCHASING 4
Let’s now review briefly the economic attributes of leasing and purchasing. Figure 24-2
summarizes the participants and transactions involved in leasing (the right side of the fig-
ure) and purchasing (the left side). In purchasing, the asset is financed via the sale of secu-
rities and the purchaser acquires title to the asset (including both the use and salvage
value of the asset). In leasing, the lessee acquires the use value of the asset but uses the
lessor as an intermediary to finance and purchase the asset. The key feature of leasing as
opposed to purchasing is the interjection of a financial intermediary (the lessor) into the
scheme used to acquire the asset’s services. Thus, the basic question that arises in lease-
purchase analysis is one of “Why does adding another financial intermediary (the lessor)
save the lessee money?” Some of the traditional answers to this question are discussed
subsequently. As you read through each, simply remember that the lessee is hiring the
lessor to perform the functions associated with ownership that he or she would perform if
the asset were purchased. Thus, for the lease to be “cheaper” than owning, the lessor
must be able to perform these functions of ownership at a lower cost than the lessee could
perform them and be willing to pass a portion of these savings along to the lessee in the
form of lower rental rates.

FIGURE 24-2 Comparison of Purchasing with Simple Financial Lease Agreement

Purchasing Leasing
Securities (e.g., Securities (e.g.,
stocks, bonds, stocks, bonds,
or notes) Capital markets or notes)
(e.g., a commercial bank
or life insurance company)

$ Net proceeds $ Net proceeds

Lease agreement
from sale from sale
(use value of asset)
of securities of securities
Lessor (retains
Purchaser Lessee
salvage value) $
$ Purchase $ Purchase
Lease
price of price of
payments
equipment equipment

Equipment
dealer
Title Title
1. Use value 1. Use value
2. Salvage value 2. Salvage value
24-17 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

POTENTIAL BENEFITS FROM LEASING6

Several purported advantages have been associated with leasing as opposed to debt
financing. These benefits include flexibility and convenience, lack of restrictions, avoid-
ing the risk of obsolescence, conservation of working capital, 100 percent financing, tax
savings, and availability of credit.

FLEXIBILITY AND CONVENIENCE

A variety of potential benefits are often included under the rubric of flexibility and con-
venience. It is argued, for example, that leasing provides the firm with flexibility because
it allows for piecemeal financing of relatively small asset acquisitions. Debt financing of
such acquisitions can be costly and difficult to arrange. Leases, conversely, may be
arranged more quickly and with less documentation.
Another flexibility argument notes that leasing may allow a division or subsidiary man-
ager to acquire equipment without the approval of the corporate capital-budgeting com-
mittee. Depending on the firm, the manager may be able to avoid the time-consuming
process of preparing and presenting a formal acquisition proposal.
A third flexibility advantage relates to the fact that some lease payment schedules may
be structured to coincide with the revenues generated by the asset, or they may be timed
to match seasonal fluctuations in a given industry. Thus, the firm is able to synchronize its
lease payments with its cash cycle—an option rarely available with debt financing.
Arguments for the greater convenience of leasing take many forms. It is sometimes
stated that leasing simplifies bookkeeping for tax purposes because it eliminates the need
to prepare time-consuming depreciation tables and subsidiary fixed asset schedules.
Finally, leasing allows the firm to avoid the “problems” and “headaches” associated with
ownership. Executives often note that leasing “keeps the company out of the real estate
business.” Implicit in this argument is the assumption that the firm’s human and material
resources may be more profitably allocated to its primary line of business and that it is
better to allow the lessor to deal with the obligations associated with ownership.
It is difficult to generalize about the validity of the various arguments for greater flex-
ibility and convenience in leasing. Some companies, under specific conditions, may find
leasing advantageous for some of the reasons listed earlier. In practice, the trade-offs are
likely to be different for every firm. The relevant issue is often that of shifting functions.
By leasing a piece of capital equipment, the firm may effectively shift bookkeeping, dis-
posal of used equipment, and other functions to the lessor. The lessee will benefit in these
situations if the lessor is able to perform the functions at a lower cost than the lessee and
is willing to pass on a portion of the savings in a lower lease rate.
The arguments that follow should be viewed in a similar vein. In many cases, the ben-
efits the firm is able to attain are not worth the cost. Compounding the problem is the
fact that it is often difficult for a lessee firm to quantify such cost-benefit trade-offs.

LACK OF RESTRICTIONS
Another suggested advantage of leasing relates to the lack of restrictions associated with a
lease. Unlike term loan agreements or bond indentures, lease contracts generally do not
contain protective covenant restrictions. Furthermore, in calculating financial ratios
under existing covenants, it is sometimes possible to exclude lease payments from the

6 The contributions of Paul P. Anderson in the preparation of this discussion are gratefully acknowledged.
 CHAPTER 24 TERM LOANS AND LEASES 24-18

firm’s debt commitments. Once again, the extent to which lack of restrictions benefits a
lessee will depend on the price it must pay. If a lessor views its security position to be
superior to that of a lender, it may not require a higher return on the lease to compensate
for the lack of restrictions on the lessee. Conversely, if the prospective lessee is viewed as
a marginal credit risk, a higher rate may be charged.

AVOIDANCE OF RISK OF OBSOLESCENCE

Similar reasoning applies to another popular argument for leasing. This argument states
that a lease is advantageous because it allows the firm to avoid the risk that the equipment
will become obsolete. In actuality, the risk of obsolescence is passed on to the lessee in any
financial lease. Because the original cost of the asset is fully amortized over the basic lease
term, all of the risk is borne by the lessee. Only in a cancelable operating lease is it some-
times possible to avoid the risk of obsolescence.
A related argument in favor of leasing states that a lessor will generally provide the
firm with better and more reliable service to maintain the resale value of the asset. The
extent to which this is true depends on the lessor’s own cost-benefit trade-off. If the lessor
is a manufacturing or a leasing company that specializes in a particular type of equipment,
it may be profitable to maintain the equipment’s resale value by ensuring that it is prop-
erly repaired and maintained. Because of their technical and marketing expertise, these
types of lessors may be able to operate successfully in the secondary market for the equip-
ment. Conversely, bank lessors or independent financial leasing companies would proba-
bly find it too expensive to follow this approach.

C O N S E R VAT I O N OF W O R K I N G C A P I TA L
One of the oldest and most widely used arguments in favor of leasing is the assertion that
a lease conserves the firm’s working capital. The conservation argument runs as follows:
Because a lease does not require an immediate outflow of cash to cover the full purchase
price of the asset, funds are retained in the business.
It is clear that a lease does require a lower initial outlay than does a cash purchase.
However, the cash outlay associated with the purchase option can be reduced or elimi-
nated by borrowing the down payment from another source. This argument leads us
directly into the next purported advantage of lease financing.

ONE HUNDRED PERCENT FINANCING

Another alleged benefit of leasing is embodied in the argument that a lease provides the
firm with 100 percent financing. It is pointed out that the borrow-and-buy alternative
generally involves a down payment, whereas leasing does not. Given that investors and
creditors are reasonably intelligent, however, it is sensible to conclude that they consider
similar amounts of lease and debt financing to add equivalent amounts of risk to the firm.
Thus, a firm uses up less of its capacity to raise nonequity funds with debt than with leas-
ing. In theory, it could issue a second debt instrument to make up the difference—that is,
the down payment.

TA X S AV I N G S
It is also argued that leasing offers an economic advantage in that the tax shield generated
by the lease payments usually exceeds the tax shield from depreciation that would be
24-19 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

available if the asset were purchased. The extent to which leasing provides a tax-shield
benefit is a function of many factors. The NAL equation (24-4), discussed earlier, is the
basis for weighing these differences in tax shields.

EASE OF O B TA I N I N G C R E D I T
Another purported advantage of leasing is that firms with poor credit ratings are able to
obtain assets through leases when they are unable to finance the acquisitions with debt
capital. The counterargument is that the firm will certainly face a high lease interest rate
to compensate the lessor for bearing this higher risk of default.

WHY DO FIRMS LEASE?

Several researchers have asked firms why they use financial leases as opposed to purchas-
ing. For example, in a study by Ferrara, Thies, and Dirsmith,7 the following factors were
found to affect the leasing decision:

FAC TO R RANK PERCENT OF RESPONDENTS

Implied interest rate 1 52

Threat of obsolescence 2 37
Income taxes 3 33
Maintain flexibility 4 12
Conserve working capital 5 12
Less restrictive financing 6 6
Off balance sheet finance 7 7

Interestingly, the factor most often mentioned was the implied cost of financing.
That is, 52 percent of the lessees considered the cost of lease financing to be an important
factor in determining their decision to use lease financing. This factor was followed by
concern over the risk of obsolescence, followed by tax considerations. In light of the the-
oretical significance given to tax considerations in the theoretical literature on lease
financing, it is interesting to note that only 33 percent of the respondents felt that tax
considerations were a factor in their decision to lease.
Ferrara, Thies, and Dirsmith also provide evidence concerning the motives under-
lying a firm’s decision to use lease financing and its financial characteristics.8
Specifically, they observed that smaller and financially weaker firms tended to justify
the use of lease financing based on qualitative benefits. These included flexibility, the
conservation of working capital, financing restrictions, off balance sheet financing, and
transference of the risk of obsolescence. Conversely, larger and financially stronger
firms tended to base their leasing decisions on more quantitative considerations. That
is, this latter group tended to use more formal comparisons of the cost of leasing versus
other forms of intermediate-term financing.

7 W. L. Ferrara, J. B. Thies, and M. W. Dirsmith, “The Lease-Purchase Decision,” National Association of Accountants,

1980, Cited in “Leasing—A Review of the Empirical Studies,” Managerial Finance 15, 1 and 2 (1989): 13–20.
8 Anderson and Bird also investigated the reasons why lessees lease. They used a survey in which the respondents

were asked to indicate both the extent to which they agreed or disagreed with the advantages attributed to leasing and
the extent to which a particular advantage was important to their lease decisions. One of the purported advantages to
leasing was the following: “All things considered, leasing is less expensive than debt as a means of acquiring equip-
ment.” The respondents accorded the lowest agreement rating to this statement (that is, they disagreed that this was
true), yet they ranked this same statement third in overall importance in terms of their decision to lease. The authors
interpret this finding as evidence that lessees believe that it is important that the cost of leasing be less than the cost
of debt financing, but they do not expect to find this to be so in practice.
 CHAPTER 24 TERM LOANS AND LEASES 24-20

CONCEPT CHECK
1. How is the net advantage of leasing related to the net present value of
purchasing an asset?
2. What are some of the potential benefits to the use of lease financing?
3. What are the most important reasons firms give for using lease financing?

HOW FINANCIAL MANAGERS USE THIS MATERIAL

Firms can and do lease just about everything. So, how do they decide when to lease? The
answer is that for big-ticket items, a formal analysis is used, along the lines of the net
advantage of leasing model discussed in this chapter. However, for smaller expenditures,
often no formal model is used.
When you discuss the decision to lease with a financial analyst, he or she will often
cite the types of points we made in our discussion of the potential benefits from leasing.
That is, leasing is simply easier than purchasing because of internal controls within the
firm regarding asset purchases. In addition, it is commonplace to hear analysts suggesting
that, by leasing, the firm can avoid the risk of obsolescence. As we learned earlier, how-
ever, the firm simply transfers the risk of obsolescence to the lessor (presumably for a fee).
Analysts also point out that, by leasing, the firm has to invest less of its own money as
there is no associated down payment (or at least a minimal one). Once again, we know
that this ignores the fact that the firm receives only the use value and not the salvage value
of the asset through the lease and often uses more financial leverage (nonowner financ-
ing) than it would if it purchased the asset. The point is that many of the potential advan-
tages of leasing fail to make the leasing alternative truly comparable to purchasing the
asset. So, when analyzing a lease financing alternative, be careful to compare “apples to
apples” and not be fooled by the claims of an overly zealous lessor.

SUMMARY

Intermediate financing is any source of financing with a final maturity greater than one year but Objective
less than 10. The two major sources of intermediate financing are term loans and financial leases. 1
Term loans are available from commercial banks, life insurance companies, and pension
funds. Although the specifics of each agreement vary, they share a common set of general char-
acteristics. These include:
1. A final maturity of 1 to 10 years
2. A requirement of some form of collateral
3. A body of restrictive covenants designed to protect the security interests of the lender
4. A loan amortization schedule whereby periodic loan payments, comprised of both principal
and interest components, are made over the life of the loan.
Term loans generally require the borrower to repay them by making level monthly, quar-
terly, or annual payments or installments. These payments include two components: (1) the
interest owed on the loan balance outstanding at the time of the last loan payment, and (2) the
difference in the installment payment and the interest component. This difference goes toward
reducing the principal amount of the loan.
Installment payments are calculated using present value analysis. They constitute the peri-
odic (monthly, quarterly, annual, and so on) payment whose present value, when discounted back
to the present using the loan rate of interest, equals the face amount of the loan.
24-21 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

There are three basic types of lease arrangements:

1. Direct lease
2. Sale and leaseback
3. Leveraged lease
The lease agreement can further be classified as a financial or an operating lease; we focused
on the financial lease. Current reporting requirements of the FASB virtually ensure the inclusion
of all financial leases in the body of the lessee firm’s balance sheet.
The lease-versus-purchase decision is a hybrid capital-budgeting problem wherein the analyst
must consider both the investment and financing aspects of the decision. The method we recom-
mend for analyzing the lease-versus-purchase choice involves first calculating the net present value
of the asset if it were purchased. Next we calculate the net advantage of leasing over purchasing.
Many and varied factors are often claimed to be advantages of leasing versus the firm’s usual
debt-equity financing mix. However, a complete lease-purchase analysis using a model similar to
the one discussed here is needed to provide a rational basis for uncovering the true advantages of
lease financing.

KEY TERMS

Eurodollar loans, 24-4 Lessee and lesser, 24-7 Sale and leaseback
Financial lease, 24-7 Net and net-net leases, 24-7 arrangement, 24-8
Go To: Lease, 24-7 Operating lease, 24-7 Term loans, 24-3
www.prenhall.com/keown
for downloads and current
events associated with this
chapter
STUDY QUESTIONS

24-1. What characteristics distinguish intermediate-term debt from other forms of debt instru-
ments?
24-2. List and discuss the major types of restrictions generally found in the covenants of term
loan agreements.
24-3. Define each of the following:
a. Direct lease
b. Sale and leaseback arrangement
c. Net-net lease
d. Operating lease
24-4. How are financial leases handled in the financial statements of the lessee firm?
24-5. List and discuss each of the potential benefits from lease financing.

Objective
2 SELF-TEST PROBLEMS

ST-1. (Analyzing a term loan) Calculate the annual installment payment and the principal and inter-
est components of a five-year loan carrying a 10 percent rate of interest. The loan amount is
$50,000.
ST-2. (Analyzing an installment loan) The S. P. Sargent Sales Company is contemplating the
purchase of a new machine. The total cost of the machine is $120,000 and the firm plans to make
a $20,000 cash down payment. The firm’s bank has offered to finance the remaining $100,000 at
a rate of 14 percent. The bank has offered two possible loan repayment plans. Plan A involves
 CHAPTER 24 TERM LOANS AND LEASES 24-22

equal annual installments payable at the end of each of the next five years. Plan B requires five Objective
equal annual payments plus a balloon payment of $20,000 at the end of year 5. 3
a. Calculate the annual payment on the loan in plan A.
b. Calculate the principal and interest components of the plan A installment loan.
c. Calculate the annual installments for plan B where the loan carries a 14 percent rate.
ST-3. (Lease versus purchase analysis) Jensen Trucking, Inc., is considering the possibility of leas-
ing a $100,000 truck-servicing facility. This newly developed piece of equipment facilitates the
cleaning and servicing of diesel tractors used on long-haul runs. The firm has evaluated the pos- Objective
sible purchase of the equipment and found it to have an $8,000 net present value. However, an 4
equipment leasing company has approached Jensen with an offer to lease the equipment for an
annual rental charge of $24,000 payable at the beginning of each of the next five years. In addi-
tion, should Jensen lease the equipment, it would receive insurance and maintenance valued at
$4,000 per year (assume that this amount would be payable at the beginning of each year if pur-
Objective
chased separately from the lease agreement). Also, for simplicity you may assume that tax savings
are realized immediately. Additional information pertaining to the lease and purchase alterna-
5
tives is found in the following table:

Acquisition price $100,000

Useful life (used in analysis) 5 years
Salvage value (estimated) $0
Depreciation method Straight-line
Borrowing rate 12%
Marginal tax rate 40%
Cost of capital (based on a target debt/total 16%
asset ratio of 30%)

a. Calculate the net advantage of leasing (NAL) the equipment.

b. Should Jensen lease the equipment?

STUDY PROBLEMS (SET A)

24-1A. (Calculation of balloon payment for a term loan) The First State Bank has offered to lend
$325,000 to Jamie Tulia to help him purchase a group home for handicapped persons. The bank
loan officer (Chris Turner) has structured the loan to include four installments of $50,000 each,
followed in year 5 by a balloon payment. The loan is to carry a 10 percent rate of interest with
annual compounding. What is the fifth-year balloon payment?
24-2A. (Calculating lease payments) Apple Leasing, Inc., calculates its lease payments such that
they provide the firm with a 12 percent pre-tax return. The firm has been asked to quote rental
payments on a $100,000 piece of equipment which is to include 10 payments spread over the
next nine years (the first payment is made immediately upon signing of the agreement with the
remaining payments coming at the end of each of the next nine years). What amount should
Apple quote on the lease?
24-3A. (Installment payments) Compute the annual payments for an installment loan carrying an
18 percent rate of interest, a five-year maturity, and a face amount of $100,000.
24-4A. (Principal and interest components of an installment loan) Compute the annual principal and
interest components of the loan in problem 24-3A.
24-5A. (Cost of an intermediate-term loan) The J. B. Marcum Company needs $250,000 to
finance a new minicomputer. The computer sales firm has offered to finance the purchase with a
$50,000 down payment followed by five annual installments of $59,663 each. Alternatively, the
firm’s bank has offered to lend the firm $250,000 to be repaid in five annual installments based on
an annual rate of interest of 16 percent. Finally, the firm has arranged to finance the needed
$250,000 through a loan from an insurance company requiring a lump-sum payment of
$385,080 in five years.
24-23 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

a. What is the effective annual rate of interest on the loan from the computer sales firm?
b. What will the annual payments on the bank loan be?
c. What is the annual rate of interest for the insurance company term loan?
d. Based on cost considerations only, which source of financing should Marcum select?
24-6A. (Cost of intermediate-term credit) Charter Electronics is planning to purchase a $400,000
burglar alarm system for its southwestern Illinois plant. Charter’s bank has offered to lend the
firm the full $400,000. The note would be paid in one payment at the end of four years and
would require payment of interest at a rate of 14 percent compounded annually. The manufac-
turer of the alarm system has offered to finance the $400,000 purchase with an installment loan.
The loan would require four annual installments of $140,106 each. Which method of financing
should Charter select?
24-7A. (Lease-versus-purchase analysis) S. S. Johnson Enterprises (SSJE) is evaluating the acquisi-
tion of a heavy-duty forklift with 20,000- to 24,000-pound lift capacity. SSJE can purchase the
forklift through the use of its normal financing mix (30 percent debt and 70 percent common
equity) or lease it. Pertinent details follow:

Acquisition price of the forklift $20,000

Useful life 4 years
Salvage value (estimated) $4,000
Depreciation method Straight-line
Annual cash savings before tax and depreciation from $6,000
the forklift
Rate of interest on a four-year installment loan 10 percent
Marginal tax rate 50 percent
Annual rentals (four-year lease) $6,000
Annual operating expenses included in the lease $1,000
Cost of capital 12 percent

a. Evaluate whether the forklift acquisition is justified through normal purchase financing.
b. Should SSJE lease the asset?
24-8A. (Installment loan payment) Calculate the annual installment payments for the following
loans:
a. A $100,000 loan carrying a 15 percent annual rate of interest and requiring 10 annual
payments.
b. A $100,000 loan carrying a 15 percent annual rate of interest with quarterly payments
over the next five years. (Hint: Refer to Chapter 5 for discussion of semiannual com-
pounding and discounting.)
c. A $100,000 loan requiring annual installments for each of the next five years at a 15 per-
cent rate of interest. However, the annual installments are based on a 30-year loan
period. In year 5, the balance of the loan is due in a single (balloon) payment. (Hint:
Calculate the installment payments using n = 30 years. Next use the procedure given in
Table 24-1 to determine the remaining balance of the loan at the end of the fifth year.)

INTEGRATIVE PROBLEM

Early in the spring of 2003, the Jonesboro Steel Corporation (JSC) decided to purchase a small
computer. The computer is designed to handle the inventory, payroll, shipping, and general cler-
ical functions for small manufacturers like JSC. The firm estimates that the computer will cost
$60,000 to purchase and will last four years, at which time it can be salvaged for $10,000. The
firm’s marginal tax rate is 50 percent, and its cost of capital for projects of this type is estimated
to be 12 percent. Over the next four years, the management of JSC thinks the computer will
reduce operating expenses by $27,000 a year before depreciation and taxes. JSC uses straight-line
depreciation.
 CHAPTER 24 TERM LOANS AND LEASES 24-24

JSC is also considering the possibility of leasing the computer. The computer sales firm has
offered JSC a four-year lease contract with annual payments of $18,000. In addition, if JSC leases
the computer, the lessor will absorb insurance and maintenance expenses valued at $2,000 per
year. Thus JSC will save $2,000 per year if it leases the asset (on a before-tax basis).
1. Evaluate the net present value of the computer purchase. Should the computer be acquired
via purchase? (Hint: Refer to Tables 24-3 and 24-4.)
2. If JSC uses a 40 percent target debt to total assets ratio, evaluate the net present value advan-
tage of leasing. JSC can borrow at a rate of 8 percent with annual installments paid over the
next four years. (Hint: Recall that the interest tax shelter lost through leasing is based on a
loan equal to the full purchase price of the asset, or $60,000.)
3. Should JSC lease the asset?

STUDY PROBLEMS (SET B)

24-1B. (Calculation of balloon payment for a term loan) In March, the Cross National Bank agreed
to finance the purchase of a new building for Harris Tweed’s men’s wear shop. The loan is for
$300,000 and will carry a 12 percent annual rate of interest with annual compounding. The loan
will require that Harris make four annual installments of $60,000 at the end of years 1 through 4.
In year 5, Harris must make a large balloon payment which will fully retire the outstanding loan
balance. What is the fifth-year balloon payment?
24-2B. (Calculating lease payments) Raucher Leasing, Inc., calculates its lease payments with a
15 percent pre-tax return. The firm has been asked to quote rental payments on a $250,000 piece
of equipment which is to include 10 payments spread over nine years (the first payment is made
immediately upon signing of the agreement with the remaining payments coming at the end of
each of the next nine years). What amount should Raucher quote on the lease?
24-3B. (Installment payments) Compute the annual payments for an installment loan carrying a
16 percent rate of interest, a seven-year maturity, and a face amount of $100,000.
24-4B. (Principal and interest components of an installment loan) Compute the annual principal and
interest components of the loan in problem 24-3B.
24-5B. (Cost of an intermediate loan) Azteca Freight Forwarding Company of Laredo, Texas,
needs $300,000 to complete the construction of several prefabricated metal warehouses. The
firm that produces the warehouses has offered to finance the purchase with a $50,000 down
payment followed by five annual installments of $69,000 each. Alternatively, Azteca’s bank
has offered to lend the firm $300,000 to be repaid in five annual installments based on an
annual rate of interest of 16 percent. Finally, the firm could finance the needed $300,000
through a loan from an insurance company requiring a lump-sum payment of $425,000 in
five years.
a. What is the effective annual rate of interest on the loan from the warehouse producer?
b. What will the annual payments on the bank loan be?
c. What is the annual rate of interest for the insurance company term loan?
d. Based on cost considerations only, which source of financing should Azteca select?
24-6B. (Intermediate-term credit) Powder Meadows, a western ski resort, is planning to purchase
a $500,000 ski lift. Powder Meadows’ bank has offered to lend it the full $500,000. The note
would be paid in one payment at the end of four years and would require payment of interest at
a rate of 14 percent compounded annually. The manufacturer of the ski lift has offered to finance
the $500,000 purchase with an installment loan. The loan would require four annual installments
of $175,000 each. Which method of financing should Powder Meadows select?
24-7B. (Lease-versus-purchase analysis) KKR Live, Inc., a carnival operating firm based in
Laramie, Wyoming, is considering the acquisition of a new German-made carousel, with a pas-
senger capacity of 30. KKR can purchase the carousel through the use of its normal financing
mix (30 percent debt and 70 percent common equity) or lease it. Pertinent details follow:
24-25 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

Acquisition price of the carousel $25,000

Useful life 4 years
Salvage value $5,000
Depreciation method Straight-line
Annual cash savings before tax and depreciation from the $7,000
carousel
Rate of interest on a four-year installment loan 11 percent
Marginal tax rate 50 percent
Annual rentals (four-year lease) $7,000
Annual operating expenses included in the lease $1,250
Cost of capital 13 percent

a. Evaluate whether the carousel acquisition is justified through normal purchase financing.
b. Should KKR lease the asset?
24-8B. (Installment loan payment) Calculate the annual installment payments for the following
loans:
a. A $125,000 loan carrying a 13 percent annual rate of interest and requiring 12 annual
payments.
b. A $125,000 loan carrying a 13 percent annual rate of interest with quarterly payments
over the next six years. (Hint: Refer to Chapter 5 for a discussion of semiannual com-
pounding and discounting.)
c. A $125,000 loan requiring annual installments for each of the next five years at a 13 per-
cent rate of interest. However, the annual installments are based on a 30-year loan
period. In year 5, the balance of the loan is due in a single (balloon) payment. (Hint:
Calculate the installment payments using n = 30 years. Next use the procedure given in
Table 24-1 to determine the remaining balance of the loan at the end of the fifth year.)
24-9B. (Lease-versus-purchase analysis) Lubin Landscaping, Inc., has decided to purchase a truck-
mounted lawn fertilizer tank and spray unit. The truck would replace its hand-held fertilizer
tanks, providing substantial reductions in labor expense. The firm estimates that the truck will
cost $65,000 to purchase and will last four years, at which time it can be salvaged for $8,000. The
firm’s tax rate is 50 percent, and its cost of capital for projects of this type is estimated to be
14 percent. Over the next four years, the management of Lubin estimates that the truck will
reduce operating expenses by $29,000 a year before depreciation and taxes. Lubin uses straight-
line depreciation.
Lubin is also considering the possibility of leasing the truck. The truck sales firm has offered
Lubin a four-year lease contract with annual payments of $20,000. In addition, if Lubin leases
the truck, the lessor will absorb insurance and maintenance expenses valued at $2,250 per year.
Thus, Lubin will save $2,250 per year if it leases the asset (on a before-tax basis).
a. Evaluate the net present value of the truck purchase. Should the truck be acquired via
purchase? (Hint: Refer to Tables 24-3 and 24-4.)
b. If Lubin uses a 40 percent target debt to total assets ratio, evaluate the net present value
advantage of leasing. Lubin can borrow at a rate of 8 percent with annual installments
paid over the next four years. (Hint: Recall that the interest tax shelter lost through leas-
ing is based on a loan equal to the full purchase price of the asset or $65,000.)
c. Should Lubin lease the asset?
 CHAPTER 24 TERM LOANS AND LEASES 24-26

SELF-TEST SOLUTIONS

ST-1.
TIME PAY M E N T P R I N C I PA L INTEREST REMAINING BALANCE
0 $50,000.00
1 $13,189.83 $ 8,189.83 $5,000.00 41,810.17
2 13,189.83 9,008.81 4,181.02 32,801.36
3 13,189.83 9,909.69 3,280.14 22,891.67
4 13,189.83 10,900.66 2,289.17 11,991.01
5 13,189.83 11,990.73 1,199.10 0.28a
aRounding error.

∑ (1.14)
1
ST-2. a. Payment = $100,000 ÷ t
t =1
= $29,128.35
b.
TIME PAY M E N T P R I N C I PA L INTEREST REMAINING BALANCE
0 — — — $100,000.00
1 $29,128.35 $15,128.35 $14,000.00 84,871.65
2 29,128.35 17,246.32 11,882.03 67,625.33
3 29,128.35 19,660.80 9,467.55 47,964.53
4 29,128.35 22,413.32 6,715.03 25,551.21
5 29,128.35 25,551.18 3,577.17 .03a
aRounding error.

c. Because the plan B loan includes a $20,000 balloon payment, the five annual install-
ments have a present value of only:
$89,613 = $100,000 − $20,000/(1.14)5
Therefore, the annual installments can be calculated as follows:
5

∑ (1.14)
1
Payment = $89,613 ÷
t
t =1
= $26,102.79
ST-3. a. NAL = $1,772.69. (Calculations are found in the following table.)
b. The NAL is positive, indicating that the lease would offer cost savings over a purchase
and therefore should be used.
24-27 PA R T 6 S P E C I A L T O P I C S I N F I N A N C E

A F T E R - TA X
O P E R AT I N G TA X S H E LT E R DISCOUNT
EXPENSES A F T E R - TA X ON TA X S H E LT E R F A C T O R AT
PA I D B Y R E N TA L DEPRECI- ON LOAN BORROWING PRESENT
YEAR LESSORa EXPENSESb AT I O N c INTERESTd R AT E e VA L U E
t Ot(1−T) − Rt(1−T) − DtT − ItT = SUM × DF = PV
0 $2,400 $14,400.00 −$12,000.00 1.000 −$ 12,000.00
1 2,400 14,400.00 $8,000.00 4,800.00 − 24,800.00 0.9328 −$ 23,134.33
2 2,400 14,400.00 8,000.00 4,044.43 − 24,044.43 0.8702 −$ 20,923.05
3 2,400 14,400.00 8,000.00 3,198.20 − 23,198.20 0.8117 −$ 18,830.85
4 2,400 14,400.00 8,000.00 2,250.42 − 22,250.41 0.7572 −$ 16,848.41
5 8,000.00 1,188.90 − 9,188.90 0.7064 −$ 6,490.67
Total −$ 98,227.31
Plus: initial outlay 100,000.00
NAL =$ 1,772.69

a$4,000 (1 − .4) = $2,400. For simplicity we assume that the tax shields on expenses paid at the beginning of the year are realized immediately.
b$14,400 = $24,000 (1 − .4).
cThe machine has a zero salvage value. Thus, its annual depreciation expense is $100,000/5 = $20,000.
dBased on a $100,000 loan with four end-of-year installments and a 12 percent rate of interest. The loan payments equal $27,740.97.
er = 12% (1 − .40) = 7.20%
b