Chapter 13
Term Loans and Leasing
Slide Prepared by:
Abdullah Al Yousuf Khan
Assistant Professor – IUBAT
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
13.1 INTERMEDIATE-TERM BANK
LOANS
• Intermediate-term loans are loans with a maturity of more
than 1year.
• Intermediate-term loans are appropriate when short-term
unsecured loans are not, such as when a business is acquired.
• The interest rate on an intermediate-term loan is generally higher
than on a short-term loan because of the longer maturity date.
• The interest rate may be either fixed or variable (according to, for
example, changes in the prime interest rate).
• The cost of an intermediate-term loan varies with the amount of
the loan and the financial strength of the borrower.
• Ordinary intermediate-term loans are payable in periodic equal
installments except for the last payment, which may be higher
(referred to as a balloon payment).
• The schedule of loan payments should be based on the
borrower's cash flow position to satisfy the debt.
The amortization
• The amortization payment in a term loan equals:
EXAMPLE 13.1
• XYZ Company contracts to repay a term loan in
five equal year-end installments. The amount
of the loan is $150,000 and the interest rate is
10 percent. The amortization payment each
year is:
EXAMPLE 13.2
• Charles Company takes out a term loan in 20
year-end annual installments of $2,000 each.
The interest rate is 12 percent. The amount of
the loan is:
Amortization Schedule
• The amortization schedule for the first 2 years
is:
Year Payment Interest Principal Balance
0 $14,938.80
1 $2,000 $1,792.66 $207.34 $14,731.46
2 $2,000 $1,767,78 $232.22 $14,499.24
Revolving Credit
• Revolving credit, typically used for seasonal
financing, may have a 3-year maturity, but the
notes evidencing the revolving credit are
short-term, typically 90days.
• The advantages of revolving credit are flexibility
and readily available credit.
• Within the time period of the revolving credit
agreement, the company may renew a loan or
engage in additional financing up to a specified
maximum amount.
13.2 INSURANCE COMPANY TERM
LOANS
• Insurance companies and other institutional
lenders may extend intermediate-term loans to
companies.
• Insurance companies generally accept loan maturity
dates exceeding 10 years, but their rate of interest is
often higher than that of bank loans.
• Insurance companies do not require compensating
balances, but usually there is a prepayment penalty
involved, which is typically not the case with a bank
loan.
• A company may take out an insurance company loan
when it desires a longer maturity range.
13.3 EQUIPMENT FINANCING
• Equipment financing may be obtained from banks,
finance companies, and manufacturers of equipment.
• Equipment loans may be secured by a chattel mortgage or a
conditional sales contract.
• A chattel mortgage serves as a lien on property except for
real estate.
• In a conditional sales contract, the seller of the equipment
keeps title to it until the buyer has satisfied all the agreed
terms; otherwise the seller will repossess the equipment.
• The buyer makes periodic payments to the seller over a
specified time period.
• A conditional sales contract is generally used by small
companies with low credit ratings.
Loan Features
• Equipment may serve as collateral for a loan.
• An advance is made against the market value of
the equipment. The more marketable the
equipment is, the higher the advance will be.
• Also considered is the cost of selling the
equipment.
• The repayment schedule is designed so that the
market value of the equipment at any given time
exceeds the unpaid principal balance of the loan.
13.4 LEASING
• The parties involved in a lease are the lessor,
who legally owns the property, and the lessee,
who uses it in exchange for making rental
payments.
Types of Leasing
•For both financing and maintenance services.
•Agreement can be cancelled before the expiration date
Operating •The payments are not sufficient to recover the cost.
(service) lease •Lessor can be manufacturer or purchased the asset for
lease.
•Not for maintenance service.
•Payments covers the full price, and
Financial lease •Non cancellable.
•A company sells assets it owns to another company and
Sale and lease it back.
•Allows extra cash flow.
lease-back •Reduce the cost of investment.
•Third party acts as lender.
•Lessor borrows money from the lender to purchase
Leveraged lease properties.
•Then lease to lessee.
Advantages of Leasing
1. Immediate cash outlay is not required.
2. Typically, a purchase option exists, permitting the lessee to obtain the property at a
bargain price at the expiration of the lease. This provides the lessee with the
flexibility to make the purchase decision based on the value of the property at the
termination date.
3. The lessor’s expert service is made available.
4. There are generally fewer financing restrictions (e.g., limitations on dividends)
placed on the lessee by the lessor than are imposed when obtaining a loan to buy
the asset.
5. The obligation for future rental payment may not have to be reported on the
balance sheet.
6. Leasing allows the lessee, in effect, to depreciate land, which is not allowed if land
is purchased.
7. In bankruptcy or reorganization, the maximum claim of lessors against the company
is 3 years of lease payments. In the case of debt, creditors have a claim for the total
amount of the unpaid financing.
8. The lessee may avoid having the obsolescence risk of the property if the lessor, in
determining the lease payments, fails to accurately estimate the obsolescence of
the asset.
Drawbacks Of Leasing
1. A higher cost in the long run than if the asset is
purchased.
2. The interest cost associated with leasing is typically
higher than the interest cost on debt.
3. If the property reverts to the lessor at termination of
the lease, the lessee must either sign a new lease or
buy the property at higher current prices. Also, the
salvage value of the property is realized by the lessor.
4. The lessee may have to retain property no longer
needed (i.e., obsolete equipment).
5. The lessee cannot make improvements to the leased
property without the permission of the lessor.