Raising Capital: Debt and Leases

Question 1

What are some basic facts of debt capital？

Answer 1

• More frequent/important than equity financing
• When companies borrow money, they are obligated to:
• make regular interest payments and
• repay the principal at maturity (fixed-term)
• Interest payments are tax-deductible
• Firms (stockholders) may “default” on their obligations (“default risk”)
• Upon default, lenders will take over the firm’s assets
• Lenders have no voting power, but protected by covenants

Question 2

What are debt covenants and their difference?

Answer 2

• Specific provisions in the debt contract
• Designed to protect interests of lenders
• Negative (or restrictive) covenants (“not to do”)
e.g. restrict holdings of certain investments or dividends paid
• Positive (or affirmative) covenants (“to do”)
e.g. provide audited financial statements to the lenders

Question 3

What are different types of debt?

Answer 3

-Bank loans and debt securities
1. Bank loans – preferred in Australia
• Bank overdraft
• Inventory loan
• Bridge loan
• Term loans(fixed,variable):long-term
2. Debt securities-from capital markets
• Commercial paper, Bills of exchange: short-term
• Debentures:medium-long-term
• Corporate bonds, Unsecured notes: long-term

Question 4

Debt vs Equity payoffs (shareholder& debt holder conflicts)

Answer 4

1. Stockholders care more about ‘upside’ payoff while debt holders worry more about ‘downside’ payoff (no upside)
2. equity+ debt = firm value (market value of asset)
   － Equity
   • Equity is more valuable if cash flows are more volatile i.e. more to gain on the upside
   • Therefore, S have more incentive to take risky projects － Debt
   • D’s main concern is S defaulting
   • D dislike risky projects: hence conflicting objectives
   between D and S
   • Through covenants, D try to reduce firm’s downside risk

Question 5

What is leasing?

Answer 5

• In the US, about 30% of new capital equipment is leased (e.g.: railroad cars, aircraft)
• Lessor = legal owner / financier of asset (use not own)
• Lessee = the asset user (own not use)
• Lease = contract where the lessor receives fixed payments from the lessee in return for the use of the asset

Question 6

What does a lessor do?

Answer 6

• GE Capital Aviation Services
• Buys aircraft from manufacturers such as Airbus and Boeing
• Leases them to airlines such as Qantas

Question 7

What are the two types of leases?

Answer 7

Operating Lease
• Operating lease is like a rental agreement (generally, short-term) e.g.: Cars, Telephones, Computers, Coffee machines…
• Cancellable by lessee at short notice or without substantial penalty
• Risks of ownership borne by lessor – why?
• Lessor is often (or closely related to) a supplier of the
asset
• “Lease versus Buy” decision

Finance Lease
• A long-term agreement (generally, over the life of the asset)
• Non-cancellable without substantial penalty
• Risks of ownership transferred to lessee – why?
• Lessor is generally a financial institution
• Effectively lessor is a source of finance for lessee - an alternative to borrowing funds to buy an asset
• “Lease versus Borrow-to-buy” decision

Question 8

What are some differences between operating and financing lease?

Answer 8

1. term of lease: 
short- term /long- term
2. Cancellable?: 
Yes/No(penalties)
3. Legal Ownership:
Lessor/ Lessor
4. Risks of ownership are borne by: 
Lessor/Lessee
5. Lessor is often a:
Supplier/Financial institution
6. Lease is essentially a: 
Rental agreement/ Alternative to borrowing to buy
7. Accounting treatment:
Not on Balance sheet/ Recognized as asset and liability on B/S (will use up some of debt capacity)
8. Decision:
Lease vs. buy/ Lease vs. borrow-buy

Question 9

How to compare lease VS borrow to buy decision?

Answer 9

NPV - to value a finance lease
• Identify the incremental cash flows from leasing as opposed to borrowing to buy
• Discount these cash flows and sum them up to get NPV
• The discount rate: opportunity cost of capital”
Incremental CF from leasing vs. borrow-to-buy (from lessee’s viewpoint):
CFs(Leasing) -CFs(Borrow-to-Buy)

Question 10

What are the tax-shields or tax payments related to a lease contract?

Answer 10

•Tax- shields from lease payments 
(lessee)
•Tax-shields from asset depreciation (lessor-owner of the asset)
• Tax on gain from the sale of asset 
(lessor -owner of the asset)

Question 11

What is the maximum annual lease payment

the lessee would be willing to pay?

Answer 11

Financing can complement investment strategy
Lease pr Buy- using debt, this is a financing decision, not an investment decision, whether to invest in this project is a separate question. But, a favorable lease may create wealth, that is, NPV(project via leasing)> NPV(project via borrowing)

Question 12

What is operating lease value?

Answer 12

•Lessee has the option to cancel an operating lease
without (significant) penalty
∴riskier fora lessor than a finance lease
•The cancellation option is valuable to the lessee:
e.g. Insurance against premature obsolescence
&Allows lessee to reduce operating expenses when demand is weak to remain profitable
•NPV(operating lease)= NPV(finance lease)+ PV(option to cancel)

Question 13

Why does leasing exist?

Answer 13

• Without any “market frictions”, the lessor and lessee have the same discount rates and their payoffs are equivalent,
but with opposite signs i.e. NPV = −NPV 𝐿𝑒𝑠𝑠𝑜𝑟 𝐿𝑒𝑠𝑠𝑒𝑒
So leasing would not exist
• However, the real world has market frictions that enable both NPV > 0 and NPV > 0 such that we
observe leasing in real life!

Question 14

List of advantages of leasing

Answer 14

frictions such as taxes, transaction costs, asymmetric information etc. and they affect the lessor and lessee differently
• Suggested advantages of leasing (sensible yes or dubious no)
• Company taxation yes
• Different costs of capital yes
• Transaction costs yes
• Off-balance sheet financing no

Question 15

Company taxation

Answer 15

• If the lessor’s tax rate is higher than the lessee’s, and if the lessor shares some of the tax benefits to the lessee in the form of low lease payment, leasing exists
• In what circumstances are firms on different tax rates? different countries, larger or smaller firms

Question 16

Different cost of capital

Answer 16

• If the cost of capital for the lessor is (sufficiently) lower than that of the lessee, we can have both NPV > 0, 𝑙𝑒𝑠𝑠𝑒𝑒 𝑙𝑒𝑠𝑠𝑜𝑟 𝑙𝑒𝑠𝑠𝑜𝑟 𝑙𝑒𝑠𝑠𝑒𝑒 and NPV > 0 i.e. when 𝑘or < 𝑘ee
• Lessor can borrow at cheaper rates. Why?
• Lessee bears the risks of ownership (in a finance lease)

Question 17

Transaction costs

Answer 17

•(Bankruptcy cost are much lower when having leasing, then the borrowing rate can be cheaper because the lessor hold assets

• Standardization also leads to low administrative and transaction costs
• e.g.: Bank gives cheaper rate when dealing with 1 lessor buying 100 than 100 lessee each buying 1

Question 18

Off-balance Sheet Financing

Answer 18

• Historically in some countries, finance leases were off balance sheet financing
• so BS basically understated the true leverage ratio or debt capacity (and thus, true financial risk) look good
• Accounting standards now require capitalization of finance lease obligations where the lease is non-cancellable and
• Lease term > 75% of the asset’s useful life or
• PV(Lease payments) > 90% of the fair value of the asset to the lessor

Question 19

Is the following statement True or False?

“Leasing increases debt capacity because it is off- balance sheet”

Answer 19

Telling the market or not, financial risk will increase any way. Maybe getting lower borrowing cost as being a safer firm

Question 20

What factors contribute to some assets being more likely to be leased ?

Answer 20

1. Flexibility and Transaction Costs
   • Quality assessment and ownership transfers involve transactions costs
   • The higher these costs, the more likely an asset will be leased
2. Comparative Advantage in Asset Acquisition/Disposal
   • If lessor can get higher disposal value than lessee or obtain asset at lower market price, asset is more likely to be leased

Question 21

What factors contribute to some assets being more likely to be purchased?

Answer 21

1. Sensitivity to Use and Maintenance
   • Lessee has little incentive to care for an asset when they have no right to its salvage value
   • Lessor incorporates the risk of abuse into lease payments
2. Specialised Assets
   • Lessee values specialised assets more than lessor
   • Disposal value for lessor is uncertain if no active second-hand market

Question 22

Leasing is ‘off the balance sheet’ so it s not needed when calculate companies capital structure.

Answer 22

We disagree with this statement. Leasing is a form of debt and should be treated as debt by management when it evaluates its company’s capital structure. Similarly, prospective lenders can be
expected to take into account the effect of lease commitments on a company’s ability to service debt. The basis for statements such as the one in the question is that, formerly, a company was not required to disclose its finance lease obligations in its financial statements. Therefore, leasing was a form of ‘off-balance sheet’ financing, and a popular view was that the leasing of an asset(s) did not reduce a
company’s access to other forms of debt. In other words, leasing used to increase a company’s access to debt but not anymore. The current Australian accounting standard requires disclosure of lease.
Therefore, the lease is now “on the balance sheet”.

Question 23

Is leasing aircraft a good choice?

Answer 23

Leasing aircraft under operating leases provides an airline with flexibility. In particular, if there is a downturn in demand for air travel, leased aircraft can be returned to the lessor at no cost to the lessee.
In contrast, if an airline wishes to sell surplus aircraft, there are likely to be delays in finding buyers and the price may be depressed, particularly if other airlines are experiencing similar declines in demand. The main disadvantage of leasing is that it is likely to be more costly than owning. This is to
be expected, because aircraft lessors will charge for providing the option to cancel the lease. Hence, to obtain a degree of flexibility at a reasonable cost, airlines usually lease only some of the aircraft they use.