Raising Debt and Leasing

Question 1

What are some characteristics of debt?

Answer 1

• Temporary contribution of capital
• Usually no voting rights
• Fixed and prior ranking contractual right to return on capital
• Fixed and prior ranking contractual right to return of capital
• Least risky form of capital

Question 2

When a company borrows what are they obligated to do?

Answer 2

They are obligated to make regular interest payments and repay the principle at maturity

Question 3

What do lenders get if a company defaults?

Answer 3

They get to take over the assets of the comapny

Question 4

How do lenders get a say over decision making over a company?

Answer 4

They indirectly use covenants, both positive and negative, to protect themselves when lending

Question 5

What types of debt are there?

Answer 5

There is bank debt and issued debt

Question 6

What are some examples of bank debt?

Answer 6

• Bank overdraft (short term)
• Inventory loan (short term)
• Bridge loan (short term)
• Term loans (long term)

Question 7

What are some examples of issued debt?

Answer 7

• Commercial paper, Bills of exchange (short term)
• Debentures (medium-long term)
• Corporate bonds (long term)

Question 8

What types of debt covenants are there?

Answer 8

Negative covenants and positive covenants

Question 9

What do positive covenants do?

Answer 9

Positive covenants ask borrows to do things as part of their contact. This includes activites such as maintaining assets and providing audited financial statements to the lender.

Question 10

What do negative covenants do?

Answer 10

Negative covenants ask borrowers to avoid doing things as part of their contract. This includes limiting access to further debt, restrict holdings of certain inverstments and restrict dividend payout

Question 11

How is firm value derived?

Answer 11

Debt + Equity = Firm Value

Question 12

Under what conditions would equity be more valuable than debt?

Answer 12

Equity is more valuable if cash flows are more volitile. This gives shareholders more incentive to encourage risky projects

Question 13

What projects to debtholders dislike?

Answer 13

The dislike risky projects as they try to avoid the risk of shareholders defaulting. This is reduced through covenants which reduce firm downside risk.

Question 14

What is a lessor?

Answer 14

Legal owner/financer of asset

Question 15

What is a lessee?

Answer 15

The asset user

Question 16

What is a lease?

Answer 16

Contract where lessor recieves fixed payments from lessee in return for the use of the asset

Question 17

What are the two types of leases?

Answer 17

There are operating leases and finance leases

Question 18

What are some characteristics of operating leases?

Answer 18

• Like a rental agreement
• Cancellable by lessee at short notice typically without substantial penalty
• Risks of ownership borne by lessor
• Lessor is often a supplier of asset
• “Lease vs Buy” decision

Question 19

What are some characteristics of financing leases?

Answer 19

• Long term agreement
• Non-cancellable without substantial penalty
• Risks of ownership transfered to lessee
• Lessor generally a financial institution
• Effectively lessor is a source of finance for lessee
• “Lease vs borrow-buy” decision

Question 20

What is the discount rate for the NPV calculation?

Answer 20

interest rate x (1 - corporate tax rate)

Question 21

How do you calculate the tax shield of lease payments?

Answer 21

lease payments x corporate tax rate

Question 22

How do you calculate the tax shield of the depreciation?

Answer 22

depreciation x corporate tax rate

Question 23

How to you calculate the tax on gain/loss on sale?

Answer 23

(residual - book value) x corporate tax rate

Question 24

What sort of decision is is the decision to undertake a financial lease?

Answer 24

It’s a financial decision

Question 25

What are the advantages of leasing?

Answer 25

• Company taxation if companys are in different tax situations they can use leasing in a way n which both parties benefit from leasing
• Different costs of capital as if the cost of capital for the lessor is sufficiently lower than that of the lessee then they can both have NPV’s
• Transaction costs as if a lessee defaults on a lease payment lessors are subject to a less costly bankruptcy process
• Off balance sheet financing (dodgy), can do these days with regualtions in place