Topic 10: Evaluating Asset Based Financings

Question 1

vendor financing

Answer 1

supplied by vendors to purchasers of their equipment. Finance is conditional on purchasing from the vendor.
Harvey Normal etc

Question 2

Lease Financing

1. What is a lease

Answer 2

1. Lease = debt obligation between lessor (owns the asset) and lessee (uses asset in exchange for payments)

Question 3

Finance Lease

1. Define
2. Lessee wears risk - how
3. Describe treatment under accounting standard

Answer 3

1. PV of lease p,mts substantially equal to value of asset or term of the lease covers useful life of asset
2. lessee usually wears the risk of the value of the lease term by the mechanism of a guaranteed residual.
3. Accounting standard requires that financial leases be capitalised (take PV of lease pmts & residual) and included as an asset & liability. Asset is depreciated & a borrowing cost is expensed in relation to the liability

Question 4

Operating Leases:

Answer 4

1. only cover portion of asset cost / asset life.
2. Op leases are office equipment, cars, etc.
3. Not req to be on B/S, just in notes to fin statements, although most credit analysts will account for op leases as debt by factoring in PV of lease payments.

Question 5

Why Lease:

Answer 5

(1) taxation: lessor might have tax shield > lessee.
(2) Asset life and residual risk: business may need to use asset for less than its useful life and attractive way to reduce residual risk.
(3) Flexibility of use: equip only needed for ST.
(4) Speed & cost: quickly with low trans costs.
(5) Secured form of financing: if unable to get debt, leasing provides alternative.

Question 6

INVALID REASONS for leasing:

Answer 6

(1) Improves B/S: not true: analysts assume as D even if not on there.
(2) Preserves borrowing capacity, not true as assumed as D.
(3) Avoid capex control

Question 7

Leases

Answer 7

1/ leases are basically debt
2/ therefore evaluate like debt
3/ hurdle rate = after tax cost of debt
4/ if leasing is cheaper than after tax cost of debt, then leasing is better

Question 8

Calculations for Finance Lease

• describe calc
• discount by x?
• salvage value?
• I(0) purchase price…

Answer 8

1. incremental cash flows of finance lease (pay lease pmts; receive tax shelter on lease pmts; vs saving the purchase price and giving up the tax shelter)
2. Discount by after tax cost of debt
3. salvage value is OMMITTED from finance lease because lessee usually receives the salvage value at conclusion
4. I(0) should be purchase price of asset ON MARKET not the purchase price specified by lessee

Question 9

Incremental value for an OPERATING lease

• describe calc
• discount by x?
• salvage value?

Answer 9

1. incremental cash flows of OPERATING lease Ensure that salvage value calcs are made. Find After tax salvage value; find PV of After tax salv value; discount; finally calculate incremental advantage.
2. Discount by appropriate risk adjusted discount rate; formula includes after tax cost of debt and WACC
3. salvage value is INCLUDED in operating lease as the lessee RETURNS the asset at the end, hence salvage value is foregone. Salvage value is a loss (incrementally).

Question 10

Equivalent Standard LOAN

1. definition
2. ESL used as…
3. decision if incremental NPV of alternative loan vs ESL is positive?

Answer 10

Equivalent Standard Loan

1. definition: $ amount of normal debt that is equivalent in CF servicing terms to our alternative loan
2. ESL used as a benchmark
   - measure the NPV of an alternative loan relative to its Equivalent Standard Loan
   - ESL refers to PV of the alternative loan’s CF discounted using the normal after tax cost of borrowing - ie how much debt could those CFs support if we pay our normal cost of borrowing
3. if incremental NPV of Alt Loan vs ESL is +ve; take out the Alt loan (we can borrow more without it costing more)

Question 11

Equivalent Standard DEBT

1. definition
2. NOTE Debt capacity and debt equivalence measured as…

Answer 11

Equivalent Standard DEBT

1. definition: the amount of normal debt the co could borrow at its normal cost BUT service the same CFs as the alt loan.
2. Debt capacity and debt equivalence measured as reference to PV of future committed CFs NOT the Principals borrowed at T=0. Need to measure effects of Pincialm + Int + Tax deduction

Question 12

Discounting when comparing cashflows, pre & post tax:

1. Compare Debt vs Equity; use (x)?
2. Compare one type of debt with another; use (?)

Answer 12

Discounting when comparing cashflows:
1. Compare Debt vs Equity; use PRE TAX
2. Compare one type of debt with another; use POST TAX
It does not matter if CFs are pre or post tax; it matters what you are comparing

Question 13

Finance Lease:
Equivalent Loan = ? (calc)
Equivalent Loan = ? (what are you trying to achieve)

Answer 13

Equivalent Loan = Incremental NCF(0) - NPV of lease
Equivalent Loan: you are trying to find how much normal debt the after tax cash flows from the lease would support.
Think of beg of year loan balance, less repayments = EOY.
Repayments are lease pmts: Lease, less payments at Kd; plus iTS = repayment

Question 14

Incremental value of OPERATING lease

Steps to calculating Salvage Value

Answer 14

• must include salvage value.
  1. Calc after tax salvage value
  2. Discount EMV (expected MV) by WACC and Book Value * T by Kd (1-T)
  3. Subtract this salvage value from the original equation for finance lease.

Question 15

Evaluate Asset Based financing: Describe:

1. Is the Alternative loan attractive?
2. If yes, accept Alt Loan Offer, but what impact does this have on project value?
3. Does Alt Loan give optimal amt debt? (too much? Too little?)

Answer 15

1. Is the Alternative loan attractive? Calc NPV advantage vs normal debt. Accept if positive
2. If yes, accept Alt Loan Offer, but what impact does this have on project value? When we value a project using WACC we embed an assumption of an after tax cost of borrowing for debt. If Alt Loan has NPV advantage over normal debt, this adds value to project
3. Does Alt Loan give optimal amt debt? (too much? Too little?) WACC embeds target D/V. Alt Loan may not be equivalent to targeted amt of debt. May need to top up or displace.

Question 16

To evaluate whether the Alternative Loan is attractive we need to compare each alternative loan to a benchmark. What is this Equivalent Standard Loan?

Answer 16

ESL = benchmark to beat.
ESL = PV of the Alt Loan’s cash flows discounted at the normal after tax borrowing.
That is: How much debt could those tax flows support if we had to pay our normal cost of borrowing?
If incremental NPV of alt loan vs ESL is positive; take the alt loan.

Question 17

Equivalent Standard Debt = ?

Answer 17

ESD = amount of normal debt the company could borrow at its normal cost of debt BUT service using the same cash flows as the Alt loan.
NOTE: Measure debt capacity and debt equivalence by reference to PV of future committed CFs; NOT the principals at T=0.

Question 18

One method of comparing ALTERNATIVE loan to Standard loan is to set out the cash flows for each. (eg paying interest at 8% over 5 years; and the cash flows for paying interest at 10% over 5 years).
Why is this not comparing like with like?

Answer 18

1. To set out the cash flows for the two different costs of debt does not take into account DEBT CAPACITY.
   The debt servicing obligations will be different, the debt capacity is different and we are not comparing like with like.
2. Rather than comparing Principals at T=0 (eg 7.5m each for ALT vs STD); we need to compare IDENTICAL CASH FLOWS.
3. We need the SAME AFTER TAX CASH FLOWS to keep debt servicing unchanged. The only difference will then be the amount borrowed at T=0.
4. The benefit of the loan is the additional amount that can be borrowed at T=0.

Question 19

Calculating Alt Loan vs Standard Loan

1. Which method;
   a) calculate the value of each of the ALT loan and the Standard Loan; get the difference. OR
   b) ; discount the CFs of the ALT loan by the STANDARD cost of debt

Answer 19

(b) is a shortcut.
Use (a) (ie calc each of the 2 components) for:
I) in the presence of tax losses
ii) when you need to consider the annual funding plan

Question 20

If the Alternative Loan (vs standard loan) is accepted; what is the impact on project value?

Answer 20

Revised NPV = NPV (normal debt) + NPV (Alt loan)
Calculate the value without the Alt loan. This will include an assumption on the benefits of debt financing (using WACC, APV or FTE approaches). Then just add on the incremental benefit. You are adding the INCREMENTAL benefit of the Alt Loan to the NPV of the normal.

Question 21

Alt Loan vs Standard Loan:

Comment on target debt ratio or displaced debt and using the APV method

Answer 21

If alternative loan is available for a project that supports the loan on a standalone basis, with no recourse to the parent, and there is no question about target D/V or displaced debt; you can use APV method.

Question 22

When to use pre vs post tax cost of debt

Answer 22

Use PRE TAX cost of debt when comparing additional value to Equity (ie using the APV / MM type of equation)
Use POST TAX when comparing debt with debt.

Question 23

Why is AFTER TAX cost of DEBT used to discount lease payments?

Answer 23

After tax cost of debt is the HURDLE rate.

It is not about the RISK of debt, it is concerned with what debt COSTS you (to determine the hurdle rate)