Lease vs Buy and Debt Financing Concepts

Lessee

In a lease agreement, the party that uses the leased asset and makes the rental payments.

Lessor

In a lease agreement, the party that owns the leased asset and receives the rental payments.

Operating lease

A lease whose term is much shorter than the expected useful life of the asset being leased.

Service lease

Requires the lessor to maintain and service the leased equipment.

Cancellation clause

Gives the lessee the right to cancel the lease and return the equipment before the lease expires.

Conventional terms

Fixed payments made to the lessor periodically, usually monthly (cost to lessee is known with certainty).

Per procedure lease terms

Fixed amount is paid each time the equipment is used (ex. Each x-ray taken).

Financial lease (capital lease)

A lease agreement that has a term life approximately equal to the expected useful life of the leased asset.

Sale and leaseback

User sells the asset to another party and sets an agreement to lease the property for a stated period (ex. real estate).

Guidance lease

Lease contract that meets the IRS requirements for a genuine lease, allowing the lessee to deduct the full amount of the lease from the taxable income.

Off-balance sheet financing

Financing that does not appear on a businesses balance sheet (ex. Short term operating lease).

Capitalizing the lease

Accounting rules require businesses that enter into certain leases to restate their balance sheet to report the leased asset as a fixed asset.

Residual value

The estimated market value of a leased asset at the end of the lease term.

Salvage value

The value of the asset at the end of the item's useful life.

Net advantage to leasing (NAL)

The discounted cash flow dollar value of a lease to lessee, similar to net present value.

Calculating After-Tax Salvage Value

1. Calculate the depreciation amount per year = (asset cost / year tax life). 2. Calculate the book value at the end of the project = (asset cost) - (depreciation x years for project). 3. Calculate the gain or loss on the sale of the asset = (salvage value - book value at the end of project). 4. Calculate the tax on the gain or loss = (gain or loss) x (marginal tax rate). 5. Calculate the after-tax cash flow from the sale of the asset = (salvage value) - (tax on gain or loss).

Financial leases vs operating leases

1. They typically don't provide maintenance. 2. They typically aren't cancellable. 3. For a period that approximates the asset's useful life. 4. Fully amortized.

Book value

How much the balance sheet says its worth.

After tax interest rate

What is the appropriate discount rate in a lease vs buy analysis?

After-tax interest rate

The interest rate after accounting for taxes.

Book value

Initial investment minus accumulated depreciation.

Gain/loss of an asset

Salvage value (selling price) minus book value.

Tax on gain/loss

Gain/loss of an asset multiplied by marginal tax rate.

After tax cash flow from sale of an asset

Salvage value minus tax or selling price minus tax savings.

After tax cost of debt

Interest rate multiplied by (1 - marginal tax rate).

Amount of interest net of taxes

(Cost of asset) multiplied by (after tax interest rate).

Depreciation tax shield in year __

(Cost of asset x MACRS tax depreciation for that year) multiplied by marginal tax rate.

Accounts payable (trade credit)

Firms making purchases from other firms on credit, recorded on balance sheet.

Credit policy

A business's rules and regulations regarding granting credit and collecting from buyers that take credit.

Discounts lost expense

If a business doesn't take the discount, the cost difference reported on the income statement.

Stretching

Cost of trade credit can be reduced by paying beyond the date the credit terms allow.

Free trade credit

The amount of credit received from a supplier that has no explicit cost attached.

Costly trade credit

The credit taken by a company from a vendor in excess of the free trade credit.

Compensating balance

A minimum checking account balance that a business must maintain to compensate the bank.

Line of credit

A loan arrangement in which a bank agrees to lend some maximum amount to a business over a designated period.

Pledging

If the person or firm that owes the receivable doesn't pay, the business that borrows against the receivable must take the loss.

Factoring

The receivables account is purchased by the capital supplier, generally without recourse to the selling business.

Term loan

Long term debt financing obtained directly from a financial institution.

Prime rate

Interest rate that banks charge their best, most trustworthy customers.

Bonds

A long term contract under which a borrower agrees to make payments of interest and principal on specific dates.

Corporate bond

Debt issued by for-profit businesses.

Municipal bond

A tax-exempt bond issued by government entities.

Zero coupon bond

A bond that pays no interest, bought at a discount from par value.

Mortgage bond

A bond issued by a business that pledges real property as collateral.

Payment-in-kind

Instead of paying interest, pays coupons that grant the lender additional bonds.

Debenture

An unsecured bond with no assets pledged as collateral.

General obligation bonds

Bonds backed by the full taxing authority of the issuer.

Special tax bonds

Bonds secured by a specific tax.

Revenue bonds

Bonds not backed by taxing power, but by revenues derived from projects.

Private placement

The sale of newly issued securities to a single investor or small group of investors.

Bond pools

Raise funds by issuing municipal bonds that are then loaned to not-for-profit hospitals.

Indenture

A legal document that spells out the rights and obligations of both bondholders and the issuing corporation.

Promissory note

A document that specifies the terms and conditions of a loan.

Restrictive covenant

A debt contract provision designed to protect creditors from managerial actions.

Debt financing

Characterized by an obligation to repay principal and interest on a prearranged schedule.

Maturity date

The date on which the principal amount of a loan must be repaid.

Refinancing

Involves either extending the maturity date or retiring existing debt and issuing new debt.

Secured debt

Guaranteed by the pledge of assets or collateral.

Trustee

An individual or institution that represents the interests of bondholders.

Call provision

A provision in a bond indenture that gives the issuing company the right to redeem the bonds prior to maturity.

Technical default

When a borrower fails to fulfill specific terms and conditions of their loan agreement.

Regular default

When an interest or principal payment is not made on time.

Investment grade bond

A bond with a BBB or higher rating.

Junk bond

A bond with a BB or lower rating.

Par value

The stated (face) value of the bond.

Coupon (interest) rate

The stated annual rate of interest on a bond.

Coupon payment

The dollar amount of annual interest on a bond.

Interest (current) yield

The annual interest return on a bond.

Capital gains yield

The percentage capital gain (loss) over some period.

Yield to maturity (YTM)

The expected rate of return on a debt security assuming it is held until maturity.

Yield to call (YTC)

The expected rate of return on a debt security assuming it is held until maturity.

Interest rate risk

The risk to current debt holders that stems from interest rate changes.

Reinvestment rate risk

The risk that falling interest rates will lower the returns on cash flows from bond investments.

Short term debt characteristics

Matures within a year and can be obtained more quickly than long-term debt.

General Valuation Model

A method that involves estimating the expected cash flow stream, assessing the riskiness of the stream, setting the required rate of return, and discounting and summing the expected cash flows.

Inverse relationship between interest rate and bond price

If R goes up, bond prices go down.

Disadvantages to term loans

A limit to the size of the term loan and lenders will not extend term loans to the maturity that businesses can attain in bond financing.

YTM

Yield to maturity, which is equal to the coupon rate.

Par Value

The bond price.

Computing yield-to-maturity in excel

Using the YIELD function with parameters such as settlement date, maturity date, coupon rate, price, redemption, and frequency.

Advantages to debt

Not an ownership interest, creditors don't have voting rights, and interest is considered a cost of doing business and is tax deductible.

Disadvantages to debt

Creditors have legal recourse if interest or principal payments are missed, and excess debt can lead to financial distress and bankruptcy.

Advantages to equity

Dividends are not a liability of the firm, stockholders have no legal recourse if dividends are not paid, and an all equity firm can't go bankrupt.

Disadvantages to equity

Ownership interest, common stockholders vote for the board of directors and other issues, and dividends are not considered a cost of doing business and are not tax deductible.

Government Bonds

Treasury securities which include federal government debt, T-bills, T-notes, and T-bonds.

T-bills

Pure discount bonds with original maturity of one year or less.

T-notes

Coupon debt with original maturity between one and ten years.

T-bonds

Coupon debt with original maturity greater than ten years.

Municipal securities

Debt of state and local departments with varying degrees of default risk and interest received is tax-exempt at the federal level.

Zero coupon bonds

Bonds that make no interest payments (coupon rate = 0%).

Yield-to-maturity for zero coupon bonds

Comes from the difference between the purchase price and the par value.

Bond ratings

Indicate how stable the company is.

Factors affecting required returns

Anything that affects the risk of the cash flows to the bondholders will affect the required returns, such as COVID, war, and tariffs.

Coupon rate

Fixed rate that does not change.

Coupon rate calculation

Coupon rate = (annual coupon rate / par value) x 100.

Current yield

Current yield = coupon (income) / current price payment.

Discount on bond purchase

Mary purchased a bond with a discount of $60.

Fund capital

Equity capital in a not-for-profit corporation, typically obtained from contributions and grants and by retained earnings.

Preferred stock

A form of equity financing that combines features of both debt and common stock.

Proxy fight

An attempt to take control of a corporation by soliciting the votes of current shareholders.