FNCE 20005 CORPORATE FINANCIAL DECISION
CORPORATE FINANCIAL DECISION
Hello, dear friend, you can consult us at any time if you have any questions, add WeChat: THEend8_
CORPORATE FINANCIAL DECISION
MAKING (FNCE 20005)
Faculty of Business and Economics
Department of Finance
1
LECTURE 3
RAISING CAPITAL: DEBT AND LEASES
Textbook Chapters 7, 15, 22
2
Big Picture of Corporate Finance
3
Shareholders’
equity
Current assets
Fixed assets
1. Tangible assets
(assets in place)
2. Intangible
assets (growth
assets)
Long-term debt
Short-term debt
Assets
generate
cash flow
Investors
provide capital
Investors get return on their capital
Table of Contents
1. Raising Debt Capital
2. Operating and Finance Leases
3. Financial Evaluation of Leasing
4. Suggested Advantages of Leasing
5. Hybrids
4
1. Raising Debt Capital
5
The Nature of Debt
• “Temporary” contribution of capital by investors
for a specified time
• Key characteristics:
• usually no voting rights
• fixed and prior ranking contractual right to a return on capital
• fixed and prior ranking contractual right to a return of capital
• from an investor’s view debt capital is the least risky type
• Different classes of debt typically distinguished by
differences in ranking
6
Debt Capital
• 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 are protected by
covenants
7
Default
8
Types of Debt: Bank or Issued Debt?
• Bank loans – preferred in Australia
• Bank overdraft
• Inventory loan
• Bridge loan
• Term loans (fixed, variable): long-term
• Debt securities - from capital markets
• Commercial paper, Bills of exchange: short-term
• Debentures: medium - long-term
• Corporate bonds, Unsecured notes: long-term
9
short-term (0 -12 months)
Sources of Debt Finance
Debt securities outstanding and issued by non-financial
corporations and bank-issued debt
Source: www.rba.gov.au Tables D4 and D5 accessed at 2 March 2022
The traded debt market in Australia is small relative to bank-debt
10
Type Amount ($bn)
Short-term securities issued in Australia 222.5
Long-term securities issued in Australia 574.3
Long-term securities issued off-shore 476.4
Bank-lending to business (direct) 1088.3
Debt Covenants
• Specific provisions in the debt contract
• Designed to protect interests of lenders
• Negative (or restrictive) covenants (“not to do”)
• limit access to further debt
• restrict holdings of certain investments
• restrict dividends paid
• Positive (or affirmative) covenants (“to do”)
• maintain assets (working capital or collateral)
• provide audited financial statements to the lenders
11
An example of restrictions
The March 27,1997 revolving loan agreement for casino operator Hollywood
Park, Inc. contains the following restrictions:
Capital Expenditures:
[Borrower shall not] Make, or become legally obligated to make, any Capital
Expenditure except:
(a) Maintenance Capital Expenditures not in excess of:
(i) $15,000,000 for the Fiscal Year ending December 31, 1997,
(ii) $15,000,000 for the Fiscal Year ending December 31,1998 and
(iii) $20,000,000 for any subsequent Fiscal Year;
(b) Capital Expenditures to the extent financed by Indebtedness permitted
under Section 6.9(h);
(c) Capital Expenditures for the construction of approximately 200 additional
hotel rooms, a restaurant, an entertainment lounge, meeting rooms, retail
space and parking facilities at the Reno Property not in excess of $25,000,000;
12
To Sum Up
• Debt + Equity = Firm Value (market value of assets)
• Equity
• Equity is more valuable if cash flows are more volatile i.e.
more to gain on the upside
• Therefore, shareholders have more incentive to take risky
projects
• Debt
• Debtholders’ main concern is shareholders defaulting
• Debtholders dislike risky projects: hence there may be
conflicting objectives between debtholders and shareholders
• Through covenants, debtholders try to reduce firm’s
downside risk
13
The nature of debt: Takeaways
• Takeaways
• Debt is a source of finance that provides contributors with a
superior claim to a return on – and of – capital.
• Debt involves choices beyond “should we borrow?”:
• Who should we borrow from?
• Should we borrow long-term or short-term?
• Should we borrow locally or overseas?
• Should we borrow at a fixed or variable rate? etc.
2. Operating and Finance Leases
15
What is Leasing?
• In the US, about 30% of new capital equipment is leased
(e.g.: trucks, farm machinery, railroad cars, aircraft, ships)
• Important terms
• Lessor = legal owner / financier of asset
• Lessee = the asset user
• Lease = contract where the lessor receives fixed
payments from the lessee in return for the use of the
asset
16
Example of Lessee
Qantas Aircrafts
17
Lease Example
18
Aircraft Manufacturer:
Airbus/Boeing
Lessor: GE Capital
• Owns the planes
• Does not use them
Lessee: Qantas
• Uses the planes
• Does not own them
Lessor arranges financing and buys asset
Lessee leases asset from lessor
and makes fixed payments
Two Types of Leases
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, typically without
substantial penalty
• Risks of ownership borne by lessor
• Lessor is often (or closely related to) a supplier of the
asset
• “Lease versus Buy” decision
19
Two Types of Leases – Cont’d
Finance Lease
• A long-term agreement (generally, over the life of the
asset)
• Non-cancellable without substantial penalty
• Risks of ownership transferred to lessee
• 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
20
Summary
21
Characteristics Operating
Lease
Finance
Lease
Term of lease Short-term Long-term
Cancellable? Yes Not without penalties
Legal Ownership Lessor Lessor
Risks of ownership are borne by Lessor Lessee
Lessor is often a… Supplier Financial institution
Lease is essentially a… Rental
agreement
Loan
Decision Lease vs. buy Lease vs. borrow-buy
3. Financial Evaluation of Leasing
22
Finance Lease Value
• Key Question: Lease vs. Borrow to buy?
• Use the NPV method 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
• But, which discount rate should be used for k?
23
= +
=
+
++
+
+
+
+=
T
t
t
t
T
T
k
C
k
C
k
C
k
C
CNPV
0
2
2
1
1
00
)1()1(
...
)1()1(
Finance Lease Value: Discount Rate
• Discount Rate: opportunity cost of capital
• Our alternatives are: 1) lease or 2) borrow to buy
• The opportunity cost of capital for the lease is
the after-tax cost of borrowing on an equivalent loan to
buy the asset:
After-tax cost of borrowing = interest rate (1 – corporate tax rate)
• We implicitly assume that the cash flows from leasing
are as safe as the interest and principal payments on a
loan issued by the lessee
24
Finance Lease Value: Tax-shield Effects
25
Company A Company B
Income 1000 1000
Allowable deduction
(e.g. interest or lease payment) - 100
Taxable income 1000 900
Tax Payable (tc=0.30) 300 270
Company B has a tax-shield of $30 = tc Deduction=0.3*$100
What are the tax-shields or tax payments related to a lease contract
and who is affected?
• 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)
Finance Lease Value
• For leasing to be advantageous for the lessee the finance
provided by leasing must be greater than the liability incurred
by leasing
• Six steps required for lessee to evaluate a lease
1. Cost of asset (avoid paying this)
2. Lease payments (must pay these)
3. Tax shield from lease payments (reduces tax payable)
4. Depreciation tax shield (miss out on this)
5. Residual payment/value (must pay/miss out)
6. Tax on gain/loss on sale of asset (depends) or
26
Financial evaluation of leases
• NPV of a lease from lessee’s point of view
• NPV of a lease from lessor’s point of view
l)PV(Residua
Deduction)ation PV(Depreci
Payments) from SavingsPV(Tax
Payments) PV(Lease Asset ofCost NPVLessee
−
−
+
−+=
*l)PV(Residua
*Deduction)ation PV(Depreci
*Payments) from SavingsPV(Tax
*Payments) PV(Lease*Asset ofCost NPVLessor
+
+
−
+−=
So – why do leases exist at all?
27
Finance Lease Value - Example
Davids Ltd needs to use a machine for its project that
costs $78,000 and has an expected life of 4 years and a
residual (or salvage) value of $20,600
• The machine can be leased over four years with annual
payments of $21,300 payable in advance
• The company annual tax rate is 34%
• Straight-line depreciation (full depreciation) is used
• The cost of borrowing is 15% p.a. (before-tax)
• The required rate of return for the machine is 22% p.a.
Q. Should Davids Ltd lease or borrow-buy?