finance management fin420 chp 8

Intermediate-Term Financing Chapter 8

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Intermediate financing involves a repayment period of

between 1 to 10 years. These funds can be obtained

either by borrowing directly from the banks, insurance

companies or other financial institutions in the form of

term loans or relying on hire-purchase financing or

lease financing.

Learning objectives

After learning this chapter, you should be able to:

1. Identify different types of intermediate financing

2. Calculate and prepare an amortization loan schedule

3. Calculate and make decision on whether to acquire assets through

leasing or by borrowing.

Intermediate-Term Financing

GOAL

Chapter 8 Intermediate-Term Financing

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8.0 INTRODUCTION Intermediate term financing is another alternative source of financing that has relative

importance to financial managers. It consists of term loans, leases and hire purchase.

These sources of financing have several common factors, such as their maturity usually

from 1 to 10 years and represent liabilities that carry an explicit interest rate, or in case of

leases it may be implied, and has to be repaid according to a fixed payment schedule. The

following sections will focus specifically on the characteristics and costs of financing of

each category to provide more insight to alternative sources of financing especially for

small and medium size firms that does not have easy access to capital markets.

8.1 TERM LOANS A term loan represents a type of intermediate-term debt extended under a formal loan

arrangement by commercial banks, equipment manufacturers, insurance companies, and

pension funds. It is used by most businesses especially for small and medium size firms

that lack of access to the public capital markets. Firms tend to use term loans because it

involves minimum formal procedures, flexible provisions, competitive rates, and can be

raise conveniently and easily.

Usually payments will cover both interest and principal and are made monthly, quarterly,

semiannually, or annually depending on the agreed terms between the firms management

and lender. The amount of loan and the repayment schedule is geared to the firms ability

to generate cash flow in future and may be fully amortized or has a balloon payment. The

common attributes of term loans are as follows:

1. The maturities of term loans are usually as depends on the source of credit. For

example, commercial banks between 1 to 5 years, insurance companies 5 to 15

years, and pension funds 5 to 15 years.

2. Majority of term loans is made on secured basis. Shorter maturity loans are

usually secured with a chattel mortgage on machinery and equipment or securities

such as stocks and bonds. Longer maturity loans are frequently secured by

mortgages on real estate. In addition to collateral, the lender on a term loan

agreement will often place restrictive covenants that are designed to maintain the

borrower's financial condition on a par with that which existed at the time the loan

was made.


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3. Provisions of Loan Agreements. It is customary for lenders to use loan agreements that spell out the terms of the loan and sets up certain conditions that

the borrower must met. The loan agreement specifies the principal, the maturity,

and interest rate on loan, payments date, collateral, and actions to be taken in even

of default. In addition, covenants, or restrictions on a borrower imposed by a lender

are spelled out that allows the lender to act or be warned early when adverse

developments are occurring that will affect the borrowing firm.

8.1.1 Purpose of Term Loans

Most term loans are made to finance the purchase of equipment, enables

the firm to acquire the use of high priced assets with minimum down

payment with the balance are paid systematically over time. This will

conserve the needed cash flows within the firm. Term loans also represent a

major source of funds to finance significant builds up in permanent working

capital such as inventories due to the increase in the operations.

In addition, term loans can be used as interim financing during high market

interest rates that prevent the firm to issue long-term debt. In the case of

interim loan, the loans are not amortized as it is going to be refinanced at

the end of maturity. Another use of term loans is for refinancing purposes.

Most of the time it is done to change the firms financial structure as

changing the debt maturities and to lower the cost of interests.

As source of financing, term loans provides flexibility in terms of repayment

schedules, annual payments, and adjustment to the changing needs of the

borrower as the loan can be revised more quickly and more easily. It is also

highly dependable as the arrangement can be made quickly and is more

readily available over time making, especially for smaller firms with limited

access to capital market.

On the other hand, the presence of loan provisions, at times, is too

restrictive and may hinder the firms ability to finance the future growth and

reduce management flexibility. Another disadvantage of term loans is that

the cost may be high, especially when it involves the issuance of options on

warrants, when exercised will significantly increases the cost of borrowing.


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8.1.2 Costs and Repayment of Term Loans

The interest rate on term loans is higher than on a short-term loan to the

same borrower. For example for a low risk borrower, interest charged is

higher between 25 to 50 basis points (0.25% to 0.50%) above the prime

rate. With floating rates, the interest charged will vary between a floor rate

and a ceiling rate. The actual cost of the loan will vary depending on the

actual cost of money, the loans term to maturity, the size of the principal,

and the financial riskiness or credit worthiness of the borrower. In addition to

the interest charged, the borrower is also required to pay legal expenses

regarding the loan agreement and a commitment fee of 25 to 75 basis

points may be imposed on the unused portion.

Each installment payment includes both an interest and a principal

component, and it is a major concern for the borrower as it represents fixed

obligations that may restrain the firms future cash flow. Term loans are

generally repaid in periodic installments in accordance with repayment

schedules established by the lender, known as amortization schedule.

In the following example we will learn how to calculate the periodic

payments that the borrower will have to pay over the life span of the loan.

1. Suppose Ah Meng wants to make a loan for RM 15,000 with an

interest of 8% per annum. Payment is to be made at the end of each

of the next 5 years. Calculate how much Ah Meng has to pay

periodically and prepare an amortization schedule for the loan.

T = 0 1 2 3 4 5

RM15,000 A A A A A

Let A be the periodic payment.

To calculate A, you can use the formula for calculating the ordinary

annuity cash flow for the time value of money.


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Formula used;

PV = FVA(PVIFA 8%, 5)

15,000 = FVA(3.9927)*

FVA = 15,000 3,9927

= 3,756.57

The figure is derived from Present Value Annuity Table in Appendix

in any Finance textbook.

Hence, the equal series of payment that Ah Meng has to pay at the

end of the year for 5 years is RM3,756.57.

Table A represents an amortization schedule that contains the

principal and interest components of the term loan taken by Ah

Meng. As seen in the Table installment of RM3,756.57 gives the

finance company an 8% return on the RM15,000 loan due.

TABLE A AH MENG S TERM LOAN AMORTIZATION SCHEDUFLE

END OF YEAR

ANNUAL PAYMENT INTEREST PRINCIPAL BALANCE

T 0

1

2

3

4

5

A -

3,756.57

3,756.57

3,756.57

3,756.57

3,756.57

B -

1,200.00

995.47

774.59

536.03

278.38

C -

2,556.57

2,761.10

2,981.98

3,220.54

3,978.19

D

15,000

12,443.43

9,682.33

6,700.35

3,479.81

1.62*

* Due to rounding up of the figures


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Column B : Interest = Interest Rate (Loan Amount)

= 0.08 (15,000) = 1,200.00

Column C : Principal = Annual Payment Interest

= 3,756.57 1,200 = 2,556.57

Column D : Balance = Loan Amount Principal

= 15,000 2,556.57 = 12,443.43

* Interest is calculated using PRT formula.

2. Golden Company is considering the purchase of a regulating

machine that costs RM100,000 through 5-year installment loan at

10%. The loan will be fully amortized. The installment payments can

be determined by setting the loan principal as the present value of

the installment payments as follows:

Loan principal P = Installment payments (PVIFAk,n )

Installment payments IP = P / PVIFAk,n

= 100,000 / PVIFA10%,5

= 100,000 / 3.7908

= 26,379.66

Therefore, Golden will make five annual installments of

RM26,379.66 to retire the principal portion of the loan of RM100,000,

and provide the lender with a return of 10% return on investment.

The breakdown of principal payments and interest payments of the

loan payments are shown in Table 8-1, the amortization schedule.

Note that installment payments are rounded to the next Ringgit

RM26,380, and thus the final payment will be adjusted to reflect the

rounding of installment payments.


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Table 8-1 Amortization Schedule for RM100,000, 5-year Term Loan at 10%

A = E t1 B = IPt C = A(k%) D = B C E = A D Year

Beginning Balance

Installment payments

Interest expenses

Principal payments

Ending balance

1 100,000.00 26,380.00 10,000,00 16,380.00 83,620.002 83,620.00 26,380.00 8,362.00 18,018.00 65,602.003 65,602.00 26,380.00 6,560.20 19,819.80 45,782.204 45,782.20 26,380.00 4,578.22 21,801.78 23,980.425 23,980.42 26,378.46 3,398.04 23,980.42 0.00

Table 8-1 shows that the principal balances declines each year by the amount of

the preceding years payment credited to principal. The decline in principal balance

results in decreasing interests and increasing installment payments as the loan

nears maturity. To fully repay the loan, the final installment payment in year 5 is

recalculated to cover the actual remaining principal repayment and the associated

interest as follows:

Final Installment payment IP5 = Beginning balance (1 + k)

= 23,980.42 (1.10)

= 26,378.46

8.2 LEASE FINANCING A lease is a rental agreement that extends for one year or longer that allows a firm to

acquire the use of asset without having to purchase it. The firm obtains the services of the

leased asset, but not the title to it. The owner of the asset or the lessor holds the title, but

grants exclusive use of the asset to the lessee for a fixed period. In return, the lessee

makes fixed periodic payments to the lessor, and this characteristic is quite similar to

borrowing. Lease displaces debt whereby missed lease payments can result in the lessor

claiming the asset, filing lawsuits, forcing firm into bankruptcy. Risk of a firms lease

payments is similar to those of its interest and principal payments. At termination, the

lessee may have the option to either renew the lease or purchase the equipment.

Leasing allows companies with higher taxable income to own equipment (lessor) and takes

accelerated depreciation, while a marginally profitable company (lessee) would prefer the

advantages afforded by leases. Thus, leases provided a means of shifting tax benefits to

companies that can fully use those benefits. Leasing has become a major source of

financing to business, and is used by small companies as well as blue chip companies.

Several important issues concerning lease financing are what are the advantages and


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obligations, who maintains the asset, is the lease cancelable or not, and what is the

lessees options at expiration of the lease?

8.2.1 Type of Leases

There are several types of leases, which a firm can enter into. With a full

service lease, lessor responsible for maintenance, insurance, and property

taxes due on them. On the other hand, net lease, lessee responsible for

maintenance, insurance, and property taxes. There are two types of leases,

which differ in their terms and the right to cancel during the contract period.

1. Operating lease is a short-term contractual agreement whereby

lessee ogres to make periodic payments to the lessor for the use of

an asset. It is also known as service lease because it requires the

lessor to maintain and service the asset. Due to its short-term in

nature, the value of the assets is not fully amortized and lessor will

depends on subsequent leases and /or disposal of the asset to

recover the full cost of the equipment. Normally operating lease is

cancelable at lessees option before the end of the lease period, as

the asset is no longer needed or becomes technically obsolete.

2. Financial lease is a long-term contract that is similar to a loan agreement and non-cancelable before the end of the lease period.

Normally it does not provide maintenance or service, not cancelable

without a penalty, and the asset is fully amortized from lease

payments over the life of the lease. Financial lease requires the

lessee to reimburse the lessor for any losses because of the

cancellation, and thus, the cost of cancellation is very high.

Financial lease represents a major source of intermediate and long-term

financing. Its is similar to term loans whereby the lessee has the exclusive

right to use the assets and receives the benefits from the usage of the

asset, except for tax benefits of depreciation and interest expenses. As

mentioned, a lease is very much like a secured loan, failure to meet the

lease payments will results in similar situations as if failure to make periodic

installment payments on loan agreement. Most financial leases are:


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1. Direct leases. In a direct lease, the firm acquires the services of an asset it did not previously own and is generally new. Normally lessee

identifies the asset it requires, and negotiates the price and delivery

terms with the lessor, either a manufacturer or arranges with lessor

to buy it from manufacturer as depicted in the diagram below. This

type of lease is often called a net lease as the lessor receives return

net of maintenance, insurance, and property tax expenses. Lessors

are insurance companies, institutional investors, finance companies,

and independent companies. For example, the firm often leases an

asset direct from a manufacturer such as computers from IBM and

copier machines from Xerox.

2. Sale-and-lease-back agreements. A firm may sells asset it already owns such as land, buildings, or equipment normally at market

value, and then leases the asset back from the buyer for a specific

period of times and under specific terms. It is used to raise needed

capital while retaining the economic use of the asset. Lessee

receives cash from the sale of the asset, and lessor assumes legal

ownership and receives associated benefits such as tax deductions

and the residual value. The seller maintains physical possession and

the use of the asset in return for periodic lease payments, and

normally has the option to repurchase the asset at the end of the

lease period. There may be a tax advantage as land is not

depreciable, but the entire lease payment is a deductible expense.

or Lease

Lease Sale of asset

Manufacture/lessor

Manufacture

Lessee

Lessee

Lessee

Lessor

Lessor Sale of asset

Lease


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3. Leveraged leases. Leveraged lease is popular for big-ticket assets such as aircraft, oilrigs and railway equipment. The role of the lessor

changes as the lessor is borrowing funds itself, 70% to 80% of the

funds to buy asset from a third party to finance the lease for the

lessee. In return, lessor grants the lender(s) a mortgage or lien on

asset and assigns the lease contract to the lender(s).

Therefore, the lenders have a prior claim on lease payments and on

asset. In event of default by lessee, lenders are entitled to seize the

asset. The balance of the purchase price is in form of equity. LLeessssoorrss

aarree manufacturers, finance companies, banks, independent-leasing

companies, special-purpose leasing companies, and partnerships

8.2.2 Advantages and Disadvantages of Leases

Leasing offers several advantages. However the actual advantage is difficult

to generalize depending on the specific conditions of the firms involved.

Each firm has different tradeoffs; the essential point is that the lease is able

to perform what is needed at a lower cost than other alternatives. Some of

the advantages are:

1. Convenient. Leasing reduces bookkeeping for tax purposes as the paper work is much less compared to owning an asset. The lessor

will handle lessees problems such as maintenance, disposal, and

others associated with ownership. Leases also represent a

convenient mean of financing or ease of obtaining credit. Small and

less creditworthy firms that do not have access to capital markets

are able to finance the assets required in the operations.

Lessee

Manufacture

Equity Investor(s)

Single purpose Leasing company

Lender(s)

Sale of asset Lien on asset

Loans

Equity


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2. Flexibility. Leasing is flexible as it allows the firm to acquire small and specialized equipment in relatively short time and at lower costs

than debt financing. Lease decisions at times can be made by lower

management and thus saves time without having to wait for the

corporate capital-budgeting committee. In addition, lease payments

may be adjusted for seasonal cash flow fluctuations of the firm.

3. Reduced cost of borrowing. Leased assets normally are generally

ready to be leased out. Therefore, in most cases no detail credit

analysis will be performed and lease documentation is standard

which lead to lower cost of transactions. Thus, lessor is willing to

extend lease financing at a lower rate compared to a stricter

conventional financing. 4. Reduced risk. Leases may reduce risk of obsolescence, especially

in short-term operating leases. It provides lessee with the convenient

uses of the asset in short-term and has the option to cancel if the

asset is no longer needed or becomes obsolete. This argument is

generally conceded to be fallacious in long-term leases because the

lessor includes the estimated cost of obsolescence in the lease

payments. Thus, the shifting of risk is less than efficient on long-term

leases, but the cancellation option is valuable in any cases.

5. Benefits of tax deductions and tax credit. Leases provide both the

lessor and lessee some form of tax-shields. The lessee may

recognize the tax deduction on lease payment, and if the asset is

purchases, tax deduction on interest and depreciation can be

recognized. It is advantages to lease for firms with lower taxable

income and has less option for tax deductions. In addition, there may

be a tax advantage when involving land as land is not depreciable,

but the entire lease payment is a deductible expense. This is

especially true in case of the sale-and-lease-back agreements.

6. New sources of funds. Lease financing provides a means of new

financing rather than conventional financing such as issuing debt

and equity securities. It also represents 100% financing that requires

no down payment on the lessees behalf. This will conserves much-

needed working capital in the firm. Leases normally require relatively


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small initial outlay compared to the purchase of asset, and this small

outflow can be overcome by borrowing from other source.

7. Bankruptcy considerations. Smaller and less creditworthy firms

may find it easy to obtain lease financing than a loan. This is

because special provisions in the bankruptcy law give the lessor

more flexibility to seize the asset in case of bankruptcy compared to

the secured lenders. The essential point is that the lessor holds

ownership of the asset.

8. Lack of restrictions. Leasing offers the opportunities to circumvent

restrictions or find a way to get around debt covenants. Lease

contracts generally do not contain protective covenant restrictions

such as in loan agreements and bond indentures.

9. Investment tax credit. Lessor and lessee can negotiate over who

uses the investment tax credit. Lessee may not in a position to use

the tax credit may settle for lower lease payments and let the lessor

retain the tax credit.

Some of the advantages presented may lead to a higher cost of lease

financing. For example, the ease of obtaining credit and other benefits of

leasing increases the cost of the leases as the lessor will demand higher

return on investment for additional risk absorb. Beside the advantages,

leasing has two disadvantages:

1. The lessee forfeits tax deductions associated with asset

ownership.

2. The lessee usually forgoes residual asset value and any rreessiidduuaall

vvaalluuee belongs to the lessor as well as any net cash inflows during

the lease.

The forgone benefits must be evaluated carefully as its value has a direct

bearing on the firms decision either to buy or lease. Details on tax

deductions or tax-shields and how will it affects cash flows associated with

lease and loan will be discussed in the next section. However, if a firm is in

no position to tax advantage of the tax deductions, the values are irrelevant.


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8.2.3 Costs of leasing

The computation of the costs of leasing will depend on its types, whether it

is a full payout lease or non-full payout lease.

1. Full payout lease. The lessor will recover the whole of its initial

capital investment plus interest charged out of the rental payments

made by the lessee. To illustrate, let assume equipment that cost

RM10,000 is leased from a finance company for a 3-year period at

interest rate of 12% per annum.

Monthly rental lease = [10,000 + (10,000 x 12% x 3)] / (12 x 3)

= 377.78

2. Non-full payout lease. This type of lease computation can be divided

into two, a residual value lease with 100% financing or residual value

with less than 100% financing (deposit lease). The term residual

value is referred to the agreed price that is the estimated fair market

value or 80% of the book value of the equipment whichever is higher

at the end of the lease period.

To illustrate, let assume that equipment that cost RM10,000 is leased from a

finance company for a 3-year period at interest rate of 12% per annum on

amount financed less residual value. Residual value is estimated at

RM2,000 with an interest rate of 14%. Security deposit required is RM2,000.

Monthly lease rental under different type of lease arrangement are as

follows:

Residual value lease = 8,000 + (2,000 x 14% x 3)+(8,000 x 12% x 3) / (12 x 3)

= 325.56

Deposit lease = 8,000 + (8,000 x 12% x 3) / (12 x 3)

= 302.22


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8.3 LEASING VERSUS BUYING DECISION The lease versus purchase decision requires a standard capital budgeting type of analysis,

as well as an analysis of two alternative "packages" of financing. It involves the analysis of

the cash flows associated with leases comparative to term loans:

Benefits Purchase prices or cost of asset that the lessee avoids having to

pay.

After tax savings due to reduction in operating cost and other

expenses, such as the operating costs that lessor pays.

Costs After tax cost of lease or rental payments.

After tax cost due to an increase in operating costs and other

expenses.

Forgone benefit of tax shelter from interest and depreciation.

Forgone benefit of net residual or salvage value and investment

tax credits.

To illustrate, Golden Company is deciding between leasing a new machine and purchasing

the machine outright that costs RM100,000.

Lease The machine can be leased over five years in an operating lease

with payments being made at the beginning of each year. The lessor

calculates the lease payments based on an expected return of 12%

over the five years, with no possible residual value of equipment to

lessor. Lessor will pay operating cost (O) worth RM500 per year.

Purchase The equipment is depreciated under straight-line method with no salvage value. It is estimated the asset would be worth RM2,000 in 5

years. Loan payments are based on a 10% loan with payments

occurring at the end of each period. The firms cost of capital is 14%

and the tax rate is 40%.


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First, let us look at the lease payment (LP) that represents an annuity due that equals

RM100,000 today. The yearly lease payment equals to:

Lease payment (LP) 100,000.00 = LP(PVIFA12%,5)(1.12)

89,285.71 = LP(3.6048)

24,768.56 = LP

or another approach 100,000.00 = LP(PVIFA12%,4 + 1)

= LP(3.0373 + 1)

24,769.03 = LP

Note that minor differences in the answers are due to rounding errors. The lessor will

charge Golden RM24,768.56, beginning today, for five years until expiration of the lease

contract. The lessee, Golden, can deduct the entire RM24,768.56 as an expense each

year. Since the lease payments are prepaid, the company is not able to deduct the

expenses until the end of each year. Thus, the net cash outflows are given as the

difference between lease payments (outflow) and tax-shield benefits (inflow). The cash

flows analysis involves:

1. Determine the costs or cash outflows

Lease Payment = RM24,768.56

2. Determine the benefits or cash inflows

Tax shield from lease payment = RM24,768.56(0.40)

= RM9,907.42

After tax savings in operating cost provided = RM500.00(1 0.40)

= RM300.00

3. Create time line associated with the timing of the cash flows.

4. Determine the present value of the net cash flows by using the lessee's after tax

cost of debt [=10% (1 0.40)].

The relevant cash flows, its timing and discounted present value are shown in details in

Table 8-2. It shows that if Golden leases the machine, the firm will incur present value of cash outflows of RM67.596.36. Should Golden lease the machine? The answer will depend on the extent of the present value of cash outflows associated with the term loan


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option. If the present value of cash outflows under term loan is lower, then term loan option

is better than lease, and vice versa.

Table 8-2 Determining the Cash Flows and the PV of Cash Flows for the Lease

0 1 2 3 4 5

Costs : LPn 24,768.56 24,768.56 24,768.56 24,768.56 24,768.56 Benefits: LP TSn 9,907.42 9,907.42 9,907.42 9,907.42 9,907.42Benefits: On 300.00 300.00 300.00 300.00 300.00Net CFATs 24,768.56 14,561.14 14,561.14 14,561.14 14,561.14 10,207.42PVIF6%,n 1.0000 0.9434 0.8900 0.8396 0.7921 0.7473PV of CFATs 24,768.56 13,736.98 12,959.41 12,225.53 11,533.88 7628.00

Total PV of CFATs 67,596.36 Note: LP TS : Lease payment tax shield, O: After tax savings in operating costs

Net cash outflows at t = 0 RM24,768.56 (PVIF6%,0) = RM24,768.56

Net cash outflows at t = 1 to 4 RM14,561.14 (PVIFA6%,4) = RM50,455.81

Net cash inflows at t = 5 RM10,207.42 (PVIF6%,5) = RM 7,628.01

Present value RM67.596.36

Under the term loan option, the net cash outflows are given as the difference between

installment payments (outflow) and tax-shield benefits (inflow) from interest and

depreciation expenses. Refer to Table 8-1 for financial data for periodic installment

payments and interests. Table 8-3 shows relevant cash flows associated with term loans

with installment payments as cash outflows and tax-shields from interest, depreciation, and

scrap value as cash inflows. The cash flows analysis under term loan option involves:

1. Determine the costs or outflows

Installment Payment = RM26,380.00

2. Determine the benefits or inflows

Tax shield from interest expenses = RM10,000.00(0.40)

= RM4,000.00 For year 1

Tax-shields from interest payments change accordingly with the annual interest as

presented in the amortization schedule in Table 8-1. For example, first year equal RM4,000

[=10,000(0.40)], second year equal RM3,344.80 [=8,362(0.40)], and so forth.


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Tax shield from depreciation expenses = RM20,000.00(0.40)

= RM8,000.00 For year 1

Terminal cash flow (TCF) = RM2,000(1 0.40)

= RM1,200.00 For year 5

As for terminal cash flow (TCF) of the asset, RM2,000 represent profits (recaptured

depreciation) since the cost of asset is being depreciated to zero. Therefore, the firm will

have to pay tax on the profits of RM800 [=2,000(0.40)] that net the firm RM1,200 (=2,000

800) out of the selling price of RM2,000.

1. Create time line associated with the timing of the cash flows.

2. Determine the present value of the net cash flows by using the firm's after tax cost

of debt [=10% (1 0.40)], except for terminal cash flows will be discounted based

on the firm's cost of capital [=14%]. The cost of capital is used to discount the after-

tax scrap value due to the uncertainty of the actual scrap value in future.

The relevant cash flows, its timing and discounted present value are shown in details in

Table 8-3.

Table 8-3 Determining the Cash Flows and the PV of Cash Flows for the Term Loan

0 1 2 3 4 5 Costs: IPn 26,380.00 26,380.00 26,380.00 26,380.00 26,378.46Benefits: I TSn 4,000.00 3,344.80 2,624.08 1,831.29 959.22Benefits: D TSn 8,000.00 8,000.00 8,000.00 8,000.00 8,000.00Net CFATs 0.00 14,380.00 15,035.20 15,755.92 16,548.71 17,419.24PVIF6%,n 1.0000 0.9434 0.8900 0.8396 0.7921 0.7473PV of CFATs 0.00 13,566.09 13,381.33 13,228.67 13,108.23 13,017.40 Benefits: TCF5 1,200.00PVIF14%,5 0.5194PV of CFAT5 623.28Total PV of CFATs 65,678.45 Note: I TS: Interest tax shield, D TS: Depreciation tax shield

Table 8-3 shows that the present value of costs for the term loan RM65,404.97, is lower

compared to that of the present value of the lease program of RM67.596.36. Therefore, the

least costly alternative is the term loan, and therefore Golden should proceed with the term

loan and purchase the machine directly rather than lease it from lessor.


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9 Lets Try Another Exercise

Bhd, wants to acquire an equipment worth RM 100,000 to be used in its business

operation. If it finances the equipment with a lease, the supplier will provide such

financing over 8 years. The lease payments of RM16,000 are to be made at the

beginning of each of the eight years. If the asset is purchased, the company is

assumed to finance it entirely with a 14% unsecured term loan; payments to be

made also in advance. The equipment is depreciated on a straight line basis. The

decision to acquire the equipment will depend on which alternative results in the

lower cashflow. The marginal tax rate is 40%.

From the above scenario, obviously YY needs to do some computation to help the

company make the right decision. As a start, we will look at cashflow relating to

lease.

Cashflow Relating to Lease

Step 1: To calculate the opportunity cost of funds (a discount rate) Discount rate = (1-tax)(Interest rate)

= (1-0.40)(0.14)

= 0.084 or 8.4%

Step 2: Draw up the cashflow schedule for leasing alternative

A B C D

Year Lease

Payment Tax Shield

Cashflow after taxes

PV of cashflow value @ 8.4%

0

1

2

3

4

5

6

7

8

16,000

16,000

16,000

16,000

16,000

16,000

16,000

16,000

16,000

-

6,400

6,400

6,400

6,400

6,400

6,400

6,400

6,400

16,000

9,600

9,600

9,600

9,600

9,600

9,600

9,600

16,000

8,856

8,169.8

7,537

6,953

6,414

5,917

5,458.4

(3,357)

Total PV 61,948.20 Cashflow


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As can be seen from the schedule above the PV cashflow for leasing is RM61,948.20.

However this figure does not have any meaning until the PV cashflow for the term loan is

computed to make a comparison.

Cashflow Relating to Loans Alternative Step 1: Before drawing up the cash flow for the loan, we need to calculate the

annual payment to be made for the loan. This can be calculated using the

following formula.

PVAn = A(1 + PVIFA i%, n-1)

Where,

PVAn = loan amount

A = annual payment

Putting in the data given, therefore the annual payment is: 100,000 = A + A(PVIFA 14%, 8-1) 100,000 = A + 4.288A 5.288A = 100,000 A = RM18,910

* See Table on PVIFA, APPENDIX IN ANY Finance Textbook

Step 2: Schedule of cash payment for the loan

Year

Annual Payment (A)

Principal (Pt)

Interest (It)

Balance (Bal) 100,000

0

1

2

3

4

5

6

7

18,910

18,910

18,910

18,910

18,910

18,910

18,910

18,910

18,910

7,557

8,615

9,821

11,196

12,764

14,551

16,589

0

11,353

10,295

9,089

7,714

6,146

4,359

2,322

81,090

73,533

64,918

55,097

43,901

31,137

16,586

0


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It = 14% (Loan Amount)

Pt = A 1t

Balt = Bal t-1-Pt

Step 3: Schedule of cashflow for loan alternative A B C D E Year Annual

Payment Annual Interest

Annual Depreciation

Tax Shield

After Tax CF

PV of CF @8.4%

0

1

2

3

4

5

6

7

8

18,910 18,910 18,910 18,910 18,910 18,910 18,910 18,910 -

0

11,353

10,295

9,089

7,714

6,146

4,359

2,322

0

0

12,500

12,500

12,500

12,500

12,500

12,500

12,500

12,500

0

9,541.2

9,118.0

9,792.0

10,274.4

10,824.4

11,451.6

12,166.4

5,000

18,910

9,368.8

9,792.0

10,274.4

10,824.4

11,451.6

12,166.4

12,981.2

(5,000)

18,910

8,643

8,333

8,066

7,839

7,651

7,499

7,381

(2,623)

Total PV 71,699 Cashflow The following column is calculated as follows : Column C = 100,000 = 12,500 8 Column D = 0.40 (Interest + Depreciation)

Column E = Column A Column D

The present value cashflow for loan alternative is higher than the present value cashflow for lease. The indicates that the loan alternative is more expensive than

the lease alternative and therefore the company should just lease the asset.


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8.4 HIRE PURCHASE

Hire purchase is a means of financing provided by finance companies and financial

institutions, except commercial bank, for the purchase of consumer goods and

industrial goods. There are three parties involved in a hire purchase agreement; the

hirer, the owner, and the dealer.

1. The hirer is the customer or purchaser and takes goods from the owner of

the financier under a hire purchase agreement. He or she will take

possession for its usage purposes without obtaining ownership. Ownership

will be transferred when the installment payments are fully paid.

2. The owner is the finance companies and financial institutions that takes

possession of the goods from the dealer, lets it to the hirer and maintains the

ownership or title of the goods. In return, the owner will receive periodic

installment payments over a specified period of time

3. The dealer is a person who negotiates leading to the making of the hire

purchase agreement. These include merchants and dealers of the goods

involved.

Hire purchase is transacted through the following steps: 1. The hirer decided on purchasing selected goods from the dealer. 2. The hirer paid minimum down payment of 10% and up to 25% of the

purchase price of the goods.

3. The hirer negotiates with the owner to finance the balance of the price with

regards to the period of hire purchase and its interest rate. The hirer and

owner signed the hire purchase agreement after the preliminary investigation

and credit analysis.

4. The owner will give a letter of undertaking to the dealer and consequently

the goods will be released to the hirer.


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5. The hirer accepts the goods in agreed upon conditions from the dealer and

inform the owner of its acceptance.

6. The owner paid the balance of the price of the goods to the dealer.

7. The hirer will pay monthly installments to the owner until the end of the hire

purchase period.

8.4.1 Types of hire purchase

Hire purchase can be classified into several categories based on its

characteristics as follows:

1. Direct collection. The dealer will act as the introducer of all

his buyers (hirer) to the finance company. The finance

company will evaluate the creditworthiness of the buyer before

the hire purchase agreement is signed based on recourse or

non-recourse, after which the hirer will pay the installments

directly to the finance company.

2. Scheduled collection. This facility is similar to the direct

collection, except that the dealer will collect the monthly

installments on behalf of the finance company. The dealer is

accountable for all installments regardless of whether the hirers

have or have not paid the installments to the dealer.

3. Block discounting. The dealer enters into hire purchase

agreement directly with the buyer, and in turn sells the

agreements in block at a discount to the finance company.

4. Floor stocking. This is the financial arrangement between a

finance company, a dealer and a car distributor. The dealer will

give a floating charge over the stock to the finance company as

a security for the facility that requires the finance company to

pay the car distributor for the stock delivered within the agreed

limit.


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8.4.2 Computation of hire purchase

The add-on interest format normally practice by banks and other lenders on

hire purchase loan, normally known as flat rate. The term add-on means

that interest is calculated and added on the funds received to determine the

face amount of the note. Under section 30 of the hire purchase act, the

maximum interest rate can be charged is 10%, and section 34 states the

maximum interest to be imposed on overdue interest is 8%. Relevant terms

for hire purchase computations includes:

P Principal or amount borrowed

I Term charges

A Monthly rental payment

APR Annual percentage rate

SR Statutory rebate

OI Overdue interest

ES Early settlement

Let T : Time

R : Rate

n : Maturity of hiring period

rp : Remaining period

N : Number of installments; n x C

C : Number of installments in one year; 12

F : Factor; (100C x I) / (N x P)

D : Total number of days in arrears

To illustrate, suppose you plan to purchase a brand new car at RM54,000

with 10% down payment. The interest on the loan is 10 percent and is to be

repaid in 5 years of monthly installment beginning 1st of January 2003.

Overdue interest is charged at 8% per annum.

1. Principal or amount borrowed = Cost of asset Down

payment

= 54,000 (54,000 x 10%)

= 48,600


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2. Term charges = PTR

= 38,600(5)0.1

= 24,300

3. Monthly rental payment = (P + I) / (n x C)

=(48,600 +24,300)/(5 x 12)

= 1,215

4. Annual percentage rate = 2Nf(300C + Nf) 2N2f + 300C(N + 1)

f = (100 x 12 x 0.10) (60 x 48,600)

= 29,160,000 2,918,000

= 10

N = 5 x 12

= 60

Thus, APR = 2 x 60 x 10 (300 x 12 + 60 x 10) (2 x 60 x 60 x 10) + 300 x 12 (61)

= 1,200(3,600 + 600) 72,000 + 219,600

= 17.28%

To further illustrate the computations, assume that the hirer paid on

time for 3 monthly installments, after which no further installment was

made that leads to the following events:

On 27 June, 2003 the hirer received a notice of repossession

from the finance company.

On 5 July, 2003 the car was repossessed. On 15 July 2003, the fifth schedule was served with the cost

of repossession and other charges of RM800.

The hirer made an early settlement within 21 days from the

notice of repossession.


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5. Statutory rebate. A rebate on the term charges when the hirer elect

to complete the hire purchase agreement earlier than the agreed

upon maturity date. In case of default, SR is calculated from the date

of repossession.

Past due = 1/1, 1/2, 1/3, 1/4, 1/5, 1/6, 1/7)

= 7 installments

rp = 60 7

= 53 months

SR = [rp(rp + 1) / n(n + 1)] I

= [53(53 + 1) / 60(60 + 1)] 24,300

= 19,001.80

6. Overdue interest. It is calculated on accumulated basis and arises

when the hirer does not pay his installment on the first day of the

month.

D 1/7 5/7 5

1/6 30/6 30 35

1/5 31/5 31 66

1/4 30/4 30 96

OI = ARD/365

= [1,215(0.08)96] / 365

= 25.56

7. Early settlement.

Total amount payable 48,600+24,300 RM72,900.00

Less: Paid installments 3x 1,215.00 3,645.00

Outstanding amount RM69,255.00

Less: Statutory rebate 19,001.80

Plus: Costs of repossession 800.00

Overdue interest 24.56

Amount to be settled RM51,078.76


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The main point to note here is that the interest is paid on the original amount

of the loan, not on the amount actually outstanding at the beginning of the

period, as was the case in amortized loans; which will be presented in time

value of money. This causes the effective interest rate to be almost double

the stated rate such as in our example, from 10% to 17.28%.


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1. XYZ Company agrees to pay a RM45,000 loan in eight equal year-end

payments. The interest rate is 11%.

i) What is the annual payment? ii) What is the total interest on the loan?

2. Ayam Selama Incorporation just obtained a RM50,000 five-year term loan

from its bank. The interest rate on the lian is 15 percent. Construct an

amortization schedule for the loan, and assume that the loan requires

annual payments.

3. Robocop company has just decided to acquire some industrial robots to

increase the efficiency of its assembly lines. The project has a positive NPV

evaluated at the firms cost of capital. However, the financial manager at

Robocop has just learned that the industrial robots can be leased. Should

Robocop lease or purchase the equipment? The data below should be used

in your analysis.

Leasing Cash Flows Purchase Cash Flows

No. of years 7 7

Equipment Cost RM350,000 RM350,000

Depreciation Straight line method

Annual maintenance RM7,500

Annual Lease payment RM97,098

Taxrate = 40%

Kd = 10%

If the asset is purchased, the entire RM350,000 will be borrowed. A seven

year term loan will be used with annual loan payments.


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finance management fin420 chp 8

Documents

term loan agreement

form of term loans

maturities of term loans

majority of term loans

term debt

lease financing

costs of financing

g e intermediate financing