Debt #
Concepts #
The nature of debt: Temporary contribution of capital by investors for a specified time
Key point
- Fixed and prior ranking contractual right to a return on capital - claimant on earnings
- Fixed and prior ranking contractual right to a return of capital - claimant of asset (in case of default)
- Least risky type (from the perspective of investors)
- Lenders have no voting rights, but are protected by covenants
- More frequent, and more large-scaled
- Interest payments are tax-deductible
Types of debt: see p.10 week 3
Covenants #
Designed to protect interest of lenders
- Negative (restrictive) covenants: Not to do
- Limit access to further debt - do not want claim to be diluted
- Restrict holdings of certain investments - restrict from speculative investments, so that principal can be repayed
- Restrict dividends paid - to maintain financial flexibility
- Positive (affirmative) covenants: To do
- Maintain assets - to generate cash flows
- Provide audited financial statements to the lenders - information transparency
Keypoint of covenants: It prevents from wasting money, but tying managements’ hands
Keypoints #
Risk preferences
- Equity holders have more incentive to hold risker projects
- Debt holders dislike risky projects
Choices beyond should we borrow
- Who to borrow from?
- Long-term or short-term?
- Locally or overseas?
- At fixed or variable rate?
Leasing #
Concept #
Literal: Giving money to someone in exchange for utility for a period
Nature: A form of debt - Imagine leasing a thing and use it throughout its lifespan
Terms
- Lessor: Legal owner of the asset
- Lessee: The user of the asset
- Lease: Contract where the lessor receive a fixed payments from the lessee in return for the use of the asset
Two types of lease
- Operating lease: Cancellable by lessee, risk of ownership borne by lessor - Lease vs. Buy decision
- Financial lease: Non-cancellable without substantial penalty, risk of ownership transferred to lessee - Lease vs. Borrow-to-buy decision
Financial evaluation of leasing #
Financial lease - Lease vs. borrow to buy #
Keypoints:
- Leasing is a financing decision, not an investment decision
- Takeaway: List a table including cost of purchasing (borrow-to-buy), lease payment (lease), tax-shield on lease(lease), tax-shield on depreciation (borrow-to-buy) and after-tax gains of salvage value (borrow-to-buy)
- Identify the incremental cash flows from leasing as opposed to borrowing to buy - What you meant to pay (in buying) is what you gain, and what you meant to gain (in buying) is what you lose
- The cash flows needs to incorporate tax-shield effects - the tax shield of lease payments and of depreciation need to be considered
- The discount rate is simply the after-tax cost of borrowing - as financial leases are as risky as debt
- Do not forget to incorporate salvage value - it is tax-payable
- In case of calculating the maximum annual lease, set incre-NPV to 0 and solve for the equation - practical in real life scenarios ahead of negotiations on financial lease
Implications
- A favorable lease may create wealth, however, even if the total NPV may be greater than 0, whether to invest is a separate decision - we should always focus on the NPV of the investment decision not the financing decision in case of determining whether to invest in a project - Find positive NPV projects to begin with
Operating lease #
Value: The lessee has the option to cancel an operating lease without penalty, hence riskier for a lessor than a financing lease - there is an issuance against the premature obsolecence, and the cancellation option is valuable
$$ NPV_{operating\ lease} = NPV_{financing\ lease} + PV_{option\ to\ cancel} $$The pricing of the cancel option may be considered as a put option, as when market price is lower, the lessee can cancel the contract and seek lower costs. For the lessee, the net cash flow will be lowered by $P_{contract} - P_{market}$ - a net cash in-flow, and if the market price is higher, the lessee will not cancel the contract, which leads to a similar principal value of put options
Implications of leasing #
Existence of lease: market frictions #
- Assume for the lessor and the lessee, the discount rate are the same (i.e. the cost of debt and tax rates are the same) and the price for the asset are the same
- Then the NPV of debt for both parties are the same, and that leasing is a 0-NPV decision, and thus does not exist
- Hence without any market frictions (difference for lessor and lessee in tax rates, interest rates and asymmetric information etc), the incremental NPV will always be 0, suggesting indifference for lessee to choose debt or lease - by lease payoffs $NPV_{lessor} = -NPV_{lessee}$
- However, the difference does exist in real world, and that lease exists.
Advantages of leasing #
Company taxation
- If the lessor have higher tax-rates, and thus have a higher tax-shield, the lessor could share some tax advantages in the form of lease payment - such as cross-border leases, progressive tax rates, or tax loss carry-forwards (that is, take past losses as tax-deductible) etc.
Different cost of capital
- Lessors may have a lower cost of capital in comparison to lessee. This advantage may share to the lessee through lease payments
- Lessors may also borrow at a lower rate.
Transaction costs
- If a lessee defaults on a lease payment, lessors may be subject to a simpler and less costly bankruptcy process because they own the asset - such as simply lease the plane to an another client at lower rate
- Standardization also leads to lower transaction costs - such as one lessor can buy multiple planes in a bulk and lease them to multiple firms
No more off-balance sheet financing
- Historically, this method was used to understate the true leverage ratio or debt capacity, and thus covering up a firm’s real financial risk
- Now accounting standards require capitalization of non-cancellable lease - financial lease (with additional requirements such as that the lease term is more than 75% of the asset lifespan and PV of lease payments is more than 90% of the value of the asset)
Hybrids #
Concept: Securities that display characteristics of both debt and equity
Hybrids in Australia - Convertible & preference shares #
Convertibles
- Convertible notes: Short-term
- Convertible bond: Long-term
- Can convert into shares at a specific date
Preference shares: Very likely debts, gives holders preference over ordinary share-holders with respect of dividends, and usually to repayment of capital
- Catagorizes: cumulative, irredeemable, non-participating and non-voting
Insights to tutorials #
Leasing does not increase a company’s access to debt
- Leasing is a form of debt, and should be considered as debt when accounting for financial risk
- In the past, leases are not taken into balance-sheet, and thus introducing lease does not increase the nominal financial risk, increasing the firm’s access to debt - however, this is not the case for today
Leasing while holding assets provide firms with flexibility
- Firms may operating lease some assets to account for high demands, when the demand is low, the firms can simply cancel the lease
- If the firms buy assets instead of leasing, during downturns of demand, the firm may not be able to sell the assets quickly and the price may be depressed
- However, the firms cannot always lease as it incurrs charge for compensation of the lessor’s risk, so the firms may buy some assets for basic demands and lease assets in response for high demands.
Insights to MST Practice #
- Lessor only shares tax benefits with lessor, i.e. lower cost of capital is not beneficial
- Convertibles have a lower interest rate than debt because it can convert into shares