Advantages of Leasing

Why is leasing so popular? It has emerged as a trillion-dollar industry, with such firms as Clark Equipment, GE Capital, and U.S. Leasing International providing an enormous amount of financing. Major reasons for the popularity of leasing include the following:

1. The lessee may lack sufficient funds or the credit capability to purchase the asset from a manufacturer, who is willing, however, to accept a lease arrangement or to arrange a lease obligation with a third party.

2. The provisions of a lease obligation may be substantially less restrictive than those of a bond indenture.

3. There may be no down payment requirement, as would generally be the case in the purchase of an asset (leasing allows for a larger indirect loan).

4. The lessor may possess particular expertise in a given industry—allowing for expert product selection, maintenance, and eventual resale. Through this process, the negative effects of obsolescence may be reduced.

5. Creditor claims on certain types of leases, such as real estate, are restricted in bankruptcy and reorganization proceedings. Leases on chattels (non–real estate items) have no such limitation.

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There are also some tax factors to be considered. Where one party to a lease is in a higher tax bracket than the other party, certain tax advantages, such as depreciation write-off or research-related tax credits, may be better utilized. For example, a wealthy party may purchase an asset for tax purposes, then lease the asset to another party in a lower tax bracket for actual use. Also, lease payments on the use of land are tax-deductible, whereas land ownership does not allow a similar deduction for depreciation.

Finally, a firm may wish to engage in a sale-leaseback arrangement, in which assets already owned by the lessee are sold to the lessor and then leased back. This process provides the lessee with an infusion of capital, while allowing the lessee to continue to use the asset. Even though the dollar costs of a leasing arrangement are often higher than the dollar costs of owning an asset, the advantages cited above may outweigh the direct cost factors.

SUMMARY

As a first consideration, corporate bonds may be secured by a lien on a specific asset or may carry an unsecured designation, indicating the bondholder possesses a general claim against the corporation. A special discussion of the hierarchy of claims for firms in financial distress is presented in Appendix 16A.

Both the issuing corporation and the investor are concerned about the rating their bond is assigned by the two major bond rating agencies—Moody’s Investor Service and Standard & Poor’s Corporation. The higher the rating assigned a given issue, the lower the required interest payments needed to satisfy potential investors. This is because highly rated bonds carry lower risk.

Bond refundings may take place when interest rates are going down. The financial manager must consider whether the savings in interest will compensate for the additional cost of calling in the old issue and selling a new one.

The zero-coupon rate bond, as the name implies, does not pay interest. It is, however, sold at a deep discount from face value. The return to the investor is the difference between the investor’s cost and the face value received at the end of the life of the bond.

A second type of innovative bond issue is the floating rate bond. In this case, instead of a change in the price of the bond, the interest rate paid on the bond changes with market conditions (usually monthly or quarterly).

When a corporation contracts to lease an oil tanker or a computer and signs a noncancelable, long-term agreement, the transaction has all the characteristics of a debt obligation, and should be recognized as such on the financial statements of the firm.

LIST OF TERMS

par value 505

maturity date 505

indenture 505

secured debt 505

mortgage agreement 505

after-acquired property clause 506

debenture 506

subordinated debenture 506

serial payment 507

sinking fund 507

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call provision 508

coupon rate 510

current yield 510

yield to maturity 510

bond rating 511

refunding 513

zero-coupon rate bond 517

floating rate bond 518

Eurobond 519

capital lease 521

operating lease 521

DISCUSSION QUESTIONS

1. Corporate debt has been expanding very dramatically in the last three decades. What has been the impact on interest coverage, particularly since 1977? (LO16-1)

2. What are some specific features of bond agreements? (LO16-1)

3. What is the difference between a bond agreement and a bond indenture? (LO16-1)

4. Discuss the relationship between the coupon rate (original interest rate at time of issue) on a bond and its security provisions. (LO16-1)

5. Take the following list of securities and arrange them in order of their priority of claims: (LO16-1)

Preferred stock	Senior debenture
Subordinated debenture	Senior secured debt
Common stock	Junior secured debt

6. What method of “bond repayment” reduces debt and increases the amount of common stock outstanding? (LO16-3)

7. What is the purpose of serial repayments and sinking funds? (LO16-1)

8. Under what circumstances would a call on a bond be exercised by a corporation? What is the purpose of a deferred call? (LO16-3)

9. Discuss the relationship between bond prices and interest rates. What impact do changing interest rates have on the price of long-term bonds versus short-term bonds? (LO16-2)

10. What is the difference between the following yields: coupon rate, current yield, yield to maturity? (LO16-2)

11. How does the bond rating affect the interest rate paid by a corporation on its bonds? (LO16-2)

12. Bonds of different risk classes will have a spread between their interest rates. Is this spread always the same? Why? (LO16-2)

13. Explain how the bond refunding problem is similar to a capital budgeting decision. (LO16-3)

14. What cost of capital is generally used in evaluating a bond refunding decision? Why? (LO16-3)

15. Explain how the zero-coupon rate bond provides return to the investor. What are the advantages to the corporation? (LO16-2)

16. Explain how floating rate bonds can save the investor from potential embarrassments in portfolio valuations. (LO16-2)

17. Discuss the advantages and disadvantages of debt. (LO16-1)

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18. What is a Eurobond? (LO16-1)

19. What do we mean by capitalizing lease payments? (LO16-4)

20. Explain the close parallel between a capital lease and the borrow–purchase decision from the viewpoint of both the balance sheet and the income statement. (LO16-4)

PRACTICE PROBLEMS AND SOLUTIONS

Bond yields

(LO16-2)

1. The Gorden Corporation has a bond outstanding with $85 annual interest payments, a market price of $860, and a maturity date in seven years.

Compute the following:

a. The coupon rate.

b. The current yield.

c. The yield to maturity.

Refunding decision

(LO16-3)

2. The Hudson Corporation has a $15 million bond obligation outstanding which it is considering refunding. Though the bonds were initially issued at 9 percent, the interest rates on similar issues have declined to 7.2 percent. The bonds were originally issued for 15 years and have 10 years remaining. The new issue would be for 10 years. There is a 9 percent call premium on the old issue. The underwriting cost on the new $15,000,000 issue is $200,000, and the underwriting cost on the old issue was $450,000. The company is in a 30 percent tax bracket, and it will use a 5 percent discount rate (rounded aftertax cost of debt) to analyze the refunding decision.

Should the old issue be refunded with new debt?