Brealey, Myers. Principles of Corporate Finance. 7th edition

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Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

VII. Debt Financing 25. The Many Different

Kinds of Debt

Companies, 2003

724 PART VII Debt Financing

In other countries the bankruptcy rules are often “creditor-oriented”; their ob-

ject is to recover as much as possible for the lenders and to ensure that the senior

claimants get first peck. For example, the bankruptcy procedures in Germany, Swe-

den, and the UK have much in common with Chapter 7 in the United States.

other words, an outside official is appointed to take over the company and to sell

the assets either piecemeal or as a going concern.

The proceeds are then distrib-

uted to creditors according to the priority of their claims.

Of course, the grass is always greener elsewhere. In the United States, critics of

Chapter 11 complain about the costs of trying to save businesses that are no longer

viable. By contrast, in Europe, bankruptcy laws are blamed for the demise of

healthy businesses and governments there have looked for ways to encourage re-

habilitation rather than liquidation.

See, for example, M. J. White, “The Costs of Corporate Bankruptcy: A U.S.–European Comparison,”

in J. S. Bhandari and L. A. Weiss (eds.), Corporate Bankruptcy, Cambridge University Press, Cambridge,

1996; and P. Stromberg, “Conflicts of Interest and Market Illiquidity in Bankruptcy Auctions: Theory

and Tests,” Journal of Finance 55 (December 2000), pp. 2641–2692.

Alhough the bankruptcy codes in these countries contain provisions to keep the firm operating, they

are relatively rarely invoked.

FURTHER

READING

A useful general work on debt securities is:

F. J. Fabozzi (ed.): The Handbook of Fixed Income Securities, Frank J. Fabozzi Associates, New

Hope, PA, 2000.

The articles by Brennan and Schwartz and by Kraus are general discussions of call provisions:

M. J. Brennan and E. S. Schwartz: “Savings Bonds, Retractable Bonds and Callable Bonds,”

Journal of Financial Economics, 5:67–88 (1977).

A. Kraus: “An Analysis of Call Provisions and the Corporate Refunding Decision,” Midland

Corporate Finance Journal, 1:46–60 (Spring 1983).

Smith and Warner provide an extensive survey and analysis of covenants:

C. W. Smith and J. B. Warner: “On Financial Contracting: An Analysis of Bond Covenants,”

Journal of Financial Economics, 7:117–161 (June 1979).

Discussions of project finance include:

R. A. Brealey, I. A. Cooper, and M. Habib: “Using Project Finance to Fund Infrastructure In-

vestments,” Journal of Applied Corporate Finance, 9:25–38 (Fall 1996).

B. C. Esty: “Petrozuata: A Case Study on the Effective Use of Project Finance,” Journal of Ap-

plied Corporate Finance, 12:26–42 (Fall 1999).

P. K. Nevitt and F. J. Fabozzi, Project Financing, American Educational Systems, London, 7th

ed., 2000.

Altman’s book is a general survey of the bankruptcy decision, while Bhandari and Weiss provide a

useful collection of readings. Also listed below are several good studies of the conflicting interests

of different security holders and the costs and consequences of reorganization:

E. A. Altman: Corporate Financial Distress and Bankruptcy: A Complete Guide to Predicting and

Avoiding Distress, and Profiting from Bankruptcy, John Wiley & Sons, New York, 2nd ed., 1993.

J. S. Bhandari and L. A. Weiss (eds.), Corporate Bankruptcy, Cambridge University Press,

Cambridge, 1996.

M. White: “The Corporate Bankruptcy Decision,” Journal of Economic Perspectives 3:129–152

(Spring 1989).

J. R. Franks and W. N. Torous: “An Empirical Analysis of U.S. Firms in Reorganization,”

Journal of Finance, 44:747–770 (July 1989).

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Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

VII. Debt Financing 25. The Many Different

Kinds of Debt

Companies, 2003

CHAPTER 25 The Many Different Kinds of Debt 725

J. R. Franks and W. N. Torous: “How Shareholders and Creditors Fare in Workouts and

Chapter 11 Reorganizations,” Journal of Financial Economics, 35:349–370 (May 1994).

L. A. Weiss, “Bankruptcy Resolution: Direct Costs and Violation of Priority of Claims,” Jour-

nal of Financial Economics, 27:285–314 (October 1990).

QUIZ

1. Select the most appropriate term from within the parentheses:

a. (High-grade utility bonds/low-grade industrial bonds) generally have only light

sinking-fund requirements.

b. Collateral trust bonds are often issued by (utilities/industrial holding companies).

c. (Utility bonds/industrial bonds) are usually unsecured.

d. Equipment trust certificates are usually issued by (railroads/financial companies).

e. Mortgage pass-through certificates are an example of (an asset-backed

security/project finance).

2. Vocabulary check. Define the following terms: indenture or trust deed, debentures, mort-

gage bonds, call provision, sinking fund, foreign bond, negative pledge clause.

3. For each of the following sinking funds, state whether the fund increases or decreases

the value of the bond at the time of issue (or whether it is impossible to say):

a. An optional sinking fund operating by drawings at par.

b. A mandatory sinking fund operating by drawings at par or by purchases in the

market.

c. A mandatory sinking fund operating by drawings at par.

4. a. As a senior bondholder, would you like the company to issue more junior debt,

would you prefer it not to do so, or would you not care?

b. You hold debt secured on the company’s existing property. Would you like the

company to issue more unsecured debt, would you prefer it not to do so, or would

you not care?

5. Use Table 25.1 (but not the text) to answer the following questions:

a. Who are the principal underwriters for the Ralston Purina bond issue?

b. Who is the trustee for the issue?

c. How many dollars does the company receive for each debenture after deduction of

the underwriters’ spread?

d. Is the debenture “bearer” or “registered”?

e. At what price was the issue callable in 1995?

f. Could the company call the bond in 1990 and replace it with a debenture yielding

5 percent?

6. Look at Table 25.1:

a. Suppose the debenture was issued on July 1, 1986, at 97.60 percent. How much

would you have to pay to buy one bond delivered on July 1? Don’t forget to

include accrued interest.

b. When is the first interest payment on the bond, and what is the amount of the

payment?

c. On what date do the bonds finally mature, and what is the principal amount of the

bonds that is due to be repaid on that date?

d. Suppose that the market price of the bonds rises to 102 and thereafter does not

change. When should the company call the issue?

7. A security dealer in New York tells you that the yield to maturity on a 10 percent five-

year corporate debenture is 7.80 percent. An international bond dealer in London tells

you that the yield to maturity on an identical international bond (eurobond) is 7.90 per-

cent. Which bond offers the higher return? Explain.

8. Explain the three principal ways in which the terms of private placement bonds com-

monly differ from those of public issues.

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Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

VII. Debt Financing 25. The Many Different

Kinds of Debt

Companies, 2003

726 PART VII Debt Financing

9. True or false? Briefly explain in each case.

a. Lenders in project financings rarely have recourse against the project’s owners if

the project fails.

b. Many new and exotic debt securities are triggered by government policies or

regulations.

c. Call provisions give a valuable option to debt investors.

d. Restrictive covenants have been shown to protect debt investors when takeovers

are financed with large amounts of debt.

e. Privately placed debt issues often include stricter covenants than public debt.

However, public debt covenants are more difficult and expensive to renegotiate.

10. What is the difference between Chapter 7 bankruptcy and Chapter 11 bankruptcy?

11. True or false?

a. When a company becomes bankrupt, it is usually in the interests of the

equityholders to seek a liquidation rather than a reorganization.

b. A reorganization plan must be presented for approval by each class of creditor.

c. The Internal Revenue Service has first claim on the company’s assets in the event

of bankruptcy.

d. In a reorganization, creditors may be paid off with a mixture of cash and securities.

e. When a company is liquidated, one of the most valuable assets to be sold is often

the tax-loss carryforward.

12. Explain why equity can sometimes have a positive value even when companies peti-

tion for bankruptcy.

PRACTICE

QUESTIONS

1. Suppose that the Ralston Purina bond was issued at face value and that investors con-

tinue to demand a yield of 9.5 percent. Sketch what you think would happen to the

bond price as the first interest payment date approaches and then passes. What about

the price of the bond plus accrued interest?

2. Find the terms and conditions of a recent bond issue and compare them with those of

the Ralston Purina issue.

3. Bond prices can fall either because of a change in the general level of interest rates or

because of an increased risk of default. To what extent do floating-rate bonds and put-

table bonds protect the investor against each of these risks?

4. Proctor Power has fixed assets worth $200 million and net working capital worth $100

million. It is financed partly by equity and partly by three issues of debt. These consist

of $250 million of First Mortgage Bonds secured only on the company’s fixed assets,

$100 million of senior debentures, and $120 million of subordinated debentures. If the

debt were due today, how much would each debtholder be entitled to receive?

5. Elixir Corporation has just filed for bankruptcy. Elixir is a holding company whose as-

sets consist of real estate worth $80 million and 100 percent of the equity of its two op-

erating subsidiaries. It is financed partly by equity and partly by an issue of $400 mil-

lion of senior collateral trust bonds that are just about to mature. Subsidiary A has

issued directly $320 million of debentures and $15 million of preferred stock. Sub-

sidiary B has issued $180 million of senior debentures and $60 million of subordinated

debentures. A’s assets have a market value of $500 million and B’s have a value of $220

million. How much will each security holder receive if the assets are sold and distrib-

uted strictly according to precedence?

6. a. Residential mortgages may stipulate either a fixed rate or a variable rate. As a bor-

rower, what considerations might cause you to prefer one rather than the other?

b. Why might holders of mortgage pass-through certificates wish the mortgages to

have a floating rate?

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Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

VII. Debt Financing 25. The Many Different

Kinds of Debt

Companies, 2003

CHAPTER 25 The Many Different Kinds of Debt 727

7. After a sharp change in interest rates, newly issued bonds generally sell at yields different

from those of outstanding bonds of the same quality. One suggested explanation is that

there is a difference in the value of the call provisions. Explain how this could arise.

8. Suppose that a company simultaneously issues a zero-coupon bond and a coupon bond

with identical maturities. Both are callable at any time at their face values. Other things

equal, which is likely to offer the higher yield? Why?

9. a. If interest rates rise, will callable or noncallable bonds fall more in price?

b. Sometimes you encounter bonds that can be repaid after a fixed interval at the option

of either the issuer or the bondholder. If the exercise price of each option is the same

and both the issuer and bondholder act rationally, what will happen when the options

can be exercised? (Ignore refinements such as transactions or issue costs.)

10. A puttable bond is a bond which may be repaid before maturity at the investor’s op-

tion. Sketch a diagram similar to Figure 25.2 showing the relationship between the

value of a straight bond and that of a puttable bond.

11. What restrictions are imposed on a company’s freedom to issue further debt? Be as pre-

cise as possible. Explain carefully the reasons for such restrictions.

12. Does the issue of additional junior debt harm senior bondholders? Would your answer

be the same if the junior debt matured before the senior debt? Explain.

13. Alpha Corp. is prohibited from issuing more senior debt unless net tangible assets ex-

ceed 200 percent of senior debt. Currently the company has outstanding $100 million of

senior debt and has net tangible assets of $250 million. How much more senior debt can

Alpha Corp. issue?

14. Explain carefully why bond indentures place limitations on the following actions:

a. Sale of the company’s assets.

b. Payment of dividends to shareholders.

c. Issue of additional senior debt.

15. Look up a recent issue of an unusual bond in, say, a recent issue of the periodical Eu-

romoney. Why do you think this bond was issued? What investors do you think it would

appeal to? How would you value the unusual features?

16. In Section 25.8 we referred to Christiania Bank’s exotic bond. Explain how you would

value tranche B. Assume that the principal repayment is fixed at 100 percent of par.

Hint: Find a package of other securities that would produce identical cash flows.

17. Explain when it makes sense to use project finance rather than a direct debt issue by the

parent company.

18. The appendix summarizes several problems with Chapter 11 bankruptcy. Which of

these problems could be mitigated by negotiating a prepackaged bankruptcy?

CHALLENGE

QUESTIONS

1. Dorlcote Milling has outstanding a $1 million 3 percent mortgage bond maturing in 10

years. The coupon on any new debt issued by the company is 10 percent. The finance

director, Mr. Tulliver, cannot decide whether there is a tax benefit to repurchasing the

existing bonds in the marketplace and replacing them with new 10 percent bonds. What

do you think?

2. Refer back to the Hub Power project in Section 25.7. There were many other ways that

the Hubco project could have been financed. For example, a government agency could

have invested in the power plant and hired National Power to run it. Alternatively, Na-

tional Power could have owned the power plant directly and funded its cost by a mix-

ture of new borrowing and the sale of shares. What do you think were the advantages

of setting up a separately financed company to undertake the project?

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Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

VII. Debt Financing 26. Leasing

Companies, 2003

CHAPTER TWENTY-SIX

728

L E A S I N G

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

VII. Debt Financing 26. Leasing

Companies, 2003

MOST OF US occasionally rent a car, bicycle, or boat. Usually such personal rentals are short-lived;

we may rent a car for a day or week. But in corporate finance longer-term rentals are common. A

rental agreement that extends for a year or more and involves a series of fixed payments is called

a lease.

Firms lease as an alternative to buying capital equipment. Computers are often leased; so are

trucks, railroad cars, aircraft, and ships. Just about every kind of asset has been leased sometime by

somebody, including electric power plants, nuclear fuel, handball courts, and zoo animals.

Every lease involves two parties. The user of the asset is called the lessee. The lessee makes peri-

odic payments to the owner of the asset, who is called the lessor. For example, if you sign an agree-

ment to rent an apartment for a year, you are the lessee and the owner is the lessor.

You often see references to the leasing industry. This refers to lessors. (Almost all firms are lessees

to at least a minor extent.) Who are the lessors?

Some of the largest lessors are equipment manufacturers. For example, IBM is a large lessor of

computers, and Deere is a large lessor of agricultural and construction equipment.

The other two major groups of lessors are banks and independent leasing companies. Leasing

companies play an enormous role in the airline business. For example, in 2000 GE Capital Aviation

Services, a subsidiary of GE Capital, owned and leased out 970 commercial aircraft. A large fraction

of the world’s airlines rely entirely on leasing to finance their fleets.

Leasing companies offer a variety of services. Some act as lease brokers (arranging lease deals) as

well as lessors. Others specialize in leasing automobiles, trucks, and standardized industrial equip-

ment; they succeed because they can buy equipment in quantity, service it efficiently, and if neces-

sary resell it at a good price.

We begin this chapter by cataloging the different kinds of leases and some of the reasons for

their use. Then we show how short-term, or cancelable, lease payments can be interpreted as

equivalent annual costs. The remainder of the chapter analyzes long-term leases used as alterna-

tives to debt financing.

729

26.1 WHAT IS A LEASE?

Leases come in many forms, but in all cases the lessee (user) promises to make a

series of payments to the lessor (owner). The lease contract specifies the monthly

or semiannual payments, with the first payment usually due as soon as the con-

tract is signed. The payments are usually level, but their time pattern can be

tailored to the user’s needs. For example, suppose that a manufacturer leases a ma-

chine to produce a complex new product. There will be a year’s “shakedown” pe-

riod before volume production starts. In this case, it might be possible to arrange

for lower payments during the first year of the lease.

When a lease is terminated, the leased equipment reverts to the lessor. However,

the lease agreement often gives the user the option to purchase the equipment or

take out a new lease.

Some leases are short-term or cancelable during the contract period at the op-

tion of the lessee. These are generally known as operating leases. Others extend over

most of the estimated economic life of the asset and cannot be canceled or can be

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

VII. Debt Financing 26. Leasing

Companies, 2003

canceled only if the lessor is reimbursed for any losses. These are called capital, fi-

nancial, or full-payout leases.

Financial leases are a source of financing. Signing a financial lease contract is like

borrowing money. There is an immediate cash inflow because the lessee is relieved

of having to pay for the asset. But the lessee also assumes a binding obligation to

make the payments specified in the lease contract. The user could have borrowed

the full purchase price of the asset by accepting a binding obligation to make in-

terest and principal payments to the lender. Thus the cash-flow consequences of

leasing and borrowing are similar. In either case, the firm raises cash now and pays

it back later. A large part of this chapter will be devoted to comparing leasing and

borrowing as financing alternatives.

Leases also differ in the services provided by the lessor. Under a full-service, or

rental, lease, the lessor promises to maintain and insure the equipment and to pay

any property taxes due on it. In a net lease, the lessee agrees to maintain the asset,

insure it, and pay any property taxes. Financial leases are usually net leases.

Most financial leases are arranged for brand new assets. The lessee identifies the

equipment, arranges for the leasing company to buy it from the manufacturer, and

signs a contract with the leasing company. This is called a direct lease. In other

cases, the firm sells an asset it already owns and leases it back from the buyer.

These sale and lease-back arrangements are common in real estate. For example, firm

X may wish to raise cash by selling a factory but still retain use of the factory. It

could do this by selling the factory for cash to a leasing company and simultane-

ously signing a long-term lease contract for the factory. Legal ownership of the fac-

tory passes to the leasing company, but the right to use it stays with firm X.

You may also encounter leveraged leases. These are financial leases in which the

lessor borrows part of the purchase price of the leased asset, using the lease con-

tract as security for the loan. This does not change the lessee’s obligations, but it

can complicate the lessor’s analysis considerably.

730 PART VII

Debt Financing

In the shipping industry, a financial lease is called a bareboat charter or a demise hire.

26.2 WHY LEASE?

You hear many suggestions about why companies should lease equipment rather

than buy it. Let us look at some sensible reasons and then at four more dubious ones.

Sensible Reasons for Leasing

Short-Term Leases Are Convenient Suppose you want the use of a car for a week.

You could buy one and sell it seven days later, but that would be silly. Quite apart

from the fact that registering ownership is a nuisance, you would spend some time

selecting a car, negotiating purchase, and arranging insurance. Then at the end of

the week you would negotiate resale and cancel the registration and insurance.

When you need a car only for a short time, it clearly makes sense to rent it. You save

the trouble of registering ownership, and you know the effective cost. In the same

way, it pays a company to lease equipment that it needs for only a year or two. Of

course, this kind of lease is always an operating lease.

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

VII. Debt Financing 26. Leasing

Companies, 2003

Sometimes the cost of short-term rentals may seem prohibitively high, or you

may find it difficult to rent at any price. This can happen for equipment that is eas-

ily damaged by careless use. The owner knows that short-term users are unlikely

to take the same care they would with their own equipment. When the danger of

abuse becomes too high, short-term rental markets do not survive. Thus, it is easy

enough to buy a Lamborgini Diablo, provided your pockets are deep enough, but

nearly impossible to rent one.

Cancellation Options Are Valuable Some leases that appear expensive really are

fairly priced once the option to cancel is recognized. We return to this point in the

next section.

Maintenance Is Provided Under a full-service lease, the user receives mainte-

nance and other services. Many lessors are well equipped to provide efficient

maintenance. However, bear in mind that these benefits will be reflected in higher

lease payments.

Standardization Leads to Low Administrative and Transaction Costs Suppose

that you operate a leasing company that specializes in financial leases for trucks.

You are effectively lending money to a large number of firms (the lessees) which

may differ considerably in size and risk. But, because the underlying asset is in

each case the same saleable item (a truck), you can safely “lend” the money (lease

the truck) without conducting a detailed analysis of each firm’s business. You can

also use a simple, standard lease contract. This standardization makes it possible

to “lend” small sums of money without incurring large investigative, administra-

tive, or legal costs.

For these reasons leasing is often a relatively cheap source of cash for the small

company. It offers financing on a flexible, piecemeal basis, with lower transaction

costs than in a bond or stock issue.

Tax Shields Can Be Used The lessor owns the leased asset and deducts its depre-

ciation from taxable income. If the lessor can make better use of depreciation tax

shields than an asset’s user can, it may make sense for the leasing company to own

the equipment and pass on some of the tax benefits to the lessee in the form of low

lease payments.

Avoiding the Alternative Minimum Tax Red-blooded financial managers want to

earn lots of money for their shareholders but report low profits to the tax authori-

ties. Tax law in the United States allows this. A firm may use straight-line depreci-

ation in its annual report but choose accelerated depreciation (and the shortest pos-

sible asset life) for its tax books. By this and other perfectly legal and ethical

devices, profitable companies have occasionally managed to escape tax entirely.

Almost all companies pay less tax than their public income statements suggest.

But there is a trap for companies that shield too much income: the alternative

minimum tax (AMT). Corporations must pay the AMT whenever it is higher than

their tax computed in the regular way.

CHAPTER 26

Leasing 731

Year-by-year differences between reported tax expense and taxes actually paid are explained in foot-

notes to the financial statements. The cumulative difference is shown on the balance sheet as a deferred

tax liability. (Note that accelerated depreciation postpones taxes; it does not eliminate taxes.)

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

VII. Debt Financing 26. Leasing

Companies, 2003

Here is how the AMT works: It requires a second calculation of taxable income,

in which part of the benefit of accelerated depreciation and other tax-reducing

items

is added back. The AMT is 20 percent of the result.

Suppose Yuppytech Services would have $10 million in taxable income but for

the AMT, which forces it to add back $9 million of tax privileges:

732 PART VII

Debt Financing

Other items include some interest receipts from tax-exempt municipal securities and taxes deferred by

use of completed contract accounting. (The completed contract method allows a manufacturer to post-

pone reporting taxable profits until a production contract is completed. Since contracts may span sev-

eral years, this deferral can have a substantial positive NPV.)

But Yuppytech can carry forward the $.3 million difference. If later years’ AMTs are lower than regular

taxes, the difference can be used as a tax credit. Suppose the AMT next year is $4 million and the regu-

lar tax is $5 million. Then Yuppytech pays only million.5 ⫺ .3 ⫽ $4.7

Regular Tax Alternative Minimum Tax

Income $10

Tax rate .35 .20

Tax $ 3.5 $3.8

10 ⫹ 9 ⫽ 19

Yuppytech must pay $3.8 million, not $3.5.

How can this painful payment be avoided? How about leasing? Lease payments

are not on the list of items added back in calculating the AMT. If you lease rather

than buy, tax depreciation is less and the AMT is less. There is a net gain if the les-

sor is not subject to the AMT and can pass back depreciation tax shields in the form

of lower lease payments.

Some Dubious Reasons for Leasing

Leasing Avoids Capital Expenditure Controls In many companies lease propos-

als are scrutinized as carefully as capital expenditure proposals, but in others leas-

ing may enable an operating manager to avoid the elaborate approval procedures

needed to buy an asset. Although this is a dubious reason for leasing, it may be in-

fluential, particularly in the public sector. For example, city hospitals have some-

times found it politically more convenient to lease their medical equipment than to

ask the city government to provide funds for purchase. Another example is pro-

vided by the United States Navy, which once leased a fleet of new tankers and sup-

ply ships instead of asking Congress for the money to buy them.

Leasing Preserves Capital Leasing companies provide “100 percent financing”;

they advance the full cost of the leased asset. Consequently, they often claim that

leasing preserves capital, allowing the firm to save its cash for other things.

But the firm can also “preserve capital” by borrowing money. If Greymare Bus

Lines leases a $100,000 bus rather than buying it, it does conserve $100,000 cash. It

could also (1) buy the bus for cash and (2) borrow $100,000, using the bus as secu-

rity. Its bank balance ends up the same whether it leases or buys and borrows. It

has the bus in either case, and it incurs a $100,000 liability in either case. What’s so

special about leasing?

Leases May Be Off-Balance-Sheet Financing In some countries, such as Germany,

financial leases are off-balance-sheet financing; that is, a firm can acquire an asset,

Brealey−Meyers:

Principles of Corporate

Finance, Seventh Edition

VII. Debt Financing 26. Leasing

Companies, 2003

finance it through a financial lease, and show neither the asset nor the lease con-

tract on its balance sheet.

In the United States, the Financial Accounting Standards Board (FASB) requires

that all capital (i.e., financial) leases be capitalized. This means that the present

value of the lease payments must be calculated and shown alongside debt on the

right-hand side of the balance sheet. The same amount must be shown as an asset

on the left-hand side.

The FASB defines capital leases as leases which meet any one of the following re-

quirements:

1. The lease agreement transfers ownership to the lessee before the lease expires.

2. The lessee can purchase the asset for a bargain price when the lease expires.

3. The lease lasts for at least 75 percent of the asset’s estimated economic life.

4. The present value of the lease payments is at least 90 percent of the asset’s

value.

All other leases are operating leases as far as the accountants are concerned.

Many financial managers have tried to take advantage of this arbitrary bound-

ary between operating and financial leases. Suppose that you want to finance a

computer-controlled machine tool costing $1 million. The machine tool’s life is ex-

pected to be 12 years. You could sign a lease contract for 8 years, 11 months (just

missing requirement 3) with lease payments having a present value of $899,000

(just missing requirement 4). You could also make sure the lease contract avoids re-

quirements 1 and 2. Result? You have off-balance-sheet financing. This lease would

not have to be capitalized, although it is clearly a long-term, fixed obligation.

Now we come to the $64,000 question: Why should anyone care whether fi-

nancing is off balance sheet or on balance sheet? Shouldn’t the financial manager

worry about substance rather than appearance?

When a firm obtains off-balance-sheet financing, the conventional measures of

financial leverage, such as the debt–equity ratio, understate the true degree of

financial leverage. Some believe that financial analysts do not always notice off-

balance-sheet lease obligations (which are still referred to in footnotes) or the

greater volatility of earnings that results from the fixed lease payments. They may

be right, but we would not expect such an imperfection to be widespread.

When a company borrows money, it must usually consent to certain restrictions

on future borrowing. Early bond indentures did not include any restrictions on fi-

nancial leases. Therefore leasing was seen as a way to circumvent restrictive

covenants. Loopholes such as these are easily stopped, and most bond indentures

now include limits on leasing.

Long-term lease obligations ought to be regarded as debt whether or not they

appear on the balance sheet. Financial analysts may overlook moderate leasing ac-

tivity, just as they overlook minor debts. But major lease obligations are generally

recognized and taken into account.

Leasing Affects Book Income Leasing can make the firm’s balance sheet and in-

come statement look better by increasing book income or decreasing book asset

value, or both.

CHAPTER 26

Leasing 733

This “asset” is then amortized over the life of the lease. The amortization is deducted from book in-

come, just as depreciation is deducted for a purchased asset.