Introduction to Corporate Finance

PART 4: CAPITAL STRUCTURE AND PAYOUT POLICY

Frequently Cited Disadvantages

1 A lease does not have a stated interest cost. In cases where the return to the lessor is quite high, the

company might be better off borrowing to purchase the asset.

2 At the end of the term of the lease agreement, the lessor realises the asset’s salvage value, if any. If

the lessee had purchased the asset, it could have claimed the asset’s salvage value. Of course, in

a competitive leasing market, if the lessor expects a higher salvage value, then the lease payments

would be lower.

3 Under a lease, the lessee is generally prohibited from making improvements to the leased property

or asset without the lessor’s approval. If the property were owned outright, this difficulty would not

arise. Of course, lessors generally encourage leasehold improvements that are expected to enhance

the asset’s salvage value.

4 If a lessee leases an asset that subsequently becomes obsolete, it still must make lease payments over

the remaining term of the lease. This is true even if the asset is unusable.

12 Why is it considered important whether a lease is classified as an operating lease or as a finance

lease?

13 What factors should be considered when deciding between leasing an asset or borrowing funds to

purchase the asset?

CONCEPT REVIEW QUESTIONS 14-4

SUMMARY

■ Long-term debt and leasing are important

sources of capital for businesses. Long-term

debt can take the form of term loans or

bonds. The characteristics of each can be

tailored to meet the needs of both the

borrower and the lender.

■ The conditions of a term loan are specified

in the loan agreement. This agreement

specifies the rights and responsibilities

of both lender and borrower, and the

agreement typically lists several positive and

negative covenants that the borrower must

not violate.

■ Syndicated loans are large-denomination

credits arranged for a single borrower by a

syndicate of institutional lenders, primarily

commercial banks. These have been

increasing in importance in recent years,

because very large loans can be arranged

quickly and inexpensively and can have

flexible borrowing terms.

■ The conditions of a bond issue are specified

in the bond indenture and are enforced by

a trustee. These legal agreements are highly

detailed and not easily modified, because

bonds are held by many investors.

■ In contrast, privately placed loan terms

can be modified rather easily, because the

borrower can negotiate directly with one

creditor or a relatively small number of

creditors.

■ When interest rates drop, bond issuers

frequently make refunding decisions, which

involve determining the NPV associated

with calling outstanding bonds and issuing

new bonds with lower-interest-coupons to

replace the refunded bonds.

LO 14.1

LO 14.2

LO 14.3

LO 14.4