CORPORATE FINANCIAL DECISION
MAKING (FNCE 20005)
Dr Chander Shekhar
University of Melbourne
Faculty of Business and Economics
Department of Finance
1
LECTURE 3
RAISING CAPITAL: DEBT AND LEASES
Textbook Chapters 7, 15, 22
2
Big Picture of Corporate Finance
3
Shareholders’
equity
Current assets
Fixed assets
1. Tangible assets
(assets in place)
2. Intangible
assets (growth
assets)
Long-term debt
Short-term debt
Assets
generate
cash flow
Investors
provide capital
Investors get return on their capital
Table of Contents
1. Raising Debt Capital
2. Operating and Finance Leases
3. Financial Evaluation of Leasing
4. Suggested Advantages of Leasing
5. Hybrids
4
1. Raising Debt Capital
5
The Nature of Debt
• “Temporary” contribution of capital by investors
for a specified time
• Key characteristics:
• usually no voting rights
• fixed and prior ranking contractual right to a return on capital
• fixed and prior ranking contractual right to a return of capital
• from an investor’s view debt capital is the least risky type
• Different classes of debt typically distinguished by
differences in ranking
6
Debt Capital
• More frequent/important than equity financing
• When companies borrow money, they are obligated to:
• make regular interest payments and
• repay the principal at maturity (fixed-term)
• Interest payments are tax-deductible
• Firms (stockholders) may “default” on their obligations
(“default risk”)
• Upon default, lenders will take over the firm’s assets
• Lenders have no voting power, but are protected by
covenants
7
Default
8
Source: 2019 Annual Global Corporate Default Study and Ratings Transitions, Standard and Poor’s Ratings Services, 2020.
Accessed at https://www.spglobal.com/ratings/en/research/articles/200429-default-transition-and-recovery-2019-annual-global-
corporate-default-and-rating-transition-study-11444862#:~:text=Key%20Takeaways,triple%2Ddigit%20total%20since%202016. on 17
June 2020.
Types of Debt: Bank or Issued Debt?
• Bank loans – preferred in Australia
• Bank overdraft
• Inventory loan
• Bridge loan
• Term loans (fixed, variable): long-term
• Debt securities - from capital markets
• Commercial paper, Bills of exchange: short-term
• Debentures: medium - long-term
• Corporate bonds, Unsecured notes: long-term
9
short-term (0 -12 months)
Sources of Debt Finance
Debt securities outstanding and issued by non-financial
corporations and bank-issued debt
Source: www.rba.gov.au Tables D4 and D5 accessed at 2 March 2022
The traded debt market in Australia is small relative to bank-debt
10
Type Amount ($bn)
Short-term securities issued in Australia 222.5
Long-term securities issued in Australia 574.3
Long-term securities issued off-shore 476.4
Bank-lending to business (direct) 1088.3
Debt Covenants
• Specific provisions in the debt contract
• Designed to protect interests of lenders
• Negative (or restrictive) covenants (“not to do”)
• limit access to further debt
• restrict holdings of certain investments
• restrict dividends paid
• Positive (or affirmative) covenants (“to do”)
• maintain assets (working capital or collateral)
• provide audited financial statements to the lenders
11
An example of restrictions
The March 27,1997 revolving loan agreement for casino operator Hollywood
Park, Inc. contains the following restrictions:
Capital Expenditures:
[Borrower shall not] Make, or become legally obligated to make, any Capital
Expenditure except:
(a) Maintenance Capital Expenditures not in excess of:
(i) $15,000,000 for the Fiscal Year ending December 31, 1997,
(ii) $15,000,000 for the Fiscal Year ending December 31,1998 and
(iii) $20,000,000 for any subsequent Fiscal Year;
(b) Capital Expenditures to the extent financed by Indebtedness permitted
under Section 6.9(h);
(c) Capital Expenditures for the construction of approximately 200 additional
hotel rooms, a restaurant, an entertainment lounge, meeting rooms, retail
space and parking facilities at the Reno Property not in excess of $25,000,000;
12
To Sum Up
• Debt + Equity = Firm Value (market value of assets)
• Equity
• Equity is more valuable if cash flows are more volatile i.e.
more to gain on the upside
• Therefore, shareholders have more incentive to take risky
projects
• Debt
• Debtholders’ main concern is shareholders defaulting
• Debtholders dislike risky projects: hence there may be
conflicting objectives between debtholders and shareholders
• Through covenants, debtholders try to reduce firm’s
downside risk
13
The nature of debt: Takeaways
• Takeaways
• Debt is a source of finance that provides contributors with a
superior claim to a return on – and of – capital.
• Debt involves choices beyond “should we borrow?”:
• Who should we borrow from?
• Should we borrow long-term or short-term?
• Should we borrow locally or overseas?
• Should we borrow at a fixed or variable rate? etc.
2. Operating and Finance Leases
15
What is Leasing?
• In the US, about 30% of new capital equipment is leased
(e.g.: trucks, farm machinery, railroad cars, aircraft, ships)
• Important terms
• Lessor = legal owner / financier of asset
• Lessee = the asset user
• Lease = contract where the lessor receives fixed
payments from the lessee in return for the use of the
asset
16
Example of Lessee
Qantas Aircrafts
17
Lease Example
18
Aircraft Manufacturer:
Airbus/Boeing
Lessor: GE Capital
• Owns the planes
• Does not use them
Lessee: Qantas
• Uses the planes
• Does not own them
Lessor arranges financing and buys asset
Lessee leases asset from lessor
and makes fixed payments
Two Types of Leases
Operating Lease
• Operating lease is like a rental agreement (generally,
short-term)
e.g.: Cars, Telephones, Computers, Coffee machines…
• Cancellable by lessee at short notice, typically without
substantial penalty
• Risks of ownership borne by lessor
• Lessor is often (or closely related to) a supplier of the
asset
• “Lease versus Buy” decision
19
Two Types of Leases – Cont’d
Finance Lease
• A long-term agreement (generally, over the life of the
asset)
• Non-cancellable without substantial penalty
• Risks of ownership transferred to lessee
• Lessor is generally a financial institution
• Effectively lessor is a source of finance for lessee
- an alternative to borrowing funds to buy an asset
• “Lease versus Borrow-to-buy” decision
20
Summary
21
Characteristics Operating
Lease
Finance
Lease
Term of lease Short-term Long-term
Cancellable? Yes Not without penalties
Legal Ownership Lessor Lessor
Risks of ownership are borne by Lessor Lessee
Lessor is often a… Supplier Financial institution
Lease is essentially a… Rental
agreement
Loan
Decision Lease vs. buy Lease vs. borrow-buy
3. Financial Evaluation of Leasing
22
Finance Lease Value
• Key Question: Lease vs. Borrow to buy?
• Use the NPV method to value a finance lease
• Identify the incremental cash flows from leasing as
opposed to borrowing to buy
• Discount these cash flows and sum them up to get NPV
• But, which discount rate should be used for k?
23

= +
=
+
++
+
+
+
+=
T
t
t
t
T
T
k
C
k
C
k
C
k
C
CNPV
0
2
2
1
1
00
)1()1(
...
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Finance Lease Value: Discount Rate
• Discount Rate: opportunity cost of capital
• Our alternatives are: 1) lease or 2) borrow to buy
• The opportunity cost of capital for the lease is
the after-tax cost of borrowing on an equivalent loan to
buy the asset:
After-tax cost of borrowing = interest rate  (1 – corporate tax rate)
• We implicitly assume that the cash flows from leasing
are as safe as the interest and principal payments on a
loan issued by the lessee
24
Finance Lease Value: Tax-shield Effects
25
Company A Company B
Income 1000 1000
Allowable deduction
(e.g. interest or lease payment) - 100
Taxable income 1000 900
Tax Payable (tc=0.30) 300 270
Company B has a tax-shield of $30 = tc Deduction=0.3*$100
What are the tax-shields or tax payments related to a lease contract
and who is affected?
• Tax-shields from lease payments (lessee)
• Tax-shields from asset depreciation (lessor - owner of the asset)
• Tax on gain from the sale of asset (lessor - owner of the asset)
Finance Lease Value
• For leasing to be advantageous for the lessee the finance
provided by leasing must be greater than the liability incurred
by leasing
• Six steps required for lessee to evaluate a lease
1. Cost of asset (avoid paying this)
2. Lease payments (must pay these)
3. Tax shield from lease payments (reduces tax payable)
4. Depreciation tax shield (miss out on this)
5. Residual payment/value (must pay/miss out)
6. Tax on gain/loss on sale of asset (depends) or
26
Financial evaluation of leases
• NPV of a lease from lessee’s point of view
• NPV of a lease from lessor’s point of view
l)PV(Residua
Deduction)ation PV(Depreci
Payments) from SavingsPV(Tax
Payments) PV(Lease Asset ofCost NPVLessee
−
−
+
−+=
*l)PV(Residua
*Deduction)ation PV(Depreci
*Payments) from SavingsPV(Tax
*Payments) PV(Lease*Asset ofCost NPVLessor
+
+
−
+−=
So – why do leases exist at all?
27
Finance Lease Value - Example
Davids Ltd needs to use a machine for its project that
costs $78,000 and has an expected life of 4 years and a
residual (or salvage) value of $20,600
• The machine can be leased over four years with annual
payments of $21,300 payable in advance
• The company annual tax rate is 34%
• Straight-line depreciation (full depreciation) is used
• The cost of borrowing is 15% p.a. (before-tax)
• The required rate of return for the machine is 22% p.a.
Q. Should Davids Ltd lease or borrow-buy?
28
Financial evaluation of leases
Lease payment tax shield
• tc x Lease payment = 0.34 x 21 300 = + 7 242
Depreciation tax shield
• tc x Depreciation = 0.34 x (78 000/4) = – 6 630
Tax on gain/loss on sale
• (Residual value – book value) x tc
• Book value = 78 000 – (19 500 x 4) = 0
• Gain on sale = 20 600 – 0 = 20 600
• Tax on gain from sale = (20 600 – 0) x 0.34 = +7 004
29
Finance Lease Value - Example
(1) Incremental cash-flows from leasing
(2) After-tax cost of borrowing = 15%(1 – 0.34) = 9.9%
(This discount rate captures tax-shields on interest payments when
borrowing money i.e. the net cost of borrowing)
30
Finance Lease Value - Example
(3) Calculate the NPV of incremental cash flows
So, Davids Ltd should reject this lease contract
and borrow money to buy the machine!
31
68.461,1$
68.403,65942,63
)099.1(
226,20
)099.1(
688,20
)099.1(
688,20
)099.1(
688,20
942,63NPV
432
−=
−=
−−−−=
Setting lease rentals
• Working with the information from the previous example:
What is the maximum annual lease payment the lessee
would be willing to pay?
32
Setting lease rentals
33
Cost +78 000
Lease Payment -L -L -L -L
Tax Shield +0.34L +0.34L +0.34L +0.34L
Depreciation Tax Shield -6 630 -6 630 -6 630 -6 630
Residual -20 600
Tax on Gain/Loss +7 004
Total +78 000 -6 630 -6 630 -6 630 -20 226
-0.66L -0.66L -0.66L -0.66L
3 3 4
3 3 4
0.66 1 6630 1 20226
NPV 78000 0.66 1 1
0.099 (1.099) 0.099 (1.099) (1.099)
0.66 1 6630 1 20226
0 78000 0.66 1 1
0.099 (1.099) 0.099 (1.099) (1.099)
0 78000 2.304216 16517 13865
0 476
L
L
L
L
L
   
= − − − − − −   
   
   
= − − − − − −   
   
= − − −
= 18 2.304216
$20666
L
L
−
=
Finance Lease Value - Wrap-up
• Financing can complement investment strategy
•
•This is a financing decision, not an investment decision
• Whether to invest in this project is a separate question
•But, a favorable lease may create wealth, that is,
NPV(project via leasing) > NPV(project via borrowing)
• As a simple example consider the following:
Investment Decision NPV = – $2 000
Financing Decision NPV = + $3 000
NPV of acquiring the asset via a lease
and using it to create wealth = + $1 000
A favourable lease may ‘rescue’ an investment project, but one should remain
sceptical
34
Lease Buy – using debtor
Operating Lease Value
• Lessee has the option to cancel an operating lease
without (significant) penalty
∴ riskier for a lessor than a finance lease
• The cancellation option is valuable to the lessee:
• Insurance against premature obsolescence
• Allows lessee to reduce operating expenses when demand is
weak to remain profitable
•
= +
35
4. Suggested Advantages of
Leasing
36
Why Does Leasing Exist?
• Without any “market frictions”, the lessor and lessee have
the same discount rates, and their payoffs are equivalent,
but with opposite signs i.e. NPV = −NPV
• If NPV > 0, then NPV < 0, so leasing would not
exist!
• However, the real world has market frictions that enable
both NPV > 0 and NPV > 0 such that we
observe leasing in real life!
37
List of Advantages of Leasing
• How can we get NPV > 0 and NPV > 0 and thus
create wealth?
• Capital markets are not perfect due to frictions such as taxes,
transaction costs, asymmetric information etc. and they affect
the lessor and lessee differently
• Suggested advantages of leasing (sensible ✓ or dubious )
• Company taxation ✓
• Different costs of capital ✓
• Transaction costs ✓
• Off-balance sheet financing 
38
Advantages of Leasing
• Company taxation ✓
• If the lessor’s tax rate is higher than the lessee’s, and if the lessor shares some of
the tax benefits to the lessee in the form of low lease payment, leasing exists
• Firms may be on different tax rates in cases of cross-border leases, progressive tax
rates, or tax loss carry-forwards etc.
• Different Costs of Capital ✓
• If the cost of capital for the lessor is (sufficiently) lower than that of the lessee, we
can have both NPV > 0 and NPV > 0 (i.e. when < )
• Lessor can sometimes borrow at cheaper rates.
• 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)
• Standardization also leads to low transaction costs e.g. one lessor can buy multiple
trucks in bulk and lease them to multiple firms
39
Off-balance Sheet Financing
• Historically in some countries, finance leases were “off balance
sheet” financing
• What’s the problem?
•Balance Sheets basically understated the true leverage ratio or debt
capacity (and thus, true financial risk)
• Accounting standards now require capitalization of finance lease
obligations where the lease is non-cancellable and,
• Lease term  75% of the asset’s useful life or
• PV(Lease payments)  90% of the fair value of the asset to
the lessor
（All leases, subject to limited exceptions, are now required to be capitalized on the
balance sheet according to IFRS 16.）
40

Hybrid securities
• Hybrid securities are securities that display
characteristics of both debt and equity
• There are two main types of hybrid securities in the
Australian market:
1. Convertible notes (short-term) and convertible bonds
(long-term)
2. Preference shares
• There are a wide variety of different structures of these
securities
41
Convertibles
• Convertibles are typically issued for a fixed-term at a
fixed interest rate, with the additional feature that the
holder has the option to convert the note or bond into
ordinary shares at a specified date
• Example
• A company may issue a 10-year, 8% convertible with a face
value of $10, that at maturity may be converted to shares at a
conversion ratio of 1-for-1
• The holder will convert if the price of the company’s share price
on the maturity date is greater than $10
• They are sometimes issued as a way of overcoming the
negative signal associated with issuing ordinary shares
• The interest rate on convertibles is less than on debt
42
Preference shares
• Preference shares give the holder preference over ordinary
shareholders with respect to the payment of dividends, and
usually with respect to the repayment of capital in the event
of liquidation
• The majority of preference shares are:
• Cumulative
• Cumulative preference shares must be paid any accumulated dividends
before paying dividends to ordinary shareholders
• Irredeemable
• Irredeemable preference shares have no maturity date
• Non-Participating
• Non-participating preference shareholders are only entitled to receive the
stated dividend rate
• Non-voting
• Non-voting preference shareholders are not entitled to vote
43
Preference shares in Australia
• Converting preference shares
• Automatically convert to ordinary shares typically 5 to 10 years
following issue
• “Convertible” preference shares may convert
• Reset preference shares
• Have a dividend rate that resets after a specified period
• Step-up preference shares
• Have a dividend rate that is variable (e.g. BBSW + 3%)
• At a specified date, the issuer may:
• Remarket the securities
• Redeem the securities at face value
• Convert the securities into ordinary shares
• If the issuer doesn’t take one of these actions the dividend rate
automatically ‘steps-up’
44
Summary of Lecture
45
Operating
Leases
Raising
Capital
Equity Debt
Bank Loans Debt Securities
Finance
Leases
Financial
Evaluation of
Leasing
Advantages
of Leasing
vs.
After Today’s Class
You should be able to answer the following questions:
• What are the general characteristics of debt capital compared with equity capital?
• Why does a debt contract usually include debt covenants and what kinds of covenants
are used?
• Where do companies raise debt finance? What are the sources of debt?
• What are the key features of operating and finance leases and how are they different?
• How can we evaluate a financial lease for the decision of whether to lease or buy via
borrowing?
• Briefly explain how to value an operating lease
• Critically assess the suggested advantages of leasing over purchasing an asset
• Briefly explain characteristics of hybrid securities
46