FM -II

Term III PGP 19 Batch

Section A & B
Pankaj Baag
Faculty Block 01, Room No
21
Mob: 8943716269
Ph (O): 0495-2809121
Ext. 121
Email:
baagpankaj@iimk.ac.in
Class 14

Raising Capital

Chapter 20

McGraw-Hill/Irwin

Copyright 2013 by the McGraw-Hill Companies, Inc. All rights reserved.

Shelf Registration
Permits a corporation to register an
offering that it reasonably expects to
sell within the next two years.
Not all companies are allowed shelf
registration.
Qualifications include:
The firm must be rated investment grade.
They cannot have recently defaulted on
debt.
The market capitalization must be > $150
Arguments:
timeliness and overhang
m.
No recent SEC violations.

Shelf Registration in India

Available to PFIs only
Allowed through an umbrella
prospectus by consolidated offer
document for the entire amount over
the next 12 months
Pressure to extend to all
But may be misused resulting in a
systemic failure

Issuing Long-Term Debt

Public issuance follows the same
general process as stocks
Direct financing
Term loans
Private placements

Direct financing may have more

restrictive covenants and higher
rates, but is less costly to issue and
easier to negotiate.

Quick Quiz
What is venture capital, and what types of
firms receive it?
What are some of the important services
provided by underwriters?
What is IPO underpricing, and why might it
persist?
What are some of the costs associated with
issuing securities?
What is a rights offering, and how do you
value a right?
What is shelf registration?

1. Companies use tombstone advertisements in the financial press

to:

A.

announce the death of the company.

B.

announce the failure of a financial strategy.

C. announce the availability of a new issue of a corporate

security.
D.

notify the public of foreclosure.

E.

None of these.

2. A new public equity issue from a company with equity

previously outstanding is called a(n):

A.

initial public offering.

B.

seasoned equity issue.

C.

unseasoned equity issue.

D.

private placement.

E.

syndicate.

3. The green shoe option is used to:

A.

cover oversubscription.

B.

cover excess demand.

C. provide additional reward to the investment bankers for a

risky issue.
D.

provide additional reward to the issuing firm for a risky issue.

E.

Both cover oversubscription and cover excess demand.

4. During the SEC/SEBI waiting period the potential issuing company can
issue a preliminary prospectus which contains:
A. exactly the same information as the final prospectus except an
indication of SEC approval.
B. all the information as the final prospectus including red writing stating
it is a red herring.
C. very limited financial information and red writing stating it is
preliminary.
D.

only a description of what the funds are to be used for.

E. information very similar to the final prospectus without a price nor

with SEC/SEBI approval.

5. Potential investors learn of the information concerning the

firm and its new issue from the:

A.

pre-underwriting negotiating meeting.

B.

red herring.

C.

letter of commitment.

D.

emails from their former finance professor.

E.

rights offering.

6. A firm commitment arrangement with an investment banker occurs when:

A.

the syndicate is in place to handle the issue.

B.

the spread between the buying and selling price is less than one percent.

C. the issue is solidly accepted in the market evidenced by a large price

increase.
D. when the investment banker buys the securities for less than the offering
price and accepts the risk of not being able to sell them.
E. when the investment banker sells as much of the security as the market
can bear without a price decrease.

7. Under the _______ method, the underwriter buys the securities for less
than the offering price and accepts the risk of not selling the issue, while
under the _______ method, the underwriter does not purchase the shares
but merely acts as an agent.

A.

best efforts; firm commitment

B.

firm commitment; best efforts

C.

general cash offer; best efforts

D.

competitive offer; negotiated offer

E.

seasoned; unseasoned

8. The reputational capital of investment bankers is based on their

roles as intermediaries with more in-depth knowledge of the issuer.
Investment bankers maintain their reputation by:

A.

certifying the issue.

B.

monitoring the issuing firm's management and performance.

C.

pricing issues fairly.

D.

All of these.

E.

None of these.

leasing

Chapter 21

Concepts
Understand the different types of
leases.
Understand how to apply NPV to the
lease vs. buy decision.
Understand the importance of tax
rates in determining the benefit of
leasing.

Types of Leases
The Basics
A lease is a contractual agreement
between a lessee and lessor.
The lessor owns the asset and for a fee
allows the lessee to use the asset.

Buying versus Leasing

Buy

Firm U buys asset and uses asset;

financed by debt and equity.

Lease

Lessor buys asset, Firm U leases it.

Manufacturer of asset

Lessor

Firm U

1. Owns asset

1.

Uses asset

2.

Owns asset

Equity shareholders

Manufacturer of asset

Creditors

2. Does not use asset

Equity
shareholdersz

Lessee (Firm U)

1. Uses asset
2. Does not own asset

Creditors

Operating Leases
Usually not fully amortized
Usually require the lessor to
maintain and insure the asset
Lessee enjoys a cancellation
option

Financial Leases
Essentially opposite of an
operating lease.
1. Do not provide for maintenance or
service by the lessor.
2. Financial leases are fully amortized.
3. The lessee usually has a right to renew
the lease at expiry.
4. Generally, financial leases cannot be
cancelled.

Sale and Lease-Back

A particular type of financial
lease
Occurs when a company sells an
asset it already owns to another
firm and immediately leases it
from them.
Two sets of cash flows occur:
The lessee receives cash today from the
sale.

Leveraged Leases
A leveraged lease is another type of
financial lease.
A three-sided arrangement between the
lessee, the lessor, and lenders:
The lessor owns the asset and for a fee allows
the lessee to use the asset.
The lessor borrows to partially finance the asset.
The lenders typically use a nonrecourse loan.
This means that the lessor is not obligated to the
lender in case of a default by the lessee.

Leveraged Leases
Lessor buys asset, Firm U leases it.

Manufacturer
of asset

Lessor
1. Owns asset
2. Does not use asset

Equity
shareholders

Lessee (Firm U)

Lessor borrows from lender to

partially finance purchase
The lenders typically use a
nonrecourse loan. This
means that the lessor is not
obligated to the lender in
case of a default by the
lessee.

1. Uses asset
2. Does not own asset

Creditors

In the event of a default by

the lessor, the lender has a
first lien on the asset.
Also, the lease payments
are made directly to the
lender after a default.

Most financial leases are arranged for brand

new assets

Financial leases: Long-term, not

cancelable
Rental lease
Net lease
Direct lease
Leveraged lease
Full service
Sale and lease back

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.
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.

why lease?

Reasons for Leasing

Short-term leases are convenient
Cancellation options are valuable
Maintenance is provided
Standardization leads to low costs
Tax shields can be used
Leasing and financial distress

These are legitimate reasons for leasing by firms.

Short-Term Leases Are Convenient

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.
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 easily 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 Lamborghini Gallardo, 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.
Maintenance Is Provided
Under a full-service lease, the user receives
maintenance and other services. Many lessors are
well equipped to provide efficient maintenance.
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 to a large number of firms (the lessees) that may differ
considerably in size and risk.
But, because the underlying asset is in each case the same salable item (a
truck), you can safely lend the money (lease the truck) without
conducting a detailed analysis of each firms 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, administrative, or legal costs.
For these reasons leasing is often a relatively cheap source of cash for the
small company.
It offers secure 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 depreciation from taxable income.
If the lessor can make better use of depreciation
tax shields than an assets 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.

Leasing and Financial Distress

Lessors in financial leases are in many ways similar to secured lenders, but
lessors may fare better in bankruptcy.
If a lessee defaults on a lease payment, you might think that the lessor
could pick up the leased asset and take it home.
But if the bankruptcy court decides that the asset is essential to the
lessees business, it affirms the lease. Then the bankrupt firm can continue
to use the asset. It must continue to make the lease payments, however.
This can be good news for the lessor, who is paid while other creditors cool
their heels.
If the lease is not affirmed but rejected, the lessor can recover the leased
asset. If it is worth less than the present value of the remaining lease
payments, the lessor can try to recoup this loss. But in this case the lender
must get in line with unsecured creditors.
Unfortunately for lessors, there is a third possibility. A lessee in financial
distress may be able to renegotiate the lease, forcing the lessor to accept
lower lease payments.

why lease?
Dubious Reasons for Leasing
Avoids capital expenditure controls
Preserves capital
May be off-balance-sheet financing
Affects book income

These are wrong reasons for leasing

and indicate bad decisions on the
part of a firm.

Leasing Avoids Capital Expenditure Controls

In many companies lease proposals are scrutinized as
carefully as capital expenditure proposals, but in others leasing
may enable an operating manager to avoid the approval
procedures needed to buy an asset.
Although this is a dubious reason for leasing, it may be
influential, particularly in the public sector.
For example, city hospitals have sometimes found it
politically more convenient to lease their medical equipment
than to ask the city government to provide funds for purchase.

Leasing Preserves Capital

Leasing companies provide 100% 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 security.
()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.

Leases May Be Off-Balance-Sheet Financing

In some countries financial leases are off balance-sheet
financing; that is, a firm can acquire an asset, finance it through
a financial lease, and show neither the asset nor the lease
contract on its balance sheet.
In the United States, 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 and written off over the life of the lease

Leasing Affects Book Income

Leasing can make the firms balance sheet and income statement look better by
increasing book income or decreasing book asset value, or both.
A lease that qualifies as off-balance-sheet financing affects book income in
only one way:
The lease payments are an expense.
If the firm buys the asset instead and borrows to finance it, both depreciation
and interest expense are deducted.
Leases are usually set up so that payments in the early years are less than
depreciation plus interest under the buy-and borrow alternative. Consequently,
leasing increases book income in the early years of an assets life.
Leasings impact on book income should in itself have no effect on firm value.

Accounting and Leasing

In the old days, leases led to offbalance-sheet financing.
Today, leases are either classified as
capital leases or operating leases.
Operating leases do not appear on the
balance sheet.
Capital leases appear on the balance
sheetthe present value of the lease
payments appears on both sides.

Consider a firm with two assets: a truck and some

land.

Accounting and Leasing (Balance

Sheet)

Truck is purchased with debt

Truck
$100,000 Debt
$100,000
Land
$100,000 Equity
$100,000
Total Assets $200,000 Total Debt & Equity
$200,000
Operating Lease
Truck
Debt
Land
$100,000 Equity
$100,000
Total Assets $100,000 Total Debt & Equity
$100,000
Capital Lease
Assets leased
$100,000 Obligations under capital lease
$100,000
Land
$100,000 Equity
$100,000

Capital Lease
A lease must be capitalized if any one of
the following is met:
The present value of the lease payments is at
least 90 percent of the fair market value of the
asset at the start of the lease.
The lease transfers ownership of the property to
the lessee by the end of the term of the lease.
The lease term is 75 percent or more of the
estimated economic life of the asset.
The lessee can buy the asset at a bargain price
at expiry.

AS 19 /Ind AS 17
financial lease
The present value of the lease
payments is at least 90 percent of
the fair market value of the asset at
the start of the lease.
The lessee can deduct lease
payments if the lease is qualified by
the ITA

Taxes, and Leases

The principal benefit of long-term leasing
is tax reduction.
Leasing allows the transfer of tax
benefits from those who need equipment
but cannot take full advantage of the tax
benefits of ownership to a party who can.
Naturally, the IRS/ITA seeks to limit this,
especially if the lease appears to be set
up solely to avoid taxes.

Taxes, and Leases

The lessee can deduct lease payments if the

lease is qualified by the IRS./ITA
1. The term must be less than 30 years.
2. There can be no bargain purchase option.
3. The lease should not have a schedule of payments that
is very high at the start of the lease and low thereafter.
4. The lease payments must provide the lessor with a fair
market rate of return.
5. The lease should not limit the lessees right to issue
debt or pay dividends.
6. Renewal options must be reasonable and reflect fair
market value of the asset.

cAsh flow of leasing

Yr company manufactures pipes and has
a current backlog of 5 yr orders
Tax rate .34
X co makes pipes machines for 10000
Yr company has decided that it needs a
machine and it will save 6000 per yr in
bills for next five yrs
Machine life is 5 yr with zero value at
the end

 Z company offers lease for the

machine at 2500 for five years (it is a
net lease)
You have prepared a cash flow of buy
vs lease

buy
Machine cost

0
1000
0
After tax operating savings
6000*.66
Depreciation tax benefit

2000*.34
total
1000
0

lease

payment

3960

3960

3960

3960

3960

680

680

680

680

680

4640

4640

4640

4640

4640

Tax benefit of LP 2500*.34

ATOS

total

Lease (-) buy

L payment

850
3960
2310

TBLP

850

-2500 -2500
850
3960
2310

-2500 -2500
850

-2500 -2500 2500

850
850
850
3960 3960 3960
2310 2310 2310

-2500 -2500 2500

850
850
850