ASSET SPECIFIC FINANCING

INTRODUCTION TO UNDERSTANDING:

If a company decides to invest in an asset, it can finance the asset, in one of the following ways:

- Buy

o Finance the asset through the company’s normal capital structure in which case the
WACC is used to finance the investment

o Finance the asset with a specific loan from the bank or the vendor

- Asset specific financing

o Asset provider provides specific financing for the asset, can either be a loan on
specific terms, a lease or an equity transaction

 Loan: company obtains ownership of the asset

 Lease: The bank or the vendor retains ownership of the asset, but the
company gets to use the asset and pays lease instalments

IF THE COMPANY BUYS THE ASSET (CASH OR LOAN), THE FOLLOWING WILL APPLY:
- The company is responsible for maintenance and insurance,

- The company can deduct wear and tear allowances on the asset for tax purposes,

- At the end of its useful life, the asset’s residual value will be an inflow benefit to the
company.

IF THE COMPANY LEASES THE ASSET, THE FOLLOWING WILL APPLY:

- The company does not take legal ownership of the asset but in substance carries the risks
and rewards of ownership (i.e. a Finance lease),

- The company can deduct the lease payments as an expense, (S11a)

- The company will not be able to deduct wear and tear allowances because the company is
not the legal owner of the asset.

IFRS16 DOES NOT AFFECT OUR DECISION-MAKING PROCESS

- In Finance we look at the return or cost of a decision in terms of NPV calculations,
regardless of how it is classified in Accounting.

NEGATIVE (NPV) CONSIDERATION

In some cases, a specific financing deal (special loan or lease) can make a capital project with a
negative net present value look like an attractive investment decision. If the seller finances the
acquisition of the asset through a special loan or a special lease agreement, the seller is likely to
provide a better financing deal at a better rate than what is applicable under normal WACC
conditions. This can result in an investment that has a negative NPV, to still be chosen by the
company because of the Net advantage of the financing option available to fund the investment.

The capital budget assumes that the asset is purchased for cash and financed through companies
treasury function. Therefore, we calculate the NPC of the special finance available, the NPC of the
normal loan terms. The difference between these is the benefit received from the special financing
(assuming the special financing was indeed cheaper). Add this benefit to the NPV of the project and
determine if NPV is positive.

CALCULATION

The discount rate used for lease vs buy Net present cost (NPC) calculations is the after-tax cost of
debt (cost of the normal loan). This is to ensure comparability.

Only relevant cash flows must be considered

- The income from the investment would not be considered because the asset will yield the
same return – whether financed through a purchase or a lease transaction.
o Therefore, we ignore any costs that would be the same for both options.

When comparing the lease option versus the buy option, prepare separate NPC calculations and then
compare the answers to determine the most cost-effective option (i.e. the option with the lower NPC).

In the “buy” decision, the cost of the asset should be recorded in Year 0 as opposed to recording the
repayments on the loan and the tax benefit on the interest, in the subsequent years.

- The reason is that the discount rate that is being used is the after tax cost rate, so if you
discount the future cash flows on the loan repayment and also discount the tax benefits of the
interest deductions, you will anyway get back to the PV which is the purchase price of the
asset. (As table 15.3 in Correia). (“SHORTCUT”)
- We can only use this simple method when both the % rate of debt in our WACD is the
same as % rate of the loan.

FORMS OF FINANCING:

Liabilities vs equity:

- We know liability is cheaper because of 2 things

o Lower risk (lenders require a much lower rate of return than shareholders do)
o Tax reduction on interest expense
- However, an increase in liabilities also increases the financial risk of the company (gearing
increases)
o As gearing increases, we can initially increase shareholder’s wealth ROE>ROA, but
if we take on too much debt we can destroy shareholder’s wealth and as financial risk
increases, the cost of finance increases.
DIFFERENCES BETWEEN LEASE AND BUY:

Lease Buy
Get full installments as a S11a deduction We only get the interest as a S11a deduction
We don’t own the asset: We own the asset:
- We CANNOT claim allowances - We CAN claim Wear n tear
allowances
- Can sell asset for scrapping after useful
life
Not responsible for any maintenance We are responsible for maintenance and
insurance
Payments are made in advance (beg of Payments are made in arrears (end of month)
month)

DIFFERENCE BETWEEN CAPITAL BUDGET AND LEASE VS BUY ‘BUDGET’:

CAPITAL BUDGET

- We use NPV
o Value arises from the use of WACC  using both the weighted average cost of Debt
and Capital as a from return
o We use WACC for INVESTMENT DECISIONS. Our return on the investment must
always be greater than the hurdle rate of WACC
- We use the highest NPV
- We use what is relevant to the project – this can be viewed as everything applicable to the
project’s growth.
- Inflows and outflows

LEASE VS BUY BUDGET:

- We use NPC
o Cost arises from the use of WACD  we use only the weighted average cost of Debt
o Remember, whenever we do weighted average cost of C/D  we use after tax rates.
o If we solely just looking at the Debt aspect of life, it will be considered a
FINANCING DECISION
- We use the lowest NPC
- We only use relevant costs applicable to the purchase of the asset.
o Relevant costs = WnT, maintenance and insurance, lease premiums.
- Only outflows
QUALITATIVE FACTORS:

These are the factors to consider that will not form part of the calculation

- If we are leasing
o We don’t purchase it forever  we don’t need to store the asset somewhere (saves
space)
o We can use the most up-to-date models which can prove to be more efficient
o If there is an uncertain demand for the use of the asset, this could be seen as more
cost effective
o Doesn’t have a lot of negotiating power

HOW TO GO ABOUT DEALING WITH A ASSET SPECIFIC FINANCING QUESTION:

STEP 1: DETERMINE YOUR CAPITAL BUDGET

- We need to know our NPV (choose the highest answer)

o Why? Because we need to see, if our current NPV is negative, will the “gain on
decision made” bring the NVP into a positive answer.

STEP 2: DETERMINE THE NPC OF BOTH STANDARD AND ASSET SPECIFIC

FINANCE OPTIONS

HOW?

- By discounting the cash flows of the options to calculate the one with the lowest NPC
- We use the After-tax cost of debt of the company.
o I.e. we use the cost of debt that is part of WACC.
 NFB: But if we are dealing with determining the NPC of a loan, we will use
a before tax rate for the purposes of calculating interest expense (excluding
tax) so we can claim that as our S11a deduction.
o We are always wanting to be comparing apples with apples (NPC with NPC)  so
we use the same required rate of return for both lease and loan

LOAN:
There are 2 ways of determining the NPC

THE EASY METHOD:

 This is when the RRR on the loan is the exact same as the RRR for the debt part of
WACD. [compare both before tax]
 If they told me the WACD as after tax, and the RRR of the loan before tax  get them to
the same level
 WACD * 100/72 = WACD before tax

 If this is the case, we can simply use the cost of the asset and place it in year zero
  Take note, if you use the quick method, the tax savings is automatically done. Its too
nxa

LONGER METHOD:
 This is when the RRR of the loan is not the same as the RRR of the debt of WACD.
 Instead of putting the cost in year zero, we must calculate the interest on each PMT so we
can determine our tax deduction.
 That’s why we use before tax rates for this calculation, or else we will be deducting a
much larger S11a expense than what we should be.

 Steps to do long method:

1) Calculate PMT
2) Use amort table to determine interest expense for every period
3) Multiply that interest expense by 28% = our tax Saving/Benefit

BUY Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Payment (130 964) (130 964) (130 964) (130 964) (130 964)

Int (Amrt) 13 611 11 369 8 909 6 211 3 249

X 28%

(117 353) (119 595) (122 055) (124 753) (127 715)

Now to calculate the NPC, we use the after tax rate.

TAKE NOTE: we said with a loan we pay in arrear  so the PMT will occur at end of the period

LEASE:
- Our lease payments are made in advance
o NOTE: that the first payment will be in year 0
o BUT, the tax benefit only occurs at year end  we put the tax benefit in Year 1

- Our lease payments are what we get to deduct for income tax purposes
 o Therefore, the tax benefit = lease payment *28%

- NOTE: we don’t own the asset, therefore, we are not responsible for WnT, maintenance,
insurance ect, nor will we be able to obtain a scrapping.
o Therefore, there will be no ‘Tax Flow’. Just a simple lease cash flow … (this could
change)

- Once we have got our net cash flows  we discount it using after tax rate (WACD)

EXAMPLE

Cost of Plant = R500 000

Buy/loan (pay off R500 000 over 5 years)

Debt financing = 9,7222% (before tax)

Maintenance = R25 000 per year

Salvage value = R70 000 (end of 5 years)

Wear & tear (Art 12 C), new equipment

Lease (lease for 5 years) (No maintenance/salvage)

Lease pmts = R125 000 per year in advance

Tax rate = 28%; WACC = 12%;

Debt rate = 9,7222% (before tax)

Do it yourself:

Loan’s NPC = 416859

Lease’s NPC = 404 884

Therefore we will use the lease.

 - Cost savings is the difference between the 2
o 426859-404884 =11596 +
o This savings can bring our NPV to a positive figure

ADVANTAGES OF LEASING
Taxation
The full lease payment is deductible whilst for debt; only the interest component is tax deductible. If a firm has an assessed loss or has
inadequate taxable income against which to claim depreciation deductions, then by leasing the plant from a profitable lessor, the lessee
can transfer tax shields to the lessor. The lessor would then lower the required interest resulting in lower lease instalments, thus sharing
the savings with the lessee.

Technology
If the industry is subject to rapid technological changes, then leases may be structured whereby the lessor will take on the risk of
technological obsolescence and the lessee will be able to upgrade to a newer model or version. This is particularly true in the IT sector.

100% debt financing

Often, the lessee will be able to obtain 100% financing as no deposit will be required. Often, with a loan or hire-purchase agreement, the
lessee will need to offer an initial deposit. The equipment will form the security for the lessor who is able to efficiently dispose of
equipment and make a market in leased equipment

Operating flexibility
The use of operating leases will enable the firm to react quickly to changes in market conditions. The example used in the textbook
relates to the leasing of airplanes for specific routes which are no longer profitable. The current leased planes were right for those routes
but not for other profitable routes. The lessee can arrange to swap its leased planes for other better suited planes with the lessor, whilst
if owned, the sale and purchase of aircraft would result in significant costs and time delays.

Increases in demand
If demand increases quickly, the firm will be able to increase its services or production levels more quickly by leasing the equipment
rather than by outright purchase. Further, if an industry is subject to a huge increase in demand in a short space of time, then there will be
a shortage of the relevant equipment and equipment suppliers will tend to first supply its large customers, being the leasing companies.
Therefore, to reduce time delays and protect its market share, it may be preferable to be linked to a leasing company for the supply of
capital equipment.

Specialisation effects
Leasing companies are able to negotiate more effectively with equipment manufacturers and are able to negotiate quantity discounts.
Further, leasing companies become specialists in relation to maintenance and will often be able to organise higher resale values for used
equipment.

Standardisation of contracts
Leasing agreements are standardised which reduce the administrative work required as compared to customised loan agreements.

Fewer restrictions
There will be fewer restrictions on the general operating decisions of the company as the lessor is looking to the asset as security for the
lease. The firm may be required to undertake certain maintenance work on the asset

Off-balance sheet financing

In certain industry sectors, such as the airline industry and other industry sectors with long-lived asset lives, the structuring of leases may
occur such that the leases are classified as operating leases and thereby do not have to be disclosed as assets on the company's balance
sheet. This will result in a lower reported level of financial leverage.

Avoidance of capital expenditure controls and budgetary constraints

Companies often impose strict controls on capital expenditure decisions which may not extend to the entering of operating leases to
acquire the same equipment. Management will then enter into agreements to acquire such equipment using leasing structures to
overcome such controls or other limitations such as budgetary constraints

Limitation on Cash
There is no requirement for cash upfront when you lease

Other qualitative factors

Will mainly relate to the financing decision as investment decision is done through the capital budget.
Cost, control, risk
Also have to consider company as a whole, to achieve optimal WACC it may be time to issue equity, therefore, debt will not be appropriate
even though it is cheaper at the time
Variable vs fixed payments (what are market expectations on interest, risk appetite of company, company preferences)