Financing Community Economic Development Class 6: Fixed Asset Financing

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1 Financing Community Economic Development Class 6: Fixed Asset Financing I. Purpose of asset financing Fixed asset financing refers to the financing for real estate and equipment needs of a business. Fixed asset investments are needed for several reasons: 1. Provides core facilities for business operations 2. Supports a firm s expansion to meet increased sales or have branch presence in new markets 3. Upgrade or introduce new technology, processes, cost saving improvements 4. Provide supporting facilities for: a. Research and development b. Warehouse and distribution c. Retail outlets d. Headquarters and administrative offices II. Fixed asset financing differs from working capital financing in several ways: Longer term financing Larger size financing; larger investment in assets Irreversible action by firm that substantially increases a firm s fixed costs Larger impact on sales, productivity and profitability 1

2 Implications for firms More careful scrutiny and attention to fixed asset investment decisions with a detailed analysis of the impact of investment on future cash flow, sensitivity analysis of the impact under different scenarios, and a net present value analysis to support investment Implication for financing\lenders Greater uncertainty of repayment requires more due diligence, higher underwriting standards, more attention to collateral value and guarantees. Lenders attempt to manage the greater risk of long-term fixed asset financing in several ways: 1. More thorough due diligence and analysis: Understanding of firm s market and competition Assessment of management Is there financial wherewithal to absorb adverse changes and still repay the loan? Careful scrutiny of projections and assumptions 2. Require more firm equity and a lower loan to value ratio 3. Stricter financial covenants to manage risk and provide early warning of potential problems 4. Corporate and personal guarantees 5. Share risk with co-lender 6. Third party guarantees, e.g., SBA III. Fixed asset debt instruments 1. Secured Term Loans 2

3 2. Leasehold Improvement Loans 3. Real Estate Mortgages 4. Equipment Leasing IV. Institutional sources of fixed asset financing 1. Commercial banks 2. Finance companies 3. Leasing companies 4. Equipment manufactures - especially for leasing 5. SBA 504 program 6. Industrial development bonds V. Potential Fixed Asset Financing Gaps 1. Asset cost may exceed collateral value, especially in weak real estate markets, for industrial properties and for specialized properties 2. High equity requirements may exceed the firm s ability to raise equity 3. Availability of financing for long-term life of the asset What are ways to address these problems? 1. Guarantees to address collateral issues and reduce equity requirements 2. Subordinate loans to serve same purposes 3. Direct financing when no long-term source is available VI. Lending Terms and Issues 1. Interest rate, term and amortization floating rate versus fixed rate; prepayment penalties 3

4 for fixed rate financing 2. Collateral, 75% loan to value or less 3. Security Position 4. Financial covenants and defaults VII. Key Legal documentation Loan Note - contract with loan payment terms Loan Agreement - defines additional terms and conditions of the loan, including representations of the borrower, loan covenants, defaults provisions, etc. Security Agreement - instrument to perfect the lender's collateral interest property and rights to take possession and sell property to collect amounts due under the note Mortgage and security agreement - same function as a security agreement when real estate is collateral Collateral assignment of contracts - gives lender right to assume company s interest in essential contracts or permits Environmental indemnification - protects lender from liability from violation of environmental laws or property contamination by company 4

5 VII. Leasing A lease is an alternative way to finance fixed assets where another party (lessor) owns the assets and the firm (lessee) rents it. Two types of leases from an accounting viewpoint: Operating lease: firm is more like a renter than owner and does not have obligations like an owner Capital lease: firm has obligations similar to an owner and lease looks more like a loan Advantages of leasing assets 1. Lower upfront costs (down payment, transaction costs) 2. Lease payments may be lower than debt payments, especially if the leased property has value at lease end 3. May avoid restrictive covenants under loan agreements 4. May avoid some costs and obligations of ownership 5. Tax advantages if lease payments exceed sum of tax credits, depreciation and interest income 6. May obtain cancellation option Disadvantages of lease 1. Lessor retains title and can easily take back asset upon default 2. No benefit from appreciation of asset 3. May be an irreversible long-term obligation; i.e., may not be cancelable like a loan, which can be repaid 4. Lose tax benefits (tax credits and depreciation) 5

6 Lease versus buy & borrow decision 1. Determine the net cash flow impact of the leasing versus buying the asset 2. Construct a loan that has equivalent cash flow impact as the lease 3. Calculate the net present value of the difference in cash flows between the lease and the equivalent loan 4. Lease if there is a positive NPV, i.e., if the lease provides more financing than the equivalent loan 6

7 Case study--cambridge Biotech Summarize the case situation A. What is your assessment of the public benefits? How significant are they, do they justify the requested level of state investment? What is the job impact and the cost per job? 260 to 340 jobs cost of $39,000 to 26,000 per job B. How risky is the loan for the Land Bank? How would you assess the risks? What are Cambridge Biotech's major business activities? What do we know about its market and competitive position? What is Cambridge Biotech s financial position & performance? Profitability and margins Liquidity Use of assets and leverage Do you see any potential problems and risks? What does the CBC s gross margins suggest about the sales volume needed to cover the required debt service? C. What is the source of revenue\cash flow to repay the loans? Is it sufficient to repay the loan? What do you know about that? What is the outlook with the information that you have? 7

8 D. What would recommend to the Land Bank Board? E. Does the Land Bank have any choice in the situation? F. What can the Land Bank do to manage or reduce its risk? 8

BA 351 CORPORATE FINANCE. John R. Graham Adapted from S. Viswanathan LECTURE 5 LEASING FUQUA SCHOOL OF BUSINESS DUKE UNIVERSITY

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