2.2Leases

Aleasecan be viewed as a debt instrument in which the owner of an asset, the lessor,

gives the right to use the asset to another party, the lessee, in return for a set of con-

tractually fixed payments. The contract between the lessor and the lessee defines:

•	The length of time for which the lessee can or must use the asset.
•	The party responsible for maintenance of the asset.
•	Whether the lessee has the right to buy the asset at the end of the leasingperiod and, if so, at what purchase price.

Driven by innovative providers and the demands of buyers, the volume of leasing has

grown sharply since the mid-1970s, when lease payments were less than $20 billion a

year, to more than $226 billion a year in 1999.⁶

The list of assets available for lease is almost endless. For example, it is possible

to lease copiers from Xerox, computers from IBM, and bulldozers from Caterpillar. A

number of firms also specialize in leasing. For example, GE Capital leases airplanes,

automobiles, trucks, trailers, tank cars, medical devices, office equipment, and even

whole office buildings which they will erect for you in short order.

Exhibit 2.4 describes the two basic types of leases—operating leases and financial

leases. Operating leases are more complicated to value than financial leases because of

the uncertainty about the length of the lease. To understand whether the payments

required on such leases are fair, it is important to understand derivative securities

valuation. Leasing is often motivated by tax considerations.⁷

2.3Commercial Paper

The most commonly used short-term source of financing for corporations is commer-

cial paper. As first defined in Chapter 1, commercial paperis a contract by which a

borrower promises to pay a prespecified amount to the lender of the commercial paper

at some date in the future, usually one to six months. This prespecified amount is gen-

erally paid off by issuing new commercial paper. On rare occasions, the borrower will

6

Equipment Leasing Association and Department of Commerce.

⁷Derivatives are covered in Chapter 7. Taxes and leasing are covered in Chapter 14.

Grinblatt94Titman: Financial	I. Financial Markets and	2. Debt Financing	© The McGraw94Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

Chapter 2

Debt Financing

35

not choose this rollover, perhaps because short-term interest rates are too high. In this

case, the company pays off the commercial paper debt with a line of credit (announced

in the commercial paper agreement) from a bank. This bank backing, along with the

high quality of the issuer and the short-term nature of the instrument, makes commer-

cial paper virtually risk free.⁸

However, defaults have occurred, the most famous of

which was the Penn Central default of June 1970 on $82 million of commercial paper.

Who Sells Commercial Paper?

Firms that lend money, such as bank holding companies, insurance companies, and pri-

vate consumer lenders like Household Finance, Beneficial Finance, and General Motors

Acceptance Corporation, issue about two-thirds of all U.S. commercial paper. The

highest-quality nonfinancial corporations issue the remaining portion. While large

financial firms issue their own commercial paper directly, much of it to money-market

funds, nonfinancial firms issue their commercial paper through dealers.

Buyback Provisions

Most commercial paper can be sold to other investors, although this rarely occurs

because the costs of such transactions are high. Aconsequence of this lack of second-

ary market activity is that virtually all issuers of commercial paper stand ready to buy

back their commercial paper prior to maturity, often with little or no penalty. However,

less than 1 percent of commercial paper is redeemed prematurely.