FIN 571 Week 6 Long-Term Financing Decisions Example

A Term Loan, a Canning Line Lease or a Brewer's Minority Stake? Cascade Ridge Chooses Long-Term Financing With a Lease-Versus-Buy Analysis and the Family's Control in View

[Student Name]

University of Phoenix

FIN/571: Corporate Finance

Week 6 Assignment

[Instructor Name]

[Date]

Cascade Ridge Beverage, its lenders, the lessor and the investor are composites written for a model paper; methods and research findings come from the sources listed.

Cascade Ridge Beverage, the composite brewer in Bend, Oregon, will build its $9 million canning line and $4.5 million Portland taproom next year, as chosen in Week 5. Internal cash flow after dividends will cover part of the cost, and the working capital improvements from Week 4 free about $4.9 million. The remaining long-term funding need is about $11 million. The founding family, which owns 80 percent of the shares, asked for a plan that keeps the company safe and keeps the family in control. Every financing source has a price, and for a family company some of the price is paid in control rather than dollars. This paper compares the options.

Option One: A Bank Term Loan

The company's bank offered a seven-year term loan of up to $15 million at about 7.25 percent, amortizing evenly, secured by equipment and real estate. Its covenants cap total debt at 3 times EBITDA and require fixed charges to be covered at least 1.25 times. Borrowing $11 million would raise debt from $48 million to $59 million. With projected EBITDA of about $30 million next year, debt would be just under 2 times EBITDA, comfortably within the limit.

Option Two: Leasing the Canning Line

An equipment finance company offered a seven-year lease on the canning line at $1.55 million a year, with each payment due in advance, with the lessor keeping the line at the end. Leasing would reduce the term loan needed by $9 million. Because a lease commits the company to fixed payments much as a loan does, the correct comparison is between leasing and borrowing to buy, with both discounted at the after-tax cost of debt, 7.25 percent times one minus the 26 percent tax rate, or about 5.4 percent (Brigham & Ehrhardt, 2022).

The Net Advantage to Leasing

Buying costs $9 million today. Against that, ownership provides depreciation tax shields under the seven-year schedule, worth about $1.9 million in present value, and the line's expected resale value of about $2 million after seven years, worth about $1.1 million after tax in present value. The present value cost of owning is about $6.0 million. The seven after-tax lease payments, each about $1.15 million and due in advance, carry a present value of about $6.9 million. The net advantage to leasing is about negative $0.9 million: leasing costs about $880,000 more than borrowing to buy. The lease would break even only at an annual payment near $1.35 million.

Why Companies Lease Anyway

Leasing can still make sense when a company cannot use tax deductions, values flexibility to return equipment or has limited borrowing capacity. Graham et al. (1998) found that firms with low tax rates lease more, consistent with lessors capturing tax benefits the lessee cannot use. Eisfeldt and Rampini (2009) argued that leasing lets financially constrained firms obtain more financing because a lessor can repossess an asset more easily than a secured lender. Cascade Ridge is profitable and has ample borrowing capacity, so neither reason applies strongly.

Nonfinancial Terms of the Lease

The lease also carried terms beyond its price. It limited annual production hours, with extra charges above a cap, and required the lessor's approval for modifications, which matters because Cascade Ridge plans to add a second filler head in year three. At the end of the term the lessor would remove the line unless the company bought it at fair market value, adding uncertainty about the company's capacity in year eight. Owning avoids these constraints. The only feature that favored the lease, a service contract on the filler, can be bought separately from the manufacturer for about $60,000 a year.

Option Three: A Brewer's Minority Stake

A large national brewer offered $25 million for 15 percent of Cascade Ridge, valuing the equity at about $167 million. That price is fair: at about 8 times EBITDA, enterprise value would be about $216 million, and after debt the equity would be worth about $168 million. The terms include a board seat, the right to approve any sale of the company and a right of first refusal to buy the family's shares. The cash would eliminate the need to borrow and fund the Hopless acquisition considered in Week 3.

What the Stake Would Cost the Family

The stake would dilute the family from 80 percent to 68 percent and, more importantly, give a competitor a seat at the table and a veto over any future sale, which could lower the price the family receives if it sells to someone else. The brewer would gain access to Cascade Ridge's distribution and plans. For a family that values independence, these terms carry a cost beyond the shares.

Testing the Recommended Debt

With an $11 million term loan, annual principal and interest would be about $2.1 million, added to existing debt service of about $7 million. Fixed charges, including taproom and warehouse rent, would total about $10.5 million against EBITDA of about $30 million, a coverage near 2.9 times. In a weak year, with EBITDA falling 25 percent to $22.5 million, coverage would still be above 2 times, and debt would be about 2.6 times EBITDA, within covenants but close enough that the company should hold its revolving line in reserve.

Fixed or Floating

The bank offered the term loan at a fixed 7.25 percent or at a floating rate starting near 6.75 percent. With the revolving line already floating and the family wanting predictable payments, the finance team chose the fixed rate for the term loan. That keeps about 80 percent of long-term debt fixed and limits the effect of a rate rise to the seasonal line. The extra half point of interest, about $55,000 in the first year, buys certainty over seven years.

Timing and Prepayment

The loan allows prepayment without penalty after year three. If the Hopless acquisition or another large opportunity arises, the company can refinance the term loan as part of a larger facility rather than layering new debt on top. Matching the loan's seven-year life to the canning line's useful life also follows the principle of funding long-lived assets with long-term money.

The Recommendation

Cascade Ridge should borrow $11 million on the seven-year term loan, buy the canning line rather than lease it, decline the minority stake and revisit equity only if it pursues a large acquisition. The plan keeps the family's control, uses the cheapest source of funds and leaves borrowing capacity for the seasonal line from Week 4.

Conclusion

Comparing a term loan, a lease and a minority stake shows that borrowing to buy is cheapest, that the lease costs about $880,000 more in present value and that the brewer's fair price carries terms that would limit the family's future choices. A term loan within covenants funds the growth plan built over the course while keeping Cascade Ridge independent.

References

Brigham, E. F., & Ehrhardt, M. C. (2022). Financial management: Theory and practice (17th ed.). Cengage.

Eisfeldt, A. L., & Rampini, A. A. (2009). Leasing, ability to repossess, and debt capacity. The Review of Financial Studies, 22(4), 1621-1657. https://doi.org/10.1093/rfs/hhn026

Graham, J. R., Lemmon, M. L., & Schallheim, J. S. (1998). Debt, leases, taxes, and the endogeneity of corporate tax status. The Journal of Finance, 53(1), 131-162. https://doi.org/10.1111/0022-1082.55404