Sources of funding for the corporate sector (Part iii)
This write-up is a continuation of an earlier publication on various funding sources available to corporate bodies and the usefulness of these funds to the expansion and growth of firms in a given economy. Discussions in the previous feature ended on sources of funding for the corporate sector in the long term.
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Lease financing
This explains a contractual agreement between the owner of an asset, called lessor, and the user of the asset, called lessee. A lease contract requires the lessee to make specific payments to the lessor at specific dates over a given period of time.
Types of leases
Leases can be grouped into two: operating lease and capital lease.
Capital lease
This refers to a long-term financing lease that has non-binding obligation and transfers ownership of the asset to the lessee at the end of the lease term; the lessee is given the option to own the asset at the end of the lease financing period. The amount required to be paid by the lessee at the end of the lease term is usually low. An example is mortgage payments. The lower payment amount required by the lessor at the end of the lease term makes an exercise of the option reasonably certain.
Seventy-five per cent (75%) or more of the estimated life of the leased asset constitutes the term of the lease. At the beginning of the lease, 90 per cent or more of the fair value is equivalent to the minimum lease payments’ present value. The value of a capital lease is recorded and capitalised on the balance sheet.
Operating lease
This refers to a short-term financing lease that has non-binding obligation and does not transfer ownership of the asset to the lessee at the end of the lease term.
Thus, the lessee does not have the option to own the asset at the end of the lease financing period; ownership is reverted to the lessor at the end of the lease term.
An example is rental of a property or building. The value of an operating lease is not recorded on the balance sheet.
Difference between capital lease and operating lease
The total amount of a capital lease is discounted to the present value on the balance sheet. On the income statement, it is treated in relation to an agreement between purchaser and borrower. The intangible asset account is amortised or written off over the life of the lease with an annual expense deduction.
Regular amortisation is used to write off the liability account, using an implied interest expense on the outstanding present value of the liability. The foregoing explanations affirm the existence of a similarity between contracting a loan (borrowing) to purchase an asset and a capital lease. An operating lease has no specific amortisation. Rather, some deductions are made on an annual basis to equal the lease payment. Here, the lessee uses the equipment released on agreement by the lessor at no additional liability on the lessee’s balance sheet. Operating lease is suitable for a firm that is close to its debt capacity and would not like to jeopardise its credit ratings.
Importance of lease financing
The use of lease as a means of funding the operations of a business is useful in several ways. First, conditions associated with a bond debenture are more restrictive than those of lease obligations. Second, lease obligations often do not require down payments, compared with an outright purchase of an asset. The non-down payment allows the lessee to secure a larger indirect loan.
Third, the incidence and negative effect of obsolescence are reduced since the lessor usually possesses specific knowledge which allows for selection of product, maintenance and eventual resale of the leased assets. Fourth, bankruptcy and re-organisation proceedings tend to limit creditors’ claims on certain types of leases such as real estate. However, the limitation does not apply to leases on chattels or non-real estate items. Finally, lease agreements allow a lessee to acquire assets that hitherto may not be possible under a direct purchase.
Sale-leaseback agreement
This is where a lessee sells an asset already owned to a lessor and leases it back. This arrangement enables the lessee to increase business capital while using the assets for business operations. Although cost of owning the asset is usually higher than the cost of leasing, the merits associated with the sale-leaseback are higher than the cost of direct purchase.
Debentures
These are negotiable instruments. They are a type of bond issued by an organisation to holders, promising to pay a fixed premium or interest usually on a semi-annual basis. A debenture holder is a creditor of the issuing firm. Maturity period of debentures may be extended to 15, 20 or more years. Debentures, especially those of public-listed companies, can be traded on the stock exchange market. The market price of debentures sometimes has an inverse relationship with current interest rates.
Merits of debentures
Raising corporate funds through debentures is useful in diverse ways. First, servicing and interest costs are known with certainty by the issuing firm. In addition, the issuing company could repurchase the loan stock from holders in the market at a later date. Also, the repurchase may be economical in periods of lower interest rates and lower refinancing costs. Finally, funds generated through debentures are used as capital over a considerable period of time.
Demerits of debentures
In spite of the numerous benefits associated with the use of debentures as essential fund mobilisation vehicle, there are some identified challenges. For instance, borrowing through issuance of debentures becomes very unattractive in periods of high interest rates; companies prefer to stay away from high interest payments over a long period of time. Similarly, debenture agreements may limit the life span of a firm when the loan is backed by a trust deed. The deed may restrict the future borrowing size and condition of the firm. In such a situation, the issuing firm may be required to settle all outstanding debenture loans before continuing with its operations.
Ebenezer M. Ashley (PhD)
Lead Consultant/CEO
Eben Consultancy
Fellow Chartered Economist &
Council Member, ICEG
Email: [email protected]
Website: www.ebenezerashley.com