Financial Management 2

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Sources of Long-term Financing

Sources of Long-term Financing

This module covers discussions of the different sources of long-term
financing such as bonds, equity shares- preferred and ordinary or common,
and leases. We will be studying the nature of the mentioned sources of long-
term funding, as well as their features, risks, advantages and disadvantages,
and other characteristics.
At the end of the module, you should be able to:
1. Identify the sources of business capital.
2. Understand the nature, features, pros and cons, of these sources.
3. Calculate the intrinsic value of preferred shares.
4. Compute the ordinary shares valuation using the finite and infinite-
period methods.
5. Understand leases as source of capital

Introduction
We have discussed in the previous module, the capital structure of a business
firm. Companies fund their current and new assets using capital. These
capital that are used to finance assets are of two origins – equity financing or
shares that the firm sells to prospective investors called shareholders, debt
financing or the firm’s borrowed money from creditors, and retained
earnings or the portion of the net income that is retained by the company and
reinvested.
The company’s preference funding capital depends on the size of the
business, its life cycle and plans for future growth.

Sources of Capital for Businesses

Personal investments made by the owners of the firm may not be enough
particularly if the business is getting bigger. Financing capital can be made
through borrowing of funds from private investors or public sources.
Equity, Debt, Debentures, retained earnings, term loans, working capital
loans, letter of credit, euro issue, venture funding are some of the sources of
funds. They are grouped based on time period, ownership control, and
source of generation.
 Time-period Financing
Time period is further classified into three:
1. Long Term Sources of finance. This long-term financing pertains to capital
needed for a period of more than five years to 10, 15, and 20 years or

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 even more. This finances are usually used to fund capital expenditures
(fixed assets e.g. plant and machinery, land and building, etc.). Examples
of long-term sources of finance are share capital, preference shares,
retained earnings, bonds, term loans from financial institutions,
international financing by means of euro issue, foreign currency loans.
2. Medium Term Sources of Finance. This pertains to financing for a period
of three to five years. There are two possible reasons for this type of
financing: long term capital is not currently available, and deferred
revenue expenditures are incurred and to be written off over the period
of three to five years. Examples of this medium term sources are
preference shares, bonds, and medium term loans for financial
institutions, lease, and hair-purchase finance.
3. Short term Sources of Finance. Short term financing is funding for a short
period of less than one year. This usually funds current assets like
inventory of materials, finished goods, debtors, etc. This is also termed
working capital financing. These sources are in the form of trade credits,
short term loan from commercial banks, advances received from
customers, creditors, factoring services, and bill discounting.
 Finances Categorized as to Ownership and Control
In selecting a finance source for the firm, there are constraints that should
be considered: interest and sharing of ownership and control.
1. Owned capital or ownership shares. This is referred to as equity
capital. These finances came from the investors or general public in
exchange of the issuance of new shares of stock. Owner’s capital is
obtained from equity capital, preference capital, retained earnings,
convertible debentures/bonds, and private equity.
2. Borrowed capital. Also called Debt financing. This capital is sourced
from outside sources including loans from family, relatives, and
friends and external loans from financing institutions, commercial
banks, and the general public in the form of debentures/bonds.
Features of borrowed capital include:
a) The company-borrower will pay the creditors first in case of
liquidation.
b) Regular payment of interest and repayment of capital.
c) There is no reduction in ownership and business control.
d) Interest or the cost of borrowed funds is a deduction for tax
purposes resulting to decrease in taxes for the company.
e) It provides the firm a leverage benefit.

The disadvantages of borrowed capital are as follows:

a) Principal and interest obligations have to be paid regardless of the
economic condition of the company.
b) Some restrictions in the indenture agreement may be a burden on
the firm.

c) Debt may weaken outstanding ordinary shares if used in a long

period.
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Sources of Long-term Financing

 Finance Source Origin

1. Internal Sources – capital is generated internally. Internal sources,
which have the same characteristics of owned capital, include
retained earnings, reduction or controlling working capital, sale of
assets, internal sourcing allows the business to growth by itself.
2. External sources –one in which the capital is generated from outside
or third party.

In the following sections, we will discuss the following major sources of long-
term financing:
1. Bonds
2. Preference shares
3. Ordinary or common shares
4. Lease

Bonds
A bond is a promise in writing under seal, to pay a definite sum of money
with a fixed rate of interest thereon, at a definite future time or date, made by
one person to another or bearer. This is evidenced by a bond certificate
issued by a corporation or a government body representing the loan made by
the investor to the issuer of bonds.
The bond certificate shows the name of the company-issuer, the principal
amount the firm borrowed from the bondholder, the bond’s face value, and
interest rate to be paid by the issuer, dates of payment, maturity date and
value.
Issuance of bonds usually requires the services of a security underwriter,
which can be an investment bank or other financial institutions. The
underwriter purchases the bonds from the issuing company and resells them
to prospective clients.
Other agreements between the underwriter and the issuing firm in trading
bonds are as follows:
1. The investment bank can negotiate directly with the issuer.
2. The underwriter can participate in bidding for the purchase of bonds.
3. An investment bank can be a sole underwriter by acquiring exclusive
right to sell the bonds.
4. The investment bank can make an agreement with the issuer to sell the
bonds at the best market price it can for issuing company, not
guaranteeing a fixed price with the selling firm.

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Advantages of using bonds in the capital structure
1. Long-term debts are less expensive and the interest payments are
deductible for tax purposes.
2. Many investors considered these as a relatively safe investment.
3. Bondholders (buyers of the bonds) are paid interest and do not share
in the extraordinary earnings of the firm.
4. Bondholders are not corporate voters.
5. Bond’s flotation costs are lower than those of ordinary equity shares.
Disadvantages of utilizing bonds are:
1. Long-term debts can cause the firm’s bankruptcy if it fails to meet
interest payments.
2. The fixed charges on bonds, other than income bonds, increase the
company’s financial leverage. This is unfavorable for firms with
unstable income.
3. Bonds’ repayment at maturity (principal amount) involves a huge
cash outflow.
4. Bonds’ restricting agreements may hamper the firm’s future financial
flexibility.

Bond Attributes and Prices

The different elements or features of debt that would be very helpful in our
understanding of bonds are as follows:
 Par Value – refers to the face value of the bonds that is returned to the
bondholder at maturity date.
 Contract interest rate or stated interest rate – pertains to the interest rate
that determines the amount of interest to be paid by the issuer and to be
received by the investor or bondholder each year. The contract rate is
stated in the bond certificate or contract and does not change during the
duration of the bonds.
 Coupon interest rate – refers to the percentage of par value that will be
paid annually in the form of interest. Computed by dividing stated
interest payment by par value.
 Market interest rate or effective interest rate – is the interest rate that
investors demand for lending their money to the bond issuer.
 Maturity (date) – refers to the date or time that the bond issuer returns
the par value of the bond and terminates it.
 Market price of the bonds – is the bond’s present value which is the total
of the present value of the principal amount/payment and the present
value of the cash interest payments.
 Present value – is the amount that an investor would invest now to
receive a greater amount at a future date.
 Yield to maturity – refers to the bonds internal rate of return (IRR). It is
the discount rate that equates the present value of the interest and
principal payments with the current market price of the bonds.
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Sources of Long-term Financing

Formula for Yield to Maturity:

Principal Payment - Price of the Bond
Annual Interest
Approximate Payment + Number of Years to Maturity
Yield to Maturity =

.6 (Price of the Bond) + .4(Principal Payment)

 Current yield – pertains to the ratio of the annual interest payment to the
market price of the bonds.
 Indenture- refers to the arrangements between the issuer and the bond
trustee who represents the bondholders. It includes the specific terms of
the loan agreement, description of the bonds, the bondholders’ rights, the
issuing firm’s rights and the responsibilities of the trustee.
 Bond Premium – is the excess of the bond’s issue price over its maturity
or par value.
 Bond Discount – is the excess of the bond’s maturity or par value over it
issue price.
 Credit quality risk – refers to the possibility that the issuer of the bonds
will not be able to meet timely payments.
 Bond ratings - relate to the opinions or perceptions about the future risk
potential of the bond. The following factors affect the bond ratings:
profitable operations, little inconsistencies of previous earnings, firm’s
size, less usage of subordinated debt, less application of financial
leverage.

Types of Bonds

1. Unsecured Long-term Bonds

 Income Bonds. These are usually issued during the reorganization of

a company facing problems. This requires interest payments only if
earned and non-payment of interest does not precede insolvency.
Accumulated unpaid interest must be paid prior to payment of
dividends to shareholders.
 Debenture Bonds. These bonds are backed only by the good faith of
the bond issuer.
 Subordinated Debentures. Subordinated debenture bondholders’
claims are honored only after the claims of the secured debt and
unsubordinated debentures have been satisfied.

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2. Secured Long-term Bonds
 Mortgage Bonds. This type of bonds is secured by a lien on real
property. The value of the real property should be greater than the
value of the mortgage bonds issued. If the issuer fails to pay the bonds
at maturity, the trustees can foreclose or sell the mortgaged property
in order to pay the bondholders.
Sub- classifications of mortgage bonds are as follows:
o First mortgage bonds – bondholders of first mortgage bonds
are prioritized first in claims on the secured assets if the same
property has been pledged on more than one mortgaged
bonds.
o Second mortgage bonds – is next to first mortgage bonds on
claims and will be paid only after the first mortgage bonds’
claims are met.
o Blanket or general mortgage bonds – all the assets of the
company are utilized as security in this type of mortgage
bonds.
o Closed-end mortgage bonds – this does not allow the further
use of the pledged assets as security for other bonds.
o Open-end mortgage bonds – this allows the same pledged
assets as security for the issuance of additional mortgage
bonds. But this requires that additional assets to be added to
the secured property if new bonds are issued.
o Limited open-end mortgage bonds. These bonds allow the
issuance of additional bonds up to a limited amount of the
same priority using the same mortgaged property as security.
3. Other types of bonds

 Eurobonds. These are bonds payable in the borrower’s currency and

sold outside the country of the issuer by an international consortium
of investment bankers. The market for these bonds is denominated by
bonds in US dollars. These bonds are the bonds issued in Europe by an
American company; the principal and interest are paid in US dollars.
Some of the popular markets of Eurobonds are United States, Britain,
Germany, Netherlands, Japan, and Switzerland.
 Floating rate bonds. Also called Variable rate bond, this interest
payment for this kind of bonds changes with market conditions. The
floating rate ponds try to counter uncertainty by allowing the interest
rate to float.
 Treasury bonds. The safest fixed-income investment as perceived by
the investors is backed up by the government. The Bangko Sentral ng
Pilipinas (BSP) issues treasury securities through public auctions to
finance the government’s budget deficit and to implement monetary
policy.
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Sources of Long-term Financing

Retiring Debts
Repayment of debts can be done in the following ways:
1. Serial payments. Serial bonds are paid in installments over the life of the
issue. Each bond has its own maturity date and receives interest only up
to that point.
2. Conversion. This method of reducing outstanding debt provides for debt
conversion into ordinary shares as a prerogative of the bondholders.
3. Call provision. Callable bonds are bonds that the issuer may call or pay off
at a specified price whenever the issuer wants. These bonds give the
issuer the benefit of low interest rates by paying off callable bonds
whenever it is favorable. Interest rates fluctuate. The issuer may be able
to borrow at a lower interest rate and use the proceeds from new bonds
to pay off bonds issued at a higher interest rate. The call price is higher
than the bond’s par value. The difference is termed call premium.
4. Bond refunding. This is the process of retiring old bond issue prior to
maturity and replacing it by a new bond issue. Refunding occurs when
interest rates have gone low and new bonds can be sold at lower interest
rates.
Refunding is done if the benefits are greater than the costs. The decision
can be arrived at after comparing the present value of the benefits from
refunding versus the present value of the costs using the after-tax cost of
borrowing as the discount rate.

Preferred Shares
Preferred share is a kind of equity that gives its owners some advantages
over ordinary shareholders. These benefits include:
1. Right to receive dividends before the ordinary shareholders.
2. Right to receive assets of the company before ordinary shares in the event
of the firm’s liquidation.

Conditions When Issuing Preferred Shares Is Favorable

1. Some problems in issuing ordinary shares.
2. Earnings or profits are huge to make additional leverage appealing to
investors.
3. Additional loans create considerable risk.
4. Low interest rates lowering the cost of preferred shares.
5. The company’s high debt ratio proposing a mixture of equity financing.

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Attributes of Preferred Shares
Some of the major aspects of preferred shares for our understanding of this
type of equity financing are as follows:
 Par value. This is the face value of the preferred share that appears on
the stock certificate.
 Dividends. Stated as a percentage of par values, generally, on a fixed rate
and paid quarterly by the issuing company.
 Cumulative and noncumulative dividends. Cumulative dividends are
those dividends on preferred shares not paid for a particular year. These
past dividends and the current ones must be paid before the ordinary
shareholders. If the dividends are noncumulative, they are not declared in
any particular year and are forfeited. No claims by the preferred
shareholders will be made.
 Call feature and sinking fund provision. Preferred shares have no
maturity date. Majority of these shares have a call feature. This allows the
firm to buy-back the shares directly from its holders or owners but at a
price higher than its par value. This is termed call premium. The sinking
fund provision, on the other hand, requires the issuing company to
repurchase and retire the share on a scheduled basis.
 Convertibility. Preferred shareholders have the choice of converting
preferred shares to ordinary shares, depending on the conditions set.
 Voting rights. Generally, preferred shares have no voting rights
 Participating features. Participating preferred shares give its owners the
right to share in the profits above and beyond the declared dividends
along with the ordinary shares.
 Maturity. After more than three decades, most preferred shares have a
sinking fund and therefore an effective maturity date.

Pros and Cons of the Preferred Shares

Advantages of Preferred Shares

 Preference shares can be easily sold to investors who are very cautious
for the safety of their capital and want to receive a regular and fixed
return (interest) on it.

 When the company’s profit in a given year is not sufficient, dividends on

preferred shares can be postponed, particularly for cumulative preferred
shares, therefore there is no fixed burden on the firm’s finances.

 Generally, preference shares do not bear voting rights. Consequently, a

company can raise capital without dilution of control. Ordinary Equity
shareholders retain exclusive control over the company.

 Preference shares do not establish any mortgage or charge on the assets

of the company, so, the company can use their fixed assets in raising
future loans.
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Sources of Long-term Financing

 A company can issue redeemable preference shares for a fixed period.

The risk of over-capitalization is eliminated and the capital structure
remains flexible
The disadvantages of preferred shares are:
 Preferred shares have none to minimal voting rights. Preferred owners
can rarely elect directors.

 Preferred shares have bigger after-tax costs of capital than debt. This is
because dividends on preferred shares are not deductible while interest
is for tax purposes.

 The preferences of preferred shares when it comes to dividends and

assets in case of the company’s liquidation may put at risk the ordinary
shares’ return.

Valuation of Preferred Shares

Preferred share is often considered a hybrid investment or security. It has
the qualities of a share and a debt (bond). This makes its valuation a bit
different than an ordinary share. The preferred shareholder is a part owner
of the firm just like an ordinary shareholder. It has fixed payment in the form
of dividend just as the bond issued by the company has its fixed interest.

The dividend payments for preferred shares can be made quarterly, monthly
or annually, depending on the stated company policy. These fixed dividends
will also be the basis for valuation of preferred shares. The value of the
preferred shares can be calculated by discounting each of the dividend
payments. The fixed dividend payments can be treated in perpetuity and be
discounted using the investors required rate of return. Perpetuity is an
annuity with an infinite life span. Annuity is stream of cash flows. In finance,
it is a constant stream of identical cash flows with no end. The concept of
perpetuity is also used the dividend discount model.

The formula to calculate the value of the preferred share is

Where:
V = value of preferred share
D = Cash Dividend per share
r = investor’s required rate of return on preferred share

Because the dividend is fixed every period, the formula can be reduced to;
V= D÷r
Illustrative Problem 4.1 Preferred Share Valuation

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 EBC Company pays an annual P 10 dividend on its issue of preferred share.
The investors require an 8% rate of return on this preferred share.
Required: compute for the expected value of the preferred share.
Solution:
V = D /r
V = P 10 / .08
V = P 125
=====

Ordinary (Common) Equity Share

Ordinary equity share, traditionally known as common stock, is the basic
form of capital stock or share. The word “stock” is meant to be “common
stock or ordinary share” unless designated otherwise. Investors of ordinary
shares take the ultimate risk with the issuing firm as the company makes no
promises to pay them. If the company is successful and earns profits, it will
pay dividends to the ordinary shareholders but if the company’s net income
is too low, it may opt not to distribute dividends to the them.
Valuation of ordinary equity shares becomes complicated because of the
uncertainty of its future returns. Uncertainties for ordinary equity
shareholders include dividends payment- because there is no legal
requirement to pay them unless the dividends are declared by the Board of
Directors; the dividends may be constant, increase or decrease; future prices
of ordinary shares are uncertain.
Valuation Methods of Ordinary Equity Shares
Our discussion on valuation of ordinary equity shares will focus on methods
based on holding periods and dividend growth rate.
Ordinary Equity Shares -Valuation models based on holding periods.
1. Finite-Period Dividend Valuation – This approach is described as one
in which the investor intends to buy ordinary equity share and keep it for
a specific span of time. During the holding period, the ordinary equity
shareholder anticipates to receive cash dividends and the sell the shares
for a price at the end of the retaining or holding period.
The formula to calculate the value of ordinary equity share:
n
Po = ∑ Dt Pn
t= 1 __________ + __________
(1 + Ks) (1 + Ks)n
Where:
D1 = Cash dividend paid per ordinary equity share in period t
Pn = share price per ordinary equity share in period n
Ks = Investor’s required rate of return on ordinary equity
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Sources of Long-term Financing

Illustrative Problem 4.2 Calculation of the Intrinsic Value of Ordinary

Equity share - Finite-Period Dividend Model
Mr. A intends to buy ordinary equity shares of LMN Corporation on January
1, 2017 and sell them at the end of the year. He is expecting that the
corporation will pay P8.50 cash dividend per share. He also plans to sell the
shares at P60 each year end. His required rate of return is 12%.
What is the value of an ordinary equity share to Mr. A.?
Solution:
Po = P8.50 + P60.00
(1+ .12) (1 + .12)
= P68.50
1.12
= P 61.16
======
2. Infinite-Period Dividend Valuation Model
This approach assumes that the investor will buy ordinary equity shares
and hold it indeterminately. The returns or dividends are only over the
multiple periods. The formula for the value of ordinary equity share
under this model is
∞
Po = ∑ Dt or Po = Dp
t= 1 __________ Ks
(1 + Ks)t
Where:
Dp = Cash dividend paid per share paid on a perpetuity
Ks = Investor’s required rate of return on ordinary equity
∞ = infinity
Illustrative Problem 4.3 Calculation of the Intrinsic Value of Ordinary
Equity share - Infinite-Period Dividend Model
Mr. A intends to buy ordinary equity shares of LMN Corporation on January
1, 2017 and hold them indefinitely. He is expecting that the corporation will
pay P8.50 cash dividend per shareHis required rate of return is 12%.
What is the value of an ordinary equity share to Mr. A.?

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Solution:
Po = Dp
______

Ks
= P8.50
.12
= P 70.83
======
Ordinary Equity Shares -Valuation models based on Dividend Growth
Rates
1. Zero Growth Dividend Valuation – This model presumes that the
dividends on ordinary equity share remain a fixed amount over time.
Formula is:
Po = Dp
______
Ks

Illustrative Problem 4.4 Calculation of the Value of Ordinary Equity

share – Zero Growth Dividend Model
LMN Corporation anticipates paying P3.60 cash dividend at the end of the
year indefinitely. Investors required rate of return is 12%.
What is the value of the ordinary share of LMN Corporation?
Solution:
Po = Dp P 3.60
______ = .12 = P 30.00
Ks
2. Gordon Constant Growth Dividend Valuation – This approach assumes
that dividends grow at a constant rate each period.
Formula:
D1
P0 =
ks − g

where: D1 = Dividends Year 1

ks = Investors' Required Rate of Return
g = Growth Rate in Dividends
D1 would be calculated by multiplying current dividends by
(1 + g).
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Sources of Long-term Financing

Illustrative Problem 4.5 Calculation of the Value of Ordinary Equity

share – Gordon Constant Growth Dividend Model
EBC Corporation is presently paying P4 per share in ordinary equity share
dividends. The company’s dividends are expected to grow at a constant rate
of 5% annually. Investors required rate of return is 16%.
What is the ordinary equity share value?
Solution;
D1 = P4.00 X (1 + .05) = P 4.20
Po = P4.20 / (.16 -.05) = P 38.18

3. Supernormal Growth Dividend Valuation Model – This model assumes

that returns in the form of dividends grow at an above normal rate over
time period and grow at a normal rate thereafter. This approach states
that the value of the company’s ordinary equity share equals the present
value of the expected dividends during the normal growth period plus
the present value of the sale price at the end of the above normal growth
period.
Formula:

m
Do (1 + gs)t
Po = ∑
T = 1 (1 + ks)t
Where:
Gs = supernormal growth rate
m = period of supernormal growth

Illustrative Problem 4.6 Calculation of the Value of Ordinary Equity

share –Supernormal Growth Dividend Model

EBC expects dividends to grow at a rate of 12% a year for the next 6 years
and 8% annually thereafter. The company’s current dividend per share is
P3.00. The investors required rate of return is 15%.

What is the value of the ordinary equity share of EBC?

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 Solution:
First, find the present value of the dividends during the above-normal
growth period.
PV
Interest PV
Year Dividend Factor Dividend
1 P 3.00 X 1.120 = P 3.360 0.86957 P 2.92
2 P 3.00 X 1.254 = 3.762 0.75614 2.84
3 P 3.00 X 1.405 = 4.215 0.65752 2.77
4 P 3.00 X 1.574 = 4.722 0.57175 2.70
5 P 3.00 X 1.762 = 5.286 0.49718 2.63
6 P 3.00 X 1.974 = 5.922 0.43223 2.56
Total P 16.42
Second, find the PV of the share price in year 6.
Ps = (P 5.92 X 1.08) / .12 = P 53.33

Third, discount the share value at the end of year 6 to the present at the
15% rate of return.
PV = P 53.33 X .43233 = P 23.06

Fourth, add the PV of the 6 years dividends and the PV of the share value
in year 6 to get the value of the share at the end of the above normal
growth period.

Po = P 16.42 + P 23.06
= P 39.48

Lease Liability
A lease is a rental agreement in which the tenant or lessee acquired the use of
an asset and agrees to make rent payments to the lessor or the owner of the
property.
Classification of leases
There are two kinds of leases: Operating lease and Capital or Finance lease.
Operating Lease
The features of an operating lease are as follows:
1. It is short-term and can easily be cancelled.
2. The lessor is responsible for the maintenance of the asset.
3. The lessee uses the asset but the lessor retains the usual risks and
rewards of owning the asset.
4. The lessee has no option to purchase the asset after the end of the lease
term.
5. The lessor has the option to lease again the asset to another party.
6. The total of all lease payments by the lessee does not guarantee the full
recovery of the cost of the asset.
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Sources of Long-term Financing

7. The lessee’s record shows no leased asset and no lease liability.

8. The lessee is safe from the burdens of technical obsolescence.

The operating lease is a better choice in the following conditions:

1. If the suitability of the asset in the long-run is uncertain.
2. If the asset is subject to fast obsolescence.
3. If there is an urgency for the use of the asset, e.g. solving a temporary
problem.

Illustrative Problem 4.7 Reporting Operating Lease

XYZ Company grants EBC Corporation a lease with three months free (no-
payment) rent under a five- year operating lease. The lease is effective
January 1, 2017, with a monthly rental of P25, 000 to start on April 1, 2017.

How much rent expense must be reported in the income statement of EBC
Corp. on December 31, 2017?

Solution:
Term of the lease – 5 years 60 months
Less rent-free months 3 months
Number of lease payment 57 months
Lease per month P25, 000
Total rentals P1, 425,000
Lease term 5 years
Rent Expense, Dec. 31, 2017 P 285,000
========
Note: If the lease agreement has a rent-free months, the total cash rental
should be amortized using the straight-line method unless there is another
specified method to use.

Finance/Capital Lease

A lease is classified as a finance lease if it transfers substantially all the risks

and rewards incident to ownership. All other leases are classified as
operating leases. Classification is made at the inception of the lease. [IAS
17.4]
Whether a lease is a finance lease or an operating lease depends on the
substance of the transaction rather than the form. Situations that would
normally lead to a lease being classified as a finance lease include the
following: [IAS 17.10]
 The lease transfers ownership of the asset to the lessee by the end of the
lease term;

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 The lessee has the option to purchase the asset at a price which is
expected to be sufficiently lower than fair value at the date the option
becomes exercisable that, at the inception of the lease, it is reasonably
certain that the option will be exercised
 The lease term is for the major part of the economic life of the asset, even
if title is not transferred
 At the inception of the lease, the present value of the minimum lease
payments amounts to at least substantially all of the fair value of the
leased asset
 The lease assets are of a specialized nature such that only the lessee can
use them without major modifications being made
Other situations that might also lead to classification as a finance lease are:
[IAS 17.11]

 If the lessee is entitled to cancel the lease, the lessor's losses associated
with the cancellation are borne by the lessee
 Gains or losses from fluctuations in the fair value of the residual fall to the
lessee (for example, by means of a rebate of lease payments)
 The lessee has the ability to continue to lease for a secondary period at a
rent that is substantially lower than market rent

Illustrative Problem 4.7 Reporting Finance Lease Liability

EBC Corporation signed a long-term lease for a building on January 1, 2017.
Terms of the lease include an annual payment pf P150, 000 starting end of
December 2017. The length of the lease is 25 years. The lease is a finance
lease. The present value of lease payments on January 1, 2017 is P 1,500,000
at 9% interest rate implicit in the lease.
How much should report as finance lease liability in the Statement of
Financial Condition (balance sheet) at December 31, 2017?

Solution:
Total lease liability, January 1, 2017 P 1,500,000
Less Payment 2017
Annual Rental P 150,000
Less
Interest (P1,500,000*9%) 135,000 15,000
Lease Liability, December 31, 2017 P 1,485,000
=========
 Financial Management 2
17
Sources of Long-term Financing

References and Online Supplementaries

Book References

Brigham, Eugene, Houston, Joel (2012) fundamentals of Financial

Management, South-Western Cengage Learning, Ohio, USA.

Cabrera, Ma. Elenita Balatbat (2015) Financial Management, Principles and

Applications, Vol. 2. GIC Enterprises Co. Inc. Manila

Horngren, Charles T., Harrizon Jr., Walter T, & Bamber, Linda S. Accounting.
Fifth Edition. Prentice Hall International Edition

Medina, Roberto G. (2016 reprint) Business Finance. Rex Book Store, Manila.

Supplementary Reading Materials

How to evaluate capital expenditures and other long-term investments

https://www.cgma.org/resources/tools/evaluate-capital-long-term-
investments.html
- Evaluating capital expenditures and long-term investments is a ... There are
two examples of investment analyses using discounted cash flow ...
Accessed: October 31, 2017

Lecture 10: Corporate Equity, Debt and Taxes

www.econ.yale.edu/~shiller/course/252/Lect11EquityDebtTaxes.ppt
Liabilities. Short-term debt $3957; Long-term debt $10994; Deferred taxes
$2263; Preferred stock $669; Other $6020; Shareholders equity $4911; Total
$28814.
Accessed: October 31, 2017

CHAPTER 11
bus.emory.edu/scrosso/BUS512M/512M.19/.../TEXTsupportch11.pdf
Long-term notes payable, bonds payable, and leasehold obligations, and how
companies .... A. Short-term investments in equity securities (Chapter 8). B.
Notes ...
Accessed: October 31, 2017

Supplementary Online videos

Video 7.4: 3M Company: Long-Term Debt and Leases - University of ...

https://www.coursera.org/.../lecture/.../video-7-4-3m-company-long-term-
debt-and-le...

Financial Management 2
Feb 5, 2016 - Video created by University of Pennsylvania for the course
"More Introduction to Financial Accounting". We move to the right-hand side
of the ...
Accessed: October 31, 2017

M2L3V1: Long-Term Liabilities - University of Illinois at Urbana ...

https://www.coursera.org/learn/financial.../lecture/O2jxf/m2l3v1-long-
term-liabilities
You will then move to financing of assets and discuss accounting for
liabilities. The course will continue with an in-depth exploration of
shareholders' equity.
Accessed: October 31, 2017