CAPITAL

STRUCTURE AND
LONG-TERM
FINANCING
DECISION
CHAPTER IV
CONTENTS
1. FACTORS TO CONSIDER IN PLANNING THE METHODS OF FINANCING
2. CHARACTERISTICS OF DEBT VERSUS EQUITY
3. COST OF CAPITAL
4. DIVIDEND POLICY
5. LONG TERM FINANCING
1. THE CAPITAL MARKET
2. OBTAINING FUNDS FROM THE CAPITAL MARKET
3. ISSUING DEBT INSTRUMENTS (DEBT FINANCING)
4. ISSUING SECURITIES (EQUITY FINANCING)
5. LEASE FINANCING
FACTORS TO CONSIDER
IN PLANNING METHODS
OF FINANCING
FACTORS TO CONSIDER IN
PLANNING METHODS OF FINANCING
1. The amount required
2. Type of expenditure/purpose for which the capital is required
3. The length of time for which the money is required
4. The size, status and ability of the business to borrow
5. The business’ current level of gearing
6. The business’ level of reserves and profits
7. The cost of the source of finance
1. THE AMOUNT REQUIRED
Some sources of finance are not suited for raising large amounts of
money. For example, bank overdrafts have a limit as to how much
can be withdrawn. In this instance, it would be best to use sources
such as debentures, share capital or long term leases. Some
sources of finance are not also suited for raising small amounts of
money. For example, it would be imprudent to issue new shares to
finance the day to day operations of the business such as paying
wages.
2. TYPE OF EXPENDITURE/PURPOSE
FOR WHICH THE CAPITAL IS REQUIRED
Long term sources of finance are better suited to finance capital
expenditure projects such as building a new factory plant. Short
term sources of finance are more suited to finance revenue
expenditure projects such as paying suppliers.
3. THE LENGTH OF TIME FOR WHICH
THE MONEY IS REQUIRED
If the money is required only for a relatively short period of time it
would be best to use short term sources of finance. But when the
money will be tied up in the project for a long time it would be
prudent to use long term sources of finance such as debentures,
shares and long tern loans.
4. THE SIZE, STATUS AND ABILITY OF
THE BUSINESS TO BORROW
If the business is large and has collateral security which it can use
to borrow then it can consider borrowing from financial institutions.
If the business is smaller and lacks the collateral security to borrow,
borrowing might not be an option for them.
5. THE BUSINESS’ CURRENT LEVEL OF
GEARING
Gearing refers to what proportion of a business’s assets are paid of
by debt finance. A highly geared business should consider using
equity finance instead so as to reduce their level of risk. A lowly
geared business would do well to consider debt finance.
6. THE BUSINESS’ LEVEL OF RESERVES
AND PROFITS
Some businesses transfers their yearly profits to special/general
reserves. This is a form of ploughing back profits but holding it in
“special funds”. A highly profitable business can make use of
retained earnings to finance its operations and projects.
7. THE COST OF THE SOURCE OF
FINANCE
The available source of finance must be ranked according to their
capital cost. It is best to go with the choice of finance that the
business can afford.
DEBT VS. EQUITY
MEANING
DEBT EQUITY
 Debt financing involves  Equity financing involves
borrowing funds from selling the part of ownership
investors by issuing rights in the company to
corporate bonds. investors by issuing stocks.

 The reward here is Interest  The reward here is Dividend

income on the corporate on the equity shares
bonds. subscribed.

 Sources: Banks, private  Sources: Private Investors

companies and even friends
and families.
INVOLVEMENT
DEBT EQUITY
 Much less since there’s no  More because equity
ownership sharing. financing is all about sharing
ownership.
 You retain ownership of your
business, which means you  Investors may have control
will not have to share-profits over key decisions and
long term. influence the culture of the
company.
 DOES THE COMPANY SHARE PROFITS?

DEBT EQUITY
 No dividends is paid.  Yes, through dividends.
Instead of paying back a loan,
you share your profits with the
investor. The investor gains some
ownership of your business by
investing.

When the creditors/equity holders are paid?

 Irrespective of earning  Unless the company makes

profits or incurring a loss, profits, the equity shareholders
debt holders need to be don’t get paid.
paid.
 DEBT
ADVANTAGES DISADVANATGE
S
 The bank can’t tell you how to  You have to pay back the loan
run your business. You maintain within a designated time period.
full ownership.  Debt financing could cause
 After you pay the loan off, you small business cash flow
have no obligations to the bank. problems.
 Interest on the loan is tax  You will probably need to offer
deductible. business collateral.
 You can get a short-term or
long-term loan.
 You know what the principal and
interest cost you, so you can
create a business budget.
 EQUITY
ADVANTAGES DISADVANATGE
S
 You have less risk than you
 The returns you pay an investor
would with a loan.
could be more than bank loan
 You don’t pay the funds back.
repayments.
 Your investor’s network could
 The investor requires some
help your business gain
ownership of your business.
credibility.
 You need to consult the investor
 Investors don’t expect to see
before making business
an immediate return on
decisions.
investment (ROI).
 Choosing between debt and
 You have more cash on hand
equity financing
without repayments.
 KEY FACTORS

• Equity financing is best for new startup having high business

potential.
• Equity financing take part with the ownership and some control.

DECISION MAKING

• The debt financing is always beneficial when the small amount of

capital is needed.
• Giving away equity for solving short-term needs is not a good
decision.
• You can use a mix of debt and equity financing to lessen the
disadvantages of each. By using both options, you reduce the
amount of debt you owe and business ownership you give to
investors.
COST OF CAPITAL
COST OF CAPITAL
Cost of capital refers to the opportunity cost of making a specific
investment. It is the rate of return that could have been earned by putting
the same money into a different investment with equal risk. Thus, the cost of
capital is the rate of return required to persuade the investor to make a
given investment.
WHY COST OF CAPITAL MATTERS
Cost of capital is an important component of business valuation work.
Because an investor expects his or her investment to grow by at least the cost
of capital, cost of capital can be used as a discount rate to calculate the fair
value of an investment's cash flows
AN OVERVIEW OF THE WEIGHTED AVERAGE
COST OF CAPITAL
* A weighted average of the component costs of debt, preferred stock, and
common equity
EXAMPLE:
 COST OF DEBT,
 The interest rate a firm must pay on its new debt is defined as its before-tax
cost of debt, . Firms can estimate by asking their bankers what it will cost to
borrow or by finding the yield to maturity (or yield to call if the debt is likely
to be called) on their currently outstanding debt However, the after-tax cost
of debt, (1 – T), should be used to calculate the weighted average cost of
capital. This is the interest rate on new debt, rd, less the tax savings that
result because interest is tax deductible:
Example: Using the same Problem
FLOTATION COSTS AND THE COST OF DEBT
Most debt offerings have very low flotation costs, especially for privately
placed debt. Because flotation costs are usually low, most analysts ignore
them when estimating the after-tax cost of debt. However, the following
example illustrates the procedure for incorporating flotation costs as well as
their impact on the after-tax cost of debt.
FORMULA:
Example: Using the same Problem
Suppose NCC can issue 30-year debt with an annual coupon rate of 9%, with coupons paid
semiannually. The flotation costs, F, are equal to 1% of the value of the issue. Instead of
finding the pre-tax yield based upon pre-tax cash flows and then adjusting it to reflect
taxes, as we did before, we can find the after-tax, flotation-adjusted cost by using this
formula
 COST OF PREFERRED STOCK,
 The component cost of preferred stock used to calculate the weighted
average cost of capital, , is the preferred dividend, , divided by the current
price of the preferred stock, .
FORMULA:
Example: Using the same Problem
 COST OF COMMON STOCK,
Companies can raise common equity in two ways: (1) by selling newly issued
shares to the public, and (2) by retaining and reinvesting earnings. If new
shares are issued, what rate of return must the company earn to satisfy the
new stockholders. However, a company must earn more than rs on new
external equity to provide this rate of return to investors, because there are
flotation costs when a firm issues new equity. Few firms with moderate or
slow growth issue new shares of common stock through public offerings.In
fact, less than 2% of all new corporate funds come from the external public
equity market. There are three reasons for this.
THE CAMP APPROACH
 To estimate the cost of common stock using the Capital Asset Pricing Model .

1. Estimate the risk-free rate, .

2. Estimate the current market risk premium, , which is the required market
return minus the risk-free rate.
3. Estimate the stock’s beta coefficient, , which measures the stock’s relative
risk. The subscript i signifies Stock i’s beta.
FORMULA:
EXAMPLE:
BOND-YIELD PLUS RISK PREMIUM APPROACH
DIVIDEND-YIELD-PLUS-GROWTH-RATE, OR
DISCOUNTED CASH FLOW (DCF), APPROACH
For companies that are expected to remain in business indefinitely, the cash
flows are the dividends; on the other hand, if investors expect the firm to be
acquired by some other company or to be liquidated, the cash flows will be
dividends for some number of years plus a terminal price when the firm is
expected to be acquired or liquidated.
FORMULA:
Example:

Based on the DCF method, 13.7% is the minimum rate of return that should be
earned on retained earnings to justify plowing earnings back into the business
rather than paying them out as dividends. Put another way, since investors are
thought to have an opportunity to earn 13.7% if earnings are paid out as
dividends, the opportunity cost of equity from retained earnings is 13.7%.
DIVIDEND
POLICY
WHAT IS A DIVIDEND?
It refers to that part of profits of a company which is distributed by
the company among its shareholders.
It is the reward of the shareholders for investments made by them in
the shares of the company.
WHAT IS A DIVIDEND POLICY?
Dividend policy is the policy a company uses to structure its
dividend payout to shareholders.
Dividend policy is a financial decision that refers to the proportion
of the firm’s earnings to be paid out to the shareholders.
UNDERSTANDING DIVIDEND
POLICY
Most companies view a dividend policy as an integral part of the
corporate strategy. Management must decide on the dividend
amount, timing and various factors that influence dividend
payments.
The investors are interested in earning the maximum return on their
investments and to maximize their wealth. On the other hand,
companies needs to provide funds to finance its long term growth.
IMPORTANCE OF DIVIDEND
POLICY
The dividend policy is important because it outlines the magnitude,
method, type and frequency of dividend distributions.
At the highest level of decision making, companies have two basic
options regarding what to do with their profits: retain or distribute
the earnings.
TYPES OF DIVIDEND POLICY
• Regular dividend Policy
• Stable dividend policy
• Irregular dividend policy
• No dividend policy
REGULAR DIVIDEND POLICY
The company pays out dividends to its shareholders every year.
If the company makes abnormal profits (very high profits), the
excess profits will not be distributed to the shareholders but are
withheld by the company as retained earnings. If the company
makes a loss, the shareholders will still be paid a dividend under the
policy.
It is used by companies with a steady cash flow and stable earnings.
STABLE DIVIDEND POLICY
The percentage of profits paid out as dividends is fixed.
Investing in a company that follows such policy is risky for
investors as the amount of dividends fluctuates with the level of
profits.
IRREGULAR DIVIDEND POLICY
The company is under no obligation to pay its shareholders and the
board of directors can decide what to do with the profits.
Used by the companies that do not enjoy a steady cash flow or lack
of liquidity.
Face very high risks as there is a possibility of not receiving any
dividends during the financial year.
NO DIVIDEND POLICY
The company does not distribute dividends to shareholders.
Profits earned is retained and reinvested into the business for future
growth.
Companies that don’t give out dividends are constantly growing and
expanding, shareholders invest in them because the value of the
company stock appreciates.
LONG-TERM
FINANCING
LONG-TERM FINANCING
means financing by loan or borrowing for a term of more than one
year by way of issuing equity shares, by the form of debt financing,
by long term loans, leases or bonds and it is done for usually big
projects financing and expansion of company and such long term
financing is generally of high amount.
LONG-TERM FINANCING
The fundamental principle of long-term finances is to finance the
strategic capital projects of the company or to expand the business
operations of the company.
These funds are normally used for investing in projects that are
going to generate synergies for the company in the future years.
Eg: – A 10-year mortgage or a 20-year lease.
THE CAPITAL
MARKET
THE CAPITAL MARKET
Capital markets are venues where savings and investments are
channeled between the suppliers who have capital and those who
are in need of capital. The entities that have capital include retail
and institutional investors while those who seek capital are
businesses, governments, and people.
THE CAPITAL MARKET
Capital markets are composed of primary and secondary markets.
The most common capital markets are the stock market and
the bond market.
Capital markets seek to improve transactional efficiencies. These
markets bring those who hold capital and those seeking capital
together and provide a place where entities can exchange securities.
THE CAPITAL MARKET
The term capital market broadly defines the place where various
entities trade different financial instruments. These venues may
include the stock market, the bond market, and the currency and
foreign exchange markets. 
Capital markets are a crucial part of a functioning modern economy
because they move money from the people who have it to those who
need it for productive use.
PRIMARY MARKET
Primary markets are open to specific investors who buy securities
directly from the issuing company. These securities are considered
primary offerings or initial public offerings (IPOs). When a company
goes public, it sells its stocks and bonds to large-scale and
institutional investors such as hedge funds and mutual funds.
SECONDARY MARKET
The secondary market, on the other hand, includes venues overseen
by a regulatory body like the Securities and Exchange Commission
(SEC) where existing or already-issued securities are traded between
investors. Issuing companies do not have a part in the secondary
market.
The secondary market serves an important purpose in capital markets
because it creates liquidity, giving investors the confidence to
purchase securities.
OBTAINING
FUNDS FROM THE
CAPITAL MARKET
OBTAINING FUNDS FROM THE
CAPITAL MARKET
A capital market is for investing funds in debentures, shares,
bonds, etc. of companies. Investors can invest their funds in a safe
and profitable manner through stock exchanges.
Method of accessing means a way of getting to a place. Firms
and institutions can raise medium and long-term funds by way of
tradable securities and non-tradable securities.
PUBLIC ISSUE
In a capital market, company can borrow funds from primary
market by way of public issue of shares and debentures. To manage
its issue a company can take the help of merchant bankers. The cost
of raising funds through public issue is high as compared to other
methods.
RIGHTS ISSUE
In capital market, rights issue means selling securities in primary
market by issuing shares to existing shareholders.
PRIVATE PLACEMENT
The capital issue is sold directly to a small group of investors.
Mainly institutional investors like insurance companies, banks,
mutual funds, few private investors, etc.
OFFERS FOR SALE
In a capital market, the company sells the entire issue of shares
or debentures to an issue house or merchant banker at an agreed
price, which is normally below the par value. The shares or
debentures are then resold by issue house / merchant bankers to be
public.
VENTURE CAPITAL
It is an important source of funds for technology based
industries and new projects that find it difficult to raise funds
directly from capital markets. In the period of 3 to 5 years, the
venture capital tries to liquidate all its investment in the
collaborative firm.
INTERNATIONAL ISSUES
Indian firms can raise funds from international markets through:
Depository Receipts (GDR) from worldwide markets, Foreign-
Currency Convertible Bonds (FCCB), American-Depository Receipts
(ADR) from American markets. However, only large firms are in a
position to raise funds from global markets.
BONDS ISSUED BY FINANCIAL
INSTITUTIONS
There are various types of bonds issued by Financial Institutions.

Bonds issued by financial institutions are:

Retirement bonds- refers to a buyback of bonds previously sold. In
other words, it means a bond issuer has paid off the debt
represented by the bonds. For example, on a company’s cash
statement, retirement of bonds may be used to explain a reduction
in the firm’s long-term debt.
Regular income bonds- a type of debt security in which only the face
value of the bond is promised to be paid to the investor, with any
coupon payments paid only if the issuing company has enough
earnings to pay for the coupon payment. An income bond is also
called an adjustment bond.
Index bonds- a bond in which payment of interest income on the
principal is related to a specific price index, usually the Consumer
Price Index (CPI). This feature provides protection to investors by
shielding them from changes in the underlying index.
Step-up liquid bonds-  a bond with a coupon that increases
("steps up"), usually at regular intervals, while the bond is
outstanding. Step-up bonds are often issued by government
agencies.
OBTAINING TERM LOANS
In capital market, companies can additionally raise long term
cashes by obtaining long-term loans, mostly from financial
institutions. Term loans are also referred to as ‘term finance.’ Which
represent a source of debt finance and is generally repayable in
more than one year but less than 10 years.
ISSUING
DEBT
INSTRUMENTS
(Debt Financing)
DEBT FINANCING
Debt financing occurs when a firm raises money for working capital
or capital expenditures by selling debt instruments to individuals
and/or institutional investors. In return for lending the money, the
individuals or institutions become creditors and receive a promise
that the principal and interest on the debt will be repaid. 

Debt financing includes loans from friends and relatives as well as

external capital such as loans from banks or venture capitalists.
ADVANTAGES & DISADVANTAGES
OF DEBT FINANCING
In a debt financing, the financial manager must consider whether
debt will contribute to or detract from the firms operation.
ADVANTAGES:
• Interest payments are tax deductible.
• The financial obligation is clearly specified and fixed nature.
• In an inflationary economy, debt may be paid back with cheaper
pesos.
• The use of debt, up to a prudent point, may lower the cost of
capital to the firm. To the extent that debt does not strain the risk
position of the firm, its low after tax cost may aid in reducing the
weighted overall cost of financing to the firms.
DISADVANTAGES:
• Interest and principal payment obligations are set by contract and
must be met, regardless of the economic position of the firm.

• Indenture agreements may place burdensome restrictions on the

firm, such as maintenance of working capital at a given level,
limits on future debt offerings, and guidelines for dividend policy.

• Utilized beyond a given point, debt may depress outstanding

ordinary equity share values.
TYPES OF DEBT
INSTRUMENTS
LOANS
Loans are possibly the most easily understood debt instrument. Loans
can be acquired from financial institutions or individuals and can be used
for a variety of purposes, such as the purchase of a home or vehicle or to
finance a business venture. Under the terms of a simple loan, the
purchaser is allowed to borrow a given sum from the lender in exchange
for repayment over a specified period of time. The purchaser agrees to
repay the total amount of the loan, plus a pre-determined amount of
interest for the privilege.
BONDS
Bonds are another common type of debt instrument issued by
governments or businesses. Investors pay the issuer the market value  of
the bond in exchange for guaranteed loan repayment and the promise of
scheduled coupon payments. This type of investment is backed by the
assets of the issuing entity.
DEBENTURES
Debentures is another type of debt instrument with no asset backing. The
bondholders' investment is expected to be repaid with the revenue those
projects generate. This type of debt instrument is backed only by the
credit and general trustworthiness of the issuer.
COST OF DEBT
The cost of debt is the interest payment to bondholders. When a
company issues debt, not only does it promise to repay the principal
amount, it also promises to compensate its bondholders by making
interest payments, known as coupon payments, to them annually.
The interest rate paid on these debt instruments represents the cost
of borrowing to the issuer.

The formula for the cost of debt financing is:

Cost of debt = Interest Expense x (1 - Tax Rate)
EQUITY
FINANCING
A method of financing in which a company issues shares of its
stock and receives money in return.
It is the process of raising capital through the sale of shares.
Companies raise money because they might have a short need to
pay bills or they might have a long-term goal require funds to invest
in their growth. By selling shares, they sell ownership in their
company in return for cash, like stock financing.
HOW EQUITY FINANCING
WORKS?
Equity financing involves the sale of common equity but also the
sale of other equity or quasi-equity instruments such a preferred
stock, convertible preferred stock, and equity units that include
common shares and warrants.
ADVANTAGES OF EQUITY
FINANCING
1. Less risk
You have less risk with equity financing because you don’t have any fixed monthly loan payments to
make. This can be particularly helpful with startup businesses that may not have positive cash flows
during the early months.
2. Credit problems
If you have credit problems, equity financing may be the only choice for funds to finance growth.
Even if debt financing is offered, the interest rate may be too high and the payments too steep to be
acceptable.
3. Cash flow
Equity financing does not take funds out of the business. Debt loan repayments take funds out of the
company’s cash flow, reducing the money needed to finance growth
4. Long-term planning
Equity investors do not expect to receive an immediate return on their investment. They have a long-
term view and also face the possibility of losing their money if the business fails.
DISADVANTAGES OF EQUITY
FINANCING
1. Cost
Equity investors expect to receive a return on their money. The business owner must be
willing to share some of the company’s profit with his equity partners. The amount of
money paid to the partners could be higher than the interest rates on debt financing.
2. Loss of control
The owner has to give up some control of his company when he takes on additional
investors. Equity partners want to have a voice in making the decisions of the business,
especially the big decisions.
3. Potential for conflict
All the partners will not always agree when making decisions. These conflicts can erupt
from different visions for the company and disagreements on management styles. An
owner must be willing to deal with these differences of opinions.
FIVE ESSENTIAL SOURCES OF
EQUITY FINANCING
1. Angel Investors
2. Venture Capital Firms
3. Institutional Investors
4. Corporate Investors
5. Retained Earnings
ANGEL INVESTORS
Those who buy equity in small firms are known as angel investors.
Normally such investors are friends or acquaintances of the
entrepreneur. The contribution of angels is supposed to be greater
and they do influence the decisions
VENTURE CAPITAL FIRMS
It is a limited liability partnership specializing in raising money to
invest in the private equity of young firms.
INSTITUTIONAL INVESTORS
Insurance companies, pension funds, mutual funds, endowments
and foundations, having large amount of money are the major
investors in private sector companies.
CORPORATE INVESTORS
Many established companies purchase equity in younger, private
companies. The investing companies are known as strategic
partners, strategic investors, corporate investors or corporate
partners.
RETAINED EARNINGS
firms can obtain equity financing by retaining earnings rather than
by distributing the earnings to their owners. For permanently
retaining the earnings, the company may issue bonus shares to its
shareholders.
LEASE
FINANCING
is one of the important sources of medium- and long-term financing
where the owner of an asset gives another person, the right to use
that asset against periodical payments.
It involves two parties: the lessor, who owns the property, and the
lessee, who obtains use of the property in exchange for one or more
lease, or rental payments.
3 IMPORTANT TYPES OF
LEASES
• Operating Leases
• Financial or Capital Leases
• Sale – and – leaseback arrangements
OPERATING LEASES
• A lease under which the lessor maintains and finances the
property; also called a service lease.
• It requires the lessor to maintain and service the leased
equipment, and the cost of the maintenance is built into the lease
payments.
FINANCIAL LEASES
• sometimes called capital leases.
• Unlike Operating Leases, Financial leases:
do not provide for maintenance services,
are not cancelable,
are fully amortized (i.e., the lessor receives rental payments that are equal
to the full price of the leased equipment plus a return on the investment).
• Financial leases are similar to sale-and-leaseback arrangements, the
major difference being that the leased equipment is new and the lessor
buys it from a manufacturer or a distributor instead of from the user-
lessee.
SALE – AND – LEASEBACK
ARRANGEMENTS
Under a sale and leaseback, a firm that owns land, buildings, or equipment
sells the property and simultaneously executes an agreement to lease the
property back for a specified period under specific terms.
It is an alternative to taking out a mortgage loan.
Note that the seller immediately receives the purchase price put up by the
buyer. At the same time, the seller-lessee retains the use of the property.
Sale-and-leaseback arrangements are almost the same as financial leases;
the major difference is that the leased equipment is used, not new, and the
lessor buys it from the user-lessee instead of a manufacturer or a
distributor. A sale-and-leaseback is thus a special type of financial lease.
TAX EFFECTS
The full amount of the lease payments is a tax-deductible expense
for the lessee provided the Internal Revenue Service agrees that a
particular contract is a genuine lease and not simply a loan called a
lease. This makes it important that a lease contract be written in a
form acceptable to the IRS. A lease that complies with all IRS
requirements is called a guideline, or tax-oriented, lease, and the tax
benefits of ownership (depreciation and any investment tax credits)
belong to the lessor.
GUIDELINES
1. The lease term (including any extensions or renewals at a fixed rental rate) must not exceed 80% of the
estimated useful life of the equipment at the commencement of the lease transaction. Thus, an asset with a
10-year life can be leased for no more than 8 years. Further, the remaining useful life must not be less than
1 year. Note that an asset’s expected useful life is normally much longer than its MACRS depreciation
class life.
2. The equipment’s estimated residual value (in constant dollars without adjustment for inflation) at the
expiration of the lease must be at least 20% of its value at the start of the lease. This requirement can have
the effect of limiting the maximum lease term.
3. Neither the lessee nor any related party can have the right to purchase the property at a predetermined
fixed price. However, the lessee can be given an option to buy the asset at its fair market value.
4. Neither the lessee nor any related party can pay or guarantee payment of any part of the price of the
leased equipment. Simply put, the lessee cannot make any investment in the equipment other than through
the lease payments.
5. The leased equipment must not be “limited use” property, defined as equipment that can be used only by
the lessee or a related party at the end of the lease.
FINANCIAL STATEMENT
EFFECTS
Under certain conditions, neither the leased assets nor the liabilities under the lease
contract appear directly on the firm’s balance sheet. For this reason, leasing is often
called off–balance sheet financing.
The Financial Accounting Standards Board issued SFAS #13, which requires that for an
unqualified audit report, firms that enter into financial (or capital) leases must restate
their balance sheets to (1) report leased assets as fixed assets and (2) show the present
value of future lease payments as liabilities. This process is called capitalizing the lease,
This process is called capitalizing the lease. Generally, leases that run for a period equal
to or greater than 75% of the asset’s life must be capitalized.
A lease must be classified as a capital lease—and hence be capitalized and shown
directly on the balance sheet—if any one of the following conditions exists:
Under the terms of the lease, ownership of the property is effectively transferred from
the lessor to the lessee.
The lessee can purchase the property or renew the lease at less than a fair market
price when the lease expires.
The lease runs for a period equal to or greater than 75% of the asset’s life.
The present value of the lease payments is equal to or greater than 90% of the initial
value of the
EVALUATION BY THE LESSEE
Any prospective lease must be evaluated by the lessee and the lessor. The lessee must
determine whether leasing an asset will be less costly than buying it, and the lessor
must decide whether the lease will provide a reasonable rate of return.
Example:
The Thompson- Grammatikos Company (TGC) needs a 2-year asset that costs $100
million, and the company must choose between leasing and buying the asset. TGC’s tax
rate is 40%. If the asset is purchased, the bank would lend TGC the $100 million at a
rate of 10% on a 2-year, simple interest loan. Thus, the firm would have to pay the bank
$10 million in interest at the end of each year and return the $100 million of principal at
the end of Year 2. For simplicity, assume that: (1) TGC could depreciate the asset over 2
years for tax purposes by the straight-line method if it is purchased, resulting in tax
depreciation of $50 million and tax savings of T(Depreciation) = 0.4($50) = $20 million in
each year; and (2) the asset’s value at the end of 2 years will be $0.
Alternatively, TGC could lease the asset under a guideline lease (by a special IRS
ruling) for 2 years for a payment of $55 million at the end of each year. The analysis for
the lease-versus-borrow decision consists of (1) estimating the cash flows associated
with borrowing and buying the asset—that is, the flows associated with debt financing;
(2) estimating the cash flows associated with leasing the asset; and (3) comparing the
two financing methods to determine which has the lower present value costs. Figure 18-
1 reports the borrow-and-buy flows, set up to produce a cash flow time line for owning
option.
The net cash flow for owning is zero in Year 0, positive in Year 1, and negative in Year 2.
The operating cash flows are not shown, but they must, of course, have a PV greater
than the PV of the financing costs or else TGC would not want to acquire the asset.
Because the operating cash flows will be the same regardless of whether the asset is
leased or purchased, they can be ignored.
To compare the cost streams of buying versus leasing, we must put them on a present
value basis. As we explain later, the correct discount rate is the after-tax cost of debt,
which for TGC is 10%(1 − 0.4) = 6.0%. Applying this rate, we find the present value of
the ownership cash flows to be $63.33 million versus a present value of leasing cash
flows of $60.50 million. The cost of ownership and leasing are the negatives of the PVs:
The PVs are based on cash flows, and a cost is a negative cash flow.
We define the net advantage to leasing (NAL) as follows:

NAL PV cost of owning − PV cost of leasing

For TGC, the NAL is $63.33 − $60.50 = $2.83 million.

EVALUATION BY THE LESSOR
Any potential lessor needs to know the rate of return on the capital invested in the lease,
and this information is also useful to the prospective lessee: Lease terms on large
leases are generally negotiated, so the lessee should know what return the lessor is
earning. The lessor’s analysis involves
1) determining the net cash outlay, which is usually the invoice price of the leased
equipment less any lease payments made in advance;
2) determining the periodic cash inflows, which consist of the lease payments minus
both income taxes and any maintenance expense the lessor must bear;
3) estimating the after-tax residual value of the property when the lease expires; and
4) determining whether the rate of return on the lease exceeds the lessor’s opportunity
cost of capital or, equivalently, whether the NPV of the lease exceeds zero.
 To illustrate the lessor’s analysis, we assume the same facts as for the Anderson Company
lease, plus the following: (1) The potential lessor is a wealthy individual whose current income is
in the form of interest and whose marginal federal-plus-state income tax rate, T, is 40%. (2) The
investor can buy 5-year bonds that have a 9% yield to maturity, providing an after-tax yield of
(9%)(1 − T) = (9%)(0.6) = 5.4%. This is the after-tax return the investor can obtain on alternative
investments of similar risk. (3) The before-tax residual value is $2,000,000. Because the asset
will be depreciated to a book value of $600,000 at the end of the 5-year lease, $1,400,000 of
this $2 million will be taxable at the 40% rate by the depreciation recapture rule, so the lessor
can expect to receive $2,000,000 − 0.4($1,400,000) = $1,440,000 after taxes from the sale of
the equipment after the lease expires.
The lessor’s cash flows are developed in Figure 18-3. Here we see that the lease as an
investment has a net present value of $81,000. On a present value basis, the investor who
invests in the lease rather than in the 9% bonds (5.4% after taxes) is better off by $81,000,
indicating that he or she should be willing to write the lease. As we saw earlier, the lease is also
advantageous to Anderson Company, so the transaction should be completed. The investor can
also calculate the lease investment’s internal rate of return based on the net cash flows shown
in Line 9 of Figure 18-3. The IRR of the lease, which is that discount rate that forces the NPV of
the lease to zero, is 5.8%. Thus, the lease provides a 5.8% after-tax return to this 40% tax rate
investor, which exceeds the 5.4% after-tax return on 9% bonds. So, using either the IRR or the
NPV method, the lease would appear to be a satisfactory investment
SETTING THE LEASE
PAYMENT
So far we have evaluated leases assuming that the lease payments have already been
specified. However, in large leases the parties generally sit down and work out an agreement on
the size of the lease payments, with these payments being set so as to provide the lessor with
some specific rate of return. In situations in which the lease terms are not negotiated, which is
often the case for small leases, the lessor must still go through the same type of analysis, setting
terms that provide a target rate of return and then offering these terms to the potential lessee on
a take-it-or-leave-it basis.
If the inputs to the lessee and the lessor are identical, then a positive NAL to the lessee
implies an equal but negative NPV to the lessor. However conditions are often such that leasing
can provide net benefits to both parties. This situation arises because of differentials in taxes, in
borrowing rates, in estimated residual values, or in the ability to bear the residual value risk.
Note that the lessor can, under certain conditions, increase the return on the lease by
borrowing some of the funds used to purchase the leased asset. Such a lease is called a
leveraged lease. Whether or not a lease is leveraged has no effect on the lessee’s analysis, but it
can have a significant effect on the cash flows to the lessor and hence on the lessor’s expected
rate of return.
OTHER ISSUES IN LEASE
ANALYSIS
1. Estimated Residual Value
It is important to note that the lessor owns the property upon expiration of the lease,
so the lessor has the claim to the assets residual value. Specifically it would appear that
if residual values are expected to be large, then owning would have an advantage over
leasing.

2. Increase Credit Availability

Leasing is sometimes said to be advantageous to firms that are seeking to increase
their financial leverage.
It is sometimes argued that firms can obtain more money, and for longer term, under a
lease agreement than under a loan secured by a specific piece of equipment.
Since some leases do not appear on the balance sheet, lease financing has been said
to give the firm a stronger appearance in a superficial credit analysis and thus to permit
a firm to use more leverage than would be possible if it did not lease.

3. Real Estate Leases

Leasing originated from real estate, and such leases still constitute a huge segment
of total lease financing. In some situations, retailers have no choice but to lease –this is
true of locations in malls and certain office buildings.
4. Vehicle Leasing
Vehicle leasing is very popular today both for large corporations and individuals,
especially professionals such as doctors, lawyers and accountants. For corporations,
the key factor involved with transportation is often maintenance and disposal of use of
vehicle. For individuals, leasing is often more convenient, and it maybe easier to justify
tax deductions on leased than on owned vehicle.
5. Leasing and Tax Laws
The ability to structure leases that are advantageous for both lessee and lessor
depends on large part of tax laws.
FACTORS INFLUENCING
LEASING
• Investment tax credits
is a direct reduction of taxes that occurs when a firm purchases new capital equipment.
• Depreciation rules
Owners recover their investment in capital assets through depreciation, which is a tax-deductible
expense. The faster an asset can be depreciated the greater the tax advantages of ownership.
• Tax Rates
The value of depreciation depends also on the firm’s tax rate, because the depreciation tax
saving equals the amount of depreciation multiplied by the tax rate. Thus, higher corporate tax
rates mean greater ownership tax savings and hence more incentive for tax driven leases.
• Alternative minimum tax
Corporations are permitted to use accelerated depreciation and other tax shelters on their tax
books but then use straight line depreciation for reporting result to shareholders.
OTHER REASONS FOR
LEASING
Leasing is not necessarily less expensive than buying, but the operating flexibility is
quite valuable. Leasing is also an attractive alternative for many high technology items
that are subject to rapid and unpredictable technological obsolescence. Leasing can
also be attractive when a firm is uncertain about the demand for its product or services
and thus about how long the equipment will be needed.
SOURCES
• http://articles-junction.blogspot.com/2013/09/methods-of-raising-funds-from-ca
pital.html
• https://www.investopedia.com/terms/i/incomebond.asp
• https://finance.zacks.com/retirement-bond-mean-7718.html
• https://www.investopedia.com/terms/i/indexlinkedbond.asp
• https://investinganswers.com/dictionary/s/step-bonds
• https://revision.co.zw/factors-consider-choosing-source-finance/
• www.Patriotsoftware.com
• www.fundingcircle.com
SOURCES
• epdf.pub_fundamentals-of-financial-management-12th-edition.pdf
• Financial_Management_Brigham_13th_Editio.pdf
• https://www.investopedia.com/terms/d/dividendpolicy.asp
• https://businessjargons.com/dividend-policy.html
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management/dividends/meaning-and-types-of-dividend-policy-financial-
management/3968
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defined-and-explained/amp/
SOURCES
• https://www.wallstreetmojo.com/long-term-financing/
• https://www.investopedia.com/terms/c/capitalmarkets.asp
• https://www.investopedia.com/terms/d/debtfinancing.asp
• Cabrera, E., Cabrera, G. (2019). Financial Management Comprehensive Volume
(2019-2020 Edition). GIC Enterprices & Co. Inc.
• https://www.investopedia.com/terms/e/equityfinancing.asp
• https://www.entrepreneur.com/encyclopedia/equity-financing
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nancing-company-management/5401
GROUP 4
CHARL LISSA RAMISCAL
ADRIELLE BAGUHIN
CHRISTINE JAVE RUTAB
CLARIBELLE AGUSTIN
DANIEL TAGALICUD JR.
JOHN PATRICK ARCAS
JEMINA KHATE ASUNCION
KAI GUILLERMO
LAREN KAYE AGANAD
MILETE AGRON