Saturday, October 24, 2009

Disadvantages of preferred stock

The two major disadvantages of preferred stock are the seniority of the holder's claims and its cost.
Seniority of the holders´ claims.
Since holders of preferred stock are given preference over common stock holders with respect to the distribution of earnings and assets, the presence of preferred stock in a sense jeopardizes common shareholder's returns. Adding preferred stock to the firm's capital structure creates additional claims prior to those of common stockholders. If the firm's after-tax earnings are quite variable, its ability to pay at least token dividends to common stockholder may be seriously impaired.
The cost of preferred stock financing is generally higher than the cost of debt financing. This is because the payment of dividends to preferred stockholders is not guaranteed, whereas interest on bond is. Since preferred shareholders are willing to accept the added risk of purchasing preferred stock rather than long-term debt, they must be compensated with a higher return. Another factor causing the cost of preferred stock to be significantly greater than that of long-term debt is the fact that interest on long-term debt is tax-deductible, while preferred dividends must be paid from earnings after taxes.

Sunday, October 11, 2009

Instruments of the money market

The key instruments of the money market include treasury bills, tax-anticipation bills, treasury notes, federal agency issues, negotiable certificates of deposit, commercial paper, banker's acceptances, money market mutual funds, and repurchase agreements. These marketable securities will be described in next topic. It is important for you to a general understanding of the key characteristics of these instruments. One characteristic common to all is liquidity. The annual rate of return, or yield, on these securities reflects directly the "tightness' or "looseness" of money. Difference in return between various instruments result from the different degrees of risk associated with the issuers. Although the list of securities given above is not all-inclusive, it does contain the key money market instruments available to the corporate purchaser. The only instrument actually issued by a nonfinancial corporate business is commercial paper.

Monday, October 5, 2009

Disadvantages of leasing

The commonly cited disadvantages of leasing include high interest costs, the lack of salvage value, the difficulty of making property improvements, and obsolesce considerations. Though not relevant in every case, they may bear importantly on the
lease-purchase decision in certain instances.
High interest cost. A lease does not have an explicit interest cost; rather, the lessor builds a return for itself into the lease payment. In many leases the implicit return to the lessor is quite high, so that the firm might be better off borrowing to purchase the asset.
Lack of salvage value. At the end of the term of lease agreement, the salvage value of assets, if any, is realized by the lessor. If assets are expected to appreciate over the life of a lease agreement, it may be wiser to purchase them, although various other factors must be considered in making this decision. Appreciation in the value of assets is especially likely when land or buildings, or both, are involved. If the lease contains a purchase option this disadvantage may not exist.
Difficulty of property improvements Under a lease, the lessee is generally prohibited from making improvements on the leased property without the approval of the lessor. If the property were owned, this difficulty would not arise. Related to this disadvantage is the fact that it is often hard to obtain financing for improvements on leased property since it is difficult for the lender to obtain a security interest in the improvements. On the other hand, the lessor may agree in the initial lease contract finance or make certain leasehold improvements specified by the lessee.
Obsolescence considerations. If a lessee leases (under financial lease) an asset that subsequently becomes obsolete, it still as to make lease payments over the remaining life of the lease. This is true even if it is unable to use the leased asset. In many instances, a lessee will continue to use obsolete assets since it must pay for them. This type of situation can weaken a firm's competitive position by raising (or failing to lower) production costs and therefore forcing the sale price of its products to be increased in order to earn a profit.

Sunday, October 4, 2009

Advantages of leasing

The basic advantages commonly cited for leasing are the ability it gives the lessor to, in effect, depreciate land, its effects on financial ratios, its effect on the firm's liquidity, the ability it gives the firm to obtain 100 percent financing, the limited claims of lessors in the event of bankruptcy or reorganization, the fact that the firm may avoid assuming the risk of obsolescence, the lack of many restrictive covenants, and the flexibility provided. Each of these often cited advantages is described and critically evaluated below.
-Effective depreciation of land. Leasing allows the lessee to, in effect; depreciate land, which is prohibited under a purchase of land. Since the lessee who leases land is permitted to deduct the total lease payment as an expense for tax purposes, the effect is the same as it would be if he or she purchased the land and then depreciated it. The greater the amount of land included in a lease agreement, the more advantageous this factor becomes from the point of view of the lessee. However, this advantage is somewhat tempered by the fact that land generally has a savage value for its purchaser, which it does not for a lessee.
- Effects on financial ratios. Leasing, since it results in the receipt o services from an asset possibly without increasing the assets or liabilities on the firm's balance sheet, may result in misleading financial ratios. With the passage of FASB No.13, this advantage no longer applies to financial lease, although in the case o operating leases it remains a potential advantage. Of course, even in the case of operating leases, the American Institute of Certified Public Accounts requires disclosure of the lease in a footnote to the Firm's statements. Today, most analysts are aware of the significance of leasing for the firm's financial position and will not view the firm's financial statements strictly as presented; instead, they will make certain adjustments to these statements that will more accurately reflect the effect of any existing operating leases on the firm's financial position.
- Increased liquidity .The use of sale-leaseback arrangements may permit the firm to increase its liquidity by converting an existing asset into cash, which can be used as working capital. A firm short of working capital or in a liquidity squeeze can sell an owned asset to a lessor ad lease the asset back for a specified number of years. Of course, this action binds the firm to making fixed payments over period years. The benefits of the increase in current liquidity are therefore tempered somewhat by added fixed financial payments incurred through the lease.
-100 percent financing; another advantage of leasing is that it provide 100 percent financing. Most loan agreements for purchase of fixed assets require the borrower to pay a portion of the purchase price as adown payment. As a result, the borrower receives only 90 to 95 percent of the purchase price of the asset. In the case of a lease, the lessee is not required to make any type of down payment; he or she must make only a series of periodic payments. in essence, a lease permits a firm to receive the use of an asset for a smaller initial out-of-pocket cost than borrowing. However, since large initial lease payments are often required in advance, it is possible to view the initial advance payment as type of down payment.
-Limited claims in the event of bankruptcy or reorganization; when a firm becomes bankrupt or is reorganized, the maximum claim of lessors against the corporation is three years of lease payments. If debt is used to purchase an asset, the creditors have a claim equal to the total amount of unpaid financing. Of course, in such a case an owned asset may have a salvage value that can be used to defray the firm's obligations to its creditors.
-Avoidance of the risk of obsolescence; in a lease arrangement, the firm may avoid assuming the risk of obsolescence if he lessor in setting the lease payments fails accurately to anticipate the obsolescence of assets. This is especially true in the case of operating leases, which generally have relatively short lives. However, most lessors are perceptive enough to require sufficient compensation in both the term and the amount of lease payments to protect themselves against obsolescence.
-Lack of many restrictive covenants; a lessee avoids many restrictive covenants that are normally included as part of a long-term loan. Requirements with respect to minimum working capital, subsequent financing, changes in management, and so on are not normally found in a lease agreement; the only restrictive covenant occasionally included in the lease relates to subsequent lease commitments. The general lack of restrictive covenants allows the lease much greater flexibility in its operations. This many be viewed as an important advantage by the lessee.
-Flexibility provided; In the case of low-cost assets that are infrequently acquired, leasing-especially operating leases-may provide the firm with needed financing flexibility. This flexibility is attributable to the fact that the firm does not have to arrange other financing for these assets and can somewhat conveniently obtain them through a lease, thereby preserving its funds-raising power for the acquisition of more costly assets. The firm also retains its ability to raise funds in economically preferred quantities at the right time, again helping to lower its overall capital costs. Flexibility is also provided in the sense that with a short-term operating lease the firm can buy time to shop around for an owned asset that may be more advantageous from the standpoint of long-run owners´ wealth maximization.

Leasing as a source of financing

Leasing is considered a source of financing provided by the lessor to the lessee. The lessee receives the service of a certain fixed asset for a specified period of time, while in exchange for the use of this asset the lessee commits itself to a fixed periodic payment. The only other way the lessee could obtain the services of the given asset would be to purchase it outright, and the out right purchase of the asset would require financing. Again, fixed-most likely periodic-payments would be required. The lessee might have sufficient funds to purchase the asset outright without borrowing, but the funds used would not be free, since there is an opportunity cost associated with the use of cash. It is the fixed-payment obligation for a set period that forces us to view the financial lease as a source of long-term financing. Although at this point the rationale for leasing may seem no different than that for borrowing when a cash purchase cannot be made, certain other considerations with respect to the lease-purchase decision do exist.

The Lease Contract

The key items in the lease contract normally include the term of the lease, provisions for its cancellation, lease payment amounts and dates, renewal features, purchase clause, maintenance and associated cost provisions, and other provision specified in the lease negotiation process. As we indicated in the preceding discussion, many provisions are optional. A lease can be cancelable or non-cancelable, but if cancellation is permitted the penalties must be clearly specified. The lease may be renewable. If it is, the renewal procedures and costs should be specified. The lease agreement may provide for the purchase of the leased assets during the contract period or at the termination of the lease. The cost and conditions of the purchase must be clearly specified. In the case of operating leases, it is likely tat maintenance costs, taxes, and insurance will be paid by the lessor. In the case of a financial lease these costs will generally be borne by the lessee. The bearer of these costs must be specified in the lease agreement.
The leased assets, the terms of the agreement, the lease payment, and the payment interval must be clearly specified in all lease agreements. The consequences of missing a payment or violating any other lease provisions must also be clearly stated in the contract. The consequences of violation of the agreement by the lessor must also be specified. Once the lease contract has been drawn up and agreed to by lessee and lessor, the notarized signatures of these parties bind them to the terms of the contract.

Saturday, October 3, 2009

Legal requirements of leases

In order to prevent business firms from using leasing arrangements as a disguise for what is actually an installment loan, the internal revenue service code, Section1031, "Exchange of property Held for productive Use or investment," specifies certain conditions under which lease payments are tax-deductible. If a lease arrangement does not meet these basic requirements, the lease payments are not completely tax-deductible. In order to conform to the IRS Code, a leasing arrangement must meet the following requirements:
1- The terms of a lease must be less than 30 years. A lease with life greater than 30 years is considered a sale by the IRS.
2- The premium paid to the lessor must be " reasonable"- that is- equal to the premium being paid on leases of similar assets. a premium between 10 and 15 percent would currently (November,1981) be considered reasonable.
3- The renewal option payment must also be "reasonable." If an outsider is willing to pay a higher amount to obtain the lease, the lease cannot be renewed with the original lessee at a lower rate. This is an application of the "fair market value" concept, which is also applied to purchase options.
4- No preferential purchase option is permitted. the lessee can be given an opportunity to purchase the asset only at a price equal to or above any other offers received by the lessor.

Advantages and Disadvantages of Common Stock

Common stock has a number of disadvantage and disadvantages. Some of the factors to be reckoned with in considering common stock financing are discussed below.
Advantages. The basic advantages of common stock stem from the fact that it is a source of financing that places a minimum of constraints on the firm. Since dividends do not have to be paid on common stock and their nonpayment does not jeopardize the receipt of payment by other security holders, common stock financing is quite attractive. The fact that common stock has no maturity, thereby eliminating future repayment obligation, also enhances the desirability of common stock financing. Another advantage of common stock over other forms of long-term financing is its ability to increase the firm's borrowing power. The more common stock the firm sells, the larger the firm's equity base and therefore the more easily and cheaply long-term debt financing can be obtained.
Disadvantages. The disadvantages of common stock financing include the potential dilution of voting power and earnings. Only when rights are offered and exercised by their recipients can this be avoided. Of course, the dilution of voting power and earning resulting from new issues of common stock may go unnoticed by the small shareholder. Another disadvantage of common stock financing is it high cost. Normally, the most expensive form of long-term financing. This is because dividends are not tax-de-ductile and because common stock is a riskier security than either debt or preferred stock.