Topic 8 - Financing Arrangements for Asset Acquisition PDF

COVENANT UNIVERSITY, OTA COLLEGE OF MANAGEMENT AND SOCIAL SCIENCE DEPARTMENT: FINANCE OMEGA SEMESTER: 2023/24 ACADEMIC SESSION COURSE CODE AND TITLE: COV-FIN 122: PRINCIPLE OF FINANCE Topic 8: Financing Arrangements for Asset Acquisition Learning Objectives:...

COVENANT UNIVERSITY, OTA COLLEGE OF MANAGEMENT AND SOCIAL SCIENCE DEPARTMENT: FINANCE OMEGA SEMESTER: 2023/24 ACADEMIC SESSION COURSE CODE AND TITLE: COV-FIN 122: PRINCIPLE OF FINANCE Topic 8: Financing Arrangements for Asset Acquisition Learning Objectives: At the end of this topic, students should be able to: 1. Understand the concept and importance of asset financing. 2. Evaluate different financing options for asset acquisition. 3. Analyse the advantages and disadvantages of each financing arrangement. Introduction Assets are essential for a business to grow and function. The acquisition of assets requires significant capital investment. Financing options help firms to raise needed funds. Understanding asset financing is essential for making informed decisions about acquiring assets and managing financial resources effectively. The focus of this topic shall be on the fundamental principles of asset financing and explore why it plays a crucial role in the success of businesses. What is Asset Financing? Asset financing refers to using financial instruments or arrangements to acquire assets for business purposes. Asset financing is a fundamental financial management component for businesses of all sizes and industries. These assets can include machinery, equipment, vehicles, real estate, technology, or other resources necessary for business operations. Asset financing allows businesses to acquire the required assets without paying the total purchase price upfront. Importance of Asset Financing: 1. Facilitates Asset Acquisition: Asset financing enables businesses to acquire essential assets for day-to-day operations or strategic growth. With asset financing, many companies would be able to afford costly assets that are critical to their success. 2. Preserve Cash Flow: By spreading the cost of asset acquisition over time through financing, businesses can preserve their cash flow and maintain liquidity. This is particularly important for young or growing businesses with limited capital reserves. 3. Improves Financial Flexibility: Asset financing allows businesses to manage their financial resources. It will enable businesses to match the timing of cash outflows with the inflow of revenues generated by the assets, thus improving overall economic stability. 4. Enables Strategic Investments: Through asset financing, businesses can invest strategically in technology, machinery, or other assets that drive growth, innovation, and competitiveness. This can give businesses a competitive advantage in the market. 1  5. Enhances Balance Sheet Structure: Proper asset financing can optimise a company's balance sheet structure by ensuring the right mix of debt and equity. This, in turn, can improve financial ratios, creditworthiness, and overall financial health. Financing Options for Asset Acquisition Various financing options are available to acquire business assets. Understanding these options is essential for making informed decisions and optimising strategies. This section focuses on exploring varying options for asset acquisition and the advantages and disadvantages of each. 1. Cash Purchase Cash purchase is one of the most straightforward ways to acquire assets. Cash purchase allows for immediate acquisition of assets without incurring interest costs and provides a sense of security to the seller. However, tying up significant cash in assets may limit liquidity and financial flexibility. Advantages of Cash Purchase 1. Immediate full asset ownership and control with no attached restrictions. 2. Avoidance of interest payments, resulting in long-term cost savings. 3. Enhanced negotiating power for better prices or terms. 4. No recurring payments post-purchase, providing financial flexibility. Disadvantages of Cash Purchase a. Requirement of the total upfront purchase price, potentially straining immediate cash resources. b. Opportunity cost of tying up capital in a single asset, limiting other investments. c. Reduced financing options lead to less cash flow management flexibility. d. Absence of tax benefits compared to financing options like hire purchase agreements. 2. Bank Loans Many businesses rely on bank loans to finance asset acquisition. Bank loans offer a structured repayment schedule and may come with lower interest rates for well-qualified borrowers. However, strict eligibility criteria and collateral requirements can make securing bank financing easier for some businesses. Advantages of Bank Loans: Bank loans help acquire assets while keeping cash reserves intact. a. Interest payments on bank loans are tax-deductible and offer tax benefits. b. Repayment terms for bank loans are flexible and can be customised. c. Repaying bank loans responsibly helps build business credit. d. Bank loans may provide lower interest rates based on market conditions and creditworthiness. 2  Disadvantages of Bank Loans a. Collateral is required to secure bank loans, limiting asset use. b. Bank loans create ongoing debt obligations impacting cash flow. c. Obtaining bank loans involves a credit checks and approval process. d. Bank loans can affect the debt-to-equity ratio and future financing. e. Some bank loans have penalties for early repayment, reducing flexibility. 3. Lease Financing: Leasing is a formal contractual agreement between the owners of an asset, commonly known as the lessor, and the individual or entity utilising the asset, known as the lessee. This arrangement grants the lessee the privilege to utilise the asset for a specified period and at an agreed-upon rental fee without purchasing the asset outright. Assets such as ships, boats, trucks, cars, aeroplanes, forklifts, machinery, generators, tractors, and trailers are frequently leased due to their high costs, making them easily accessible through leasing. There are two types of leasing: operating lease and finance lease. i. The operating lease does not cover the economically useful life of the asset, and the lessor can cancel it on short notice. The lessor is responsible for the leased asset's upkeep, maintenance, servicing, and insurance. All risks and rewards associated with the asset remain with the lessor. At the end of the lease agreement, the lessor can lease the same asset to someone else (or the same lessee) and obtain a good rental for it. Since all risk and reward incidents to ownership remain with the lessor, the lessor relies on subsequent leasing or eventual disposal of the asset to recover his capital outlay. ii. A finance lease, on the other hand, cannot be terminated on short notice. The lease is for a period that covers the economic life of the asset. The lessee is responsible for the asset's upkeep, insurance, maintenance and servicing. Consequently, all risks and rewards incident to ownership are substantially transferred to the lessee. The title may or may not be transferred at the end of the agreement. At the expiration of the primary period, the lessee can continue to lease the asset indefinitely for a very low nominal rent. Alternatively, the lessee can buy or sell the asset on the lessor's behalf. Under a finance lease, the lessee is the asset's owner throughout its life, in substance, although not in law. Advantages of Leasing: a. Leasing helps preserve capital by allowing acquisition without a significant upfront investment, thus keeping cash reserves for other operations. b. Leases offer flexible upgrade options with shorter terms, c. Tax benefits:- Lease payments are generally tax-deductible as operating expenses, providing potential tax savings for the lessee. d. Predictable costs: Leases typically have fixed monthly payments, making budgeting and managing cash flow easier. e. potential residual value: At the end of the lease term, the lessee may have the option to purchase the asset at a reduced residual value 3 Disadvantages of Leasing a. Leasing involves ongoing payments throughout the term, b. potentially exceeding the cost of outright purchase in the long run. c. Limited ownership: Leased assets are not owned by the lessee, which means they have limited control and flexibility over the asset. d. potential penalties: Leases may include penalties for early termination, excess wear and tear, or exceeding mileage/usage limits. e. strict credit evaluation: Lessors typically conduct a thorough credit evaluation of the lessee, which may be more stringent than for a bank loan. Forms of finance lease A finance lease can take any of the following forms; a. Direct lease – Under this arrangement, a company acquires an asset it does not previously own and is granted the use of it through a lease arrangement. The lessor could be a bank, a manufacturer or a finance company. b. Sale and leaseback is an arrangement by which a firm sells its assets to a financial institution (usually an insurance company) or a leasing company for cash, and the financial institution or the leasing company immediately leases it back to the firm. c. Leverage leasing -There are three parties to leverage lease. The lessor (equity participant), the lender and the lessee. The lessor acquires the asset with the term of the lease arrangement and finances the acquisition partly with its own resources, say 25% of the total sum; a long-term lender finances the remaining 75%, but the loan is secured on the leased asset, so that in case of default the asset reverts to the lender. On its own part, the lessee does not have anything to do with the lease arrangement except the normal lease rental and payment usage of the asset. 4. Hire Purchase A hire purchase agreement is a contractual arrangement in which a buyer, known as the hiree, acquires assets on credit with the owner or supplier, known as the hirer, granting the purchaser the right to possess the asset while retaining ownership until all payments are completed. Payments are made over a specified period, as agreed upon initially. The aim is for the buyer to gain ownership once the final instalment is paid. In the case of a company acquiring equipment through a hire purchase agreement, full ownership is transferred after the hire period. These payments include both capital payments for the asset purchase and interest charges. This type of agreement helps companies maintain resources and liquidity for other purposes. Additionally, it can serve as a valuable financial strategy for achieving optimal risk-adjusted returns and avoiding less favourable investment options. 4 Advantages 1. Assets that could not be acquired outright may be obtained on hire purchase now, and payment may be made over time. This avoids a strain on the hiree's cash resources. 2. There is no recourse to the hirer even if the hiree defaults in repayment 3. The hirer can receive the credit from the hirer in the form of instalment payments over an agreed period. 4. It enables the hiree to benefit from the capital allowance, unlike leasing where the capital allowances are given to the hirer except for finance leases (in Nigeria). Disadvantages 1. The disadvantage of hire purchase to the hiree is that the finance cost, i.e. interest rate, is likely to be higher than other forms of finance. 2. Unlike leasing, the hiree must make an initial deposit out of capital, which may be very limited. 5