Session 4: Other Sources of Finance

Learning Objective
The Learners will have an understanding of leasing as one of the alternative source of financing for the ICT investment projects

Leasing
Telecommunication firms are normally interested in using building and equipment. One way of obtaining their use is through buying them but an alternative is to lease them. Leasing simultaneously provides for the acquisition of assets and their financing. Its advantage with debt is that lessor has a better position than a creditor if the user firm experiences financial difficulties. The lessor can take back the asset.

When the owner of an asset (the lessor) rents the use of the asset to a user (the lessee) without conveying the benefits or risks of legal ownership, a lease is created.

Because of the tax savings that can be realized when an asset is classified as a leased item and the lease payments are expensed, firms may have an incentive to disguise the use of the asset as a lease rather than as an instalment purchase to be depreciated.

Types of leases
1. Sale and Leaseback
A firm owning land, building or equipment sells the property to a financial institution and simultaneously executes an agreement to lease the property back for a certain period under specific terms.

2. Operating lease
This includes both financing and maintenance lease. Photocopy machines, computers, elevators, automobiles, transmission stalls, etc are examples of assets where an operation lease can be applied. The lessor is obligated among others to maintain the equipment/assets provided for leasing purposes in an agreed upon condition. The operational lessee can cancel the lease agreement and return the assets before the expiration of the basic agreement.

3. Financial Lease
A lease meeting any one of the following criteria (at the inception of the lease) is classified as a financial lease:
• Ownership of the asset is transferred to the lessee at the end of the lease agreement.
• The agreement grants the lessee an option to purchase the asset at a "bargain" price.
• The lease term is equal to at least 75% of the estimated economic life of the asset.
• The present value of the minimum lease payments equals at least 90% of the asset's market value using the lessee's incremental borrowing rate or the implicit interest rate of the lessor, whichever is lower.

The Accounting Treatment of Leases
Under an operating lease arrangement the periodic lease payments are treated as current period expenses and deducted as tax-reducing expenses on the income statement. The balance sheet is not specifically affected.

Under a financial (or capital) lease arrangement the lease expense is subdivided into periodic depreciation expense and amortization of the lease "liability." The former expense appears on the income statement as a tax-deductible expense; the latter item represents a contribution of the firm to its ultimate "ownership" of the asset.

When a lease is capitalized it is assumed the firm will enjoy the benefits and bear the risks as if the asset were legally owned. As a result, the leased asset appears on both the asset and liability sides of the balance sheet and its use is amortized over time according to the matching principle.

The Lease versus Buy Choice
The decision to lease or buy an asset with borrowed funds depends upon which alternative has the lower present value of after-tax costs.
• If funds are borrowed to purchase an asset, the tax shield provided by interest expense and depreciation should be considered in the lease/buy decision.
• If an asset is categorized as an operating lease, the tax-shield due to lease expense should be considered in the lease/buy decision.

Discussion 9
Post your response in the discussions area. (See the procedure for discussions in Course Info.)

1. Ms. Neema Kissaka is a policy analyst in the Botswana telephone regulatory body. She had a confused understanding of the operation of capital markets and of the advantages that the firm and investors can gain form the stock exchange. Most of the telephone operators in the country are private companies. She wishes that all the companies should be listed, i.e., go public.

a) Explain the advantages of listing a firm from the following:
(1) Firms view point
(2) Investor Point of view

b) Explain some reasons why some companies may prefer to remain private.

2. What is the advantage of the firm investing using debt instead of equity?

3. Assume that two mobile operators are in a conflict over the rates charged by each company. As a regulator you are required to intervene.

i) in your opinion which company is at risk?
ii) Which company should charge a higher rate, and why?

4. An incumbent telephone company is ready to find a deal with a new telephone company on its existing lines. The incumbent company is ready to lease its lines for three years at an annual payment of US$100,000 or the new telephone firm can buy some of the lines for US$90,000 plus 10% of the shares of the new company. If you are to advise the new telephone company, which is the better deal?

PREPARATION FOR THE FIRST TEST
You are now half way through the course and it is important that you are tested by doing a test. The test will cover most of the issues studied from chapter 5 –11 of this course. To prepare yourself for the test, go through all the review questions and exercises. The test will constitute 10% of your coursework/continuous assessment.