LESSON 4: SOURCES OF FINANCE (CONT…)

. Lease financing
This is an agreement where the right repossession and enjoyment of an asset is transferred for a definite
period of time. The person transferring the right i.e. the owner of the asset is referred to as leasor. The
recipient of the asset is the lessee.

A lease is an agreement between two parties, the "lessor" and the "lessee". The lessor owns a capital
asset, but allows the lessee to use it. The lessee makes payments under the terms of the lease to the
lessor, for a specified period of time.

Leasing is, therefore, a form of rental. Leased assets have usually been plant and machinery, cars and
commercial vehicles, but might also be computers and office equipment. There are two basic forms of
lease: "operating leases" and "finance leases".

Operating leases

Operating leases are rental agreements between the lessor and the lessee whereby:

a) the lessor supplies the equipment to the lessee

b) the lessor is responsible for servicing and maintaining the leased equipment

c) the period of the lease is fairly short, less than the economic life of the asset, so that at the end of the
lease agreement, the lessor can either

i) lease the equipment to someone else, and obtain a good rent for it, or
ii) sell the equipment secondhand.

Finance leases

Finance leases are lease agreements between the user of the leased asset (the lessee) and a provider of
finance (the lessor) for most, or all, of the asset's expected useful life.

Suppose that a company decides to obtain a company car and finance the acquisition by means of a
finance lease. A car dealer will supply the car. A finance house will agree to act as lessor in a finance
leasing arrangement, and so will purchase the car from the dealer and lease it to the company. The
company will take possession of the car from the car dealer, and make regular payments (monthly,
quarterly, six monthly or annually) to the finance house under the terms of the lease.

Other important characteristics of a finance lease:

a) The lessee is responsible for the upkeep, servicing and maintenance of the asset. The lessor is not
involved in this at all.

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b) The lease has a primary period, which covers all or most of the economic life of the asset. At the end of
the lease, the lessor would not be able to lease the asset to someone else, as the asset would be worn out.
The lessor must, therefore, ensure that the lease payments during the primary period pay for the full cost of
the asset as well as providing the lessor with a suitable return on his investment.

c) It is usual at the end of the primary lease period to allow the lessee to continue to lease the asset for an
indefinite secondary period, in return for a very low nominal rent. Alternatively, the lessee might be allowed
to sell the asset on the lessor's behalf (since the lessor is the owner) and to keep most of the sale
proceeds, paying only a small percentage (perhaps 10%) to the lessor.

Requirements of a Long Term lease

1. The present value of lease rentals must be greater than 90% the year value of the asset.
2. 75% of the assets life is the lease term.
3. It is non-cell unsalable
4. Maintenance costs, insurance and taxes are paid by the lessee.
According to terms of payment
1. Net lease
This is on in which the leasee pays all or a substantial part of the maintenance cost. It is therefore
where the lessee pays for all the expenses except taxes, insurances and exterior repairs.
2. Flat Lease
This is one which opts for periodic payment for use of the asset over the term of the lease. Such a
lease is usually made for such periods of time since inflation can easily erode the buying power of
the fixed rentals.

3. Step Up lease
This provides for the fixed payments to be adjusted periodically. This adjustments can be made either
b new rentals taking effect after the passages of a certain period of time or by periodically adjusting
the fixed payments for inflation. The term of a stepup lease is usually longer than a flat lease.
4. Percentage lease
This is where the lessee is required to pay a fixed basic percentage rate and a designated percentage
of sales volume. The percentage factor acts as an inflation gauge as well as a means of Keeping
lease rentals in line with the market conditions.
5. Escalator lease
This calls for an increase in taxes insurance and operating costs to be paid for the lessee.

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 6. Sandwich lease
This refers to a multiple lease in which the lessee in turn sub-lease to a sub-lessee who in turn sub-
leases to another sub-lessee. Example: A the original owner of an asset leases to B. B executes a
sub-lease to C who then sub-leases to D.
This is a sandwich lease between B & C, B being the sandwich lessor and C the sandwich lessee.
Advantages of lease
i) To avoid the risk of ownership. When a firm purchases an asset, it has to bear the risk of
obsolescence especially if the asset is vulnerable to technological changes e.g. computers.
ii) Avoidance of investment outlay. Leasing enables a firm to make full use of an asset without
making an immediate investment in the form of initial cash outflow.
iii) Increased flexibility. A St. lease is a cancelable lease especially when the asset is needed for a
short period of time e.g. during construction, equipment can be leased on a seasonal basis after
which the lease can be cancelled.
iv) Lease charges are tax allowable expenses. This therefore reduces the tax liability.
6. Hire purchase
This is arrangement whereby a company acquires an asset on making a down payment or deposit and paying
the balance over a period of time in installments. This source of finance is more expensive than a bank loan
and companies that use this source need guarantors since it does not require security or collateral. The
company hiring the asset will be required to honour the terms of the agreement which means that any term
in violated, the selling firm may repossess the asset. This is therefore finance in kind and the hirer will not
get title to the asset until he clears the final installment and any charges thereof.

Hire purchase is a form of instalment credit. Hire purchase is similar to leasing, with the exception that
ownership of the goods passes to the hire purchase customer on payment of the final credit instalment,
whereas a lessee never becomes the owner of the goods.

Hire purchase agreements usually involve a finance house.

i) The supplier sells the goods to the finance house.

ii) The supplier delivers the goods to the customer who will eventually purchase them.
iii) The hire purchase arrangement exists between the finance house and the customer.

The finance house will always insist that the hirer should pay a deposit towards the purchase price. The
size of the deposit will depend on the finance company's policy and its assessment of the hirer. This is in
contrast to a finance lease, where the lessee might not be required to make any large initial payment.

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An industrial or commercial business can use hire purchase as a source of finance. With industrial hire
purchase, a business customer obtains hire purchase finance from a finance house in order to purchase
the fixed asset. Goods bought by businesses on hire purchase include company vehicles, plant and
machinery, office equipment and farming machinery.

7.Mortgages
A Mortgage can be defined as a pledge of security over property or an interest therein created by a formal
written agreement for the repayment of monetary debt.
Minimum mortgage requirements
1. All mortgages should be in writing.
2. All parties must have contractual capacity.
3. Interest in the property being mortgaged should be specific e.g. rental income lease hold
etc.
4. A description of true loan or obligation secured by the mortgage should appear in the
mortgage agreement.
5. A legal description of the mortgage must be included in the documents.
6. The mortgage must be signed by the mortgagor
7. The mortgage must be acknowledged and delivered to the mortgagee.
8.Debentures
A debenture is a long-term promissory note used to raise debt funds. The firm promises to pay periodic
interest and principal at maturity. Ideally, a debenture is a long-term bond that is not secured by a pledge
of a specific property. However, like other general creditors claims, its secured by a pledge of a specific
property not otherwise pledged.

Debentures are a form of loan stock, legally defined as the written acknowledgement of a debt incurred by a
company, normally containing provisions about the payment of interest and the eventual repayment of capital.

Debentures with a floating rate of interest

These are debentures for which the coupon rate of interest can be changed by the issuer, in accordance
with changes in market rates of interest. They may be attractive to both lenders and borrowers when
interest rates are volatile.

Security

Loan stock and debentures will often be secured. Security may take the form of either a fixed charge or a
floating charge.

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a) Fixed charge; Security would be related to a specific asset or group of assets, typically land and
buildings. The company would be unable to dispose of the asset without providing a substitute asset for
security, or without the lender's consent.

b) Floating charge; With a floating charge on certain assets of the company (for example, stocks and
debtors), the lender's security in the event of a default payment is whatever assets of the appropriate class
the company then owns (provided that another lender does not have a prior charge on the assets). The
company would be able, however, to dispose of its assets as it chose until a default took place. In the event
of a default, the lender would probably appoint a receiver to run the company rather than lay claim to a
particular asset.

Features of debenture

(a) Interest rate

The interest rate on a debenture is fixed and known. It is called the contractual or coupon interest
rate. It indicates the percentage of the par value that will be paid out annually (or semi-annually)
in form of interest. The interest must be paid whether the firm makes profit or not. However,
debenture interest is tax deductible on the part of the company.
(b) Maturity
Debentures are usually issued for a specific period of time. The maturity of a debenture indicates
the length of time the debenture remains outstanding before the company redeems it. However,
there are debentures that have no maturity period.
(c) Redemption
The redemption of debentures can be accomplished either through a sinking fund or call provision.
A sinking fund is cash set aside periodically for retiring the debentures. The fund is placed under
the control of the trustee who redeems the debenture either by purchasing them in the market or
calling them in an acceptable manner. The advantage of a sinking fund is that it reduces the
amount required to redeem the remaining debt at maturity. Particularly when the firm faces
temporary financial difficulties at the time of debt maturity, the repayment of huge amount of
principal could endanger the firm's financial viability.

Call provisions enable the company to redeem debentures at a specific price before the maturity
date. The call price is usually higher than the par value, the difference being a call premium.

(d) Security
Debentures are either secured or unsecured. A secured debenture is secured by a claim on the
company's specific assets. When debentures are not protected by any security, they are known
as unsecured or naked debentures.
(e) Convertibility
A convertible debenture is one which can be converted, fully or partly into shares at a specified
price at a given date. Debentures without a conversion feature are called non-convertible or
straight debentures.

(f) Yield
We can distinguish two types of yield: the current yield and the yield to maturity. The current yield
on a debenture is the ratio of the annual interest payment to the debentures market price.

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 Current yield = Annual interest
Market price

The yield to maturity takes into account the payments of interest and principal over the life of the
debenture. It is an internal rate of return on the debenture and is given by the following formula.
M - PX
C+
YIELD T0 MATURITY = n
(M + P) /2

Where C is the annual interest

M is the maturity value = Face Value
P is the current market value
n is the number of periods to maturity

Claim on Assets and Income

Debentures have a claim on the company's earnings prior to that of the shareholders since their interest
has to be paid before paying any dividend to preference and common shareholders.
In case of liquidation, the debenture holders have a claim on assets prior to that of shareholders. The
secured debentures will have priority over the unsecured debentures
Types of debentures

1. Subordinated debentures
2. Redeemable debentures
3. Irredeemable debentures

Advantages of debentures
It involves less cost to the firm than the equity financing because:

i. Investors consider debentures as a relatively less risky investment alternative and therefore require a
lower rate of return.
ii. Interest payments are tax deductible.
iii. The floatation costs on debentures is usually lower than floatation costs on common shares.
(b) Debenture holders do not have voting rights and therefore, debenture issue does not cause
dilution of ownership.
(c) Debenture holders do not participate in extraordinary earnings of the company. Thus their
payments are limited to interest.
(d) During periods of high inflation, debenture issue benefits the company. Its obligations of
paying interest and principal, which remain fixed, decline in real terms.
Disadvantage of debentures

(a) Debentures issue results in legal obligation of paying interest and principal, which, if not paid can
force the company into liquidation.
(b) Debenture issue increases the firm's financial leverage and reduces its ability to borrow in future.
(c) Debentures must be paid at maturity and therefore at some point, it involves substantial cash
outflows.

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 (d) Debentures may contain restrictive covenants which may limit the firm's operating flexibility in
future

9. Retained earnings

For any company, the amount of earnings retained within the business has a direct impact on the amount
of dividends. Profit re-invested as retained earnings is profit that could have been paid as a dividend. The
major reasons for using retained earnings to finance new investments, rather than to pay higher dividends
and then raise new equity for the new investments, are as follows:

a) The management of many companies believes that retained earnings are funds which do not cost
anything, although this is not true. However, it is true that the use of retained earnings as a source of funds
does not lead to a payment of cash.

b) The dividend policy of the company is in practice determined by the directors. From their standpoint,
retained earnings are an attractive source of finance because investment projects can be undertaken
without involving either the shareholders or any outsiders.

c) The use of retained earnings as opposed to new shares or debentures avoids issue costs.

d) The use of retained earnings avoids the possibility of a change in control resulting from an issue of new
shares.

Another factor that may be of importance is the financial and taxation position of the company's
shareholders. If, for example, because of taxation considerations, they would rather make a capital profit
(which will only be taxed when shares are sold) than receive current income, then finance through retained
earnings would be preferred to other methods.

A company must restrict its self-financing through retained profits because shareholders should be paid a
reasonable dividend, in line with realistic expectations, even if the directors would rather keep the funds for
re-investing. At the same time, a company that is looking for extra funds will not be expected by investors
(such as banks) to pay generous dividends, nor over-generous salaries to owner-directors.

10. Franchising

Franchising is a method of expanding business on less capital than would otherwise be needed. For
suitable businesses, it is an alternative to raising extra capital for growth. Franchisors include Budget Rent-
a-Car, Wimpy, Nando's Chicken and Chicken Inn.

Under a franchising arrangement, a franchisee pays a franchisor for the right to operate a local business,
under the franchisor's trade name. The franchisor must bear certain costs (possibly for architect's work,
establishment costs, legal costs, marketing costs and the cost of other support services) and will charge the
franchisee an initial franchise fee to cover set-up costs, relying on the subsequent regular payments by the
franchisee for an operating profit. These regular payments will usually be a percentage of the franchisee's
turnover.

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Although the franchisor will probably pay a large part of the initial investment cost of a franchisee's outlet,
the franchisee will be expected to contribute a share of the investment himself. The franchisor may well
help the franchisee to obtain loan capital to provide his-share of the investment cost.

The advantages of franchises to the franchisor are as follows:

 The capital outlay needed to expand the business is reduced substantially.

 The image of the business is improved because the franchisees will be motivated to achieve good results
and will have the authority to take whatever action they think fit to improve the results.

The advantage of a franchise to a franchisee is that he obtains ownership of a business for an agreed
number of years (including stock and premises, although premises might be leased from the franchisor)
together with the backing of a large organisation's marketing effort and experience. The franchisee is able
to avoid some of the mistakes of many small businesses, because the franchisor has already learned from
its own past mistakes and developed a scheme that works.

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Self-Assessment Questions

QUESTION ONE

(a) Differentiate the following:-

(i) Participative and non-participative preference shares.
(ii) Subordinated and naked debentures
(iii) invoice discounting and factoring
(b) List the functions of a factor

QUESTION TWO

Maendeleo Ltd has 900,000 shares outstanding the current price is Ksh. 130. The company needs cash, Ksh
22,500,000 to finance a new project. The Board of directors have decided to declare rights issue at a
subscription price of Ksh. 85.
Required:
(a) Compute the number of rights required to buy one share.
(b) Compute the Ex-rights price of the shares of the rights.
(c) Compute the theoretical value of each right.

QUESTION THREE
State and explain any FIVE sources of external finance to a Co-operative Society, giving two advantages
and two disadvantages of each.

QUESTION FOUR
ABC ltd is incorporated under the companies Act with a total of 100, 000 0rdianry shares outstanding and
eligible to vote at all the AGMs. The Company is controlled by 5 directors who are usually electe3d at every
AGM.

Mr. King has approached you for advice on the following issues:-
(i) He bought 25,000 ordinary shares from the company and therefore wants to know the number
of directors he can elect.
(ii) He has a friend who to indirectly control the company by electing single handedly 3 directors and
wishes to know the number of shares he must buy at the stock market so as to elect the directors,
Advise him.

QUESTION FIVE
As a finance manager of Kasuku products ltd, you decide to raise sufficient capital in the next five years to
enable your company to expand. You decide to raise the capital by combining both internal and external
opportunities

Required:-
(a) Explain the major internal sources of capital to an organisation.
(b) In details, explain the main disadvantages of sourcing funds externally. (20Mks)

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QUESTION SIX
State and explain any FIVE sources of external finance to a Co-operative Society, giving two advantages
and two disadvantages of each.

QUESTION SEVEN
(i) Maendeloeo Ltd has 900,000 shares outstanding the current price is kshs. 130. The company needs cash,
ksh 22,500,000 to finance a new project. The Board of directors have share decided to declare rights issue
at a subscription price of ksh. 85.
Required:
a) Compute the number of rights required to buy one share.
b) Compute the Ex-rights price of the shares of the rights.
c) Compute the theoretical value of each right.

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