Section 3 - Advantages & Disadvantages of Debt Financing (3.14)

Benefits of leasing

-Businesses unable to obtain credit to purchase an asset may be able to lease it instead -Terms in lease agreements are often less strict than in bond indentures -Leases often do not involve down payments -In bankruptcy, creditors have weaker rights over some assets financed by leases -Leases may transfer the tax benefits of debt financing to lessors, prompting lessors to reduce the cost of leases -Under operating lease type, the lessee does not have to recognize the financed item as an asset or the resulting obligation as a liability in its financial statements.

Advantages of using debt financing

-interest is tax deductible for issuer -the obligation is generally fixed -if current owners issue debt instead of new shares of stock, the current owners avoid giving up control to the new shareholders -if excess EPS, owners will benefit not bondholders -debt is less costly than equity (cost of capital is lower) -with inflation, debt is paid back with less valuable dollars

Disadvantages of using debt financing

-the business must make pre-determined interest and principal payments independently of its performance -with bond covenants, businesses effectively forgo some control -high debt levels increase the risk that the business may fail

Capital lease Accounting

Lessee capitalizes the lease at the present value of the minimum lease payments -DR: Asset ---CR: Liability

Two types of leases

Operating lease Capital: --Sales type --direct finance --In substance this type is more of a purchase (i.e. bargain purchase at the end of the lease term)