Discuss the attractions of operating leasing as a source of finance.

Operating leasing is a popular source of finance for companies of all sizes and many reasons have been advanced to explain this popularity. For example, an operating lease is seen as protection against obsolescence, since it can be cancelled at short notice without financial penalty. The lessor will replace the leased asset with a more up-to-date model in exchange for continuing leasing business. This flexibility is seen as valuable in the current era of rapid technological change, and can alsoextend to contract terms and servicing cover. Operating leasing is often compared to borrowing as a source of finance and offers several attractive features in this area. There is no need to arrange a loan in order to acquire an asset and so the commitment to interest payments can be avoided, existing assets need not be tied up as security and negative effects on return on capital employed can be avoided. Since legal title does not pass from lessor to lessee, the leased asset can be recovered by the lessor in the event of default on lease rentals. Operating leasing can therefore be attractive to small companies or to companies who may find it difficult to raise debt. Operating leasing can also be cheaper than borrowing to buy. There are several reasons why the lessor may be able to acquire the leased asset more cheaply than the lessee, for example by taking advantage of bulk buying, or by having access to lower cost finance by virtue of being a much larger company. The lessor may also be able use tax benefits more effectively than the lessee. A portion of these benefits can be made available to the lessee in the form of lower lease rentals, making operating leasing a more attractive proposition that borrowing.Operating leases also have the attraction of being off-balance sheet financing, in that the finance used to acquire use of the leased asset does not appear in the balance sheet.

in choosing between equity finance and debt finance as a source of finance

Gearing and financial risk Equity finance will decrease gearing and financial risk, while debt finance will increase them. Gearing for THP Co is currently685% and this will decrease to 45% if equity finance is used, or rise to 121% if debt finance is used. There may also be some acquired debt finance in the capital structure of CRX Co. THP Co needs to consider what level of financial risk is desirable, from both a corporate and a stakeholder perspective. Target capital structure THP Co needs to compare its capital structure after the acquisition with its target capital structure. If its primary financial objective is to maximise the wealth of shareholders, it should seek to minimise its weighted average cost of capital (WACC). In practical terms this can be achieved by having some debt in its capital structure, since debt is relatively cheaper than equity, while avoiding the extremes of too little gearing (WACC can be decreased further) or too much gearing (the company suffers from the costs of financial distress). Availability of security Debt will usually need to be secured on assets by either a fixed charge (on specific assets) or a floating charge (on a specified class of assets). The amount of finance needed to buy CRX CO would need to be secured by a fixed charge to specific fixed assets of THP Co. Information on these fixed assets and on the secured status of the existing 8% loan notes has not been provided. Economic expectations If THP Co expects buoyant economic conditions and increasing profitability in the future, it will be more prepared to take on fixed interest debt commitments than if it believes difficult trading conditions lie ahead. Control issues A rights issue will not dilute existing patterns of ownership and control, unlike an issue of shares to new investors. The choicebetween offering new shares to existing shareholders and to new shareholders will depend in part on the amount of finance that is needed, with rights issues being used for medium-sized issues and issues to new shareholders being used for large issues. Issuing traded debt also has control implications however, since restrictive or negative covenants are usually written into the bond issue documents.

why a company may choose to finance a new investment by an issue of debt

Pecking order theory suggests that companies have a preferred order in which they seek to raise finance, beginning with retained earnings. The advantages of using retained earnings are that issue costs are avoided by using them, the decision to use them can be made without reference to a third party, and using them does not bring additional obligations to consider the needs of finance providers. Once available retained earnings have been allocated to appropriate uses within a company, its next preference will be for debt. One reason for choosing to finance a new investment by an issue of debt finance, therefore, is that insufficient retained earnings are available and the investing company prefers issuing debt finance to issuing equity finance. Debt finance may also be preferred when a company has not yet reached its optimal capital structure and it is mainly financed by equity, which is expensive compared to debt. Issuing debt here will lead to a reduction in the WACC and hence an increase in the market value of the company. One reason why debt is cheaper than equity is that debt is higher in the creditor hierarchy than equity, since ordinary shareholders are paid out last in the event of liquidation. Debt is even cheaper if it is secured on assets

of the company. The cost of debt is reduced even further by the tax efficiency of debt, since interest payments are an allowable deduction in arriving at taxable profit. Debt finance may be preferred where the maturity of the debt can be matched to the expected life of the investment project. Equity finance is permanent finance and so may be preferred for investment projects with long lives.

role of financial intermediaries in providing short-term finance for use by business organisations.
The role of financial intermediaries in providing short-term finance for use by business organisations is to provide a link between investors who have surplus cash and borrowers who have financing needs. The amounts of cash provided by individual investors may be small, whereas borrowers need large amounts of cash: one of the functions of financial intermediaries is therefore to aggregate invested funds in order to meet the needs of borrowers. In so doing, they provide a convenient and readily accessible route for business organisations to obtain necessary funds. Small investors are likely to be averse to losing any capital value, so financial intermediaries will assume the risk of loss on short-term funds borrowed by business organisations, either individually or by pooling risks between financial intermediaries. This aspect of the role of financial intermediaries is referred to as risk transformation. Financial intermediaries also offer maturity transformation, in that investors can deposit funds for a long period of time while borrowers may require funds on a short-term basis only, and vice versa. In this way the needs of both borrowers and lenders can be satisfied.