This is an arrangement whereby a company which owns some assets arranges to sell the same assets and at the same time agrees with the buyer to lease the same asset back at an agreed rental charge. This type of arrangement is possible if the asset back at an agreed rental charge. This type of arrangement is possible if the asset is fixed asset whose return must outweigh the cost of the same finance. Also the parties involved must have had an intimate relationship before i.e. they should be acquitted to one another.
Advantages of using Sale and Lease Back
1. The company gets finance in cash and finance in kind which boost its operations tremendously
2. Since the lessor and the lessee are known to each other, this finance may not entail any conditions or restrictions on the part of the lessee.
3. This arrangement does not involve tedious formalities, thus is flexible to raise for financing reasons.
4. The risks of obsolescence shifts from the lessee to he lessor thus will entail less risk of capital loss the lessee.
5. It is easily available i.e faster because the two parties are known to each other.
Disadvantages of using sale and lease back.
1. The company’s asset will be removed from the balance sheet which will in essence affect its financial position i.e reflect a bad financial picture.
2. The lessee may not enjoy the benefits of wear and tear as such this will increase his tax liability.
3. The finance is limited to the cost of the asset leased, and cannot be versatile.
4. If it is an operating lease, then it will be used for short-term purpose.
5. It entails implicit costs such as repairs and maintenance costs of the asset leased.
Conditions under which sale and lease back is ideal as a source of finance
1. If the asset is required for seasonal purpose
2. If the asset is technologically sensitive i.e may soon be technologically obsolete.
3. If the asset cannot meet the company’s contemplated expansion programmes
4. Where the asset has a tendency of depreciating fast
5. If the asset is not sensitive or central to the company’s operations.
Sale of an asset
For companies with assets which are not very necessary for their operations, such assets can be sold to raise finance for the company. These assets should only be sold if the funds from the sale of assets can be invested in ventures which can generate returns higher than those the asset sold was generating.
This is an agreement whereby a company acquires an asset on hire by paying an initial installment usually 40% of the cost of the asset and repays the other part of the cost of the asset over a period of time. The source is more expensive than bank loans. Companies that use this source of finance need guarantors as it does not call for collateral securities to raise. The company hiring the asset will be required to honour all the terms of the agreement which means that if any term is violated then the hiree may repossess the asset e.g in Kenya if the hirer fails to pay any installment before he clears 2/3 of the value of the assert the hiree may reposes it.
Companies that offer this finance in Kenya are;
- National industries E.A ltd
- Diamond trust (K) ltd.
- Kenya Finance Corporation
- Credit Finance Co. Ltd.
They avail hire purchase facilities for such assets as;
1. plant and machineries
4. heavy transport machines
6. Agricultural equipments.
Conditions under which Hire Purchase is an ideal source of finance.
1. If the asset is so expensive that there is no single source of finance that can finance it e.g aircrafts.
2. Under conditions of credit squeeze or restrictive credit control.
3. If the company cannot obtain securities to cover a loan to finance this type of asset.
4. if the asset will meet the company’s future expansion programmes
5. If the asset is not very sensitive to technology.
6. If the company is highly geared and cannot borrow to finance such an asset.
Advantages of using hire purchase as a source of finance.
1. It does not call for securities in acquiring it an as such it is a flexible source of finance.
2. this finance is a long-term finance and as such it can be used to acquire fixed assets which are very essential for the company’s profitability
3. It is useful under conditions where the company cannot raise finance due to the amount involved i,e if it is substantial.
Disadvantages of using hire purchase as a source of finance
1. it is an expensive source of finance and in most case the interest on it may outweigh bank rates and at the end of the hire purchase contract the total installments paid may double the cost of the asset.
2. it involves a lot of formalities to obtain e.g legal implications and accounting formalities prior to
Signing Hire Purchase Agreement.
1. the hiree has a lien over the asset until the final installment is cleared in which case if the hirer defaults the hiree may repossess the asset in particular if the hirer has not paid 2/3 of the value of the asset this will entail a capital loss to the hirer once the asset is repossessed by the hiree.
2. It may be difficult to get a guarantor for expensive purchases e.g huge machinery as their value may be beyond the financial capabilities of a number of guarantors making it difficult to acquire heavy fixed assets necessary for the company’s operations.
3. By not purchasing the asset outright, the hirer foregoes discounts which will be an opportunity cost as a result of hire purchase.
4. Hire purchase is limited to those assets which are available with the hiree and as such may not cover all areas of the company’s financing needs e,g for working capital.
These are body corporates which avail finance for long term use, and avail their finances though purchase of shares in the stock exchange, debentures and through mortgage finance to deserving financially strong companies. Companies that avail this finance include trustee companies, pension organizations, insurance companies, and investment companies’ e.t.c. these avail finance in large quantities and usually do this to earn a return on the same finance or to acquire ownership in those companies so as to safeguard their investments. Companies which are financially strong will attract institutional investors.
Advantages of using finance from institutional investors.
1. it is cheaper to raise this finance because it will be available in large sums and from a few companies i.e flotation costs will be low.
2. These institutions using their financial experience can advise the company in its investment activities so as to utilize such finance more profitably.
3. the cost of servicing their finance is low as these will be paid with a few cheques unlike the case with a company having a large number of shareholders with will issue many cheques this increasing the cost of servicing this finance.
4. These investors will come to the rescue of the company permanent finance if they purchase ordinary shares and this will be used in long term ventures.
5. Being major shareholders they will contribute valuable ideas during the annual general meetings and such ideas may improve the running of the company benefiting from such finance.
Disadvantages of raising finance from institutional investors.
- They may disrupt the company’s running through the various ideas they would want the company to implement which may not be in the interest of other shareholders.
- They influence the company’s dividend policy and as such this may be to the detriment of small shareholders.
- In case they decide to sell their shares this will lead over supply of shares which will lower the price of the company’s shares in the stock exchange; this may erode the company’s credibility.
Factors affecting the type of finance sought.
Finance to be raised by accompany should be at a cost than the return expected from the project where such finance has to be invested for this reason two types of costs should be considered before raising any finance:
1. Explicit costs
These are costs that the company has to pay directly to the lenders for using their money this could be either interest payable for using debt finance or dividends payable for using share capital; these two costs are paid to retain such finance in the business.
2. Implicit costs
These are costs which are not necessarily paid to lenders directly but which must be paid to obtain finance these include such costs as; insurance of the security, its maintenance costs and floatation costs for raising share capital. These two costs should be weighed against benefits to be derived from the use of such finance.
- Need for finance.
A company may raise finance to finance its working capital needs, this finance is known as bringing finance such as finance will be raised form such sources as overdraft and short-term loans.
To acquire a fixed asset this will be raised from long-term sources of finance
- ordinary share capital
- preference shares capital
- long term debt financed or sell of debenture
- hire purchase finance
- lease finance et.c
3. The company’s gearing level.
The gearing level will influence the company’s ability to raise further finance in as much as highly geared companies are viewed as highly risky as they have used more debt finance than equity finance. This exposes it to chances of receivership and consequently liquidation as creditors can recall their money at short – notice. This means that high gearing will not allow the company to raise debt finance as creditors will be reluctant to lend to a highly geared company. Also such a company cannot raise equity finance as the demand for its shares will be low due to such indebtedness.
4. The size of the company
The size of the company will determine which finance it can raise. This is so because small companies may not be able to raise difference finances due to the following reasons;
- such companies will find it difficult to have access to different finances because:
They may be unknown to the lenders and as such their credibility will be questionable.
Such companies may not have the necessary securities to pledge in order to raise various finances available in the financial market.
They may be ignorant of the various finances available on the financial market.
- They may not meet the requirements of the stock exchange so as to float their shares e.g for a company to go public such a company must have a minimum of shs. 2,000,000 or such £ 100,000 which very few companies may have.
- Lenders also discriminate against small companies in their lending activities in particular due to ownership of small companies most of which are sole traders whose life span is equivalent to that of the owner, this means that they viewed as highly risky areas of investment.
- Big companies not only are they able to raise share capital, but also can sell their debentures even under credit squeeze, which condition usually makes it difficult for small companies to raise finance.
These include the repayment of principal and interest. Ideally a company’s repayment of principal should be spared over such a period as can enable the asset and or the project financed to pay back. In case of interest the company.