Off-Balance Sheet Financing and Bonds\" Please respond to the following: Company
ID: 2449518 • Letter: O
Question
Off-Balance Sheet Financing and Bonds" Please respond to the following: Company XYZ is considering using off-balance-sheet financing in order to obtain a loan from a local bank, but the company is unsure of the various forms of off-balance-sheet financing. For management, compare and contrast the various forms of off-balance-sheet financing. Give your opinion on whether or not Company XYZ should engage in off-balance-sheet financing. Provide a rationale with your response. Explain the primary advantages and disadvantages of issuing bonds with call features to potential buyers. Suggest two (2) improvements that a company could implement in order to make bonds with call features more attractive to potential buyers.
Explanation / Answer
Two popoular methods of off balance sheet financng to obtain loan are operating lease arrangement and receivables sale. Getting loan from a bank needs a clean balance sheet of the firm where the required debt equity ratio and is maintained and the cureent assets are recovered quickly and liabiities are settled in time.
When a firm wants to hide its debt to maintain debt equity ratio for future loans it takes the way of opearting lease financing . Instead of direct purchase, the asset is purchased by a special purpose entity (SPE) which then leases it to the firm under an opearting lease. As the firm is not controlling SPE , it need not consolidate the assets and liabilities but only account the lease rental. But the effective control of the asset remain with the firm. This way the firm can use the asset without showing the liability and maintaining its debt quity ratio.
Similarly , Accounts receivables when sold to financing subsidiary with less than 50% control, the parent need to consolidate the liability of the subsidiary in its book but it casn show its AR position improved. Most of the times , the AR sale it done with a higher recourse provision than normal which is not disclosed in financials.
Similar off balance sheet financing happen when the non performing assets or liabilities are transferred to Join ventures or Partnerships which need to be consoildated and the firm's balance sheet is shown as cleaner without those poor assets or liabilities.
In my opinion such Off balance sheet transactions should never be done. This is equal to masking of the financial information as the investors do not understand the real risks the company is subjected to if those are transferred to such off balance sheet entities. Therefore for fairnes and disclosing real financial position such transactions should not be done. SEC has also made the rules stricted to report such Off balnce sheet SPEs in a company's financials for better compliance and disclosure.
2. Callable bonds have the option of recalling the bonds at a predefined date and rate. The issuer has advantage in callable bonds as it has the option to recall the bond by paying the maturity if the interest rate goes down so that it can stop paying higher interest and reissue the bond at alower rate. If the market rate is higher the call option may not be exercised to enjoy the lower cost of financing.
The disadvantage of callable bond is that the interest is higher than the normal bonds due to the higher risk to the investors and the investors are generally averse to invest in callable bonds over other normal bonds.
The company may do improvements to make callable bonds mre attractive;
1. By making the redemption price above par to offer some premium on redemption.
2. Offering better marginal yield over the similar non callable bonds.
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