*I am taking the financial management course and they want us to use the financi
ID: 2754027 • Letter: #
Question
*I am taking the financial management course and they want us to use the financial management lingo when it comes to answering the question below.
One advantage of leasing voiced in the past is that leasing kept liabilities off the balance sheet, thus making it possible for a firm to obtain more leverage than it otherwise could have. This raised the question of whether or not both the lease obligation and the asset involved should be capitalized and shown on the balance sheet. Discuss the pros and cons of capitalizing leases and related assets.
Explanation / Answer
The Lease is like a loan you have to pay regular lease payments for the assets brought from the lessor. These lease payments are like regular payments on a loan therefore the present value of these lease payments can be considered as a debt on which a regular payments are to be made to repay the entire Debt. Usually the Lease payments are considered as a part of operating expenses but these lease payments could be consolidated into a Debt and divide the regular lease payments into interest and principal portion.
The lease payments and the asset should be capitalized and shown on the Balance sheet, the present value of lease payments should be added to the debt on the balance sheet to get the real debt that company is really holding, the asset can be added to the Asset portion of the balance sheet.
The benefits of capitalizing really is that firstly, you get to see the real picture of what the actual Debt and assets the company is holding, because the lease payments are really like payments of a loan or Debt and the Assets being utilized fully by company for operations should be added to the total assets the company is holding. Secondly, the Asset value of the company increases. Thirdly you get to get the tax savings arising from depreciation of the asset. At the same time since entire lease payments are not subtracted as operating expenses the operating income for the firm increases and as a result cash flow from operations increases. The lease is deducted in form of interest from income statement and financing cash outflow from the cash flow statement.Fourthly, the weighted average cost of capital decreases due to higher Debt level which together with higher operating cash flows increase the value of the firm.
The arguments against capitalizing leases is that the Debt increases as shown on the balance sheet these prevents the firm from taking further leverage, therefore this could be detrimental to the growth of the firm. The financial ratios can take a hit like the asset turnover ratio(Sales/Total Assets) which becomes lower or the Debt to equity ratio which increases these changes do cause credit deterioration of the firm that causes difficulties in raising further debt.Second you get to get tax savings on the entire operating expense when leasing is not capitalized as compared to when it is capitalized. Finally not capitalizing decreases the overall real debt of the firm is holding this allows to take further leverage.
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