Comprehensive Finance Report: Leasing, Bankruptcy, and Risk Assessment

This report provides a detailed analysis of several key financial concepts. It begins by exploring the pros and cons of leasing, differentiating between operating and financial leases, and discussing the impact on profitability and cash flow. The report then examines the differences between leasi...Read More

1) The Pros & Cons of leasing
a) Definition:
 A lease is a contractual agreement between a lessee and
lessor.
 The lessor owns the asset and for a fee allows the lessee to
use the asset.
b) Types:
 Operating lease
 Financial lease:
Pros Cons
Lease payment is tax deductible.
Taxes can be reduced by leasing.
The agency cost problem: In a lease,
the lessor will transfer all rights to the
lessee for a specific period of time =>
the lessee who controls the asset is
not the owner of the asset, the lessee
may not exercise the same amount of
care as if it were his/her own asset.
Impact on profitability (effect on ROA
and net income)
The lease contract may reduce certain
types of uncertainty.
Lower cash flow required upfront
versus buy option
Conclusion: A lease payment is like the debt service on a
secured bond issued by the lessee. A simple method for
evaluating leases: discount all cash flows at the aftertax interest
rate on secured debt issued by the lessee.
2) Leasing vs Borrowing
Definition:
Leasing:
 A lease is a contractual agreement between a lessee and
lessor.
 The lessor owns the asset and for a fee allows the lessee to
use the asset.
 Operating lease vs Financial lease
Borrowing:

 A loan is borrowing funds from any financial institute by an
individual or an organization.
Borrowing Leasing
Borrowing can be of various
types depending on the need
of the borrower
Operating lease vs Financial
lease
Borrowing can be applied by
organizations or individuals
whoever needs funds to meet
its requirement.
Only businesses avail the
facility of lease whenever they
have any requirement
anything, which they do not
want to buy uprights.
Conclusion:
These are quite similar, however, there are one key difference
between these 2 concepts: While the loan is that situation
where an individual or a business borrows money from a
financial institution, lease refers to a contract between a lessor
and lessee where the lessee uses the asset of the lessor for a
specified time period but in return of periodic payments.
3) What are the direct and indirect costs of bankruptcy?
 Bankruptcy is a legal proceeding initiated when a person or
business is unable to repay outstanding debts or obligations.
The possibility of bankruptcy has a negative effect on the
value of the firm.
 Direct cost: Legal and administrative costs
 Indirect cost: Impaired ability to conduct business (e.g., lost
sales)
4) What factors affect debt-equity levels
 Taxes: Since interest is tax deductible, highly profitable firms
should use more debt
 Types of Assets: The costs of financial distress depend on
the types of assets the firm has. Firms with large tangible
assets likely to have higher D/E ratio

 Uncertainty of Operating Income: Even without debt, firms
with uncertain operating income have a high probability of
experiencing financial distress.
5) What is the difference between systematic and
unsystematic risk?
 A systematic risk is any risk that affects a large number of
assets, each to a greater or lesser degree.
 An unsystematic risk is a risk that specifically affects a single
asset or small group of assets.
6) How do flotation costs affect the capital budgeting process?
- Flotation costs represent the expenses incurred upon the
issue, or float, or stocks, or bonds
- Floatation cost refers to the cost of raising funds. Higher the
flotation cost of a particular source, lower is its preference in
the capital structure and vice versa.