Incurring minimum possible cost or generating maximum possible return is at the centre of any financial analysis. The same is the central theme while evaluating the various means in which an asset can be financed. In this article, I have described my experience, my thought process, my logic on a deep thinking on the concept of “Asset Financing”. I have tried to touch the basics such as presenting solutions to the questions of ground level – In which ways can an asset be financed? Why any method can be selected and why not the other? Why in academic syllabus, the sums end up comparing lease with debtfinancing despite of other broad means? I have tried my level best to narrow down the content in simple lucid language.
An asset despite being financed through any means generate the same amount of cash inflow. It is the source that varies the cash outflow under various methods. E.g. under debt financing, installment is the cash outflow whereas under lease, lease rentals are the cash outflow. So the option under which it generates minimum amount of cash outflow is selected. An additional asset affects the liquidity as well as solvency position of any organization. In simple words, say for e.g. if a transformer manufacturer purchases a newtesting equipment through debt financing, it increases debt burden (thus affects solvency) & brings/loses cash flow depending on the usage (thus affects liquidity). Thus it generates the additional inflow against the additional (marginal) cost it creates on the organization.
METHODS AND BROAD OVERVIEW
In initial classes we are taught that additional debt carries more cost than the previous one depending on the solvency, liquidity as well as habit ofrepayment of the previous debt. Same is over here when an additional asset comes into picture. So it has to be evaluated by the marginal cost concept. The rates used should be the marginal rates, to say that in the example of transformer manufacturer, if it approaches debt financing in a not so good Debt: Equity ratio, the subsequent debt shall carry higher cost against the extra risk that it carries. Now let us analyse that how can each method be used to finance the asset, what are the pros & cons of these methods?
1. Equity financing
This method involves issue of new share capital for the purchase of an asset. This finance can be raised from the existing or new investors. The idea of raising through new retail investors is a costly process. Even more this sounds meaningless. Equity creates ownership for the lifetime whereas the asset may undergo drastic technological changes in the entire term. Even the cost of equity is the highest. Consequently, if the organization is not able to meet the expectations, then it would result into decrease in share price of the company, further leading to a losing control over the capital markets. (Remember I am talking about financing of an asset and not a project). To clarify this further let’s take the example of PVR Cinemas in India, it is expanding by its own funds as well as funds raised through venture capitalists. It purchases/leases land & builds infrastructure. On the other hand the transformer manufacturer cannot try to finance its testing equipment through these venture capitalists as even these financers are not interested in financing of a single asset; they invest in businesses/projects. PVR’s plan encompasses a project and I am talking about asset financing. Thus equity is not resorted and even sounds bit impractical for asset financing.
2. Cash financing
By cash financing I mean that the transformer manufacturer purchases the testing equipment in exchange of cash & cash equivalents. We all know that cash is a current asset, an important tool of working capital. Generally companies keep cash to meet the WC requirements. The companies that have high stock turnover ratio must maintain this liquid asset in a definite proportion. The companies aren’t willing to maintain high amount of unused funds in the form of cash. The opportunity cost that the cash carries is internal sustainable growth rate (g). So the asset must at least generate a return of g%. During my thinking, I merged the available cash with the accumulated profits (a usual mistake that a CA student may do), but both are different. Thecompany may be having high accumulated profits but it is not necessary that the same will be in the liquid form of cash. It may have re-invested even. So cash financing is adopted only & only when the company’s post-purchase liquidity position is still healthy. This may be witnessed in mature companies (remember product life cycle).
On account of the reasons seen above both these methods are not preferred in the academic syllabus (typically CA, CWA & CS curriculum in India) which even sounds logical.
3. Debt financing
This is the method an academic student evaluates while financing of an asset. Debt creates a charge on the liquidity in the form of installment, which even provides interest tax shield. In comparison to lease financing, as an asset is purchased, depreciation tax shield is even the benefit under this option. Debt is for a limited period which is more or less tried to be equal to the asset’s life. So cost is incurred only that period for which the asset is used. Even more trading on equity benefit is available when an asset is financed through debt. In simple words, borrowing money at lower amount, generating higher returns than the cost of capital and thus the return on equity gets magnified. Thus, debt financing is evaluated as an option.
4. Lease financing
Under this arrangement, the company pays a fixed amount as usage charge“rent” to the owner of the asset. Thus, the lessee (company) effectively uses the asset for the period it actually requires without any corresponding increase in the asset base as on the face of balance sheet. Tax shield benefit is available as rent is a tax deductible expense. Only liquidity position of the company gets affected, there is no effect on the present solvency position. (But actually the amount financed as lease results into debt displacement i.e. it is difficult for company to obtain subsequent debt as the lease rent eats up a portion of generated cash flow). Consequently, we see that even lease financing is evaluated as an option for Asset financing.
Finally in “ASSET FINANCING – PART 1”, I conclude on account of above stated reasons that, for asset financing, debt and lease are the options for effective evaluation. In my next article “ASSET FINANCING – PART 2”, I shall try to explain the IRR method, which I consider is the most appropriate method of comparison between debt and lease financing.
I am very very thankful for your patient reading. I am hopeful that this article will help the student of curiosity to understand the basics of asset financing. Whenever you are free, please critically evaluate the article & without any hesitation point out any needed improvements. I shall try my level best to address it.