The two basic types of leases available to a business are operating leases and financial leases.

An operating lease is typically a contractual arrangement whereby the lessee agrees to make periodic payments to the lessor, often for five years or less, to obtain an asset’s services. The lessee generally receives an option to cancel the lease by paying a cancellation fee.
A financial (or capital) lease is longer term than an operating lease. Financial leases are non-cancellable and therefore obligate the lessee to make payments over a predefined period.

The advantages of leasing are:

• the ability of the lessee to depreciate land, which is prohibited if the land were purchased,
• the use of sale-leaseback arrangements may permit the firm to increase its liquidity by converting an asset into cash, which can then be used as working capital,
• leasing provides 100 percent financing,
• the maximum claim of lessors if a lessee becomes bankrupt is three years of lease payments along with reclaiming the asset,
• the lessee may avoid the cost of obsolescence if the lessor fails to accurately anticipate the obsolescence of assets and sets the lease payment too low,
• the lessee avoids many of the restrictive covenants that are usually included as part of a long term loan, and in the case of low-cost assets leasing may provide the firm with needed financing flexibility.              (Any 4 points)
  

• It is very possible if not probable that as working capital in a firm increase so does profit. This is because the level of working capital: stocks, debtors and creditors should follow the level of business which in turn should be generating profits. As a business expands in terms of fixed assets it will usually require additional working capital too. Also as profit increases it allows working capital to be increased too.
• However it is not working capital per se that generates profits or profits that generates working capital. What is important is how and in what proportions working capital is used. A company needs to exercise control over working capital. Particularly when credit markets are tight, a company’s liquidity is as important as its profitability. Changes in working capital will usually change a company’s liquidity.
• Depending on the nature of a business, its working capital requirements will be different. Unlike a typical service company, a manufacturing company may need substantial levels of stocks. It may also have high levels of debtors and creditors as well. However a decision to use “Just In Time” methods of production, if implemented successfully, could result in lower levels of stocks. Also producing in smaller batches could result in the reduction of finished goods.
• Therefore it is not necessary to have higher working capital to have higher profits. In fact in companies with loose financial management that carry high stocks and are too generous with giving credit while not taking advantage of credit available for them will not be as profitable as ones that are more tightly managed.                          (Any 2 points)
  

Overtrading refers to a situation where turnover is increased without a matching increase in equity or other long-term sources of funds; as a result, a company which can be earning good profits can run into a liquidity crisis and default in payment of its current liabilities. The company is unable to finance the level of operations which it has achieved. Further business growth increases the pressure upon working capital. A major cause of overtrading is where a company considerably increases its sales by offering generous credit terms without obtaining any equivalent credit terms from its own creditors. The company may try to obtain further short term finance by borrowing or non-payment of its own creditors which can quickly lead to considerable financial distress or even liquidation.

Companies experiencing overtrading might notice the following symptoms;

• The increased investment in current assets needed to support the increased sales are financed mainly from short-term sources like creditors and bank overdraft, resulting in a declining current ratio and quick ratio.
• Sales tend to increase very quickly in relation to equity, resulting in sharp increases in the ratio of sales to equity.
• The increase in debt would lead to higher gearing ratios
• The net working capital will tend to decline, and may even become negative. A negative net working capital implies a current ratio less than unity (current assets less than current liabilities), and a business in such a position is likely to face considerable difficulty in meeting its current liabilities.
• Even where the current ratio is satisfactory, any erosion of net working capital would worsen the liquidity of the business and make it more vulnerable to cyclical risk.               (Any 3 points)

Solving Overtrading

• The instant solution to overtrading is to take more trade credit and bank overdraft finance. However this is likely to be only a short-term fix that ultimately exacerbates the situation and worsens the liquidity crisis.
• Better short-term solutions would be to either restrict the growth in turnover to manageable proportions
• or improve working capital management so that the investment in current assets required to support the level of sales is reduced (i.e. better inventory control, credit policy and debt collection).
• The long-term solution is to provide more long-term funds for working capital purposes – i.e. improve the Net Working Capital position of the firm.                            (Any 2 points)
  

Features of Convertible bonds

• Convertible bonds are fixed return securities that may be converted into ordinary shares of a company at pre-determined date(s) and at a pre-determined rate at the option of the holder. Often the terms of the conversion may seem to be less attractive at conversion dates further away. This reflects expected share price growth.
• At the conversion date or dates, the holder has the option to convert the stock into ordinary shares or continue to hold the stock and earn the fixed interest until the bond matures. However, if the investor decides to convert the bond into ordinary shares, they cannot convert the ordinary shares back into the original fixed security.
• The conversion premium is the difference between the nominal issue value of the bonds and the conversion value at the date of issue. From the issuers viewpoint the larger the conversion premium the better as less shares need be issued for a given amount of capital raised.
• However to be acceptable and valuable to investors the premium must reflect the growth prospects of the issuers ordinary share price.               (Any 2 points)

Attractions of convertible bonds to the investor and issuer:

• The price of the convertible bond in effect includes an option to buy the ordinary shares.
• The potential value of the conversion rights.
• Interest income which would not be received if the investor simply bought a call option on the shares.
• The interest cost to the company is lower than for conventional, non-convertible stock.
• Most issuers expect the bonds to be converted and hence view them as delayed equity.
• Thus EPS is not immediately affected as it would with the issue of ordinary shares.
• If bond is converted into equity then this removes the necessity to raise funds to redeem the initial loan stock.             (Any 2 points)
  

• Time – mergers or acquisitions allows a firm to increase its market share or enter a new market more quickly than might be incurred if the firm tried to expand organically. As ―time is money‖, the ability to enter a market or increase market share fast by mergers or acquisitions could be the cheapest way to expand.
• Cost – cost savings could be achieved by mergers or acquisitions due to synergy. Alternatively due to a ―premium for control, acquisitions might be the most expensive way to expand. This may be particularly true if it is resisted by the directors of the target company or the government under the terms of competition legislation. However at least acquisitions can be made by means of share exchange unlike organic growth which requires funding in cash.
• Regulation / legislation / culture – mergers or acquisitions can allow for an easy entry into a market, particularly a foreign market where organic growth would be forbidden / restricted / meet local opposition. Alternatively organic growth is unlikely to result in referral to competition authorities while mergers or acquisitions often do. Similarly the customers / government may not appreciate the new (foreign) owners.
• Assimilation – Mergers and acquisitions can lead to quicker entry into a new market but it could also lead to problems of assimilating new employees and new operating systems. Likewise staff need to assimilate an increasing range of products, suppliers, customers and markets. This can lead to a large strain on staff at all levels but particularly management and lead to ―corporate indigestion‖ mentioned earlier.
• Strategy – mergers and acquisitions will be most successful when they allow the strategic objectives of the firm to be achieved at a lower cost and / or faster than would they be by organic growth. Mergers and acquisitions are probably only desirable if organic growth alone cannot achieve the strategic objectives that a company has set itself. However their purpose should be to increase long term shareholder wealth and not just short term profits.                   (Any 2 points)
  

Organic growth involves a firm expanding its customer or product base using their own internal resources. Alternatively this can be achieved through acquisitions or mergers. Although both can have a similar result in terms of growth they can each have different strategic effects on the expanding firm. A company which is planning to grow must decide on whether to pursue a policy of organic growth or acquisitions or mergers, or a combination of the two. Irrespective of how it is achieved, growth especially when it is achieved by diversifying into new markets or into new products can cause strategic problems and lead to ―corporate indigestion‖. This can be seen in terms of Customer Relation Management, (CRM), problems, an increase in human resources issues, ―span of control‖ and decisions making issues, and in increase in alienation of stakeholders from each other.

A company pursuing a policy of organic growth should take account of the following strategic issues:

• Optimal scale of production – organic growth will allow the firm to choose the level of production it requires. Mergers and acquisitions are ―lumpy. The firm must absorb entire firms, with whatever level of production that entails and whatever resources they contain. The firm buys the head office functions of other companies and there will either be fewer economies of scale, or more redundancies.
• Human resources – organic growth will allow the firm to offer its original staff greater opportunities and responsibilities. Similarly where the firm does not have the required expertise within itself, targeted recruitment to select the best people can be used. In mergers and acquisitions the firm has little control over the number and skills of the staff of those businesses it absorbs.
• Capital resources – similar to human resources, capital resources can be used and obtained more efficiently with organic growth. The location of new outlets or offices for example can be most advantageously placed to maximise operational efficiency. In mergers and acquisitions the firm has little control over existing locations. This can lead to duplication and/or gaps in distribution networks for example
• Cost – how will resources to allow for the growth be obtained? Retained profits? New / additional equity? Increase in borrowing? How much can it afford? Is ―over trading‖ a serious risk?                 (Any 2 points)
  

• Credit controls
  This could be achieved through legislation and through the guidelines of the Central Bank of Ghana. The amount of funds available to the banks for commercial credit and the interest rates are directly regulated by the government through CBN. The effects will be to make borrowing more difficult since credit controls will affect the cost and available of funds, the share values, and the profit levels.
• Taxation
  Government policies on taxation will have an impact on the company’s cash flow by way of withholding tax on interest, dividends etc, sales tax, capital allowances claimable and balancing charges.
  Company taxation via allowances claimable could restrict or encourage investment in fixed assets (qualifying capital expenditure) and will determine the acceptable or rejection of certain projects as well as the method of financing such ventures.
  Personal income taxation affects corporate funds since it reduces personal disposable income or may encourage savings/investments. Both personal income and capital gains taxes affect shareholders preference for dividends against retentions and vice versa, hence posing dividend decision problems for the financial manager especially where the company has a wide spread of shareholders.
• Custom duties, tariffs and other trade barriers
  These can encourage or discourage imports/exports. Complete ban of products or high custom duties or tariffs will affect investment decisions covering these products and their close substitutes. This may also encourage backward integration and local sourcing of imported raw materials and spare parts.
• Control of income, prices, dividends etc.
  The effect of Productivity Prices and Incomes Boards guidelines through restriction of dividends and wage/price increases is a shortage of funds otherwise available for increase in cost of capital, and diversion of income seeking investors’ funds into non-equity stocks.
• Exchange controls
  For a country like ours that is heavily dependent on overseas trade, exchange controls will have serious effects on foreign exchange available and the prevailing exchange rates. With the second – tier foreign exchange market, most financial managers are finding it extremely difficult to plan adequately for purchase of foreign exchange. In addition, the rationing of foreign exchange in IFEM has restricted investment in projects that require imported heavy duty machinery and equipment.

The investment decision considers the benefits of investing cash either in projects or in working capital or even in high yield deposit accounts. This is important to shareholders as it will determine the cash flows which are generated by the company and will ultimately affect the dividends paid and the share price. Assessing projects can sometimes be difficult as the returns may be spread over many years making the cash flows harder to estimate. Shareholders will also be concerned to compare the risk as well as the return between profits, as a higher risk investment should carry a higher return to compensate.

The financing decision considers the source of the finance required for the business operations. This will be a mixture of equity and long-term debt finance; companies need to balance the benefits to their shareholders – debt is a cheaper form of finance as the returns required are lower (due to lower risk) and the debt interest is tax allowable, but excessive gearing can increase the risk to the company, and hence the shareholders, dramatically.

The dividend decision looks at how much of the surplus cash generated should be paid out to the shareholders, and how much retained for future investments. Companies often make two payments a year, and shareholders generally prefer a predictable, steadily rising, dividend rather than one which follows the fluctuations of the profits. A dividend policy is often declared for a number of years to give this predictability. A company which then delivers what it promises will generally be regarded as less risky, and hence more valuable, by shareholders.

The three decisions are, therefore, interrelated as the finance needed for viable projects will come from both internal funds, which have not been paid out as dividends, and externally raised finance. The mixture of funds raised and used will then affect the cost of capital, which in turn will affect the viability of investments.