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Operating and Financial Leases (Capital Leases)

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Within an accounting context, a lease can be classified as an operating lease or a financial lease.

Operating lease (service lease) refers to a short-term lease of an asset with a useful life longer than the term of the lease. For example, this applies when fixed assets with a useful life of 15 years are leased for 3 years. This type of lease is common for fixed assets with a longer useful life but which become less efficient and even technologically obsolete relatively fast, such as computer systems and office equipment.

Operating leases usually can be cancelled but generally a cancellation penalty will apply. They also usually include maintenance clauses which require the lessor to conduct maintenance of the asset as well as tax and insurance payments.

Operational leases usually include a renewal option since the economic life of the asset is generally relatively longer than the lease term. This allows the lessee to renew the lease of the asset at the end of the term of the lease. A purchase option may be included at the end of the lease which will allow the lessee to acquire the asset.

Under an operating lease, a lessor transfers to lessee only the right to use the asset. The lessee does not have any level of ownership over the asset. Under an operating lease, periodic payments, as per the lease agreement, are recorded as expenses in the income statement. Operating lease expense is not recorded in the balance sheet.

Consequently, under an operating lease (compared to capital lease), financial ratios present misleading results. For example, leverage ratios are understated because no liability is recorded associated with the lease. For example, the debt-equity ratio is lower and so is the debt ratio. The times interest earned ratio is higher because under an operating lease, depreciation is not recorded.

Liquidity ratios are also affected. Both, the current ratio and quick (Acid-Test) ratio are overstated because the lease is not reflected in current liabilities. Moreover, the ROA profitability ratio is overstated because total assets are not affected under an operating lease.

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Advantages & Disadvantages of Leasing

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Advantages of Leasing

  • Businesses avoid large capital outlays when acquiring the use of an asset, thereby freeing up cash for more productive uses.
  • In the case of the start ups, leasing also helps to ascertain a business’s asset requirements before purchase of assets is made. As an example, a business can rent a building space for a year to obtain a better understanding of the business’s building requirements before committing to purchasing a space.
  • Leasing offers flexibility, especially with assets which tend to become obsolete very fast.
  • Leasing does not result in restrictions on company’s financial operations due to loan covenants.
  • If firm experiences liquidity problem, it can lease back an asset to the lessor that the firm already owns. Sale-leaseback arrangements consist of selling an asset to the lessor and leasing it back. Such action can the improve liquidity of the firm.
  • If the firm will go bankrupt or if it is undertaking reorganization, the firm is better off if assets are leased because the lessor can claim a maximum of 3 years worth of lease payments. Lenders, on the other hand, can claim the entire outstanding debt.
  • Leases usually do not require down payment. Therefore, lease provides 100% financing. In comparison, when an asset is purchased, lenders often usually require down payment of 10% or at least 5% of the asset.
  • Under operational lease some financial ratios look better because the asset is not capitalized, which refers to asset not being recorded in the balance sheet as an asset and corresponding liability.
  • Lease can be undertaken as a hedge against rapid obsolescence of equipment.
  • Leasing allows the revenue generated by the asset to provide funds for the payment for the asset. This benefit is especially relevant for start ups which usually have very limited resources.
  • Organizations can adjust the term of the lease for the duration of time when the leased asset is planned to be used and then update the asset when required.
  • Leasing provides organizations with options. Under a lease agreement the organization may have options of returning the asset, renewing the lease or purchasing the asset.
  • It is usually easier to obtain a lease that to obtain a loan to purchase the asset.
  • Leases may offer tax advantages which depend on how the lease is structured.

Disadvantages of leasing

  • Purchase is likely to be preferred to lease if the asset is planned to be used for a long duration of time without renewal of asset.
  • If the business no longer requires an asset or if the asset becomes obsolete before the end of the lease term, it may be expensive and very difficult to terminate the lease before the end of the contract. If asset is owned, it may be easier to make appropriate arrangements to sell or rent out the unnecessary or obsolete asset.
  • Although the initial large cash outlay is avoided, over the long-term the lease may account for a larger capital outlay than if firm purchased an asset instead.

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Leasing

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A lease is a contract between tenant (a lessee) and owner (a lessor) of the asset which allows the tenant to use owner’s property over specified period of time in exchange for periodic payments which the lessee makes to lessor. The contract must be signed by both lessee and lessor and is usually called a lease agreement.

Leases can be arranged for both tangible and intangible assets. Lease of tangible assets is lease of assets that one can see and touch and includes assets such as automobiles, buildings and equipment. Lease of intangible assets is a lease of assets that one cannot see and touch. An example will be a lease of use of a radio frequency.

Leasing is a substitute for purchase of a fixed asset. It is one of the ways in which an organization can finance its assets. It allows the firm to make use of an asset in exchange for contractual periodic payments which are tax deductible.

 

Agency problem and agency costs

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Agency costs refer to costs which arise due to an agency problem. Agency problem, which is also called principal–agent problem or agency dilemma, occurs when an agent acts on behalf of the principal. The problem arises because agents’ interests and priorities may be different from that of the principal.

Agency costs are costs that a principal incurs to decrease or eliminate the agency problem by providing agent with incentive to act in the best interests of the principal as well as by monitoring the agent’s actions to ensure the agent is acting honestly and in the best interests of the principal.

In the context of an organization

In the context of an organization, agency costs refer to the costs of eliminating or decreasing the agency problem which arises due to management (agent) acting on behalf of shareholders (principal).

Agency problem, in the context of an organization, refers to the tendency of management to pursue its own needs as a first priority, which may be at the expense of the needs of the shareholders.

Agency costs include costs which arise due to maintenance of corporate governance structure of the organization. The goal is to give the management incentive to treat the needs of shareholders as a priority as well as ensuring honest dealings of management and monitoring management’s performance.

A typical example of agency costs occurs when rewards of management are tied to shareholders’ wealth maximization or performance of the company.

As an example, to tie rewards of management to the shareholders’ wealth maximization management may be given portion of shares of the company. Therefore, management becomes shareholders as well and their needs and interests become more aligned with other shareholders.

Alternatively, management is given stock options which will allow purchasing stock at the market price set at the time when stock options are granted at some point in the future. This gives management an incentive to be interested in shareholders’ wealth maximization since management will be able to benefit from it personally by buying appreciated shares at some point in the future at the price set at the time stock options were granted (at the lower price).

To tie rewards of management to the performance of the company, management may be evaluated based on their ability to achieve certain measures such as EPS. Performance shares or cash bonus may be given to reward management for meeting specific performance measures.

The other ways which help to decrease the agency problem in organisations is the pressure that shareholders place on the management and negative implications which will materialize if management cannot meet shareholders’ expectations.

Another factor that helps to decrease the agency problem in organisations is the threat of takeover by an individual, group or company which believes that company could be managed better. It serves as impetus for management to work harder in meeting shareholders’ needs.

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Stock repurchases (share buyback)

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Stock repurchases is a form of dividends. If stock repurchases are made instead of cash payment, it increases the earnings per share of current shareholders and it increases the market price per share.

Market price per share increases because earnings available for distribution to shareholders are now divided among fewer shareholders. Share price also increases because when a firm is buying back its shares it sends a positive signal to the market that management considers shares undervalued. Of course, repurchasing stock is especially beneficial for firm to undertake if the share price is really perceived by management to be undervalued.

Repurchase of stock also discourages unfriendly takeovers. This happens firstly because takeover can be attractive due to a company’s liquidity position. If a company has a lot of cash, it can be used to cover the debt undertaken to finance the acquisition. By using available cash to repurchase stock, a firm decreases its attractiveness as a takeover target. Moreover, repurchase of shares increases the price per share which makes takeover more expensive.

Another benefit of repurchase of stock is that it delays the tax liability of the shareholders. If cash dividends are paid out to the shareholders, then shareholders will have to pay part of it to the government as taxes. Repurchase of stock delays taxes that shareholders will be liable for until capital gain is realized, which occurs when shareholder sells stock.

Agency problem also have something to do with managements’ incentive to repurchase stock. Executive’s rewards are often tied to performance measures such as earnings per share. If firms have fewer shares outstanding and earnings stay the same than its earnings per share will inevitably increase.

Therefore, a part of the agency cost that firm has to incur is due to a necessity to monitor management actions to ensure that stock is not repurchased because an executive’s compensation is tied to EPS measure.

Repurchase of stock also allows a firm to have shares available for employee stock option plans. Buying back shares also temporarily provides a higher floor for the stock price.

Shares repurchase methods

The most common share repurchase method is purchasing shares on the open market. A second option is to negotiate with major stockholders to purchase a large bulk of shares. Another option is a formal fixed price tender offer that can be made to purchase shares at above market price.

Dutch auction tender offer, which originated in 1981, is another option to repurchase stock. This option entails invitation to shareholders to tender their shares at prices within  ranges established by the firm. The firm will try to purchase shares at the lowest possible prices. Thus, if more than enough shares are tendered then shares will be purchased up to a certain price at which an adequate amount of shares will be available. If not enough of shares are tendered then firm can either cancel the offer or buy back all the shares tendered.

Under every method of shares repurchase the reasons behind repurchase of shares must be clearly stated to the shareholders. The intention as to how repurchased shares are intended to be used should also be communicated. For example, it can be used for executive compensation or for trading it in exchange for shares of another firm.

In conclusion, companies need to maintain a target payout ratio which is suitable for the company’s needs. Organizations must also try not to neglect acceptable projects (with NPV higher than zero and IRR greater than weighted marginal cost of capital) to pay out large dividends. The main objective, as always, should be owner’s wealth maximization.

Also it is important to remember that whereas it is important to try not to decrease dividends to ensure that no negative signals are sent to the market, it is also important to maintain a healthy liquidity position. Organizations certainly should not borrow to be able to pay out large dividends.

 

Stock splits and reverse stock splits

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Organizations undertake stock splits when it is perceived within the firm that shares of the company are traded at a too high price and this may slow down trading activity. If a stock split is undertaken, the market value of shares can slightly increase. Such increase tends to be maintained as long as dividends after the split also increase.

If a firm undertakes a 2 for 1 split than 2 new shares will be given in exchange for every 1 old share. The stock split does not affect the organizational capital structure.

Organizations can also do reverse stock splits when firm wants to increase the share price. Increase in share price may help to enhance trading of a shares activity. This occurs because unsophisticated investors tend to equate low priced stocks to low quality investments.

If firm undertakes a 1 for 2 split, one new share will be exchanged for 2 old shares.

Dividend policies and dividend payout ratio

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An important concept to know when it comes to the distribution of dividends is the dividend payout ratio. The dividend payout ratio indicates which percentage of each dollar earned is distributed in cash to the shareholders. It is calculated as follows:

Dividend payout ratio = cash dividend per share/earnings per share

Generally the higher the dividend payout ratios the more attractively are shares of the firm seen by investors. Dividend payout ratios vary significantly between industries and organizations. The liquidity position of the company is one of the factors that affect the dividend payout ratio the company selects.

Test yourself:

ABC Company issued cash dividends of $3 per share. ABC’s earnings per share are $8. What is the dividend payout ratio?

Solution:

Dividend payout ratio of ABC = 3/8= 37.5%

This indicates that out of each dollar of earnings, 37.5% is distributed to shareholders as cash dividends.

Constant payout ratio dividend policy – according to this dividend policy, stockholders receive dividends at a fixed percentage rate from earnings every financial period that resulted in a profit. In financial periods when loss is incurred, no dividends are distributed. Dividends increase or decrease based on the amount of profit the firm made during a particular year. This type of dividend policy is not recommended because fluctuations in the dividends from one period to another may adversely affect the share price.

Constant dollar (stable) dividend policy – according to this dividend policy, a fixed amount of dollars per share are paid each period which resulted in a profit. The amount of fixed dollar dividend only increases after an increase in earnings proves to be stable.

Regular with extras dividend policy – according to this dividend policy, fixed amount of dollars per share is paid every period. On years when the profit exceeds normal, extra dividend is paid.

Residual dividend policy – This dividend policy is aligned with the residual theory of dividends. The residual from retained earnings is paid after all acceptable investments were undertaken.

Target dividend payout ratio

It is advisable for firms to establish target dividend payout ratio and then use it for guidance in determining dividend levels. Target dividend payout ratio refers to a specific percentage of earnings that firms would like to pay in dividends.

For example, if the target dividend payout ratio is 40% then the firm intends to try to keep its dividends around 40% of its earnings. The target dividend payout ratio is very useful in cases of constant dollar dividend policy and regular with extras dividend policy. Under these policies a regular dividend is paid each period. However, organizations can use the target dividend payout ratio as a guide to decide when dividends can be adjusted to reflect a stable new level of earnings.

Shareholders usually prefer regular and regular with extras dividend policies because it involves a smaller degree of uncertainty regarding the dividends to be received in each period.

Cash dividends and stock dividends

Cash dividends are dividends which are paid out in cash to the shareholders via cheque or electronic transfer. When cash dividends are distributed to shareholders, the share price tends to drop by an amount similar to the cash dividend. This occurs because the economic value was distributed from the firm to shareholders. Shareholders have to pay tax on cash dividends. Therefore, the amount that they receive decreases in value.

Stock dividends are dividends paid out in additional stock. There is no cash outflow. The funds are just shifted between accounts (from retained earnings to common stock and paid-in capital in excess of par).

If a company issues a 3% stock dividend this means that if one owns 100 shares of this company than 3 additional shares will be received. Overall, stock dividends do not bring any value to the shareholder. Stock dividends decrease the share price.

To determine by how much share price will decrease, let’s look at an example. Assume that shares of ABC sold for $17 each. ABC decided to distribute a 10% stock dividend. The share price will decrease as follows: $17 * (1/1.1)=$15.45.

If individual Y owned 1,000 shares before the stock distribution, after stock distribution individual Y will own 1,100 shares. The market value of shares of individual Y remains unchanged as shown below:

1,000 * $17     = $17,000

1,100 * $15.45 = $16,995

Therefore, as can be seen from the above, the shareholders’ market value of shares remains unchanged.

If the most recent earnings of ABC were $350,000 and individual Y owned 1% of the firm’s shares than earnings per share before stock dividends were $3.5 ($350,000/$100,000). If earnings are expected to stay the same than after the stock dividends, then earnings per share would decrease to $3.18 ($350,000/$110,000). Individual Y’s share in earnings stays the same. It was $3,500 (3.5*1000) and now it is $3498 (3.18*1,100).

Shareholders do not really obtain real value due to such stock dividends. It is more a perceived value of obtaining more stock. Consequently, shareholders generally do not have to pay tax on stock dividends unless the cash dividend option is present. For organizations, stock dividends are more costly but can be appropriate if the organization needs cash to finance a rapid growth.

Test yourself:

ABC shares are currently sold for $20 each. ABC decided to distribute 5% stock dividend. By how much the share price will decrease?

Solution:

The share price will decrease as follows: $20 * (1/1.05)=$19.05.

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Establishing a dividend policy

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Dividend policy refers to the policy which is used as a guide when a firm makes dividend decisions. It assists the board of directors in establishing how much should be paid to shareholders in dividends.

Dividend policy should be established in such a way that it provides for adequate financing for the firm. Dividend policy must also be aligned with the main objective of the firm which is to maximize shareholders’ wealth.

Investors tend to prefer stable increasing dividends as opposed to fluctuating dividends.

Factors which affect dividend policy

There are number of external and internal factors which affect dividend policy.

External factors which affect dividend policy

Contractual constraints – refer to restrictive provisions in a loan agreement and may include dollar or percentage of earnings limit on dividends and an inability to make dividend payments until certain levels of earnings is reached.

Legal constraints – this type of constraints depends on the location of the firm. Usually, due to legal constraints, firms are not able to pay out any dividends if the firm has any overdue liabilities or if it is bankrupt.

Firm also cannot pay any part of par value of common stock. Sometimes, in addition to the inability to pay any part of par value of common stock, firm also may not pay any part of paid-in capital in excess of par.

Market reactions – a firm needs to consider how markets will react to its dividend decisions. For example, if dividends are not paid or decreasing then markets will see it as a negative signal and the stock price will likely to drop. This will decrease shareholders’ wealth. If dividends are paid out consistently or even increasing in amounts, this can be seen as a positive signal by the market participants and stock price will likely to increase. This will increase shareholders’ wealth.

Shareholders generally prefer fixed or increasing dividends. This decreases uncertainty and investors are likely to use lower rate at which earnings will be discounted. This will lead to an appreciation of share and an increase in shareholders’ wealth.

Current and expected state of the economy – If state of the economy is uncertain or heading downward than it may be wise for management to pay smaller or no dividends to prepare a safety reserve for the company which can help to deal with future negative economic conditions.

However, if the economy is growing very fast then the firm may have more acceptable investments to take advantage of. It can be best not to distribute dividends but rather use these funds for investments.

Changes in government policies and state of the industry must also be taken into account.

Internal factors which affect dividend policy

Financing needs of the firm – Mature firms usually have better access to external financing. Therefore, they are more likely to pay out a large portion of earnings in dividends. If a company is young and rapidly growing than it will likely be unable to pay a large portion of earnings in dividends as it will require retained earnings to finance acceptable projects and its access to external financing is likely to be limited.

Preference of the shareholders – a firm should consider the needs and interests of the majority of its shareholders when making dividend decisions. For example, if shareholders will be able to earn higher returns by investing individually then what firm can earn by reinvesting funds than a higher dividend payment should be considered.

If the firm will have to issue more stock to be able to pay out dividends than it may be in the best interest of the current stakeholders not to issue dividends to avoid potential dilution of ownership. Dilution of ownership occurs because after issuing of additional stock, retained earnings will have to be distributed over a larger amount of the shareholders. This leads to dilution of earnings for existing shareholders. This also leads to dilution of control.

Firms also need to consider the wealth level of the majority of its shareholders. If the majority of shareholders are lower income earners than they likely will need dividend income and will prefer payment of dividends. However, if the majority of shareholders are high income earners then they will likely to prefer appreciation of share as it will defer tax payment even if the tax applicable on dividends and capital gains is the same, as in US after 2003 Tax Act.

Interestingly, in an efficient market, preferences of the shareholders should be met by price mechanism. If dividend payments are lower than required by many investors than those investors will sell their shares. Share prices will drop and this will raise an investors’ expected return. Higher expected return will increase the weighted marginal cost of capital and intersection between IOS and WMCC schedules will occur at a lower optimal capital budget point. Due to higher WMCC, fewer of the projects will be acceptable and more of the retained earnings can be paid out as dividends. Therefore the owners’ preferences are satisfied by price mechanism.

Stability of earnings – If earnings of the company are not stable from period to period than it is wise to follow conservative payments of dividends.

Earnings requirement – this constraint is imposed by the firm. It consists of a firm not being able to pay out in dividends more than the sum of the current and the most recent past retained earnings. However, the firm still can pay out dividends even if it incurred losses in the current financial period.

One of the reasons firms may want to pay dividends in years when the firm incurred a loss is to send positive signal to the market indicating that the loss is only a temporary phenomenon and that the company has its operations under control. Otherwise, shareholders may start selling shares which will decrease price of the shares and even further decrease wealth of the owners of the company (shareholders).

Lack of adequate cash and cash equivalents – occurs when firm do not have adequate cash and cash equivalents, such as marketable securities, to make dividend payments. Borrowing with intention to use funds to pay out dividends is usually not welcomed by lenders because the use of funds is not aligned with activity that would help firm to pay back debt to the lender. Borrowing to pay dividends is also usually not a wise business decision.

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Factors favouring higher and lower dividends

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Higher dividends

There are factors that make higher dividends beneficial. For example, higher dividends tend to decrease an agency’s costs. This occurs because the more dividends management needs to pay out, the more external financing the firm will require. External financing increases the scrutiny that management actions have to undergo and, therefore, decreases the agency problem and agency costs.

It is also suggested that for investors to sell current stock to obtain income equivalent to dividends is not the same psychologically as receiving dividends. It is harder psychologically to sell stock to obtain income than to use dividends to obtain income. Therefore, it is argued, that these two actions cannot be viewed as substitutes, as proposed by the dividend irrelevance theory. The above point suggests that shareholders who need income that comes from dividends are psychologically more comfortable with receiving dividends than with selling part of their shares.

Another argument for the benefits of higher dividends refers to the fact that $1 of dividends received now cannot be seen as equivalent to $1 of future dividends or stock appreciation to be received at some point in the future.

Investors will prefer $1 to be received now to $1 to be received in the future. The only way they will be indifferent is if the amount to be received in the future will be adjusted to account for the time value of money.

Time value of money refers to the fact that investors will prefer $1 today to $1 tomorrow. For example, if an investor can receive $100 today or a certain amount 1 year from now, the only way the investor will be indifferent is if the amount 1 year from now is larger by an equivalent to investor’s required return.

In other words, future dividends or share appreciation must bring benefit of $1 plus additional return based on the required return of the investor. Only in such case investor will be indifferent. If investor’s required return is 9% per year than the investor will be indifferent if $100 is received today or $109 received in 1 year from now.

Lower dividends

Transactions costs often make lower dividends more beneficial for stockholders and for the firm. It is more beneficial for a stock holder to have lower dividends if an investor intends to reinvest dividends in stock. This occurs because there are transactions costs that investor have to incur to buy stock such as brokerage fees.

The firm will benefit from paying lower dividends in the case where external financing is required. This is because external financing results in costs such as flotation costs. If firm just uses retained earnings available instead of paying out dividends then the costs of external financing will be avoided or decreased.

Tax that investors have to pay on capital gains is generally lower than tax that they have to pay on dividends (this, however, may differ depending on location of investors and is no longer applicable to US investors as a result of the 2003 Tax Act).

Moreover, tax on capital gains must only be paid in the future, when the gain will be realized. The tax on dividends must be paid when payment of dividends occurs. Therefore, from this perspective, it is generally more beneficial to reinvest earnings compared to paying it out as dividends to the shareholders.

Also, if investors want to reinvest dividends by buying more stock, investors still lose money by paying taxes on dividends. Therefore, an argument made by dividend irrelevance theory suggesting that investors can reinvest dividends by buying more stock and therefore obtaining the same result as by funds being reinvested is irrelevant as soon as assumptions of a perfect world (which includes the assumption that there are no taxes) is no longer hold.

 

Dividend relevance theory

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Dividend relevance theory was proposed by Myron J. Gordon and John Lintner. Dividend relevance theory suggests that investors are generally risk averse and would rather have dividends today (“bird-in-the-hand”) than possible share appreciation and dividends tomorrow.

Dividend relevance theory proposes that dividend policy affect the share price. Therefore, according to this theory, optimal dividend policy should be determined which will ensure maximization of the wealth of the shareholders.

Empirical studies do not support dividend relevance theory. However, actions of market participants tend to suggest that there is some connection between dividend policy and share price.

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