Unit 10 Sources of finance

Unit 10 Sources of finance - BFA103 FINANCIAL ACCOUNTING...

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BFA103 FINANCIAL ACCOUNTING AND DECISION MAKING TUTOR NOTES Unit 10– Sources of Finance Discussion Questions 14.4 Agency theory predicts that in debt contractual arrangements management may have an incentive to: (a) Substitute assets (borrow for A buy spend on B). (b) Claim deduction (borrow from A and then borrow from B, putting A’s claim at risk). (c) Undertake excessive dividend payments to owners and salary payments to management. (d) Under-invest when the firm faces liquidation. Loan covenant restrictions to address matters such as these may include: (i) Maximum debt or leverage ratio (ie liabilities to assets; or long- term liabilities to long-term liabilities + owners equity). (ii) Minimum interest coverage ratio. (iii) Maximum dividend payout ratio. (iv) Minimum required return on assets (v) Specified accounting rules. (vi) More frequent financial reporting. (vii) Restriction on asset sales. (viii) Specific security on assets. 14.5 (a) In general ‘operating’ leases are short term rental/hiring arrangements whereas ‘finance’ leases are longer term borrow and buy equivalents. In an accounting context the party that effectively receives the benefit or incurs the risks incidental to possession of the leased asset determines whether it is classified as a finance lease. (b) Firms prefer to have leases classified as ‘operating’ leases because they do not have to include the lease asset and lease liability on the balance sheet. Inclusion of such assets and liabilities on the balance sheet would reduce ‘return on assets’ and increase the ‘gearing’ level. 14.6 Possible disadvantages of using overdraft finance: (a) It is repayable on demand. (b)
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Unit 10 Sources of finance - BFA103 FINANCIAL ACCOUNTING...

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