Debt Management and the Use of Leasing Finance in UK Corporate Financing Strategies

Debt Management and the Use of Leasing Finance in UK Corporate Fi nan ci n g St rateg i es

PROFESSOR R. A. FAWTHROP and BRIAN TERRY

University of Warnick

(Received November 1974, revised March 1975)

Introduction

There is a growing interest in the use and evaluation of short-term debt as part of corporate financing strategies. In part, this is a reflection of the current widespread anxiety in industry over the twin issues of liquidity and survival. A notable aspect of this trend has been the deepening interest and focus on leasing (i.e. the leasing of production, distribution, transportation and communications equipment).

We can define a financial lease as:

A contract involving payment over a specified period, of a sum sufficient to amortize the initial outlay and associated costs of the lessor plus his profit. This obligatory, or ‘primary’, period is generally less than, or at the most equal to, the estimated useful life of the asset. Once this primary period is completed, the lessee may negotiate for a secondary period of usage of the asset, generally at something of a nominal period rental. The primary lease involves a major unavoidable future commitment of cash-flows, as it cannot be can- celled. Nor, usually, can it be made the subject of a major revision in the terms. (In practice, cancellations or revisions are not unknown: but given honourable intentions on the part of the lessee, they are not usually envisaged when the lease is agreed.)

J. Business Finance & Accounting 2, 3 . Printed in Great Britain

296 R. A. Fawthrop and Brian Terry

Normative discussions of lease evaluation abound,l but there is a serious dearth of information on how UK corporate financial management perceives and uses this method of financing.2

The results and observations that follow are drawn from extensive industrial field research into the corporate use of debt and lease financing.3 The study, carried out over the period January-July 1974, involved senior financial executives of 54 major corporations located in the UK: who agreed to complete a questionnaire on their corporate financing policies and, in the majority of cases, to discuss their answers during subsequent interviews.

Using Capital Employed at the date of the last balance-sheet prior to the questionnaire as an indicator the distribution of respondents by size was a s follows:

Capital employed (Em) Number of companies

Under 20 21-50

51-100

I 0 1-500 500 plus

I 5 I 1

I0

I2

6 The widespread use of leasing is clearly demonstrated by our sample

of companies :

1 See R. F. Vancil, Leasing of Industrial Equipment, McGraw-Hill, 1963; R. S. Bower, F. C . Herringer and P. Williamson, ‘Lease Evaluation, Account- ing Rmiew, April 1966; R. W. Johnson and W. G. Lewellen ‘Analysis of the Lease or Buy Decision’, Journal of Finance, Sept. 1972; R. J. Roenfeldt and J. S. Osteryoung, ‘Analysis of Financial Leases’, Financial Management, 2 (I), Spring 1973 ; and E. C . Bloomfield and R. Ma, ‘The Lease Evaluation Solution’, Journal of Accounting &f Business Research, Autumn 1974.

2 Although not directly relevant to the UK capital market, there have been two studies of a reasonably similar nature in the USA (the former is now out of date, and the latter is of a somewhat specialized nature). Their results contribute little to our understanding of UK attitudes towards lease financing. See R. F. Vancil and R. N. Anthony, ‘The Financial Community Looks at Leasing’, Hamard Business Review, Nov.-Dec. 1959; and V. J. McGugan and R. E. Caves, ‘Integration and Competition in the Equipment Leasing Industry’, Journal of Business, July 1974.

8 Acknowledgment: We wish to thank the Norman-Houblon Fund, c/o The Bank of England, for the necessary financial support to undertake this research study.

Debt Management and the Use of Leasing Finance in UK 297

9. I 'Does your company use, or has it used leasing?'

In the last Actively 2 or 3 years Now considering

For plant and machinery 18 32 7 For goods vehicles '5 '5 7 For company cars '3 I2 I 0 For any other equipment '7 '7 I 0

Not at all 9 6 3

The interviews attempted to establish to what extent financial management in these companies :

I. Used leasing as part of a formal financing strategy, compared with its use as emergency financing. 2. Evaluated alternative leasing agreements, first against each other and secondly against alternative methods of financing. 3. Included leasing, as 'off balance sheet' financing, in their evaluation of the debt capacity of their organization (associated with this is the understanding which companies have, of the perceptions of their external financial advisers in this matter), and 4. Delegated, if in fact leasing was used in their organization, the authority for its use amongst the different levels of the management structure.

Lease financing is of course debt financing; it was thought, therefore, to be relevant to include in the enquiry and discussion, questions relating to UK financial management attitudes towards debt and in particular towards the measurement of debt and corporate debt capacity. The concepts and argument of Donaldson4 in these fields, to which the authors personally subscribe, was used as a framework within which to structure query and discussion of debt as a whole.

Corporate Debt Capacity: How is it Determined?

The role played by debt financing, and in particular the methods management selected to determine the extent of debt they were pre-

4 G. Donaldson, Corporate Debt Capacity, Harvard University, Boston, 1961, in particular Chapters 4 and 5 , pp. 68-120.

298 pared to carry in their financial structure, was a significant part of our study.

Apart from their familiarity with bank overdraft-of which more anon-researchers have in the past commented upon a reluctance in some areas of British industry and commerce to utilize debt financing of any sort. Currently, developments in the secondary banking sector and the unhappy experiences of some property and leisure industry firms, do indicate that an excessive and uncontrolled use of debt can be disastrous. However, the gains from financial leverage, and the oppor- tunities of linkage5 are not necessarily incompatible with a planned use of debt financing-where the plan is related more to the ability to service the debt than to adhere to some rule-of-thumb balance sheet ratio.6

This, anyway, increasingly appears to be the opinion of the large majority of financial executives questioned during our research.’

R. A. Fawthrop and Brian Terry

Q- 2 ‘Judging from the reported comments of their chairman, some companies seem to plan their capital expenditures in a given period entirely out of the sum of depreciation plus retentions generated in that or a preceding trading period.’

Do you tend to implement this sort of constraint? I

Always Usually Sometimes Seldom Never Is it implemented? ‘4 ‘9

Rigorously

Flexibly 9 6 Relaxedly

Firmly 2

Evidently, restriction of capital expenditures to internally generated financial sources, which some five years ago seemed to be commonly

5 For a definition of linkage and its application to corporate finance see R. A. Fawthrop, ‘Underlying Problems in Discounted Cash Flow’, Account- ing and Business Research, Summer 1971, p. 195.

6 G. Donaldson, Ibid. Chapters 6 and 7; plus ‘New Framework for Cor- porate Debt Policy’, Harvard Business Review, April-March 1962. See also, W. H. L. Anderson, Corporate Finance and Fixed Investment, Harvard University, Boston, 1964, Chapter 4.

7 In their answers some respondents would make more than one reply, others would decline to answer a particular section. Hence, our aggregated answers will not always exactly equal the sample size of the companies.


accepted by company executives as being indicative of good financial management, is no longer the force it was. However, the practice of regarding the bank manager as the first line of debt capital supply is very strong. What is surprising is the catholicity of second choice of debt financing. Below, we see leasing finance enjoys the unusual reputa- tion of being at one and the same time a principal second source of finance and the ‘source of finance that companies most love to hate!’

Q- 3

‘Would you resort to debt to finance capital expenditure?’

‘Would you tend to use a series of short-term debt expedients, periodically ‘consolidated’ by a longer- term funding operation?’

‘Which type of debt would you use?’ As second choice

if this was not Firstly available

Bank overdraft 36 7 Merchant bank loan 5 9 Formal debenture 3 4 Hire purchase 0 2

Leasing 4 9 Bill of exchange 2 2

Acceptance credit I 7

Yes No

44 I

39 3

As a last resort

I

3 8 4 7

5 2

Others 0 I (term loan) I (Eurodollar)

However, in a previous question, Q.r , the companies revealed that lease financing was widely used, whatever the opinion of the executives who have authorized that use. What is more, our sample, in concert with the rest of UK industry, who now lease approximately E960 million worth of assets, shows a marked trend towards an increasing use of leasing.

Without doubt, the principal concern which financial management must have in using debt finance, is the increase in risk to corporate financial health which is inseparable from that use. As was anticipated, Q.4, indicates very clearly indeed the overwhelming preponderance of opinion that there must be some limit to the amount of debt which a company ought to use. The question is, how should that limit be set?

300

Q-4


‘Do you consider that there is a limit to the amount of debt a company ought to use (apart from the limits imposed by the borrowing powers of

Yes No

directors)?’ 5 0 I

Q-5 ‘Does this limit tend, infact, to be set by any or all of the following factors?’

Very relevant Relevant Irrelevant

The ratio of debt to equity in

The prior charges cover in the P. & L. account. 23 ‘9 6

the balance sheet. 35 I1 2

The prior charges cover afforded by a cash-flow forecast of some kind. ‘7 ’9 I2

Pushing borrowing up to the limit obtainable from all sources of lending open to the company, without regard to any special ratio or indicator. 3 I2 33

In question 5 we sought the opinions of our interviewees on two commonly used measures of debt capacity (balance sheet gearing, and prior charges cover). We believe strongly that the real debt capacity of an organization is determined by the ability of its cash-jlms to service that debt in terms both of payment of interest and repayment of capital, having had prior regard to the settlement of all operating, taxation and distributional outflows; and subject to the maintenance of a minimum or base stock of cash against emergencies.8 As our subsequent discussion confirmed, the answers to question 5 must be treated with considerable circumspection. Importance clearly is placed upon the maintenance of a ‘respectable’ debt-to-equity ratio in the balance sheet. There were, however, clear indications that the regard for this ratio was as

* See G. Donaldson, op. cit.


much (if not more) something which was emphasized to corporate financial executives by their financial advisers, as it was the belief or experience of those executives themselves. There were many occasions when the 40% limit of debt financing was mentioned. Despite this tendency towards an acknowledged group norm? no one could furnish a satisfactory explanation why 40% should be the ‘magic figure’: a number of financial executives expressed significant scepticism as to its validity, and a desire to experiment with higher debt-equity ratios. Something of this dissatisfaction with a mechanistic balance sheet ratio may be detected in the number of respondents who found either or both of the two cover ratios to be ‘very relevant’ or ‘relevant’. In discussion, most readily accepted that the prior charges cover derived from the P. & L. account, was really a surrogate for a true cash-flow prior charges cover.

The whole situation is not without its considerable inconsistencies. I n the end, the corporate risk which is associated with the use of debt finance can be said to consist of two elements:

r . That debt servicing payments will so absorb after-tax net cash-flows that there are no funds available for distribution to the shareholders, and 2. That after-tax net cash flows will be inadequate to service debt, so that at best corporate management will be seriously hampered in their direction of the organizations affairs, or at worst the organization will itself have to be wound up and its assets realized to satisfy the suppliers of debt capital.

Both of these elements have to do with cash, not with profits or balance sheet values. In the end, all that a balance sheet debt-equity ratio can be is some readily accessible crude proxy for a more rigorous examination of the debt-servicing adequacy of corporate cash-flows. The crudeness of this proxy is revealed in Q.6. There appears to be no clear outstanding reason why a given debt-to-equity ratio is or is not acceptable. A vague comparison with like organizations (in terms of industry or size) appears to be one basis. But the reaction of share-

9 An American study by Lev observed a similar phenomenon: he devised a statistical model to test ‘whether firms tend to adjust their financial ratios to industrial averages’. From a sample of 900 companies Lev concluded that the empirical results were consistent with this hypothesis. Our respondents rarely questioned the validity of the 40% debt limit.. . it would appear to have become established folklore in financial circles. See B. Lev, ‘Industrial Averages as Targets for Financial Ratios’, Journal of Accounting Research, Autumn 1969, pp. 290-9. 22

302

holders (either directly, or via the return they require on their investment-the cost of equity finance) appears to be another important reason.


Q-6 ‘If you consider that the debt/equity ratio in the balance sheet is at least “relevant”: is the standard for that ratio set by any or all of the following?’ :

An acceptable ratio for UK industry at large? An acceptable ratio for companies in your industry? An acceptable ratio for companies of your size? An acceptable ratio for your company because : (a) It will minimize the overall cost of finance? (b) It will be acceptable to your shareholders? (c ) It does not seem too risky to management in terms of company survival? ( d ) It does not seem too risky to management in terms of ‘flexibility’ or ‘future room to manoeuvre’? An acceptable ratio as specified by your merchant bank or other financial adviser?

very relevant

9

16

‘3

2‘

18

16

20

I2

Relevant Irrelevant

‘7 21

‘4 ‘7

‘7 16

‘ 5 I ’

22 8

‘7 ‘4

16 I 0

18 ‘7

It is likely that managerial concern in terms of ‘future room to manoeuvre’, which figured fairly prominently in the replies, really relates to ‘future room to manoeuvre in raising additional finance’-which has strong connotations with shareholder reactions. Yet not one respondent was able to point to any clear example or evidence of shareholder concern with balance sheet ratios : there prevailed an almost universal uncer- tainty as to the role or wishes of shareholders in setting debt policy.

Debt Management and the Use of Leasing Finance in UK 303 Indeed, several respondents felt that their shareholding was made up of so mixed a group of people that it would be quite impossible to establish a common ‘shareholder posture’ so far as concerned the capital structure of the organization. The only construction that can be placed on this (if it is an explanation) is that, in effect, the shareholders grant a proxy, in absentia, to their professional advisers; who themselves use market stereotypes of acceptable debt-to-equity ratios rather than rigorous enquiry into the debt-servicing adequacy of corporate cash-flows,

Several executives openly censured the banks for their continued rejection, or more accurately distrust, of cash-flow projections : believing them to be remiss in not employing this vital data as a more meaningful debt-capacity indicator during financing discussions. As one treasurer remarked :

I think that cash-flow is something that financial analysts have got to get their teeth into, certainly in this country. In prospectuses for debentures it is not unusual to see a cash-flow statement showing how these funds are to be flowing and hence how they can service the debt. I think it is absolutely crucial to the lending of money. When I deal with banks they do not expect me to produce too much in the way of forecasts in this area. I think they could smarten up quite a lot here.

Enquiry as to what type of information was in fact usually required when a new tranche of debt was being negotiated, almost always extracted the reply ‘the balance sheet for the last three to five years’. Very little evidence was asked for, or volunteered, about an organization’s ability to service that debt. Indeed, a number of respondents expressed opposition to revealing future cash-flow projections feeling such information should be restricted to the board.

I don’t think in a big and financially sound company like ours that the banks have the option to ask for such information. Your projected cash-flows are your own affair and to offer them u p like that is not on, unless you are driven to it. I have not seen any evidence of the banks seeing anything projected into the future.

We felt, however, that on balance the research indicated a slow turn- ing towards the use of cash flow projections, generally as an important managerial instrument of financial planning and control, although as yet any such trend is but in its adolescence, if not infancy.10 We agree

10 Since this article was written, a number of discussions with senior executives of the larger joint-stock banks indicate that the present squeeze on corporate liquidity is producing a rapidly increasing use of cash-flow projections as a major verification instrument on application for overdraft facilities-often at the banks’ insistence.

304 with those executives who found it strange that what is essentially a cash item should be scrutinized in terms of non-cash ratios (especially given the notorious unreliability of much of balance sheet data in terms of informational content), and we can only attribute this to a general suspicion of forecasts: which may well be compounded by common distaste for even moderately sophisticated statistical techniques when these are used to improve the quality of the forecasting exercise.

If then the balance sheet ratio continues to be regarded as a primary determinant of the amount of debt which an organization can safely use, it becomes important to know what is generally considered as constituting ‘debt’. Table Q.7 is instructive in this respect:


‘In thinking about debtlequity ratios would you include’ Yes No

Overdraft 45 5 Hire purchase ‘9 30 Leasing ‘3 35 Bill of exchange 25 24

It would appear that in very many cases instalment debt would not be included in arriving at a figure for debt. (Indirect support for this attitude is given by the fact that very few of the auditors whom we have verbally questioned over the past few years would regard leasing, especially, as falling within the limitations on director’s borrowing powers as set out in the articles of association of a company.) In fact, we come now to another of those inconsistencies which typify this area of research. In discussing their answers, few if any respondents pro- fessed themselves as being influenced by the argument that leasing is ‘off balance-sheet finance’, thereby not affecting borrowing capacity yet improving the apparent return on capital employed (see Q.8).

The non-inclusion of instalment debt when computing debt-equity ratios appears therefore to be an act of inadvertent omission rather than deliberate commission. Yet, when asked why they thought that leasing continues to grow as a method of finance (despite the fact that the same respondents had already replied that they thought it an expensive form of finance) a very typical reply was of the kind ‘it leaves conventional credit lines clear’, ‘it relieves a shortage of borrowing power’ or ‘it meets a desire to have a better (less debt-ridden?) balance sheet’.


Q.8 ‘If your company used, uses or will use leasing, do any or all of the

following factors apply?’ Very

relevant Relevant Irrelevant The need was/is/will be urgent, no other funds being available, i.e. leasing is ‘emergency financing’. 7 4 28 Leasing is part of a ‘planned finan-

Leasing is ‘Spill-over’ financing, i.e. covers deficiencies or short-falls

Leasing is ‘off balance sheet’ finance and so:

(b) Improves the apparent return on

Because your company has very large capital allowances, any new equipment would be unable to benefit fully from the 100% first year relief and so leasing was used as an alter-

cing mix’. ‘7 I2 I2

in planning. 7 6 25

(u) Does not affect borrowing capacity. 8 ‘ 5 I8

capital employed. 4 14 ‘9

native. 8 5 25

Evidently the ‘off balance sheet finance’ attribute of instalment debt is ‘OK for the other guy’, but smacks too much of questionable financial practice to claim it for oneself.

Investment Appraisal and Lease Financing

A capital expenditure is the outcome of two decisions: (i) the decision to physically acquire the asset (the inwestment decision, the analysis of which is summarized in the question ‘what is the best way of allocating the money we have available?’) and (ii) the decision to commit funds to the acquisition (theJinuncing decision, the analysis of which is summarized in the question, ‘what is the best source to obtain finance from?’).

306 Conventional wisdom advocates the separation of the two decisions,11

but increasingly this is being questioned12 on a variety of grounds. Not suprisingly, the techniques used, and the degree of sophistication

adopted, in capital budgeting routines varied widely in our sample, from payback through accounting rate of return to discounted cash- flow :

R. A . Fawthrop and Brian Terry

8.9 ‘Which of the following techniques are used by your company to evaluate capital proposals?’

Replies Payback ‘ 5 Average profit to average capital Discounted cash flow ‘7 DCF plus payback or average return Financial computer models 7

I 0

21

Opportunity was also taken to investigate the forecasting routines used in corporate financial policy, out of which financing decisions must derive.

8.10 ‘In preparing financial forecasts for capital budgeting purposes, what period do they cover?’

Replies

One year ‘3 One to three years 7 Three to five years 23

Longer 5 11 For example, E. Solomon, The Theory of Financial Management, Col-

umbia University Press, 1963; plus a variety of standard texts,e.g. J. F. Weston and E. F. Brigham, Managerial Finance, Holt, Rinehart & Winston, 1971.

12 For example, J. C. T. Mao, Quantitative Analysis of Financial Decisions, Macmillan, 1969, Chapter 8, p. 269. For a more mathematical treatment see D. Chambers, ‘The Joint Problem of Investment and Finance’, Operational Research Quarterl~~, 22 (3), 1971, and, S. C. Myers, ‘Interactions of Corporate Financing and Investment Decisions-Implications for Capital Budgeting’, Journal of Finance, XXM (I), March 1974, pp. 1-25. For more theoretical aspects of the problems see, E. M. Lerner and W. T. Carleton, A Theory of Financial Analysis, Harcourt, Brace & World, 1964, Chapters 9 and 10,

and B. Hallsten, Znwestment and Financing Decisions, Economic Research Institute, Stockholm, 1966.

Debt Management and the Use of Leasing Finance in UK 307 Q.II

‘Do you base your financial projections upon?’ : Cash flow forecasts only o Earnings and income only o

Both of the above 35

Q.r2 ‘In planning any investment strategy or financing strategy which of the following estimates would you use?’

Worst possible 15 Most optimistic 5

Most likely 34

Q.13 ‘If you do, in fact, consider more than one type of estimate, is this complemented by more than one strategy or plan which could be called upon as events change?’ Yes No

23 12

We further enquired how the lease agreements were accommodated

For many of the companies interviewed, leasing, per se, was not con- within the budgeting process.

sidered as an investment decision at all :

The question to lease or not would come after the investment appraisal. Our first decision, to invest, is based upon outright purchase, we may then look at the lease arrangements for finance.

Having committed ourselves to undertake the project, whether we lease or purchase becomes part of the financial appraisal, not part of the investment appraisal.

This is a clear separation of the investment and financing decisions; a methodology adopted by over 60% of our sample. Of the rest, subsequent discussion revealed that any integrated decision process was carried out at a very superficial level or by routines which were frankly highly suspect as to their validity.

Q-14 ‘When capital expenditures are presented for appraisal it is the company policy to calculate the investment (“spending”) decision quite separately Yes No from the related financing decision?’ 22 13

308 It is our contention that the act of leasing, which is undeniably a

simultaneous investment and financing decision, should be evaluated in terms of some integrative technique; applying the two decision criteria to a single analysis.13 However, as will be seen later in Q.18, many of the respondents undertook a comparative study of leasing versus an alternative debt source as their principal accept-reject criter- ion: and, judging from replies to Q.15 and Q.16, the sample of companies had quite a depth of financial support available to them as a direct substitute for instalment debt.

R. A . Fawthrop and Brian Terry

Q.15 ‘Has your company negotiated a debt cushion: the difference between the amount of debt presently in use and the amount that is available on call if deemed necessary?’ Yes No

29 3 Q.16

extra credit available on immediate call over that in current use?’ ‘Could you place an approximate figure (say nearest 10%) on the

Percentage credit available I

A v 0-20 2-40 40-60 60-80 80+

Number of companies 5 I 0 5 3 4

Thus. alternative leasing plans would be evaluated against each other, and against a datum interest rate based upon the present incremental cost of the cheapest source of funds available to the company; generally their overdraft facility. Question 17 is relevant here:

Q.17 ‘When evaluating a lease proposal do you make the decision upon’: (a) Whether the interest rate implicit in the lease repayment is higher or lower than a specified Yes No

(b) An aggregate of lease repayments, operating cost and revenues generated by the project; clearing

interest rate (current bank rate for example)? 21 4

a DCF hurdle rate? ‘7 5 13 Discussion of this inherently complex technique is deferred until a

subsequent companion paper. See R. A. Fawthrop and Brian Terry, ‘The Evaluation of an Integrated Investment and Lease Financing Decision’ (forthcoming in JBFA).

Debt Management and the Use of Leasing Finance in UK 309 Thc, ‘to lease or not to lease’ decision process most often mentioned

during the interviews is typified by the following quote:

Since the merger we have been well below the gearing we set ourselves. We have got 40 or 50 million pounds worth of borrowing capacity we could go for without getting over the top of our gearing. Therefore, the alternative has been, borrow more or lease, just that.

Thus we do not compare the leasing rate of return with our internal rate of return but against our outside borrowing rate. We compare it with the cost from the banks on fixed debt. It is a straight comparison of interest rates against lending rates. This criteria is very tough for leasing and has caused us to come out of it.

One of the consequences of incorporating lease financing into the corporate budgeting mechanism is that instead of paying for an asset outright, the company only needs to produce sufficient funds to cover the first instalment. It could be argued, therefore, that the amount of capital saved,l4 because there has been a decision to lease rather than to purchase, should, in some manner, be incorporated, or at the very least considered, in the analysis of the initial lease contract. T o test this viewpoint we asked the question whether or not our respondents per- formed such an appraisal, be it quantitatively or qualitatively, and, if so, were the relevant gains or losses attributable to the lease alternative.

Several of the financial executives interviewed did consider this a pertinent factor in their decision, albeit in an imprecise and qualitative manner. As such there was no evidence, of any direct and unambiguous introduction of this return into the lease cash-flow analysis.

I would consider the alternative opportunity created by the residual capital balances; it is probably right to consider it as an incremental revenue brought about by the decision to lease.

Our decision to lease in the first place was based on the fact that it would release funds for further use.

Although it is not made explicit in the quote, this respondent practised the lease strategy shortly to be described as ‘plannedfinancing mix’. Under these circumstances it is argued15 by the writers that the residual capital balances concept is applicable and any resulting pecuniary advantage should be attributable to the leasing alternative. Not everyone

14 We have termed this the residual capital balance which, in year 0-1, is the difference between the initial capital cost of an asset and the first lease i nst alment .

15 As mentioned in footnote 13 we will justify this statement in a subsequent paper.

310 R. A. Fawthvop and Brian Terry

agreed, however. They argued that the residual balances concept would depend upon their financial position at the time.

It’s not attributable to the leasing deal. We have only been pushed into leasing because of the non-availability of other funds. Therefore, the remaining sum has not been available to spend elsewhere.

Here we observe the strategy termed ‘spill over $financing’ where available funds have become exhausted. I n this situation no residual capital balances can exist and therefore no advantage can accrue to leasing.

The Strategic Use of Lease Financing

The research study has identified three major leasing policies adopted by companies in their overall financing strategies:

I. Leasing is to form an integral part of the corporate financial structure. As a result of this policy, any capital expenditure presented for review could become a candidate for leasing financing. We may call this the ‘plannedjinancing mix’ strategy. 2. The company may decide only to utilize leasing as a last resort when corporate funds, available internally or externally, are otherwise close to exhaustion. This utilization is a product of a gradual progression through other forms of finance, first utilizing those sources considered (on whatever grounds) to be cheapest-or sometimes to be the most readily available. Having reached the stage where, apparently, the only remaining financing capacity is lease financing, management take the view that it must be used to fund some vital capital expenditure. We may call this ‘spill-over $naming’: because the set or ‘pool’ af capital expenditures to be undertaken spills over the reservoir or ‘pool’ of funds available to finance it.16 3. A by no means negligible aspect of financial management is the use of leasing as a taxation strategy. All the companies interviewed who practised such a policy had as a common characteristic the fact that

16 The concept of a ‘pool’ of projects matched to a ‘pool’ of finance is that of R. F. Vancil, op. cit., pp. 18-43. It exemplifies the need to optimize the aggregate of capital expenditure decisions rather than to optimize each project on a one-by-one basis. However, optimization of the profitability and liquidity of a set of capital expenditure proposals involves the utilization of mathematical programming models, and is not discussed further in this paper.

Debt Management and the Use of Leasing Finance in UK 31 I

they were operating in a minimal or no tax liability situation. Such a condition would result from a carry forward or containment of sub- stantial capital allowances from major capital expenditures in previous years. Any large capital expenditure now, such as an oil tanker or areoplane, would therefore derive little if any benefit from the attached capital allowances. There may indeed be a deferred benefit as the capital allowances become effective in future years, having been carried forward; although it was not always clear to us that users of leasing as a taxation strategy had seriously attempted to quantify this; but if a series of such major capital expenditures is anticipated during coming periods, then there was a well-nigh indefinable deferment. However, if the asset is leased, the leasing company retains the equity of the asset and, as such, they will receive the allowance, thereby becoming a ‘tax sponge’ for the lessee. In effect we observe the sale of capital allowances to the high profit sectors of the city, namely the banks and finance houses. In return, the size of the lease repayments are correspondingly reduced from what they would have been. This unique feature of leasing has undoubtedly been the prime instrument in the growth of the industry. But we were again unsure that those employing this strategy had adequately traded-off the reduced value of the tax shield, generated by the reduced leasing payments, against the avoidance of a reduced value of capital allowances.

Reply Q.8 indicated that the ‘plannedFnancing mix’ use of leasing is somewhat greater than the ‘spill oaer’ use of leasing, even when the latter use is stretched to include ‘ m g e n c y financing.17 Care must be used in interpreting what is meant by the utilization of leasing as. part of a planned capital structure. Strictly speaking, this means that a predetermined share of the total capital to be used during a capital expenditure planning period is to be made up out of leasing finance. In fact, we suspect that in many cases the ‘planning’ was not this precise. It consisted more of a willingness to entertain the usage of leasing finance even though internally generated funds were not yet totally exhausted. Sometimes this was because the assets involved were known to be particularly acceptable to leasing companies so that the best terms might be anticipated: and sometimes because some major capital expenditure(s) which would require large amounts of internally generated finance was (were) in review, creating a wish to conserve such finance by

17 By definition, ‘emergency finance’ is a special form of ‘spill werjinancing’. The common characteristic is that all other regular financial sources have been exhausted.

3 I 2 the use of alternative sources of capital in suitable cases. The former case has about it something of a note of expediency, whereas the latter is more indicative of a planning approach.

The signal to lease originates at corporate headquarters as they are the only group with access to the company’s overall financial situation, both now and in the future. Hence, there was a marked reluctance to incorporate leasing within the innate devolution of any financing policy. The authority vested at divisional level would only extend to the choice of asset to be leased, with head-office adopting the role of banker.

When we look at our forward projections over the next two or three years we may see we are hitting our overdraft limit. This tends to take us into a position of capital shortage so we cut the proposals from the divisions to ensure that we will not be embarrassed. So because of this cut back the divisions have had to resort to looking at leasing.I8


Thus, the use of leasing was sometimes regarded as an activity initiated when the company had got to the limit of its normal borrowing capacity and, due to a variety of reasons, just had to raise further finance. As one finance director replied :

If we were in a situation where we were getting up to our borrowing limits then we might get into leasing again. This is the only reason we went into leasing at all. Cash constraints and borrowing constraints were tight. We see leasing very much as fringe finance. We had projects that could not be funded by the cash we had avaliable so we considered leasing.18

On average about three leasing companies were asked to quote for any particular contract with the quoted rates very much subject to the processes of negotiation and bargaining. This produces a very flexible lease repayment schedule which can contribute to the profitability of any venture (or .indeed the total company) and may ease cash-flow in the early years of an asset’s life.

We have persuaded some lease companies to quote us variable interest rate agreements: and equally to allow us to pay during the course of the lease at varying amounts. As such the meetings became a discussion and detailed analysis of what was most suitable to the both of us.

As the finance houses are competitive in the terms on which they offer lease finance, such flexibility of arrangement is an added boost to cash-flow planning. Furthermore, because capital allowances accrue to the lessor, it becomes extremely significant, in terms of cost, to establish the tax position of the lessor.

18 A clear example of ‘spill over’ financing.

Debt Management and the Use of Leasing Finance in UK 313 When we got into leasing for the first time on a big scale, k2.75 millions, the range of interest rates quoted varied enormously. This made us appreciate that the rate quoted by the leasing companies will depend upon when they can use the first year allowance and this may not always be in one year. Therefore you have to check which leasing company can pick up the immediate benefit. In the last deal we completed it was a sharing of the profits in almost precisely 50/50.

Not all respondents considered leasing to be a sound financial prop- osition, reasoning that if the lessor, as a third party, was introduced between the seller and buyer of an asset, then it must always be cheaper to purchase. An alternative argument, generally put forward by the larger international companies in our sample, was that they could always obtain funds at a cheaper price than the leasing companies: so why lease? As question 18 indicates some company executives still rely on vague perceptions and intuitive guesses rather than economic analysis.

Q.18

to other sources?’ ‘Do you consider leasing to be an expensive form of finance in relation

Yes No

By detailed comparative cost studies 33 12 Intuitively 25 6

Conclusion

There often appears to be an implicit assumption in much of the writing on lease appraisal that the leasing decision takes place in an unidentified corporate world: one which is assumed to exist in isolation from the normal capital budget and one which does not reflect corporate reality or explain the causes behind the use of leasing. As has been shown, different leasing policies are a product of the financial circumstances facing the company. It is important that this is realized and appropriate analytical techniques are used.

Debt financing is now the principal source of new capital for UK industry, and there is every reason to believe that this will be so for the foreseeable future. Thus, how, when, under what circumstances, and by what criteria of judgement debt is raised, becomes a key problem facing financial management today.

314 Despite observable warnings of illiquidity and cash insolvency,

corporate executives still persist in their reliances on rule of thumb balance sheet ratios, or external advice and indicators, as a measure of debt capacity. The research has identified a small, but timely and significant trend towards more realistic methods of analysis using cash-flow data as a means of establishing safe and controllable levels of debt.

A very significant aspect of the current capital market is the ever- increasing trend towards instalment debt. The growth of leasing has now established itself as a vital part of corporate finance. It is, however, quite clear in all but a handful of companies, that the use of leasing (along perhaps with other more respectable( ?) forms of debt) continues to be viewed with suspicion.19

Leasing still faces psychological barriers to its ready and efficient utilization, with the feeling that it is somehow an ‘infra-dg sourceof funds still persisting; although these barriers are based upon irration- ality and a lack of sound analysis. The latter comment is perhaps under- standable in that academic and professional journals treat leasing either superficially, or they continue to depict the analysis of a lease as being a straight financing decision when in fact it is a far more complex problem requiring an integrated investment and financing decision.

Finally we reviewed the current leasing strategies and methods of lease appraisal; concluding that the analysis is situation dependent. We also introduce the concept of ‘residual capital balances’ as an implicit and necessary factor which should be incorporated in the decision process. Evaluation analysis incorporating this concept is the subject of a forthcoming paper.


19 Since this article was written, economic pressure and a growing experience of leasing appear to have combined to reduce such suspicion in many companies.

Debt Management and the Use of Leasing Finance in UK Corporate Financing Strategies

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