Diploma – Business Finance

Chapter 10: Financing Decisions: LONG-TERM DEBT FINANCING

CHAPTER 10: Financing Decisions: LONG-TERM DEBT FINANCING

Learning objectives:

Aarsheeya should be able to: -

1. Understand what capital structure and long-term debt financing mean.

2. Explain key features, pros, and cons of using debt.
3. Analyse how debt affects returns (ROE) through financial leverage.
4. Identify factors that influence interest rates on loans.
5. Learn about different sources of long-term debt: loans, bonds, leases.
6. Understand special bond features like convertibility, warrants, and call options.
7. Compare leasing vs buying decisions from a financial viewpoint.

Section A: Theory and Concepts

1. Introduction
In Session 1, we learned that one of the most important business decisions is how to arrange money
— this is called a financing decision.

In this session, we will learn about debt financing, which means borrowing money. This is an
important part of how a company gets its money (capital structure).
We will look at:
 What debt is like (its features)
 The good and bad sides of using debt
 What affects the interest rates on debt
Earlier, in Session 6, we talked about short-term debt (money borrowed for a short time).
Now, we will study long-term debt options like:
 Bank loans
 Bonds
 Leases
Later, in Session 11, we will finish this topic by looking at equity financing (raising money by selling
shares).
2. Capital Structure – Debt Financing
The right side of a company’s balance sheet shows how the company gets its money — this is called
the financing decision.
Capital Structure means how a company pays for its assets using a mix of two things:
 Debt (borrowed money)
 Equity (owner's money or shares)

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Chapter 10: Financing Decisions: LONG-TERM DEBT FINANCING

Debt includes both:

 Short-term debt (borrowed for a short time)
 Long-term debt (borrowed for a longer time)
Debt is money that the company has to pay back, like:
 Bank loans
 Bonds
 Leases
3. Effects of Debt Financing

3.1 Advantages of Using Debt

(a) Debt is cheaper than equity
Borrowing money (debt) usually costs less than raising money by selling shares (equity).
This is because lenders get paid before shareholders, so it’s less risky for them.
Also, lenders receive fixed interest, while shareholders get dividends which are not guaranteed.
(b) Interest on debt reduces taxes
When a company pays interest on its debt, that amount is subtracted before tax is calculated.
This means the company pays less tax, which helps lower the overall cost of borrowing.
(c) Debt increases returns for shareholders
Using debt can increase the profits for shareholders — this is called financial leverage.
It means the company uses borrowed money to try to make more profit, which can lead to higher
returns for the owners.
3.2 Disadvantages of Using Debt
(a) Debt must be repaid with interest
When a company borrows money, it must pay interest regularly to the lender.
These payments are required by contract, and the company must pay them.
If it fails to pay, the lender can take legal action and the company may even go bankrupt.
(b) Lenders set strict rules
Lenders know there is a risk that the company might not repay the loan (called default).
So, they often add rules (called covenants) in the contract.
These rules may say things like:
 The company can’t take risky projects
 It can’t borrow more money or issue new shares without asking the lender
If the company breaks these rules, the lender can ask for the loan to be paid back immediately.

Illustration: Debt vs Equity Financing

Let’s compare two companies, Company A and Company B.
 Both companies are the same in size and business.
 Company A uses only equity for financing.

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Chapter 10: Financing Decisions: LONG-TERM DEBT FINANCING

 Company B uses 50% equity and 50% debt.

 The debt interest rate for Company B is 10%.
 Both companies have total assets = $100,000.
Scenario 1: EBIT = $30,000

Particulars Company A (Equity $100,000) Company B (Equity $50,000, Debt $50,000)

EBIT $30,000 $30,000

Interest $0 $5,000

Earnings Before Tax (EBT) $30,000 $25,000

Tax @ 20% $6,000 $5,000

Earnings After Tax (EAT) $24,000 $20,000

ROA (EAT / Total Assets) 24% 20%

ROE (EAT / Equity) 24% 40%

Scenario 2: EBIT = $8,000

Particulars Company A (Equity $100,000) Company B (Equity $50,000, Debt $50,000)

EBIT $8,000 $8,000

Interest $0 $5,000

Earnings Before Tax (EBT) $8,000 $3,000

Tax @ 20% $1,600 $600

Earnings After Tax (EAT) $6,400 $2,400

ROA (EAT / Total Assets) 6.4% 2.4%

ROE (EAT / Equity) 6.4% 4.8%

Key Observations:
(a) Financial Leverage Increases ROE
 In Scenario 1, Company B (with debt) has a higher ROE (40%) than Company A (24%).
 Even though Company B pays interest, its ROE is higher because the equity amount is lower,
so profits are divided over a smaller base.
 This shows that using debt can help increase returns for shareholders when the company is
earning well.
(b) Debt is a Double-Edged Sword
 In Scenario 2, Company A’s ROE is 6.4%, but Company B’s ROE drops to 4.8%.

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Chapter 10: Financing Decisions: LONG-TERM DEBT FINANCING

 Here, the company’s profits are too low to cover the cost of debt (10% interest).
 This shows the risk of using debt. If earnings are low, ROE falls and the company struggles to
pay interest.
 So, debt can be helpful in good times, but dangerous in bad times.
(c) Interest Reduces Tax (Tax Benefit)
 In Scenario 1:
o Company A pays $6,000 in tax
o Company B pays only $5,000 (due to interest deduction)
 In Scenario 2:
o Company A pays $1,600 in tax
o Company B pays only $600
 The tax saving for Company B = $5,000 (interest) × 20% = $1,000
 This shows that interest on debt is tax-deductible, which reduces the cost of borrowing.
Conclusion:
 Debt financing can increase profits for shareholders when business is good (high EBIT).
 But it can also increase risk when profits are low.
 It offers tax benefits but comes with obligations to pay interest.
 Companies must use debt carefully, depending on their earning potential and risk capacity.
4. Factors Affecting Interest Rates
(a) Size of the Loan
 Smaller loans = Higher interest rate
 Reason: Processing costs (like paperwork and staff time) are the same whether the loan is big
or small.
 If the loan is small, these costs don’t spread out well.
 But with a large loan, the same cost spreads over more money, making it cheaper per dollar.
Example: A ₹10 lakh loan and a ₹1 lakh loan may have similar processing costs, but the ₹1 lakh loan
will be more expensive per rupee.

(b) Tenure or Maturity

 Longer loan period = Higher interest rate
 Why? The longer the time taken to repay, the greater the risk for the lender.
 More time means more uncertainty (e.g., inflation, changes in your financial situation).
 So, the lender charges extra interest to cover this risk.

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Chapter 10: Financing Decisions: LONG-TERM DEBT FINANCING

Think of it like renting money—longer rentals cost more.

(c) Borrower’s Creditworthiness
 If a person has a bad credit score (history of missed or delayed payments), they are seen as
risky.
 So, the lender increases the interest rate to protect themselves from possible non-payment.
Good credit = lower interest
Bad credit = higher interest
(d) Restrictive Covenants
 These are rules or conditions added to the loan by the lender.
 They limit what the borrower can do (like taking more loans or selling important assets).
 If there are more restrictions, the lender feels safer, so they may charge lower interest.
More control = less risk = lower interest.
(e) Basic Cost of Borrowing (Market Conditions)
 Interest rates also depend on market demand for money.
 When many people want loans, the demand increases, and so does the interest rate.
 This is because money becomes more “expensive” when more people compete to borrow it.
Think of it like a product – more demand = higher price (interest).
Summary Table

Factor Effect on Interest Rate Why?

Size of the Loan Small loan → Higher interest Less cost efficiency for banks

Tenure of Loan Longer loan → Higher interest More time = more risk

Creditworthiness Poor credit → Higher interest More risk of default

Restrictive Covenants More covenants → Lower interest Safer borrower for lender

Basic Cost of Higher market demand → Higher Competition for funds increases
Borrowing interest borrowing cost

5. Sources of Debt Financing – Bank Loans

 A bank term loan is a type of loan where the bank gives money to a person or business for a
fixed period of time.
 This loan is usually for more than one year (long-term loan).
 The borrower must repay the full amount (called the principal) plus interest by the end of
the loan period.

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Chapter 10: Financing Decisions: LONG-TERM DEBT FINANCING

Example: If a business takes a ₹5 lakh loan for 3 years, it must repay ₹5 lakh plus interest within
those 3 years.
6. Sources of Debt Financing – Bonds
 Bonds are a type of long-term loan.
 The borrower (called the issuer) receives money from the lender (called the bondholder).
 The borrower must repay the full amount (called the principal) on a specific future date
(called maturity).
 During the time the bond is active, the borrower pays the lender regular interest payments
(called coupons) – usually yearly or every 6 months.
 Unlike equity shares, which do not have a maturity date, bonds must be repaid by a fixed
maturity date.
Example: A company issues a ₹1 lakh bond for 5 years at 8% interest. It must pay ₹8,000 every year
as coupon and repay ₹1 lakh at the end of 5 years.
6.1 Characteristics of Bonds
(a) Face Value (P$):
 This is the principal loan amount that the bondholder lends to the issuer.
 It is the amount that the issuer must repay at maturity.
(b) Maturity:
 Refers to the duration or life of the bond.
 At maturity, the issuer redeems (buys back) the bond and repays the face value to the
bondholder.
 After redemption, the bond ceases to exist in the market.
(c) Coupon (C$):
 The interest paid annually or semi-annually to the bondholder.
 It is calculated as a percentage of the face value.
 For example, if a bond has:
o Face value = $1,000
o Coupon rate = 6%
o Then, annual coupon = 6% × $1,000 = $60

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Chapter 10: Financing Decisions: LONG-TERM DEBT FINANCING

Cash Flow Diagrams

➤ Investor Who Buys a Bond (Lender):
 Time 0: Pays P$ (face value) to the issuer.
 Annually (Years 1, 2, 3, ..., n): Receives C$ (coupon payments).
 At Maturity (Year n): Receives P$ back from the issuer.
Interpretation: The investor lends money and earns regular interest until repayment.

➤ Issuer Who Sells the Bond (Borrower):

 Time 0: Receives P$ from the investor.
 Annually: Pays C$ to the bondholder.
 At Maturity: Pays back P$ to redeem the bond.
Interpretation: The issuer borrows money and pays interest regularly, then repays the full amount at
maturity.
6.2 Bond Features
Bond features are optional clauses added to a bond to make it more attractive to either the issuer
(borrower) or the investor (lender). These features can affect the interest rate (coupon) offered on
the bond.
General Principle:
 If a bond is more attractive to the investor, the issuer can offer a lower coupon rate.
 If a bond gives more flexibility to the issuer, they may need to offer a higher coupon rate to
attract investors.

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Chapter 10: Financing Decisions: LONG-TERM DEBT FINANCING

(a) Convertible Feature

 This gives the bondholder the right to convert the bond into a predetermined number of
shares of the issuing company.
 The bond remains a debt instrument until the bondholder chooses to convert it.
When is Conversion Likely?
 If the market share price > conversion price, the bondholder can profit by converting to
shares.
Impact on Capital Structure:
 Upon conversion, debt is replaced by equity.
 The total capital remains the same—just changes form from debt to equity.
Coupon Rate Effect:
 Because of the potential upside (share conversion) for bondholders, issuers can offer lower
interest (coupon) rates on convertible bonds.
Illustration:

A company issues a 5-year bond with a face value of $1,000. This bond is convertible into 20
ordinary shares.
 This means the Bond Conversion Ratio is 20.
 The Bond Conversion Price is:

So, each share is valued at $50 for conversion.

This tells us:
You can exchange the $1,000 bond for 20 shares, each worth $50.

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Chapter 10: Financing Decisions: LONG-TERM DEBT FINANCING

When NOT to Convert

If the current market price of the share is less than $50, say $40:
 You’d get:

So, converting gives you $800 worth of shares, which is less than the $1,000 bond value.
Conclusion: Do not convert because you'd be losing $200.

When to Convert
If the market price of the share is more than $50, say $51:
 You’d get:

Now, converting gives you $1,020 worth of shares, which is more than the $1,000 bond value.
Conclusion: Convert the bond into shares and gain $20.
(b) Warrant Feature
A warrant is an option given to the bondholder to buy the company’s shares at a fixed price (e.g.,
$50 per share) in the future.
When it's Beneficial
 If the market price of the share goes above $50, say $51:

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o The bondholder can buy at $50 and sell at $51, making a profit of $1 per share.
 This profit opportunity adds value to the bond for the bondholder.
Effect on Company
 When the warrant is exercised:
o The company issues new shares.
o Equity increases.
o Debt remains the same (bond is not converted or redeemed).
 This raises capital without increasing debt.
Impact on Coupon Rate
 Since the warrant is a benefit to the bondholder, the company can offer the bond at a lower
interest (coupon) rate.
(c) Call Feature
A call feature gives the issuer (company) the right to buy back the bond early (before maturity) at a
pre-agreed call price.
When it's Beneficial
 If market interest rates drop, the company can:
o Call back the old bond (which has a high coupon rate).
o Reissue new bonds at a lower interest rate.
 This helps the company save on interest payments.
Effect on Company
 Debt remains the same, but the company replaces expensive debt with cheaper debt.
Impact on Coupon Rate
 The call feature Favors the issuer, not the bondholder.
 So, the company must offer a higher coupon rate to attract investors to buy such bonds.
7. Sources of Debt Financing – Leases
Leasing is when a person or company (the lessee) pays another company (the lessor) for the right to
use an asset, like equipment or property, for a certain period of time. The lessee makes regular
payments, which can be deducted from taxes. It’s similar to renting, but in leasing, there must be an
official agreement and payment.
7.1 Types of Leases
(a) Operating Lease
 This is a short-term lease, usually with the option to cancel.
 The lessor (owner of the asset) can lease it out again after the lease ends.
 The total amount paid during the lease is less than the cost of the asset because it’s a short-
term agreement.

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 Common examples: computers, office furniture, etc.

 Operating leases are not shown on the balance sheet.
(b) Financial Lease
 This is a long-term lease and usually cannot be cancelled.
 The lessor cannot lease the asset to someone else after the lease ends.
 Since it’s long-term, the total payments made by the lessee are higher than the asset’s cost.
 The assets are usually specific to the lessee’s needs, like land or buildings.
 Financial leases are recorded as a liability in the lessee’s balance sheet.
Key Difference:
 The main difference between operating and financial leases is whether the asset can be
leased out again.
 In a financial lease, the asset is often specialized and useful only to the lessee. The lessor
needs to cover the cost and make a profit, so the payments are higher and the lease is long-
term and non-cancellable.
7.2 Leasing versus Buying
When a company needs an asset, it can either buy the asset or lease it. If the company has enough
funds, it can buy the asset. But if it doesn't have the large amount of money needed to buy, the
company might choose to lease the asset, where the lessor (the owner) provides the financing. There
are a few things to consider when deciding between leasing and buying.
(a) Advantages of Leasing
 Initial Payment: If the company doesn’t have enough money to buy the asset, leasing allows
them to avoid a large initial payment.
 Financial Flexibility: Leasing frees up cash that the company can use for other needs, like
buying inventory or investing in growth. This improves the company’s financial flexibility.
 Tax Benefits: Lease payments are tax-deductible, reducing the company’s taxable income.
This can especially benefit companies leasing assets like land, which don’t depreciate.
 Improved Financial Ratios: If the asset is leased (especially through an operating lease), it
doesn’t show up on the company’s balance sheet. This can help improve certain financial
ratios like Asset Turnover, Liquidity Ratio, and Debt Ratio.
 Avoiding Obsolescence: In operating leases, since the lease can be canceled, the company
isn’t stuck with outdated or obsolete assets.
(b) Disadvantages of Leasing
 Higher Cost: Leasing can be expensive because the lessor needs to make a profit. Since the
lessor already paid for the asset or is making payments, they charge high lease rates.
 Restrictions on Changes to the Asset: In operating leases, the lessee can’t make changes to
the asset without the lessor’s approval. This limits the ability to customize the asset for
maximum benefit, potentially limiting the company’s competitive advantage.

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Chapter 10: Financing Decisions: LONG-TERM DEBT FINANCING

 Outdated Technology: In financial leases, the lessee is stuck paying for an asset even if it
becomes obsolete due to advances in technology because financial leases are non-
cancellable.
 No Salvage Value: The lessee doesn’t own the asset, so they can’t sell it for any remaining
value (salvage value) once the lease ends.

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Chapter 10: Financing Decisions: LONG-TERM DEBT FINANCING

Section B: Questions and Answers

Fill in the Blanks

1. The interest rate (%) represents the price of money.

2. The smaller the size of the loan, the higher the cost (%) of the loan.
3. The longer the maturity, the higher the cost (%) of the loan.
4. The lower the creditworthiness, the higher the cost (%) of the loan.
5. The more restrictive requirements there are, the higher the cost (%) of the loan.
6. The higher the basic cost of borrowing, the higher the cost (%) of the loan.
7. When an investor buys bonds, he or she is lending money.
8. When an issuer sells bonds, he or she is borrowing money.
9. The convertible feature allows bondholders to exchange their bonds for a specified number
of shares of common stock.
10. A call feature gives the issuer the opportunity to repurchase the bond prior to maturity at
the stated price.
11. Including warrants typically allows the company to raise debt capital at a lower cost.
12. A lease is a contractual agreement by which an owner of assets (the lessor) allows another
party (the lessee) to use the assets for a specific period of time in return for periodic cash
payments.
13. Generally, in a/an operating lease, the assets can be leased again to another party, while in
a/an financial lease, the assets cannot be leased again to another party.
14. One advantage with leasing is the financial flexibility, where the lessee can use its funds for
other purposes.
15. One disadvantage with leasing is that it is usually very costly and that it does not have a
stated interest cost.
16. The use of debt will increase the financial leverage of a firm.

Multiple Choice Questions (MCQs)

1. When funds are lent, the cost of borrowing (in percentage term) is the _______________.
(A) coupon amount
(B) annuity due
(C) interest expense
(D) interest rate

2. Gearing refers to the amount of _______________ in the company relative to its

_______________.
(A) current assets; current liabilities
(B) preferred equity; common equity
(C) current assets; fixed assets
(D) debt finance; assets

3. If the company’s balance sheet consists of $1,000,000 assets and $400,000 equity, its debt
ratio is __________.
(A) 0.4
(B) 1.0
(C) 0.6
(D) 1.4

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Chapter 10: Financing Decisions: LONG-TERM DEBT FINANCING

4. Which of the following will most likely DECREASE the coupon interest rate that a bond issuer
pays?
(A) An inclusion of a callable feature.
(B) An inclusion of a convertible feature.
(C) An increase in the tenure of the bond.
(D) A decline in the credit standing of the bond issuer.

5. Leasing allows the __________ to ‘depreciate land’ and achieve tax savings, which is
prohibited if the land was purchased.
(A) lender
(B) lessee
(C) lessor
(D) bank

Section C: Activities

NA

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Chapter 10: Financing Decisions: LONG-TERM DEBT FINANCING

Practice Again before Exams

MCQs
1. Which of the following best explains why interest on debt is tax-deductible?
A. Debt reduces the company’s expenses
B. Interest payments are considered a business expense
C. Debt holders own part of the company
D. Debt is cheaper than equity

2. Which scenario illustrates financial leverage being beneficial?

A. ROE decreases when EBIT increases
B. ROE is the same for both debt and non-debt companies
C. ROE increases for the company using debt when EBIT is high
D. EBIT is lower than the interest payment

3. What type of lease allows the lessee to cancel the agreement and is not shown on the
balance sheet?
A. Financial lease
B. Operating lease
C. Convertible lease
D. Call lease

4. Which bond feature benefits the issuer and typically requires a higher coupon rate to
attract investors?
A. Convertible feature
B. Call feature
C. Warrant feature
D. Maturity feature

5. Which factor does NOT typically lead to a lower interest rate on a loan?
A. High creditworthiness
B. More restrictive covenants
C. Higher loan processing costs
D. Lower market demand for funds

6. What is the effect of a longer loan tenure on interest rates, all else being equal?
A. It reduces interest rates due to loyalty rewards
B. It increases interest rates due to increased uncertainty
C. It has no impact
D. It depends only on borrower’s income

Short Subjective Questions

1. Explain the concept of financial leverage and its impact on ROE under high and low EBIT
scenarios.
2. Discuss how restrictive covenants protect lenders and influence interest rates.
3. Compare and contrast the features and implications of convertible and callable bonds.
4. What are the advantages and disadvantages of leasing compared to buying assets?
5. Describe how interest payments create a tax shield and why this is beneficial for companies.

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Chapter 10: Financing Decisions: LONG-TERM DEBT FINANCING

Practical Question

1. ROE Comparison
A company has the following details:
o EBIT = ₹40,000
o Debt = ₹1,00,000 at 10% interest
o Tax rate = 30%
o Equity = ₹1,00,000
Calculate ROE and compare it with a similar company that is 100% equity-financed.
2. Bond Cash Flow Calculation
A company issues a ₹1,000 face value bond with a 6% annual coupon for 5 years.
o Calculate the total coupon payments the investor will receive.
o What is the amount paid by the issuer at maturity?
3. Conversion Decision
A convertible bond with a face value of ₹1,000 is exchangeable into 25 shares.
o Calculate the conversion price.
o Should the bondholder convert if the current share price is ₹38? What if it is ₹42?
4. Lease vs Buy Decision (Descriptive)
A firm can either lease equipment for ₹1,20,000 per year (tax-deductible) or buy it for
₹4,50,000. Discuss which might be preferable if the firm is facing cash constraints and why.

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Chapter 10: Financing Decisions: LONG-TERM DEBT FINANCING

QP – 2024 November
Question 3 (A) - Discuss the concept of financial leverage and explain how a firm can use it to
magnify returns for shareholders.
[6 Marks, Page Number – 4]
Solution –
Concept of Financial Leverage
Financial leverage refers to the use of borrowed funds (debt) by a company to finance its assets or
operations. The main aim is to increase the potential return to the owners or shareholders of the
company.
When a firm uses debt, it pays a fixed interest on the borrowed money. If the firm earns a return on
investment (ROI) that is higher than the cost of debt, the excess profit belongs to the shareholders,
leading to magnified returns.
How It Magnifies Returns for Shareholders
When a company earns more from its investments than it pays in interest on debt, the extra profit
boosts the return on equity (ROE). This is because the company is using other people’s money
(debt) to generate income without issuing more shares.
This is called positive financial leverage.
Example:
 Suppose a company earns 12% return on total assets.
 It borrows money at an interest rate of 6%.
 The difference (12% – 6% = 6%) is the extra return that benefits the shareholders.
So, instead of using only shareholders' money, the company uses debt to increase total profits, while
shareholders still own the same number of shares—this increases earnings per share (EPS).
Risk of Financial Leverage
While financial leverage can increase returns, it also increases financial risk. If the company’s profits
fall or it suffers a loss, it must still pay the interest, which can reduce shareholder returns or even
lead to losses and default.
Hence, companies must balance debt and equity to maintain an optimal capital structure.
Conclusion
Financial leverage helps companies boost shareholder returns when used wisely, but too much debt
can be dangerous. Proper planning and a healthy balance of equity and debt are essential for long-
term success.

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Chapter 10: Financing Decisions: LONG-TERM DEBT FINANCING

QP – 2024 November
Question 3 (B) - Explain THREE (3) advantages of leasing
[9 Marks, Page Number – 4]
Solution –
Three (3) Advantages of Leasing
1. Preserves Cash Flow and Working Capital
Leasing allows a business to use expensive equipment or assets without making a large upfront
payment, unlike purchasing which often requires a significant lump sum.
🔹This helps preserve the company’s cash reserves, enabling the firm to allocate funds to other
important areas such as daily operations, salaries, marketing, or inventory.
🔹 Especially for new or growing businesses with limited capital, leasing ensures they can obtain the
assets they need without straining liquidity.
🔹 It helps maintain a healthier working capital position, improving short-term financial stability.
2. Access to Latest Technology and Equipment
Leasing gives companies the opportunity to use up-to-date equipment without being tied down to
outdated or depreciating assets.
🔹 When the lease term ends, businesses can upgrade to newer models or technology, allowing
them to stay competitive and efficient.
🔹 This is especially beneficial in industries where technology changes quickly (e.g., IT, manufacturing,
or medical sectors).
🔹 Leasing ensures the business avoids the risks of owning obsolete equipment and reduces the
burden of resale or disposal.
3. Tax Advantages and Better Financial Reporting
In many jurisdictions, lease payments are treated as a business expense, which may be tax-
deductible, reducing the company’s taxable income.
🔹 This lowers the overall tax liability, which can be particularly helpful for smaller companies looking
to manage costs.
🔹 In the case of operating leases, the lease obligation may not be recorded as debt on the balance
sheet, which is known as off-balance sheet financing.
🔹 This improves key financial ratios like the debt-to-equity ratio or return on assets, making the
company appear financially healthier to investors and lenders.
Conclusion
Leasing offers several strategic advantages: it improves cash flow, gives access to updated
equipment, and provides tax and accounting benefits. For companies with limited resources or those
operating in fast-evolving industries, leasing is a smart, flexible financing option that supports
business growth while managing financial risks.

QP – 2025 March

BF: Chapter 10: Financing Decision

Diploma – Business Finance
Chapter 10: Financing Decisions: LONG-TERM DEBT FINANCING

Question 3 (A) - Due to expansion plans, Digital Media Ltd needs to move into a bigger building for
its operations. It is considering whether to buy or lease the new building.
(i) Discuss TWO (2) advantages and TWO (2) disadvantages of leasing versus buying
the building. (8 marks)
(ii) Digital Media Ltd has decided to lease the building. Explain TWO (2) differences
between Operating Lease and Financial Lease. (4 marks)
(iii) Would you advise Digital Media Ltd to take up an Operating Lease or a Financial
Lease? Explain your answer. (3 marks)
[15 Marks, Page Number – 4]
Solution –
(I) Advantages and Disadvantages of Leasing vs Buying a Building
Advantages of Leasing:
1. Lower Initial Cost: Leasing usually requires a smaller upfront payment compared to buying,
which preserves cash flow and working capital for other business needs.
2. Flexibility: Leasing allows Digital Media Ltd to move or upgrade to a different building more
easily after the lease term ends, which is helpful if expansion plans change.
Disadvantages of Leasing:
1. No Ownership: At the end of the lease, the company does not own the building and
therefore misses out on building equity or property appreciation.
2. Long-Term Cost: Over a long period, leasing can be more expensive than buying because
lease payments continue indefinitely without generating an asset.
Advantages of Buying:
1. Ownership and Equity: The company gains ownership of the building, which can appreciate
in value and be used as an asset or collateral.
2. Control: Ownership gives full control over the property, allowing modifications and no
restrictions from a landlord.
Disadvantages of Buying:
1. High Initial Capital Outlay: Buying requires a large upfront investment or mortgage, which
can reduce liquidity.
2. Risk of Depreciation: The property may lose value, and the company bears the full risk of
maintenance and repairs.

(ii) Differences Between Operating Lease and Financial Lease

BF: Chapter 10: Financing Decision

Diploma – Business Finance
Chapter 10: Financing Decisions: LONG-TERM DEBT FINANCING

Aspect Operating Lease Financial Lease

Asset ownership remains with the Lessee has the right to use and eventually
Ownership
lessor own the asset

Short-term, usually less than the Long-term, often covers most of the
Lease Duration
asset's useful life asset's useful life

Maintenance Lessor is responsible for maintenance Lessee is responsible for maintenance

Balance Sheet Usually off-balance sheet (expense On-balance sheet (asset and liability
Impact recognized) recorded)

(iii) Advice on Operating Lease vs Financial Lease for Digital Media Ltd
I would advise Digital Media Ltd to take up an Operating Lease because:
 It offers greater flexibility if the company’s expansion plans change or if they want to
relocate without the burden of owning a building.
 The company can avoid a large initial capital outlay, preserving cash for operational needs.
 As leasing fits their decision to avoid buying, operating lease typically has fewer obligations
and risks related to maintenance and asset depreciation.

BF: Chapter 10: Financing Decision