Leasing - Fund Based Financial Services

FUND BASED FINANCIAL SERVICES

INTRODUCTION

Leasing is not a concept which emerged in the modern days. Even in the olden days we had leasing in the form of Charter Party agreement, when in an entire ship is taken on lease either for a particular period or for a particular voyage. Similarly we had agricultural lands are given on lease for a specified period.

FUND BASED FINANCIAL SERVICES

Some of the fund based financial services are leasing, hire purchase agreements. These are discussed below in detail in the pages to come.

LEASING:

It is a contract by which one party conveys land, property, services etc., to another for a specified time.

Definitions:

The Transfer of Property Act, 1882 (as amended in 1952) describes Lease as follows ―A Lease of the movable property is a transfer of a right to enjoy such property, made for a certain time, express of implied, or in perpetuity, inconsideration of a price paid or promised or of money, a share of crops, service or any other things of value, to be rendered periodically or on specified occasions to the transferor by the transferee, who accepts the transfer on such terms."

• The transferor is called the Lessor

• The transferee is called the Lessee

• The price is called the Premium

• The money, share, service or other thing to be rendered is called the Rent.

1 Definition:

Section 105 of the above Act defines a lease as follows: ―A Lease is a trans to enjoy the property. The consideration may be a price or a rent. The rent may be either money, or share of crops, service of anything of value, to be rendered periodically by the transferee to the transferor.

Basic Concepts: In Leasing Broker an agent who brings two parties together, enabling them to enter into a contract to which he is not a principal. His remuneration consists of a brokerage, which is usually calculated as a percentage of the sum involved in the contract.

Deposit

1. A sum of money paid by a buyer as part of the sale price of something in order to reserve it. Depending on the terms agreed, the deposit may or may not be returned if the sale is not completed.

2. A sum of money left with an organization, such as a bank, for safekeeping or to earn interest or with a broker, dealer, etc., as a security to cover any trading losses incurred.

3. A sum of money paid as the first installment on a hire-purchase agreement. It is usually paid when the buyer takes possession of the goods.

Depreciation

1. Depreciation is principally a means of allocating the cost of an asset over its useful life. It is an amount charged to the profit and loss account of an organization to represent the wearing out or diminution in value of an asset. The amount charged is normally based on a percentage of the value of the asset as shown in the books.

Finance Broker A broker who arranges finance.

Lease Broker Any broker who arranges a lease between a lender and a lessee.

Lease Purchases It is a type of leasing where, at the end of the lease period the goods become the lessee’s property.

Lender The person or institution, that grants a loan.

Operating Lease Essentially long term rent, not a capital expense transaction.

Refinancing The process of repaying some or all of the loan capital of a firm by obtaining fresh loans, usually at a lower rate of interest.

Residual Value The expected selling price of an asset at the end of its useful life.

Term: A specified period of time.

2 Evolution of Leasing

The concept and practice of leasing is not an innovation of the late 20th century. There are historical evidences to show that the practice of leasing was found even five centuries earlier. Such leases were for leasing land, agricultural tools, animals and ships, as documented in the Sumerian and Greek civilizations. These operators found leasing a viable alternative for enhanced operations as they were desperately short of their own funds. They could not also rely upon conventional sources of funds. The unparalleled success of Rail Road companies highlighted the importance of equipment leasing as a tool for promoting capital formation. In the post-Second World War era, European rail companies also took to equipment leasing on a large scale. In the early sixties, this practice of equipment leasing has gained popularity and it is believed that approximately 25% of all business equipments in terms of value are leased. The later half of 19th century bore witness to this practice as the Rail Road operators in the USA leased Rail Cars and Locomotives. The practice of Equipment Leasing is of recent origin in India. Equipment leasing took roots only in the eighties. Equipment leasing includes, leasing of plant and machinery, office equipments, automobiles, ships and aircrafts.

3Legal aspects of Leasing

As there is no separate statue for equipment leasing in India, the provisions relating to bailment in the Indian Contract Act govern equipment leasing agreements as well section 148 of the Indian Contract Act defines bailment as:

―The delivery of goods by one person to an they shall, when the purpose is accomplished, be returned or otherwise disposed off according to the directions of the person delivering them. The person delivering the goods is called the 'bailor‘ and the person to whom they are delivered is called the 'bailee‘.

Since an equipment lease transaction is regarded as a contract of bailment, the obligations of the lessor and the lessee are similar to those of the bailor and the bailee (other than those expressly specified in the least contract) as defined by the provisions of sections 150 and 168 of the Indian Contract Act. Essentially these provisions have the following implications for the lessor and the lessee.

The lessor has the duty to deliver the asset to the lessee, to legally authorize the lessee to use the asset, and to leave the asset in peaceful possession of the lessee during the currency of the agreement.

 The lessor has the obligation to pay the lease rentals as specified in the lease agreement, to protect the lessor‘s title, to take reasonable care of the asset, and to return the leased asset on the expiry of the lease period.

3.Contents of a Lease Agreement:

The lease agreement specifies the legal rights and obligations of the lessor and the lessee.

It typically contains terms relating to the following:

^Ø   Description of the lessor, the lessee, and the equipment.

^Ø   Amount, time and place of lease rentals payments.

^Ø   Time and place of equipment delivery.

^Ø   Lessee‘s   responsibility   for   taking   deliver

^Ø   Lessee‘s responsibility for maintenance, r case of default by the lessee.

^Ø   Lessee‘s right to enjoy the benefits of manufacturer/supplier.

^Ø   Insurance to be taken by the lessee on behalf of the lessor.

^Ø   Variation in lease rentals if there is a change in certain external factors like bank interest rates, depreciation rates, and fiscal incentives.

^Ø   Options of lease renewal for the lessee.

^Ø   Return of equipment on expiry of the lease period.

^Ø   Arbitration procedure in the event of dispute.

5.Types of Leasing

Classification of Lease

Lease may be classified as

1. Finance Lease and Operating Lease.

2. Sale and Lease Back and Direct Lease.

3. Single Investor Lease and Leveraged Lease.

4. Domestic Lease and International Lease.

Finance Lease:

A lease is defined as a finance lease if it transfers a substantial part of the risks and rewards associated with ownership from the lessor to the lessee. Thus the finance lease is characterized by whether:

a) The lease transfers ownership of the asset to the lessee by the end of the lease term; or

b) The lessee has the option to purchase the asset at a price within is expected to be sufficiently lower than the Fair Market Value (FMV) at the date, the option becomes exercisable that, at the inception of the lease it is reasonably certain that the option will be exercised; or

c) The lease term is for a major part of the useful life of the asset. The title may or may not be transferred eventually; or

d)The Present Value of the minimum lease payments is greater than or substantially equal to the Fair Market Value (FMV) of the asset at the inception of the lease. The title may or may not be transferred eventually.

These are largely based on the criteria laid down by the Financial Accounting Standards Board (FASB) of the USA. If the lease term exceeds 75% of the useful life of the asset or if the present value of the minimum lease payments exceeds 90% of the FMV of the asset, at the inception of the lease, the lease will be classified as „Financial Lease.

To determine the present value, the discount rate to be used by the lessor will be the rate of interest implicit in the lease and the discount rate to be used by the lessee will be its incremental borrowing rate. In the Indian context, criteria (a) and (b) above are inapplicable, because, inclusion of any one of these conditions in the lease agreement will make the agreement being treated as a Hire Purchase Agreement. Hence a lease can be classified as a finance lease only if any one of criteria (c) and (d) are satisfied.

The lessee is responsible for repair, maintenance and i also undertakes an extreme obligation to pay rental regardless of the condition or the suitability of the asset.

A finance lease, which prevails over the entire useful life of the equipment, is called a 'full payout lease.

Operating Lease

The International Accounting Standard Committee defines operating lease as “any lease other than a finance lease”. An operating lease has the following characteristics:

1.     The lease term is significantly less than the economic life of the equipment.

2. The lessee enjoys the right to terminate the lease at short notice without any significant penalty.

3. The lessor usually provides the operating know-how, supplies the related services and undertakes the responsibility of insuring and maintaining the equipment, in which case the operating lease is called a Wet Lease’.

4. An operating lease where the lessee bears the cost of insuring and maintaining the leased equipment is called a Dry Lease’.

5. An operating lease does not shift the equipment-related, business and technological risks from the lessor to lessee. The lessor structuring an operating lease transaction has to depend upon multiple lease or on the realization of substantial resale value (on the expiry of first lease), to recover the instrument cost plus reasonable rate of return thereon. To deal in operating leasing one requires an in-depth knowledge of the equipments and the resale market. In our country, as the resale market for most of the used capital equipments is not active, operating leases are not very popular.

Sale and Lease Back

In the case of sale and lease back, the owner of equipment sells it to a leasing company, which, in turn, lease it back to the seller of the equipment, who then becomes the lessee. The ‘Lease Back’ arrangement in this transaction operating lease e.g., the sale and lease back of safe deposit vaults practiced by commercial banks. The banks sell the safe deposit vaults in its custody to a leasing company at a market price, which is substantially higher than the book value. The leasing company then offers these lockers on a long-term lease to the bank. This sale an available source of funds for the expansion and diversification programmes of a firm where high- cost short-term debt has been used for capital investments in the past, the sale and lease back gives an opportunity to substitute the short-term debt by medium-term finance (provided the lease back arrangement is a finance lease). For the leasing company offering sale and lease back arrangement, it is difficult to establish a fair market value of the asset being acquired as the resale markets are virtually absent.

Direct Lease:

It is defined as any lease, which is not a sale and lease back transaction'. A direct lease can be of two types: (i) Bipartite lease, and (ii) Tripartite Lease.

Bipartite Lease:

There are two parties to the transaction, 1. Equipment supplier cum lessor 2. The lessee. It functions like an operating lease with built-in facilities like up gradation of the equipments called as Upgrade Lease. The lessor undertakes to maintain the equipment and even replaces the equipment that is in need of major repair with the similar functioning equipment called as Swap

Lease‖.

Tripartite Lease

It involves three different parties

1. The equipment supplier

2. The lessor

3. The lessee. Most of the equipment lease transactions fall under this category. In this form of lease

1. The equipment supplier may provide a reference about the customer to the leasing company.

2. The equipment supplier can negotiate the terms of the lease with the customer and complete the necessary paper work on behalf of the leasing company.

3. The supplier can take the lease on his own account and discount the lease receivables with the designated leasing company. So the leasing company owns the equipment and obtains an assignment of the lease rentals. This form of lease has recourse to the supplier in case of default by the lessee, either to buy back the equipment from the lessor on default or providing a guarantee on behalf of lessee.

Single Investor Lease

The entire investment is funded by the lessor by arriving at a judicious mix of debt and equity. The debt funds raised by the leasing company are without recourse to the lessee, i.e., in the event of the default by the leasing company on its debt-servicing obligation, the lender cannot demand payment from the lessee.

Leveraged Lease

It is a lease which is leveraged through a trustee. The leasing company invests in equipments by borrowing large investments with full recourse to the lessee without any recourse to it. The lender (loan participant) gets an assignment of the lease and enjoys benefit of the rentals to be paid by the lessee and a first mortgage on the leased assets. This transaction is routed through the trustee to take care of the lender and the lessee.

Leveraged Lease Process Loan Participant

A leveraged lease entitles the lessor to avail the shields on depreciation, other capital allowances on the entire investment cost, though; a substantial part of the investment cost is funded with non-recourse debt. So, the return on equity (profit after tax divided by net worth) tends to be high. For, the lessee, the rate of interest is less than that of a straight loan as the lessor extends the tax benefits to the lessee in the form of lower rental payments. This lease is usually preferred for leasing investment-intensive assets like aircraft, ships, etc. Lessor Trustee Leases the Lessee Equipment to Loan Participant.

Domestic Lease and International Lease

In domestic lease, all the parties to the lease transaction i.e., the equipment supplier, lessor and lessee are domiciled in the same country. An international lease transaction pre supposes : 1. An understanding of the political and economic climate; and 2. A knowledge about the tax and other regulatory framework governing these transactions in the respective countries, the payments to be effected in different currencies and hence knowledge about exchange rate variation. As a result international lease is exposed to country risk and currency risk.

Players In Leasing Financial Institutions (FIs) FIs are term lending institutions. There are over 10 such institutions handling project finance on an all-India basis and over 20 State-level institutions. While FIs have over 30 per cent of the total lease market, it is not their main line of business.

Commercial Banks State Bank of India, k,India’senteredthemarketlargestin 1997. This has altered market dynamics considerably because State Bank of India has a very large deposit base from savings accounts and deposit accounts, leading to the lowest cost of capital amongst all players.

Foreign banks The roles of foreign banks are very limited in the leasing market. Few foreign banks such as ABN-AMRO and ANZ Grind lays, have organized aircraft leasing for private airlines. Citicorp Securities & investment, the financial services arm of Citibank has leased assets worth US $ 6.7 million in 1996-97.

Non-banking Finance Companies (NBFCs) All those Indian finance companies that do not fall into any of the above categories are called as NBFCs. NBFCs has a market share of over 50 per cent of the leasing market. On the other hand, 70 per cent of leasing and hire-purchase activities. In 1998, Anagram Finance and ITC Classic merged with the Industrial Credit and Investment Corporation of India (ICICI), a leading all-India FI. In addition, Twenty-First Century Finance merged with Centurion Bank. Although all of the companies recorded profits in 1996-97, fears of a harder recovery and squeezed margins led them to the decision to exit the NBFC segment of the market.

Foreign Institutional Investors (FIls): There are no legislative barriers that prevent FIIs from entering the leasing market, the only FIIs with measurable involvement in the market are the U.S. Company GE Capital and the Japanese company Orix Corporation.

Advantages of Lease Financing:

^Ø   It offers fixed rate financing; you pay at the same rate monthly.

^Ø   Leasing is inflation friendly. As the costs go up over five years, you still pay the same rate as when you began the lease, therefore making your dollar stretch farther. (In

addition, the lease is not connected to the success of the business. Therefore, no matter how well the business does, the lease rate never changes.)

^Ø   There is less upfront cash outlay; you do not need to make large cash payments for the purchase of needed equipment.

^Ø   Leasing better utilizes equipment; you lease and pay for equipment only for the time you need it.

^Ø   There is typically an option to buy equipment at end of lease term.

^Ø   You can keep upgrading; as new equipment becomes available you can upgrade to the latest models each time your lease ends.

^Ø   Typically, it is easier to obtain lease financing than loans from commercial lenders.

^Ø   It offers potential tax benefits depending on how the lease is structured.

There are several extolled advantages of acquiring capital assets on lease:

(1) Saving Of Capital: Leasing covers the full cost of the equipment used in the business by providing 100% finance. The lessee is not to provide or pay any margin to Manufacturer, Lessor and Lessee.

(2) Flexibility and Convenience: The lease agreement can be tailor- made in respect of lease period and lease rentals according to the convenience and requirements of all lessees.

(3)  Planning Cash Flows: Leasing enables the lessee to plan its cash flows properly. The rentals can be paid out of the cash coming into the business from the use of the same assets.

(4) Improvement in Liquidity: Leasing enables the lessee to improve their liquidity position by adopting the sale and lease back technique.

Disadvantages of lease financing:

^Ø   Leasing is a preferred means of financing for certain businesses. However it is not for everyone. The type of industry and type of equipment required also need to be considered. Tax implications also need to be compared between leasing and purchasing equipment.

^Ø   You have an obligation to continue making payments. Typically, leases may not be terminated before the original term is completed. Therefore, the renter is responsible

for paying off the lease. This can pose a major financial problem for the owners of a business experiences a downturn.

^Ø   You have no equity until you decide to purchase the equipment at the end of the lease term, at which point the equipment has depreciated significantly.

^Ø   Although you are not the owner, you are still responsible for maintaining the equipment as specified by the terms of the lease. Failure to do so can prove costly.