Chapter: Business Science : Merchant Banking and Financial Services : Leasing

Types of Leasing

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.

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




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.

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