Advanced Sources of Finance

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Advanced Sources of Finance

Other than the traditional modes of financing certain off balance sheet financing is becoming very popular nowadays. These are called off balance sheet financing because they don’t get reflected in the Liability side of the balance sheet. Hence there is no pressure on the debt service capacity of the firm. The debt equity ratio does not get affected in any way. As a result the firm’s capacity to raise further debt does not get reduced. The two most popular off balance sheet financing techniques are Lease and Hire Purchase.

Concept and Classification Lease

Conceptually an 'equipment lease' (lease hereafter) can be defined as a contractual arrangement where the owner (lessor) of an equipment transfers the right to use the equipment to the user (lessee) for an agreed period of time in return for rental. At the end of the lease period the asset reverts back to the lessor unless there is a provision for the renewal of contract or there is a provision for transfer of ownership to the lessee. Operationally, an equipment lease transaction comes into existence as follows: The lessee identifies the exact specification of the equipment, its supplier, price, terms of guarantee and warranty, delivery period, etc. and approaches the leasing company a financial intermediary - with a lease proposal. The negotiation between the lessor and the lessee revolves around the duration of the lease, lease rentals, terms and conditions relating to usage, maintenance and insurance of the equipment, etc. Once the negotiations culminate into a lease contract, the lessor buys the equipment and delivers it to the lessee. The lessee usually bears the costs of insuring and maintaining the asset. Given the nature of an equipment lease transaction, the natural question is: How does it differ from the other asset financing plans say hire purchase or conditional sales agreement? In the Indian context, the fundamental difference between a lease transaction and other asset financing plans like the hire purchase is that a lease contract cannot provide for a transfer of ownership from the lessor to the lessee whereas the other asset based financing plans carry this feature. Consequently, the tax and the accounting aspects of lease transactions are different from that of the other financing plans. An equipment lease transaction can vary along the following dimensions; extent to which the risks and rewards of ownership are transferred, number of parties to the transaction, domiciles of the equipment manufacturer, the lessor and the lessee, etc.

Based on these variations, the following classifications have been developed:

· Finance Lease and Operating Lease

· Sale and Leaseback and Direct Lease

· Single Investor Lease and Leveraged Lease

· Domestic Lease and International Lease.

Finance Lease and Operating Lease

The distinction between a finance lease and an operating lease is of fundamental importance in the financial evaluation and accounting of leases. The distinction is based on the extent to which the risks and rewards of ownership are transferred from the lessor to the lessee.

Finance Lease

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

According to the International Accounting Standards Committee (IASC), there is a transfer of a substantial part of the ownership-related risks and rewards if:

i. the lease transfers ownership of the asset to the lessee by the end of the lease term; (or)

ii. the lessee has the option to purchase the asset at a price which is expected to be sufficiently lower than the fair market value at the date the option becomes exercisable and, at the inception of the lease, it is reasonably certain that the option will be exercised (or)

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

iv. the present value of the minimum lease payments is greater than or substantially equal to the fair market value of the asset at the inception of the lease. The title may or may not eventually be transferred

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The aforesaid criteria are largely based on the criteria evolved by the Financial Accounting Standards Board (FASB) of U.S.A. The FASB has in fact defined certain cut-off points for criteria (iii) and (iv). According to the FASB definition of a finance lease, if the lease term exceeds seventy five percent of the useful life of the asset or if the present value of the minimum lease payments exceeds ninety percent of the fair market value of the asset at the inception of the lease, the lease will be classified as a 'finance lease'. For the purpose of determining 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, conditions (i) and (ii) are inapplicable because inclusion of any of these conditions in the lease agreement will result in the agreement being treated as a hire purchase agreement. Therefore, a lease is to be classified as a finance lease if one of the conditions (iii) or (iv) is satisfied.

Operating Lease

The International Accounting Standards Committee defines an Operating Lease as "any lease other than a finance lease".

An Operating Lease has the following characteristics:

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

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

· The lessor usually provides the operating know-how, suppliers, the related services and undertakes the responsibility of insuring and maintaining the equipment in which case an operating lease is called a 'wet lease'. An operating lease where the lessee bears the costs of insuring and maintaining the leased equipment is called a 'dry lease'.

From the features of an operating lease, it is evident that this form of a lease does not shift the equipment-related business and technological risks from the lessor to the lessee. The lessor structuring an operating lease transaction has to depend upon multiple leases or on the realization of a substantial resale value (on expiry of the first lease) to recover the investment cost plus a reasonable rate of return thereon. Therefore, specializing in operating leases calls for an in-depth knowledge of the equipments per se and the secondary (resale) market for such equipments. Of course the prerequisite is the existence of a resale market. Given the fact that the resale market for most of the used capital equipments in our country lacks breadth, operating teases are not in popular use. But then this form of lease ideally suits the requirements of firms operating in sun rise industries which are characterized by a high degree of technological risk.

Sale and Leaseback

In a sale and leaseback transaction, the owner of equipment sells it to a leasing company which in turn leases it back to the erstwhile owner (the lessee). The 'leaseback' arrangement in this transaction can be in the form of a 'finance lease' or an 'operating lease'.

A classic example of this type of transaction is the sale and leaseback of safe deposit vaults resorted to by commercial banks. Under this arrangement, the bank sells 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 offers these lockers on a long-term lease to the bank. The advantages to the bank are:

· It is able to unlock its investment in a low income yielding asset.

· It is able to enjoy the uninterrupted use of the lockers (which can be leased to its customers).

· It can invest the sale proceeds (which are not subject to the reserve ratio requirements) in high income yielding commercial loans.

In general, the 'sale and leaseback' arrangement is a readily available source of funds for financing the expansion and diversification programs of a firm. In case where capital investments in the past have been funded by high cost short-term debt, the sale and lease back transaction provides an opportunity to substitute the short-term debt by medium-term finance (assuming that the leaseback arrangement is a finance lease). From the leasing company's angle a sale and leaseback transaction poses certain problems. First, it is difficult to establish a fair market value of the asset being acquired because the secondary market for the asset may not exist; even if it exists, it may lack breadth. Second, the Income Tax Authorities can disallow the claim for depreciation on the fair market value if they perceive the fair market value as not being 'fair'.

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Direct Lease

A direct lease can be defined as any lease transaction which is not a "sale and leaseback" transaction. In other words, in a direct lease, the lessee and the owner are two different entities. A direct lease can be of two types: Bipartite Lease and Tripartite Lease.

Bipartite Lease

In a bipartite lease, there are two parties to the transaction - the equipment supplier cum-lessor and the lessee. The bipartite lease is typically structured as an operating lease with in-built facilities like up-gradation of the equipment (Upgrade Lease) or additions to the original equipment configuration. The lessor undertakes to maintain the equipment and even replaces the equipment that is in need of major repair with similar equipment in working condition (swap lease). Of course, all these add-ons to the basic lease arrangement are possible only if the lessor happens to be a manufacturer or a dealer in the class of equipments covered by the lease.

Tripartite Lease

A tripartite lease on the other hand is a transaction involving three different parties the equipment supplier, the lessor, and the lessee. Most of the equipment lease transactions fall under this category. An innovative variant of the tripartite lease is the sales-aid lease where the equipment supplier catalyzes the lease transaction. In other words he arranges for lease finance for a prospective customer who is short on liquidity. Sales-aid leasing can take one of the following forms:

· The equipment supplier can provide a reference about the customer to the leasing company

· 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.

· The supplier can write the lease on his own account and discount the lease receivables with the designated leasing company.

The effect of the transaction is that the leasing company owns the equipment and obtains an assignment of the lease rental. By and large, sales-aid lease is supported by a recourse to the supplier in the event of default by the lessee. The recourse can be in the form of the supplier offering to buyback the equipment from the lessor in the event of default by the lessee or in the form of providing a guarantee on behalf of the lessee.

Single Investor Lease and Leveraged Lease

This classification is also based on the number of parties to the lease transaction. In a single investor lease transaction there are only two parties to the transaction - the lessor and the lessee in contrast to a leveraged lease transaction where there are three parties to the transaction - the lessor (equity investor), the lender and the lessee.

Single Investor Lease

In a single investor lease transaction, the leasing company (lessor) funds the entire investment by raising an appropriate mix of debt and equity. The important point to be noted is that the debt funds raised by the leasing company are without recourse to the lessee. Put differently, the under cannot demand payment from the lessee in the event of the leasing company defaulting on its debt-servicing obligations.

Leveraged Lease

In a leveraged lease transaction, the leasing company (called equity investor) invests in the equipments by borrowing a large chunk of the investment with full recourse to the lessee and without any recourse to it. The lender (also called the loan participant) obtains an assignment of the lease and the rentals to be paid by the lessee, and a first mortgage on the leased asset. The transaction is routed through a trustee who looks after the interests of the lender and lessor. On receiving the rentals from the lessee, the trustee remits the debt-service component of the rental to the loan participant and the balance to the lessor. A schematic representation of the transaction is provided in Figure 11.1.

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Like any other lease transaction, a leveraged lease transaction entitles the lessor to claim tax shields on depreciation and other capital allowances on the entire investment cost despite the fact that a substantial part of the investment cost has been funded with non-recourse debt. Therefore, the return on equity (defined as Profit after Tax divided by Net worth) tends to be high. From the lessee's angle, the effective rate of interest implied by the lease transaction turns out to be less than that of a straight loan because the lessor passes on a portion of the tax benefits to the lessee in the form of lower rental payments. Leveraged lease packages are usually structured for leasing investment-intensive assets like aircraft, ships, etc.

Advantage of Leasing

Having seen the different types of lease arrangements, let us try to identify the principal reasons for leasing. The proponents of equipment leasing offer the following reasons:

Flexibility: Equipment leasing is a flexible financing arrangement in sense that the lease rentals can be structured in a manner that squares with the cash flow pattern anticipated by the lessee. If the lessee expects a constant net cash flow stream from the project in which the leased assets are employed, the lease rentals can be evenly spread over the lease term. On the other hand, if the lessee anticipates a steadily increasing stream of cash flows, the lease rentals can be stepped up gradually. If the lease finance is availed for a project with a gestation period, the lease rentals can be structured with a deferment period.

User Oriented Variants: There are several variants of a lease transaction which are designed to meet the specific requirements of the lessee. Examples of such innovative variants are the Upgrade Lease, which helps is hedging the risk of obsolescence or the cross border lease which reduce the cost of the lease from the lessee's point of view. There are also leases which provide all services related to the usage and maintenance of the asset. For example, in a full service car lease, the lessee pays a predetermined charge for the use of a car or a fleet of cars and he gets the entire spectrum of services ranging from the provision of chauffeurs to break-down maintenance.

Tax Based Benefits: Leasing makes a lot of financial sense to a firm which has no capacity to absorb the investment-related tax shelters like depreciation. A lessor who can absorb these tax shelters can acquire the assets and lease them to the firm at a lower lease rental. The cross border lease is a classic example of how leasing helps in exploiting multiple tax shelters to the advantage of both the lessor and the lessee.

Less Paper Work and Expeditious Disbursement: Compared to the term loan arrangement, a lease arrangement requires (a) less of paper work to be done by the lessee and (b) involves a shorter lead time between the date of submitting the proposal and the date of disbursement of funds.

Convenience: Convenience determines the decision to lease when a firm intends using an asset for a very short period of time. For example, a firm which requires the use of a fleet of cars for a week will find it easier to rent a fleet for a week than to buy it on Monday morning and sell it on Saturday evening. Apart from convenience, it is also a financially sensible proposition because the transaction costs associated with buying and selling like search costs, legal charges, selling commissions, etc. will outweigh the rentals to be paid for the short-term lease.

Hundred Percent Financing: The proponents of leasing often emphasize this feature of leasing as an advantage not available with the other forms of equipment financing. For example, the Equipment Finance Scheme of IFCI requires a borrower's contribution of 25% of the equipment cost. Most of the other financing plans including hire purchase call for down payments varying between 15 to 25 percent. While it is true that equipment leasing does not call for as high a margin as other financing schemes, the fact remains that where lease rentals are payable say monthly in advance, the first installment amounts to a down payment.

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Better Utilization of Own Funds: The proponents argue that leasing is a sensible route for acquiring non-income generating assets like air conditioners, office equipments and vehicles. The firm can deploy its own funds in more productive channels.

Hire Purchase

Among the alternative asset-based financing plans offered by the finance companies, hire purchase is one of the popular plans. In India, the market for hire purchase has been dominated by the road transport operators and hire purchase has been always associated with financing of commercial vehicles. But in the last few years hire purchase, as a means of financing equipments, has come into popular use. Given a choice between industrial hire purchase and equipment leasing, the question before the hirer (lessee) is: Which one should I choose? A similar question before the finance company (lessor) is: Which one is more profitable?

A hire purchase can be defined as a contractual arrangement under which the owner lets his goods on hire to the hirer and offers an option to the hirer for purchasing the goods in accordance with the terms of the contract. According to the Hire Purchase Act, 1972 an agreement which fulfills the following conditions is also a Hire Purchase Agreement, (i) the possession of goods is delivered by the owner thereof to a person on condition that such person pays the agreed amount in periodic installments; (ii) the property in such goods is to pass to such person on the payment on the last of such installments; and (iii) such person has the right to terminate the agreement at any time before the property so passes on.

So the two distinct features of a hire purchase transaction are (i) the option to purchase the goods at any time during the term of the agreement and the (ii) the right available to the hirer to terminate the agreement at any time before the payment of the last installment. Therefore from the hirer's angle, a hire purchase contract can be compared to a cancelable lease contract with a call (purchase) option.

The call option and the right of termination available with the hirer form the basis for distinguishing a hire purchase transaction from other asset-financing plans like installment sale and conditional sale where the buyer is committed to paying the full price. A hire purchase differs from installment sale on one more count. In installment sale, the ownership of the asset is transferred to the buyer on payment of the first installment whereas in a hire purchase the ownership is transferred to the hirer only when he exercises the option to purchase or on payment of the last installment.

The salient features of a hire purchase transaction are therefore as follows:

· The finance company (the counterpart of the lessor) purchases the equipment from the equipment supplier and lets it on hire to the hirer.

· The hirer is required to make a down payment of 20 to 25 percent of the equipment cost and repay the balance with interest in equated monthly installments spread over 36 to 48 months either in advance or in arrear.

· As an alternative to the down-payment plan, some finance companies offer a deposit-linked plan. Under this plan, the hirer is required to invest 20 to 25 percent of the equipment cost in the fixed deposits of the company. In return the hirer is provided with hundred percent finance, which has to be repaid with interest in equated monthly installments spread over 36 to 48 months. On payment of the last installment, the deposit with accumulated interest is returned to the hirer.

· The interest component of each hire purchase installment is calculated on the basis of a flat rate of interest. The rate of interest charged usually lies in the band of 13-15% p.a.

· During the currency of the contract (hire period), the hirer can opt for an early repayment and purchase the asset. The hirer, exercising this option, is required to pay the remaining amount of hire purchase installments (installments which have not fallen due) less an interest rebate. The interest rebate is calculated in different ways which are discussed in the following part.

· Theoretically the hirer can exercise the cancelable option and terminate the contract after giving due notice to the finance company. But in practice such terminations are few and far in between because the hirer loses the tax shields on capital allowances (like depreciation) by exercising this option.

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International Capital Markets

The genesis of the present international markets can be traced back to 1960s, when there was a real demand for high quality dollar-denominated bonds from wealthy Europeans (and others) who wished to hold their assets outside their home countries or in currencies other than their own. These investors were driven by the twin concerns of avoiding taxes in their home country and protecting themselves against the falling value of domestic currencies. The bonds which were then available for investment were subjected to withholding tax, Further it was also necessary to register the ownership of the bonds. Dollar denominated Euro-bonds were designed to address these concerns. These were issued in bearer forms and so, there was no record of ownership and no tax was withheld.

The Instruments

The early eighties witnessed liberalization of many domestic economies and globalization of the same. Issuers from developing countries, where issue of dollar/foreign currency denominated equity shares are not permitted, can access international equity markets through the issue of an intermediate instrument called 'Depository Receipt'.

A Depository Receipt (DR) is a negotiable certificate issued by a depository bank which represents the beneficial interest in shares issued by a company. These shares are deposited with the local 'custodian' appointed by the depository, which issues receipts against the deposit of shares.

The various instruments used to raise funds abroad include: equity, straight debt or hybrid instruments. The following figure shows the classification of international capital markets based on instruments used and market(s) accessed.

Figure 11.2 Structures of International Capital Markets

Equity GDRs

GDR stands for Global Depository Receipts.

A GDR is a negotiable instrument which represents publicly traded local-currency-equity share. GDR is any instrument in the form of a depository receipt or certificate created by the Overseas Depository Bank outside India and issued to non-resident investors against the issue of ordinary shares or foreign currency convertible bonds of the issuing company. Usually, a typical GDR is denominated in US dollars whereas the underlying shares would be denominated in the local currency of the Issuer. GDRs may be - at the request of the investor - converted into equity shares by cancellation of GDRs through the intermediation of the depository and the sale of underlying shares in the domestic market through the local custodian.

GDRs, per se, are considered as common equity of the issuing company and are entitled to dividends and voting rights since the date of its issuance. The company effectively transacts with only one entity - the Overseas Depository - for all the transactions. The voting rights of the shares are exercised by the Depository as per the understanding between the issuing company and the GDR holders.

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American Depository Receipts

ADR is a dollar denominated negotiable certificate, it represents a non-US company's publicly traded equity. It was devised in the late 1920s to help Americans invest in overseas securities and to assist non-US companies wishing to have their stock traded in the American Markets. ADRs are divided into 3 levels based on the regulation and privilege of each company's issue.

i. ADR level-I: It is often the first step for an issuer into the US public equity market. The issuer can enlarge the market for existing shares and thus diversify the investor base. In this instrument only minimum disclosure is required to the SEC and the issuer need not comply with the US GAAP (Generally Accepted Accounting Principles). This type of instrument is traded in the US OTC market.

The issuer is not allowed to raise fresh capital or list on any one of the national stock exchanges.

ii. ADR Level-II: Through this level of ADR, the company can enlarge the investor base for existing shares to a greater extent. However, significant disclosures have to be made to the SEC. The company is allowed to list on the American Stock Exchange (AMEX) or New York Stock Exchange (NYSE) which implies that the company must meet the listing requirements of the particular exchange.

iii. ADR Level-Ill: This level of ADR is used for raising fresh capital through public offering in the US Capital Markets. The company has to be registered with the SEC and comply with the listing requirements of AMEX/NYSE while following the US-GAAP.

Debt Instruments

The process of lending money by investing in bonds originated during the 19th century when the merchant bankers began their operations in the international markets. Issuance of Eurobonds became easier with no exchange controls and no government restrictions on the transfer of funds in international markets.

Eurobond

All Eurobonds, through their features can appeal to any class of issuer or investor. The characteristics which make them unique and flexible are:

a. No withholding of taxes of any kind on interests payments.

b. They are in bearer form with interest coupon attached.

c. They are listed on one or more stock exchanges but issues are generally traded in the over-the-counter market.

Typically, a Eurobond is issued outside the country of the currency in which it is denominated. It is like any other Euro instrument and through international syndication and underwriting, the paper is sold without any limit of geographical boundaries. Eurobonds, are generally listed on the world's stock exchanges, usually on the Luxembourg Stock Exchange.

a. Fixed-rate Bonds / Straight debt bonds: Straight debt bonds are fixed interest bearing securities which are redeemable at face value. The redemption of straights is done by bullet payment, where the repayment of debt will be in one lump sum at the end of the maturity period, and annual servicing.

b. Floating Rate Notes (FRNs): FRNs can be described as a bond issue with a maturity period varying from 5 to 7 years having varying coupon rates - either pegged to another security or re-fixed at periodic intervals. Conventionally, the paper is referred to as notes and not as bonds. The spreads or margin on these notes will be above 6 months LIBOR (London Inter Bank Offer Rate) for Eurodollar deposits.

Foreign Bonds

These are relatively lesser known bonds issued by foreign entities for raising medium to long-term financing from domestic money centers in their domestic currencies. A brief note on the various instruments in this category is given below.

a. Yankee Bonds: These are US dollar denominated issues by foreign borrowers (usually foreign governments or entities, supranational and highly rated corporate borrowers) in the US bond markets.

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American Depository Receipts

The issuer is not allowed to raise fresh capital or list on any one of the national stock exchanges.

Debt Instruments

Eurobond

All Eurobonds, through their features can appeal to any class of issuer or investor. The characteristics which make them unique and flexible are:

a. No withholding of taxes of any kind on interests payments.

b. They are in bearer form with interest coupon attached.

c. They are listed on one or more stock exchanges but issues are generally traded in the over-the-counter market.

Foreign Bonds

a. Yankee Bonds: These are US dollar denominated issues by foreign borrowers (usually foreign governments or entities, supranational and highly rated corporate borrowers) in the US bond markets.