Assignment on Management of Financial Services Topic: Leasing

Submitted to:
Mr. Amit Kr. Das Asst. Professor

Submitted by:
Kailash Khandelia 61 Sujoy Paul 03 Biplab Dey 34 MBA - 4th Semester

Assam University Silchar 2012

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MEANING 0F LEASE FINANCING

A lease transaction is a commercial arrangement whereby an equipment owner or Manufacturer conveys to the equipment user the right to use the equipment in return for a rental. In other words, lease is a contract between the owner of an asset (the lessor) and its user (the lessee) for the right to use the asset during a specified period in return for a mutually agreed periodic payment (the lease rentals). The important feature of a lease contract is separation of the ownership of the asset from its usage. Lease financing is based on the observation made by Donald B. Grant: Why own a cow when the milk is so cheap? All you really need is milk and not the cow. Leasing industry plays an important role in the economic development of a country by providing money incentives to lessee. The lessee does not have to pay the cost of asset at the time of signing the contract of leases. Leasing contracts are more flexible so lessees can structure the leasing contracts according to their needs for finance. The lessee can also pass on the risk of obsolescence to the lessor by acquiring those appliances, which have high technological obsolescence. To day, most of us are familiar with leases of houses, apartments, offices, etc.

LEASING IN INDIA
Leasing has grown by leaps and bounds in the eighties but it is estimated that hardly 1% of the industrial investment in India is covered by the lease finance, as against 40% in USA and 30% in UK and 10% in Japan. The prospects of leasing in India are good due to growing investment needs and scarcity of funds with public financial institutions. This type of lease finances is particularly suitable in India where a large number of small companies have emerged more recently. Leasing in the sphere of land and building has been in existence in India for a long time, while equipment leasing has become very common in the recent times.

TYPES OF LEASE AGREEMENTS

FINANCIAL LEASE Long-term, non-cancellable lease contracts are known as financial leases. The essential point of financial lease agreement is that it contains a condition whereby the lessor agrees to transfer the title for the asset at the end of the lease period at a nominal cost. At lease it must give an option to the lessee to purchase the asset he has used at the expiry of the lease. Under this lease the lessor recovers 90% of the fair value of the asset as lease rentals and the lease period is 75% of the economic life of the asset. The lease agreement is irrevocable. Practically all the risks incidental to the asset ownership and all the benefits arising there from are transferred to the lessee who bears the cost of maintenance, insurance and repairs. Only title deeds remainwith the lessor. Financial lease is also known as capital lease. In India, financial leases are very popular with high-cost and high technology equipment.

OPERATING LEASE An operating lease stands in contrast to the financial lease in almost all aspects. This lease agreement gives to the lessee only a limited right to use the asset. The lessor is responsible for the upkeep and maintenance of the asset. The lessee is not given any uplift to purchase the asset at the end of the lease period. Normally the lease is for a short period and even otherwise is revocable at a short notice. Mines, Computers hardware, trucks and automobiles are found suitable for operating lease because the rate of obsolescence is very high in this kind of assets. SALE AND LEASE BACK It is a sub-part of finance lease. Under this, the owner of an asset sells the asset to a party (the buyer), who in turn leases back the same asset to the owner in consideration of lease rentals. However, under this arrangement, the assets are not physically exchanged but it all happens in records only. This is nothing but a paper transaction. Sale and lease back transaction is suitable for those assets, which are not subjected depreciation but appreciation, say land. The advantage of this method is that the lessee can satisfy himself completely regarding the quality of the asset and after possession of the asset convert the sale into a lease arrangement. . LEVERAGED LEASING Under leveraged leasing arrangement, a third party is involved beside lessor and lessee. The lessor borrows a part of the purchase cost (say 80%) of the asset from the third party i.e., lender and the asset so purchased is held as security against the loan. The lender is paid off from the lease rentals directly by the lessee and the surplus after meeting the claims of the lender goes to the lessor. The lessor, the owner of the asset is entitled to depreciation allowance associated with the asset. DIRECT LEASING Under direct leasing, a firm acquires the right to use an asset from the manufacturer directly. The ownership of the asset leased out remains with the manufacturer itself. The major types of direct lessor include manufacturers, finance companies, independent lease companies, special purpose leasing companies etc

ADVANTAGES OF LEASING
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 Manufacturer Lessor Lessee Lender money as there is no down payment. In this way the saving in capital or financial resources can be used for other productive purposes e.g. purchase of inventories.

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 LIQUADITY: Leasing enables the lessee to improve their liquidity position by adopting the sale and lease back technique.

CONCEPT AND MEANING OF HIRE PURCHASE

Hire purchase is a type of instalment credit under which the hire purchaser, called the hirer, agrees to take the goods on hire at a stated rental, which is inclusive of the repayment of principal as well as interest, with an option to purchase. Under this transaction, the hire purchaser acquires the property (goods) immediately on signing the hire purchase agreement but the ownership or title of the same is transferred only when the last instalment is paid. The hire purchase system is regulated by the Hire Purchase Act 1972. This Act defines a hire purchase as an agreement under which goods are let on hire and under which the hirer has an option to purchase them in accordance with the terms of the agreement and includes an agreement under which: 1. The owner delivers possession of goods thereof to a person on condition that such person pays the agreed amount in periodic instalments. 2. The property in the goods is to pass to such person on the payment of the last of such instalments, and 3. Such person has a right to terminate the agreement at any time before the property so passes. Hire purchase should be distinguished from instalment sale wherein property passes to the purchaser with the payment of the first instalment. But in case of HP (ownership remains with the seller until the last instalment is paid) buyer gets ownership after paying the last instalment. HP also differs form leasing.

DIFFERENCE BETWEEN LEASING & HIRE PURCHASE

Overview
Term/Rent Generally, the term of an equipment lease will begin on acceptance of the equipment, which sounds much more simple than we all know it actually is. This is one of many areas where the reliance on standard form documentation, without periodic review and a bit of thought in individual circumstances, can lead to disaster. Coordination of the lease the schedule (if a master lease is used), the delivery and acceptance certificate and the purchase order are key The date on which the term begins should be clear. Most leases clearly state whether the rent is intended to be paid in advance or in arrears. Be mindful of this in structuring casualty or termination value tables Interest/Late Charges Far more common than problems about the term and rent provisions are problems regarding the lessee's late payment of rent. Generally, this is not a usury problem in most states penalty rent is not considered to be "interest" for usury purposes under most state laws. However, several types of problems can arise if the late charges are not consistently applied. If the lessee is going to be given grace for any reason, a written letter to the lessee should explain that the lessor reserves the right to reinstitute the penalty later on. Late charges fall into several categories. Some leases require a single lump sum payment, which should be invoiced to the lessee as soon as it is due. Other leases require a calculation of interest, usually from the date due until the date of payment.

Net Lease/Hell or High Water Clause/Warranty Disclaimer The net lease provision states that the lessee is responsible for paying operating costs, taxes and insurance. This effectively means that the rent payment is "net" to the lessor (except for the lessor's income taxes and overhead). Hell or high water clause 6

The hell or high water clause is important to establish that the lessee must pay the full amount of rent whether or not the equipment functions and has no right of offset. If this clause is explained to the lessee, it should be pointed out that the lessee does not, in this clause alone, give up its right to sue the lessor if it feels that the lessor has breached any terms of the lease, including representations regarding the equipment. Warranty Disclaimer Under Article 2A, a warranty is implied by the lessor whether the equipment is leased under a true lease or a disguised security arrangement. In other words, you are all deemed to be making an implied warranty that the equipment is "merchantable" and "fit" for the lessee's intended use UNLESS THE WARRANTY DISCLAIMER LANGUAGE IS PRESENT IN YOUR LEASE. Delivery & Acceptance/PurchaseOrders As a general rule, virtually all of the lessee's obligations to the lessor, including the obligation to pay rent and to indemnify the lessor, arise only when the equipment has been accepted. Likewise, the lessor's obligation to make payment to the vendor of the equipment arises on the lessee's acceptance. Return Provisions

One of the provisions which addresses directly the lessor's anticipated residual value realization is the return provision of the lease. These provisions include provisions addressing the condition in which the equipment must be on the date of return, the allocation of the costs of redelivery and what additional charges the lessee may be required to pay. Purchase/Renewal Options

On their face, few things are as simple as the concept of a renewal or purchase option. In fact, few provisions cause more problems. It is essential that the Lessor be fully familiar with the terms of the renewal or purchase option provision as it relates to the particular lessee and equipment. "Fair market value" may be a difficult concept If the lessee desires to exercise a renewal or purchase option, check to ensure that no default exists, that no liabilities are outstanding and that the lessee has complied with all notice and other requirements. In addition, a provision describing how fair market value should be in your lease form. Be sure you are comfortable with its workings and the potential cost in dollars and time. 7

Contact potential appraisers in advance and be sure that they are familiar not only with the type of equipment but the concept of a fair market value determination for equipment lease purposes.

Some Terms Gross Lease In this form of lease the lessor is responsible for all expenses associated with ownership of the equipment such as maintenance, taxes and insurance. Net Lease A net lease is the opposite of a gross lease. Here, the lessee is responsible for expenses related to the operation of the equipment such as maintenance, taxes and insurance. Residual Value This is the value of the equipment at the end of the term. Vehicle----- an example

On Buying vs. leasing basics Ownership Up-front costs Monthly payments Early termination Vehicle return Future value Mileage Excessive wear and tear End of term Customizing RBI Guidelines to Leasing Companies Leasing companies are expected to here the following norms while availing financial facility from banks:

Formation of consortium by a bank is not necessary, even if credit limit per borrower exceeds Rs50 crores Banks are permitted to extent credit using the need based approach. Banks are permitted to adopt syndication route instead of consortium route irrespective of the quantum of credit invdived, if the arrangements suits the borrower and financing banks. The level of loan and cash credit component in case borrower with a limit of less than Rs10 core would be settled between banks and the borrower The loan component of working capital limit(MPBF) i.e. maximum permissible bank finance is enhanced to 80% and 75% in case of borrower enjoying working capital credit limit of Rs20 core and more, and between 10-20 core respectively the balance being in form of cash credit.

Accounting aspect of leasing:

Financial leasing: Lessee According to IAS 19, the lessee should recognise the lease at the inception of a finance lease as an asset and a liability. Fair value and minimum lease payments whichever is lower. Finance lease payments should be apportioned between the finance charge and the reduction of the outstanding liability.

Operating leasing: Lessee Operating lease should be recognised as an expense in the statement of profit and loss on a straight line basis over the lease term.

Financial leasing: Lessor The lessor should recognise assets given under a finance lease in its balance sheet as a receivable at an amount equal to the net investment in the lessee. The recognition of finance income should be based on pattern reflecting a constant periodic rate of return on the net investment of the lessor outstanding with respect to the financial lease. Initial direct cost should be recognised as an expense in the statement of profit and loss at the inception of lease.

Operating Leasing: Lessor Asset should be presented under fixed assets. Lease income should be recognised in the statement of profit and loss on a straight line basis over the lease term. 9

Sale and lease back- Financial Any excess or deficiency of sale proceeds over the carrying amount should deferred and amortised over the leased term in proportion to the depreciation of the leased assets.

Sale and lease back- Operating If the fair value at the time of a sale-and-lease back transaction is less than is less than the carrying amount of the asset, then the loss should be recognised immediately. If sale price= Fair value, profit or loss should be recognised immediately. If sale price below fair value, profit or loss should be recognised immediately. (exception: if the loss is compensated by future lease payment below the market price, it should be deffered and amortised in proportion to the lease payments). If the sale price is above the fair value, the excess over the fair value should be deffered and amortised over the period for which the asset is expected to be used.

References:
Siddaiah T., Management of Financial Services. Khan M. Y., Financial Services.

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