CHAPTER IV

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.

4.1 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 term.

• 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 Rent.

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4.1.1 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 instalment 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.
2. 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
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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
lessees 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.

4.1.2 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.

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Equipment leasing includes, leasing of plant and machinery, office equipments,
automobiles, ships and aircrafts.

4.1.3 Legal 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 another they shall, when the purpose is accomplished,
be returned or otherwise disposed of 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 re asset on the expiry of the lease period.

4.1.4 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:
Description of the lessor, the lessee, and the equipment.
Amount, time and place of lease rentals payments.
Time and place of equipment delivery.
Lessee‘s responsibility for taking deliver
Lessee‘s responsibility for maintenance, r case of default by the lessee.
Lessee‘s right to enjoy the benefits of manufacturer/supplier.
Insurance to be taken by the lessee on behalf of the lessor.

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 Variation in lease rentals if there is a change in certain external factors
like bank interest rates, depreciation rates, and fiscal incentives.
Options of lease renewal for the lessee.
Return of equipment on expiry of the lease period.
Arbitration procedure in the event of dispute.

4.1.5 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

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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 fullpay
out 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

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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 le

can be of two types:

(i) Bipartite lease, and
(ii) (ii) Tripartite Lease.

Bipartite Lease:
There are two parties to the transaction,
1. Equipment supplier cum lessor

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 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 leasel
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.

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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, entered the market largest in India 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

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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:


It offers fixed rate financing; you pay at the same rate monthly

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.)

There is less upfront cash outlay; you do not need to make large cash payments for
the purchase of needed equipment.

Leasing better utilizes equipment; you lease and pay for equipment only for the time
you need it.

There is typically an option to buy equipment at end of lease term.

You can keep upgrading; as new equipment becomes available you can upgrade to

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 the latest models each time your lease ends.

Typically, it is easier to obtain lease financing than loans from commercial lenders.

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:

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.
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.
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.
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.

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4.2 HIRE PURCHASE
According to the Hire Purchase Act of 1972, the term hire purchase is defined 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;
a. Possession of goods is delivered by the owner thereof to a person on the
condition that such person pays the agreed amount in periodic payments
b. The property of the goods is to pass to such a person on the payment of the last
of such instalment
c. Such a person has a right to terminate the agreement any time before the
companies are controlled by the Hire Purchase Act, 1972.
A Hire purchase transaction has two elements, Bailment which is governed by the
Indian Contract Act, 1872 and Sale under the Sale of Goods Act, 1930.

4.2.1 Hire Purchase Agreement

A Hire Purchase Agreement is an agreement between the seller and the buyer,
where the ownership of goods does not pass to the buyer until he pays the last
instalment.
There are two parties to the hire purchase agreement. The hire vendor, who is the
seller and other, is the hire purchaser, the buyer. The purchaser has to make a
down payment of 20 to 25% of the cost and the remaining amount has to be paid
in equal monthly instalments.
In the case of a Deposit linked plan, the hire purchaser has to invest a fixed amount
as fixed deposits in the finance company which is returned together with interest
after the payment of the last instalment.

Parties to the Hire Purchase Contract:

There are two parties in a hire purchase contract
1. The intending seller
2. The intending purchaser or the hirer.

Tripartite agreement
1. Seller

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2. Financier
3. Hirer/Purchaser

4.2.2 Difference between Hire Purchase and Leasing:

Characteristics Leasing Hire purchasing
With the finance company,
Ownership the It is transferred to the hirer on the
Lessor payment of the last installment

Depreciation Lessor, and not the lessee is The hirer is entitled to claim
entitled to claim depreciation
tax depreciation tax shield
Shield
Capitalization Done in the books of lessor Done in the books of hirer

Payments The entire lease payments are Only the hire interest is eligible for
eligible for tax computation
in tax computation in the books of
the books of lessee hirer
Magnitude Used as a source of finance, Used as a source of finance, usually
usually for acquiring high
cost for acquiring low cost assets such
assets such as machinery,
ships as automobiles, office equipments
Etc etc
Maintenance of Lessee in case of financial, It is the hirer‘s r
Upkeep is the responsibility
Asset of ensure the maintenance of the asset
the lessor in the case of bought
operating lease

Nature of asset Asset- as a fixed asset of the Shows the asset either as a stock in
Lessor trade or as receivables

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 Down payment No down payment required It is required

4.2.3 Financial Evaluation:

It is an evaluation by the hirer of the desirability for lease and hire purchase. The hirer makes
decision based on the Present Value of Net Cash Outflow.
The decision is considered favorable when the PV of Net Cash Outflow under Hire Purchase
is less than the PV of Net cash Outflow under leasing. Following are the steps involved.
Step 1 Calculate annual interest amount
Step 2 Find the principal amount outstanding at the beginning of the each year =
Total outstanding principal –principal paid in the previous year.
Step 3 Find principal paid in the previous year = Annual installment amount –Annual Interest
Step 4 Find Annual ITS = Annual Interest x Tax rate
Step 5 Find Annual Depreciation
Step 6 Find Annual DTS = Annual depreciation x Tax rate
Step 7 Find Total TS = Step 4 + Step 6
Step 8 Find Annual instalment amount = Total HP amount + (HP amount x flat rate of
interest) / No. of HP years
Step 9 Find PV of salvage value of assets = SV x PVF
Step 10 Find Net Cash Outflow of HP = Step 8 –Step 7
Step 11 Find PV of net cash outflow of HP at the appropriate discount rate.
Step 12 Find Total PV net cash outflow of HP = Step 11 –Step 9.
Step 13 Find Tax shield on annual ease rentals = Annual Lease rental x Tax rate.
Step 14 Find Net cash outflow of Leasing = Annual lease rental –Step 13.
Step 15 Find Total PV of net cash outflow of Leasing at the appropriate Discount rate = Net
cash outflow of Leasing x PVAF.
Step 16 Make a decision: HP is desirable if total PV of net cash flow of HP is Less than that
of leasing.

4.3 HIRE PURCHASE LEASING

1. It is a tripartite agreement, involving the seller, finance company and the purchaser/hirer
2. Depreciation is claimed by the purchaser/hirer
3. The agreement is entered for the transfer of ownership after a fixed period.
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1. It is a bipartite agreement involving lessor and lessee.
2. Depreciation is claimed by the lessor in the lease agreement.
3. In finance lease the ownership will get transferred. While in operating lease, the
ownership is not transferred.

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