Type of Financing: LONG-TERM SOURCES OF FINANCE
FINANCIAL NEEDS FINANCE OF A BUSINESS AND SOURCES OF Financial Needs of a Business
Business enterprises need funds to meet their different types of requirements. All the financial needs of a business may be grouped into the following three categories:
(i) Long-term financial needs: Such needs generally refer to those requirements of funds which are for a period exceeding 5-10 years. All investments in plant, machinery, land, buildings, etc., are considered as long-term financial needs. Funds required to finance permanent or hard-core working capital should also be procured from long term sources.
(ii) Medium-term financial needs: Such requirements refer to those funds which are required for a period exceeding one year but not exceeding 5 years. For example, if a company resorts to extensive publicity and advertisement campaign then such type of expenses may be written off over a period of 3 to 5 years. These are called deferred revenue expenses and funds required for these are classified in the category of medium-term financial needs.
(iii) Short-term financial needs: Such type of financial needs current assets such as stock, debtors, cash, etc. Investment in these assets are known as meeting of working capital requirements of the concern. The main characteristic of short-term financial needs is that they arise for a short period of time not exceeding the accounting period. i.e., one year.
Basic Principle for Funding Various Needs:
The basic principle for meeting the short-
term financial needs of a concern is that such needs should be met from short term
sources, and medium-term financial needs from medium term sources and long term
financial needs from long term sources. Accordingly, the method of raising funds is to be decided with reference to the period for which funds are required.
General rule for financing of different assets would take place. These rules can be changed depending on the nature of the borrower i.e. depending on the borrower’s level of operation.
| Purpose | Type of Borrowing | Borrower nature |
|---|---|---|
| Non-Current Asset | Equity; Long Term Loan | Equity; Long-Term Loan |
| Current Asset | Medium-term loan for SMEs | Start-up; Small and Medium Enterprises (SMEs). Mid corporates; Large corporates. |
| Non-Current Asset | Short term loan | Large Corporates |
Besides, the stage of development of the business and the nature of the business would also decide the type of borrowing. Generally, it can be as follows:
| Stage | Nature of Business | Sources of Fund |
|---|---|---|
| Early stage | High Uncertainty High to moderate Uncertainty | Equity; mainly Angel fund Equity; Venture capital; Debt |
| Growth Stage | Moderate to Low Uncertainty | Debt; Venture Capital; Private Equity |
| Stable stage | Low Uncertainty | Debt |
CLASSIFICATION OF FINANCIAL SOURCES
There are mainly two ways of classifying various financial sources
(i) Based on basic Sources
(ii) Based on Maturity of repayment period.
LONG-TERM SOURCES OF FINANCE
There are different sources of funds available to meet long term financial needs of the business. These sources may be broadly classified into:
⚫ Share capital (both equity and preference) &
⚫ Debt (including debentures, long term borrowings or other debt instruments). The different sources of long-term finance have been discussed as follows:
Owners Capital or Equity Capital:
A public limited company may raise funds from promoters or from the investing public by way of owner’s capital or equity capital by issuing ordinary equity shares. Some of the characteristics of Owners/Equity Share Capital are:
⚫ It is a source of permanent capital. The holders of such share capital in the company are called equity shareholders or ordinary shareholders.
Equity shareholders are practically owners of the company as they undertake the highest risk.
⚫ Equity shareholders are entitled to dividends after the income claims of other stakeholders are satisfied. The dividend payable to them is an appropriation of profits and not a charge against profits.
⚫ In the event of winding up, ordinary shareholders can exercise their claim on assets after the claims of the other suppliers of capital have been met.
The cost of ordinary shares is usually the highest. This is due to the fact that such
shareholders expect a higher rate of return (as their risk is the highest) on their investment as compared to other suppliers of long-term funds.
Ordinary share capital also provides a security to other suppliers of funds. Any institution giving loan to a company would make sure the debt-equity ratio is comfortable to cover the debt. There can be various types of equity shares like New issue, Rights issue, Bonus Shares, Sweat Equity.
Advantages of raising funds by issue of equity shares are:
(1) It is a permanent source of finance. Since such shares are not redeemable, the company has no liability for cash outflows associated with its redemption. In other words, once the company has issued equity shares, they are tradable i.e. they can be purchased and sold. So, a company is in no way responsible for any
cash outflows of investors by which they become the shareholders of the company by purchasing the shares of existing shareholders.
(ii) Equity capital increases the company’s financial base and thus helps to further
the borrowing powers of the company. In other words, by issuing equity shares a company manage to raise some money for its capital expenditures and this helps it to raise more funds with the help of debt. This is because; debt will enable the company to increase its earnings per share and consequently, its share prices
(iii) A company is not obliged legally to pay dividends. Hence in times of uncertainties or when the company is can be reduced or even suspended. y is not performing well, dividend payments
(iv) A company can make further increase its share capital by initiating a right issue
Disadvantages of raising funds by issue of equity shares are:
Apart from the above mentioned advantages, raising of funds through equity share capital has some disadvantages in comparison to other sources of finance. These are as follows:
(i) Dividend income is taxable in the hands of the recipient of the dividend.
(ii) Investors find ordinary shares riskier because of uncertain dividend payments and capital gains.
(iii) The issue of new equity shares reduces the earning per share of the existing shareholders until and unless the profits are proportionately increased.
(iv) The issue of new equity shares can also reduce the ownership and control of the existing shareholders.
Preference Share Capital
These are special kind of shares; the holders of such shares enjoy priority, both as regard to the payment of a fixed amount of dividend and also towards repayment of capital on winding up of the company. Some of the characteristics of Preference Share Capital are as follows:
Long-term funds from preference shares can be raised through a public issue of shares.
⚫Such shares are normally cumulative, ie., the dividend payable in a year of loss gets carried over to the next year till there are adequate profits to pay the cumulative dividends.
The rate of dividend on preference shares is normally higher than the rate of interest on debentures, loans etc.
Most of preference shares these days carry a stipulation of period and the funds have to be repaid at the end of a stipulated period.
Preference share capital is a hybrid form of financing that imbibes within itself some characteristics of equity capital and some attributes of debt capital. It is similar to equity because a preference dividend, like an equity dividend is not a tax-deductible payment. It resembles debt capital because the rate of preference dividend is fixed.
Cumulative Convertible Preference Shares (CCPs) may also be offered, under which the shares would carry a cumulative dividend of a specified limit for a period of say three years after which the shares are converted into equity shares. These shares are attractive for projects with a long gestation period.
Preference share capital may be redeemed at a pre-decided future date or at an earlier stage inter alia out of the profits of the company. This enables the promoters to withdraw their capital from the company which is now self-sufficient, and the withdrawn capital may be reinvested in other profitable ventures.
Various types of Preference shares can be as below:
| Sl. No. | Type of Preference Shares | Salient Features |
|---|---|---|
| 1 | Cumulative | Arrear Dividend will accumulate. |
| 2 | Non-cumulative | No right to arrear dividend. |
| 3 | Redeemable | Redemption should be done. |
| 4 | Participating | Can participate in the surplus which remains after payment to equity shareholders. |
| 5 | Non-Participating | Cannot participate in the surplus after payment of fixed rate of Dividend. |
| 6 | Convertible | Option of converting into equity Shares. |
Advantages of raising funds by issue of preference shares are:
(I) No dilution in EPS on enlarged capital base – On the other hand if equity shares are issued it reduces EPS, thus affecting the market perception about the company.
(ii) There is also the advantage of leverage as it bears a fixed charge (because companies are required to pay a fixed rate of dividend in case of an issue of preference shares). Non-payment of preference dividends does not force a company into liquidity.
(iii) There is no risk of takeover as the preference shareholders do not have voting rights except where dividend payment are in arrears.
(iv) The preference dividends are fixed and pre-decided. Hence preference shareholders cannot participate in surplus profits as the ordinary shareholders can except in case of participating preference shareholders.
(v) Preference capital can be redeemed after a specified period.
Disadvantages of raising funds by issue of preference shares are:
(i) One of the major disadvantages of preference shares is that preference dividend is not tax deductible and so does not provide a tax shield to the company. Hence preference shares are costlier to the company than debt e.g. debenture.
(ii) Preference dividends are cumulative in nature. This means that if in a particular year preference dividends are not paid they shall be accumulated and paid later. Also, if these dividends are not paid, no dividend can be paid to ordinary shareholders. The non-payment of dividends to ordinary shareholders could seriously impair the reputation of the concerned company.
Difference between Equity Shares and Preference Shares are as follows:
| Sl. No. | Basis of Distinction | Equity Share | Preference Share |
|---|---|---|---|
| 1 | Dividend payment | An equity Dividend is a Payment of a preference dividend. | Payment of preference dividend is preferred over equity dividend. |
| 2 | Rate of dividend | Fluctuating | Fixed |
| 3 | Convertibility | Not convertible | Convertible |
| 4 | Voting rights | Equity shareholders full voting rights | They have very limited voting rights |
Retained Earnings
Long-term funds may also be provided by accumulating the profits of the company and by ploughing them back into business. Such funds belong to the ordinary shareholders and increase the net worth of the company.
A public limited company must plough back a reasonable amount of profit every year keeping in view the legal requirements in this regard and also for its own expansion plans. Such funds also entail almost no risk. Further, control of present owners is also not diluted by retaining profits.
Debentures
Loans can be raised from public by issuing debentures or bonds by public limited companies. Some of the characteristics of debentures are:
Debentures are normally issued in different denominations ranging from 100 to 1,000 and carry different rates of interest.
Normally, debentures are issued on the basis of a debenture trust deed which lists the terms and conditions on which the debentures are floated.
Debentures are basically instruments for raising long-term debt capital.
The period of maturity normally varies from 3 to 10 years and may also increase for projects having high gestation period.
Debentures are either secured or unsecured. They may or may not be listed on the stock exchange.
The cost of capital raised through debentures is quite low since the interest payable on debentures can be charged as an expense before tax. From the investors’ point of view, debentures offer a more attractive prospect than the preference shares since interest on debentures is payable whether or not the company makes profits.
Debentures can be divided into the following three categories based on their convertibility.
(i) Non-convertible debentures – These types of debentures do not have any feature of conversion and are repayable on maturity.
(ii) Fully convertible debentures – Such debentures are converted into equity shares as per the terms of issue in relation to price and the time of conversion. Interest rates on such debentures are generally less than the non-convertible debentures because they carry an attractive feature of getting themselves converted into shares at a later time.
(iii) Partly convertible debentures – These debentures carry features of both convertible and non-convertible debentures. The investor has the advantage of having both the features in one debenture.
Other types of Debentures with their features are as follows:
| Sl. No. | Type of Debenture | Salient feature |
|---|---|---|
| 1 | Bearer | Transferable like negotiable instruments |
| 2 | Registered | Interest payable to registered person |
| 3 | Mortgage | Secured by a charge on Asset(s) |
| 4 | Naked or simple | Unsecured |
| 5 | Redeemable | Interest payable to a registered person |
| 6 | Non-Redeemable | Not repayable |
Advantages of raising finance by issue of debentures are:
(1) The cost of debentures is much lower than the cost of preference or equity capital as the interest is tax-deductible. Also, investors consider debenture investment safer than equity or preferred investment and, hence, may require a lower return on debenture investment.
(ii) Debenture financing does not result in dilution of control.
(iii) In a period of rising prices, the debenture issue is advantageous. The fixed monetary outgo decreases in real terms as the price level increases. In other words, the company has to pay a fixed rate of interest.
The disadvantages of debenture financing are:
(i) Debenture interest and the repayment of its principal amount is an obligatory
payment.
(ii) The protective covenants associated with a debenture issue may be restrictive.
(iii) Debenture financing enhances the financial risk associated with the firm because of the reasons given in point
(iv) Since debentures need to be paid at the time of maturity, a large amount of outflow is needed at that time.
Public issues of debentures and private placement to mutual funds now require that a debenture issue must be rated by a credit rating agency like CRISIL (Credit Rating and Information Services of India Ltd.).
The credit rating is given after evaluating factors like the track record of the company, profitability, debt servicing capacity, creditworthiness, and the perceived risk of lending.
Difference between Preference Shares and Debentures:
| Basis of difference | Preference shares | Debentures |
|---|---|---|
| Ownership | Preference Share Capital is a special kind of share | A debenture is a type of loan that can be raised from the public |
| Payment of Dividend/interest | The preference shareholders enjoy priority both as regard to interest. the payment of a fixed amount of dividend and also towards repayment of capital in case of winding up of a company | It carries fixed percentage of interest. |
| Nature | Preference shares are a hybrid form of financing with some characteristic of equity shares and some attributes of Debt Capital. | Debentures are instrument for raising long term capital with a fixed period of maturity. |
Bond
Bond is fixed income security created to raise fund. Bonds can be raised through
Public Issue and through Private Placement.
Types of Bonds
Based on call, Bond can be categorized as:
(i) Callable bonds and
(ii) Puttable bonds
(i) Callable bonds: A callable bond has a call option which gives the issuer the right to redeem the bond before maturity at a predetermined price known as the call price (Generally at a premium).
(ii) Puttable bonds: Puttable bonds give the investor a put option (ie, the right to sell the bond) back to the company before maturity.
Various Bonds with their salient feature are as follow:
| Sl. No. | Name of Bond | Salient Features |
|---|---|---|
| 1 | Foreign Currency Convertible Bond (FCCB) | This bond comes at a very low rate of interest. The advantage to the issuer is that the issuer can get foreign currency at a very low cost. The risk is that in case the bond has to be redeemed on the date of maturity, the issuer has to make the payment and at that time the issuer may not have the money. |
| 2 | Plain Vanilla bond. | The issuer would pay the principal amount along with the interest rate. This type of bond would not have any options. This bond can be issued in the form of discounted bond or can be issued in the form of coupon-bearing bond. |
| 3 | Convertible Floating Rate Notes (FRN) | A convertible FRN is issued by giving its holder an option to convert it into a longer term debt security with a specified coupon It protects an investor against falling interest rate. The long-term debt security can be sold in the market and the investor can earn profit. Capital gain is not applicable to FRN It is a Floating Rate Note with a normal floating |
| 4 | Drop Lock Bond. | The floating rate bond would be automatically converted into fixed rate bond if interest rate falls below a predetermined level The new fixed rate stays till the drop lock bond reaches its maturity The difference between the convertible floating rate note and drop lock bond is that the former is a long option structure and the later one is a short option structure |
| 5 | Variable Rate Demand Obligations | A normal floating rate note with a nominal maturity. The holder of the floating rate note can sell the obligation back to the trustee at par plus accrued interest. It gives the investor an option to exit, so it is more liquid than the normal FRN |
| 6 | Yield CurveNote (YCN). | It is a structured debt security Yield increases when prevailing interest rate declines Yield decreases when prevailing interest rate increases This is used to hedge the interest rate This works like inverse floater |
| 7 | Yankee Bond | These bonds are denominated in dollars Bonds issued by non- US banks and non- US corporations Bonds are issued in USA Bonds are to be registered in SEC (Securities and Exchange Commission) Bonds are issued in tranches Time taken can be up to 14 weeks Interest rate is dollar LIBOR (London Interbank Offered Rate) |
| 8 | Euro Bond | Euro bonds are issued or traded in a country using a currency other than the one in which the bond is denominated. This means that the bond uses a certain currency, but operates outside the jurisdiction of the Central Bank that issues that currency Eurobonds are issued by multinational corporations, for example, a British company may issue a Eurobond in Germany, denominating it in U.S. dollars. It is important to note that the term has nothing to do with the euro, and the prefix “euro-” is used more generally to refer to deposit outside the jurisdiction of the domestic central bank. |
| 9 | Samurai Bond | Samurai bonds are denominated in Japanese Yen JPY Issued in Tokyo Issuer Non-Japanese Company Regulations: Japanese Purpose: Access of capital available in Japanese market Issue proceeds can be used to fund Japanese operation Issue proceeds can be used to fund a company’s local opportunities. It can also be used to hedge foreign exchange risk It is denominated in Bulldog Pound |
| 10 | Bulldog Bond | Sterling/Great Britain Pound (GBP) Issued in London Issuer Non-UK Company Regulations: Great Britain Purpose: Access of capital available in UK market Issue proceeds can be used to fund UK operation Issue proceeds can be used to fund a company’s local opportunities |
(ii) Indian Bonds
| Sl. No. | Name of Bond | Salient Feature |
| 1 | Masala Bond | Masala (means spice) bond is an Indian name used for Rupee denominated bond that Indian corporate borrowers can sell to investors in overseas markets. These bonds are issued outside India but denominated in Indian Rupees. NTPC raised 2,000 crore via masala bonds for its capital expenditure in the year 2016. |
| 2 | Municipal Bonds | Municipal bonds are used to finance urban infrastructure are increasingly evident in India. Ahmedabad Municipal Corporation issued a first historical Municipal Bond in Asia to raise 100 crore from the capital market for part financing a water supply project. |
| 3 | Government or Treasury Bonds | Government or Treasury bonds are bonds issued by Government of India, Reserve Bank of India, any state Government or any other Government department. |
Loans from Commercial Banks
financing of industries in several ways.
(a) The banks provide long term loans for the purpose of expansion or setting up of new units. Their repayment is usually scheduled over a long period of time. The
liquidity of such loans is said to depend on the anticipated income of the borrowers.
(b) As part of the long-term funding for a company, the banks also fund the long term working capital requirement (it is also called WCTL i.e. working capital term loan). It is funding of that portion of working capital which is always required (the minimum level) and is not impacted by seasonal requirement of the company.
Bridge Finance: Bridge finance refers to loans taken by a company normally from commercial banks for a short period because of pending disbursement of loans
sanctioned by financial institutions: Though it is of short-term nature but since
it is an important step in the facilitation of long-term loan, therefore it is being discussed along with the long term sources of funds. Normally, it takes time for financial institutions to disburse loans to companies.
However, once the loans are approved by the term lending institutions, companies, in order not to lose further time in starting their projects, arrange short term loans from commercial banks. The bridge loans are repaid/ adjusted out of the term loans as and when disbursed by the concerned institutions.
Bridge loans are normally secured by hypothecating movable assets, personal guarantees and demand promissory notes. Generally, the rate of interest on bridge finance is higher as compared with that on term loans.
Having discussed funding from share capital (equity/preference), raising of debt from financial institutions and banks, we will now discuss some other important sources of long-term finance.
VENTURE CAPITAL FINANCING
Meaning of Venture Capital Financing : The venture capital financing refers to financing of new high risky venture promoted by qualified entrepreneurs who lack experience and funds to give shape to their ideas. In broad sense, under venture capital financing, venture capitalist make investment to purchase equity or debt securities from inexperienced entrepreneurs who undertake highly risky ventures with potential to succeed in future.
Characteristics of Venture Capital Financing
Some of the characteristics of Venture Capital financing are:
It is basically an equity finance in new companies. It can be viewed as a long-term investment in growth-oriented small/medium firms.
Apart from providing funds, the investor also provides support in form of sales strategy, business networking and management expertise, enabling the growth of the entrepreneur.
Methods of Venture Capital Financing
Some common methods of venture capital financing are as follows:
(i) Equity financing: The venture capital undertakings generally require funds for a longer period but may not be able to provide returns to the investors during the initial stages. Therefore, the venture capital finance is generally provided by way of equity share capital. The equity contribution of venture capital firm does not exceed 49% of the total equity capital of venture capital undertakings so that the effective control and ownership remains with the entrepreneur.
(ii) Conditional loan: A conditional loan is repayable in the form of a royalty after the venture is able to generate sales. No interest is paid on such loans. In India venture capital financiers charge royalty ranging between 2 and 15 per cent actual rate depends on other factors of the venture such as gestation period, cash flow patterns, risk and other factors of the enterprise. Some Venture capital financiers give a choice to the enterprise of paying a high rate of interest (which could be well above 20 per cent) instead of royalty on sales once it becomes commercially sound.
(iii) Income note: It is a hybrid security which combines the features of both
conventional loan and conditional loan. The entrepreneur has to pay both interest and royalty on sales but at substantially low rates. IDBI’s VCF provides funding equal to 80-87.50% of the projects cost for commercial application of indigenous technology.
(iv) Participating debenture: Such security carries charges in three phases – in the start-up phase no interest is charged, next stage a low rate of interest is charged up to a particular level of operation, after that, a high rate of interest is required to be paid.
DEBT SECURITISATION
Meaning of Debt Securitisation
Securitisation is a process in which illiquid assets are pooled into marketable securities that can be sold to investors. The process leads to the creation of financial instruments that represent ownership interest in, or are secured by a segregated income producing asset or pool of assets. These assets are generally secured by personal or real property such as automobiles, real estate, or equipment loans but in some cases are unsecured.
Example of Debt Securitisation:
A finance company has given a large number of car loans. It needs more money so that it is in a position to give more loans. One way to achieve this is to sell all the existing loans. But, in the absence of a liquid secondary market for individual car loans, this is not feasible.
However, a practical option is debt securitisation, in which the finance company sells its existing car loans already given to borrowers to the Special Purpose Vehicle (SPV). The SPV, in return pays to the company, which in turn continue to lend with this money. On the other hand, the SPV pools these loans and convert these into marketable securities. It means that now these converted securities can be issued to investors.
So, this process of debt securitization helps the finance company to raise funds and get the loans off its Balance Sheet. These funds also help the company disburse further loans. Similarly, the process is beneficial to the investors also as it creates a liquid investment in a diversified pool of car loans, which may be an attractive option to other fixed income instruments.
The whole process is carried out in such a way that the original debtors i.e. the car loan borrowers may not be aware of the transaction. They might have continued making payments the way they are already doing. However, these payments shall now be made to the new investors who have emerged out of this securitization process.
LEASE FINANCING
Leasing is a general contract between the owner and user of the asset over a specified period of time. The asset is purchased initially by the lessor (leasing company) and thereafter leased to the user (lessee company) which pays a specified rent at periodical intervals.
Thus, leasing is an alternative to the purchase of an asset out of own or borrowed funds. Moreover, lease finance can be arranged much faster as compared to term loans from financial institutions.
Types of Lease Contracts: Broadly lease contracts can be divided into following two categories:
(a) Operating Lease
(b) Financial Lease.
(a) Operating Lease: An operating lease is a form of lease in which the right to use the asset is given by the lessor to the lessee. However, the ownership right of the asset remains with the lessor. The lessee gives a fixed amount of
periodic lease rentals to the lessor for using the asset. Further, the lessor also bears the insurance, maintenance and repair costs etc. of the asset.
In operating lease, the lease period is short. So, the lessor may not be able to recover the cost of the asset during the initial lease period and tend to lease the asset to more than one lessee. Normally, these are callable lease and are cancelable with proper notice.
The term of this type of lease is shorter than the asset’s economic life. The lessee is obliged to make payment until the lease expiration, which approaches useful life of the asset.
An operating lease is particularly attractive to companies that continually update or replace equipment and want to use equipment without ownership, but also want to return equipment at lease end and avoid technological obsolescence.
(b) Financial Lease: In contrast to an operating lease, a financial lease is long term in nature and non-cancelable i.e. the lessee cannot terminate the lease agreement subsequently So, the period of lease is generally the full economic life of the leased asset.
In other words, a financial lease can be regarded as any leasing arrangement that is to finance the use of equipment for the major parts of its useful life. The lessee has the right to use the equipment while the lessor retains legal title. Further, in such lease, the lessee has to bear the insurance, maintenance and other related costs. It is also called capital lease, which is nothing but a loan in disguise.
Thus, it can be said that a financial lease is a contract involving payments over an obligatory period of specified sums sufficient in total to amortise the capital outlay of the lessor and give some profit.
Comparison between Financial Lease and Operating Lease
| Financial Lease | Operating Lease |
|---|---|
| 1. The risk and reward incident to ownership are passed on to the lessee. The lessor only remains. | The lessee is only provided the use of the asset for a certain time. Risk incident to ownership belong wholly to the lessor. |
| 2. legal owner of the asset. The lessee bears the risk of obsolescence. | The lessor bears the risk of obsolescence. |
| 3. The lessor is interested in his rentals and not in the asset. He must get his principal back along with interest. Therefore, the lease is non-cancellable by either party. lessor. | As the lessor does not have difficulty in leasing the same asset to other willing lessee. |
| 4. The lessor enters into the transaction only as financier. He repairs, does not bear the cost of repairs, maintenance or operations. | the lease is kept cancelable by the Usually, the lessor bears cost of maintenance or operations. |
| 5. The lease is usually full payout, that is, the single lease repays the cost of the asset together with the interest. | The lease is usually non-payout, since the lessor expects to lease the same asset over and over again to several users. |
Other Types of Leases
(a) Sales and Lease Back: Under this type of lease, 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 a lease rentals.
Under this arrangement, the asset is not physically exchanged but it all happen in records only. The main advantage of this method is that the lessee can satisfy himself completely regarding the quality of an asset and after possession of the asset convert the sale into a lease agreement.
Under this transaction, the seller assumes the role of lessee (as the same asset which he has sold came back to him in the form of lease) and the buyer assumes the role of a lessor (as asset purchased by him was leased back to the seller). So, the seller gets the agreed selling price and the buyer gets the lease rentals.
(b) Leveraged Lease: Under this lease, a third party is involved besides lessor and the lessee. The lessor borrows a part of the purchase cost (say 80%) of the asset from the third party i.e., lender and 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 is entitled to claim depreciation allowance.
(c) Sales-aid Lease: Under this lease contract, the lessor enters into a tie up with a manufacturer for marketing the latter’s product through his own leasing operations, it is called a sales-aid lease. In consideration of the aid in sales, the manufacturer may grant either credit or a commission to the lessor. Thus, the lessor earns from both sources i.e. from lessee as well as the manufacturer.
(d) Close-ended and Open-ended Leases: In the close-ended lease, the assets get transferred to the lessor at the end of lease, the risk of obsolescence, residual value etc., remain with the lessor being the legal owner of the asset. In the open-ended lease, the lessee has the option of purchasing the asset at the end of the lease period.
In recent years, leasing has become a popular source of financing in India. From the lessee’s point of view, leasing has the attraction of eliminating immediate cash outflow, and the lease rentals can be deducted for computing the total income under the Income tax Act.
As against this, buying has the advantages of depreciation allowance (including additional depreciation) and interest on borrowed capital being tax-deductible. Thus, an evaluation of the two alternatives is to be made in order to take a decision. Practical problems for lease financing are covered at Final level in paper – Financial Services and Capital Markets.
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