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Asset based financing

Aug 19, 2014

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IntroductionThe traditional financing is related to the liability side of the balance sheet. The firm issues long-term debt or equity to meet its financing needs, and in the process, expands its capitalization. The dangers of traditional financing are that equity becomes an expensive method of financing because of decreasing corporate earnings and low price ratios. The high rate of inflation causes long-term debt that is an expensive source of financing as interest rates rise. The corporate finance managers therefore are developing financing alternatives related to the asset side of the balance sheet. These alternatives may lower the cost and redistribute the risk. Asset based financing uses assets as direct security. There are 3 main types: Lease Hire purchase Project financing

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Lease FinancingLeasing is used widely in the western countries to finance investments. USA has the largest leasing industry in the world and lease financing contributes approximately one third of total business investments. In the changing economic and financial environment of India, it has assumed an important role.

What is lease?Lease is a contract between a lessor, the owner of the asset, and a lesse, the user of the asset. Under the contract, the owner gives the right to use the asset to the user over an agreed period of time for a consideration called the lease rental. The lessee pays the rental to the lessor as regular fixed payments over a period of time at the beginning or at the end of a month, quarter, half-tear or a year. Although generally fixed, the amount and timing of payment of lease rentals can be tailored to the lessees profit or cash flows. In up-fronted leases, more rentals are charged in the initial years and less in the later years of the contract. The opposite happens in back-ended leases. At the end of the lease contract, the asset reverts to the lessor, who is the legal owner of the asset. As the legal owner, it is the lessor and not the lesse, who is entitled to claims depreciation on the leased asset. In long-term lease contracts, the lesse is generally given an option to buy or renew the lease. Sometimes, the lease contract is divided into 2 parts- primary lease and secondary lease for the purpose of lease rentals. Primary lease provides for the recovery of the cost of the asset and profit through lease rentals during a period of about 4-5 years. A perpetual, secondary lease may follow it on nominal lease rentals. Various other combinations are possible.

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Although the lessor is the legal owner of a leased asset, the lesse bears the risk and enjoys the returns. The lesse benefits if the leased assets operates profitably, and suffer if the asset fails to perform. Leasing separates ownership and use as 2 economic activities and facilities asset use without ownership. A lesse can be individual firm or a firm interested in the use of an asset without owning. Lessor may be a equipment manufacturer or leasing companies who bring together the manufacture and the users. In USA equipment manufacturers are the largest group of lessor followed by banks. In India, independent leasing companies form the major group in number in the leasing industry. Banks together with financial institutions such as the Industrial Credit and Investment Corporation of India are the largest group in terms of the volume of business.

Three party lease1st party

LessorEquipment

2nd party

Equipment

Manufa cturer or dealer

3rd party

Lessee

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LF L L E E V A E I N A N C I A

EL

AL

SNE

I NA O SN

GI - N F GI N A N C

R S A A G L E FD A I N N AD NS CH I O A R L L T O - T N E G R - MT S L E E S A S E L B E A A C S K LE ES A S LE ES A S E S O L P E E A R S A E T S I N G

Types of leasesTwo types of leases can be distinguished. Operating lease Financial lease

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Operating lease:Short term, cancelable lease agreements are called operating leases. Convenience and services are the hallmarks of operating leases. Example: a tourist renting a car, lease contracts for computers, office equipment, car, trucks, and hotel rooms. For assets such as computers or office equipment, an operating lease may run for 3-5 years. The lessor is generally responsible for maintenance and insurance. He may also provide other services. A single operating lease contract may not fully amortize the original cost of the asset; it covers a period considerably shorter than the useful life of the asset. Because of the short duration and the lessees option to cancel the lease, the risk of obsolescence remains with the lessor. Naturally the shorter the lease period and/or higher the risk of obsolescence, the higher will be the lease rentals.

Financial leaseLong-term, non-cancelable lease contracts are known as financial leases. Example: plant, machinery, land, building, and aircrafts, in India financial leases are very popular with high-cost and high technology equipment. Financial leases amortize the cost of the asset over the term of lease; they are, therefore also called capital of full-payout leases. Most financial leases are direct leases. The lessor buys the asset identified by the lesse from the manufacturer and signs a contract to lease it out to the lesse.

Sale and lease backSometimes a user may sell an (existing) asset owned by him to the lessor (leasing company) and lease it back from him. Such a sale and lease back arrangements may provide substantial tax benefits. For example in 1989, Shipping credit and Investment Corporation of India purchased Great Eastern Companys bulk carrier, Jag Lata for Rs.12.5 crore and then leased it back to the

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Great Eastern on a five year lease, the rentals being Rs.28.13 lakhs per month. The sips written down book value was Rs. 2.5 crore. In financial lease, the maintenance and insurance are normally the responsibility of the lesse. The lesse also bears the risk of obsolescence. A financial lease agreement may provide for renewal of contract or purchase of the asset by the lesse after the contract expires. The option of purchasing the leased asset by the lesse is not incorporated in the lease contract in India, because if such an option is provided the lease is legally constructed to be a hire purchase agreement.

Cash flow consequences of a financial leaseA financial lease has cash flow consequences. It is a way of normal financing for a company. Suppose a company has found it financially worthwhile to acquire an equipment costing rs. 9 crore. The equipment is estimated to last eight years. Instead of buying the company can lease the equipment for eight years at an annual lease rental of Rs.1.6 crore from its manufacturer. The company will have to provide for the maintenance, insurance, and other operating expenses associated with the use of the asset in both alternatives-lease and buying. The following are the consequences: Avoidance of the purchase price- The company can acquire the asset without immediately paying for it. Cash outflow saved is equivalent to a cash inflow; there is a cash inflow of Rs. 8 crore. Loss of depreciation tax shield Depreciation is a deductible expense and saves taxes. Depreciation tax shield is equal to the amount of depreciation multiplied by the tax rate for each of the eight years. The company will lose a series of depreciation tax shields when it takes the lease. Thus cash flow consequences depend upon the company and the nature of its business transactions.

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Advantages of Leasing If an asset is needed for a short period, leasing makes sense. Buying an asset and arranging to resell after use is time consuming, inconvenient and costly. Long-term financial leases also offer flexibility to the user. In India borrowing from banks and financial institutions involve long, complicated procedures. Institutions often put restrictions on borrowers, stipulate conversion of loan into equity and appoint nominee directors on the board. Financial leases are less restrictive and can be negotiated faster, especially if the leasing industry is well developed. Yet another advantage of a lease is the flexibility it provides to tailor lease payments to the lessees cash flows. Such tailored payment schedules are helpful to a lease that has fluctuating cash flows. New or small companies in nonpriority sectors, such as confectionaries, bottlers and distilleries find it difficult to raise funds from banks and financial institutions in India. When the technology embedded I the assets, as in a computer is subject to rapid and unpredictable changes, a lessee can, through a short-term cancelable lease, shift the risk of obsolescence to the lessor. A manufacturer-lessor, or a specialized leasing company, is usually in a better position than the user to assume the risk of obsolescence and manage the fast advancing technology. Specialized leasing companies are emerging in India, for example The Standard Leasing Company leases medical equipments, the Apple leasing company leases computers and the Industrial Credit and Investment Corporation of India specializes in leasing for technology development. In fact in such situations the lessee is buying an insurance against obsolescence, paying a premium in terms of higher lease rentals.

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With a full service, a lessee can look for advantages in maintenance and specialized services. For example computer manufacturers who lease out computers are better equipped than the user to provide effective maintenance and specialized services. Their cost too may be less than what the lessee would have to incur if he were to maintain the leased asset. The lessor is able to provide maintenance and other services cheaply because of his larger volume and specialization. He may pass on a part of that advantage to the lessee. Certain types of lease fin