Lease, Hire Purchase and Venture capital

Lease DefinedLease is a contract under which a lessor, the owner of the assets, gives right to use the asset to a lessee, the user of the assets, for an agreed period of time for a consideration called the lease rentals.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.Primary lease provides for the recovery of the cost of the assets and profit through lease rentals during a period of about 4 or 5 years. It may be followed by a perpetual, secondary lease on nominal lease rentals.

Types of LeasesOperating LeaseFinancing LeaseSale and Lease Back

Operating LeaseShot-term, cancelable lease agreements are called operating lease.Tourist renting a car, lease contracts for computers, office equipments and hotel rooms.The Lessor is generally responsible for maintenance and insurance.Risk of obsolescence remains with the lessor.

Financial LeaseLong-term, non-cancelable lease contracts are known as financial lease.Examples are plant, machinery, land, building, ships and aircrafts.Amortise the cost of the asset over the terms of the leaseCapital or Full pay-out leases.

Cash Flow Consequences of a Financial LeaseAvoidance of the purchase price.Loss of depreciation tax shield.Aftertax payments of lease rentals.

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 sale and lease back arrangements may provide substantial tax benefits.In April 1989, Shipping Credit and Investment Corporation of India purchased Great Eastern Shipping Company bulk carrier, Jag Lata, for Rs 12.5 Cr and then leased it back to GESC on a 5 years lease, the rentals being Rs 28.13 Lakh per month. The ships WDV was Rs 2.5 Cr.

Commonly Used Lease TerminologyLeveraged Lease.(three parties)Cross-border lease.Closed and open ended lease.Direct lease. (Mix of operating & financial lease)Master lease. (Period longer than assets life)Percentage lease. (Fixed rent + some % of previous years gross revenue)Wet and dry lease. (Financing & servicing)Net net net lease. (maintenance, tax & insurance)Update lease. (lessor agrees to replace in case of obsolescence)

Myths about LeasingLeasing Provides 100% FinancingLeasing Provides Off-the-Balance-Sheet Financing.Leasing Improves Performance.Leasing Avoids Control of Capital Spending.

Advantages of LeasingConvenience and Flexibility.Shifting of Risk of Obsolescence.Maintenance and Specialized Services.Fewer restrictive covenantsQuick implementationMatching of lease rentals to cash flow capabilities.

Evaluating a LeaseEquivalent Loan Method.Net Advantage of a Lease Method.IRR Approach.

Equivalent Loan MethodEL is that amount of loan which commits a firm to exactly the same stream of fixed obligations as does the lease liability.

MethodFind out incremental cash flows from leasing.Determine the amount of equivalent loan such cash flow can service.Compare the equivalent loan so found with lease finance.

Net Advantage of a Lease MethodThe direct cash flow consequences are:The purchase price of the asset is avoided.The depreciation tax shield Is lost.The after tax lease rentals are paid.The net present value of these cash flows at after tax cost of debt should be calculated. If it is positive lease is beneficial.

Combination of Net Present Value of Investment and Net Advantage of Leasing

Situation(a) NPV of Investment(b) Net Advantage of LeasingDecision1Positive PositiveLease2PositiveNegativeBuy3NegativeNegativeReject4NegativePositiveLease if a>b

Lease Benefits to Lessor and LesseeA lease can benefit both when their tax rate differs. Leasing pays if the lessees marginal tax rate is less than that of the lessor. In fact in a lease, the lessee sells his depreciation tax shield to the lessor.In the absence of taxes it is hard to believe that leasing would be advantageous if the capital markets are reasonably well functioning. Gain of both is loss to the government in form of taxes.

Internal Rate of Return ApproachIRR of a lease is that rate which makes NAL equal to zero.Ao = Purchase Price.L = Lease Rentals.DEP = DepreciationT = Tax RateOC = Operating CostSV = Salvage Value

Hire Purchase Financing: ConditionsThe owner of the asset (the Hiree can be the manufacturer or finance company) gives the possession of the asset to the Hirer with an understanding that the Hirer will pay agreed installments over a specified period of time.

The ownership of the asset will transfer to the hirer on the payment of all installments.

The Hirer will have the option of terminating the agreement any time before the transfer of ownership of assets. ( Cancellable Lease)

Difference

Hire Purchase FinancingLease FinancingHirer is entitled to claim Depreciation Tax Shield.Lessee is not entitled to claim depreciation tax shield.Hirer can charge only interest Portion.Lessee can charge the entire lease payments as expense for tax computation.Once the hirer has paid all instalments, he becomes the owner of the asset and can claim its salvage value.Lessee does not become the owner of the asset. Therefore he has no claim over the asset salvage value.

Venture Capital Financing

Venture capital play a strategic role in financing small scale enterprises & high technology & risky ventures.Risky capital & early stage financing.It is a financial innovation of twentieth century.Conventional financiers support proven technologies.Guidelines of SEBI govern the operations of VCFs.Examples : Apple, Google, Microsoft, Intel, Naukri.com, Biocon

*Features of Venture CapitalEquity Participation.Long-term Investments.Participation in Management.

Venture capitalist combines the qualities of bankers, stock market investors and entrepreneur in one.

Venture capitalist look for the following in ventures:Superior businessQuality & depth managementModern corporate governanceAppropriate investment structure (good deal)Exit plan

*Stages in Venture FinancingEarly Stage Financing(Seed financing, R&D financing, start up capital, first stage financing)2) Expansion Financing(second stage, development financing, bridge financing)3) Acquisition/Buyout Financing(Acquisition, Management buy out, Turnaround)

*Methods of Venture FinancingEquityConditional Loan (repayable in royalty form)Income Note (interest & loyalty)Other Financing MethodsParticipating DebenturesPartially Convertible DebenturesCumulative Convertible Preference SharesDeferred SharesConvertible Loan StockSpecial Ordinary Shares (with voting rights & no dividend)Preferred Ordinary Shares (with voting, dividend, share in profit rights)

*Venture Capital Investment Process

Deal Origination (referrals, active search & intermediaries)Screening (their familiarity in terms of technology, product, market scope, size of investment, location, stage of financing etc.)Evaluation (Subjective & comprehensive evaluation & also primary & detailed evaluation also risk analysis)Deal Structuring (deal terms, amount form & price of investment, protective covenants)Post-investment activity (Partner & collaborator)Exit (IPO, acquisition, purchase of share by promoter or outsider)

*Disinvestment Mechanisms of Venture capitalist.BuybacksInitial Public OfferingsSecondary Stock MarketsManagement Buyouts

*Development of Venture capital in IndiaIndustry is not in developed stage

Concept was formally introduced in 1987 when goverment announced creation of venture fund operated by IDBI

VCFs in India provide services like: managerial consultancy, technical support & information, equity participation , assist in obtaining term loans, working capital also in preparing business strategy resource identification,tetc

*Category of Venture capital in IndiaVCFs promoted by development finance institutions.(IDBI)VCFs promoted by State government(Gujarat Venture Finance Ltd.)VCFs promoted by Public sector banks (SBI-Cap)VCFs promoted by Foreign & private banks (Indus venture Fund)

*Entrepreneurs Role Entrepreneurs are drivers of innovations, of job creation and of economic development.Entrepreneurship should be advocated and supported by the entire business world.Entrepreneurs in developed economies consider the primary contribution of the venture capitalists to be other than financial.Assistance with recruitment, financial planning, strategic partnering and complex negotiations are important contributions of VCs.

*Entrepreneurial RequirementTo build entrepreneurial companies, there is need To develop service infrastructure.To reduce bureaucracy with regard to the creation of small businesses.To provide adequate incentives for entrepreneurs by reforming tax treatment of stock options and capital gains.To reform labour laws that takes into account the needs and limitations of small businesses.

*Future Prospects of Venture FinancingRehabilitation of sick units.Assist small ancillary units to upgrade their technologies.Provide financial assistance to people coming out of universities etc.

*Success of Venture CapitalEntrepreneurial Tradition.Unregulated Economic Environment.Disinvestment Avenues.Fiscal Incentives.Broad Based Education.Venture Capital Managers.Promotion Efforts.Institute Industry Linkage.R&D Activities.

CharacteristicsA separate project entity is created that receives loans from lenders and equity from sponsors.The component of debt is very high in project financing.The project funding and all its other cash flows are separated from the parent companys balance sheet.Debt services and repayments entirely depends on the projects cash flows. Project assets are used as collateral for loan repayments.Project financers risk are not entirely covered by the sponsors guarantees.Third Parties like suppliers, customers. government and sponsors commit to share the risk of the project.

Project Financing ArrangementsThe Build Own Operate Transfer Structure.The Build Own Operate Structure.The Build Lease Transfer Structure.

Project Financing Risk and their AllocationRisksProject Completion RiskMarket RiskForeign Currency RiskInputs Supply RiskRisk MitigationBy GovernmentCountry RiskSector Policy RiskBy OthersCommercial Risk

Project FinancingScheme of financing a particular economic unit in which a lender is satisfied in looking at the cash flows and the earnings of that economic unit as a source of funds, from which a loan can be repaid and to the assets of the economic unit as a collateral for the loan.It is different from the traditional form of financing, i.e., the corporate financing or the balance sheet financing.