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
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.
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
Manufa cturer or dealer
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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
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
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.
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.
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 financing are not shown on the balance sheet of the lessee. Therefore these leases do not raise the debt equity ratio nor impair the borrowing capacity of the firm. The current and acid test ratios are not affected by operating leases either. Lease financing conserves working capital. Leases typically require a smaller down payment than do installment loans. Moreover, unlike many bank loans, no compensating balances are required. Delivery and installation charges can often be included as part of each future lease payment which also conserves working capital. Since cash flow is a prime concern in most businesses, opting the lease route is beneficial because it does not require the initial outflow of funds for sales tax, as would the purchase. Some states levy a sales tax as high as 10%. Clearly this has a significantly undesirable impact o cash flow. Leasing permits postponement of taxes because sales tax is charged as a percentage of each future lease payment. Generally one of the criteria used by a lessor in determining the lease price is level of usage of the asset by the lessee. If the lessee expects to use the asset more than average, leasing the asset may prove beneficial.
Disadvantages of Lease Financing Some leases do require down payments in the form of lease or rental payments in advance. The number of advance payments is partially determined by the riskiness of the lessee. If a borrower has a well established working relationship with a bank then the terms of an installment loan can be structured to match the term of any competing lease arrangement, including no down payment and financing of delivery and installation charges as part of the equipment loan. Some states levy a sales tax on the monthly lease payment. This tax is usually included as a part of the periodic payment. Since the monthly payment includes maintenance and implicit interest costs, more sales tax is being paid over the life of the lease than if the tax was levied on the purchase price only. In effect sales tax is being paid on maintenance and interest. However the after tax present value of these costs in many cases is less than paying the total sales taxes due at the inception of the lease. Although it is true that lessors consider the expected usage in their profit calculations, their returns are usually sufficiently large to provide a cushion. Consequently it is unlikely that the lessee will be able to gain any real advantage from excess usage. Even if the lessor has been taken advantage of, it will probably happen only once. A lease should require the same capital budgeting analysis as a purchase since both are basically alternative forms of financing. If timing is so critical then the capital budgeting department had best shorten its processing time. Such action would be preferable to transacting leases without proper analysis.
Tax advantages exist only if the lessee can take advantage of the additional tax shield offered by the lease agreement. In fact there are generally more tax advantages to buying than leasing since the buyer can use accelerated depreciation and obtain an investment tax credit and deduct the interest portion of debt installments. Although leasing might be more steady and predictable in terms of cash outflow than short-term financing, it is less desirable than long-term bond financing. Bonds are frequently issued at lower interest rates than the interest implicit in leases, and bonds are not required to be paid off for periods of 15-20 years. The lessee will benefit from relinquished tax benefits only if the lessor passes on the resulting savings in the form of lower lease payments. All too often these tax savings are not passed on to the lessee. It is important to note that the lessor also assumes the risk of obsolescence and therefore builds this into the cost of the lease payment. Obsolescence is frequently over emphasized. Many outdated computers are still doing the work they were intended for. Purchasing might therefore might cost less than leasing if obsolescence is not considered a real threat or problem. Unless the lessor can pass on to the lessee economies derived from access to secondary markets, quantity discounts and intensive use of maintenance facilities, such leases usually offer very little real savings. A lease that contains a variable residual is preferable to a variable payment lease. Nevertheless such leases are still expensive alternatives to buying or to leasing under a conventional fixed payment lease. 10
Risk Assessment of a LesseeThe first step in structuring a lease is for the lessor to evaluate and then quantify the risk inherent in the lease. Risk results from the degree of credit worthiness of the lessee combined with the collateral and residual value of the equipment to be leased. In general if the lessor deems a lease risky, any of the following variables might be affected: 1. Lease yield increased with all other factors except payment amount remaining constant 2. Additional advance payments required. 3. Security deposit required or increased. 4. Guaranteed residual required in lieu of a purchase option. 5. Lease term shortened. 6. Personal guarantee required. 7. Additional collateral beyond the leased equipment. 8. Increased late fees for delinquent rental payments (5% if 10 days late plus 18% interest for e.g.) 9. Security interest obtained to facilitate repossession 10. All insurable risk insured.
Assignment of the risk inherent in a lease transaction is primarily a credit worthiness decision. Many lessors as well as bankers or other moneylenders base their evaluation of risk on the 10 Cs. They are: Character Capacity Capital Credit Conditions Competition Collateral Cross-border Complexity Currency
Lessor RequirementsOnce the lessor has assessed the risk and credit worthiness of the lessee and converted that into structuring variables, the lessor must look to its remaining needs and then to the requirements of the lessee. Meeting the sometimes conflicting needs of the lessor and lessee represents the more difficult part of lease structuring. Sometimes a lessor will insist on structuring an operating lease in order to retain tax benefits while at the same time the lessee desires a capital lease so it too may avail itself of the depreciation and tax benefits. Typical lessor requirements that might be at variance with lessee needs in lease structuring are: A yield sufficient to meet the lessors after-tax weighted cost of capital Accounting for the lease on the lessors books as a capital lease. Tax structure of the agreement as an operating lease to obtain tax benefits. A net lease rather than a full service lease Residual dependence- the lessor may want the equipment purchased by the lessee to avoid resale problems. On the other hand the lessor may want the equipment returned at the end of the lease due to its increased value.
Leveraged leaseUnder a leveraged lease, four parties are involved: the manufacturer of the asset, the lessor, the lender from whom the lessor borrows a substantial portion of the assets purchase price and the lessee. In a direct lease, the lessor buys the asset and becomes the owner by making the full payment of the asset. In a leveraged lease, the lessor makes substantial borrowing, even up to 80% of the assets purchase price. He provides the remaining amount- 20% or so as equity to become the owner. The lessor claims all tax benefits related to the ownership of the asset. Lenders, generally the large financial institutions provide loans on a non-recourse basis to the lessor. Their debt is serviced exclusively out of the lease proceeds. To secure the loan provided by lenders, the lessor also agrees to give them a shortage on the asset. Thus lenders have the first claim on the lease payments together with the collateral on the asset. Lenders will take charge of the asset if the lessee is unable to make lease payments. Leveraged lease is called so because the high no-recourse debt creates a high degree of leverage. The effect is to amplify the return of the equity-holder ie the lessor. But the risk is also quite high if the lease payments are not received. Leverage lease is quite useful for large capital equipment with long economic life say 20 years or more. It is one of the popular means of financing large infrastructure projects.
Steps in the formation of a lease contract The lessee decides on the precise nature of type of equipment that he proposes to purchase. The lessee then approaches the manufacturers or vendors who deal in the equipment required and begins negotiations The lessee simultaneously makes an application to a lessor stating his intention to enter into a lease agreement. The lessee may approach more than one lessor, in which case negotiations are carried out and a lessor offering the most convenient terms is chosen. The lessee completes negotiations with the supplier or suppliers, as the case may be, and the purchase agreement is communicated to the lessor. The lessee is expected to furnish such details to the lessor as: the specification of the equipment, the price, the terms of payment, terms of warranties, delivery period, installation costs, and other costs pertaining to the equipment into operation. The negotiations between the lessor and the lessee are finalized with respect to the length of the lease period, the distribution of rentals over the period, the amount of rentals to be collected and the mechanism of collecting rentals. The lessee is then allowed to take the possession of the asset, for which, the necessary ownership papers are processed in favor of the lessor. The lessor undertakes to pay the supplier on the terms agreed to between the supplier and the lessee. The lessee in turn undertakes to take full
responsibility for the performance of the equipment. To this end the lessee is expected to provide a certificate to the lessor, that the lessee has inspected the equipment and that it is as per the specifications asked for. The lessee is further expected to certify that the equipment is in good working condition and that it can be used for the purpose for which it was obtained. The lessor makes the payment to the supplier and lessee takes the possession of the asset. The lessee continues thereafter to discharge his obligation under the lease agreement.
The structure of a lease agreementA lease agreement is a statement indicating the intention of the parties concerned and a document providing the terms and conditions under which the performance of the intention is to be undertaken. A lease agreement therefore is a set of self-made and mutually acceptable rules of a commercial transaction that is consistent with law. Most lease agreements contain the following provisions: 1) The lease transaction 2) Title, identification, and ownership of the asset 3) Costs of maintenance and use 4) Liabilities of lessee 5) Liabilities of lessor 6) Default of lessees 7) Remedies in the event of default 8) Arbitration
(1) The lease transaction: The central part of every lease transaction pertains to the lease rental, terms of payment, and the period of lease. The lease rental is normally a matter of negotiation and is determined by such factors as the current market rate of lease rental and the period of the lease. It goes without saying that the lease rental must in itself reflect the economics of commercial viability on the part of the lessor and the lessees. The terms of payment cover such factors as the mode of payment, the periodic intervals, the precise amounts becoming due at various due dates and so on. The period of the lease states the period in terms of days, or months, or years as being the period during which the lessee has a right to use the asset subject to the conditions of the lease being fulfilled. Both the period of the lease and the terms of payment have an effect on the lease rental determination. In the case of financial leases, the normal practice is to restrict the lease period to eight years, where investment is available, which is consistent with the carry-forward period available under the income tax act. (2) Title, ownership and identification of asset: The legal title of the asset resides with the lessor. This is so stated explicitly in the agreement. Hence all accounting charges associated with ownership are claimed by the lessor, which is also explicitly provided in the agreement. (3) Costs of maintenance and use: The costs of maintenance and use may either be borne by the lessor or the lessee. In the case of financial leases the maintenance costs are borne by the lessee and in the case of operating leases the maintenance costs are borne by the lessor. The reasons for such differences in the agreements relating to maintenance costs revolve around the term of the contract. Financial leases being for relatively longer periods of time, one lessee enjoys the best part of the assets useful economic life. Operating leases are for relatively shorter periods of time and more than one lessee uses the asset over its economic life.
(4) Liabilities of lessee: Express provisions highlighting the liabilities of the lessees with respect to the implementation of the contract are provided. These express provisions normally relate to insurance, quality of asset, safety, damage, and surrender. In case of insurance the responsibility to pay insurance may rest either with the lessor or the lessee. The traditions that have evolved however link maintenance costs to insurance, in the sense that whoever bears the maintenance costs also bears the insurance costs. In the case of financial leases therefore the lessee ends up paying the insurance costs and enters a net lease agreement. The lessor has an unconditional right to inspect the asset, and an equally unconditional indemnity against any defect in the performance or construction of the asset. The lessee in most cases is required to provide a certificate that it has inspected the asset before any payment is effected. In its use the lessor would not be responsible for any loss, theft or damage to the asset. The lessee is expected to indemnify the lessor against such possibilities. This may vary slightly with respect to operating leases of certain types (e.g. cars, cycles etc.) where the lessor would be required to provide a reasonable opportunity for inspection. In most cases however it would be the sole responsibility of the lessee to inspect and pass the asset for use. Further every lease-deed would contain an express clause that specifies the return of the asset to the lessor unless the purchase option is exercised. This again is the responsibility of the lessee, who undertakes to return the asset to a place desired by the lessor at the end of the lease period. (5) Liabilities of the lessor: normally lease deeds contain numerous clauses on the lessees duties and responsibilities and virtually none fo the lessor. The lessors responsibility starts and stops with the payment of the money for acquiring the asset, and the lessor does not undertake any responsibility for the performance, in the case of a financial lease. In the case of a contract hire, or operating leases, the lessor is responsible for the upkeep of the asset. The implied condition of hire is that the asset is fit for use. Thus in the case of a car
being hired on day-to-day basis the car must be in good working condition for use. Some lease-deeds may also specify that the responsibility for actually carrying out the maintenance and repairs on the asset rest with the lessee, while the lessor simply undertakes to bear the cost. Such a method may seem reasonable where maintenance activity schedules can be drawn up accurately. E.g. if a machine needs to be oiled and greased for every 8 hours of operation, such tasks can be undertaken by the lessee, rather than the lessor. (6) Default of lessees: Lease agreements normally provide clauses specifying the exact deeds or actions that will be constructed as default on the part of lessees. Any of the following events may be termed as default: Lessee fails to pay money due Lessee fails to observe any covenant, condition, or agreement specifically mentioned in the lease deed. Lessee attempts to remove, sell, transfer, encumber, part with possession or sublet without lessors consent. Lessee becomes insolvent. Lessees financial condition materially deteriorates and the lessor considers the equipment to be insecure. A lessee may be considered to have defaulted in an agreement, if with the same lessor, the lessee has defaulted with any other agreement. The lease agreements may provide for grace periods for payment of any money, or for submitting any documents or papers. The normal practice followed in the case of default is that the lessor sends a written notice by hand delivery or 20
by registered post specifying that the lessee is at fault, and this may or may not be followed by reminders. The lease-deed specifies the precise procedure to be followed in this regard. (7) Remedies: The lease agreement provides also for the remedial action to be undertaken in the event of default. Once the lessee has committed an act of default, the provisions of the Contract Act 1872 govern further actions. The underlying principles of remedies are that where there is a right, there must exist a remedy for any breach of that right. A remedy is the means given by law for the enforcement of a right. As per the provisions of the Contract Act, in the case of a breach of contract by one the assenting parties, the other party may: Rescind the contract Sue for damages Sue for quantum merit Sue for specific performance Sue for an injunction There exists a specific circumstance under which the aggrieved party has an option to follow any specific course of action. Stemming from such authority provided by law, lease agreements may have any or all the following remedial actions specified in the deed.
The lessor with an interest that must be specified in default may claim the amount. All future rentals, including the purchase price option, if any becomes payable to the lessor. A time period may be specified for such a payment. The lessor may terminate the contract. The lessor may demand that all equipment leased under the contract be returned at the lessees risk and cost. The lessor may also dispose of the equipment under the contract through sale or any other form of transfer. The lessor may also at its option waive a default, by an express provision to this effect or by implication or by a written notice on the happening of the act of default. (8) Arbitration: The lessor and the lessee may agree to an arbitration procedure in the case of any dispute. An arbitration agreement must be in writing to be valid, though, it is not necessary to name the arbitrators at the time of drawing up the lease deed. Matters pertaining to the process of arbitration are subject to the Arbitration Act 1940. (9) Miscellaneous provisions: In addition to the main points mentioned, the lease deed may have other clauses on any major issue pertinent to the transaction being undertaken. Further the manner in which the lease deed is to be administered and the implementation of the contract may be specified. Thus it may provide all communication between the lessor and the lessee be in the form of registered post only as no verbal transmission of information would be given 22
cognizance. The lease deed so drawn would be the legal basis for any dispute that may arise in the future and is the basis on which the performance of the contract depends. Finally the lease agreement though bound by law in its provisions can be a matter of traditions and customs. In the simplest terms the parties entering into an agreement draw up the rules and regulations to which their association would be subject to. These rules and regulations are contained in the lease-deed. So long as they dont infringe upon some legal prohibitions, the concerned parties are free to make any rules of their choice.
Hire purchase financingHire purchase is a popular financing mechanism especially in certain sectors of Indian business such as he automobile sector. In hire purchase financing, there are three parties: the manufacturer, the hiree and the hirer. The hiree may be a manufacturer or a finance company. The manufacturer sells asset to the hiree who sells it to the hirer in exchange for the payment to be made over a specified period of time. A hire purchase agreement between the hirer and the hiree involves the following three conditions: The owner of the asset (the hiree or the manufacturer) gives the possession of the asset to the hirer with an understanding that the hirer will pay the 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 the asset. Thus for the hirer the hire purchase agreement is like a cancelable lease with a right to buy the asset. The hirer is required to show the hired asset on his balance sheet and is entitled to claim depreciation, although he does not own the asset until full payment has been made. The payment made by the hirer is divided into two parts: interest charges and repayment of principal. The hirer thus gets tax relief on interest paid and not the entire payment.
How does hire purchase work?When a customer buys goods on hire purchase there are three parties involved The customer who buys the goods The retailer who sells the goods The finance company who provides the finance
You make the initial agreement with the customer. Once the security agreement has been signed you are likely to assign the agreement (including your security interest in the goods) to the finance company. The customer makes payments to the finance company. Whether the security interest will revert back to you will depend on the terms and conditions of your agreement with the finance company.
The normal tripartite hire purchase process between the dealer, customer and the finance company is as follows: When the business connection between the finance company and
the dealer is first established a master agreement may be drawn up regulating the conditions upon which the finance company is prepared to consider the hire purchase transactions submitted by the dealer. After the customer has selected the goods he desires to acquire on hire purchase, the dealer arranges for him to complete the schedule to a form of hire purchase agreement. The larger finance companies have their own standard forms of printed agreement. In the schedule to the hire purchase agreement the dealer will insert the hirers name, address, occupation, and certain other details indicating his financial standing. It is also the dealer responsibility to insert details about the price and the installments payable. 25
The intending hirer is often required to make a down payment as an
indication of the customers financial reliability. The deposit or down payment is usually paid to the dealer at the time the proposal form is completed and is normally retained by him as a payment on account of the price to be paid to him by the finance company. The deposit having duly paid the dealer sends the appropriate set of documents to the finance company, requesting the company to purchase the designated goods from him. If the finance company decides to accept the transaction, the hire purchase agreement is signed by one of its officers and a copy dispatched to the hirer with instructions as to the mode of the installments. At the same time as a copy is sent to the hirer, the finance company notifies the dealer that the proposal has been accepted and that it is in order for the dealer to deliver the goods, if he has not already done so. Upon notification of acceptance the dealer delivers the goods to the hirer and obtains the hirers signature to a form of delivery receipt constituting an acknowledgement by the hirer that he has received the goods in proper condition. of hire On completion of the hire term, the finance company issues to the dealer a completion certificate whereupon the hirer becomes the owner of the asset. The hirer makes payment of hire installment throughout the period
Key features of Hire Purchase:
Repayment schedules are flexible. An Offer to Hire can be arranged with no deposit or an amount that suits you. Balloon payments at the end of the term can be arranged. Esanda owns the goods until the final payment is made, at which point you gain automatic ownership. The interest component of the rental and depreciation on the equipment are tax deductible, provided it is used to produce assessable income or the expense is necessarily incurred in carrying on a business.
Hire Purchase Financing
sells asset to
hires asset to
What law applies to a hire purchase?Hire purchase sales must comply with the Hire Purchase Act 1971. Where a customer is paying more than the cash price of goods (e.g., with interest added) the sale must also comply with the Credit Contracts Act 1981. Where the customer fails to pay their installments or puts the goods at risk, the finance company or you as the seller must comply with the Credit (Repossession) Act 1997 if the goods are "consumer goods" (if the goods are not "consumer goods" then the Personal Property Securities Act 1999 will apply). Sale of goods on hire purchase is also subject to the Fair Trading Act 1986 and the Consumer Guarantees Act 1993.
Credit Contracts Act 1981The Act covers loan and hire purchase contracts that have a value not exceeding $250,000. If the customer has several loans with the same finance company the $250,000 rule will apply to the total of those loans. There must be a charge for providing the credit (e.g., the amount repaid by the customer must exceed the cash price of the goods). The Act sets out information that must be in the contract (the rules about disclosure). One must state: The cash price of the goods The amount of credit The total cost of credit The finance rate Name and address of the creditor The rate, frequency, and number of installments, when
payment is due, and who payment is made to 28
The right to cancel within three working days, and All other terms of the contract.
Hire Purchase Act 1971The Act sets out writing The particular format for that contract Rules for assigning a hire purchase Rules for early settlement of the contract Rules for variations to the contract. The requirement to provide a hire purchase contract in
Hire Purchase vs. Lease FinancingBoth hire purchase and lease financing are a form of secured loan. Both displace the debt capacity of the firm since they involve fixed payments. However they differ in terms of the ownership of the asset. The hirer becomes the owner of the assets as soon as he pays the last installment. In case of lease, the asset reverts back to the lessor at the end of lease period. In practice the lessee may be able to keep the asset after the expiry of the primary lease period for nominal lease rentals.
The following are the differences between hire purchase and lease financing: Hire purchase Lease financing
1. Depreciation- Hirer is entitled to 1. Depreciation- lessee is not entitled claim depreciation. to claim depreciation.
2. Payments- hirer can charge only 2. Payments- lessee can charge the interest payments computation. 3. Salvage value- Once the hirer has 3. Salvage value- Lessee does not paid all installments; he becomes the become salvage value. the owner of the asset. owner of the asset and can claim its Therefore he has no claim over the assets salvage value. portion as of hire purchase entire lease payments as expenses for for tax tax computation. expenses
Principle types of hire purchase
1. Consumer installment creditThe ground for distinction here is whether the goods are producer goods or consumer goods. Finance provided to consumers for acquisition of consumer durables is called installment credit. Installment credit for consumers is usually extended in one of the following forms: (a) Personal loan: this is made directly by the lending a dealer may introduce company through the consumer. The loan may be unsecured or secured. E.g. by a mortgage on the borrowers property. (b) Hire purchase or conditional sale: here funds are advanced for the acquisition of particular goods, which the customer take under a hire-purchase or conditional sale agreement, acquiring title on completion of payment. Where title is reserved in this way the agreement usually used is a hire purchase agreement, though some companies use conditional sale agreements. Retail hire purchase agreements take three different forms namely Direct collection- the dealer sells the goods to the finance house, which lets them out on hire purchase to the customer. This is the most common form of installment financing and is known in the trade as direct collection because the installments are collected under a hire-purchase agreement concluded direct between the finance house and the hirer, as opposed to an agreement between the dealer and the hirer which is later discounted under block-discounting agreement. Usually the finance house collects the installments itself from the hirer, and the dealer drops out of the transaction. Such transactions are called non-recourse for the dealer.
Agency collection: this is a variant of direct collection. As before the dealer sells goods to the finance company but in this case signs the agreement himself as undisclosed agent for the finance company and as
such agent collects installments on behalf of the company, usually in return for appropriate commission. Because the agreements are in practice handled in blocks, this form of hire purchase is also misleadingly referred to as agency block discounting, though it is not a form of block discounting at all since there is no assignment of the agreement by the dealer to the finance company and the dealer is acting merely as an agent. Block discounting: in this case the dealer enters into the hire purchase agreement direct with the customer and later discounts it to the finance company. Agreements are usually discounted in blocks at a time; hence it is called block discounting. Once the agreement is discounted the finance company becomes entitled to receive rentals from the hirer concerned but quite commonly, in order not to disturb the business relationship existing between the dealer and his customer, the dealer is made responsible for collecting the installments and remitting these to the finance company. (c) Credit sale: here the title passes to the customer from the outset. Again the agreement may be with the finance house from the beginning or it may be entered into between the dealer and customer direct and later assigned by the dealer to the finance house. (d) Rental: the renting of domestic goods is fast developing as a form of installment credit. It is increasingly the practice and to a very larger extent in the U.S., of finance houses to enter direct into rental agreements relating to domestic goods.
DOCCUMENTS IN HIRE PURCHASE
All the parties must sign a hire purchase agreement and the agreement, among other things, must specify the date when the hiring commences, the number of installments, the amount of each installment, the time for the payment of each installment, the description of the goods and where the goods are kept. Note that the agreement must be in writing. An oral agreement is not a valid hire purchase agreement.
Benefits of Hire Purchase Retention of cash flow Regular Payments Existing credit lines preserved Cost of acquisition spread overtime Repayment schedules can be structured to suit your cash flow. You can obtain the use of goods for minimal cash outlay, so working capital is not significantly affected. You may be able to make use of the taxation benefits of hiring.
The Hire Purchase AgreementWhen you buy goods on hire purchase, you and the seller sign a written agreement. How many agreements will be made How often to pay The amount to pay When to pay Where to pay The name and address of the seller
Other information in the hire purchase agreement What happens if payment is not made as agreed The right to repossess goods if one fails to make payments on time Ones obligation to keep the goods safe and in good order How to return the goods if one cannot pay. This information may be in the fine print on the back of the agreement. If any of this information is missing from the agreement one may not be liable for some of the cost of credit. The agreement cannot be enforced until the required information has been supplied.
Termination of a hire purchase agreement.Every hire purchase agreement must by definition confer on the hirer a power of termination, if the absence of such power would commit the hirer to paying either the whole price or all but a nominal sum. Omission of any provision entitling the hirer to terminate will result in the agreement being characterized as a conditional sale agreement and not a hire purchase agreement. A hire purchase agreement may terminate in the following ways: Under the agreement itself By performance By subsequent agreement By notice at common law independent of agreement By acceptance by one party of the other partys repudiation By release By waiver By merger By frustration
Under the hire purchase agreement
In the first case it is usual for hire purchase agreement to stipulate the circumstances in which the agreement should be terminated. The most common causes of termination by virtue of the agreement are the return of the goods by the hirer, notice of termination by the owner, notice of termination by the hirer, breach by the hirer. In the second case a hire purchase agreement usually comes to an end by performance a soon as an option to purchase has been exercised. This is not necessarily conterminous with the end of hiring, since the agreement may provide that the option to purchase shall be exercised by payment of a further nominal sum after the expiration of the period of hire. Thirdly, the parties may at any time make a fresh agreement terminating the contract concluded between them, provided that such contract has not already come to an end. The new agreement may simply release both parties from their obligations under the original agreement without doing anything further or it may substitute new obligations for those released. Fourthly, there are two cases where even at common law the hire purchase agreement can be determined by notice given by either party. The first is where one party has repudiated his obligations under the agreement to an end by notifying the other party that the unlawful repudiation has been accepted. The second case is where the hiring I periodic one, that is for an indefinite term running month to month or year to year, the hirer having an option to purchase the goods by making a payment which, when added to the total rent paid, amounts to the stated price.
In the fifth case, where a party to the agreement renounces his future obligations or commits a breach of the agreement such as to indicate an intention no longer to be bound by its provisions and the other party accepts the renunciation or breach discharging the contract. However where the hirer does not renounce the agreement. But is merely guilty of failure of performance, the owner will not be entitled to treat the agreement as repudiated unless the hirers default goes to the root of the contract. The sixth case is one where a hire purchase agreement has been completely performed by one party but there are obligations remaining unfulfilled by the other, the former agrees to release the latter from the outstanding obligations, and thereupon if the release be legally operative, the agreement will come to an end. A release being a unilateral discharge by one party shall be legally operative only if it is either given by a written deed or is supported by consideration, failing which the release will be inoperative for want of consideration. Seventhly, waiver may also determine a hire purchase agreement. A waiver is an intentional relinquishment of a known right. Waiver is a distinct release, as in the latter there has to be release under the seal or for a consideration. If a party grants a release that is not under the seal or for a consideration, the party shall be estopped from denying the efficacy of the release. Eighth is the case of merger. Where the obligations of a party to a contract become embodied in a security of a higher order, then the original contract is merged by operation of law into the higher security and is extinguished in absence of a contrary intention of the parties. In a hire purchase agreement, where an agreement not under the seal is followed by a deed under seal between the same parties relating to the same goods, then unless a contrary intention on the part of the parties is established the later document will be deemed to have extinguished and replaced the earlier.
Ninth, where complete or substantial performance of the agreement becomes impossible by reason of some act or event occurring subsequent to the formation of the agreement, the supervening impossibility will in certain circumstances automatically determine the agreement and discharge the parties from further liability thereunder. Lastly the hire purchase act, 1972 also contains specific instances where the owner or the hirer may terminate the agreement.
Who can get HP?Any person can choose to buy on hire purchase. But some retailers will not enter into a hire purchase deals where the buyer's credit history shows to the retailer that they are a poor credit risk. Buyers who present a risk to the finance company may require a co-borrower or a guarantor before credit approval is given. Younger borrowers (those over 16) may be asked to provide a guarantor either because they have no credit history or have only just started working making it difficult for the retailer to assess the credit risk. Retailers and finance companies must comply with the Human Rights Act. This means that they cannot deny credit only on the basis of gender, marital status, race, color, religious or ethical belief, national or ethnic origins, disability, political opinion, employment status, family status, sexual orientation, or age.
Finance companiesShops often have an arrangement with a finance company to provide the hire purchase finance. One makes the payments to the finance company, not to the shop. The name of the finance company will be on the hire purchase agreement. In most cases one pays more than the price on the price tag. Hire purchase includes interest and other administrative costs. E.g. A shop offers fridges for $800 cash or "credit over 24 months". One pays a deposit at the shop, signs and agreement and the fridge is delivered home. One pays the rest of the money in monthly installments to a finance company named in the agreement. One pays back more than $1000 because interest and other costs are added to the cash price.
Insurance and hire purchaseInsurance against theft, loss or damage: Law does not require this insurance but the seller can insist the goods are insured for theft, loss or damage. If one has household insurance one may not wish to buy separate insurance for the goods. When one goes shopping for goods on hire purchase, one must take proof of having up-to-date insurance. If one has household insurance seek advice if the seller insists one must have additional and separate insurance for the goods on hire purchase. This may be considered and oppressive condition. One may agree to separate insurance cover for the goods. The seller may then decide which company one must insure the goods with. The cost of insurance must be at reasonable market rates. If one doesnt have insurance and the goods are stolen, lost or damaged, one may have to keep on paying for the goods.
Repayment or Consumer Protection InsuranceConsumer protection insurance (CPI) offers to make the payments for a set time if one loses your income through illness, accident or redundancy. This insurance is also called payment protection insurance or repayment insurance. Law does not require this insurance but some shops make it a requirement for taking out hire purchase with them.
Cancellation of the HP agreementIf the goods are not taken home one may cancel the credit part of the agreement. The seller must be told within three working days that one wants to cancel the credit and one must pay the cash price of the goods within 15 working days of the date of cancellation. One must cancel the credit in writing.
If one has taken the goods home but not received a copy of the agreement one can cancel the credit at any time. This also applies if the agreement does not contain all the information it should. One then has 15 working days to pay the cash price of the goods. One can ask the shop to take the goods back In case of an interest-free deal with no cost of credit then one does not have a three-day right to cancel unless the right is included in your agreement. In case of a hire purchase deal with a door-to-door seller one has extra cancellation rights. If the seller breaks the terms of the agreement one can cancel the agreement. For example, if the seller does not deliver the goods or agrees to insure the goods but does not do so.
Faulty goods on HPIf goods are faulty, break down or are not what one ordered you have the rights under the Consumer Guarantees Act. One can expect to be given correct information about the goods and the hire purchase agreement. The Fair Trading Act says the seller must not mislead the buyer or give false information. Early repayment If the cash price of the goods is under $15,000 one can pay the hire purchase off early at any time. One will be entitled to a rebate. This is a reduction in the amount that one has agreed to pay. There are rebates for the finance charges (interest and booking fees), insurance charges and maintenance service contracts.
Project financingThere is a growing realization in many developing countries of the limitations of governments in managing and financing economic activities, particularly large infrastructure projects. Provision of infrastructure facilities, traditionally in the government domain is now being offered for private sector investments and management. This trend has been reinforced by the resource crunch faced by many governments. Large investments, long gestation periods and very specific domestic markets usually characterize infrastructure projects. In evaluating these projects, an important question is the appropriate rate of return on the equity investment. Tolls and tariffs are set as to recover operating costs and to provide a return to capital-interest and repayment of debt and return on equity. Therefore the decision on the appropriate return to equity has implications for the overall viability and acceptability of the project. While most elements of costs can be determined with reference to market prices, return to equity cannot be determined in the same way since most of the equity is provided by the sponsor or by a small number of investors. This leaves room for disagreement on the appropriate return to equity. In the case of the Indian power projects, this has been one of the contentious issues. Return to equity will depend upon the risk of cash flows fro the project and the financial structure i.e. the relative proportion of debt and equity. Since infrastructure projects employ a number of risk mitigation contracts, it is important have knowledge about the agreements.
What is project financing?In project financing, the project, its assets, contracts, inherent economies and cash flows are separated from their promoters or sponsors in order to permit credit appraisal and loan to the project, independent of the sponsors. The assets of the specific project serve as a collateral for the loan, and all loan payments are made out of the cash flows of the project. In this sense, the loan is said to be of non-recourse or limited recourse to the sponsor. Thus project financing may be defined as that scheme of financing of 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. In the past, project financing was mostly used in oil exploration and other mineral extraction through joint ventures with foreign firms. The most received use of project financing can be found in infrastructure projects, particularly in power and telecommunications projects. Project financing is made possible by combining undertakings and various kinds of guarantees by parties who are interested in a project. It is built in such a way that no one party alone has to assume the full credit responsibility of the project. When all the undertakings are combined and reviewed together, it results in an equivalent of the satisfactory credit risk for the lenders. It is often suggested that project financing enables a parent company to obtain inexpensive loans without having to bear all risks of the project. But in practice the parent company is affected by the actual plight of the project, and the interests on the project loan depends on the parents stake in the project. The traditional form of financing is the corporate financing or the balance sheet financing. In this case although financing is apparently for a project, the lender looks at the cash flows and assets of the whole company in order to service the debt and provide security.
Characteristics of Project Financing: A separate project entity is created that receives loans from lenders and equity from sponsors. The component of debt is very high in Project Financing. Thus the project financing is a highly leveraged financing. The Project funding and all its other cash flows are separated from the parent companys balance sheet. Debt services and repayments entirely depend on the projects cash flows. Project assets are used as collateral for loan repayments. Project financers risks 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 is most appropriate for those projects that require larger amount of capital expenditure and involve high risk. It is used by companies to reduce their own risk by allocating the risk to a number of parties. It allows sponsors to: Financing large projects than the companys credit and financial capability would permit.
Insulate the companys balance sheet from the impact of the project. Use high degree of leverage to benefit the equity owners.
Advantages of project financing Non-recourse: The typical project financing involves a loan to enable the sponsor to construct a project where the loan is completely "nonrecourse" to the sponsor, i.e., the sponsor has no obligation to make payments on the project loan if revenues generated by the project are insufficient to cover the principal and interest payments on the loan. In order to minimize the risks associated with a non-recourse loan, a lender typically will require indirect credit supports in the form of guarantees, warranties and other covenants from the sponsor, its affiliates and other third parties involved with the project. Maximize Leverage. In a project financing, the sponsor typically seeks to finance the costs of development and construction of the project on a highly leveraged basis. Frequently, such costs are financed using 80 to 100 percent debt. High leverage in a non-recourse project financing permits a sponsor to put less in funds at risk, permits a sponsor to finance the project without diluting its equity investment in the project and, in certain circumstances, also may permit reductions in the cost of capital by substituting lower-cost, tax-deductible interest for higher-cost, taxable returns on equity. Off-Balance-Sheet Treatment. Depending upon the structure of a project financing, the project sponsor may not be required to report any of the project debt on its balance sheet because such debt is non-recourse
or of limited recourse to the sponsor. Off-balance-sheet treatment can have the added practical benefit of helping the sponsor comply with covenants and restrictions relating to borrowing funds contained in other indentures and credit agreements to which the sponsor is a party.
Maximize Tax Benefits. Project financings should be structured to maximize tax benefits and to assure that all available tax benefits are used by the sponsor or transferred, to the extent permissible, to another party through a partnership, lease or other vehicle.
Disadvantages of project financing Project financings are extremely complex. It may take a much longer period of time to structure, negotiate and document a project financing than a traditional financing, The legal fees and related costs associated with a project financing can be very high. The risks assumed by lenders may be greater in a non-recourse project financing than in a more traditional financing. The cost of capital may be greater than with a traditional finance
Risks involved in Project financingFrom the perspective of potential investors the main risks relate to project completion, market, foreign currency and supply of inputs. The objective is to allocate these risks to those parties who are in the best position to control particular risk factors. This reduces the moral hazard problem and minimizes the cost of bearing risks.
Project completion risk:This is the major risk factor in most infrastructure projects. It is usually covered by a fixed price, firm date, and turnkey construction project with liquidated damages for delay supported by performance bonds. The contract specifies performance parameters and warranty periods for defects. Lenders require sponsors of the project company to provide a guarantee to fund cost overruns. In addition a standby credit facility may also be employed.
Market risk:Having long-term quantity and price agreements covers this risk. In the case of power projects where the electricity is likely to be sold to a government controlled distribution company, this is achieved through a take or pay power purchase agreement (PPA). Under this contract, certain payments have to be made irrespective of the actual off-take as long as the company makes available the capacity. The tariff is determined on a cost plus basis using standard costs. For power projects in India, the government has evolved a system of two part tariffs. The first part ensures recovery of fixed costs based on performance at normative parameters. Fixed costs include depreciation, operating and maintenance expenses, tax on income, interest on loans, and working capital and a return on 47
equity. This part of the tariff is paid irrespective of the amount of power actually taken. The second part covers variable expenses based on the units of electricity actually supplied. Variable costs are the costs of primary and secondary fuel based on set norms for fuel consumption. Apart from the PPA, payments may be made to a trustee, usually an international bank, as additional security, in an escrow account that then directly makes payments to creditors and suppliers. These arrangements effectively transfer the market risk to the power purchaser. In more sophisticated and privatized regulatory environments, independent power producers may take more market risk. For example in a Chilean power project, the company is developing the project without having a single purchaser PPA. Instead it has signed several long-term contracts with different private purchasers. In the case of transport projects, tolls have to be collected from the public and not from a government agency. This can give rise to problems while enforcing toll agreements. Competition from alternative roads or transit systems can also affect the traffic flow. Therefore unlike power projects that have power purchase agreements, in transport projects, lenders cannot rely on fixed revenue over the life of the project. Hence the project continues to carry market risk. This is sought to be mitigated by several other agreements. If traffic flows are below expectations, the project has recourse to such measures as an adjustment in the revenue sharing proportion; an increase in tolls on the system, and an extension of the concession periods. In many cases, there are automatic escalation clauses in the toll agreement to account for inflation.
Foreign exchange risk:Foreign exchange risks are perhaps the single largest concern of foreign financiers investing in developing countries. In the case of infrastructure projects, the risk is greater since most of these projects, with the exception of some telecommunication and port projects, generate local currency revenues. The risk is at two levels: Macro economic convertibility: Whether the project will have access to foreign exchange to cover debt service and equity payments. Tariff adjustment for currency depreciation: Whether the foreign exchange equivalent of the projects local revenues will be adequate to service foreign debts and equity. The risk of macro economic convertibility will generally require a few government guarantees. In many projects, there is provision for tariff escalation to account for currency depreciation and project returns to investors in foreign currency terms. For Indian power projects, the return on foreign equity included in the tariff can be provided in the respective foreign currency.
First Step in a Project Financing:(A) The Feasibility Study
Generally. As one of the first steps in a project financing the sponsor or a technical consultant hired by the sponsor will prepare a feasibility study showing the financial viability of the project. Frequently, a prospective lender will hire its own independent consultants to prepare an independent feasibility study before the lender will commit to lend funds for the project.
Contents. The feasibility study should analyze every technical, financial and other aspect of the project, including the time-frame for completion of the various phases of the project development, and should clearly set forth all of the financial and other assumptions upon which the conclusions of the study are based, Among the more important items contained in a feasibility study are: Description of project. Description of sponsor(s). Sponsors' Agreements. Project site. Governmental arrangements.
Source of funds. Off take Agreements. Construction Contract. Management of project. Capital costs. Working capital. Equity sourcing. Debt sourcing. Financial projections. Market study. Assumptions Feedstock agreements.
(B) The Project Company. 1. Legal Form. Sponsors of projects adopt many different legal forms for theownership of the project. The specific form adopted for any particular project will depend upon many factors, including:
The amount of equity required for the project The concern with management of the project The availability of tax benefits associated with the project
The need to allocate tax benefits in a specific manner among the project company investors.
The three basic forms for ownership of a project are: Corporations. This is the simplest form for ownership of a project. A special purpose corporation may be formed under the laws of the jurisdiction in which the project is located, or it may be formed in some other jurisdiction and be qualified to do business in the jurisdiction of the project. General Partnerships. The sponsors may form a general partnership. In most jurisdictions, a partnership is recognized as a separate legal entity and can own, operate and enter into financing arrangements for a project in its own name. A partnership is not a separate taxable entity, and although a partnership is required to file tax returns for reporting purposes, items of income, gain, losses, deductions and credits are allocated among the partners, which include their allocated share in computing their own individual taxes. Consequently, a partnership frequently will be used when the tax benefits associated with the project are significant. Because the general partners of a partnership are severally liable for all of the debts and liabilities of the partnership, a sponsor frequently will form a wholly owned, single-purpose subsidiary to act as its general partner in a partnership. Limited Partnerships. A limited partnership has similar characteristics to a general partnership except that the limited partners have limited control over the business of the partnership and are liable only for the debts and liabilities of the partnership to the extent of their capital contributions in the partnership. A limited partnership may be useful for a project financing when the sponsors do not have substantial capital and the project requires large amounts of outside equity.
Limited Liability Companies. They are a cross between a corporation and a limited partnership.
2. Project Company Agreements. Depending on the form of projectcompany chosen for a particular project financing, the sponsors and other equity investors will enter into a stockholder agreement, general or limited partnership agreement or other agreement that sets forth the terms under which they will develop, own and operate the project. At a minimum, such an agreement should cover the following matters:
Ownership interests. Capitalization and capital calls. Allocation of profits and losses. Distributions. Accounting. Governing body and voting. Day-to-day management. Budgets. Transfer of ownership interests. Admission of new participants. Default. Termination and dissolution.
Project financing participants and agreements
Sponsor/Developer. The sponsor(s) or developer(s) of a project financing is the party that organizes all of the other parties and typically controls, and makes an equity investment in, the company or other entity that owns the project. If there is more than one sponsor, the sponsors typically will form a corporation or enter into a partnership or other arrangement pursuant to which the sponsors will form a "project company" to own the project and establish their respective rights and responsibilities regarding the project Additional Equity Investors. In addition to the sponsor(s), there frequently are additional equity investors in the project company. These additional investors may include one or more of the other project participants. Construction Contractor. The construction contractor enters into a contract with the project company for the design, engineering and construction of the project. Operator. The project operator enters into a long-term agreement with the project company for the day-to-day operation and maintenance of the project. Feedstock Supplier. The feedstock supplier(s) enters into a long-term agreement with the project company for the supply of feedstock (i.e., 54
energy, raw materials or other resources) to the project (e.g., for a power plant, the feedstock supplier will supply fuel; for a paper mill, the feedstock supplier will supply wood pulp). Product Off taker. The product off taker(s) enters into a long-term agreement with the project company for the purchase of all of the energy, goods or other product produced at the project. Lender. The lender in a project financing is a financial institution or group of financial institutions that provide a loan to the project company to develop and construct the project and that take a security interest in all of the project assets
Principal Agreements in a Project Financing.(A) Construction Contract. Some of the more important terms of theconstruction contract are: Project Description. The construction contract should set forth a detailed description of all of the work necessary to complete the project. Price. Most project financing construction contracts are fixed-price contracts although some projects may be built on a cost-plus basis. If the contract is not fixed-price, additional debt or equity contributions may be necessary to complete the project, and the project agreements should clearly indicate the party or parties responsible for such contributions. Payment. Payments typically are made on a "milestone" or "completed work" basis, with a retainage. This payment procedure provides an incentive for the contractor to keep on schedule and useful monitoring points for the owner and the lender. Completion Date. The construction completion date, together with any time extensions resulting from an event of force majeure, must be consistent with the parties' obligations under the other project documents. If construction is not finished by the completion date, the contractor typically is required to pay liquidated damages to cover debt service for each day until the project is completed. If construction is completed early, the contractor frequently is entitled to an early completion bonus. Performance Guarantees. The contractor typically will guarantee that the project will be able to meet certain performance standards when completed. Such standards must be set at levels to assure that the project will generate sufficient revenues for debt service, operating costs and a 56
return on equity. Such guarantees are measured by performance tests conducted by the contractor at the end of construction. If the project does not meet the guaranteed levels of performance, the contractor typically is required to make liquidated damages payments to the sponsor. If project performance exceeds the guaranteed minimum levels, the contractor may be entitled to bonus payments.
(B) Feedstock Supply Agreements. The project company will enter intoone or more feedstock supply agreements for the supply of raw materials, energy or other resources over the life of the project. Frequently, feedstock supply agreements are structured on a "put-or-pay" basis, which means that the supplier must either supply the feedstock or pay the project company the difference in costs incurred in obtaining the feedstock from another source. The price provisions of feedstock supply agreements must assure that the cost of the feedstock is fixed within an acceptable range and consistent with the financial projections of the project.
(C) Product off take Agreements. In a project financing, the product offtake agreements represent the source of revenue for the project. Such agreements must be structured in a manner to provide the project company with sufficient revenue to pay its project debt obligations and all other costs of operating, maintaining and owning the project. Frequently, off take agreements are structured on a "take-or-pay" basis, which means that the off taker is obligated to pay for product on a regular basis whether or not the off taker actually takes the product unless the product is unavailable due to a default by the project company. Like feedstock supply arrangements, off take agreements frequently are on a fixed or scheduled price basis during the term of the project debt financing.
(D) Operations and Maintenance Agreement. The project companytypically will enter into a long-term agreement for the day-to-day operation and maintenance of the project facilities with a company having the technical and 57
financial expertise to operate the project in accordance with the cost and production specifications for the project. The operator may be an independent company, or it may be one of the sponsors. The operator typically will be paid a fixed compensation and may be entitled to bonus payments for extraordinary project performance and be required to pay liquidated damages for project performance below specified levels.
(E) Management Agreement. (F) Loan and Security Agreement. The borrower in a project financingtypically is the project company formed by the sponsor(s) to own the project. The loan agreement will set forth the basic terms of the loan and will contain general provisions relating to maturity, interest rate and fees. The typical project financing loan agreement also will contain provisions such as these: Disbursement Controls. These frequently take the form of conditions precedent to each draw down, requiring the borrower to present invoices, builders' certificates or other evidence as to the need for and use of the funds. Progress Reports. The lender may require periodic reports certified by an independent consultant on the status of construction progress. Covenants Not to Amend. The borrower will covenant not to amend or waive any of its rights under the construction, feedstock, offtake, operations and maintenance, or other principal agreements without the consent of the lender. Completion Covenants. These require the borrower to complete the project in accordance with project plans and specifications and prohibit the borrower from materially altering the project plans without the consent of the lender.
Dividend Restrictions. These covenants place restrictions on the payment of dividends or other distributions by the borrower until debt service obligations are satisfied. Debt and Guarantee Restrictions. The borrower may be prohibited from incurring additional debt or from guaranteeing other obligations. Financial Covenants. Such covenants require the maintenance of working capital and liquidity ratios, debt service coverage ratios, debt service reserves and other financial ratios to protect the credit of the borrower. Subordination. Lenders typically require other participants in the project to enter into a subordination agreement under which certain payments to such participants from the borrower under project agreements are restricted (either absolutely or partially) and made subordinate to the payment of debt service. Security. Multiple forms of collateral typically will secure the project loan, including: 1) Mortgage on the project facilities and real property. 2) Assignment of operating revenues. 3) Pledge of bank deposits. 4) Assignment of any letters of credit or performance or completion bonds relating to the project under which borrower is the beneficiary. 5) Liens on the borrower's personal property. 6) Assignment of insurance proceeds. 7) Assignment of all project agreements.
8) Pledge of stock in Project Company or assignment of partnership interests. 9) Assignment of any patents, trademarks or other intellectual property owned by the borrower.
(G) Site Lease Agreement. The project company typically enters into along-term lease for the life of the project relating to the real property on which the project is to be located. Rental payments may be set in advance at a fixed rate or may be tied to project performance.
InsuranceThe general categories of insurance available in connection with project financings are:
(A) Standard Insurance. The following types of insurance typically areobtained for all project financings and cover the most common types of losses that a project may suffer: Property Damage, including transportation, fire and extended casualty Boiler and Machinery. Comprehensive General Liability. Worker's Compensation. Automobile Liability and Physical Damage. Umbrella or Excess Liability.
(B) Optional Insurance. The following types of insurance often are obtainedin connection with a project financing. Coverages such as these are more expensive than standard insurance and require more tailoring to meet the specific needs of the project. Design Errors and Omissions. System Performance (Efficiency). Pollution Liability. Cost Overrun/Delayed Opening Performance Bonds. Business Interruption.
ConclusionToday asset based financing has formed an integral part of the Financing scenario. This is because firms today cant afford to buy the equipments/machines outright. Not all firms today are that financially sound. Today firms find it extremely difficult to obtain financial aid from the normal sources. Firms that have the financial capacity prefer to hire/lease the equipment as it releases the financial burden as well as provides tax benefit of depreciation. Especially Project financing has come of age as most of the banks today are into project financing. Earlier it was chartered accountants who indulged into project financing but now it is more of bank involvement. But today the growth in Project Finance is low where as lease and hire purchase are on a upward trend with more and more companies like Bajaj, Hero Honda providing their products on hire. So in the changing economic and financial environment of India, asset based financing has assumed an extremely important role.
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