Introduction
The 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 Financing
Leasing 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 lessee’s 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 lease
1st party
Equipment
2nd party Equipment
3rd party
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Lessor
Lessee
Manufacturer
or dealer
Types of leases
Two 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 lessee’s 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 back Sometimes 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
Company’s 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 sip’s 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 lessee’s cash flows. Such tailored payment schedules are helpful to a
lease that has fluctuating cash flows. New or small companies in non-
priority 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 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.
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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.
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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.
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Risk Assessment of a Lessee
The 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.
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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 C’s. They are:
Character
Capacity
Capital
Credit
Conditions
Competition
Collateral
Cross-border
Complexity
Currency
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Lessor Requirements
Once 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 lessor’s after-tax weighted cost of capital
Accounting for the lease on the lessor’s 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.
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Leveraged lease
Under 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
asset’s 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 asset’s
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.
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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
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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.
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The structure of a lease agreement
A 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
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(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 asset’s useful economic life. Operating leases are for
relatively shorter periods of time and more than one lessee uses the asset over
its economic life.
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(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 lessee’s duties and responsibilities and virtually none fo the lessor. The
lessor’s 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
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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 lessor’s consent.
Lessee becomes insolvent.
Lessee’s 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
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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.
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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 lessee’s 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
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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 don’t infringe upon some legal prohibitions,
the concerned parties are free to make any rules of their choice.
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Hire purchase financing
Hire 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.
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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 hirer’s name, address, occupation, and certain other
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details indicating his financial standing. It is also the dealer’
responsibility to insert details about the price and the installments
payable.
The intending hirer is often required to make a down payment as an
indication of the customer’s 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 hirer’s signature to a form of delivery receipt
constituting an acknowledgement by the hirer that he has received
the goods in proper condition.
The hirer makes payment of hire installment throughout the period
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.
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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
Manufacturer sells asset to hires asset to
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Manufacturer Hiree Hirer
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 1981
The 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
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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
The right to cancel within three working days, and
All other terms of the contract.
Hire Purchase Act 1971
The Act sets out
The requirement to provide a hire purchase contract in
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.
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Hire Purchase vs. Lease Financing
Both 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
claim depreciation.
1. Depreciation- lessee is not entitled
to claim depreciation.
2. Payments- hirer can charge only
interest portion of hire purchase
payments as expenses for tax
2. Payments- lessee can charge the
entire lease payments as expenses for
tax computation.
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computation.
3. Salvage value- Once the hirer has
paid all installments; he becomes the
owner of the asset and can claim its
salvage value.
3. Salvage value- Lessee does not
become the owner of the asset.
Therefore he has no claim over the
asset’s salvage value.
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 borrower’s 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
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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
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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.
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The Hire Purchase Agreement
When 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
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One’s 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
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By notice at common law independent of agreement
By acceptance by one party of the other party’s 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
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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 hirer’s
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
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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.
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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 companies
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Shops 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 purchase
Insurance 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 doesn’t have insurance and the goods
are stolen, lost or damaged, one may have to keep on paying for the goods.
Repayment or Consumer Protection Insurance
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Consumer 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 agreement
If 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 HP
If goods are faulty, break down or are not what one ordered you have the rights
under the Consumer Guarantees Act.
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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 financing
There 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
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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
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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 company’s balance sheet.
Debt services and repayments entirely depend on the project’s cash flows.
Project assets are used as collateral for loan repayments.
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Project financers risks are not entirely covered by the sponsor’s
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 company’s credit and financial capability
would permit.
Insulate the company’s 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 "non-
recourse" 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
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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,
46
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 financing
From 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.
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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
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
48
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 project’s 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
49
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
50
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 the
ownership 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
51
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.
52
Limited Liability Companies. They are a cross between a corporation and a
limited partnership.
2. Project Company Agreements. Depending on the form of project
company 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
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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.,
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).
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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.
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(A) Construction Contract. Some of the more important terms of the
construction 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
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.
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(B) Feedstock Supply Agreements. The project company will enter into
one 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 off
take 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 company
typically 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
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.
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(E) Management Agreement.
(F) Loan and Security Agreement. The borrower in a project financing
typically 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.
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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 a
long-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.
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Insurance
The general categories of insurance available in connection with project
financings are:
(A) Standard Insurance. The following types of insurance typically are
obtained for all project financings and cover the most common types of
losses that a project may suffer:
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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 obtained
in 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
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Performance Bonds.
Business Interruption.
Conclusion
Today asset based financing has formed an integral part of the Financing
scenario. This is because firms today can’t 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
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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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