This article throws light upon the five major areas of fund based activities. The areas are: 1. Leasing 2. Hire-Purchase 3. Bill Discounting 4. Factoring 5. Venture Capital.
Fund Based Activity: Area # 1. Leasing:
Leasing is the most significant development as a method of procuring assets which has taken place in the field of finance during the past five decades although it was on real estate leasing at first During the past several years, various firms are granting lease almost all types of fixed assets.
Although at present, it is not known to us the amount of leased equipment in use, even then it may be safely concluded that lease financing is one of the major sources of external financing which are being used by many industries.
It is not possible to comment the reasons for its popularity, i.e., whether it is the result of financial controller’s desire to conserve funds or, it arises from the increased effort of the so called leasing companies.
There are two principle techniques of leasing, viz.:
(i) Leasing rather than purchasing the assets; and
(ii) Sale and Lease Back.
However, in the case of former, a firm makes a contract to rent an asset from another firm.
The contract contains usually the following terms and conditions:
(i) A basic term during which the lease cannot be cancelled;
(ii) Periodic rental payments (cost of original investment plus a return);
(iii) The cost of maintenance (e.g., taxes, insurance etc.)
(iv) An agreement that will permit the firm to continue to use the assets after the basic lease term.
Advantages of Leasing:
There are some authorities who do not accept all the advantages of lease financing.
But the following advantages are accepted by them:
(i) Permits a lease to obtain the use of property that he cannot acquire in any other way;
(ii) Provides facilities that are needed only temporarily;
(iii) Avoids the risks of obsolescence;
(iv) Relieves the user of maintenance, service and administrative problems;
(v) Provides an additional source of financing; and
(vi) Gives the lease flexibility.
The following four advantages are not accepted unanimously by the authorities. They are:
(i) Lease frees working capital;
(ii) It yields a tax savings;
(iii) It improves the lessees’ apparent financial position; and
(iv) It spares management the need to review capital expenditure.
Disadvantages, of leasing:
Although leasing finance has some district edges, even it is not free from snags. They are:
(i) High cost;
(ii) Loss of residual values;
(iii) The possibility that a premium will be demanded for vital equipment unless adequate care is taken when the lease is negotiated;
(iv) Inadequate evaluation due to habitual leasing;
(v) The lack of accumulation of equity, which could have some adverse effects on future financing; and
(vi) Various facilities may be lost at the end of the lease period.
However, the validity of the above disadvantage depends on the various alternatives which should carefully be chosen while negotiating lease agreement. Because, there are several factors which directly affect the leasing finance for alternations, e.g., rate of tax, the repayment schedule, the rate of interest, the method of depreciation etc.
The following illustration will make the above principle clear:
Thus, from the above three alternative methods of financing, it becomes clear that the alternatives whose cash outlays are the lowest present value will naturally be the most desirable one. As such, alternatives II and III are superior to alternative I as they are cheaper if present value of cash outlay is considered as the basis of comparison.
But from the standpoint of the number of rupees actually paid out alternatives I and II are inferior to alternative II, without giving any adequate consideration time value of money and tax savings.
Sale and Lease back:
Under a Sale and Lease back arrangement, a firm sells an asset which it owns to another party who again leases it back to the firm. The asset is usually sold at a market price and the firm receives such amount in cash and also receives the economic use of assets during the lease period. Periodic lease payments are made in return and give up the title of the assets.
As such, the lessor will realise the residual value, if any, at the end of the lease period. Usually the firm sells the asset to a financial institution, Insurance companies, finance companies or institutional investors. It is to be noted that most lease-back are on a net-to-net basis which implies that the lessee pays all maintenance expenses including taxes, insurance and lease payments as well.
Sometimes it may so happen that the lease arrangement allows the lessee to re-purchase the asset when the lease period is terminated. The purchase price may be determined on the basis of economic condition, e.g., at its fair market value.
Classification of Leases:
Basically, the leases can be classified into three following groups:
(a) Operating Lease:
Under the circumstances it does not impose any long-term obligation neither the lessor nor the lessee and it may be cancelled by either side after serving a stipulated notice, e.g., the rental of an office space on a 3-year lease cancellable on 30 days.
(b) Service Lease:
Under the circumstances, the lessor supplies both financing and servicing the asset during the lease period. Usually, capital assets, e.g., computers, trucks etc. are leased under this type of contract which provide maintenance or servicing of the assets
(c) Financial Lease:
Under the circumstance, the lease arrangement is considered as long- term lease on fixed assets which must not be cancelled either by the lessor or by the lessee. It is, practically, like long-term debt financing.
Characteristics of Leases:
(1) Service Leases:
Services leases are becoming popular as the modern machinery and equipment require frequent specialised maintenance and servicing.
Thus, its significant characteristic are:
(i) Cost of Maintenance is included in Lease:
According to the terms, the lessor is liable for maintaining the equipment and supplying all routine services including repairs It actually protects the lessee from correcting major break-downs for the same,
(ii) Lease may be Cancelled:
Usually, the service lease is cancelled by the lessee. For this purpose, the lessee makes some provisions for a penalty if the lease is cancelled before its expiry date although a stipulated notice is necessary for cancellation.
(iii) Equipment Machinery may not totally he Amortized:
In case of amortization, usually a firm writes it off completely during the period under consideration. In this type of lease, however, the lease payment may be insufficient to allow the lessor to recover the original cost of such asset which implies that the lease period is comparatively less than the service life of the asset.
(2) Financial Leases:
The characteristic of financial leases are noted below:
(i) Long-Term Period:
These types of leases cover a long-time period, e.g., 1 to 10 years. At this period, the firm must have to satisfy lease requirements even if the equipment becomes obsolete or of no use.
(ii) Rigid Obligation:
It imposes certain obligations. It cannot be cancelable.
(iii) Fully Amortizing:
According to the terms of agreement the lease covers the service period i.e., if the expected life of the equipment/machinery is 10 years, the firm also takes the period of lease approximately 10 years.
It is interesting to note that if asset possess an indefinite life, like Land and Building, the lease will be written as even service life may be considered as 30 years. Under the circumstance, the Land and Building is totally amortized.
(iv) Profit earned during the period of lease:
This lease gives some profit to the lessor (i.e., total lease payment is more than the total cost of the assets) during the period of lease. If the asset possesses any residual value, the entire amount will be treated as an extra profit.
Sources of Funds for Leasing. It has been highlighted above that financial institutions, insurance companies, finance companies and institutional investors supply funds for leasing. In other words, a firm who seeks funds finds various institutions for the purpose.
Some of them are:
(a) Commercial Bank
At present commercial banks are increasingly interested in lease financing. The banks make necessary arrangement to buy equipment and lease the same to a customer either directly or through a company. As the additional service is provided by the bank it attracts the customers for other financial services.
(b) Financial Service Companies:
We know that there are some commercial finance companies/leasing companies who supply the necessary funds for specialised machinery or equipment. Usually these companies take expert staffs who are acquainted with the re-sale market for such specialised equipment or machinery and terms of the lease agreement is practically developed by them.
(c) Life Insurance Companies:
The Life Insurance Companies are quite known in long-term leasing, particularly in the case of real estate. Usually a life insurance company has a large cash inflow which can easily be invested as the amount is not immediately required for the payment of policies. As such, these excess cash can easily be invested by them in office-building, warehouse which can be leased to the occupants.
ABC Company Ltd. has two financial options in respect of procuring an equipment for utilizing the same for 5 years costing Rs. 10,00,000.
The two options are:
Borrow Rs. 10,00,000 at an interest rate of 15%. The loan is repayable at 5 year-end installments. The equipment could be sold at the end of its 5 years economic life at a realisable value of Rs. 1,00,000.
Lease in the asset for a period of 5 years at an yearly rental of Rs. 3,30,000 payable at the year-end.
The rate of depreciation allowable on the equipment is 15%. The company has to pay income-tax @ 50% and has a discounting rate of 16%. Restrict working up to 10 years in case of option I.
Evaluate the two options and give your opinion.
Before giving the valued opinion relating to the two options, we are to apply the DCF technique for evaluating the options.
As per Option I Borrowing:
Borrowing up to Rs 10,00,000 at an interest rate of 15% depreciation (Rs. in ‘000)
Thus, it is evident from the two table that option II i.e., lease financing is more profitable applying DCF technique as it is comparatively low than option I.
Fund Based Activity: Area # 2. Hire-Purchase:
A line-put transaction is one when the seller owner of certain goods delivers has goods to a person (known as hire-purchase) with a condition that he (hire-purchaser) with repay the price of the goods which is inclusive of certain amount of interest) by different specified periodical instalments and acquires the property (goods) immediately but the same is transferred only when the last instalment is paid.
In other words, a hire purchase agreement is one under which a person takes delivery of goods promising to play the price by a certain number of instalments and. until full payment is made, to pay hire charges for using the goods. The law regaining the subject has been codified by the parliament in 1972 viz the Hire-Purchase Act (No 25 of 1972).
Generally a certain sum of money is paid at the time of taking delivery known as down payment’ or ‘initial payment’ and the instalment is paid at the end of the period, say, yearly, half-yearly or quarterly. Needless to mention here that the total payment made under hire purchase agreement should always be higher than the cash price since interest is charged with cash price of hire-purchase transactions.
Legal Position/Hire-Purchase Agreement:
The Hire-Purchase Act came into being on 1st Sept 1972. According to the Act, a hire-purchase agreement means “an agreement under which goods are let on hire and under which the hirer has an option to purchase them in accordance with the terms of the agreement and includes an agreement under which — (i) Possession of goods is delivered by the owner thereof to a person on condition that such person pays the agreed amount in periodical installments, and (ii) The property in the goods is to pass to such person on the payment of the last of such instalments, and (iii) Such person has a right to terminate the agreement at any time before the property so passess “— Sec. 2 (c).
“Hire-purchase agreement must be in writing and signed by parties. A surity, if any, must sign the hire-purchase agreements. The agreement shall be void if the above requirements have not been complied with”— Sec. 3.
According to Sec. 4 the contents of hire-purchase agreement which includes the following:
(i) The hire-purchase price of the goods to which the agreement relates;
(ii) The case price of the goods i.e., the price at which the goods may be purchased by the hirer for cash;
(iii) The date on which the agreement shall be deemed to have commenced;
(iv) the number of installments by which the hire-purchase price is to be paid, the amount of each of those instalments and the date, or the mode of determining the date, upon which it is payable, and the person to whom and the place where it is payable;
(v) The goods to which the agreement relates, in a manner sufficient to identify them;
(vi) where any part of the hire-purchase price is, to be paid otherwise than by cash or by cheque, the hire-purchase agreement shall contain a description of that part of the hire-purchase price; and
(vii) where any of the above requirements has not been complied with, the hirer may institute a suit for getting the hire-purchase agreement rescind, and the court may, if it is satisfied that the failure to comply with any such requirement has prejudiced the hirer, rescind the agreement on such terms as it thinks just, or pass such other order as it thinks fit in the circumstances of the case.”
Certain Terms used in Hire-Purchase Agreement:
The following terms are widely used in hire-purchase transactions:
The H. P. Act defines various terms in relation to prices which are noted below:
(i) Cash Price Installment:
An amount which bears to the net price the same proportion as the amount of the hire-purchase instalment bears to the total amount of hire- purchase price.
(ii) Hire-Purchase Price:
The total sum payable by the hirer as per hire-purchase terms in order to complete the transactions.
(iii) Net Hire-Purchase Charges:
The difference between the net hire-purchase price and the net cash price of the goods.
(iv) Net Cash Price:
Total cash price less any deposit.
(v) Down Payment:
The amount which is paid at the time of taking delivery of the goods.
(vi) Net Hire-Purchase Price:
Total amount of hire-purchase price minus:
(a) Delivery expenses, if any;
(b) Registration or other kinds of fees related to agreement; and
(c) Insurance expenses, if any.
The person who obtains the possession of goods from the owner under a hire-purchase agreement.
The sum payable periodically by the hirer under the agreement.
The amount which is inclusive of interest together with principle paid at the end of the period.
Limitation of Hire-Purchase Charge:
It has been pointed out above that (Net) hire-purchase charge is the difference between the net hire-purchase price and the net cash price of the goods. To avoid the exorbitant hire charges levied by the owner. Sec. 7 has been introduced by the Government which states that the maximum statutory charge may be @ 30% of the instalment, or, the charges may be ascertained with the help of the following formula:
SC = CI x R x T /1000
where, SC = the statutory charges,
CI = the amount of cash price installment expressed in rupee or fraction of rupee,
R = the rate, and
T = the time, expressed in years and fractions of years, that elapse between the date of the agreement and the date on which the hire-purchase instalment corresponding to the cash price instalment is payable under the agreement.
Rights of Hirers:
The H. P Act has given the following rights to a hirer:
“(a) The owner cannot terminate the hire-purchase agreement for default in payment of hire or due to an unauthorized act or breach of expressed conditions unless a notice in this regard in writing is given to the hirer. The notice period is (i) one week where the hire is payable at weekly or less than that interval, and (ii) two weeks in other cases. (b) In the following case, the right to repossess the goods will not exist unless it is sanctioned by court — i. If the hire-purchase price is less than Rs. 15,000, ½ of the hire-purchase price has been paid; ii. Where the hire-purchase price is hirer, ¾ of the hire-purchase price has been paid. But, the right of re-possession will lapse in the case of motor vehicles, if the H. P. price is less than Rs. 5,000 and ½ of the amount has been paid or ¾ of the H P, has been paid in other cases. (The Central Government has the power of raising the limit to where hire-purchase price is Rs. 15,000 or more.) (c) The hirer has the right of receiving from the owner, on payment of Re. 1 for expenses, a statement showing the amount paid by or on behalf of the hirer, the amount which has become due under the agreement which remains unpaid together with the dates concerned and the amount which has not yet become payable under the agreement and the dates and the modes concerned. (d) If the amount paid by the hirer till the date of re-possession of the goods and the value of the goods on the date of the re-possession together exceeds the hire purchase price, the excess is payable to the hirer. For ascertaining the value of the goods, the owner or the vendor has the right of deducting reasonable expenses for re-possessing the goods, for storing the goods or repairing them, for selling them and for payment of arrears of taxes.”
Fund Based Activity: Area # 3. Bill Discounting:
When the holder of a bill wants to get the money before the due date, he can sell the bill to a bank against a small charge, known as discounting charges i.e., a supplier or creditor of goods discounts the incomes for sale of goods.
Discounting charge is imposed by the bank at a fixed rate present p. a from the date of discounting to the date of maturity. At present in our country, through the discounting of bills of exchange a major part of lending of money taken place by commercial banks.
However, a clean bill carries only the personal security of the drawer and drawee, but a documentary bill, however, accompanied by Bill of Lading, Railway Receipt or other documents of title of goods, which provide extra security in addition to the personal security of the drawer and drawee.
It is needless to say that if the bill is dishonored by the drawee/drawer, the bank naturally will recover the amount from the drawer/creditor of the bill.
Fund Based Activity: Area # 4. Factoring:
A factor is a financial institution who takes the responsibility of financing and collecting debts that may arise out of credit sales. It is done on a continuous basis. Under the arrangement as soon as new bills receivables come in they are taken by the factor and the proceeds are credited to the accounts of the client correspondingly.
If there is no default or irregularities overdraft facility may also be allowed In Western country, factoring is well-established.
But in our country, factoring have been set up by nationalized banks only in four regions, viz:
(i) State Bank of India (in the West);
(ii) Canara Bank (in the south);
(iii) Punjab National Bank (in the north); and
(iv) Bank of Allahabad (in the east)
However, RBI Study Group suggested that there is greater scope of factoring in India and the demand has been estimated at about 4.000 crores. They also suggested that in the case of Textile, Engineering, Automobile Ancillaries, Chemicals and Consumer Durable industries factoring services are urgently needed.
Characteristics of a Factoring Arrangement:
The significant characteristics of a factoring arrangement are presented below:
(i) The factor takes the responsibility for realising/collecting the debts. It pays to the client when the amount is collected or at the end of the credit period which one is earlier for each and individual transaction.
(ii) Usually, the factors take a commission of 1% to 3% of the face value of the debt.
(iii) It may be on the following two basis:
(a) Recourse basis (when risk is borne by the client);
(b) Non-recourses basis (when risk is borne by the factor).
In our country, however the former one is taken into consideration.
(iv) The factor usually advanced 70% to 80% of the face value of the debt and the rate of interest becomes a slight higher than the prevailing bank rate although the factor advances the credit against not yet dud not yet collected debts to the clients.
Fund Based Activity: Area # 5. Venture Capital:
Venture capital implies the financial investment to high-tech growing companies (i.e., higher risk based) as equity capital with the expectation of a higher rate of return which is inclusive of initial as well as development capital for a company.
Although the concept is very old, it is not widely accepted. Sometimes, this capital is being introduced as a result of the product of any scientific improvement and technology and to bring it into real world situation. It also helps the new companies to issue shares who find it difficult.
It is to be noted that there is no such standard form on which venture capital will be supplied.
However, the following characteristics are denoted:
(i) In the first two years, the financial burden becomes negligible;
(ii) The venture capital firms take a high degree risk with the expectation of a high rate of return in future;
(iii) Usually, the venture capital firms desires to liquidate its investment after 3 to 5 year; and
(iv) The Venture Capital firm takes the active participation in the management of the assisted firm including the help extended to procure fund
Venture Capital Scheme of India:
At first, the Industrial Finance Corporation of India (IFCI) took the pioneering effort relating to venture capital by setting up the Risk Capital Foundation in 1975. Later on, it was converted into the Risk Capital and Technology Finance Corporation Ltd. in 1988.
Moreover, Investment Credit and Investment Corporation of India (ICICI), Industrial Development Bank of India (IDBI), Unit Trust of India (UTI) and Canara Bank also started their venture capital funds in India.
Some of the above schemes introduced by the above financial institutions are explained below:
(a) Venture Capital Scheme of ICICI:
In 1986, ICICI started its newly promoted company as Technology Development and Investment Corporation of India (TDIC1) in order to take over its Venture Capital Operation in the country.
Its main characteristic are:
(i) The Technology Development and Investment Corporation of India invests in various companies in order to earn long-term capital gains along with the highly potential growth and earnings.
(ii) TDICI can assist up to Rs. 2 crores either in the form of equity shares or in the form of conditional loans per project.
(iii) The said conditional loan will not carry any interest during the period of development and after that period, the rate of interest will be ascertained on the basis of commercial viability.
(iv) The equity, on the other hand, may be retained against the period of 5 to 8 years and after the period is over, the same may be sold either in the open market or to the promoter at the accepted price.
(v) TDICI also becomes ready to help those technocrats who are associated with the development of technology, or various products or untested technologies on a commercial basis.
(vi) It is ready to meet the long term needs of private industry for both domestic and foreign capital.
Thus, the ICICI via TDICI, primarily finances the purchase of capital assets and provides also managerial, technical and administrative advice to the assisted companies.
(b) Venture Capital Scheme of IDBI:
The Industrial Development Bank of India (IDBI) was set up in 1964 in order to provide long-term finance to industry. It was set up as a subsidiary of the RBI but was delinked from it in the year 1975 and was running at an autonomous corporation.
It is an apex body to co-ordinate the operation of other institutions to supply term-finance to industry as well as an agency to provide direct financial assistance to industrial units. However, the Venture Capital Scheme of the Industrial Development Bank of India was establish having an initial capital of Rs. 10 crores.
The significant characteristics of the scheme are noted below:
(i) IDBI usually provides 80% to 90% of the total projected cost and the balance must be supplied by the promoters themselves.
(ii) During the period of development, IDBI may provide assistance in between Rs. 5 lakhs and Rs. 2 crores and Rs. 50 lakhs in order to cover each both capital and revenue expenditures.
(iii) IDBI may provide assistance either in the form of equity or in the form of loan. It should be noted that in the case of equity, the service charges to be considered as 1% whereas in the case of loan, the same may be taken at 6% during the period of development. When the period is over, the rate of interest is taken at 14% and such loan should be repaid within a period of 10 years,
(iv) Its primary function is to provide funds to such projects which have commercial importance of various improved technology and also applied imported advance technologies which are rather quite new in the Indian context.
(v) If it is found that the project proves unsuccessful, IDBI will try to transfer to such technology to other promoters.
Cumulative, by March 1993 IDBI has sanctioned and disbursed assistance aggregating Rs. 65,460 crores and Rs. 47,087 crores respectively.
Other Venture Capital Schemes:
In addition to the above, there are other venture capital institutions or schemes in India.
Some of them are described below in short:
(i) SBI Capital Markets:
It has a Bought-out-deal scheme
(ii) Credit Capital Finance Corporation (CCFC):
It is a private venture capital fund.
(iii) National Grindlays Bank:
It induced an Investment fund by taking the amount from Non-Resident Indians.
(iv) Risk Capital and Technology Finance Corporation (RCTFC):
It has already been stated earlier that it is the Risk Capital Foundation which was set up in 1975 was converted into a separate entity in 1988 as RCTFC. It is an independent organization.
Position of Venture Capital in India:
Venture capital is provided to those industries which are going to induce technological development, inducing innovation and creativity in the various commercial fields through the promoters.
In order to be more effective the Government, various financial institutions, private sectors including other agencies/organisations should take the necessary steps for the growth and development of venture capital in our country. In short it becomes necessary to establish a favourable fiscal and regulatory surroundings and also to extend the necessity of venture capital finance in the field of commercial entity.
Suggestions to create a favourable condition for the growth and development of venture capital through fiscal and regulatory measures
For the growth and development of the venture capital a favourable fiscal as well as regulatory measures must be taken into considerations.
Some of them may be enumerated as under:
(i) From Taxation Point of View:
(a) The long-term capital gains arising out of venture capital either should be exempted from tax or may be taxed at a lower rate;
(b) A greater tax relief may be given to the investor who will subscribe and help to raise funds for venture capital.
(ii) From Investors Point of View:
In order to encourage the foreign investors who directly help to create venture capital fluids should be given some liberal facilities for them.
(iii) From its Application Point of View:
Its area of activities should be extended i.e., it will finance not only its own operation but also to help it, other assisted units from the standpoint of commercial activities.