Session 1

Introduction to Financial Services

Merchant Banking and Financial Services

Faculty- Niladri Das

Department of Management Studies
IIT (ISM), Dhanbad
 Financial Services in India

• Financial services mean all those kinds of services

provided in financial terms, where the essential
commodity is money.

• One of the main entities that offer financial

services in India are NBFCs. These NBFCs
registered with RBI mainly perform fund based
services to the customer.

• NBFCs used to provide merchant banking services

also. For better regulation,RBI has ordered for
siphoning of merchant banking services of NBFCs
into separate units.

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 Leasing
• Leasing as financial service is a contractual
arrangement where the owner (lessor) of an
equipment transfers the right to use the equipment
to the user (lessee) for an agreed period of time in
return for a rental.

• At the end of the lease period the assets reverts

back to the lessor unless there is a provision for the
renewal of the contract or there is a provision for
transfer of ownership to the lessee.

• If there is any such provision of transfer of

ownership, the deal is treated as hire purchase.
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 Leasing contd…
• Practice of ‘equipment leasing’ came into being in
the later half of 19th century where railroad
manufacturers in USA resorted to leasing of rail
cars and locomotives.
• Today it is estimated that in USA and many other
countries of the world, about 25% of all business
equipment in terms of value are leased.
• Equipment leasing includes leasing of
– Plants and Machinery
– Office equipments (including computer)
– Automobiles
– Ships and aircrafts.

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 Leasing contd…
• In eighties leasing graduated from ‘equipment
leasing’ to ‘project leasing', for e.g.. leasing power
projects, manufacturing facilities, large construction
projects.

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 Evolution of Indian Leasing industry

• Equipment leasing industry came into

being in 1973 when the first leasing
company, aptly named FLCI was
incorporated in Chennai.
• However, this industry remained relegated
until early eighties because of easy
availability of funds at reasonable cost.
• No need to look for alternative means of
financing.
• Second leasing company-Twentieth Century
Leasing Limited was started in 1979.

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Evolution of Indian Leasing industry contd…
• In early eighties there was a credit squeeze
announced by RBI coupled with strict
implementation of Tandon & Chore
Committee norms on Maximum Permissible
Bank Finance (MPBF) for working capital.
• This forced manufacturing companies to
look for alternative means of funding their
capital expenditure program.

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Evolution of Indian Leasing industry contd…

• Hence sudden spurt in demand for equipment

leasing resulted in spectacular performance of the
few leasing company that were in existence. It also
created an active investor following for equity
stocks of these companies.

• This encouraged the spawning of number of leasing

companies.

• By end of 1985,there were about 300 leasing

companies.

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Evolution of Indian Leasing industry contd…

• The demand for leasing also encouraged the

Financial institutions and commercial
banks to enter this industry. In 1983,ICICI
entered the leasing industry followed by
IFCI,IDBI etc.

• In 1983,the Banking Regulation Act,1949

was amended, whereby commercial banks
were permitted to promote subsidiaries
specializing in equipment leasing and
financial services.

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Evolution of Indian Leasing industry contd…

• The first commercial bank to set up

financial services subsidiary was SBI which
became operational in 1986 under the
name of SBI Capital Markets Ltd.
• This was followed by
– Canara Bank setting up Can bank Financial
services Ltd.
– PNB setting up PNB Financial services Ltd.
– ILFS was jointly promoted by CBI,HDFC and
UTI.

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Evolution of Indian Leasing industry contd…

• Standard Chartered Bank was the 1st foreign bank

to participate in the equity of a leasing company. It
promoted the Cholamandalam Investment and
Finance company at Chennai jointly with Tube
Investments of India Ltd.
• Many foreign banks started offering the service of
lease broking to their corporate clientile.
• In 1994,RBI had permitted all commercial banks
(excluding RRB s) to undertake equipment leasing
and hire purchase financing activities directly
without establishing subsidiaries.

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 Equipment Leasing
• Operationally, an equipment lease transaction
comes into existence as follows:
– The lessee identifies the exact specification of the
equipment
• Its supplier price
• Terms of guarantee and warranty
• Delivery period
– Approaches the leasing company (financial
intermediary) with a lease proposal.
– Negotiations happen
– After culmination of lease contract, the lessor buys
the equipment and delivers to lessee.
– Lessee usually bears the costs of maintenance and
insurance of the asset.
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 Equipment Leasing contd…
• Equipment lease transaction can vary along the
following dimensions;
– extent to which the risks and rewards of ownership are
transferred,
– number of parties to the transaction,
– domiciles of the equipment manufacturer, the lessor and
the lessee.
• Risk refers to the possibility of loss arising on
account of under utilization or technological
obsolescence of the equipment.
• Reward refers to the incremental net cash flows
that can be generated from
– The usage of the equipment over its economic life;
– The realization of the anticipated residual value on expiry
of the economic life.

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 Lease defined
• In up-fronted leases, more rentals are charged in
the initial years and less in the later years of the
contract. The opposite happens in back ended
leases.

• Primary lease provides for the recovery of the cost

of the assets and profit through lease rentals during
a period of about 4 or 5 years. It may be followed by
a perpetual, secondary lease on nominal lease
rentals.
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 Classification of Equipment Lease
• Finance & Operating Lease
• Sale and Leaseback & Direct Lease
• Bipartite and Tripartite Lease
• Single Investor Lease & Leveraged
Lease
• Domestic Lease & International Lease

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 Finance & Operating Lease
• The distinction is based on the extent
to which the risks and rewards of
ownership are transferred from lessor
to lessee.
• A lease is defined as Finance lease if it
transfers a substantial part of risks
and rewards from lessor to lessee or
else it is known as Operating lease.

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 Finance & Operating Lease contd…
• According to IASC, there is a transfer of a substantial
part of ownership related risks and rewards if

i. The lease transfers ownership of the asset to the lessee by

the end of the lease term; or)

ii. The lessee has the option to purchase the asset at a price
which is expected to be sufficiently lower than the fair
market value at the date the option becomes exercisable;
or)

iii. The lease term is for a major part of the useful life of the
asset. The title may or may not eventually be transferred;
or)

iv. The present value of the minimum lease payments is

greater than or substantially equal to the fair market
value of the asset at the inception of the lease. The title
may or may not eventually be transferred.

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 Finance & Operating Lease contd…
• In the Indian context, conditions (i) and (ii) are
inapplicable because inclusion of any of these
conditions in the lease agreement will result in the
agreement being treated as hire purchase agreement.

• Hence, a lease is to be classified as a finance lease if

one of the conditions (iii) or (iv) is satisfied.

• The FASB of USA has infact defined certain cut off

points for criteria (iii) and (iv). According to the FASB
definition of finance lease,
– if the lease term exceeds 75 percent of the useful life of the
asset or;
– if the PV of the minimum lease payments exceeds 90
percent of the fair market value of the asset at the inception
of the lease, the lease will be classified as a ‘finance lease’.
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 Useful Life (Economic Life)
The useful life (or economic life) is the minimum of the
following:
1. Physical life refers to the period for which the equipment
can perform the function for which it has been acquired.
2. Technological Life refers to the period for which the
equipment is not rendered technologically obsolete.
3. Product Market Life refers to the period for which the
product line in which the equipment is used enjoys a
satisfactory market.

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 Operating Lease
• IBM was one of the pioneers of operating lease
contracts.
• Computers & office copying machines, together with
automobiles, trucks, and medical diagnostic
equipment, are the primary types of equipment
involved in operating leases.
• As the lease term is shorter than asset’s economic
life, lease rentals paid under the agreement are not
sufficient to recover the full cost – thus the lessor
recovers the full cost by re-leasing or selling the
asset
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 Financial Lease
• Long-term, non-cancelable lease contracts are known as financial
lease, generally coincides with the economic life of the assets ( e.g.
plant, machinery, land, building, ships and aircrafts).
• Fully amortized i.e. lessor receives the total amount ( cost of the
asset & a return there on) from the lessee.
• Lessee is expected to maintain & serviced the leased asset.

In a typical financial lease:

1. the lessee selects the item it requires and negotiates the price and
delivery terms with the manufacturer;
2. the lessee then arranges to have a leasing firm (lessor) buy the
equipment from the manufacturer; &
3. the lessee simultaneously executes a lease agreement with the
lessor
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 Discussion Case
• Menon Industrial Corporation (MIC) has recently
leased equipment costing Rs.400 lakhs on the
following terms:
• Lease terms - 5 years
• Lease Rentals - Rs.300/ Rs.1,000 per annum
• The incremental borrowing rate for MIC is 18% p.a.
Can the transaction be classified as a financial
lease as per FASB if the useful life of the asset is
six years? Ten years?
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 Interpretation
1. If the estimated life of the asset is 6 years & the lease term is for 5 years, the % of
the lease term = 83.3%. Since lease term exceeds 75% of the estimated useful life
of the asset, the transaction may be classified as Finance Lease (as per FASB).

2. If the estimated life of the asset is 10 years & the lease term is for 5 years, the % of
the lease term is 50%. Since the lease term is below 75% of the estimated useful
life of the asset, the transaction may not be classified as a Finance Lease ( as per
FASB).

3. PV of minimum lease payments = (400 x 0.3) x PVIFA (18,5) = 120 x 3.127 =

Rs.375.24 lakhs & Fair Market Value at the time of inception = Rs.400 lakhs; PV as
a % of fair value = 94% ( this is as per the 4th condition & it exceeds 90% of the fair
value as per FASB – so this may be considered as a Finance Lease.

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 Financial Lease
• The lessee undertakes a “hell or high
water obligation” to pay rent regardless of
the condition or suitability of the asset.
• A financial lease which operates over the
entire economic life of the equipment is
called a “ full payout lease”.

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 Wet and Dry Lease
• The operating lease is a wet lease if the
lessor provides the operating know-how,
suppliers, the related services and
undertakes the responsibility of insuring and
maintaining the equipment.
• An operating lease where the lessee bears
the costs of insuring and maintaining the
leased equipment is called a dry lease.

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Sale and Leaseback and Direct
Lease
• In a sale and leaseback transaction, the
owner of an equipment sells it to a leasing
company which in turn leases it back to
erstwhile owner (lessee) e.g. safe deposit
vaults.
• A direct lease is a lease in which lessee and
owner are two different entities.

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 Bipartite and Tripartite Lease
• In a bipartite lease there are two parties to
the transaction – the equipment supplier
cum lessor and the lessee.
• In a tripartite lease the transaction involves
three parties- the equipment supplier, the
lessor and the lessee.

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 Single Investor Lease and
Leveraged Lease
• In a single investor lease transaction, the leasing
company (lessor) funds the entire investment by
raising an appropriate mix of debt and equity. The
debt funds raised are without recourse to the
lessee.
• In a leveraged lease, the leasing company (called
the equity investor) invests in the equipment by
borrowing a large chunk of the investment with full
recourse to the lessee and without recourse to it.

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 Domestic Lease and
International Lease
• A lease transaction is classified as a
domestic lease if all parties to the
transaction – the equipment supplier, the
lessor and the lessee – are domiciled in
the same country.
• On the other hand if these parties are
domiciled in different countries, the
transaction is classified as an international
lease transaction.
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 Import Lease and cross border
lease transaction
• In an import lease transaction, the lessor
and lessee are domiciled in the same
country, but the equipment supplier is
located in a different country.
• On the other hand, in a cross-border lease
transaction, the lessor and lessee are
domiciled in different countries. The
domicile of supplier is immaterial.

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 Advantages of Leasing
• Flexibility : Flexibility in structuring (Equated,
Stepped, Ballooned, Deferred Leasing)
• User Oriented Variants : Upgrade lease, Full
Service lease, etc.
• Tax based benefits
• Less paper work and expeditious disbursement
• Convenience
• Hundred Percent Financing
• Better Utilization of own funds
• Off Balance Sheet Financing
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