FINANCE LEASE AS A SOURCE OF PROJECT FINANCE_
- 1. FINANCE LEASE AS A SOURCE OF PROJECT FINANCE INTRODUCTION It is undeniable that finance is an important factor in any business venture and is crucial to its success or failure. Investors constantly seek for better ways of financing their businesses without tying up capital which can be otherwise converted to working capital for the running of the venture. Whether an investor is establishing a new business venture, expanding an existing business venture to make it more profitable or even introducing a new product into the market, adequate funding needs to be generated. While there exist several means of financing a business venture, the mode of financing the business would largely depend on the type of venture to be undertaken. For example, a small business enterprise or small startup company might borrow money from friends or family, or even save up to raise the capital needed, while a large business enterprise needing large capital assets to operate may raise finance through sales of shares, debt financing (loans), venture capital or leasing. WHAT IS LEASING? Leasing simply entails a legal agreement or contractual relationship between two parties, the Lessor and the Lessee, whereby the Lessor owns the capital or capital asset and allows the Lessee to use or hire it upon the condition that the Lessee pays a form of rental for a specified period of time. It is the business of letting or sub-letting movable property on hire for the purpose of the use of such property by the hirer or any other person in any business whatsoever. Under this arrangement, the Lessor is the owner of the property regardless of whether the letting is with or without an option to purchase the property1 . Leasing is essentially a 1 Banks and Other Financial Institutions Act CAP B3, Laws of Federation 2004 Page 1 of 14
- 2. form of rental involving tangible resources such as buildings and equipment. This form of financing is usually between the company and a Leasing/Finance company. WHY LEASE? Leasing has become a major source of financing in today’s competitive market. It provides easy access to the much needed assets for productive business. Globally, leasing has become a very attractive and preferred form of project financing in recent times. At present, the leasing industry accounts for an annual global turnover of about US$750bn and in the United States of America, leasing remains the single most widely-used method of external finance, representing 30% of investment in capital equipment2 . In Nigeria, leasing has become an increasingly preferred source of financing business ventures. According to the Equipment Leasing Association of Nigeria (ELAN) the industry has grown significantly. Statistics show that in 2012 the industry recorded a growth of 7.8% with trade volume of over N671Billion while in 2013 the industry recorded a growth of 16.3% with trade volume of over N780Billion3 . Increasing acceptability of leasing as an innovative form of business finance for real economic growth by the Government, Investors and businesses in Nigeria is largely as a result of changing global and national economic climate and this has occasioned the remarkable growth in the industry in recent years. Leasing has the following advantages: 1. PRESERVATION OF LINES OF CREDIT Leasing as a form of business financing provides an alternative to debt financing i.e. bank loans. Where a company leases equipment needed for its business operations instead of taking out a loan to finance its acquisition, the company is able to preserve lines of credit which it would need in the near future. 2 Equipment leasing: A creative financing option for MSMEs http://dailyindependentnig.com/2014/10/equipment-leasing-creative-financing-option-msmes/ 3 http://www.elannigeria.org/news1.html Page 2 of 14
- 3. 2. CASH MANAGEMENT/CASH CONSIDERATIONS Lease financing provides a unique cash management advantage for business ventures in that it creates room for preservation of funds as working capital instead of the funds being used to acquire capital assets. Business ventures are able to acquire capital assets and equipment needed for their business activities without spending the bulk of their available funds to purchase them, therefore retaining the funds as working capital while only paying rentals which are small fractions of the purchase price of the asset to the Lessor. This ensures that businesses can adequately fund their operations and growth without relying on debt financing and it guarantees the business’s health and viability. There are certain business ventures that require huge amounts of capital to acquire the requisite assets and equipments employed in the business such as telecommunications, oil and gas etc. Companies in such industries easily opt for the lease option as it provides a less capital consuming alternative. For example, a large number of telecommunications operators in Nigeria lease facilities such as Voice Processing Hardware, Masts, Multiplexers and switches4 , while those in the oil and gas industry lease vessels and rigs employed in their operations. Where a business venture requires a large number of equipment for its business activities, for example a car-hire company or cab operator, the option of lease seems shrewd and financially prudent, taking into account the large number of cars needed for their fleet and the huge debt liability that would be incurred from outright purchase. Also in some cases, the cost of repaying a loan is more than the cost of leasing the asset. Time value of money is hardly lost. The fact that assets can be procured for business operations by merely making flexible periodic payment makes it increasingly attractive to businesses. 4 Diamond Bank (2003) DEVELOPING TELECOMMUNICATIONS INFRASTRUCTURE IN NIGERIA: THE LEASING OPTION – Telecoms Lease Presentation to ELAN. Page 3 of 14
- 4. 3. FLEXIBILITY AND CONVENIENCE Leasing enables business enterprises to access latest technology, equipment and infrastructure through flexible, innovative rental programs and effective Asset Life Cycle Management. Leasing rarely goes through capital expenditure control and is usually not subject to the close scrutiny often associated with capital expenditure proposals. A Lessee can also borrow in excess of the statutory limits provided in its Memorandum and Articles. The terms and conditions of a finance lease are also easier to negotiate unlike those of traditional finance options such as a term loan. Furthermore, as the leasing industry is characterized by aggression which is translated into adaptability to meet the peculiar needs of the Lessee’s, the Lessee easily accesses needed equipments. The rental payments are also structured to suit the peculiarities of the Lessee including his cash flow pattern and any seasonal or cyclical business conditions to which it is exposed5 . 4. OBSOLESCENCE HEDGE Leasing capital asset and equipment for business activities helps companies keep up with technological advancements and new technologies employed in their industry. It also reduces the risk of being caught with obsolete equipment or technology. As businesses do not purchase the capital assets and equipments which they use in their business operations, they can easily move on to better technologies and equipment without losing any capital. In fact, this is one of the major reasons why businesses consider the lease option more favourable than outright purchase. 5. LESS RESTRICTIVE FORM OF FINANCING Most conventional forms of business finance such as loans, venture capital etc, place heavy financial burden and strain on businesses and they also take a big chunk of the generated working capital which is never the case with lease financing. The rentals paid by the Lessee, which account for the purchase price and interest accruing to the Lessor, are well spread out over the primary lease 5 Esosa Bob Osaze, Ph.D.: LEASE FINANCING IN NIGERIA. Pacific Printers Nig. Ltd ©ELAN 1993 Page 4 of 14
- 5. period and this eases the financial burden on the Lessee. Also, it eradicates the need to tie down large chunks of working capital in acquiring capital assets and equipments thereby creating more available capital for operations and business growth. 6. ABSENCE OF COLLATERAL/SECURITY Unlike bank loans or other forms of credit/debt financing, leases obviate the need of collateral to secure the funds invested into the business by a creditor. The Lessor buys the asset from the manufacturer and makes full payment for the purchase. The only obligation required of the Lessee is the payment of the periodic rentals without any imposition of lien on any of the assets of the Lessee. TYPES OF LEASES Lease as a source of business finance takes several forms but there are two primary types which are Finance Lease and Operating Lease. In the International Accounting Standard IAS176 , lease has been classified into the two identified categories based on the extent to which risks and rewards incidental to the ownership of the leased asset lie in the Lessor or Lessee. Other types or variations of lease have been identified over the years which fall under the two main categories of leases. The ELAN7 and OPC Asset Solutions8 have identified these variants as follows: 1. Leveraged and non-leveraged leases. 2. Sale and leaseback 3. Full-payout and non-payout leases 4. Specialized service lease 5. Net and Net-net leases 6. Sales-Aid lease and vendor lease 7. Small-ticket and big-ticket leases 6 http://www.ifrs.org/documents/ias17.pdf 7 Esosa Bob Osaze, Ph.D.: LEASE FINANCING IN NIGERIA. Pacific Printers Nig. Ltd ©ELAN 1993, 13 8 http://www.opc.co.in/aboutleasing.php Page 5 of 14
- 6. 8. Cross-border lease 9. Consumer leasing 10.Wrap lease 11.Swap lease 12.Syndicated/Consortium lease This paper would be focusing on Finance Lease as it is the form of leasing that relates to assets and equipment that are directly employed in the core activities and production systems of business enterprises. However, before discussing in extenso Finance Lease, it is important to take a look at Operating Lease. OPERATING LEASE Operating lease is a contract wherein the owner, called the Lessor, permits the user, called the Lessee, to use an asset for a particular period which is shorter than the economic life of the asset without an option of transfer of ownership rights. The Lessor gives the right of use to the Lessee in return for regular payments for an agreed period of time9 . An operating lease is such that the cost of the asset is not fully recovered from a single lessee. The lease period is therefore short to enable the Lessor recover the cost of the asset from multiple lessees. Repair and maintenance of the asset is the Lessor's responsibility10 . The ELAN has defined Operating Lease as a lease agreement in which the asset is not fully amortized during the primary lease and the Lessor does not necessarily depend on the lease rentals during the period for his returns but looks to the recovery of the balance of his costs and profits from the resale of the used asset at the expiration of the lease period11 . Under this arrangement, the Lessee hires the asset or equipment from the Lessor for a short period of time and all the risks of ownership are borne by the Lessor. The asset is usually used by a number of users successively and the Lessee can easily terminate the lease at any point in time because the lease asset by its nature can be easily re- 9 The Economic Times: http://economictimes.indiatimes.com/definition/operating-lease 10 http://www.opc.co.in/aboutleasing.php 11 Esosa Bob Osaze, Ph.D.: LEASE FINANCING IN NIGERIA. Pacific Printers Nig. Ltd ©ELAN 1993, 12 Page 6 of 14
- 7. leased to another Lessee within a short period of time. The Lessor is also specialized in the handling and operating the leased out asset or equipment and usually provides specialized services. For this reason, operating lease is usually classified into two categories to wit; simple operating lease and specialized service operating lease. However unlike Finance lease, operating lease does not directly fund the growth and development of businesses in that most of the assets leased under this arrangement are hardly employed in the production business of the Lessee. An example of such asset or equipment includes private jets. Some of the distinguishing features of an Operating Lease are as follows: 1. The asset or equipment is leased for a relatively short period of time thereby making it possible for the asset or equipment to be used by several Lessees during its economic life. The asset may also be sold as second hand at the end of the lease period. 2. The Lessor is responsible for the servicing and maintenance of the leased asset or equipment. 3. The lease can be terminated by the Lessee at any point in time. 4. The Lessor can offer specialized services in the handling and operation of the leased asset or equipment. 5. The Lessor bears the entire risks incidental to the ownership of the leased asset or equipment. FINANCE LEASE A finance lease can simply be defined as a long-term lease of an asset whereby the Lessor leases the asset to the Lessee for most part or all of its economic life. Finance lease is a lease involving rental payment over an obligatory period sufficient in total to amortize (repay) the capital outlay of the equipment and also give the Lessor some Page 7 of 14
- 8. benefits. The lessee also has the option of purchasing the leased equipment at the expiration of the lease agreement12 . Here, the Lessee in need of a capital asset for its business activities approaches a finance house for the acquisition of this capital asset. The finance house which usually acts as the Lessor acquires the asset or equipment needed by the Lessee for its business activities and leases it out to the Lessee. The Equipment Leasing Association of Nigeria (ELAN) publication “LEASE FINANCING IN NIGERIA”13 summed up Finance Lease in the following words; “A Finance Lease also known as a Capital or Full Pay-out Lease. This is a contract involving the payment over a period of time (known as the primary or basic period) of specified sums sufficient in total to amortize the capital outlay of the Lessor and to provide for the Lessor’s cost of funds plus desired return. The Lessee in a finance lease arrangement is normally responsible for maintenance of the leased asset. Usually, after the expiration of the primary lease period, the Lessee has a choice of either purchasing the asset through an arms length deal or extending the lease over a secondary period.” For example, Company A decides to acquire staff buses for its staff and it approaches a dealer who agrees to supply them. Company A then approaches a Finance House which agrees to act as the Lessor , purchase the buses from the car dealer and in turn lease them out to Company A. Company A would then take possession of the buses from the car dealer and make periodic payments, as may be agreed under the lease agreement, to the Finance House throughout the duration of the lease. Under a finance lease, the Lessee is obligated to make periodic payments or rentals in consideration for the use of the asset, which payments are structured such that the principal purchase price is repaid to the Lessor as well as the interest accruable on it during the desired payback period (usually the primary lease period). However, the Lessee has an option to purchase the asset at the end of the lease period. 12 Central Bank of Nigeria – Revised Guidelines for Finance Companies in Nigeria (April, 2014) 13 Esosa Bob Osaze, Ph.D.: LEASE FINANCING IN NIGERIA. Pacific Printers Nig. Ltd ©ELAN 1993, 4 Page 8 of 14
- 9. A Finance lease cannot be cancelled or revoked by any of the parties throughout the primary period of the lease (i.e. the lease period also known as the obligatory period) and the Lessee bears all the risks and also enjoys the rewards incidental to the ownership of the asset even though the title to the asset is not transferred to him. The Lessee is also responsible for the maintenance and service of the asset though ownership and title of the asset are still vested in the Lessor. The Association of Chartered Certified Accountants (ACCA) in its paper “Lease – Finance or Operating”14 has identified features that characterize a lease as Finance lease to include the following: • The lease transfers ownership of the asset to the lessee by the end of the lease term; • The lease term is for the major part of the economic life of the asset, even if title is not transferred; • At the inception of the lease, the present value of the minimum lease payments amounts to at least substantially all of the fair value of the leased asset; • The leased assets are of a specialized nature such that only the lessee can use them without major modifications being made; • If the lessee is entitled to cancel the lease, the Lessor’s losses associated with the cancellation are borne by the lessee; • Gains or losses from fluctuations in the fair value of the residual fall to the lessee; • The lessee has the ability to continue to lease for a secondary period at a rent that is substantially lower than market rent. Lease financing has been regarded over the years as a very ingenious model of financing a business however, it is still not fully accepted in this part of the world. In most developed parts of the world and some specialized industries in Nigeria, Finance lease has become a preferred option for businesses because it carries along with it has more advantages to business ventures over conventional means of finance. 14 ACCA(2014): Lease – operating or finance? http://www.accaglobal.com/za/en/student/acca-qual-student- journey/qual-resource/acca-qualification/f7/technical-articles/lease.html Page 9 of 14
- 10. Finance lease in Nigeria is provided by Finance Houses which are licensed and regulated by the Central bank, CBN15 . OPERATION OF A FINANCE LEASE A finance lease transaction usually passes through the following stages16 : 1. Investment decision stage – this is the incubation stage of all finance leases. At this stage, the lessee makes a decision to acquire a particular asset or otherwise. This is usually an internal affair of the Lessee. 2. Asset/Product decision stage – After deciding which asset to acquire/invest in, the Lessee then proceeds to this stage in which it selects the asset after satisfying itself about its specifications, suitability of purpose and functionality. 3. Financing decision stage – The Lessee weighs all the project financing options available to it and makes a decision on the most suitable one. This is the point at which the Lessee decides to use finance lease as the means of acquiring the capital asset. 4. Preferred Lessor decision stage – After a decision has been made to lease the asset, the Lessee makes a decision on the finance house to approach to finance the acquisition and act as Lessor. 5. Negotiation stage – This is the stage wherein the parties (i.e. the Lessor and Lessee) negotiate a lease agreement and the terms are agreed to. Usually, a letter of intent/term sheet is signed at this stage. 6. Ratification stage – This stage is not generally relevant to all leases, however, a lease agreement such as a cross-border lease where certain statutory approvals, permits and consents from government agencies are required would feature this stage. Additional approvals might be needed if the asset/machinery to be leased requires an operating permit such as in the case of aircrafts, dredgers or ships 15 See Central Bank of Nigeria – Revised Guidelines for Finance Companies in Nigeria (April, 2014) 16 LEASE FINANCE - http://www.iflr.com/Article/2027422/Lease-Finance.html Page 10 of 14
- 11. 7. Lease agreement stage – All the terms of the lease are finalized and a formal lease is drawn up for execution by the parties along with other necessary documentation. 8. Order placement stage – The Lessor, consequent upon the signing of the lease agreement, contacts its preferred manufacturer to place an order for the asset required by the Lessee. Advance payments may be needed at this stage. Upon placing the order, the Lessor makes the advance payments and charges interest on these until the lease commences. 9. Commencement stage – Here, the lease commences after the manufacturer delivers the ordered asset or equipment to the Lessee who in turn notifies the Lessor of acceptance of the asset. The Lessor also converts the advance payments made for the purchase of the asset into leased asset in its books of account. 10. Primary lease stage – The primary lease stage is the period through which the lease is expected to run and the Lessor targets to recover the purchase price of the asset and any interest charged on it. The Lessee is given an option to renew the lease usually for a secondary period which is more often than not undefined. 11. Terminal stage – At the end of the primary lease period, the asset automatically reverts to the Lessor. However, the Lessee is allowed the option of re-leasing the asset for a secondary lease period. Ordinarily, no purchase option is written into the lease agreement, however, where the Lessor makes a decision to sell the asset the Lessee may be given the right of first refusal, allowed to participate in the auction or share a percentage of the sales profit where the asset is sold to a third party depending on the negotiations between the parties. ADVANTAGES OF FINANCE LEASE AS A BUSINESS FINANCE MODEL Finance lease is seen today all over the globe as a revolutionary means of financing business operations. It has become a preferred finance solution simply because of the unique options it affords business ventures and the advantages that come with it. Page 11 of 14
- 12. Business ventures may therefore consider financing their businesses using the finance lease model for the following reasons17 ; 1. FAVORABLE FINANCIAL REPORTING Under finance lease, an asset is treated as being owned by the lessee in its books and therefore reflected on the balance sheet. This has the ability of enhancing the book value of the lessee company. It is not in doubt that a healthy balance sheet increases investor confidence in a company. 2. TAX BENEFITS Finance lease also confers tax benefits on the Lessee. Since he is considered the owner of the equipment, he can claim depreciation on the leased asset unlike the lessee in the operating lease. Under the Companies Income Tax Act 2007, a lessee in a finance lease, can claim capital allowances on the total lease payments (excluding interest) made to the Lessor.18 The lessee under an operating lease, has no such entitlement, although for both types of leases, the interest and other related expenses are deductible expenses for income tax purposes.19 3. OPTION TO PURCHASE In a finance lease, the lessee has the option of purchasing the asset after the expiration of the primary lease period at a price often lease than the fair market value of the asset. ROLE OF THE LAWYER IN A LEASE TRANSACTION 17 Equipment leasing: A creative financing option for MSMEs http://dailyindependentnig.com/2014/10/equipment-leasing-creative-financing-option-msmes/ 18 Paragraph 18(2) of the 2nd Schedule to the CITA 19 FIRS Information Circular No. 2010/01. Published on 12th April 2010 Page 12 of 14
- 13. 1. Lawyers are involved in the negotiations relating to the terms of the lease particularly the end-of-term options. 2. Lawyers have the responsibility of preparing of the lease agreement, paying particular attention to dispute resolution clauses. 3. In the event of a dispute, lawyers initiate the dispute resolution procedure and guide parties through the resolution process. 4. A lawyer is usually involved in the sale of the asset after the termination of the lease. CONCLUSION Finance lease may just be the ultimate solution business ventures have been looking for to finance their operations without the concomitant huge liabilities associated with traditional forms of business financing. The relative convenience in procuring assets and equipments as well as the other associated advantages makes it indeed a very attractive form of business financing. Businesses are therefore enjoined to take advantage of the promise finance lease holds for business development and real economic growth. SOURCES 1. Daily Independent Newspaper – Equipment leasing: A creative financing option for MSMEs http://dailyindependentnig.com/2014/10/equipment-leasing-creative- financing-option-msmes/ 2. Equipment Leasing Association of Nigeria (ELAN) – http://www.elannigeria.org/news1.html Page 13 of 14
- 14. 3. Esosa Bob Osaze, Ph.D.: Lease Financing In Nigeria. Pacific Printers Nig. Ltd ©ELAN 1993 4. International Financial Law Reporting (IFLR 2001): LEASE FINANCE http://www.iflr.com/Article/2027422/Lease-Finance.html 5. Diamond Bank (2003): DEVELOPING TELECOMMUNICATIONS INFRASTRUCTURE IN NIGERIA: THE LEASING OPTION – Telecoms Lease Presentation to ELAN. 6. http://www.ifrs.org/documents/ias17.pdf 7. ACCA (2014): Lease – operating or finance? http://www.accaglobal.com/za/en/student/acca-qual-student-journey/qual- resource/acca-qualification/f7/technical-articles/lease.html 8. http://www.opc.co.in/aboutleasing.php 9. The Economic Times: http://economictimes.indiatimes.com/definition/operating- lease 10. Central Bank of Nigeria – Revised Guidelines for Finance Companies in Nigeria (April, 2014). 11. Companies Income Tax Act 2007 12. Federal Inland Revenue Service Circular No. 2010/01 published on 12th April 2010. Page 14 of 14