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

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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 CREDITLeasing 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

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2. CASH MANAGEMENT/CASH CONSIDERATIONSLease 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.

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3. FLEXIBILITY AND CONVENIENCELeasing 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 HEDGELeasing 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 FINANCINGMost 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

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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/SECURITYUnlike 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 LEASESLease 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 leases6 http://www.ifrs.org/documents/ias17.pdf7 Esosa Bob Osaze, Ph.D.: LEASE FINANCING IN NIGERIA. Pacific Printers Nig. Ltd ©ELAN 1993, 138 http://www.opc.co.in/aboutleasing.php

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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 LEASEOperating 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-lease10 http://www.opc.co.in/aboutleasing.php11 Esosa Bob Osaze, Ph.D.: LEASE FINANCING IN NIGERIA. Pacific Printers Nig. Ltd ©ELAN 1993, 12

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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 LEASEA 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

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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

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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

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Finance lease in Nigeria is provided by Finance Houses which are licensed and

regulated by the Central bank, CBN15.

OPERATION OF A FINANCE LEASEA 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

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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.

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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 BENEFITSFinance 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 PURCHASEIn 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 CITA19 FIRS Information Circular No. 2010/01. Published on 12th April 2010

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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

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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 12 th April

2010.

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