Crack Grade B 1

Alternate source of finance, private and social cost-benefit, Public

Private Partnership
Factoring is a financial transaction and a type of debtor finance in which a
business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at
a discount. It differs from invoice discounting. The concept of invoice discounting involves,
getting the invoice discounted at a certain rate to get the funds, whereas the concept of
factoring is broader. Factoring involves the selling of all the accounts receivable to an
outside agency. Such agency is called a factor.

CONCEPT OF FACTORING
Factoring works best in cases where the seller doesn’t have enough balance sheet standing
or collateral support to raise standalone working capital finance but has good quality
receivables. Factoring typically works well for the small and medium (SME) segment and
companies in their growth phase where risk appetite remains constrained. A seller will, in
such cases, be able to convert such receivables to cash (for a fee) thus aiding his working
capital cycle. The clear benefit here is that the cash raised is directly proportionate to the
underlying sales and is hence largely scalable unlike traditional bank finance. While
various structures are in vogue, a Factor can also provide a company with specialized add-
ons like credit protection against bad debts, outsourcing of their sales book and funds
collections etc.

The seller makes the sale of goods or services and generates invoices for the same. The
seller then sells all its invoices to a third party called the factor. The factor pays the seller,
after deducting some discount on the invoice value. The rate of discount in factoring varies.
The factor does not make the payment of all invoices immediately to the seller. Rather, it
pays only up to 75 to 80 percent of invoice value after deducting the discount. The
remaining percentage of the invoice value is paid after the factor receives the payments
from the seller’s customers. A Factor will normally therefore prepay only to the extent of
the cost of goods sold.

A Factoring company undertakes a transaction based on the quality of the receivables

unlike a bank which takes credit decisions based on a company's financial history, cash
flow and collateral. Empirically, Factoring companies are able to turn around a funding
proposal within days as compared with weeks for banks in general.

Charges: The cost structures of factoring companies vary across geographies. However,
the usual heads of costs include an interest charge for the funded amount and service
fees on transactions. Additional add-on services availed of like credit protection and
collection etc. could be charged separately depending on the package structured with the
client company.

Types of Factoring
Based on the features built into the factoring transactions, different types of factoring
arrangements have come into existence:

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Recourse factoring: In recourse factoring, the factor purchases trade debts and
essentially renders collection service and maintains sales ledgers. But, in case of default
or non-payment by a trade debtor, the factor has the right to collect the unpaid invoice
amount from the seller. Hence, recourse factoring does not include bad debts protection.
It is popular in the developing countries.

Non-recourse factoring: Under non-recourse factoring, the factor’s obligation to the seller
becomes absolute on the due date of the invoice, irrespective of the payment made or not
made by the trade debtor. In other words, if the trade debtor fails to make a payment, the
factor cannot recover this amount from the seller. In non-recourse factoring, factor
charges are high as they offer the seller protection against bad-debts. The loss arising out
of irrecoverable receivables is borne by the factor. This type of factoring arrangement is
found in developed countries such as UK and USA, where reliable credit rating services
are available.

Advance and maturity factoring: Sometimes, the factor and the client make an
arrangement whereby the factor pays a pre-specified portion of the factored receivables in
advance to the client on submission of necessary documents. This type of arrangement is
known as advance factoring. The balance portion is paid upon collection or on the
guaranteed payment date. Generally, factoring is advance factoring and factor pays 80 per
cent of the invoice amount in advance. Under maturity factoring no advance payment is
made by the factor but payment is made only on the guaranteed payment date or on the
date of collection. Maturity factoring is also known as collection factoring.

Old line factoring: Old line factoring is also known as full factoring as it provides an
entire spectrum of services, such as collection, credit protection, sales ledger
administration, and short-term finance. It includes all features of non-recourse and
advance factoring.

Cross-border factoring/International factoring: In domestic factoring, three parties are

involved, namely, customer (buyer), client (seller), and factor (financial institution or
intermediary) while in international factoring there are four parties, namely, exporter
(client), importer (customer), export factor, and import factor. Thus, in international
business transactions, factoring services are provided by factors of both countries, that is,
the exporter country’s factor and the importer country’s factor. This is known as cross-
border factoring or international factoring.

Factoring in India
The RBI formed a committee headed by C. S. Kalyanasundaram, a former managing
director of the State Bank of India (SBI) to examine the need for and scope of factoring
organisations in India. The committee submitted its report in December 1988 and
recommended introduction of factoring services in India. The RBI advised banks to take
up factoring activity through a subsidiary.

The State Bank of India, in association with the State Bank of Indore, the State Bank of
Saurashtra, the Small Industries Development Bank of India, and the Union Bank of India
set up the SBI Factors and Commercial Services in February 1991. SBI Factors
commenced operations from April 1991. SBI Factors was the first factoring company to be
set up in India.

SBI factors offers two types of products under domestic factoring:

1. Bill 2 cash (Receivables factoring facility)—the seller invoices the goods to the buyer,
assigns the same to SBI factors, and receives prepayment up to 90 per cent of the invoice
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value immediately. The balance amount is paid to the client when the customer pays to
SBI factors. This facility can be ‘with recourse’ or ‘without recourse’.

2. Cash 4 purchase (Purchase bill factoring)—facilitates instant payment for purchases

made and is generally sanctioned in conjunction with receivable factoring facility or export
factoring facility.

Canbank Factors Limited is another factoring company and it is also into recourse
factoring. Canbank factors is a subsidiary of Canara Bank and was incorporated in the
year 1991 with Small Industries Development Bank of India (SIDBI) and Andhra Bank as
co-promoters. It is registered as a non-banking finance company (NBFC) and hence is
governed by the regulatory norms of the RBI.

Global Trade Finance Private Limited was set up in September 2001 by West Deutesche
Landesbank Girozentrate, EXIM Bank of India, and International Finance Corporation for
promoting cross-border factoring services. In March 2008, the SBI acquired 92.85 per cent
stake and the remaining 7.15 per cent is with Bank of Maharashtra. It is the only provider
of international factoring, domestic factoring, and forfaiting services under one roof in
India.

Some of the key differences between factoring and bill discounting is stated below:

 Bill discounting is always with recourse, whereas factoring can be either with
recourse or without recourse.
 In bill discounting, the drawer undertakes the responsibility of collecting the
bills and remitting the proceeds to the financing agency, while the Factor usually
undertakes to collect the bills of the client.
 Bill discounting facility limits itself to a mode of finance and only that, but a
Factor also provides other services like sales ledger maintenance and advisory
services.
 Discounted bills may be rediscounted several times before they mature for
payment. Debts purchased for factoring cannot be rediscounted, they can only
be refinanced.
 Factoring implies the provision of bulk finance against several unpaid trade
generated invoices in batches; bill financing is individual transaction oriented
i.e. each bill is separately assessed and discounted.
 Factoring is an off balance sheet mode of financing.
 Bill discounting does not involve assignment of debts as is the case with
factoring.
 Bill discounting is individual transaction based, whereas in a factoring facility
the client would have to route all invoices raised on an approved debtor through
the factoring company.

Forfaiting is a method of trade finance that allows exporters to obtain cash by selling
their medium term foreign account receivables at a discount on a “without recourse” basis.
A forfaiter is a specialized finance firm or a department in banks that performs non-
recourse export financing through the purchase of medium-term trade receivables. Similar

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to factoring, forfaiting virtually eliminates the risk of nonpayment, once the goods have
been delivered to the foreign buyer in accordance with the terms of sale. However, unlike
factors, forfaiters typically work with the exporter who sells capital goods, commodities,
or large projects and needs to offer periods of credit from 180 days to up to seven years.
In forfaiting, receivables are normally guaranteed by the importer’s bank, allowing the
exporter to take the transaction off the balance sheet to enhance its key financial ratios

Trade receivables, include bills of exchange, promissory notes, book receivables and
deferred payments under letters of credit. The exporter surrenders trade receivables to the
forfaiting agency, which pays him in cash after deducting some charges. The forfaiting
agency then collects the dues from the importer on expiry of the same period. Thus,
forfaiting enables exporters to offer longer-term financing to importers of capital goods
from India.

Initially, forfaiting developed as a fixed interest rate and medium-term (3 to 5 years)

financing. Now it can be tailor-made to suit the exporter’s requirements on the basis of
interest rate, credit period, moratorium, and variable shipment schedule. Credit periods
can range from 60 days to 10 years.

Forfaiting is used in the following situations:

• There is a request for deferred payment for more than 60 days.
• The contract is for at least USD 1,00,000 or its equivalent, in a freely convertible
currency, and when each shipment is not less than USD 25,000.
• Either a letter of credit or a bank guarantee is available or the exporter believes that the
buyer is an acceptable standalone risk.
• The sale is made to a buyer in a high credit risk country.
• The exporters’ own bank limits are inadequate or not available.

Key Points:
 Eliminates virtually all risk to the exporter with 100 percent financing of contract
value.
 Allows offering open account in markets where the credit risk would otherwise be
too high.
 Generally works with bills of exchange, promissory notes, or a letter of credit.
 Normally requires the exporter to obtain a bank guarantee for the foreign buyer.
 Financing can be arranged on a one-shot basis in any of the major currencies,
usually on a fixed interest rate, but a floating rate option is also available.
 Forfaiting is a non-recourse and off-balance sheet financing. It eliminates all risks
from the exporter’s books.
 Commercial banks usually do not fund credit risks beyond 180 days. Hence, for
financing long tenor receivables, forfaiting is the only option.

Pricing of a Forfaiting Transaction: The pricing consists of four elements: discount rate,
commitment fees, grace days, and handling fee.
• Discount rate: Discount rate is the interest element and reflects the cost of funds. It is
the rate at which the face value of a negotiable instrument is discounted. The discount
rate is usually quoted as a margin over London Inter-Bank Offer Rate (LIBOR). The margin
depends upon the country/bank risk and the credit period. A high country risk and longer
credit period will attract higher margins.

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• Commitment fees: The commitment fees is calculated from the date the forfaiter is
committed to undertake the financing until the date of discounting.
• Grace days: These are the number of days beyond the stated maturity. They represent
the anticipated number of days required for transmission and receipt of funds at maturity.
It normally ranges from two to five days and can extend upto 15 days and beyond.
• Handling fee: A handling fee is applicable for documentation and custom clarification.

Growth of Forfaiting in India: In India, the RBI vide its circular dated February 13, 1992,
approved forfaiting as an export financing option. Exim Bank was the first institution
which got approval in 1992 to finance exports through forfaiting. Forfaiting facility is
provided by an international forfaiting agency and a forfaiting transaction is routed
through an authorised dealer (AD). This authorised dealer provides services such as
handling documentation and providing customs clarification for GR form purposes.
Forfaiting proceeds are to be received in India as soon as possible after shipment but
within the 180-day period specified by the RBI for all exports.

The International Trade & Forfaiting Association (ITFA) was founded in 1999 as a
worldwide trade association for the forfaiting industry with a cash contribution of the VEFI
(VEFI, founded in 1978 is the oldest forfaiting association in the world). Its purpose is to
develop business relationships and assist other forfaiting-related organizations.

Crowdfunding: In layman's language crowdfunding is the practice of project funding by

raising small amounts from a large number of people. However, the medium on which
such amounts are collected is the internet. Crowdfunding is an alternative source of
finance to traditional means like debt funding or equity. Earlier crowdfunding used to be
through mail subscription also, but this modern crowdfunding is based on internet. This
funding requires three major elements:

Project initiator - The entity who proposes the idea

Individuals or groups who support the idea,

The "platform" that brings the parties together to launch

Crowdfunding has been used to fund a wide range of projects like artistic, creative,
medical expenses, travel, or community-oriented projects. It can be used by both profit &
non-profit organizations.

The following are the financial benefits: -

Crowdfunding allows access to low-cost capital.

Creators can find funders from around the world.

Obtain early feedback on the product.

Benefits for the investor:

Cost Reduction - Cost to investors is reduced because of this type of funding. As

investment is done just by using the internet without any documentation requirement as
such its beneficial to investors.

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Neglected sectors Are Focused - Crowdfunding opens some of these neglected markets
to individual investors. Crowdfunding doesn't make sense in every industry, but for some,
like retail and consumer, it does.

Increased Value to New Investors - Another reason why crowdfunding is attractive is

that the investors add value to companies. They act as brand advocates and can even be
used as a focus group. Crowdfunding allows individual investors to be a valuable part of
the company they invest in.

Risks for the investor

Due Diligence - In crowdfunding the due diligence procedure cannot take place. Hence
such funding can be risky to investors.

Failure of Project Execution - If the project fails to get executed in early stage the whole
investment is washed away, as returns of capital from the initiator may not take place.

Frauds - In the growing age of technology many unscrupulous activities take place as
crowdfunding is majorly through the online platforms or the internet risk of frauds is high.

Types of crowdfunding:

Reward-based: Reward-based crowdfunding has been used for a wide range of purposes
such as inventions development, scientific research and civic projects. It is a non-equity
based funding and it is not location specific.

Equity: Equity capital is created through the formation of company and the creator should
produce the product for which they are raising capital. Equity crowdfunding unlike
rewards-based crowdfunding, involves the offer of securities which include the potential
for a return on investment.

Debt-based: Online application is filed by the borrower mostly for free of cost and the said
application is reviewed and verified by the automated system. It determines the credit risk
and interest rate. Investors buy securities in a fund which makes the loans to individual
borrowers or bundles of borrowers. Investors make money from interest on the unsecured
loans; the system operators make money by taking a percentage of the loan and a loan
servicing fee.

Donation-based: Donation-based crowdfunding is the collective effort of individuals to

help charitable causes. In charity crowdfunding, funds are raised for social or
environmental purposes.

Peer to Peer Lending: P2P lending is a form of crowd-funding used to raise loans which
are paid back with interest. It can be defined as the use of an online platform that matches
lenders with borrowers in order to provide unsecured loans. The borrower can either be
an individual or a legal person requiring a loan. The interest rate may be set by the
platform or by mutual agreement between the borrower and the lender. Fees are paid to

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the platform by both the lender as well as the borrower. The borrowers pay an origination
fee (either a flat rate fee or as a percentage of the loan amount raised) according to their
risk category. The lenders, depending on the terms of the platform, have to pay an
administration fee and an additional fee if they choose to use any additional service (e.g.
legal advice etc.), which the platform may provide.

The platform provides the service of collecting loan repayments and doing preliminary
assessment on the borrower’s creditworthiness. The fees go towards the cost of these
services as well as the general business costs. The platforms do the credit scoring and
make a profit from arrangement fees and not from the spread between lending and deposit
rates as is the case with normal financial intermediation. While crowd funding - equity,
debt based and fund based- would fall under the purview of capital markets regulator
(SEBI), P2P lending would fall within the domain of the Reserve Bank.

RBI Guidelines: The Reserve Bank of India (RBI) said, through a notification, that peer-
to-peer lenders (P2P)—companies that provide loan facilitation services from their
platform—will be treated as non-banking financial companies (NBFCs).
Eligibility Criteria:
 No non-banking institution other than a company shall undertake the business of
Peer to Peer Lending Platform.

 No NBFC-P2P shall commence or carry on the business of a Peer to Peer Lending

Platform without obtaining a Certificate of Registration (hereinafter referred to as
“CoR”) from the Bank.

 Every company seeking registration with the Bank as an NBFC-P2P shall have a net
owned fund of not less than rupees twenty million or such higher amount as the
Bank may specify.
Scope of Activities: An NBFC-P2P shall-
 act as an intermediary providing an online marketplace or platform to the
participants involved in Peer to Peer lending;

 not raise deposits as defined by or under Section 45I(bb) of the Act or the
Companies Act, 2013;

 not lend on its own;

 not provide or arrange any credit enhancement or credit guarantee;

 not facilitate or permit any secured lending linked to its platform; i.e. only clean
loans will be permitted;

 not hold, on its own balance sheet, funds received from lenders for lending, or
funds received from borrowers for servicing loans;

 not cross sell any product except for loan specific insurance products;

 not permit international flow of funds;

 ensure adherence to legal requirements applicable to the participants as

prescribed under relevant laws.

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 store and process all data relating to its activities and participants on hardware
located within India.
Prudential Norms:
(1) NBFC-P2P shall maintain a Leverage Ratio not exceeding 2.

(2) The aggregate exposure of a lender to all borrowers at any point of time, across all
P2Ps, shall be subject to a cap of ₹ 50,00,000/-. The lender investing more than ₹
10,00,000 across P2P platforms shall produce a certificate to P2P platforms from a
practicing Chartered Accountant certifying minimum net-worth of ₹ 50,00,000.

(3) The aggregate loans taken by a borrower at any point of time, across all P2Ps, shall be
subject to a cap of ₹ 10,00,000/-.

(4) The exposure of a single lender to the same borrower, across all P2Ps, shall not exceed
₹ 50,000/-.

(5) The maturity of the loans shall not exceed 36 months.

(6) P2Ps shall obtain a certificate from the borrower or lender, as applicable, that the limits
prescribed above are being adhered to.

Companies that are undertaking the business of Peer to Peer Lending Platform, as
on the date of effect of these directions, shall apply for registration as an NBFC-P2P
to the Bank within 3 months from that date.
Fund Transfer Mechanism: Fund transfer between the participants on the Peer to Peer
Lending Platform shall be through escrow account mechanisms which will be operated by
a trustee. At least two escrow accounts, one for funds received from lenders and pending
disbursal, and the other for collections from borrowers, shall be maintained. The trustee
shall mandatorily be promoted by the bank maintaining the escrow accounts. All fund
transfers shall be through and from bank accounts and cash transaction is strictly
prohibited.

What is TReDS?

TReDS refers to Trade Receivable Discounting System. TReDS is being setup as per the
RBI guideline issued on December 3, 2014. It is an online electronic platform and an
institutional mechanism for financing / factoring of trade receivables of MSME Sellers
against Corporate Buyers, Govt. Departments and PSUs.

RXIL, a joint venture between National Stock Exchange of India Limited (NSE) and Small
Industries Development Bank of India (SIDBI) has been authorised by Reserve Bank of
India (RBI) to operate the TReDS platform. The main objective of the TReDS platform is to
address the financing needs of MSMEs as well as the delayed payments issue.
Following are the Salient Features of TReDS:
 Unified platform for Sellers, Buyers and Financiers
 Eliminates Paper
 Easy Access to Funds
 Transact Online
 Competitive Discount Rates

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Manufacturing(Investment in Service Sector(Investment in

Plant and Machinery) Equipment)

Micro Does not exceed Rs. 5 Crore Does not exceed Rs. 5 Crore

More than Rs. 5 Crore but More than Rs. 5 Crore but does not
Small
does not exceed Rs. 75 Crore exceed Rs. 75 Crore

More than Rs. 75 Crore but More than Rs. 75 Crore but does not
Medium
does not exceed Rs. 250 Crore exceed Rs. 250 Crore

 Seamless Data Flow

 Standardised Practices

The following categories of participants can join the TReDS platform:

Participants Eligibility

MSME entities as per the definition of the Micro, Small and

Sellers
Medium Enterprises Development Act, 2006 (“MSMED Act”)

Corporates including companies and other buyers including

Government Departments and Public Sector Undertakings and
Buyers
such other entities as may be permitted by the Reserve Bank of
India (RBI)

Banks, NBFC Factors, Financial Institutions and such other

Financiers
institutions as may be permitted by RBI from time to time

*The TReDS platform will support not only invoices raised by MSMEs in the manufacturing
sector but also for the service sector as per the MSMED Act, 2006.

The eligibility criteria for MSME enterprises to join the TReDS platform as Sellers
are given below:

Important points:

Factoring: Factoring is a financial transaction and a type of debtor finance in which a

business sells its accounts receivable (i.e., invoices) to a third party (called a factor) at
a discount. A business will sometimes factor its receivable assets to meet its present and
immediate cash needs. Forfaiting is a factoring arrangement used in international trade
finance by exporters who wish to sell their receivables to a forfaiter. Factoring is

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commonly referred to as accounts receivable factoring, invoice factoring, and sometimes
accounts receivable financing.

Reverse Factoring: In case of Reverse Factoring, the Buyer initiates the process of
financing of trade receivables of Sellers. The Buyer may or may not bear the interest or
financing cost as may be agreed between the Buyer and Seller.

Registration Fee: All the participants intending to register on the TReDS platform will
need to pay one-time non-refundable Registration Fee at the time of registration. In
addition to the Registration Fee, the participants will have to pay an Annual Fee with
service tax by 30th day of April every year. The registration fee and annual fees will be
notified by RXIL through notifications on its website.

TReDS Instrument: Instrument is nothing but invoice details and scanned invoice
uploaded either by the Seller or Buyer reflecting the underlying trade receivables of MSME
Sellers. Only the Tax Invoice is accepted as a valid invoice.

Participants must have engaged in business for at least 1 year (Except Financiers).
As per RBI TReDS guidelines, it is mandatory for the counterparty to provide acceptance
of the invoice on the TReDS platform. In case the Seller uploads the invoice it needs to be
accepted by the Buyer; while in case of Buyer uploading the invoice, the Seller must accept
the invoice for factoring or financing on the TReDS platform.

Both Buyer and the Seller must be registered on the TReDS platform for financing /
factoring of trade receivables of the MSME Seller. As mentioned earlier, the counterparty
needs to provide acceptance for the invoice as per the RBI TReDS guidelines.

TReDS platform provides the flexibility for either the Seller or the Buyer to bear the interest
cost. The interest obligation for financing of factoring units is accordingly calculated by
the TReDS platform.

Cap Rate is the maximum rate acceptable to the Seller or Buyer (whoever is the interest
cost bearer) for financing of the trade receivables of the MSME Seller on the platform. Both
Seller and the Buyer can define the Cap Rate for financing / factoring of trade receivables
on the TReDS platform. If the Seller is the cost bearer then the Cap Rate defined by the
Seller then the Seller’s Cap Rate will be taken into account. If the Buyer is the cost bearer
then Buyer’s Cap Rate will be taken into account.Buyer can define only one cap rate; while
the Seller can define Cap Rate for each Buyer.

Only Tax invoice for Manufacturing and Service activity with minimum balance tenor of
15 days, which have not been financed from any other source and not encumbered, can
be uploaded on the TReDS platform.

Seller or Buyer whoever is having right to accept the bid, can see the bids offered by the
Financiers.

On acceptance of the instrument (comprising of invoice details and scanned invoice) by

the counterparty, the instrument becomes a Factoring Unit. Only accepted instruments
enter into an auction.

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The Auction Market where the Financiers can enter bids shall be open from 9:00 AM to
9:00 PM every day.

There are two types of the costs involved in the factoring of each factoring unit.

 Interest cost payable by the Seller or Buyer, as the case may be, to the Financier
 Transaction Charge (with Service Tax) to be paid by the Seller to the RXIL for
factoring

No security is required to be given by Seller or Buyer to RXIL for the purpose of factoring
of trade receivables on the TReDS Platform. However, any financing transaction on the
TReDS portal of RXIL will tantamount to an assignment of receivables in favour of the
Financier. The same is also required to be registered with Central Registry of
Securitisation Asset Reconstruction and Security Interest (CERSAI).

Payment Mechanism: Once the bid is accepted by the seller or buyer whoever is the cost
bearer, the designated bank account of the Financier will be auto-debited based on the
mandated provided by them on T+1 (Bid acceptance date = 1 working day) and RXIL to
strive to make the payment to the designated account of the Seller on T+1.

If the payment from Financier to Seller fails, the factoring unit will be marked as Failed
on the TReDS portal of RXIL. In such circumstance, the Buyer needs to pay to the Seller
directly on the due date outside the system.There is also a provision for the Seller or the
Buyer to re-initiate auction in such cases.

Non-payment by the Buyer on the due date to the Financier is tantamount to a default by
the Buyer. The transaction is marked as Failed in the TReDS platform. The Buyer is
required to settle directly with the Financier.

Lease financing is one of the important sources of medium- and long-term financing
where the owner of an asset gives another person, the right to use that asset against
periodical payments. The owner of the asset is known as lessor and the user is called
lessee.
The periodical payment made by the lessee to the lessor is known as lease rental. Under
lease financing, lessee is given the right to use the asset but the ownership lies with the
lessor and at the end of the lease contract, the asset is returned to the lessor or an option
is given to the lessee either to purchase the asset or to renew the lease agreement.

Different Types of Lease: Depending upon the transfer of risk and rewards to the lessee,
the period of lease and the number of parties to the transaction, lease financing can be
classified into two categories. Finance lease and operating lease.

i. Finance Lease: It is the lease where the lessor transfers substantially all the risks and
rewards of ownership of assets to the lessee for lease rentals. In other words, it puts the
lessee in the same condition as he/she would have been if he/she had purchased the
asset. Finance lease has two phases: The first one is called primary period. This is non-
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cancellable period and in this period, the lessor recovers his total investment through
lease rental. The primary period may last for indefinite period of time. The lease rental for
the secondary period is much smaller than that of primary period.

Features of Finance Lease:

From the above discussion, following features can be derived for finance lease:
1. A finance lease is a device that gives the lessee a right to use an asset.
2. The lease rental charged by the lessor during the primary period of lease is sufficient
to recover his/her investment.
3. The lease rental for the secondary period is much smaller. This is often known as
peppercorn rental.
4. Lessee is responsible for the maintenance of asset.
5. No asset-based risk and rewards is taken by lessor.
6. Such type of lease is non-cancellable; the lessor’s investment is assured.
7. A Finance-lease contract provides for the option to purchase the asset at the end of
the contract.
8. In Financial Lease, all the cost relating to maintenance, taxes and insurance are to be
borne by the lessee.
9. Lease financing is more costly than other sources of financing because lessee has to
pay lease rental as well as expenses incidental to the ownership of the asset.

ii. Operating Lease:

Lease other than finance lease is called operating lease. Here risks and rewards incidental
to the ownership of asset are not transferred by the lessor to the lessee. The term of such
lease is much less than the economic life of the asset and thus the total investment of the
lessor is not recovered through lease rental during the primary period of lease. In case of
operating lease, the lessor usually provides advice to the lessee for repair, maintenance
and technical knowhow of the leased asset and that is why this type of lease is also known
as service lease.

Features of Operating Lease:

Operating lease has following features:
1. The lease term is much lower than the economic life of the asset.
2. The lessee has the right to terminate the lease by giving a short notice and no penalty
is charged for that.
3. The lessor provides the technical knowhow of the leased asset to the lessee.
4. Risks and rewards incidental to the ownership of asset are borne by the lessor.
5. Lessor has to depend on leasing of an asset to different lessee for recovery of his/her
investment.
6. In Operating Lease all the cost relating to maintenance, taxes and insurance are to be
borne by the lessor.

Leasing in India: The first leasing company of India pioneered the concept of leasing in
India in 1973. Till 1981, it was the only leasing company in the country. Looking at its
success, many companies and development financial institutions forayed into this
business. The government also encouraged competition in leasing business. The banks
were allowed to enter into this business in 1994. The State Bank of India is into big-ticket
finance leasing. The cost of the equipment being leased is the ticket size. The ticket size
may be small, medium or big.

Equipment-leasing companies and hire-purchase companies are classified as Asset

Finance Companies (AFC). The RBI has defined AFC as any company which is a financial
institution carrying on as its principal business the financing of physical assets supporting
productive/economic activity, such as automobiles, tractors, lathe machines, generator

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sets, earth-moving and material-handling equipments, moving on own power and general-
purpose industrial machines. The principal business for this purpose is defined as an
aggregate of financing real/physical assets supporting economic activity and income
arising there from is not less than 60% of its total assets and total income, respectively.

HIRE PURCHASE: Hire purchase is a method of financing of the fixed asset to be

purchased on future date. Under this method of financing, the purchase price is paid in
installments. Ownership of the asset is transferred after the payment of the last
installment.

Hire Purchase is defined as an agreement in which the owner of the assets lets them on
hire for regular installments paid by the hirer. The hirer has the option to purchase and
own the asset once all the agreed payments have been made. These periodic payments
also include an interest component paid towards the use of the asset apart from the price
of the asset.

FEATURES AND CHARACTERISTICS OF HIRE PURCHASE: Hire purchase (as per Hire
Purchase Act 1972, India) is a typical transaction in which the assets are allowed to be
hired and the hirer is provided an option to later purchase the same assets.

Following are the features of a regular hire purchase transaction:

 Rental payments are paid in installments over the period of the agreement.
 Each rental payment is considered as a charge for hiring the asset. This means that,
if the hirer defaults on any payment, the seller has all the rights to take back the
assets.
 All the required terms and conditions between both the parties involved are
documented in a contract called Hire-Purchase agreement.
 The frequency of the installments may be annual, half-yearly, quarterly, monthly,
etc. according to the terms of the agreement.
 Assets are instantly delivered to the hirer as soon as the agreement is signed.
 If the hirer uses the option to purchase, the assets are passed to him after the last
installment is paid.
 If the hirer does not want to own the asset, he can return the assets any time and
is not required to pay any installment that falls due after the return.
 However, once the hirer returns the assets, he cannot claim back any payments
already paid as they are the charges towards the hire and use of the assets.
 The hirer cannot pledge, sell or mortgage the assets as he is not the owner of the
assets till the last payment is made.
 The hirer, usually, pays a certain amount as an initial deposit while signing the
agreement.
 Generally, the hirer can terminate the hire purchase agreement any time before the
ownership rights pass to him.

ADVANTAGES OF HIRE PURCHASE

Hire Purchase has the following advantages:

 Immediate use of assets without paying the entire amount.

 Expensive assets can be utilized as the payment is spread over a period of time.

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 Fixed rental payments make budgeting easier as all the expenditures are known in
advance.
 Easy accessibility as it is a secured financing.
 No need to worry about the asset depreciating quickly in value as there is no
obligation to buy the asset.
 Hire purchasers also enjoy the tax benefit on the interest payable by them.

DISADVANTAGES OF HIRE PURCHASE

Hire Purchase suffers from the following disadvantages:

 Total amount paid towards the asset will be higher than the cost of the asset.
 The long duration of the rental payments.
 Ownership only at the end of the agreement. The hirer cannot modify the asset till
then.
 If the hired asset is no longer needed because of any change in the business strategy,
there may be a resulting penalty.
 The cost of financing through hire purchase is very high.

Public Private Partnership (PPP) means an arrangement between a

governments/statutory entity/government owned entity on one side and a private sector
entity on the other.

It is often done for the provision of public assets or public services, through investments
being made and/or management being undertaken by the private sector entity, for a
specified period of time.

There is well defined allocation of risk between the private sector and the public entity.

The private entity who is chosen on the basis of open competitive bidding, receives
performance linked payments that conform (or are benchmarked) to specified and pre-
determined performance standards, measurable by the public entity or its representative.

Characteristics of PPP

 The private sector is responsible for carrying out or operating the project and takes
on a substantial portion of the associated project risks
 During the operational life of the project the public sector’s role is to monitor the
performance of the private partner and enforce the terms of the contract
 The private sector’s costs may be recovered in whole or in part from charges related
to the use of the services provided by the project, and may be recovered through
payments from the public sector
 Public sector payments are based on performance standards set out in the contract
 Often the private sector will contribute the majority of the project’s capital costs,
although this is not always the case

Advantages of PPP:
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 Access to private sector finance
 Efficiency advantages from using private sector skills and from transferring risk to
the private sector
 Potentially increased transparency
 Enlargement of focus from only creating an asset to delivery of a service, including
maintenance of the infrastructure asset during its operating lifetime
 This broadened focus creates incentives to reduce the full life-cycle costs (ie,
construction costs and operating costs)

Public Private Partnership in India:

A committee chaired by Kelkar also made valuable recommendations to empower the
PPP mechanism.

India’s experience with PPP in a serious manner started from 2006 onwards. India has
systematically rolled out a PPP program for the delivery of high-priority public utilities and
infrastructure and, over the last decade or so, developed what is perhaps one of the largest
PPP Programs in the world. With close to 1300 PPP projects in various stages of
implementation, according to the World Bank, India is one of the leading countries in
terms of readiness for PPPs.

As per the 2015 Infrascope Report of the Economist Intelligence Unit, “Evaluating the
environment for PPPs in Asia-Pacific 2014”, India ranks first in the world in “Operational
Maturity” for PPP projects, third for sub-national PPP activity and fifth overall in terms of
having an ideal environment for PPP projects.

Building on the learning from the past experience, the Government has in the last three
years, undertaken some noteworthy steps to strengthen the PPP framework and the
enabling ecosystem in India. This includes formulation of guidelines for new innovative
PPP models, with due consideration to the extant risk outlook and investor appetite, like
monetization of publically funded highway projects worth ~Rs. 35,600 crore under Toll-
Operate-Transfer Model (ToT) and construction and expansion of over 60 highway projects
under Hybrid-Annuity-Model (HAM). With implementation of PPP models like HAM & TOT,
the Government has optimally taken over the project implementation risk and thereby
revived the interest of private players and financial institutions in PPP projects in the road
sector to a considerable extent. Further the Government has liberalized the exit policies
for concessionaires to free-up equity for re-investment into new projects; approved the
policy of railway station development through PPP and is currently in the process of
formulating suitable PPP policy for newer sectors and asset classes.

Toll-Operate-Transfer Model (ToT): Under this model, the right of collection of user-fee
or toll on selected national highway stretches that have been built through public funding
is proposed to be assigned for a 30-year period to developers and investors against an
upfront payment of a lump-sum amount to the government. During the tenure of the
contract, the operation and maintenance would be the responsibility of the developer.

What is hybrid annuity?

In financial terminology hybrid annuity means that payment is made in a fixed amount
for a considerable period and then in a variable amount in the remaining period. This
hybrid type of payment method is attached under the HAM.

The Hybrid Annuity Model (HAM)

In India, the new HAM is a mix of BOT Annuity and EPC models. As per the design, the
government will contribute to 40% of the project cost in the first five years through annual
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payments (annuity). The remaining payment will be made on the basis of the assets
created and the performance of the developer. Here, hybrid annuity means the first 40%
payment is made as fixed amount in five equal installments whereas the remaining 60%
is paid as variable annuity amount after the completion of the project depending upon the
value of assets created. As the government pays only 40%, during the construction stage,
the developer should find money for the remaining amount. Here, he has to raise the
remaining 60% in the form of equity or loans.

There is no toll right for the developer. Under HAM, Revenue collection would be the
responsibility of the National Highways Authority of India (NHAI).

Advantage of HAM is that it gives enough liquidity to the developer and the financial risk
is shared by the government. While the private partner continues to bear the construction
and maintenance risks as in the case of BOT (toll) model, he is required only to partly bear
the financing risk. Government’s policy is that the HAM will be used in stalled projects
where other models are not applicable.

PPP Cell, Department of Economic Affairs (DEA): The PPP Cell which was set up in
2006 in the DEA, acts as the Secretariat for Public Private Partnership Appraisal
Committee (PPPAC), Empowered Committee (EC), and Empowered Institution (EI) for the
projects proposed for financial support through Viability Gap Fund (VGF). The PPP Cell is
responsible for policy level matters concerning PPPs, including Policies, Schemes,
programmes, Model Concession Agreements and Capacity Building. The PPP Cell is also
responsible for matters and proposals relating to clearance by PPPAC, Scheme for
Financial Support to PPPs in Infrastructure (VGF Scheme) and India Infrastructure Project
Development Fund (IIPDF).

www.pppinindia.gov.in has been developed by the PPP Cell, Department of Economic

Affairs (DEA) to provide key information related to PPP initiatives in India and to share
PPP best practices for PPP practitioners whether in Government or the Private Sector. The
website is a repository of Policy Documents, Government Guidelines, Model Documents,
project Information, information on the Institutional Mechanisms for appraisal of PPP
infrastructure projects, Schemes developed for financial support to PPP projects and
Guidance Material and Reference Documents developed by the PPP Cell. There is another
website www.infrastructureindia.gov.in, developed by the PPP Cell, which provides
information on infrastructure projects implemented in India.
PPP requires private sector participation in public asset creation through money,
technology and management. For this, several models inviting thier participation were
launched for different projects. Some of the commonly adopted forms of PPPs include
build-operate-transfer (BOT) and its variants, build-lease-transfer (BLT), design-build-
operate-transfer (DBFOT), operate-maintain-transfer (OMT), etc.

These models operate on different conditions on the private sector regarding level of
investment, ownership control, risk sharing, technical collaboration, duration of the
project, financing mode, tax treatment, management of cash flows etc.

Following are the main models of PPPs:

(a) Build Operate and Transfer (BOT): This is the simple and conventional PPP model
where the private partner is responsible to design, build, operate (during the contracted
period) and transfer back the facility to the public sector. Role of the private sector partner
is to bring the finance for the project and take the responsibility to construct and maintain
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it. In return, the public sector will allow it to collect revenue from the users. The national
highway projects contracted out by NHAI under PPP mode is a major example for the BOT
model.

(b) Build-Own-Operate (BOO): This is a variant of the BOT and the difference is that the
ownership of the newly built facility will rest with the private party here. The public sector
partner agrees to ‘purchase’ the goods and services produced by the project on mutually
agreed terms and conditions.

(c) Build-Own-Operate-Transfer (BOOT): This is also on the lines of BOT. After the
negotiated period of time, the infrastructure asset is transferred to the government or to
the private operator. This approach has been used for the development of highways and
ports.

(d) Build-Operate-Lease-Transfer (BOLT): In this approach, the government gives a

concession to a private entity to build a facility (and possibly design it as well), own the
facility, lease the facility to the public sector and then at the end of the lease period transfer
the ownership of the facility to the government.

(e) Lease-Develop-Operate (LDO): Here, the government or the public sector entity retains
ownership of the newly created infrastructure facility and receives payments in terms of a
lease agreement with the private promoter. This approach is mostly followed in the
development of airport facilities.

(f) Rehabilitate-Operate-Transfer (ROT): Under this approach, the governments/local

bodies allow private promoters to rehabilitate and operate a facility during a concession
period. After the concession period, the project is transferred back to governments/local
bodies.

(g) DBFO (Design, Build, Finance and Operate): In this model, the private party assumes
the entire responsibility for the design, construction, finance, and operate the project for
the period of concession.
.
(h) Management contract: Here, the private promoter has the responsibility for a full
range of investment, operation and maintenance functions. He has the authority to make
daily management decisions under a profit-sharing or fixed-fee arrangement.

(i) Service contract: This approach is less focused than the management contract. In this
approach, the private promoter performs a particular operational or maintenance function
for a fee over a specified period of time.

Infrastructure Leasing & Financial Services Limited is one of India's leading

infrastructure development and finance companies. Its central mandate is catalysing the
development of innovative world-class infrastructure in the country. Widely acknowledged
as the pioneer of Public Private Partnership (PPP) in India, the IL&FS Group has,
through a variety of projects, benchmarked the private sector’s role in and commitment
towards infrastructure development in India.

IL&FS was incorporated in 1987, initially promoted by the Central Bank of

India (CBI), Housing Development Finance Corporation Limited (HDFC) and Unit Trust of
India (UTI). Over the years, we have broad-based our shareholding and inducted
institutional shareholders including State Bank of India, Life Insurance Corporation of
India, ORIX Corporation Japan, and Abu Dhabi Investment Authority (ADIA).
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Project finance is nothing but sourcing funds to a long term infrastructure project, or
any other project, and using the cash flow generated from the project to payback the
financing procured.

Project finance is often confused with corporate finance, but the two are structurally
different. Unlike corporate finance, where a company can directly raise funds from equity
and debt, in project finance, the company which invests equity (usually known as
sponsor), forms a Special Purpose Vehicle (SPV) which manages the funds procurement
and management of the specific project.

Project Finance companies or banks typically earn money from the interest income on
loan. Apart from that banks can choose to sell them on the secondary market. There are
many market participants who have the desire to purchase these loans as investments. A
classic example is insurance companies as they are interested in long-term cash flows,
which can be used for duration matching.

Breakdown of Project Finance: Now let us break down each of the components of this
definition to get a detailed understanding of what it incorporates:

1. Financing of long-term infrastructure, industrial projects, and public services

Project Finance is generally used in oil extraction, power production, and infrastructure
sectors. These are the most appropriate sectors for developing this structured financing
techniques as they have low technological risk, a reasonably predictable market and the
possibility of selling to a single buyer or a few large buyers based on multi-year contracts
(e.g. take-or-pay contracts).

2. Non-Recourse/Limited Recourse Financial structure: Project Finance is the

structured financing of a specific economic entity – a Special Purpose Vehicle (SPV) –
created by the sponsors using equity or debt. The lender considers the cash flow generated
from this entity as the major source of loan reimbursement.
Hence, if the borrower defaults, the issuer can seize the assets of the said SPV but cannot
seek out the borrower for any further compensation, even if the SPV does not cover the
full value of the amount defaulted.

3. Payment from cash flow generated by the project: Cash flows generated by the SPV
must be sufficient to cover payments for operating costs and to service the debt in terms
of capital repayment and interest. Because the priority use of cash flow is to fund operating
costs and to service the debt, only residual funds after the latter are covered can be used
to pay dividends to sponsors undertaking project finance.

What is a Special Purpose Vehicle and why is it created?

A Special Purpose Vehicle is a legal entity which is formed for a specific purpose such as
a project in this case. During the execution, the project’s funding requirements will be
solely managed by the SPV. The purpose is to insulate the holding company from any
riskiness and eventualities arising in the project. Moreover, when the project funds are
duly protected and managed by the SPV, even external investors gain more confidence in
the company’s operations.
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SPVs are mostly formed to raise funds from the market. Technically, an SPV is a company.
It has to follow the rules of formation of a company laid down in the Companies Act. Like
a company, an SPV must have promoter(s) or sponsor(s).
There are different organisations, like the Infrastructure Development Finance Company
(IDFC), Power Finance Corporation (PFC), Indian Rail Finance Corporation (IRFC) etc.,
which are engaged in raising funds for development of infrastructure sector projects for
the sectors they are involved in. The proposed SPV, which is likely to be a government
company, will add to the availability of long-term funds for infrastructure sector projects.

Hybrid Financing can be defined as a combined face of equity and debt. This means
that the characteristics of both equity and bond can be found in Hybrid Financing.
Hybrid financing instruments are those sources of finance which possess
characteristics of both equity and debt. Some well-known hybrid financing
instruments are preference shares, convertible debentures, warrants, options etc.

Private and social cost-benefit: Every business activity which takes place has some
benefits and costs attached to it. The benefits go both to the owners of the firm as well as
to external stakeholders. In the same way the owners and the external stakeholders have
to pay a cost for the activities of the business.

Social cost:-
Social cost is the sum of private cost and external cost. For example, the manufacturing
cost of a car (i.e., the costs of buying inputs, land tax rates for the car plant, overhead
costs of running the plant and labor costs) reflects the private cost for the
manufacturer. Water or air is also polluted as part of the process of producing the car,
This is an external cost borne by those who are affected by the pollution or who value
unpolluted air or water. Because the manufacturer does not pay for this external cost,
and does not include this cost in the price of the car. The air pollution from driving the
car is also an externality produced by the car user in the process of using his good. The
driver does not compensate for the environmental damage caused by using the car.

Social-Cost is the cost to an entire society resulting from an event, an activity or a change
in policy. Social cost equals the sum of private cost and external cost.

When assessing the overall impact of its commercial actions in terms of social costs, a
socially responsible business operator should take into account its own production
expenses, as well as any indirect expenses or damages borne by others.

Private cost:
It is the cost of setting up the business. The owner(s) pay for the hire of machinery, buying
of materials, payments of wages. This is termed as Private Cost.

External Cost:
The problems that the external stakeholders have to bear due to the firm’s activity are
known as external cost. Example: cleaning a river which has been polluted by a firm’s
waste products. Private firms usually ignore external cost.

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Social benefits:-
Social benefits are the sum of private benefits and external benefits. For example, a college
decides to slash its tuition rates by half. This encourages more people to get educated. A
better-educated workforce, in turn, helps businesses produce more. Thus, even though
the businesses did not pay for the reduced college tuition, they still reap a positive external
benefit from the college’s move. The increase in the welfare of a society that is derived from
a particular course of action. Some social benefits, such as greater social justice, cannot
easily be quantified.

Social benefits is the sum of private benefits and external benefits:

Private benefit:
The benefit enjoyed by those involved in the production or consumption. For example, the
revenue earned by the firm is a benefit for the owner and is termed as Private benefit.

External benefits:
Some firms can cause external benefits. These are the benefits to the external stakeholders
due to the activity of firm. For example, a firm may train workers, which might get them
better wages in other firms. These external benefits are free

CSR activities in India: As per as Corporate Social Responsibility is concerned, the

Companies Act, 2013 is a landmark legislation that made India the first country to
mandate and quantify CSR expenditure. The inclusion of CSR is an attempt by the
government to engage the businesses with the national development agenda. The details
of on corporate social responsibility is mentioned in the Section 135 of the Companies Act,
2013. The Act came into force from April 1, 2014, every company, private limited or public
limited, which either has a net worth of Rs 500 crore or a turnover of Rs 1,000 crore or
net profit of Rs 5 crore, needs to spend at least 2% of its average net profit for the
immediately preceding three financial years on Corporate social responsibility activities.

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