Lease_finance_and_investment_banking.pdf

Lease Finance and Investment Banking Department Of Finance Jagannath University, Dhaka.

Prepared By Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University. Email:[email protected] Mobile: 01198150195

Lease Finance and Investment Banking A Simple Solution

About the Author Md. Mazharul Islam Jony, studying BBA, major in Finance at Jagannath University, Dhaka. He is completed his HSC from Cantonment College, Jessore and SSC from Chowgacha Shahadat Pilot High School, Chowgacha, Jessore with the highest performance result in 2006 and 2008 consecutively. His favorite hobby is to search new teaching technique and learning method.

Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University. Email:[email protected] Mobile: 01198150195

Lease Finance and Investment Banking

Name of chapters included in this book Serial number Lease Finance: 1 2 3 4 4.1 5 6 7

Name of the chapter

Introduction Introduction to leasing Economics of leasing Accounting aspects of lease financing Mathematical problems and solution Tax aspects of leasing Equipment lease financing Sale and lease back in real estate Short Notes Investment Banking: 8 Investment Banking 9 Laws governing Investment Banking 10 Investment Banking Process and IPOs 11 Corporate Finance 12 Trading 13 Financial Engineering 13.1 Financial Engineering: Derivatives Instrument 14 Merchant Banking and Other activities

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Lease Finance and Investment Banking

Lease Finance

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Md. Mazharul Islam Jony

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Lease Finance and Investment Banking

Chapter 1 Introduction Concept of Lease Finance: (Q 1a: 2010, 2011) A lease could be generally defined as, A contract where a party being the owner (lessor) of an asset (leased asset) provides the asset for use by the lessee at a consideration (rentals), either fixed or dependent on any variables, for a certain period (lease period), either fixed or flexible, with an understanding that at the end of such period, the asset, subject to the embedded options of the lease, will be either returned to the lessor or disposed off as per the lessor‘s instructions. Leasing was prevalent during the ancient Sumerian and Greek civilizations where leasing of land, agricultural implements, animals mines and ships took place. The practice of leasing came into being sometime in the later half of the 19th century where the rail road manufacturers in the U.S.A resorted to leasing of rail cars and locomotives. The equipment leasing industry came into being in 1973 when the first leasing company, appropriately named as First Leasing This industry however remained relegated to the background until the early eighties, because the need for these industry was not strongly felt in industry. The public sector financial institutions – IDBI, IFCI, ICICI and the State Financial Corporation‘s (SCFs) provided bulk of the term loans and the commercial banks provided working capital finance required by the manufacturing sector on relatively soft terms. Given the easy availability of funds at reasonable cost, there was obvious no need to look for alternative means of financing. The credit squeeze announced by the R.B.I coupled with the strict implantation of the Tandon & Chore committees‘ norms on Maximum Permissible Bank Finance (MPBF) for working capital forced the manufacturing companies to divert a portion of their long – term funds for their working capital.

History and development of Leasing: The history of leasing dates back to 200BC when Sumerians leased goods. Romans had developed a full body law relating to lease for movable and immovable property. However the modern concept of leasing appeared for the first time in 1877 when the Bell Telephone Company began renting telephones in USA. In 1832, Cottrell and Leonard leased academic caps, grown and hoods. Subsequently, during 1930s the Railway Industry used leasing service for its rolling stock needs. In the post war period, the American Air Lines leased their jet engines for most of the new air crafts. This development ignited immediate popularity for the lease and generated growth of leasing industry. The concept of financial leasing was pioneered in India during 1973. The First Company was set up by the Chidambaram group in 1973 in Madras. The company undertook leasing of industrial equipment as its main activity. The Twentieth century Leasing Company Limited was established in 1979. By 1981, four finance companies joined the fray. The performance of First Leasing Company Limited and the Twentieth Century Leasing Company Limited motivated others to enter the leasing industry. In 1980s financial institutions made entry into leasing business. Industrial Credit and Investment Corporation was the first all India financial institution to offer leasing in Jagannath University

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Lease Finance and Investment Banking 1983. Entry of commercial banks into leasing was facilitated by an amendment of Banking Regulation Act, 1949. State Bank of India was the first commercial bank to set up a leasing subsidiary, SBI capital market, in October 1986. Can Bank Financial Services Ltd., BOB Financial Service Ltd., and PNB Financial Services Limited followed suit. Industrial Finance Corporation‘s Merchant Banking division started financing leasing companies as well as equipment leasing and financial services. There was thus virtual explosion in the number of leasing companies rising to about 400 companies in 1990. In the subsequent years, the adverse trends in capital market and other factors led to a situation where apart from the institutional lessors, there were hardly 20 to 25 private leasing companies who were active in the field. The total volume of leasing business companies was Rs.5000 crores in 1993 and it is expected to cross Rs.10, 000 crores by March 1995.

Background of Leasing in Bangladesh: Lease financing was first introduced in Bangladesh in the early 1980s. Industrial Development Leasing Company of Bangladesh Ltd. (idlc), the first leasing company of the country, was established in 1986 under the regulatory framework of BANGLADESH BANK. It was a joint venture of the Industrial Promotion and Development Company of Bangladesh Ltd. (ipdc), International Finance Corporation, and Korea Development Leasing Corporation. Another leasing firm, the UNITED LEASING COMPANY Ltd. started its operations in 1989. The number of leasing companies grew quickly after 1994 and by the year 2000, rose to 16. The leasing business became competitive with the increase in the number of companies and wider distribution of their market share. There are, however, 6 other companies conducting leasing business in the country, although they do not use the word leasing in their names. In terms of money value, the leasing business in Bangladesh increased from Tk 41.44 million in 1988 to Tk 3.16 billion in 2000. The leasing companies now operating in the country are Industrial Development Leasing Company of Bangladesh, United Leasing Company, GSP Finance Company (Bangladesh), Uttara Finance and Investments, Bay Leasing and Investment, Phoenix Leasing Company, Prime Finance and Investment, International Leasing and Financial Services, Union Capital, Vanik Bangladesh, Peoples Leasing and Financial Services, Bangladesh Industrial Finance Company, UAEBangladesh Investment Company, Bangladesh Finance and Investment Company, and First Lease International. Lease financing, as organised in Bangladesh, operates with the following objectives: (a) to assist the development and promotion of productive enterprises by providing equipment lease financing and related services; (b) to assist in balancing, modernisation, replacement and expansion of existing enterprises; (c) to extend financial support to small and medium scale enterprises; (d) to provide finance for various agriculture equipment; and (e) to activate the capital market by operating as managers to the issue, underwriters, or portfolio managers. The functions of a lease business include lease financing, short-term financing, house building financing, and merchant banking and corporate financing. In this last group of functions, the leasing business in Bangladesh moved away from regular leasing activities and is now involved in stock-market related activities such as issue management, underwriting, trust management, private placement, portfolio management, and mutual fund operation. Broad capital market operations of the lease financing institutions include bridge financing, corporate counseling, mergers and acquisition, capital restructuring, financial engineering, and lease syndication. Prominent among

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Lease Finance and Investment Banking the sectors of the economy that now receive lease financing services are textiles, apparels and accessories, transport, construction and engineering, paper and printing, pharmaceuticals, food and beverage, chemicals, agro-based industries, telecommunications, and leather and leather products. Commercial banks and development finance institutions (DFIs) have been the traditional lending institutions in Bangladesh. In fact, the concept of lease financing is a relatively new one in the country. Initially, leasing companies had to adopt the role of educators to make Bangladeshi entrepreneurs aware of the benefits of leasing. However, as DFIs demonstrated poor recovery and fund recycling performances, leasing got the opportunity to develop as an alternative source of funding. A few other factors also contributed to development of the leasing business in the country. For example, the commercial banks have been keener in providing trade financing and FOREIGN EXCHANGE dealings rather than long-term loans because of the risks involved and their longer gestation period. The selection of lease proposals is relatively free from extraneous pressure and is subject to a quality level appraisal. Under lease agreements in the private sector, projects are sanctioned and implemented expeditiously, resulting in benefits in time and cost savings. Private leasing companies also attract clients by providing relatively better services. The down payments in leasing are not high and the gestation period is low. Also, in case of lease financing, incidental costs incurred in the process of import clearing, installation, and commercial production are capitalised, which substantially reduce the initial investment. Leasing companies, however, face some problems in conducting their business in the country. The relatively slow growth of the demand side compared to the fast growth of the lease business is one such problem. This leads many leasing companies to operate in partial capacity. The culture of loan default that prevails in the country is also a deterrent. Leasing companies often find it difficult to raise funds through short- or long-term borrowing from money and capital markets. They are hard pressed to deal with the financial assets because of the present laws of the country, which are also not fully enforceable. Leasing business is gaining increased importance in the economy of Bangladesh with its gradual transformation from an agrarian to industrial one. The government periodically revises the trade and industrial policy to create a liberal business environment both for domestic and foreign investment. Increased investment in the energy sector as well as in power, transport, telecommunications, water and sanitation, and safe disposal of wastes is expected to bring further opportunities for leasing industries.

Importance of Lease Finance (Q: 2b, 2010) Lease finance or lease financing means contract between owner of asset and user of asset. In this contract only rent is paid at periodical intervals for using of asset by user. If user of asset has no money to pay initial amount of leasing contract, he can also do contract with third part to pay initial amount or specific period rent of lease. It will be also lease finance. In following words, we can explain its importance,  Lease finance is easy to get than getting loan for buying all fixed assets.  Monthly rent payment for lease finance will be operating expenses. It will be allowed to deduct total income. So, company can get tax benefits in lease financing.

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Lease Finance and Investment Banking  It can show as invisible debt of company out of its balance sheet. You can show lease finance in the footnote of balance sheet, if you did contract directly with the owner of asset.  One of major important point is that it is more flexible way of finance. You can fix your need of asset and get it one lease through lease financing.  A study from IFC has revealed that 30% of total share of lease financing as investment of fixed asset is of emerging and developed economies and now 15% of developing countries.

Legal aspects of leasing Essentially the following implications for the lessor and the lessee must be maintained.  The lessor has the duty to deliver the asset to the lessee, to legally authorise the lessee to use the asset, and to leave the asset in peaceful possession of the lessee during the currency of the agreement.  The lessor has the obligation to pay the lease rentals as specified in the lease agreement, to protect the lessor‘s title, to take reasonable care of the asset, and to return the leased asset on the expiry of the lease period.

Contents of a lease agreement: The lease agreement specifies the legal rights and obligations of the lessor and the lessee. It typically contains terms relating to the following:  Description of the lessor, the lessee, and the equipment.  Amount, time and place of lease rentals payments.  Time and place of equipment delivery.  Lessee‘s responsibility for taking delivery and possession of the leased equipment.  Lessee‘s responsibility for maintenance, repairs, registration, etc. and the lessor‘s right in case of default by the lessee.  Lessee‘s right to enjoy the benefits of the warranties provided by the equipment manufacturer/supplier.  Insurance to be taken by the lessee on behalf of the lessor.  Variation in lease rentals if there is a change in certain external factors like bank interest rates, depreciation rates, and fiscal incentives.  Options of lease renewal for the lessee.  Return of equipment on expiry of the lease period.  Arbitration procedure in the event of dispute.

Prepared By Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University. Email:[email protected] Mobile: 01198150195 Jagannath University

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Lease Finance and Investment Banking

Chapter 2 Introduction to leasing Lease: Conceptually, a lease may be defined as a contractual arrangement/transaction in which a party owning an asset/ equipment (lessor) provides the asset for use to another/ transfers the right to use the equipment to the user (lessee) over a certain/for an agreed period of time for consideration in the form of/in return for periodic payment (rentals) with or without a further payment (premium). At the end of the period of contract (lease period), the asset/ equipment reverts back to the lessor unless there is a provision for the renewal of the contract. Leasing essentially involves the divorce of ownership from the economic use of an asset/ equipment. It is a contract in which a specific equipment required by the lessee is purchased by the lessor (financier) from a manufacturer/vendor selected by the lessee. The lessee has possession and use of the asset on payment of the specified rentals over a predetermined period of time. Leasing is, thus, a device of financing/money lending. GAAP defines a lease as ―an agreement conveying the right to use property, plant, or equipment usually for a stated period of time.‖ A lease involves a lessee and a lessor. A lessee acquires the right to use the property, plant, and equipment; a lessor gives up the right. The position of a lessee is akin to that of a person who owns the same asset with borrowed money. The real function of a lessor is not renting of asset but lending of funds/finance/credit and lease financing is, in effect, a contract of lending money. The lessor (financier) is the nominal owner of the asset as the possession and economic use of the equipment vests in the lessee. The lessee is free to choose the asset according to his requirements and die lessor does not take recourse to the equipment as long as the rentals are regularly paid to him.

Essentials of Lease Financing The essential elements of leasing are the following: Parties to the Contract: There are essentially two parties to a contract of lease financing, viz. the owner and the user, respectively called the lessor and the lessee. Lessors as well as lessees may be individuals, partnerships, joint stock companies, corporations or financial institutions. Sometimes, there may be joint lessors or joint lessees, particularly where the properties or the amount of finance involved is enormous. Lease-broker: There may be a lease-broker who acts as an intermediary in arranging lease deals. Merchant banking divisions of certain foreign banks in India, subsidiaries of some Indian banks and even some private merchant bankers are acting as lease-brokers. They charge certain percentage of fees for their services, ranging between 0.50 to 1 percentages. Lease financier: A lease contract may involve a lease financier, who refinances the lessor, either by providing term loans or by subscribing to equity or under a specific refinance scheme. Asset: The asset, property or equipment to be leased is the subject-matter of a contract of lease financing. The asset may be an automobile, plant and machinery, equipment, land and building,

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Lease Finance and Investment Banking factory, a running business, aircraft, and so on. The asset must, however, be of the lessee's choice suitable for his business needs. Ownership Separated from User: The essence of a lease financing contract is that during the lease-tenure, ownership of the asset vests with the lessor and its use is allowed to the lessee. On the expiry of the lease tenure, the asset reverts to the lessor.

Types of Lessors Lessors generally come in one of four varieties: 1. Captive leasing companies: These are usually subsidiaries of a parent company that manufactures the product being leased, e.g., IBM Credit Corp. leases IBM computers. 2. Commercial banks: Companies enter into leasing agreements with banks they already do business with or by other means. Sometimes banks buy and sell their lease portfolios, or serve as the front end for an outside leasing service. 3. Independent leasing companies: These firms typically are unaffiliated with the manufacturer or the lessee and derive most of their business from leasing to businesses, e.g., GE Capital provides general leasing and financing services for a diverse range of commercial and industrial equipment. 4. Brokers: Leasing brokerages act as intermediaries to link lessees and lessors.

Types of Leasing FASB (Financial Accounting Standards Board) divides lease from the lessee‘s standpoint into groups, capital lease and operating lease. Also two types of hybrid lease discussed most commonly and that are leveraged leases and sale and leaseback. 1. Finance Lease or Net Lease or Capital Lease: (Q: 2a, 2010 1b, 2011) An agreement where the lessor receives lease payments to cover its ownership costs. The lessee is responsible for maintenance, insurance, and taxes. Some finance leases are conditional sales or hire purchase agreements. In other words, A long-term lease in which the lessee must record the leased item as an asset on his/her balance sheet and record the present value of the lease payments as debt. Additionally, the lessor must record the lease as a sale on his/her own balance sheet. A capital lease may last for several years and is not callable. It is treated as a sale for tax purposes. It is also called a financial lease. Structure of Financial Lease: A finance lease is structured to include the following features,  The lessee (the intending buyer) selects the equipment according to his requirements, from its manufacturer or distributor.  The lessee negotiates and settles with the manufacturer or distributor, the price, the delivery schedule, installation, terms of warranties, maintenance and payment, and so on.

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Lease Finance and Investment Banking  The lessor purchases the equipment either directly from the manufacturer or distributor (under straight- forward leasing) or from the lessee after the equipment is delivered (under sale and lease back).  The lessor then leases out the equipment to the lessee. The lessor retains the ownership while lessee is allowed to use the equipment.  A finance lease may provide a right or option, to the lessee, to purchase the equipment at a future date. However, this practice is rarely found in Bangladesh.  The lease period spreads over the expected economic life of the asset. The lease is originally for a non- cancelable period called the primary lease period during which the lessor seeks to recover his investment along with some profit. During this period, cancellation of lease is possible only at a very heavy cost. Thereafter, the lease is subject to renewal for the secondary lease period, during which the rentals are substantially low.  The lessee is entitled to exclusive and peaceful use of the equipment during the entire lease period provided he pays the rentals and complies with the terms of the lease.  As the equipment is chosen by the lessee, the responsibility of its suitability, the risk of obsolescence and the liability for repair, maintenance and insurance of the equipment rests with the lessee. The finance company is the legal owner of the asset during duration of the lease. However the lessee has control over the asset providing them the benefits and risks of (economic) ownership.

2. Operating Lease or Service Lease (Q: 2a, 2010 1b, 2011) According to the IAS-17, an operating lease is one which is not a finance lease. In an operating lease, the lessor does not transfer all the risks and rewards incidental to the ownership of the asset and the cost of the asset is not fully amortized during the primary lease period. The lessor provides services (other than the financing of the purchase price) attached to the leased asset, such as maintenance, repair and technical advice. For this reason, operating lease is also called service lease. The lease rentals in an operating lease include a cost for the 'services' provided, and the lessor does not depend on a single lessee for recovery of his cost. Operating lease is generally used for computers, office equipments, automobiles, trucks, some other equipment, telephones, and so on.

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Lease Finance and Investment Banking Structure of Operating Lease:  An operating lease is-generally for a period significantly shorter than the economic life of the leased asset. In some cases it may be even on hourly, daily, weekly or monthly basis. The lease is cancellable by either party - during the lease period.  Since the lease periods are shorter than the expected life of the asset, the lease rentals are not sufficient to totally amortize the cost of the assets.  The lessor does not rely on the single lessee for recovery of his investment. He has the ultimate interest in the residual value of the asset. The lessor bears the risk of obsolescence, since the lessee is free to cancel the lease at any time.  Operating leases normally include the maintenance clause requiring the lessor to maintain the leased asset and provide services such as insurance, support staff, fuel, and so on. 3.

Leveraged Lease:

There are three parties to the transaction: (i) lessor (equity investor), (ii) lender and (iii) lessee. In such a lease, the leasing company (equity investor) buys the asset through substantial borrowing with full recourse to the lessee and without any recourse to itself. The lender (loan participant) obtains an assignment of the lease and the rentals to be paid by the lessee are a first mortgaged asset on the leased asset. The transaction is routed through a trustee who looks after the interest of the lender and lessor. On receipt of the rentals from the lessee, the trustee remits the debt-service component of the rental to the loan participant and the balance to the lessor. 4. Sale and leaseback: (Q: 1b, 2011) In a sale and leaseback transaction, the owner of equipment sells it to a leasing company which in turn leases it back to the erstwhile owner (the lessee). The ‗leaseback‘ arrangement in this transaction can be in the form of a ‗finance lease‘ or an ‗operating lease‘. A classic example of this type of transaction is the sale and leaseback of safe deposit vaults resorted to by commercial banks. Under this arrangement the bank sells the safe sells the safe deposit vaults in its custody to a leasing company at a market price which is substantially higher than the book value. In general, the ‗sale and leaseback‘ arrangement is a readily available source of funds for financing the expansion and diversification programs of a firm. In case where capital investments in the past have been funded by high cost short-term debt, the sale and lease back transaction provides an opportunity to substitute the short-term debt by medium-term finance (assuming that the leaseback arrangement is a finance lease). From the leasing company‘s angle a sale and leaseback transaction poses certain problems. First, it is difficult to establish a fair market value of the asset being acquired because the secondary market for the asset may not exist; even if it exists, it may lack breadth. Second, the Income Tax Authorities can disallow the claim for depreciation on the fair market value if they perceive the fair market value as not being ‗fair‘. Before taking on a sale and lease back operation or on a sale and rent back operation, a company has to take the following elements into consideration:  

The assets to be sold must be fully owned and free of any security obligations. If the company's goodwill is pledged in favor of a bank, this bank must give its consent prior to the deal being signed.

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Lease Finance and Investment Banking 

The sale of assets can generate either a windfall or shortfall, either of which must be taken into account from a fiscal and/or accounting point of view.

Opportunities of sale and lease back A sale and rent back operation is the answer to many problems your company may be facing regardless of its size.      

safeguard the availability of capital stock preserve the availability of bank credit facilities make funds available for a new project restructure the debts cash in a latent asset appreciation realise, in certain conditions, a company tax saving

Some variants of leases 1. Direct Lease A direct lease can be defined as any lease transaction which is not a ―sale and leaseback‖ transaction. In other words, in a direct lease, the lessee and the owner are two different entities. A direct lease can be of two types: Bipartite Lease and Tripartite Lease.  Bipartite Lease: In a bipartite lease, there are two parties to the transaction – the equipment supplier cum-lessor and the lessee. The bipartite lease is typically structured as an operating lease with in-built facilities like up gradation of the equipment (upgrade lease) or additions to the original equipment configuration. The lessor undertakes to maintain the equipment and even replaces the equipment that is in need of major repair with similar equipment in working condition (swap lease). Of course, all these add-ons to the basic lease arrangement are possible only if the lessor happens to be a manufacturer or a dealer in the class of equipments covered by the lease.  Tripartite Lease: A tripartite lease on the other hand is a transaction involving three different parties -the equipment supplier, the lessor, and the lessee. Most of the equipment lease transactions fall under this category. An innovative variant of the tripartite lease is the sales-aid lease where the equipment supplier catalyzes the lease transaction. In other words, he arranges for lease finance for a prospective customer who is short on liquidity. Sales-aid leasing can take one of the following forms: a. The equipment supplier can provide a reference about the customer to the leasing company. b. The equipment supplier can negotiate the terms of the lease with the customer and complete the necessary paper work on behalf of the leasing company. c. The supplier can write the lease on his own account and discount the lease receivables with the designated leasing company. d. The effect of the transaction is that the leasing company owns the equipment and obtains an assignment of the lease rental. By and large, sales-aid lease is supported by recourse to the supplier in the event of default by the lessee. The recourse can be in the form of the supplier offering to buy back the equipment from the lessor in the event of default by the lessee or in the form of providing a guarantee on behalf of the lessee.

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2. Domestic Lease and International Lease  Domestic Lease: A lease transaction is classified as domestic if all parties to the agreement, namely, equipment supplier, lessor and the lessee, are domiciled in the same country.  International Lease: If the parties to the lease transaction are domiciled in different countries, it is known as international lease. This type of lease is further sub classified into import lease and cross-border lease.

Comparison between Leasing and Ownership Many times, comparisons between leasing and owning come down to little more than a funding comparison. And certainly, leasing almost always allows a better cash flow for individuals and corporations. 1. Improvement of cash flow: The main advantage of leasing is that it frees up cash. Equipment leases rarely require down payments, though you may have to set aside some cash for a refundable security deposit. By contrast, loans to finance the purchase of equipment typically require down payments of up to 25 percent or more. 2. Easier to finance than purchases: Before extending a capital equipment loan, banks will usually want to see two to three years of financial records — which most new companies do not have. Leasing companies, on the other hand, usually require only six months to a year of credit history before approving a furniture or office equipment lease. 3. Sales Tax Implications: The impact of sales and use tax can vary dramatically based on whether a vehicle is leased or owned. Consider this; tax is applied to the lease vehicle's monthly rental payment instead of being an up-front charge against the vehicle's initial purchase cost. Paying taxes on the monthly payment stream not only reduces the total tax paid, but also improves cash flow. 4. Keep pace with technology: Leasing is especially attractive if your business relies upon cutting-edge technology such as the latest computers, communications devices, or other equipment. A series of short-term leases will cost you less than buying new equipment every year or two. Some office equipment leases even have yearly computer upgrades built into them — eliminating that difficult decision of whether you can afford to upgrade or not. 5. Allows affording more: While you might not be able to afford to purchase those pricey ergonomic chairs your employees are asking for, you may be able to lease them. Better furniture and equipment can create a more professional image and boost morale and productivity. 6. Balance sheet benefits: You may be able to exclude some leased assets and related obligations from your balance sheet. Such moves might improve financial indicators such as your firm's debt-to-equity ratio or earnings-to-fixed-assets ratio. Bear in mind, however, that accounting rules do require your balance sheet to report assets leased under certain types of agreements.

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Differences between Finance and Operating Leases: (Q: 2a, 2010, 2d, 2011) Financial Lease

Operating Lease



Risks and rewards of ownership are transferred to, and borne by, the lessee. This includes the risks of accidental ruin or damage of the asset (although these risks may be insured or otherwise assigned). Thus damage that renders an asset unusable does not exempt the lessee from financial liabilities before the lessor.







The goal of the lessee is either to acquire the asset or at least use the asset for most of its economic life. As such, the lessee will aim to cover all or most of the full cost of the asset during the lease term and therefore is likely to assume the title for the asset at the end of the lease term. The lessee may gain the title for the asset earlier, but not before the full cost of the asset has been paid off.







The lessor retains legal ownership for the duration of the lease term, though the lessee may or may not buy out the leased asset at the end of the lease, with the lessor charging only a nominal fee for the transfer of asset to the lessee.







The lessee chooses the supplier of the asset and applies to the lessor for funding. This is significant because the leasing company that funds the transaction should not be liable for the asset quality, technical characteristics, and completeness, even though it retains the legal ownership of the asset. The lessee will also generally retain some rights with respect to the supplier, as if it had purchase asset directly.

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Economic ownership with all corresponding rights and responsibilities are borne by the lessor. The lessor buys insurance and undertake responsibility for maintenance.

The goal of the lessee is usage of the leased asset for a specific temporary need, and hence the operating lease contract covers only the short-term use of the asset. Further, the duration of an operating lease is usually much shorter than the useful life of the asset.

It is not the lessee‘s intention to acquire the asset, and lease payments are determined accordingly. In addition, an asset under an operating lease may subsequently be rented out.

The present value of all lease payments is significantly less than the full asset price.

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Chapter 3 Economics of Leasing Why Do Companies Lease Equipment? Companies choose operating leases because the leased asset and the related obligation do not appear on the balance sheet, allowing them to show a more favorable debt ratio and return on assets. In general, companies with operating leases report less interest, higher income, and more favorable returns on equity than companies with capital leases.  

Companies recognize that the value of equipment comes from its use, not its ownership. Leasing allows managers to budget more efficiently and get better equipment without large initial capital outlays.  Companies lease for efficiency and convenience.  Leasing permits a close matching of rental payments to revenue produced by using the equipment.

What condition will company favor financial lease or operating lease Several possible answers can be given to this questions, but it must be considered within the context of specific situation; in other words, circumstances could arise that would invalidate the assumptions on which answer are based.  Companies with low marginal tax rates or low taxable capacity generally find leasing to be advantageous, because they do not need or cannot obtain the tax advantages (depreciation) that go with the ownership of the assets. In this case, either type of lease is appropriate. Companies with high tax rates prefer finance leases, because expenses are normally higher in early periods.  Operating lease are advantageous when management compensation depends on return on assets or invested capital.  An operating lease is advantageous when an entity wants to keep debt off its Statement of Financial Position. This can help them if they have indenture covenants requiring low debt to equity ratios or high interest-coverage ratios.  Finance lease are favored if an entity wants to show a high cash flow from operations.  Finance lease have advantageous when there is a comparative advantage to reselling property.

Prepared By Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University. Email:[email protected] Mobile: 01198150195 Jagannath University

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Lease Finance and Investment Banking

Advantages of lease financing or why do companies lease: (Q: 2a, 2011) Lease financing is one of the better known business strategy followed by most of the groups we can easily found the plans which are ideal to go with. Lease finance is more useful for the small and big company for the daily routine transaction. Lease finance we have to give back after some period, and on that lease finance business have to pay interest. So we can used lease finance and get more and more benefit. Also we get some other advantages and they are,  It offers fixed rate financing; lessee has pay at the same rate monthly.  Leasing is inflation friendly. As the costs go up over five years, lessee still pay the same rate as when he began the lease, therefore making his dollar stretch farther. (In addition, the lease is not connected to the success of the business. Therefore, no matter how well the business does, the lease rate never changes.)  There is less upfront cash outlay; lessee does not need to make large cash payments for the purchase of needed equipment.  Leasing better utilizes equipment; lessee leases and pays for equipment only for the time he needs it. There is typically an option to buy equipment at end of lease term.  Lessee can keep upgrading; as new equipment becomes available he can upgrade to the latest models each time your lease ends.  Typically, it is easier to obtain lease financing than loans from commercial lenders.  Small upfront deposit and the option of a balloon payment.  Finance lease payments can be offset against tax. It offers potential tax benefits depending on how the lease is structured  User can decide when to cancel contract but will incur early termination charges.

Limitation of Leasing:  Restrictions on Use of Equipment A lease arrangement may impose certain restrictions on use of the equipment, or require compulsory insurance, and so on. Besides, the lessee is not free to make additions or alterations to the leased asset to suit his requirement.  Limitations of Finance Lease A finance lease may entail higher payout obligations, if the equipment is found not useful and the lessee opts for premature termination of the lease agreement. Besides, the lessee is not entitled to the protection of express or implied warranties since he is not the owner of the asset.  Loss of Residual Value The lessee never becomes the owner of the leased asset. Thus, he is deprived of the residual value of the asset and is not even entitled to any improvements done by the lessee or caused by inflation or otherwise, such as appreciation in value of leasehold land.  Consequences of Default If the lessee defaults in complying with any terms and conditions of the lease contract, the lessor may terminate the lease and take over the possession of the

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Lease Finance and Investment Banking leased asset. In case of finance lease, the lessee may be required to pay for damages and accelerated rental payments.  Understatement of Lessee's Asset Since the leased assets do not form part of the lessee's assets, there is an effective understatement of his assets, which may sometimes lead to gross underestimation of the lessee. However, there is now an accounting practice to disclose the leased assets by way of footnote to the balance sheet.  Double Sales Tax With die amendment of sale tax laws of various States, a lease financing transaction may be charged to sales tax twice—once when the lessor purchases the equipment and again when it is leased to the lessee.

Problems of Leasing (Q: 2b, 2010) Leasing has great potential in India. However, leasing in India faces serious handicaps which may mar its growth in future. The following are some of the problems. 1. Unhealthy Competition: The market for leasing has not grown with the same pace as the number of lessors. As a result, there is over supply of lessors leading to competitor. With the leasing business becoming more competitive, the margin of profit for lessors has dropped from four to five percent to the present 2.5 to 3 percent. Bank subsidiaries and financial institutions have the competitive edge over the private sector concerns because of cheap source of finance. 2. Lack of Qualified Personnel: Leasing requires qualified and experienced people at the helm of its affairs. Leasing is a specialized business and persons constituting its top management should have expertise in accounting, finance, legal and decision areas. In India, the concept of leasing business is of recent one and hence it is difficult to get right man to deal with leasing business. On account of this, operations of leasing business are bound to suffer. 3. Tax Considerations: Most people believe that lessees prefer leasing because of the tax benefits it offers. In reality, it only transfers; the benefit i.e. the lessee‘s tax shelter is lessor‘s burden. The lease becomes economically viable only when the transfer‘s effective tax rate is low. In addition, taxes like sales tax, wealth tax, additional tax, surcharge etc. add to the cost of leasing. Thus leasing becomes more expensive form of financing than conventional mode of finance such as hire purchase. 4. Stamp Duty: The states treat a leasing transaction as a sale for the purpose of making them eligible to sales tax. On the contrary, for stamp duty, the transaction is treated as a pure lease transaction. Accordingly a heavy stamp duty is levied on lease documents. This adds to the burden of leasing industry.

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Lease Finance and Investment Banking 5. Delayed Payment and Bad Debts: The problem of delayed payment of rents and bad debts add to the costs of lease. The lessor does not take into consideration this aspect while fixing the rentals at the time of lease agreement. These problems would disturb prospects of leasing business.

Uses of Leases: Leases are used for the rental (either short- or long-term) of homes and apartment dwellings, as well as automobiles and other mechanical equipment. The purpose of the lease is to spell out the lease costs, upfront deposits, maintenance, repair, insurance coverage, use and how and when the lease will end. Leases spell out any future ownership of the property when the lease ends, which could include a sale price in case the lessee is buying the property or item at the end of the lease. They also will spell out legal ramifications in the event the lessor or owner of the item or property does not keep promises as agreed, and will spell out the coverage of court and legal costs in the event that legal issues arise.

Leases on Real Estate: Leases are used in the rental of residential properties (including apartments) to spell out the length of time a tenant will reside in the home and what happens at the end of the lease period. A lease will spell out dates that rental fees are due, costs, late charges and upfront deposits. It will also spell out the tenant's responsibility of maintenance and upkeep (small repairs, grass cutting, etc.) and the owner's responsibility (major repairs such as repair of heat and air systems, appliances and any items not required to be cared for by the tenant). The lease will discuss what restrictions are placed on the property. It may state that no drug use or similar illegal activity is to go on in the home or the lease will end and the lessee will face eviction. The lease may cover the issue of pets and the number of people in the household, as well as the number of people who may visit from time to time.

Commercial Leases: Leases are used for tenants who rent commercial properties. Space may be rented by the square foot, set as a dollar amount per square foot of space. The tenant may be offered one of three different types of lease: The first is a gross lease, which mandates a set amount of rent to be paid each month. The owner agrees to pay taxes, insurance and all maintenance on the building. The second type of lease is a net lease, which requires the tenant pay an amount for the use of the space (rent) plus some of the maintenance, insurance and other costs involved. The third type of lease is a triple net lease. This is common for freestanding buildings, and has the tenant paying rent plus all costs involved with the building including insurance and taxes. Office Equipment leases: Leasing office or business equipment has its advantages. When a new entrepreneur sets up a business, cash flow is usually low. Leasing is an option to obtain needed

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Lease Finance and Investment Banking equipment but avoid going into debt with a loan. The business owner will spend a smaller amount for deposits, and have only a monthly payment. In the long run, equipment costs more when leased, but leasing has its advantages. An example of this would be with computers. Computer technology has changed so much and so often that computers become obsolete very quickly. A leased computer can offer the advantage of upgrades as technology changes, guaranteed for no extra cost in the lease. There is usually a clause to buy out the equipment at the end of the lease. Leasing can become a necessity if you find that you cannot get a loan to buy equipment, and leasing or buying with cash are your only options. Leases on Automobiles: As the cost of new automobiles, vans, trucks and SUVs have increased, so has the cost of the homes, food and energy it takes to live. Consumers are always looking for ways to drive safe and dependable cars and keep all of the necessary expenses within their budget. Automobile leasing can do that by keeping the lease payment lower than an actual payment would be, because all you are paying for is the depreciation on the vehicle, taxes and rent. Automobile leases are considered to be closed-end leases because at the end of the lease, you turn in the vehicle and walk away from the lease. You will be limited to a certain mileage per year (typically 12,000 to 15,000 miles), or you can negotiate for higher mileage for a higher monthly payment (which pays for increased depreciation of the vehicle's quality). You have the option to buy the vehicle at the end of the lease period for a depreciated price, or to select another new car and begin another lease period. Roughly 20 to 25 percent of all new cars, trucks and SUVs are leased, but 75 percent of high-end luxury cars are leased vehicles. Leasing cars, equipment, homes or anything else gives the user the use of the item or property without a long-term obligation to purchase. It can save the lessee money on monthly payments while giving him the opportunity to try out something for a time. The language in a lease should give both the lessor and lessee an exit to break the lease in the event that leasing the item or home no longer serves its purpose, or if either party can no longer perform as initially agreed.

Economic Rationale for Leasing (Q: 1a, 2011) The prime reason for the existence of leasing is that the companies, individuals and financial institutions derive different tax benefits from the ownership of assets. The marginally profitable company may not be able to reap the full benefits of accelerated depreciation, whereas the high income Taxable Corporation or individual is able to realize such. The former may be able to obtain a greater portion of the overall tax benefits by leasing the asset from the latter party as opposed to buying it. Because of competition among lessors, part of the tax benefits may be passed on to the lessee in the form of lower lease payments than would otherwise be the case. Another tax disparity has to do with the alternative minimum tax. For a company subject to the AMT, accelerated depreciation is a ‗tax preference item‘, whereas a lease payment is not. Such a company may prefer to lease, particularly from another party that pays taxes at higher effective rate. The greater the divergence in abilities of various parties to realize the tax benefits associated with owning an asset, the greater the attraction of lease financing overall. It is not the existence of taxes per se that gives rise to leasing but divergences in the abilities of various parties to realize the tax benefits.

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Lease Finance and Investment Banking Another consideration, although smaller one, is that lessors enjoy a somewhat superior position in bankruptcy proceedings over what would be case if they were secured lenders. The riskier the firm that seeks financing, the greater is the incentive for the supplier of capital to make the arrangement a lease rather than a loan. From the above discussion we can find out the following economic rationale for leasing in brief:  Leasing allows higher-income taxable companies to own equipment (lessor) and take accelerated depreciation, while a marginally profitable company (lessee) would prefer the advantages afforded by leases.  Thus, leases provide a means of shifting tax benefits to companies that can fully utilize those benefits.  Other non-tax issues: economies of scale in the purchase of assets; different estimates of asset life, salvage value, or the opportunity cost of funds; and the lessor‘s expertise in equipment selection and maintenance.

Financial Evaluation: Lessor’s viewpoint The lease evaluation from the point of view of the lessor aims at ascertaining whether to accept a lease proposal or to choose from alternative proposals. As in the case of the evaluation by a lessee, the appraisal method used is the discounted cash flow technique based on the lessor's cash flows. The leaser related cash flow from his angle consists of (a) outflows in terms of the initial investment/acquisition cost of the asset at the inception of the lease; income tax on lease payments, sales tax on lease transaction, if any; lease administration expenses such as rental collection charges, expenses on suits for recovery and other direct cost, and so on, (b) inflows such as lease rentals, management fee, tax shield on depreciation residual value and security deposit, if any, and so on. This section illustrates lease evaluation from the point of view of a lessor and includes aspects such as break-even rental for the lessor, negotiation and fixation of lease rentals.

Advantage of leasing from lessee’s viewpoint: (Q: 2b, 2011)  Financing Benefits:  The lease provides 100% financing, so the there is no down payment required.  The lease contracts contain fewer restrictions and provisions making it more flexible than other debt agreements  The leasing arrangement creates a claim that is against only the leased equipment and not all assets.  Risk Benefit: The Lease may reduce the risk of obsolescence and inadequacy.  Tax Benefit: By deducting lease payments, the lessee can write off the full cost of the asset including the part that relates to land.  Financial Reporting Benefit: In certain cases (for operating leases), the lease does not add a liability to the lessee‘s balance sheet and does not affect certain financial ratios such as rate of return.  Billing Benefit: For certain contract-type work, leasing may permit the contractor to charge more because the interest element contained in the rental payments is allowed as a contract charge, whereas interest on borrowed money to purchase assets is usually not.

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Md. Mazharul Islam Jony

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Lease Finance and Investment Banking

Advantages of Leasing form Lessor’s Viewpoint  A way of indirectly making a sale  An alternative means of obtaining profit opportunity by engaging in a transaction that enables the lessor company to transfer an asset by the lease agreement.

How do I find a "standard" lease document? Unfortunately, there is no such thing. To make matters worse, the terms and conditions of the lease and related documents are getting to be at least as important as the amount of the lease payment itself. Some leases are very lessor-friendly, some are more lessee-friendly, and some are rather balanced between the interests of the two parties. The terms and conditions can make a large difference to the economics and overall desirability of a particular lease finance transaction. Sometimes this wide variety of terms and conditions makes it very difficult to choose a lessor, since the decision usually involves a certain amount of "apples to oranges" comparisons.

Prepared By Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University. Email:[email protected] Mobile: 01198150195

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Md. Mazharul Islam Jony

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Lease Finance and Investment Banking

Chapter 4 Accounting aspect of lease financing Accounting by Lessee Operating Lease: An operating lease is a lease that does not meet any one of the four Capitalization criteria Group I listed below. Under the Operating Lease method the Lessee does not capitalize the asset, only a lease expense is recorded. Capital Lease: In order the lessee to capitalize a lease it must be non-cancelable and meet one of the following four requirements: 1. The lease transfers ownership to the lessee. 2. The lease contains a bargain purchase option 3. The lease term is equal to 75% or more of the estimated economic life of the leased property. 4. The present value of the minimum lease payments (excluding executor costs) equals or exceeds 90% of the fair value of the leased property. If the lease is capital the lessee records an asset and a liability equal to the sum of the present value at the beginning of the lease term, of the minimum lease payments during the lease term. Accounting by Lessor From the standpoint of the Lessor, all leases may be classified for accounting purposes as one of the following: 1. Operating Lease 2. Direct Financing Lease 3. Sales-Type Lease Capitalization Criteria (Lessor) (Q: 2c, 2011) Group I (Criteria Applicable to Both Lessee and Lessor “Column A”) 1. The lease transfers ownership of the property to the lessee. 2. The lease contains a bargain purchase option 3. The lease term is equal to 75% or more of the estimated economic life of the leased property. 4. The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90% of the fair value of leased property. Group II (Criteria Applicable to Lessor Only “Column B”) 1. Collectibility of the payments required from the lessee is reasonably predictable 2. No important uncertainties surround the amount of unreimbursable costs yet to be incurred by the lessor under the lease (lessor‘s performance is substantially complete or future costs are reasonably predictable. Jagannath University

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Md. Mazharul Islam Jony

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Lease Finance and Investment Banking

If at the date of the lease agreement the lessor is party to a lease the meets one or more of the Group I requirements and both of the Group II criteria, the lessor shall classify the lease as a direct financing lease or a sales type lease. From this point, if the lease include manufacturer’s or dealer’s profit (loss) it is considered to be a sales-type lease. If it does not it is considered a direct financing lease. All leases that do not qualify as a direct financing or sales-type lease are classified as an operating lease.

Operating Lease (Lessor)  Under and operating lease, a lessor company leasing an asset to a lessee retains substantially all the risks and benefits of ownership.  Rental receipts are recorded as rental revenue.  The leased asset is depreciated in the normal manner and the expense of the period is matched against rental revenue.

Direct Financing Leases (Lessor)  The net amount at which the lessor records the receivable must be equal to the cost of carrying value the property.  Then net receivable is equal to the present value of the future lease payments to be received.  There are two components of the net receivable, gross receivable and the unearned interest.  The gross receivable of the lessor includes the lessor includes the sum of:  The undiscounted minimum lease payments to be received by the lessor (net of executory cost paid by the lessor) plus  The unguaranteed residual value accruing to the benefit of the lessor.  The interest rate implicit in the lease is the rate that, when applied to the gross receivable, will discount that amount to a present value that is equal to the net receivable. Initial Direct Cost Involved in a Direct Financing Lease of a completed lease transaction include incremental direct cost and certain other direct costs. Incremental direct costs include those cost that result directly from and are essential to the leasing transaction and would not have been incurred by the lessor if the transaction had not occurred.

Sales-Type Leases (Lessor) (Q: 5a, 2010)  In distinguishing between a sales-type lease and a direct financing lease, the major differences are the presence of a manufacturer‘s or dealer‘s profit or loss in a sale-type lease and the accounting for initial direct costs.  The manufacturer‘s profit of loss is measured as the difference between the following two items:

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Md. Mazharul Islam Jony

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Lease Finance and Investment Banking

 The present value of the minimum lease payments (net of executory costs) computed at the interest rate implicit in the lease  The cost or the carrying value of the asset plus any initial direct costs less the present value of the unguaranteed residual value accruing to the benefit of the lessor.

Are there accounting benefits to leasing? The biggest benefit is the ability to get certain leases off the balance sheet by virtue of compliance with the FASB 13 tests. Such lease obligations are typically not on a firm's Balance Sheet but are listed in the footnote section of the financials. This treatment can not only improve financial ratios, but other performance criteria such as Return on Assets, etc.

For most high technology assets, a lease also tends to avoid future accounting surprises that can result when purchased assets are sold for less than their current book value. In other words, leasing high technology equipment tends to track with real costs / market values better than the depreciation tables, which were set up many years ago. This is even true when accelerated depreciation such as MACRS is used.

'Off' the balance sheet Financing: (Q: 1c, 2011) Leasing has the advantage of being 'off' the balance sheet. In the case of operating leases, future rental payments are currently not included on the balance sheet of the lessee as a liability and the leased asset is not included as an asset. Operating leases differ from Finance leases in that the lessor enjoys the benefits and shoulders the risk of ownership while the lessee has possession and use of the leased asset. The lessee does not guarantee the residual value and returns the asset to the lessor at the end of the lease period. Insight: some businesses consider operating leases to be advantageous, especially if the efficiency of their operation is measured by reference to return on assets. However, it should be noted that future rentals do need to be disclosed by way of a note in the financial accounts.

Prepared By Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University. Email:[email protected] Mobile: 01198150195

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Department of Finance

Md. Mazharul Islam Jony

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Lease Finance and Investment Banking Mathematical Problems and Solutions Math 1: Basket Wonders is deciding between leasing a new machine or purchasing the machine outright. The equipment, which manufactures Easter baskets, costs $74000 and can be leased over 7 years with payments being made at the beginning of the each year. The lessor calculates the lease payments based on an expected return of 11% over the 7 years. The lease is a net lease. The company is in 40 % marginal tax bracket. If bought, the equipment is expected to have a final Salvage value of $7500. The purchase of the equipment will result in depreciation schedule of 20%, 32%, 19.2%, 11.52%, 11.52%, 5.76% for the first 6 years (5 year property class) based on $74000 depreciable base. Loan payments are based on a 12% loan with payments occurring at the beginning of each period. (Math of exam 2011) Solution of math 1 Cost of the equipment = $74000 Useful life = 7 years Tax bracket = 40% Salvage value = $7500  Lease payments will be made at the beginning of the each year.  Lease payments will be calculated basing on an expected return of 11%.  Depreciation rates basing on $74000 depreciable base 20%, 32%, 19.2%, 11.52%, 11.52%, 5.76%.  Loan payments are based on a 12% loan with payments occurring at the beginning of each period. Cost of capital = 12% (1-.40) = 7.2% Lease payment for each year =

74000 1− 1+.11 −7 .11

1+.11

= $14148 NPV Analysis of Leasing: Year 0 1 2 3 4 5 6 7

Lease Rent $14148 $14148 $14148 $14148 $14148 $14148 $14148 $7500

Installment of loan =

Tax Savings $0 $5659 $5659 $5659 $5659 $5659 $5659 $5659

COAT $14148 $8489 $8489 $8489 $8489 $8489 $8489 (1841) NPV =

PV of COAT at 7.2% $14148 $7919 $7387 $6891 $6428 $5996 $5594 $1132 $55495

74000 1− 1+.12 −7 .12

1+.12

= $14477 Jagannath University

Department of Finance

Md. Mazharul Islam Jony

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Lease Finance and Investment Banking Loan Repayment Schedule: Year 0 1 2 3 4 5 6

Beginning Balance 74000 59523 52188 43973 34772 24468 12926

Installment 14477 14477 14477 14477 14477 14477 14477

Interest ……. 7143 6263 5277 4173 2936 1551

Amortization 14477 7335 8215 9201 10305 11541 12926

Ending Balance 59523 52188 43973 34772 24468 12926 0

Depreciation and tax savings schedule: Year 0 1 2 3 4 5 6 7

Interest ……… $7143 6263 5277 4173 2936 1551 ………..

Depreciation ……….. $14800 $23680 $14208 $8525 $8525 $4262 ………

Total ………… $21943 $29943 $19485 $12698 $11461 $5813 ……….

Tax Savings ………. $8777 $11977 $7794 $5079 $4585 $2325 ………..

NPV Analysis of Owing: Year 0 1 2 3 4 5 6 7

Installment – Tax Savings $14477 - $0 $14477 - $8777 $14477 - $11977 $14477 - $7794 $14477 - $5079 $14477 - $4585 $14477 - $2325 $0 - $0

COAT PV of COAT at 7.2% $14477 $14477 $5700 $5317 $2500 $2175 $6683 $5425 $9398 $7116 $9892 $6987 $12152 $8008 ………. ………. Total = $49505 Less: PV of Salvage Value = (4610) NPV = $44895

Decision: Considering above NPVs of two alternatives, we can say that Company should borrow and buy the machine as NPV of buying is less than that of taking lease.

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Md. Mazharul Islam Jony

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Lease Finance and Investment Banking Math 2: A company has decided to acquire an asset costing Tk. 260000. The asset has a useful life of 6 years, at the end of which a salvage value of Tk. 35000 is expected. The company is trying to determine whether it is better to finance the asset with debt or with lease financing. If debt, the interest rate would be 15 percent, and the debt payment would be due at the very beginning of each of the 6 years. The company is in 40 % tax bracket. If the asset is acquired through lease financing, lease payments of Tk. 50000 would be required at the beginning of each year for the lease periods. Show your analysis to recommend the method of financing which the company would prefer for acquiring the asset.(Math of exam 2010)

Solution of math 2 Cost of the equipment = $260000 Useful life = 6 years Tax bracket = 40% Salvage value = $35000    

Lease payments will be made at the beginning of the each year. Lease payments per year $50000. Depreciation will be calculated on a straight line basis for 6 years. Loan payments are based on a 15% loan with payments occurring at the beginning of each period.

Cost of capital = 15% (1-.40) = 9%

NPV Analysis of Leasing: Year 0 1 2 3 4 5 6

Lease Rent $50000 $50000 $50000 $50000 $50000 $50000 ……….

Installment of loan =

Tax Savings ………. $20000 $20000 $20000 $20000 $20000 $20000

COAT $50000 $30000 $30000 $30000 $30000 $30000 ($20000) NPV =

PV of COAT at 9% $50000 $27523 $25250 $23165 $21253 $19498 ($11925) $154764

260000 1− 1+.15 −6 .15

1+.15

= $59740

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Department of Finance

Md. Mazharul Islam Jony

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Lease Finance and Investment Banking Loan Repayment Schedule: Year 0 1 2 3 4 5

Beginning Balance $260000 $200260 $170558 $136401 $97121 $51948

Depreciation Per Year =

Installment $59740 $59740 $59740 $59740 $59740 $59740

$260000 −$35000 6

Interest ……. $30039 $25584 $20460 $14568 $7792

Amortization $59740 $29702 $34157 $39280 $45172 $51948

Ending Balance $200260 $170558 $136401 $97121 $51948 $0

= $37500

Depreciation and tax savings schedule: Year 0 1 2 3 4 5 6

Interest ……. $30039 $25584 $20460 $14568 $7792 …….

Depreciation ……….. $37500 $37500 $37500 $37500 $37500 $37500

Total ………… $67539 $63084 $57960 $52068 $45292 $37500

Tax Savings ………. $27016 $25234 $23184 $20827 $18117 $15000

NPV Analysis of Owing: Year 0 1 2 3 4 5 6

Installment – Tax Savings $59740 - $0 $59740 - $27016 $59740 - $25234 $59740 - $23184 $59740 - $20827 $59740 - $18117 $0 - $15000

COAT PV of COAT at 9% $59740 $59740 $32734 $30008 $34506 $29054 $36556 $28221 $38913 $27550 $41623 $27055 ($15000) ($8940) Total = $192688 Less: PV of Salvage Value = (20869) NPV = $171818

Decision: Considering above NPVs of two alternatives, we can say that Company should take lease the machine as NPV of taking lease is less than that of borrowing and buying.

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Department of Finance

Md. Mazharul Islam Jony

26 | P a g e

Lease Finance and Investment Banking

Math 3: Lease versus purchase: The Hot Bagel Shop wishes to evaluate two plans, leasing and borrowing to purchase for financing an oven. The firm is in the 40% tax bracket. Lease alternative: the shop can lease the oven under a 5 year lease requiring annual end of year payments of $6000. All maintenance costs are borne by lessor and insurance and other costs will be borne by the lessee. The lessee will exercise its option to purchase the asset for $4000 at termination of the lease. Purchase alternative: the oven costs $24000 and will have a 5 year life. It will be depreciated under MACRS of 5 year recovery period. The total purchase price will be financed by a 5 year, 9% loan requiring equal annual year end payments of $6170. The firm will pay $1500 for a service contract that covers all maintenance costs, insurance and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its 5 year recovery period. a. For the leasing plan calculate the following: 1) The after tax cash outflow each year. 2) The present values of cash outflows using 6% discount rate. b. For the purchasing plan calculate the following: 1) The annual interest expense for each year 2) Annual after tax cash outflow resulting from the purchase for each of the 5 years. 3) The present values of cash outflows using 6% discount rate. c. Compare the present values of the cash outflow streams for these two plans and determine which plan would be preferable. (Math of exam 2012)

Solution of Math 3: Given, cost of the machine = $24000 Tax bracket = 40% Cost of capital = 6%

   

Lease alternative: Every year end lease payments = $6000 Lease term = 5 years Lessee can purchase for $4000 at the end of lease term. All maintenance costs are borne by lessor.

Purchase alternative:  9%, 5year loan with installments of $6170 at the end of each year.  Maintenance cost = 1500 per year.  Depreciation rates are 20%, 32%, 19%, 12% and 12% respectively. Jagannath University

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Md. Mazharul Islam Jony

27 | P a g e

Lease Finance and Investment Banking

After tax cash outflow of lease = lease rental ( 1- tax rate) = $6000(1- 0.40) = $3600 NPV Analysis of Leasing: Year 1 2 3 4 5

COAT

PV of COAT at 6% $3396 $3204 $3023 $2852 $5679 $18154

$3600 $3600 $3600 $3600 $3600+ $4000 Total =

Loan Repayment Schedule: Year Beginning Balance 1 24000 2 19990 3 15619 4 10854 5 5660

Installment Interest 6170 2160 6170 1799 6170 1405 6170 977 6170 510

Amortization Ending Balance 4010 19990 4371 15619 4765 10854 5194 5660 5660 0

Depreciation and tax savings schedule: Year (1) 1 2 3 4 5

Interest (2) 2160 1799 1405 977 510

Maintenance (3) 1500 1500 1500 1500 1500

Depreciation (4) $4800 $7680 $4560 $2880 $2880

Total (5) $8460 $10979 $7465 $5357 $4890

Tax Savings (6)=(5)*40% $3384 $4392 $2986 $2143 $1956

NPV Analysis of Owing: Year (1)

Installment (2)

1 2 3 4 5

6170 6170 6170 6170 6170

Maintenance Tax Savings (3) (4) 1500 1500 1500 1500 1500

$3384 $4392 $2986 $2143 $1956

COAT (5)= (2)+(3)-(4) $4286 $3278 $4684 $5527 $5714 Total =

PV of COAT at 6% $4043 $2917 $3933 $4378 $4270 $19541

Decision: Considering above NPVs of two alternatives, we can say that Company should take lease the machine as NPV of taking lease is less than that of borrowing and buying.

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Math 4: Lease versus purchase: The Hot Bagel Shop wishes to evaluate two plans, leasing and borrowing to purchase for financing an oven. The firm is in the 40% tax bracket. Lease alternative: the shop can lease the oven under a 5 year lease requiring annual end of year payments of $5000. All maintenance costs are borne by lessor and insurance and other costs will be borne by the lessee. The lessee will exercise its option to purchase the asset for $4000 at termination of the lease. Purchase alternative: the oven costs $20000 and will have a 5 year life. It will be depreciated under MACRS of 5 year recovery period. The total purchase price will be financed by a 5 year, 15% loan requiring equal annual year end payments of $5967. The firm will pay $1000 for a service contract that covers all maintenance costs, insurance and other costs will be borne by the firm. The firm plans to keep the equipment and use it beyond its 5 year recovery period. d. For the leasing plan calculate the following: 3) The after tax cash outflow each year. 4) The present values of cash outflows using 9% discount rate. e. For the purchasing plan calculate the following: 4) The annual interest expense for each year 5) Annual after tax cash outflow resulting from the purchase for each of the 5 years. 6) The present values of cash outflows using 9% discount rate. f. Compare the present values of the cash outflow streams for these two plans and determine which plan would be preferable. Solution of Math 4:  Given, cost of the machine = $20000  Tax bracket = 40%  Cost of capital = 9% Lease alternative:    

Every year end lease payments = $5000 Lease term = 5 years Lessee can purchase for $4000 at the end of lease term. All maintenance costs are borne by lessor.

Purchase alternative:  15%, 5year loan with installments of $5967 at the end of each year.  Maintenance cost = 1000 per year.  Depreciation rates are 20%, 32%, 19%, 12% and 12% respectively.

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After tax cash outflow of lease = lease rental ( 1- tax rate) = $5000(1- 0.40) = $3000 NPV Analysis of Leasing: Year 1 2 3 4 5

COAT

PV of COAT at 6% $2752 $2525 $2317 $2125 $4550 $14269

$3000 $3000 $3000 $3000 $3000+ $4000 Total =

Loan Repayment Schedule: Year 1 2 3 4 5

Beginning Balance 20000 17033 13621 9697 5185

Installment Interest 5967 3000 5967 2555 5967 2043 5967 1455 5967 778

Amortization Ending Balance 2967 17033 3412 13621 3924 9697 4512 5185 5189 -4

Depreciation and tax savings schedule: Year (1) 1 2 3 4 5

Interest (2) 3000 2555 2043 1455 778

Maintenance (3) 1000 1000 1000 1000 1000

Depreciation (4) $4000 $6400 $3800 $2400 $2400

Total (5) $8000 $9955 $6843 $4855 $4178

Tax Savings (6)=(5)*40% $3200 $3982 $2737 $1942 $1671

COAT (5)= (2)+(3)-(4)

PV of COAT at 6%

NPV Analysis of Owing: Year (1)

Installment (2)

1 2 3 4 5

5967 5967 5967 5967 5967

Maintenance Tax Savings (3) (4) 1000 1000 1000 1000 1000

$3200 $3982 $2737 $1942 $1671

$3767 $2985 $4230 $5025 $5296 Total =

$3456 $2512 $3266 $3560 $3442 $16237

Decision: Considering above NPVs of two alternatives, we can say that Company should take lease the oven as NPV of taking lease is less than that of borrowing and buying. Leasing rather than purchasing the oven should result in an incremental savings of $1968.

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Lease Finance and Investment Banking

Math 5: U.S. Bilvet wishes to acquire a $100000 bilvet-degreasing machine, which has a useful life of 8 years. At the end of this time, the machine‘s scrap value will be $8000. The asset falls into 5 years property class for cost recovery (depreciation) purposes. The company use either lease or debt financing. Lease payments of $16000 at the beginning of each year for the lease periods would be required. If debt financed, the interest rate would be 14 percent, and the debt payment would be due at the beginning of each of the 8 years. The company is in 40 % tax bracket. Which method of financing has the lower present value of cash outflows? Solution of Math 5:        

Cost of the equipment = $100000 Useful life = 8 years Tax bracket = 40% Salvage value = $8000 Lease payments will be made at the beginning of the each year. Lease payments per year $16000. Depreciation rates are 20%, 32%, 19%, 12% 12% and 5% respectively. Loan payments are based on a 14% loan with payments occurring at the beginning of each period.

Cost of capital = 14% (1-.40) = 8.4%

NPV Analysis of Leasing: Year 0 1 2 3 4 5 6 7 8

Lease Rent

Tax Savings ………. ($6400) ($6400) ($6400) ($6400) ($6400) ($6400) ($6400) ($6400)

$16000

$16000 $16000 $16000 $16000 $16000 $16000 $16000 ………..

Installment of loan =

COAT $16000 $9600 $9600 $9600 $9600 $9600 $9600 $9600 ($6400) NPV =

PV of COAT at 8.4% $16000 $8856 $8170 $7537 $6953 $6414 $5917 $5458 ($3357) $61948

100000 1− 1+.14 −8 .14

1+.14

= $18910

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Loan Repayment Schedule: Year 0 1 2 3 4 5 6 7

Beginning Balance $100000 $81090 $73533 $64918 $55097 $43895 $31130 $16578

Installment Interest $18910 ……. $18910 $11353 $18910 $10295 $18910 $9089 $18910 $7714 $18910 $6145 $18910 $4358 $18910 $2321

Amortization Ending Balance $18910 $81090 $7557 $73533 $8615 $64918 $9821 $55097 $11196 $43895 $12765 $31130 $14552 $16578 $16589 -$11

Depreciation and tax savings schedule: Year 1 2 3 4 5 6 7

Interest $11353 $10295 $9089 $7714 $6145 $4358 $2321

Depreciation $20000 $32000 $19000 $12000 $12000 $5000 ……….

Total $31353 $42295 $28089 $19714 $18145 $9358 $2321

Tax Savings $12541 $16918 $11236 $7886 $7258 $3743 $928

NPV Analysis of Owing: Year 0 1 2 3 4 5 6 7

Installment – Tax Savings $18910 - $0 $18910- $12541 $18910 - $16918 $18910 - $11236 $18910- $7886 $18910 - $7258 $18910- $3743 $18910 - $928

COAT PV of COAT at 8.4% $18910 $18910 $6369 $5875 $1992 $1695 $7674 $6025 $11024 $7984 $11652 $7785 $15167 $9348 $17982 $10224 Total = $73846 Less: PV of Salvage Value = ($4196) NPV = $69650

Decision: Considering above NPVs of two alternatives, we can say that Company should take lease the machine as NPV of taking lease is less than that of borrowing and buying.

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Lease Finance and Investment Banking

Chapter 5 Tax aspects of leasing When is leasing advantageous from a tax viewpoint? (Q: 5c, 2010) Since the lessor purchases the asset and turns around and leases it to the lessee, the evaluation of the lease from the point of view of the lessor is exactly the same as from the lessee's point of view, except that the signs of the cash flows are switched around. If the tax rates for lessor and lessee were the same, it follows that the gain to the lessee from leasing would equal the loss to the lessor. Hence for leasing to make sense economically, there must be some asymmetries between lessor and lessee. The lease made sense when the lessor had a lower tax rate. However, in general, where accelerated depreciation is allowed for tax purposes, it may be more advantageous for the party with the higher tax rate to be the lessor, who can use the depreciation tax deduction. In general, if the lessor's tax rate is higher, it would be optimal for depreciation to be accelerated and for lease payments to be concentrated towards the end of the lease. If the lessee's tax rate is higher, the reverse would be optimal. In both cases, the advantage to leasing is greater, the greater the interest rate--with a zero interest rate, there would be no advantage to postponing the payment of taxes.

Post tax evaluation from lessee viewpoint      

Lessor‘s tax benefit is the lessee‘s tax loss and vice versa Tax loss to the lessee: depreciation Tax gain to the lessee: principal repayment embedded in lease payments So net lessee gain: (PV of prn repayment – PV of depreciation)* tax rate = A There is nothing like a mutually beneficial transaction So, to compute effective post-tax cost to the lessee, lessee‘s IRR should be obtained by equating (asset cost – A) with lease rentals.

Prepared By Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University. Email:[email protected] Mobile: 01198150195 Jagannath University

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Chapter 6: Equipment lease financing A lease is in essence an extended rental agreement wherein the owner of the equipment (the lessor) allows the user (the lessee) to operate or otherwise make use of the equipment in exchange for periodic lease payments. "There are a number of reasons that companies sometimes prefer to lease equipment rather than buying it," said Richard A. Brealey and Stewart C. Myers in Principles of Corporate Finance. For example, there may be good tax reasons. If the operator cannot use the depreciation tax shield, it makes sense to sell the equipment to someone who can. Also, the lessor may be better able to bear the risk of obsolescence, or be in a better position to resell secondhand assets. The lessor may be able to offer a very good deal on maintenance. Finally, it may be much less costly in time and effort to arrange a simple lease contract on a standard item of equipment than to arrange a normal loan.

Equipment Loans and leases: All businesses need equipment, machinery and tools as well as other business or office equipment in the operation of their company. Equipment can include large items like dry cleaning washers, construction backhoes and tractors, and CNC routing machines to office equipment like copy machines, fax machines, and computer and server hardware and software.

Businesses have several options in purchasing needed equipment. First, businesses can use their cash on hand to purchase the equipment out right. While this provides several benefits in overall equipment costs, it also uses necessary business capital that can be used for other revenue growth opportunities like increasing sales and profits. Second, companies can get an equipment loan - from a bank, financial institution, or other nonbank lender to purchase the equipment. This requires lower amounts of cash out of pocket but means regular monthly payments and interest charges as well as possible upfront fees. Third, businesses can lease the equipment. Leasing could mean no out of pocket expenses, tax benefits just like the other two options above and 100% financing including shipping and set up. Although each business loan / equipment loan option above has its pros and cons, it is always best to leverage current cash flow to purchase an asset to be used in business - then let that assets, through your operations, pay for itself. What this means is obtaining an equipment loan or equipment lease based on your business's current cash flow - purchase the equipment with little or no upfront cash (cash that can be used to grow the business) - then use the equipment to generate more, profitable business. In this type of scenario, the business uses very little of its capital on hand but still gets the equipment needed to grow sales and operate the business. Mostly, this type of scenario allows the business to use the equipment it is paying for to pay for itself through increased business or better profits. Jagannath University

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Equipment Loan: With an equipment loan, some banks, financial institutions, or other lenders will finance (provide an equipment loan or lease) up to 100% of the purchase price - not including shipping, taxes and installation cost. However, most will lend on a minimum loan-to-value (LTV) of say 80% to 90% of the appraised (if used) or purchase price (if new) and require significant cash flow to cover the P & I payments. However, paying 20% for a piece of business equipment is much better than paying 100% for the equipment, especially since the equipment itself could pay for the remaining 80% - saving the business' capital for other opportunities.

Equipment Lease: An equipment lease is great way for growing businesses to acquire the equipment or machinery they need without paying the full purchase price up front. Thus, the equipment can be used in the operation of the business; allowing the business to generate additional revenue from the use of the equipment, without having to waste needed capital - letting the equipment pay for itself. Further, some businesses may not qualify for an equipment loan but will qualify for an equipment lease. When traditional equipment loans are out of the question, new or growing businesses can often find what they need with an equipment lease. Leasing offers many, unique benefits to business owners - especially for businesses with limited cash flow.

Equipment Leasing Versus Equipment Loans Requires a significant downpayment? Secured with collateral? Who bears the risk of equipment obsolescence? Can claim tax deductions? Recorded on the balance sheet? Effect on cash flow?

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Equipment Lease No

Equipment Loan Yes

No. The equipment itself is collateral. The lessor

Yes. Additional assets are often required. The end-user

The entire lease payment can be claimed under most types of leases With an operating lease, the equipment does not appear as an asset. Lease payments are generally spread out comfortably over time

The end-user may claim tax deductions for depreciation and interest. Equipment is recorded as an asset and liability.

Department of Finance

The initial downpayment and strict repayment schedule can put a strain on cash flow.

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ELEMENTS OF EQUIPMENT LEASING CONTRACTS Writing in The Entrepreneur and Small Business Problem Solver, William A. Cohen delineated ten major terms of most equipment leasing contracts:          

Duration of the lease Total rate or lease payment due the lessor Specific financial terms (date of the month that payment is due, penalties for late payment, etc.) Residual values and purchase options Market value of equipment (necessary for insurance purposes in the event of lost or damaged equipment) Tax responsibility Equipment updating or cancellation provisions Lessee renewal options Penalties for early cancellation without good cause Miscellaneous options (security deposits, warranties)

Advantages of an Equipment Lease:  These business loans have lower upfront costs. No down payments or up front fees and usually 100% financing.  100% includes the purchase price, shipping, taxes, and installation.  Leasing payments can be lower than finance payments as a business can lease or finance a small portion of the equipment - not the full purchase price (does not amortize the residual value).  Some equipment lease agreements provide lessees with cancellation options in the event that the equipment proves inadequate for the company's needs over the course of the agreement. Upgrades are sometimes available through these options. One vital category of equipment that often includes such an option is computer systems.  Equipment Leasing shifts risks to the lessor if the equipment looses value over time. Leasing can provide more flexibility to businesses who expects to grow over the immediate short-term. As the business grows, its equipment needs will grow. Thus, the business is not stuck with an asset that has no value to the business yet it is still paying for.  Lease payments are considered business expenses, which can be set off against revenue when calculating tax payments.

Types of Equipment Leases: Finance Lease - also termed capital lease - allows a business to finance the equipment without actually taking ownership of the asset. The business has control over the asset, its benefits and risks, but may not actually own the equipment until the end of the lease. The term of the lease is usually tied to the useful life or close to the useful life of the asset. Think rent to own. Operating Lease - A lease where the term is much shorter than the useful life of the asset being leased. The business can acquire the asset for a short period, to be used in the business, then given back to the lessor. The remaining or residual value is held by the lessor. Sale Lease Back - Let's not forget that business that already own equipment but need working capital for their businesses, can sell their equipment to a financing or leasing company for cash Jagannath University

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Lease Finance and Investment Banking (cash that can be used in the business) then lease that equipment back from the leasing company at fixed monthly payment (just like a loan). Remember, this is a paper transaction - you don't have to take the equipment to the finance company. Sale lease backs are great ways to improve the cash flow of any business.

Why choose equipment lease financing? Equipment lease is a favored option mainly due to the ease of access to lease contracts at competitive monthly rentals from reputed leasing companies. The other reasons that contribute to the popularity of this mode of equipment finance are: 









 

Equipment lease is available for a wide variety of business needs ranging from: software, furniture, industrial equipment, office technology, professional equipment, telecom equipment, security equipment and others. Monthly rentals are considered as an expense while a loan for purchasing business equipment is recorded as a debt; this is an important consideration for companies‘ balance sheet. Tax deductible monthly rentals on leased equipment imply savings as compared to purchasing and owning equipment wherein only the interest paid for purchasing the equipment is eligible for a tax deduction. Investments in assets lock capital for small businesses leaving less capital to take advantage of new opportunities or market changes; leasing prevents locking of capital. Money saved from investing in expensive machinery by leasing can be utilized for other important business expenditures. Leasing equipment helps safeguard interests of businesses with constant change in technology or obsolescence. Investment in obsolete technology can turn into a liability while leasing can protect business interests as companies only have to abide to the lease contract for the specified period. Flexible payment options are offered by both banks as well as leasing companies. Some such options include: fixed payments, level payments and annual payments. Leasing companies may also finance deals for used equipments with small or no upfront costs.

It is important to note that leasing equipment may not necessarily cover ―soft costs‖. Soft costs in equipment leasing parlance are all costs associated with setting up the equipment such as: installation, maintenance, service, training, shipping, software etc. A business must evaluate the importance of such services and the additional costs the business may need to shell out for such services.

Prepared By Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University. Email:[email protected] Mobile: 01198150195 Jagannath University

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Lease Finance and Investment Banking

The various equipment lease payment options Just as there are different types of equipment leasing schemes, so are there a number of payment options available. Some of the popular lease payment options are:  Standard lease: As the name suggests, this payment option is amongst the most common and requires upfront payment of the first and last installment while maintaining a level monthly installment scheme throughout the term of the lease. Such terms range between a repayment period of two to five years and also provide various end-of-term buyout options.  Step lease: In this case, the payments scale from low to a normal amount. This type of payment option is best suitable for equipment costing more than $50,000. Step lease also provides various end-of-term buyout options.  Skip lease: The skip lease payment option is designed to ensure that payments are made only during certain months in a calendar year. This payment option is most suitable for businesses having seasonal highs or those that are more cyclical in nature.  Deferred lease: In the case of a deferred lease, the payments are deferred to a set period such that you have enough time to generate income by using the leased equipment and ensure payment of the lease rental. Most of the above payment options provide end of term buy out options. Obviously, there are advantages and disadvantages of each of the above repayment options depending on the nature of the business, the quantum of the financing availed, the projected returns from the business (and more specifically, the equipment being leased). Therefore, it is very important to analyze the various payment options in the context of one‘s business and income generation strategy and potential.

Simple tips on equipment leasing Here are some important tips to ensure leasing equipment is a profitable decision: 





Get quotes directly: It is important to note that very often equipment leasing companies are referred through lease financiers. It is advisable to get a quote from the company selling the lease directly. Dealing with leasing companies directly help save on broker fees and other costs associated with completing the lease formalities. Make apples-to-apples comparison: Compare quotes closely from the various providers so that you get a profitable deal. While you may get several quotes, note the exact terms of the deal, the type of lease, the repayment options and any other service conditions. Very often, the devil is in the details. Before deciding that one deal is better than the other, make sure you are making an apples-to-apples comparison. Evaluate qualitative attributes and seek external inputs: Referrals from business associates or friends are good sources to locate a reliable and reasonable equipment leasing firm. Known sources or referrals also help gauge qualitative attributes such as customer service much better. Choose a leasing firm that qualifies on the grounds of good experience, reputation, knowledge, ability to deliver, service and relationship building approach.

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Lease Finance and Investment Banking 

Be clear about implications of a lease contract: Choose the right lease program taking into account the lease pricing, lease flexibility, balance sheet considerations, equipment obsolescence, the anticipated period of equipment usage, and your firm‘s credit status.



Understand the lease and fees structure: Evaluate and understand the fees associated with equipment leasing very carefully before entering into a contract. Commitment fees, non-use fees or facility fees, per schedule documentation charges, attorney fees, UCC financing statements, penalty charges for late rental payments and early lease termination charges are some fees associated with lease rentals--- getting a clear idea of what kind of payments you will be liable to make is very important.



Negotiate reduction in interim rent: This type of rent is payable from the day of equipment acceptance to the start date of the lease.



Avoid unintended renewals and lease charges: It is advisable to keep the end of lease notice and renewal periods short to avoid automatic renewal and unintended lease charges. Such periods usually range from one to six months.

FINDING A Equipment Leasing Company Business consultants and long-time equipment lessees agree that leasing companies vary considerably in terms of product quality, leasing terms, and customer service. Small business owners should approach a number of lease companies if possible to inquire about lease terms. They should then carefully study the terms of each outfit's lease agreements, and check into the reputation of each company (present and former customers and agencies like the Better Business Bureau can be helpful in this regard). Finally, it is also important for entrepreneurs and business owners to take today's fast-changing technology into account when considering an equipment leasing arrangement. "Because rapidly changing technology can cause an asset to become obsolete before it wears out or the lease expires, you will want to be sure the provisions of your lease permit exchanges for more advanced equipment or replacements, as they become necessary," stated Borow.

Unplanned obsolescence All equipment is subject to either functional or technical obsolescence (or both). Functional obsolescence means that the equipment simply wears out over time or loses structural integrity. Technological obsolescence means that there is something new and improved in the market that renders the older technology less desirable. The desktop computer you bought five years ago is still just as fast as it was when it came out of the box, but is now essentially useless for most real-world business applications and therefore worthless in the used equipment marketplace.

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Lease Finance and Investment Banking

Chapter 7 Sale and lease back in real estate Introduction: A sale/leaseback transaction occurs upon the sale of property by the owner and a lease of the property back to the seller. In these transactions, the "seller" is often referred to as the seller/lessee and the "buyer" is often referred to as the buyer/lessor. Sale/leaseback transactions typically are entered into as a means of financing, for tax reasons or both. In addition, if a property owner has accumulated significant equity in a property, a sale/leaseback transaction provides a way to realize the equity without giving up the use of the property. In recent years, due to low interest rates and the supply of real estate debt financing, there has been an emphasis away from the sale/leaseback transaction as an affordable method for the restaurant operator to proceed with development and financing transactions or access equity and capital. Sale and leaseback transactions have, however, been used in commercial real estate for many years, and, due to the underlying real property asset represent a traditional means of financing. Notwithstanding the cyclical nature of real estate and occasional over influence on the market by outside factors (e.g., the real estate tax shelters of the early 1980's), lenders and investors have enjoyed appropriate returns on real estate using sale/leaseback transactions. As the current interest rate market stabilizes and debt financing in the restaurant industry returns to more traditional levels, it is likely that the rates offered on sale/leaseback transactions will again appear attractive. The actual sale/leaseback transaction has been streamlined by a number of financing sources in the restaurant industry. Financing through the use of a sale/leaseback can be used for existing properties in connection with takeout of construction loans, refinancing or accessing equity in real estate. Sale/leaseback transactions can also be structured for development of new restaurants.

Sale And Leaseback How you can raise finance against equipment you own or spread the payments for new items. Lease purchase works quite similarly to equipment leasing in that it allows you to buy high grade equipment - possibly in quantities or at levels of quality which you couldn't otherwise afford - and spread the payments over the lifetime of the item. As with equipment leasing, lease purchase agreements can also be drawn up against used the equipment and so they can be used to raise funds against the value of assets you already own. Essentially, you sell them to the lease company and buy them back. Clearly this is an excellent way of freeing up the value of assets and reducing the strain purchasing might place on capital. At the end of the terms of the lease, which can run for anything from one year to seven, ownership of the equipment or property is transferred (or reverts) to you.

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Why sell and leaseback? If you have the right kind of assets the advantages it brings are the ability to upgrade resources for your business and staff without making too large an impact on your capital. In this respect it is much like leasing but at the end of the contract the item belongs to your business out right.

How does it work? The equipment or asset is sold to a leasing company. Then, the lessor, will then produce a finance document and lease the same equipment back you, the original owner or intended buyer, the lessee. You can use lease purchase for the acquisition of equipment, property (land and buildings) or even entire businesses as part of the purchasing financing. So, for example, if you are buying a business and sufficient closing funds are not obtainable through normal borrowing channels, unused plant, equipment or vehicles can be sold to a leasing company and then leased back through a normal leasing agreement over a period of time. The capital produced from this exercise can be given to the original seller of the business to make up the final purchase price. Sale/leaseback transactions can be broken down into two general structures. The first would be the sale/leaseback of improved land and the second would be the sale/leaseback of unimproved land. With regard to the first, sale/leaseback of improved land, these transactions are typically structured as one of two types, indirect or direct purchase of the land by buyer/lessee. Indirect Purchase. This type of structure involves a structure whereby the seller/lessee enters into a purchase agreement to acquire certain improved property from a third party seller. Then, simultaneously with the closing between the seller/lessee and the third party seller, the seller/lessee assigns its rights under the purchase agreement to buyer/lessor who actually takes title to the property from the third party seller. This assignment is usually handled by way of assignment of the purchase agreement. The assignability aspect of this structure is usually negotiated when the purchase agreement is executed. Direct Purchase. This type of structure involves an arrangement whereby the seller/lessee actually closes on the purchase of the property and takes title in its name. Then subsequent to this closing the buyer/lessor will enter into a purchase agreement to purchase the property from the seller/lessee. Depending on the transaction, the period of time between the two closing can be short or long periods of time. The longer time periods are typical of transactions that entail development and construction on the site. Construction Sale/Leaseback. The other typical type of sale/leaseback transaction, which is somewhat more complicated, is the sale/leaseback transaction with construction financing. This type of transaction involves the acquisition of raw land by the seller/lessee and the development and construction of the property. This type of transaction usually includes a structure similar to the direct purchase, however, on occasion the indirect purchase structure is used. As mentioned above, this type of structure involves additional risk to the buyer/lessor. The additional risk arises out of the construction aspect of the deal. In particular, the increased risk arises from the fact that there will be lienable improvements to the land and draws to pay for such improvements. These types of issues could give rise to mechanic‘s liens or contractor‘s liens that

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Lease Finance and Investment Banking may attach to the property if not paid and lien releases obtained. Additionally, in a recent Eighth Circuit Court of Appeals decision, the Court held that the Franchisor who designs and constructs premises may have ADA (American's with Disabilities Act) liability if the design and construction does not comply with ADA. United States v. Days Inn of America, Inc., 151 F.3rd 822 (8th Cir. 1998). Sale/leaseback transactions with construction financing present a higher level of risk to the buyer/lessee in that it has to exercise additional caution to insure that all lienable work is paid for, that lien waivers are obtained, that the improvements are built in accordance with the various laws, rules and regulations and, as a result of the Eighth Circuit decision on ADA liability, that the design and construction of the premises conform with all federal, state and local laws and ordinances regarding building construction. Lease Terms. While the third party seller and the seller/lessee are negotiating the initial purchase of the property, the seller/lessee and the buyer/lessor are simultaneously negotiating the sale/leaseback terms. The sale/leaseback terms generally focus on the buyer/lessor being able to realize an adequate rate of return on the transaction and will also include the normal rent provisions of rent escalations through the term of the lease. The lease is generally structured as a triple net lease. Also, these sale/leaseback transactions may include an option for the seller/lessee to purchase the property, but as discussed below, caution needs to be taken when drafting such purchase options. Sale/leaseback transactions are not without complications. In addition to the issues discussed above, as well as real estate title, environmental and construction related issues and requirements noted above, sale/leaseback transactions may generate unique accounting and tax issues. Accounting Issues. There are numerous rules and regulations devoted to the accounting treatment for sale/leaseback transactions. A real estate sale/leaseback transaction that covers the remaining economic life of a property may be treated as a financing transaction or a capital lease. There are a number of technical factors accountants look to in determining whether a sale/leaseback transaction will result in capital lease treatment or operating lease treatment. In general, an operating lease characterization will result in the removal of the property (and the related financing) from the balance sheet of the seller/lessee. On the other hand, capital lease characterization will, from financial statement standpoint, continue to reflect the real estate as an asset and the accompanying liability. These considerations can be very important in connection with negotiating financial covenants or maintaining loan agreement requirements (particularly for those operators that have financing from multiple sources). In determining if a sale/leaseback transaction is an operating lease or a financing (capital) lease, accountants will look at the following factors:   

transfer of ownership of the property to the lessee at the end of the lease term; a bargain purchase option; whether the lease term equals 75% or more of the estimated economic life of the property; and  whether the present value of lease payments equals or exceeds 90% of the fair market value. Tax Issues. There may also be numerous tax issues associated with a sale/leaseback transaction. While a number of factors used to determine the tax treatment are similar to those analyzed for accounting purposes, these factors are not always consistent. From a tax standpoint, the primary issue is whether the sale/leaseback transaction will be treated as a true sale or a financing transaction. In a true sale situation, the seller/lessee will be required to recognize gain (or loss) on the transaction and will be treated as entering into an operating lease (providing for deductible rental payments over the life of the lease). In the financing (capital) lease scenario, the buyer/lessor

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Lease Finance and Investment Banking is treated as providing financing against the real property asset and the seller/lessee continues ownership of the asset. In this situation, rental payments will be characterized for tax purposes as interest and principal payments. In addition to those factors cited above, the typical factors that define a capital lease for tax purposes include:    

lease payments substantially exceed fair rental value of the property; little or no investment risk by the lessor; burdens and benefits of ownership of the property rests with seller/lessee; and economic viability of the leasing transaction.

Criteria of sales type lease: (Q: 5a, 2010) A lease is classified as a sales type lease, direct financing, leveraged or operating lease. To be classified as a sales type lease, a lease must meet one of the four criteria specified below. a) The lease transfers the ownership of the property to the lessee by the end of the lease term. b) The lease contains an option to purchase the leased property at a bargain price. c) The lease term is equal to or greater than 75 percent of the estimated economic life of the leased property. d) The present value of rental and other minimum lease payments equals or exceeds 90 percent of the fair value of the leased property less any investment tax credit retained by the lessor. Moreover, a sales type lease also contains the following two criteria. i. ii.

Collectivity of minimum lease payment is reasonably predictable. No important uncertainties surround the amount of unreimbursable cost yet to be incurred by the lessor under the lease.

A lease meeting those criteria is classified as sales types lease if fair value of the leased property is different from its carrying amount.

Validity of Sale and Leaseback To take advantage of the benefits of a sale and a leaseback, both must be valid. No one factor controls; the overall facts and circumstances surrounding the transactions determine their validity. Ultimately, the determination will center on whether the transactions have economic substance and have been based on reasonable market conditions.

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Sale. (Q: 5b, 2010) For the sale to be valid, the controlling shareholder must have taken an equity interest in the property and assumed the risk of loss. An equity interest exists if the funds for the purchase of the property came from the shareholder or if he or she borrowed money to make the purchase. The shareholder‘s purchase of an insurance policy on the property would show assumption of the risk of loss. A sale of property is indicated when one or more of the following has occurred: 1. Portions of periodic lease payments are made specifically applicable to an equity interest to be acquired by the lease. 2. The lease acquires title to the property. 3. The lease payments over a relatively short period constitute an inordinately large proportion of the amount needed to secured the title. 4. The lease payments materially exceed the fair rental value. 5. A bargain purchase option is provided in the lease. 6. A part of periodic payment is specifically designed or recognized as interest. 7. The lease payments plus the option price approximate the purchase price and provide for renewal of the lease at token amounts. 8. The lease payments over a short period of time approximate the purchase price and provide for renewal of the lease at token amounts. The courts may treat a lease as a sale or financing for tax purposes even though the lease agreement specifically excludes transfer of title. Leaseback. For a leaseback to be valid, four tests must be met:  

The useful life of the leased property must exceed the term of the lease. If the corporation repurchases the property at the end of the lease, it must do so at fair market value and not at a discount.  If the transaction allows for a renewal at the end of the original lease term, the renewal rate must be set at a fair rental value.  The shareholder must have a reasonable expectation that he or she will generate a profit from the sale and leaseback, considering both the value of the property when it is eventually sold and the rent received during the lease term.

Sale Leaseback Agreements Sale leaseback agreements can give sellers additional options while selling a home. Simply stated, a sale leaseback agreement allows the homeowner to sell his property and then lease it from the buyer. The previous homeowner becomes the renter and a third party actually owns the property. A sale leaseback agreement can allow a seller to quickly raise a large sum of cash as well as gain a long-term housing arrangement. Additionally, the leaseback helps the original owner have more use of his capital since the financial obligations of homeownership are alleviated. A sale leaseback agreement is also referred to as a ―leaseback‖ or ―sale and lease back.‖

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Lease Finance and Investment Banking Option to Purchase Under the sale leaseback agreement, the renter does not own the property. Instead the renter has access to and possession of the home. The leaseback agreement is a long-term arrangement that typically lasts 10 to 30 years. In many cases, the renter may be given the option to repurchase her former home after paying an option fee. The option fee is a fee charged for the privilege of being able to purchase the home. Real Estate Financing A sale leaseback agreement can provide the seller with advantageous real estate financing. With a leaseback option there is no need for the seller to obtain traditional bank financing or to seek a refinance through a separate lender. The seller may set a fixed lease payment, an option to renew the lease (which is similar to a refinance) or an option to repurchase his property. The seller also receives a lump sum of cash upon the sale of his property. The buyer benefits from a lower purchase price -- which could be less than the market value -- and a premium rate on the lease payments. Sale Leaseback Contracts The sale leaseback processes can be seamless, meaning that the sale and leaseback occur simultaneously. For the property sale portion, a standard real estate purchase and sales contract should be utilized in the sale from the original owner to the new buyer. Similarly, a traditional residential lease agreement should be used to document the terms of the leaseback. The seller is referred to as the lessee and the buyer is called the lessor. Sale Leaseback Consequences A sale leaseback agreement does bring about tax, insurance and legal ramifications. The date the leaseback transaction takes place will affect taxes levied. Sale leaseback transactions can certainly trigger an IRS audit -- particularly if the property sells for much lower or higher than the current market rate. The way the property is classified will affect the insurance rate and coverage. For legal purposes, the documents should be properly executed to ensure the legitimacy of the transaction. Both the buyer and seller are advised to consult with competent professionals regarding how a sale leaseback agreement will impact their situation.

Prepared By Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University. Email:[email protected] Mobile: 01198150195 Jagannath University

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Short Notes Kinds of leases Operating Leases: An operating lease, broadly speaking, substitutes for a rental. Hence: 

The term of the lease is usually less than the economic life of the asset. Consequently, the asset is not fully amortized: lease payments are not enough to recover the entire cost of the asset.  The lessor is required to maintain and insure the assets.  There is often a cancellation option that gives the lessee the option to cancel the lease contract before expiration. Financial or Capital Leases: A financial lease substitutes for a purchase. Hence:    

Financial leases do not provide for maintenance or service by the lessor. Financial leases are fully amortized. The lessee usually has a right to renew the lease on expiration. Financial leases usually cannot be cancelled.

Types of financial leases: 

Sale and lease-back: In this kind of lease, a company sells an asset it owns to another firm and leases it back immediately.  Leveraged lease: In this case, the lessor finances the asset partly by debt. Accounting rules promulgated by FASB (FAS 31) specify the conditions under which a lease can be treated as an operating lease. Unless these conditions are met, the lease must be capitalized-appear on the company's balance sheet. Leveraged Lease(Q: 6e, 2010) In a leveraged lease a third-party, long-term creditor provides nonrecourse financing for a lease agreement between a lessor and a lessee; The term leveraged refers to the fact that the lessor acquires title to the asset after borrowing a large part of the investment. Leveraged leases are true (tax oriented) leases because the lessor enjoys all the tax benefits of ownership (such as depreciation) whereas the lessee can claim the full amount of lease payment as expenses. A lease in which a bank or other financial institution provides the lessor (the party granting the lease and retaining title to the lease good) with credit, which the lessor then uses to finance the lease. For example, suppose a car dealer (lessor) extends a lease to someone buying a car (lessee).

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Lease Finance and Investment Banking The lessor may take a loan from a bank in order to receive capital from the lease of the car while the lessee drives away with the car. The lessee then makes payments on the lease, which the lessor then uses to repay the loan to the bank. Importantly, the lessor may take the leased asset away from the lessee if the lessee defaults, and the bank may do the same if the lessor defaults. Due Diligence(Q: 6a, 2010) Due diligence is a term used for a number of concepts involving either an investigation of a business or person prior to signing a contract, or an act with a certain standard of care. It can be a legal obligation, but the term will more commonly apply to voluntary investigations. In other words, A due diligence investigation is a type of pre-transaction or pre-employment corporate investigation that tries to uncover details of a company's management, finances, performance, mission, history, aims, suppliers, clients, industry and any other details that may affect how a company does business. Due diligence is vital before a merger, company purchase, or acquisition because it ensures that liabilities are not hidden. Due diligence ensures that there will be no unpleasant surprises down the road. A common example of due diligence in various industries is the process through which a potential acquirer evaluates a target company or its assets for acquisition. When Due Diligence Investigations should be performed:         

Hiring a key employee or employees Creating a partnership with another, or beginning a business with another Loaning substantial money. Banks have special due diligence needs. See below Taking on a new client or customer, particularly for professionals (accountant firms, CPAs,) or a customer of size or significance to the future or the operations Engaging a new vendor that may be central to operations or obligations Prior to a merger or acquisition, or as part of the process For investments of some magnitude or where there are unknowns, e.g. IPOs Engaging with or purchasing a franchise, or choosing a franchise operation to franchise your business When a decision is being made to do business with entities or individuals outside of the country.

Advantages and Disadvantages of Due Diligence Inquiries Due diligence investigations allow you to get the current information you need to make good business and financial decisions. These investigations can help you avoid costly mistakes and can help you avoid lawsuits caused by a bad business partnership. Investigations such as these can also be crucial in negotiations by helping you cut through business claims to the actual facts about a corporation, they help you get the proof you need to negotiate betters terms. The only real drawbacks to due diligence investigations is that they are sometimes met with disapproval from companies. If you investigate a company and find irregular business practices, that company may be quite resentful. On the other hand, most investigators are very discreet and no legitimate companies would object to an inquiry, anyway. Jagannath University

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Lease Finance and Investment Banking Restructuring(Q: 6 ii, 2011) The act or process of changing the terms on the assets and/or liabilities of a company. That is, a company may consolidate its debts, significantly change the size and scope of its operations, and take other measures to reduce the strain of continuing operation. Most companies restructure either as part of a bankruptcy or as an effort to avoid it. If the company is restructuring as part of a corporate bankruptcy, it is said to be in receivership. Corporate restructuring can cover a whole range of activities, from cost-cutting and streamlining, re-branding, financial restructuring to the worst case scenario of winding down a business. Businesses can go through many forms of corporate restructuring to remain competitive and stay in business. Restructuring does not have to be something drastic, but can be a series of measures undertaken on a regular basis by the company‘s management. In the current economic climate, many companies are facing a difficult operating environment. In some cases, this means that corporate restructuring may have to be undertaken for the business to remain viable. Sale and Lease back(Q: 6c, 2010) Leaseback, short for sale-and-leaseback, is a financial transaction, where one sells an asset and leases it back for the long-term; therefore, one continues to be able to use the asset but no longer owns it. The transaction is generally done for fixed assets, notably real estate and planes, trains and automobiles, and the purposes are varied, including financing, accounting, and taxing. In other words, Arrangement in which one party sells a property to a buyer and the buyer immediately leases the property back to the seller. This arrangement allows the initial buyer to make full use of the asset while not having capital tied up in the asset. Leasebacks sometimes provide tax benefits. also called leaseback. Sometimes, a sale-leaseback occurs in order to grant the seller access to capital to make improvement on the property; for example, the seller may use the proceeds from the sale to build a factory. A form of sale-leaseback, known as sukuk al-ijara, is a common structure for sukuk, or the equivalent of a bond, in Islamic finance. Sale-leaseback is also called simply leaseback. Lease agreement or contract A contract between a lessor and lessee that allows the lessee rights to the use of a property owned or managed by the lessor for a period of time. The agreement does not provide ownership rights to the lessee; however, the lessor may grant certain allowances to modify, change or otherwise adapt the property to suit the needs of the lessee. During the lease period, the lessee is responsible for the condition of the property. Formal document that identifies the lessor, lessee, and the leased asset or property, states lease term and fee (rent), and detailed terms and conditions of the lease agreement. Lease purchase Lease contract under which a portion of the lease payment or rent is applied to the purchase price of the leased asset or property. When the full price is paid up, the title to the item is Jagannath University

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Lease Finance and Investment Banking transferred from the seller or owner (the lessor) to the buyer or tenant (the lessee). Lease purchases are a type of hire-purchase and are generally considered to be capital leases for accounting purposes.

Leased back guarantee A guarantee by a bank that is then leased back to a third party in return for a fee. Due diligence is conducted by the bank on the creditworthiness of the customer that is seeking the bank guarantee. When approved, the issuing bank will become a backer for the debts that are incurred by the borrower, up to the amount of the guarantee. A type of long-term, typically for commercial property, lease in which the payments are variable and adjusted periodically to reflect changes in the property's appraised value or changes in a certain publicized benchmark rate, such as the Consumer Price Index (CPI). A graduated lease provides for periodic changes in the payments rather than employing a fixed payment throughout the life of the lease. In addition to basing payments on current and changing market conditions, the terms of a graduate lease can state that the payments automatically increase by a specified percentage or dollar amount at regularly specified time intervals. For example, if a company has a 99 year lease on land under a graduated lease, the payments can be adjusted every 10 years to reflect the current market value of the land. If market values increase, this helps protect the land owner against losses resulting from payments that would be too low for current market conditions. In a different scenario, a graduated lease may be used to entice a company to lease a property that in the beginning has relatively small payments. As time passes, the payments increase on a regular basis, such as with an annual rent increase of 5%. This scenario is helpful to entrepreneurs who need to save money in the first few years of a lease while the business is being established. Lease schedule Formal attachment or annex to a master lease that lists and describes the leased item, lease payments, and other terms applicable to the lease. A new lease schedule is executed whenever an item is added to the master lease. The lease terms and conditions either may be fixed as per the master lease or may be subject to individual negotiations for every schedule. Lease to own An agreement between an owner and lessee which allows for the option of purchasing a leased item when the lease period expires. A lease to own arrangement generally includes a clause with a predetermined time and price for the lessee to make the purchase. In most cases, some or all of the lease payments can be applied toward the purchase. Lease underwriting Arrangement under which a lender (such as a bank or leasing company) enters into a lease agreement and assumes the responsibility of arranging any financing required.

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Lease Finance and Investment Banking Leasehold Property held under a lease for a stated period and under specified terms and conditions. In contrast, a freehold property is held for an indefinite period under absolute rights of ownership. Leasehold estate Exclusive right to enjoy the possession and use of a parcel of land or a limited period. In contrast, a freehold estate is for an indefinite period.

other asset for

Leasehold cost A method for capitalizing the expenses associated with initiating and maintaining a lease. Leasehold costs in the case of may include delay rental payments, taxes, bonuses paid to the holder of mineral rights to the leased property, and similar costs. Lease utilization The use of a parcel of land in accordance with the zoning classification, plat or deed restrictions, and the lease provisions outlined between the lessor and lessee. Any departure from the utilization agreement between the parties is grounds for cancellation of the agreement and may result in civil litigation. Leased employees Employees that have been attained from a professional employer organization (PEO). The PEO is the official employer of the leased workers and handles payroll, tax reporting, and benefits. However, the employees complete the work for the leasing company or business owner. Some company owners find this to be a more beneficial way of completing projects without the added responsibility of human resource management. Also called contracted workers. Lease with option to renew Lease agreement under which a lessee has the right to renew the lease at the end of the lease term, at the same or a different rate.

The End of Lease options at the end of the lease Lessee may have a few flexible options to choose from; he may purchase the equipment for its purchase option amount, renew the lease for a specified period of time, or return the equipment with no further obligation. Running rate The running rate is obtained by computing the interest rate of the lease payments over the term of the lease, using the cost of the equipment as present value in the calculation. Since it doesn‘t include the return that the lessor hopes to earn from the asset‘s residual value, the running rate will generally be quite low and in certain cases may even be negative.

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Lease Finance and Investment Banking Effective rate The effective rate means different things to different people. It usually means the interest rate being paid by the lessee, similar to the way running rate is calculated, but including a reasonable assumption as to what the ultimate residual value of the equipment may be at the end of the lease term. Since residual value estimates tend to vary, the estimated effective rate for the same transaction will also tend to vary, depending upon who is trying to come up with the rate. Open-end Lease A conditional sale lease in which the lessee guarantees that the lessor will realize a minimum value from the sale of the asset at the end of the lease. Sales-type Lease A lease by a lessor who is the manufacturer or dealer, in which the lease meets the definitional criteria of a capital lease or direct financing lease. Synthetic Lease A synthetic lease is basically a financing structured to be treated as a lease for accounting purposes, but as a loan for tax purposes. The structure is used by corporations that are seeking off-balance sheet reporting of their asset based financing, and that can efficiently use the tax benefits of owning the financed asset. Tax Lease A lease wherein the lessor recognizes the tax incentives provided by the tax laws for investment and ownership of equipment. Generally, the lease rate factor on tax leases is reduced to reflect the lessor's recognition of this tax incentive. Trac Lease A tax-oriented lease of motor vehicles or trailers that contains a terminal rental adjustment clause and otherwise complies with the requirements of the tax laws. True Lease A type of transaction that qualifies as a lease under the Internal Revenue Code. It allows the lessor to claim ownership and the lessee to claim rental payments as tax deductions. Full Payout Lease A lease in which the lessor recovers, through the lease payments, all costs incurred in the lease plus an acceptable rate of return, without any reliance upon the leased equipment's future residual value. Guideline Lease A lease written under criteria established by the IRS to determine the availability of tax benefits to the lessor.

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Lease Finance and Investment Banking Direct Financing Lease (Direct Lease) A non-leveraged lease by a lessor (not a manufacturer or dealer) in which the lease meets any of the definitional criteria of a capital lease, plus certain additional criteria. First Amendment Lease The first amendment lease gives the lessee a purchase option at one or more defined points with a requirement that the lessee renew or continue the lease if the purchase option is not exercised. The option price is usually either a fixed price intended to approximate fair market value or is defined as fair market value determined by lessee appraisal and subject to a floor to insure that the lessor's residual position will be covered if the purchase option is exercised. If the purchase option is not exercised, then the lease is automatically renewed for a fixed term (typically 12 or 24 months) at a fixed rental intended to approximate fair rental value, which will further reduce the lessor's end-of-term residual position. The lessee is not permitted to return the equipment on the option exercise date. If the lease is automatically renewed, then at the expiration of that initial renewal term, the lessee typically has the right either to return the equipment without penalty or to renew or purchase at fair market value. Vendor leasing This type of lease involves a financing source and a vendor to ensure and promote vendor sales with adequate financial support from the financing firm. The financing firm ties up with the vendor to offer financing schemes, conditional sales contracts and leases to the vendors customers. Full-service lease The lessor or leasing firm incurs expenses for additional services such as maintenance, insurance and property taxes such that the expense is built into the lease payments. Technology refresh" options? In this world of high technology, being "state of the art" usually lasts about as long as it takes to install the equipment! As a result, many lessees are beginning to insist on technology refresh clauses, which give them some defined alternatives as to upgrading technology, adding additional assets, etc., without having to renegotiate and then rewrite the entire lease transaction. Bargain Purchase Option An option in a lease agreement that allows the lessee to purchase the leased asset at the end of the lease period at a price substantially below its fair market value. The bargain purchase option is one of four criteria, any one of which, if satisfied, would require the lease to be classified as a capital or financing lease that must be disclosed on the lessee's balance sheet. The objective of this classification is to prevent "off-balance sheet" financing by the lessee. For example, assume that the value of an asset at the end of the lease period is estimated at $100,000, but the lease agreement has an option that enables the lessee to purchase it for $70,000. This would be considered as a bargain purchase option and would require the lessee to treat the lease as a capital lease. There are significant differences in the accounting treatment of the leased asset and lease payments for capital leases and operating leases.

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Investment Banking

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Chapter 8: Investment Banking History of Investment Banking Investment banking practices such as extending credit to merchants date back to ancient times. In the 1600s, early investment institutions such as acceptance houses and merchant banks helped finance foreign trade and accumulated funds for long-term investments overseas. The nineteenth century saw the rise of several prominent banking partnerships such as those created by Rothschilds, the Barings and the Browns. These firms had their origins in the Atlantic trade; financing the importation of commodities for European manufacturers and helping them export their finished products around the world. In the United States, investment banking received a boost during the American Civil War. Syndicate banking houses sold millions of dollars worth of government bonds to large numbers of individual investors to help finance the war. This marked the first mass-market securities sales operation, a practice that continued later in the 1800s to finance the expansion of the transcontinental railroads. The 1800s also saw the birth of some of the most famous firms in investment banking, many of which are still with us, in one form or another, 150 years later. The firm of J. P. Morgan played a major role in the corporate mergers of the era, such as the merger of U.S. Steel Corp and the Northern Pacific and Great Northern railroads. The firm grew to such size and prominence at the turn of the century that J.P. Morgan, the founder, is credited for ―saving‖ Wall Street during the banking crisis of 1907 by allegedly locking top executives from major banks in his office until they hammered out a solution. Goldman Sachs was founded in 1869 by German Jewish immigrants Marcus Goldman who later partnered with his son-in-law, Samuel Sachs. Goldman Sachs was among the pioneers of the initial public offering (IPO), and managed one of the largest IPOs at that time, for Sears, Roebuck and Company in 1906. In the early twentieth century, investment banking expanded dramatically. One reason was an increase in the number of individuals who owned stock, something that resulted from the prosperous years after the First World War. However, the ensuing run-up in stock prices created an unsustainable bubble that finally collapsed with the Great Depression in 1929. The U.S. plunged into one of the worst depressions in history. More than 11,000 banks failed or merged, and a quarter of the population was out of work. The excesses of that period and the many bank failures led to a flood of new regulations to protect investors from fraudulent stock promoters and stabilize the banking system. It led to the passing of the Federal Securities Act of 1933, which required ―full disclosure‖ of accurate information for publicly offered securities and a prospectus filed with the Securities and Exchange Commission. More importantly for investment banks, the government passed the Glass-Steagall Act in 1933, which compelled commercial banks to separate themselves from their securities distribution arms. Large universal banks such as JP Morgan, for instance, split into separate entities. In JP Morgan‘s case, it created JP Morgan as a commercial bank, Morgan Stanley as an investment bank, and Morgan Grenfell, as a British merchant bank. The Glass-Steagall Act remained in force until it was repealed during the Clinton administration in 1999.

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Investment Banking: An investment bank is a financial institution that assists individuals, corporations and governments in raising capital by underwriting and/or acting as the client's agent in the issuance of securities. An investment bank may also assist companies involved in mergers and acquisitions, and provide ancillary services such as market making, trading of derivatives, fixed income instruments, foreign exchange, commodities, and equity securities. It is a specific division of banking related to the creation of capital for other companies. Investment banks underwrite new debt and equity securities for all types of corporations. Investment banks also provide guidance to issuers regarding the issue and placement of stock. The meaning of investment banking is not the financial investment in the banking sector. But in fact, investment banking is a kind of banking function which is used to help clients in creating wealth and funds. The commercial banks use this type of banking in accord with sensible and practical use of the available resources. Not only this, investment banking and people engaged in this sector also provides advice on how to transact in business they are currently in. At Last we can say that, Investment banking is a form of banking which finances the capital requirements of enterprises. Investment banking assists as it performs IPOs, private placement and bond offerings, acts as broker and helps in carrying out mergers and acquisitions.

Investment Bank: A financial intermediary that performs a variety of services is known as investment bank. This includes underwriting, acting as an intermediary between an issuer of securities and the investing public, facilitating mergers and other corporate reorganizations, and also acting as a broker for institutional clients. An investment bank is a financial institution which raises capital, trades securities, and manages corporate mergers and acquisitions. Another term used for investment banking is corporate finance. Investment banks work for companies and governments, and profit from them by raising money through the issuance and selling of securities in capital markets (both equity and debt) and insuring bonds (for example selling credit default swaps), and providing the necessary advice on transactions such as mergers and acquisitions. Most of investment banks provide strategic advisory services for mergers, acquisitions, divestiture or other financial services for clients, like the trading of derivatives, commodity, fixed income, foreign exchange, and equity securities. The role of the investment bank begins with pre-underwriting counseling and continues after the distribution of securities in the form of advice.

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Investment Banker: A person representing a financial institution that is in the business of raising capital for corporations and municipalities is known as investment banker. An Investment Banker can be considered as a total solutions provider for any corporate, desirous of mobilizing its capital. The services provided range from investment research to investor service on the one hand and from preparation of the offer documents to legal compliances & post issue monitoring on the other. A long lasting relationship exists between the Issuer Company and the Investment Banker.

Types of Investment Most probably there are two types of investment are available in this present business world. A brief discussion is given below.

1. Financial Instruments  Equities: Equities are a type of security that represents the ownership in a company. Equities are traded (bought and sold) in stock markets. Alternatively, they can be purchased via the Initial Public Offering (IPO) route, i.e. directly from the company. Investing in equities is a good long-term investment option as the returns on equities over a long time horizon are generally higher than most other investment avenues. However, along with the possibility of greater returns comes greater risk.  Mutual funds: A mutual fund allows a group of people to pool their money together and have it professionally managed, in keeping with a predetermined investment objective. This investment avenue is popular because of its cost-efficiency, risk-diversification, professional management and sound regulation. You can invest as little as Rs. 1,000 per month in a mutual fund. There are various general and thematic mutual funds to choose from and the risk and return possibilities vary accordingly.  Bonds: Bonds are fixed income instruments which are issued for the purpose of raising capital. Both private entities, such as companies, financial institutions, and the central or state government and other government institutions use this instrument as a means of garnering funds. Bonds issued by the Government carry the lowest level of risk but could deliver fair returns.  Deposits: Investing in bank or post-office deposits is a very common way of securing surplus funds. These instruments are at the low end of the risk-return spectrum.  Cash equivalents: These are relatively safe and highly liquid investment options. Treasury bills and money market funds are cash equivalents.

2. Non-financial Instruments  Real estate: With the ever-increasing cost of land, real estate has come up as a profitable investment proposition.  Gold: The 'yellow metal' is a preferred investment option, particularly when markets are volatile. Today, beyond physical gold, a number of products which derive their value from the price of gold are available for investment. These include gold futures and gold exchange traded funds. Jagannath University

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Types of Investment Banking Many investment banks are divided into three categories that deal with front office, back office, or middle office services. 

Front Office Investment Bank Services: Front office services typically consist of investment banking such as helping companies in mergers and acquisitions, corporate finance (such as issuing billions of dollars in commercial paper to help fund day-to-day operations, professional investment management for institutions or high net worth individuals, merchant banking (which is just a fancy word for private equity where the bank puts money into companies that are not publicly traded in exchange for ownership), investment and capital market research reports prepared by professional analysts either for in-house use or for use for a group of highly selective clients, and strategy formulation including parameters such as asset allocation and risk limits.

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Middle Office Investment Bank Services: Middle office investment banking services include compliance with government regulations and restrictions for professional clients such as banks, insurance companies, finance divisions, etc. This is sometimes considered a back office function. It also includes capital flows. These are the people that watch money coming into and out of the firm to determine the amount of liquidity the company needs to keep on hand so that it doesn't get into financial trouble. The team in charge of capital flows can use that information to restrict trades by reducing the buying / trading power available for other divisions.

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Back Office Investment Bank Services: The back office services include the nuts and bolts of the investment bank. It handles things such as trade confirmations, ensuring that the correct securities are bought, sold, and settled for the correct amounts, the software and technology platforms that allow traders to do their job are state-of-the-art and functional, the creation of new trading algorithms, and more. The back office jobs are often considered unglamorous and some investment banks outsource to specialty shops such as custodial companies. Nevertheless, they allow the whole thing to run. Without them, nothing else would be possible.

Principal Functions of Investment Banks Global investment banks typically have several business units, each looking after one of the functions of investment banks. For example, Corporate Finance, concerned with advising on the finances of corporations, including mergers, acquisitions and divestitures; Research, concerned with investigating, valuing, and making recommendations to clients – both individual investors and larger entities such as hedge funds and mutual funds regarding shares and corporate and government bonds); and Sales and Trading, concerned with buying and selling shares both on behalf of the bank‘s clients and also for the bank itself. For Investment banks management of the bank‘s own capital, or Proprietary Trading, is often one of the biggest sources of profit. For example, the banks may arbitrage stock on a large scale if they see a suitable profit opportunity or they may structure their books so that they profit from a fall in bond price or yields. In short the functions of Investment banks include:

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Raising Capital Brokerage Services Proprietary trading Research Activities Sales and Trading

1. Raising Capital Corporate Finance is a traditional aspect of Investment banks, which involves helping customers raise funds in the Capital Market and advising on mergers and acquisitions. Generally the highest profit margins come from advising on mergers and acquisitions. It also can be segregated by,  Advisory functions: Investment banking serves a potential security issuer in an advisory capacity. It helps the issuing firm analyze its financing needs and suggests different ways of raising funds.  Administrative functions: Investment banking shares with issuer the responsibility of conforming to the securities laws involving with the preparation of registration statement and prospectus. Securities and Exchange Commission requires that most primary issues should be accompanied by a registration statement disclosing information that should allow potential investors to assess the quality of the new issues. The information must be published in registration statements are set by law. After filling the registration statement with SEC, there is usually a brief waiting until the new issue may be offered for sales.  Underwriting functions: Underwriting refers to the guarantee by investment banking that the issue of the new securities will receive certain amount of cash for them. Investment banking buys the securities from issuing firm on the day of offering. It forms syndicate and take the responsibility of selling all the new issues to the public.

2. Brokerage Services Brokerage Services, typically involves trading and order executions on behalf of the investors. This in turn also provides liquidity to the market. These brokerages assist in the purchase and sale of stocks, bonds, and mutual funds.

3. Proprietary Trading Under Investment banking proprietary trading is what is generally used to describe a situation when a bank trades in stocks, bonds, options, commodities, or other items with its own money as opposed to its customer‘s money, with a view to make a profit for itself. Though Investment Banks are usually defined as businesses, which assist other business in raising money in the capital markets (by selling stocks or bonds), they are not shy of making profit for itself by engaging in trading activities.

4. Research Activities Research, is usually referred to as a division which reviews companies and writes reports about their prospects, often with ―buy‖ or ―sell‖ ratings. Although in theory this activity would make the

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Lease Finance and Investment Banking most sense at a stock brokerage where the advice could be given to the brokerage‘s customers, research has historically been performed by Investment Banks (JM Morgan Stanley, Goldman Sachs etc). The primary reason for this is because the Investment Bank must take responsibility for the quality of the company that they are underwriting Vis a Vis the prices involved to the investor.

5. Sales and Trading Often referred to as the most profitable area of an investment bank, it is usually responsible for a much larger amount of revenue than the other divisions. In the process of market making, investment banks will buy and sell stocks and bonds with the goal of making an incremental amount of money on each trade. Sales are the term for the investment banks sales force, whose primary job is to call on institutional investors to buy the stocks and bonds, underwritten by the firm. Another activity of the sales force is to call institutional investors to sell stocks, bonds, commodities, or other things the firm might have on its books.

Conclusion Whatever the conflicts the investments banks raises in their operation, the role of them in the capital market is undeniable. In promoting the business of the larger companies by raising capitals, distributing shares or bonds; in handling the risk of the little investors by suggesting them on their trading along with managing their investments and above all in making a bridge between sellers & buyers of certain products available in the money market, the investment bankers have already proved themselves to be the indispensable part.

Characteristics of Investment Banking An investment bank is a financial institution that helps companies take new bond or stock issues to market, usually acting as the intermediary between the issuer and investors.  Investment banks may underwrite the securities by buying all the available shares at a set price and then reselling them to the public. Or the banks may act as agents for the issuer and take a commission on the securities they sell.  Investment banks are also responsible for preparing the company prospectus, which presents important data about the company to potential investors.  In addition, investment banks handle the sales of large blocks of previously issued securities, including sales to institutional investors, such as mutual fund companies.  Unlike a commercial bank or a savings and loan company, an investment bank doesn't usually provide retail banking services to individuals.

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Operations of Investment Banking This involves data-checking trades that have been conducted, ensuring that they are not erroneous, and transacting the required transfers. Many banks have outsourced operations. It is, however, a critical part of the bank. Due to increased competition in finance related careers, college degrees are now mandatory at most Tier 1 investment banks. A finance degree has proved significant in understanding the depth of the deals and transactions that occur across all the divisions of the bank.

How Investment Banking Operations Differ From Other Banks Unlike commercial banks and savings and loans, investment banks do not seek cash deposits from customers in the form of checking and savings accounts, and they do not make traditional interestbearing loans to individual customers. Investment banks instead make their money primarily 

By advising corporate clients on the creation of stocks, bonds and other securities  By underwriting securities  By facilitating mergers and acquisitions, along with any due diligence and securities exchanges that may go along with them.  And by brokering (or selling) securities to investors. Investment bankers have also created a broad array of investment options to go along with traditional stocks and bonds, including securities derivatives such as call and put options, which allow investors to lock in a buy or sell price on an investment at a future date, and credit default swaps, which insure bond buyers against the risk that a bond seller will renege on the debt. Investment banks also lend stocks to facilitate short trades, in which speculators borrow stock and sell it in hopes that its price will decline before they rebuy it and return it to the lender.

Investment Banking: The Role of Investment Banking In the Society: Investment banking is a particular banking system that allows customers to invest their money directly or indirectly and also helps companies, government and individual raise fund by means of bond selling, security sales, mergers and acquisitions and issuing of IPO. Investment banking gives both the learned and the novice in the investment industry the opportunity to maximize better dividend of their business or property by way of mergers and acquisitions. Investment banking helps to boost the economy of the commercial sections of the society in other words they create more opportunity for both the employed and unemployed ones to raise capital and make profit. They also help boost the financial security of a country from possible financial drop down. Every economy that wants to have a growing financial status must require the services of investment banking.

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Buy side and Sell side of Investment Bank (Q. 4b, 2011) Buy Side The buy side is the side that buys stuff. On the other hand, the sell side of the business is selling stuff. Buy side buys, and sell side sells! So the question is what is buy side buying, and what is sell side selling? The buy side consists of institutions such as hedge funds, mutual funds, pension funds, and insurance firms that are buying large quantities of securities for money management purposes. Their goal is to make investments that align with investors‘ expectations. As oppose to sell side analysts, buy side analysts‘ research and strategies do not get published and it‘s used to benefit the specific firm that came up with it. Sell Side To an investment banker, stock is a product. That product is created, through an IPO, and then sold in the market. The creators and "servicers" of stock product are collectively called "the sell-side." This includes investment bankers who bring the company public, analysts who do research on stocks and make public upgrades and downgrades on the stock, and the market makers who trade stock continually, and profit from the spread between the bid and the ask. At an investment bank, all of these functions are performed at a single institution. Anyone associated with an institution that does all or part of these functions is said to be "from the sell-side." Sell side is selling research, advice and securities it created to the companies and investors. Whenever you see a report that advises you to buy, sell, or hold the stock, that‘s coming from the sell side of the business. Investment banking falls in the category of the sell side.

 The Sell-Side: Investment Banking, Sell-Side Research, (Some) Trading at Banks  The Buy-Side: Private Equity, Hedge Funds, Buy-Side Research, Prop Trading, Venture Capital, Asset Management, Other Types of Miscellaneous ―Investment Firms‖

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Chapter 9: Laws governing Investment Banking These rules are necessary for Investment Banking  Securities and Exchange Ordinance 1969  Securities and Exchange Rules 1987  Securities and Exchange commission Act 1993  Merchant Bank Rules  Public Issue Rules  Bond Issue Rules  Right Issue Rules  Credit Rating Rules

All the Acts and Rules are available in this websites, described Below1. Business laws of Bangladesh: http://www.businesslaws.boi.gov.bd/index.php?option=com_eregistry&view=Law&Ite mid=60&lang=en 2. Securities and Exchange Commission of Bangladesh: http://www.secbd.org/lawsupdated.html

Prepared By Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University. Email:[email protected] Mobile: 01198150195

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Roles of Securities and Exchange Commission in the Protection of the Interest of the Investor:( Q 4d, 2011) Securities and Exchange Commission has introduced different acts, rules and regulation in protection of the interest of the investors. They are described belowSecurities and Exchange Commission Act, 1993: It is expedient for the establishment of the Securities and Exchange Commission for the purpose of the protection of interest of investors in securities, for the development of the securities markets toward achieving the objectives of the securities investors. To protect the interest of the investors in securities, the securities and exchange commission can apply all the power under the code of civil procedures, 1908 (Act V of 1908) with a view to investing into the affairs of brokers, sub-brokers, share transfers agents, bankers to an issuer, underwriters, portfolio managers, investment advisers and such other intermediaries associated with the dealing in securities markets. The Depository Act, 1999: The act has effects on any other law for the time being relating to the holding and transfer of securities. To avoid any fraudulent a transfer of securities must be effective by making an appropriate entry in the depository register as per provision of the regulation as per provision, the commission preserves the right, for the interest of the investors to issue an order and direction to any person associated with the depository or with the issuer. Mutual Fund regulation,1997: In exercise of the powers conferred by section 25 of the securities and exchange commission act, 1993 (Act No, 15 of 1993), the commission makes some regulations to protect the interest of the investor, as for example, a penalty of cancellation of registration of mutual fund may be imposed when indulges in manipulation of price rigging or any activity affecting securities markets and the investors interest as well. Action may also be taken against mutual funds when its financial position deteriorates to such an extent that the commission may consider that its continuance is not in the interest of the investors. Depository Regulation, 1999: Under the purview of the depositories act, 1999, the Securities and Exchange Commission, by the depository‘s regulations, 1999 may seek further document or information for the consideration of an application. If any document or information furnished to the commission by any depository is found to be incorrect or misleading in material particular after the grant of the registration certificate, the said certificate may be cancelled. If the Commission finds that, it is not suitable to protect the interest of and helpful to capital market, it may reject the application mentioning the reasons thereof. Self Regulation: The stock exchange (both DSE & CSE) regulate and monitor trading and all activities of broker/dealer and the listed firms as well for the benefit of the investors and for the safeguard of the financial system. The exchanges regulate themselves as part of combined effort involving the SEC itself and member firms. During a typical trading f=day the exchanges continuously monitor all market participants. They also monitor the performance of brokers, dealers and specialists in their responsibilities for maintaining a fair and orderly market on the stocks they are dealing. After the market crash in 1996, DSE has instituted several measures one of which is called ―circuit-breaker‖ to reduce the market volatility and serve the investors best interest. By using this rules and regulation Securities and Exchange Commission protects the interest of the Investors.

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Chapter 10: Investment Banking and IPOs Initial Public Offering (IPO) An initial public offering (IPO) or stock market launch is a type of public offering where shares of stock in a company are sold to the general public, on a securities exchange, for the first time. Through this process, a private company transforms into a public company. Initial public offerings are used by companies to raise expansion capital, to possibly monetize the investments of early private investors, and to become publicly traded enterprises. A company selling shares is never required to repay the capital to its public investors. After the IPO, when shares trade freely in the open market, money passes between public investors. Although an IPO offers many advantages, there are also significant disadvantages. Chief among these are the costs associated with the process, and the requirement to disclose certain information that could prove helpful to competitors, or create difficulties with vendors. Details of the proposed offering are disclosed to potential purchasers in the form of a lengthy document known as a prospectus. Most companies undertaking an IPO do so with the assistance of an investment banking firm acting in the capacity of an underwriter. Underwriters provide a valuable service, which includes help with correctly assessing the value of shares (share price), and establishing a public market for shares (initial sale). Alternative methods, such as the Dutch auction have also been explored. In terms of size and public participation, the most notable example of this method is the Google IPO. China has recently emerged as a major IPO market, with several of the largest IPO offerings taking place in that country.

IPO Process handled by investment bank. (Q. 4b, 2010) IPOs generally involve one or more investment banks known as "underwriters". The company offering its shares, called the "issuer", enters into a contract with a lead underwriter to sell its shares to the public. The underwriter then approaches investors with offers to sell those shares. The main activity of the investment banker is underwriting, which involves the purchase of the security issue from issuing at an agreed-upon price and bearing the rise of selling it to the public at profit. The process of initial public offering can be illustrated through the following flowchart.

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IPO Process Issuing Company Originating Investment Bank Investment Banker

Investment Banker

Investment Banker

Underwriting Syndicate

O r i g i n a t o r

Selling Group

Investing Public Issuing Company: When a company is aiming to go public, at first it hires an investment bank to do the underwriting, the way of raising money through equity or debt, functions associated with the issue. Although, a company itself also may sell its shares but, usually an investment bank is selected for that purpose. Underwriters act as intercessors between the public, who are investing, and the companies. Originator: An investment banker works as originator. It advises the issuer of securities about analysis of financing needed and suggests different way of raising fund. In this part Originator have to maintain different activities such as,  The investment bank and the company will first initiate the process of deal negotiation. The main discussing issues are the money amount that the company is going to raise, security type to be issued and all the other details involved with the underwriting agreement.  Once the deal gets finalized, the investment bank sets a registration statement up which will be submitted to the Securities and Exchange Commission. That registration statement consists of information regarding the offering and also other company information like, background of the management, financial statements, legal issues etc.  Then the Securities and Exchange Commission (SEC) needs a cooling off period during which it will examine all the submitted documents and make sure that all information regarding the deal has been given to them. After getting the SEC's approval, a date is going to be fixed on which the company will offer the stock to the public.  During the above mentioned cooling off period the underwriter publishes an initial prospectus that contains all the necessary information regarding the company. The effective date of issuing the stock as well as the price has not been mentioned in the prospectus, for these are not known at this time. Jagannath University

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Lease Finance and Investment Banking  Then the company and the underwriter meet to decide the price of the stock. This decision depends highly on the current market condition.

Selling Group: Selling group consists of various investment bankers or banks through which invests pay for the purchase price of shares. They are the last level of IPO process before investors. Investors communicate to the issuing company through selling groups. Investors: Investors are common people or institutions who are interested to invest their money in security market. They are the original owner of the firm.

Under pricing The pricing of an initial public offering (IPO) below its market value. When the offer price is lower than the price of the first trade, the stock is considered to be underpriced. A stock is usually only underpriced temporarily because the laws of supply and demand will eventually drive it toward its intrinsic value. It is also known as the initial return or first day return of the IPO.

Under pricing = (First day Closing Price – Offer Price) ÷ Offer price × 100% The first-day closing price represents what the investors are willing to pay for the firm‘s shares. If the offer price is lower than the first-day closing price, the IPO is said to be underpriced and money is left on the table for new investors. Since existing shareholders settle for a lower offer price/proceeds than what they could have got, money left on the table represents the wealth transfer from existing shareholders to new shareholders. Money left on the table = (First-day closing price – Offer price) × Number of shares On average, the amount of money left on the table is about twice the amount of direct underwriting fees, and for many IPO firms it can equal several years of operating profit. Although most IPOs are underpriced, the level of under pricing varies across IPOs with different issue characteristics, allocation mechanisms, underwriter reputation, and general financial market conditions. For example, the level of under pricing is reduced for larger IPOs, those underwritten by prestigious investment banks, firms with a longer operating history or more experienced insiders on the board, and those which intend to use the proceeds to repay debt. On the other hand, technology firms, firms backed by venture capital, firms with negative earnings prior to the IPO, or firms that went public during a bull market experience greater under pricing.

It is believed that IPOs are often underpriced because of concerns relating to liquidity and uncertainty about the level at which the stock will trade. The less liquid and less predictable the shares are, the more underpriced they will have to be in order to compensate investors for the risk they are taking. Because an IPO's issuer tends to know more about the value of the shares than the investor, a company must underpriced its stock to encourage investors to participate in the IPO.

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Lease Finance and Investment Banking The pricing of an IPO at less than its market value. Under pricing can be seen in the difference between the offer price and the price of the first trade. This results in the company raising less capital in the IPO than it could have raised. There is no definite way to determine if a stock issue is underpriced until it is too late and the price of the first secondary trade is much higher than the IPO.

Under pricing Investment & Finance Pricing securities offering too low; typically applied to initial public offerings (IPOs). When the issue begins trading on the stock exchange, the price shoots up, sometimes rising over 100 percent. The price increase indicates that there is strong demand for shares and that they could have been priced higher. If they had been priced higher, the company would have earned more money. When an issue is underpriced, it is said that the company has ―left some money on the table.‖ However, those who have bought the shares at the original price benefit from the fact that they can now sell the shares in the aftermarket, depending on IPO restrictions, and make a substantial profit.

Overpriced 120Taka Stock Price 100 Taka Under Priced 90taka

Overvalued/ Overpriced A stock with a current price that is not justified by its earnings outlook or price/earnings (P/E) ratio and, therefore, is expected to drop in price. Overvaluation may result from an emotional buying spurt, which inflates the stock's market price, or from a deterioration in a company's financial strength.

Why I.P.O.’s Get Underpriced There are a number of overlapping and nonexclusive theories: Information Asymmetry: The most prominent explanation and the one with the most empirical support is that I.P.O. under pricing occurs because of informational asymmetry. The information asymmetry theory assumes that the I.P.O. pricing is a product of information disparities. A Good Taste In Investors' Mouths: Issuers like to donate some money to investors. They will want to come back to investors later for more funds, and those investors will remember if they got a good or a raw deal at the IPO. Pre-Selling: Under pricing is necessary to solicit information from investors about potential interest. Why would investors tell underwriters that they like an offering, unless they knew that if they told the underwriters that they liked it, the underwriter would give them more shares for a better price.

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Marketing: If one important investor defects, maybe all investors will follow. (This is sometimes called a "herd mentality.") To make sure the important first investor does not defect, it is better to play it safe, and leave too much money on the table. Agency: This reason concentrates on the conflict between investors and underwriters. Because underwriters prefer to work less, especially when the price is high which makes selling painful, it is best to make selling a little easier for them and underprice the offering. Placement: The issuer cares more about who to place shares with than what the price is. By giving shares at a bargain price, the issuer can pick and choose. Behavioral Explanations: These theories have gained attention in the wake of the technology bubble. One form of this theory posits that either institutional investors or managers gain from taking advantage of retail shareholders who act irrationally or otherwise against their economic interests. And that both institutional shareholders and managers therefore underprice I.P.O.‘s to lock in these gains. A variation of this theory posits that it is the institution that allows this under pricing as a result of its own inability to recognize the loss.

Advantages of IPO / Should The Company Go Public? New Capital: Almost all companies go public primarily because they need money. All other reasons are of secondary importance. The typical (firm-commitment) IPO raises $20-40M, but offerings of $100M are not unusual either. This can vary widely by industry.

Future Capital: Once public, firms can easily go back to the public markets to raise more cash. Typically, about a third of all IPO issuers return to the public market within 5 years to issue a "seasoned equity offering" (the term secondary is used to denote shares sold by insiders rather than by firms). Those that do return raise about three times as much capital in their seasoned equity offerings as they raised in their IPO.

Cashing Out: Although it is a bad signal to investors when an entrepreneur sells his own shares (indicating that [s]he is jumping ship), it still makes sense for many entrepreneurs to cash out some of their wealth to diversify or just to enjoy life.

Mergers and Acquisition: Many private firms just do not appear on the "radar screen" of potential acquirers. Being public makes it easier for other companies to notice and evaluate the firm for potential synergies.

Image: Public firms tend to have higher profiles than private firms. This is important in industries where success requires customers and suppliers to make long-term commitments. For example, software requires training and no manager wants to buy software from a firm that may not be around for future upgrades, improvements, bug fixes, etc. Indeed, the suppliers' and customers' perception of company success is a self-fulfilling prophesy.

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Lease Finance and Investment Banking But public firms also tend to be larger to begin with, and this may explain why public firms on average have a better image. For example, although Gateway is private, there is no question that it will be around for a while. Going public would not aid increase its sales. The important question is if going public improves the firm's stakeholders' perception of success.

Employee Compensation: Having a public share price makes it easy for firms to give employees a formal stake in the company.

Hot Issue Hot Issue is an IPO in heavy demand. The indications are interest from the prospective purchasers. Underwriting the issues Received by the broker-dealers far exceeds the number of shares that the issuing company plans to sell. The stock issued, the share price rises above the offering price. The company issuing shares is able to increase the number it will be selling to reflect the heavy demand. It will offer shares of stock and will not dampen the enthusiasm for a very hot issue. The stock issued will show a dramatic short- term rise, before falling below the original offering price. An issue that sells at a premium over the public offering price on the first day of trading. A hot issue is most often association with an initial public offering (IPO), in which the stock of the newly offered company is in great demand, causing the initial trading price to surge above the IPO price. Over the course of history, many newly issued stocks have become hot issues, only to drop down shortly after, often falling far below their IPO price. For example, during the late 1990s, many Internet stocks shot up dramatically in price upon their initial offering, only to crash and burn months later during the tech crash of 2000. Hot issues can also refer to other types of asset classes as well, such as fixed income and ETF issues.

Hot Issue

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Chapter 11: Corporate Finance Underwriting The word "underwriter" is said to have come from the practice of having each risk-taker write his or her name under the total amount of risk that he or she was willing to accept at a specified premium. In a way, this is still true today, as new issues are usually brought to market by an underwriting syndicate in which each firm takes the responsibility (and risk) of selling its specific allotment. Securities underwriting refers to the process by which investment banks raise investment capital from investors on behalf of corporations and governments that are issuing securities (both equity and debt capital). The services of an underwriter are typically used during a public offering. This is a way of selling a newly issued security, such as stocks or bonds, to investors. A syndicate of banks (the lead managers) underwrites the transaction, which means they have taken on the risk of distributing the securities. Should they not be able to find enough investors, they will have to hold some securities themselves. Underwriters make their income from the price difference (the "underwriting spread") between the price they pay the issuer and what they collect from investors or from broker-dealers who buy portions of the offering.

Underwriting contract In investment banking, an underwriting contract is a contract between an underwriter and an issuer of securities. The following types of underwriting contracts are most common: In the firm commitment contract the underwriter guarantees the sale of the issued stock at the agreed-upon price. For the issuer, it is the safest but the most expensive type of the contracts, since the underwriter takes the risk of sale. In the best efforts contract the underwriter agrees to sell as many shares as possible at the agreedupon price. Under the all-or-none contract the underwriter agrees either to sell the entire offering or to cancel the deal. Stand-by underwriting, also known as strict underwriting or old-fashioned underwriting is a form of stock insurance: the issuer contracts the underwriter for the latter to purchase the shares the issuer failed to sell under stockholders' subscription and applications.

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Underwriting syndicate Temporary group of underwriters and investment banks formed for marketing of a new bond or share (stock) issue that is too large for any single entity to handle. It is dissolved after completion of the sale of the securities. Also called underwriting group.

Secondary Market A newly issued IPO will be considered a primary market trade when the shares are first purchased by investors directly from the underwriting investment bank; after that any shares traded will be on the secondary market, between investors themselves. In the primary market prices are often set beforehand, whereas in the secondary market only basic forces like supply and demand determine the price of the security. For the general investor, the secondary market provides an efficient platform for trading of his securities. For the management of the company, Secondary equity markets serve as a monitoring and control conduit-by facilitating value-enhancing control activities, enabling implementation of incentive-based management contracts, and aggregating information (via price discovery) that guides management decisions.

Functions of Secondary Market  To facilitate liquidity and marketability of the outstanding equity and debt instruments.  To contribute to economic growth through allocation of funds to the most efficient channel through the process of disinvestments to reinvestment.  To Provide instant valuation of securities caused by changes in the internal environment (that is, company –wide and industry wide factor). Such valuation facilitates the measurement of the cost of capital and the rate of return of the economic entities at the micro level.  To ensure a measure of safety and fair dealing to protect investors‘ interest. To induce companies to improve performance since the market price at the stock exchanges reflects the performance and this market price is readily available to investors

Segment of Financial Market: (Qc, 2011) Financial Market is a mechanism that brings buyer and seller of financial assets together for fixing the price of a particular security. Financial market can be segmented on the following basis: A) On the basis of Maturity of securities, 1. Money market 2. Capital market B) On the basis of trading mechanism. 1. Primary market 2. Secondary market

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Capital market

Money market

Primary market

Secondary market

A

B

C

D

 Market ―A‖ indicates that primary capital instruments say IPOs of shares and stocks.  Market ―B‖ says that primary money market instruments say IPOs of T-bills.  Market ―C‖ implies that secondary capital market instruments such as shares and stocks outstanding.  Secondary Money market instruments like debentures and bonds outstanding with the maturity.

Brokers Brokers buy and sell investment securities for external clients. Often their function includes financial consulting. A broker has a lower capital requirement than a dealer. A broker is compensated through a commission on transactions, and buys and sells securities according to the client's wishes, acting as a middleman. Brokers are licensed and regulated by the Securities and Exchange Commission, or SEC. They have specific fiduciary duties and responsibilities with respect to management of their client's accounts.

Dealers Dealers buy and sell securities for their own account, through a broker or otherwise, and make the investment decisions related to those purchases. Dealers face a lower burden of regulation than do brokers, but have higher capital requirements. Dealers generally are involved in regular, systematic transactions, including market-making and organization and support of liquidity, Dealers by definition conduct transactions as part of a business, whereas those doing so on an individual basis are considered to be day traders, or traders.

Broker-dealer A broker-dealer is a term used in United States financial services regulations. It is a natural person, a company or other organization that trades securities for its own account or on behalf of its customers. Although many broker-dealers are "independent" firms solely involved in broker-dealer services, many others are business units or subsidiaries of commercial banks, investment banks or investment companies. When executing trade orders on behalf of a customer, the institution is said to be acting as a broker. When executing trades for its own account, the institution is said to be acting as a dealer. Securities bought from clients or other firms in the capacity of dealer may be sold to clients or other firms acting again in the capacity of dealer, or they may become a part of the firm's holdings. Jagannath University

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Main points of activity 

Professional participant in securities market who carries out dealer activity shall be called dealer.  Announcing the price, the dealer is committed to announce other essential conditions of the buy-sell contract of securities: minimum and maximum number of securities subject to purchase and/or sale, as well as the term of announced prices validity.

Functions  

All the functions of broker including financial consulting Organization and support of turnover (liquidity), or so-called market-making (price announcing, duty of sell and buy of security at announced price, announcing of min and max number of securities that can be bought/sold at announced price, implementing time periods when announced prices are available)

Broker Vs Dealer Brokers and dealers are terms associated with securities. Though both have almost the same work, they are different in many aspects. The main difference between a broker and a dealer is in respect of their role in the market, as well as the capital required.  A broker is a person who executes the trade on behalf of others, whereas a dealer is a person who trades business on their own behalf.  A dealer is a person who will buy and sell securities on their account. On the other hand, a broker is one who will buy and sell securities for their clients.  While dealers have all the rights and freedom regarding the buying and selling of securities, brokers seldom have this freedom and these rights.  It is interesting to note that many dealers were brokers in the beginning of their career. It is equally important to note that both the dealer and the broker are businessmen.  A broker is normally paid a commission for transacting the business. A dealer is not paid a commission, and he or she is a primary principal. At last we can say that, the difference between them is their method of operation. As a matter of fact both of them should be aware of the changes that take place in the stock market on a daily basis. Clients are the primary concern for a broker whereas trade is the primary concern for a dealer.

Discount versus Full Service Brokers Years ago the individual investor needed access to a full service broker for research information. However, today with the growth of the Internet, there is a level playing field for the do-it-yourself investor. Let‘s compare and contrast full service and discount brokers.

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Price One of the primary factors influencing an investors‘ decision to open an account with a brokerage firm has to do with the price to buy or sell stocks, or commission costs. Discount brokers have the edge in this category. Commission costs range from a $4 minimum cost with Sharebuilder to $12.95 with Charles Schwab. It‘s not uncommon for full service brokers to have a $50 minimum charge. If you are starting with a small account, less than $10,000, then it makes sense to consider a discount broker. Otherwise, a full service firm will eat up your capital in commission costs. In addition to those costs, pay close attention to other fees such as account maintenance, wire transfer fees, check writing privileges and inactivity fees, costs charged to your account if you have not bought or sold a stock in several months. If you decide to go with a discount broker you will have the lower commissions by trading online. It‘s not uncommon for a firm to have a $10 commission for trading online and a $29 charge to speak to a broker.

Research Full service firms have the advantage in the research category. They employ analysts to conduct primary research on several stocks and provide written reports to assist investors in making buy or sell decisions. One of the reasons full service firms charge more in commissions is to help pay the fat salaries they give to their research staff. Discount brokers don‘t typically have analysts because they are trying to keep overhead costs to a minimum.

Market Share Discount brokers have proliferated since the advent of online trading, with more and more customers opting to manage their own finances and trade online. As a result, full-service brokers have lost market share to discounters and had to consolidate through mergers and acquisitions or by becoming subsidiaries of large commercial banks.

Target Market Because full-service brokers can no longer be all things to all people, they've been increasingly concentrating on the affluent market--clients with substantial assets and specialized needs-although many wealthy investors prefer to do business with discounters.

Services Another area full service brokers have an edge is in product offerings. Many of these firms offer insurance products, mortgages, credit cards and checking accounts in addition to investment accounts. Discount brokers are no frills shops, so don‘t expect to receive any of these additional products if you choose to go that route.

Compensation Full-services brokers (who prefer to call themselves financial advisers, wealth managers or account executives) are compensated based on assets under management or through commissions on the products and services they sell. Discount brokers (registered representatives) are salaried employees. Full-services brokers justify higher fees and costs by offering a full range of services under one roof. With a discount broker, you only pay for what you use.

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Short-Selling VS Margin Buying Short-Selling Professionals in finance sometimes make reference to speculation and arbitrage. In both of these trading activities, the investor attempts to buy an asset at one price and sell it at a higher price. This is often summed up in the phrase, "Buy low, sell high." However, is also possible to sell high before buying low. This is called selling short. In selling short, the investor borrows shares of the security from his broker and immediately sells them. Since he believes that the price of the security will decrease, he expects to pocket some money. At a later time he purchases the shares on the open market and returns them to the broker. His profit will be the difference in price between when he borrowed the shares and when he purchased them from the market (less any transaction costs).

Margin Buying Another common method of making money in the stock market is to utilize trading on margin. A margin account is simply a line of credit the investor has with his broker. By having more money available to invest, potential gains are increased. Any funds borrowed for purchasing stock on margin will eventually have to be repaid, and interest is charged on a margin loan. Typically, investors to whom brokers extend margin accounts are established customers who hold significant assets with the broker. Those assets often constitute collateral, protecting the broker should the investor otherwise be unable to repay the margin loan.

Dangers of Shorting Neither of these activities should be undertaken recklessly. When purchasing a stock "long," the maximum that can be lost is the amount invested in the security (the stock can decrease in price, or even become completely worthless should the company go bankrupt). This is not the case when selling short. If the shorted stock rises in price, the investor will still have to purchase it from the market to return the shares to the broker. Because there is no defined maximum to which the price can increase, there is no maximum loss that a short-sell can result in.

Margin Risks Margin accounts, like any other form of debt, can also present a risk. If stock purchased on margin decreases in price, the broker may require payment of cash towards the loan. If such payments cannot be made and the price of the stock drops too low, a margin call may be made. This orders all the shares of the stock be sold immediately, and the proceeds thereof applied to the margin loan.

Firm commitment underwriting An underwriting in which an investment banking firm commits to buy and sell an entire issue of stock and assumes all financial responsibility for any unsold shares. Also known as bought deal. A lending institution's promise to enter into a loan agreement with a specific entity within a certain period of time. An underwriter's agreement to assume all inventory risk and purchase all securities directly from the issuer for sale to the public at the price specified. The lender specifies the terms that that must be met in order for the loan to be processed. Also known as a "standby loan commitment".

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Lease Finance and Investment Banking In a firm commitment, underwriters act dealers and are responsible for any unsold inventory. The dealer profits from the spread between the purchase price and the public offering price. Also known as a "firm commitment underwriting".

Standby Agreement An agreement between the issuer of a security and its underwriters stating that the underwriters are responsible for any unsold portion of the issue. That is, the underwriters agree to buy the remainder of a new issue if they are unable to place its entirety with investors. This transfers the risk of the unsold portion of the issue from the issuer to the underwriters. This guarantees that the issuer will raise the capital it intends to raise, but leaves the underwriters with the possibility that they must purchase an issue with low value. As a result, underwriters charge a standby fee for a standby agreement. It is also called firm commitment underwriting or a backstopped deal. A type of underwriting in which an investment bank (the underwriter) agrees to purchase the portion of the new securities issue that remains after a public offering. This eliminates the issuer's risk, but it increases the investment banker's risk.

Private Placements Private placements are direct transactions between the issuer and investors, i.e., the bonds are sold directly by the issuer to investors without an underwriter. In this process, instead of underwriters, placement agents act as intermediaries between the issuer and investors. However, they do not assume any underwriting risks. In recent years, some issuers have bypassed placement agents and have done private placements directly with ultimate investors. This kind of private placement is called a direct purchase.

Zero-coupon security A zero-coupon security, or "stripped bond", is basically a regular coupon-paying bond without the coupons. The process of "stripping" or "zeroing" a bond is usually done by a brokerage or a bank. The bank or broker stripping the bonds then registers and trades these zeros as individual securities. Once the bonds are stripped, there are two parts: the principal and the coupons. The interest payments are known as "coupons", and the final payment at maturity is known as the "residual" since it is what is left over after the coupons are stripped off. Both coupons and residuals are bundled and referred to as zero-coupon bonds or "zeros".

The basic objective of a zero-coupon security is "buy low, sell high". You purchase the bond for a sum of money, and once it reaches maturity you will be paid an even larger sum of money. When interest rates are low, the price of the zero will be higher. The best time to buy a zero is when interest rates are high because the bond will be at a deeper discount.

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Chapter 12: Trading Investment Investment in simple is referred to as monitory asset that is purchased with the hope that it would yield income in the future. Investments can be made in a number of forms depending on the investment return the investor requires and the risk that he is willing to take. Investments can be made through the purchase of an asset that is expected to appreciate in value in the future. Examples are the purchase of land, buildings, equipment and machinery. Investors can also invest their funds in money markets using investment instruments such as bills, bonds, etc. The investment made by an individual depends on their risk appetite and the return that they expect. An investor with a lower risk tolerance may chose to invest in safe securities such as treasury bills and bonds which are very safe but have very low interest. Investors with a high risk tolerance may make risky investments in stock markets that yield higher rates of return.

Speculation: Speculation is the practice of engaging in risky financial transactions in an attempt to profit from short or medium term fluctuations in the market value of a tradable good such as a financial instrument, rather than attempting to profit from the underlying financial attributes embodied in the instrument such as capital gains, interest, or dividends. Many speculators pay little attention to the fundamental value of a security and instead focus purely on price movements. Speculation can in principle involve any tradable good or financial instrument. Speculators are particularly common in the markets for stocks, bonds, commodity futures, currencies, fine art, collectibles, real estate, and derivatives. Speculators play one of four primary roles in financial markets, along with hedgers who engage in transactions to offset some other pre-existing risk, arbitrageurs who seek to profit from situations where fungible instruments trade at different prices in different market segments, and investors who seek profit through long-term ownership of an instrument's underlying attributes. The role of speculators is to absorb excess risk that other participants do not want, and to provide liquidity in the marketplace by buying or selling when no participants from the other categories are available. Successful speculation entails collecting an adequate level of monetary compensation in return for providing immediate liquidity and assuming additional risk so that, over time, the inevitable losses are offset by larger profits.

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Speculation vs. Investment  Speculation and investment are often times confused by many to be the same thing, even though they are quite different to each other in terms of the asset that is being invested in, the amount of risk taken, investment holding period and the expectations of the investor.  Investment in simple is referred to as monitory asset that is purchased with the hope that it would yield income in the future.  Speculation is the taking of higher risk and standing the possibility of losing all money invested. Speculation is similar to gambling and entails a very high risk that an investor may lose all his money or make very substantial returns if his speculation turns out to be correct.

Arbitrage Arbitrage is where a trader will simultaneously purchase and sell an asset with hopes to make a profit from the differences in the price levels of the asset that is bought and the asset that is being sold. It must be kept in mind that the assets are bought and sold off different market places; which is the reason for the differences in the price levels. The reason as to why there are differences in price levels in different markets is because of the market inefficiencies; where even though the conditions in one market place have resulted in a change, in price levels, as this information has not yet impacted the other market place, the price levels remain different. A trader looking to make a profit can use these market inefficiencies to their advantage by merely buying the asset at a cheaper price from one market and selling it off at a higher price afterwards to make an arbitrage profit.

Arbitrage Vs Speculation  The aim of both arbitrage and speculation is to make some form of profit even though the techniques used are quite different to each other.  Arbitrage traders take lower levels of risk, and benefit from the natural market inconsistencies by buying at a lower price from one market and selling at a higher price at another market.  Speculation is done by trading instruments such as stocks, bonds, currency, commodities, and derivatives, and a speculator looks to make a profit through the rising and falling of the prices in these assets.

Risk Management The process of identification, analysis and either acceptance or mitigation of uncertainty in investment decision-making. Essentially, risk management occurs anytime an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment and then takes the appropriate action (or inaction) given their investment objectives and risk tolerance. Inadequate risk management can result in severe consequences for companies as well as individuals. For example, the recession that began in 2008 was largely caused by the loose credit risk management of financial firms.

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Lease Finance and Investment Banking Simply put, risk management is a two-step process - determining what risks exist in an investment and then handling those risks in a way best-suited to your investment objectives. Risk management occurs everywhere in the financial world. It occurs when an investor buys low-risk government bonds over more risky corporate debt, when a fund manager hedges their currency exposure with currency derivatives and when a bank performs a credit check on an individual before issuing them a personal line of credit.

Risk Participation A type of off-balance-sheet transaction in which a bank sells its exposure to a contingent obligation, such as a banker's acceptance, to another financial institution. Risk participation allows banks to reduce their exposure to delinquencies, foreclosures, bankruptcies and company failures.

Risk Capital Investment funds allocated to speculative activity. Risk capital refers to funds used for high-risk, high-reward investments such as junior mining or emerging biotechnology stocks. Such capital can either earn spectacular returns over a period of time, or may dwindle to a fraction of the initial amount invested if several ventures prove unsuccessful. Diversification is key for successful investment of risk capital. In the context of venture capital, risk capital may also refer to funds invested in a promising start-up.

Risk Arbitrage In theory true arbitrage is riskless, however, the world in which we operate offers very few of these opportunities. Despite these forms of arbitrage being somewhat risky, they are still relatively lowrisk trading strategies which money managers (mainly hedge fund managers) and retail investors alike can employ.

Risk Arbitrage A broad definition for three types of arbitrage that contain an element of risk: 1) Merger and acquisition arbitrage - The simultaneous purchase of stock in a company being acquired and the sale (or short sale) of stock in the acquiring company. 2) Liquidation arbitrage - The exploitation of a difference between a company's current value and its estimated liquidation value. 3) Pairs trading - The exploitation of a difference between two very similar companies in the same industry that have historically been highly correlated. When the two company's values diverge to a historically high level you can take an offsetting position in each (e.g. go long in one and short the other) because, as history has shown, they will inevitable come to be similarly valued.

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Leveraged Buyout - LBO The acquisition of another company using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Often, the assets of the company being acquired are used as collateral for the loans in addition to the assets of the acquiring company. The purpose of leveraged buyouts is to allow companies to make large acquisitions without having to commit a lot of capital.

A leveraged buyout (LBO) is an acquisition (usually of a company but it can also be single assets like a real estate) where the purchase price is financed through a combination of equity and debt and in which the cash flows or assets of the target are used to secure and repay the debt. As the debt usually has a lower cost of capital than the equity, the returns on the equity increase with increasing debt. The debt thus effectively serves as a lever to increase returns which explain the origin of the term LBO.

Credit risk Credit risk refers to the risk that a borrower will default on any type of debt by failing to make payments which it is obligated to do. The risk is primarily that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The loss may be complete or partial and can arise in a number of circumstances. For example: 

A consumer may fail to make a payment due on a mortgage loan, credit card, line of credit, or other loan  A company is unable to repay amounts secured by a fixed or floating charge over the assets of the company

Types of credit risk Credit risk can be classified in the following way: 

Credit default risk - The risk of loss arising from a debtor being unlikely to pay its loan obligations in full or the debtor is more than 90 days past due on any material credit obligation; default risk may impact all credit-sensitive transactions, including loans, securities and derivatives.  Concentration risk - The risk associated with any single exposure or group of exposures with the potential to produce large enough losses to threaten a bank's core operations. It may arise in the form of single name concentration or industry concentration.  Country risk - The risk of loss arising from a sovereign state freezing foreign currency payments (transfer/conversion risk) or when it defaults on its obligations (sovereign risk).

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Systematic Risk Systematic risk is a kind of risk inherent to the entire market or entire market segment which cannot be diversified, minimized and controlled or even cannot be eliminated; therefore systematic risk is the proportion of total risk that a security must assume. It is also called market risk, aggregate risk, or undiversifiable risk. This is the market risk of any security which affects all securities in the market. So systematic risk is equal to total risk (SD) minus unit risk.

Systematic risk = 𝜷𝒊 = 𝝈𝒊 − 𝒖𝒏𝒊𝒕 𝒓𝒊𝒔𝒌 𝒐𝒓 𝐟𝐢𝐫𝐦 𝐬𝐩𝐞𝐜𝐢𝐟𝐢𝐜 𝐫𝐢𝐬𝐤 𝜷𝒊 𝒃𝒆𝒕𝒂 = 𝝈𝒊 − (𝑩𝒖𝒔𝒊𝒏𝒆𝒔𝒔 𝒓𝒊𝒔𝒌 + 𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒂𝒍 𝒓𝒊𝒔𝒌)

Return on Asset =

𝑵𝒆𝒕 𝑷𝒓𝒐𝒇𝒊𝒕

Return of Equity =

𝑨𝒔𝒔𝒆𝒕𝒔 𝑵𝒆𝒕 𝑷𝒓𝒐𝒇𝒊𝒕 𝑬𝒒𝒖𝒊𝒕𝒚

Unsystematic Risk By contrast, unsystematic risk, sometimes called specific risk, idiosyncratic risk, residual risk, or diversifiable risk, is the company-specific or industry-specific risk in a portfolio, which is uncorrelated with aggregate market returns. Company or industry specific risk that is inherent in each investment. The amount of unsystematic risk can be reduced through appropriate diversification. Unsystematic risk can be mitigated through diversification, and systematic risk cannot be. For example, news that is specific to a small number of stocks, such as a sudden strike by the employees of a company you have shares in, is considered to be unsystematic risk.

Sovereign Risk The risk that a foreign central bank will alter its foreign-exchange regulations thereby significantly reducing or completely nulling the value of foreign-exchange contracts. This is one of the many risks that an investor faces when holding forex contracts. Additionally an investor is exposed to interest-rate risk, price risk and liquidity risk amongst others.

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Sovereign Default A failure on the repayment of a county's government debts. Countries are often hesitant to default on their debts, since it will be difficult and expensive to borrow funds after a default event. However, sovereign countries are not subject to normal bankruptcy laws and have the potential to escape responsibility for debts without legal consequences. Sovereign defaults are relatively rare, and are often precipitated by an economic crisis affecting the defaulting nation. Investors in sovereign debt closely study the financial status and political temperament of sovereign borrowers in order to determine the risk of sovereign default.

Settlement risk Settlement risk is the risk that a counterparty does not deliver a security or its value in cash as per agreement when the security was traded after the other counterparty or counterparties have already delivered security or cash value as per the trade agreement. One form of settlement risk is foreign exchange settlement risk or cross-currency settlement risk, sometimes called Herstatt risk after the German bank that made a famous example of the risk. The risk that one party will fail to deliver the terms of a contract with another party at the time of settlement. Settlement risk can be the risk associated with default at settlement and any timing differences in settlement between the two parties. This type of risk can lead to principal risk.

Prepared By Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University. Email:[email protected] Mobile: 01198150195

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Chapter 13: Financial Engineering Financial Engineering The use of mathematical techniques to solve financial problems. Financial engineering uses tools and knowledge from the fields of computer science, statistics, economics and applied mathematics to address current financial issues as well as to devise new and innovative financial products. Financial engineering is sometimes referred to as quantitative analysis and is used by regular commercial banks, investment banks, insurance agencies and hedge funds. Financial engineering has led to the explosion of derivative trading that we see today. Since the Chicago Board Options Exchange was formed in 1973 and two of the first financial engineers, Fischer Black and Myron Scholes, published their option pricing model, trading in options and other derivatives has grown dramatically.

Use of Financial Engineering Financial engineering is the application of mathematical methods to the solution of problems in finance. It is also known as financial mathematics, mathematical finance, and computational finance. Financial engineering draws on tools from applied mathematics, computer science, statistics, and economic theory. Investment banks, commercial banks, hedge funds, insurance companies, corporate treasuries, and regulatory agencies employ financial engineers. These businesses apply the methods of financial engineering to such problems as new product development, derivative securities valuation, portfolio structuring, risk management, and scenario simulation. Quantitative analysis has brought innovation, efficiency and rigor to financial markets and to the investment process. As the pace of financial innovation accelerates, the need for highly qualified people with specific training in financial engineering continues to grow in all market environments.

Conversion Arbitrage An options trading strategy employed to exploit the inefficiencies that exist in the pricing of options. Conversion arbitrage is a risk-neutral strategy, whereby the trader buys a put and writes a covered call (on a stock that the trader already owns) with identical strike prices and expiration dates. A trader will profit through a conversion arbitrage strategy when the call option is overpriced. If the price of the underlying security falls, the put purchased increases in value by the same amount as the loss incurred by writing the call. If the underlying security's price increases, both the put and the call expire worthless. In both situations, the trader is risk neutral, but profits from the difference between the price at which the call was sold and the put was purchased. As with all arbitrage opportunities, conversion arbitrage is rarely available. This is because any opportunity for risk-free money is acted on quickly by those who can spot these opportunities quickly.

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Reinvestment Risk The risk that future coupons from a bond will not be reinvested at the prevailing interest rate when the bond was initially purchased. Reinvestment risk is more likely when interest rates are declining. Reinvestment risk affects the yield-to-maturity of a bond, which is calculated on the premise that all future coupon payments will be reinvested at the interest rate in effect when the bond was first purchased. Zero coupon bonds are the only fixed-income instruments to have no reinvestment risk, since they have no interim coupon payments. Reinvestment risk is one of the main genres of financial risk. The term describes the risk that a particular investment might be canceled or stopped somehow, that one may have to find a new place to invest that money with the risk being there might not be a similarly attractive investment available. This primarily occurs if bonds (which are portions of loans to entities) are paid back earlier than expected.

Purchasing Power Risk In our last blog we discussed risk and promised to talk about various types of risk. Today I want to talk about Purchasing Power Risk. Although we don‘t often hear it discussed, changes in the price levels of consumer goods result in risk. Inflation – the rise in prices over a period of time – tends to reduce purchasing power. As the prices go up, the purchasing ability of our fixed amount of money declines. In other words, if investments don‘t grow faster than the rate of inflation, the investor is losing money. Therefore, it is important that investors look for investments that produce a rate of return that makes up for lost purchasing power.

The risk that unexpected changes in consumer prices will penalize an investor's real return from holding an investment. Because investments from gold to bonds and stock are priced to include expected inflation rates, it is the unexpected changes that produce this risk. Fixed income securities, such as bonds and preferred stock, subject investors to the greatest amount of purchasing power risk since their payments are set at the time of issue and remain unchanged regardless of the inflation rate.

Treasury receipt A bond issued by a brokerage that is collateralized by treasury securities. Typically these bonds are zero-coupon bonds created when the interest payments are stripped from treasury bonds and they are sold at a discount from the value of the principal. A zero-coupon bond issued by a brokerage firm and collateralized by treasury securities held for the investor by a custodian. In general, stripped U.S. Government bonds are referred to as Treasury receipts but are better known as TIGRS (Treasury Investment Growth Receipts), CATS (Certificates of Accrual on Treasury Securities), etc.

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Certificate of Participation – COP/ Participation certificate A participation certificate (PC) is a financial instrument of a form of financing used by municipal or government entities which allows an individual to buy a share of the lease revenues of an agreement made by these entities. It is different from a bond issued by these agencies since these are secured by those revenues. Municipal and Government entities use this instrument to circumvent the restrictions that might exists on the amount of debt other forms of instruments able to take on. The PCs are a new form of credit instrument whereby banks can raise funds from other bank and other central bank approved financial institution.

Another form of participation certificate is used by banks to ease liquidity. In this case banks have the option to share their credit asset(s) with other banks by issuing participation certificates. With this participation approach, banks and financial institutions come together either on risk sharing or non-risk sharing basis. While providing short term funds, participation certificates can also be used to reduce risk. The rate at which these certificates can be issued will be negotiable depending on the interest rate scenario. A type of financing where an investor purchases a share of the lease revenues of a program rather than the bond being secured by those revenues.

Bootstrapping Bootstrapping or booting refers to a group of metaphors that share a common meaning: a selfsustaining process that proceeds without external help. The term is often attributed to Rudolf Erich Raspe's story The Surprising Adventures of Baron Munchausen, where the main character pulls himself out of a swamp by his hair (specifically, his pigtail), but the Baron does not, in fact, pull himself out by his bootstraps. Instead, the phrase appears to have originated in the early 19th century United States (particularly in the sense "pull oneself over a fence by one's bootstraps"), to mean an absurdly A situation in which an entrepreneur starts a company with little capital. An individual is said to be boot strapping when he or she attempts to found and build a company from personal finances or from the operating revenues of the new company.

Pass-Through Certificate A pass-through certificates (PTC) is an instrument that evidences the ownership of two or more equipment trust certificates. In other words, equipment trust certificates may be bundled into a pass-through structure as a means of diversifying the asset pool and/or increasing the size of the offering. The principal and interest payments on the equipment trust certificates are "passed through" to certificate holders. A Pass Through Certificate is an instrument which signifies transfer of interest in receivables in favor of the holder of the Pass Through Certificate. The investor in a Pass Through transaction acquire the receivables subject to all their fluctuation, prepayments etc. the material risks and rewards in the asset portfolio, such as the risk of interest rate variations, risk of prepayment etc., transferred to the investor.

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Lease Finance and Investment Banking Fixed-income securities that represent an undivided interest in a pool of federally insured mortgages put together by the Government National Mortgage Association (Ginnie Mae). Mortgage-backed certificates are the most common type of pass-through, where homeowners' payments pass from the original bank through a government agency or investment bank to investors.

Amortization schedule An amortization schedule is a table detailing each periodic payment on an amortizing loan (typically a mortgage), as generated by an amortization calculator. Amortization refers to the process of paying off a debt (often from a loan or mortgage) over time through regular payments. A portion of each payment is for interest while the remaining amount is applied towards the principal balance. The percentage of interest versus principal in each payment is determined in an amortization schedule. While a portion of every payment is applied towards both the interest and the principal balance of the loan, the exact amount applied to principal each time varies (with the remainder going to interest). An amortization schedule reveals the specific monetary amount put towards interest, as well as the specific amount put towards the principal balance, with each payment. Initially, a large portion of each payment is devoted to interest. As the loan matures, larger portions go towards paying down the principal.

Level Payment Mortgage A mortgage requiring the same payment each month until full amortization. Also called a flat mortgage. A type of mortgage that requires the same dollar payment each month or payment period. Level payment mortgages allow borrowers to know exactly how much they will have to pay on their mortgages each pay period. This stability makes it easier for them to create budgets and stick to them.

Embedded option An Embedded option is a component of a financial bond or other security, and usually provides the bondholder or the issuer the right to take some action against the other party. There are several types of options that can be embedded into a bond. Some common types of bonds with embedded options include callable bond, puttable bond, convertible bond, extendible bond, and exchangeable bond. A bond may have several options embedded if they are not mutually exclusive. An embedded option is an option that is part of another security. It therefore does not trade by itself, but it does affect the value of the security of which forms a part. Analysing embedded options is essential to valuing securities that contain them. For example, the value of a convertible bond is (by the law of one price) that of an equivalent bond that is not convertible plus that of a call option on a share. The embedded call option is on the issuer's share with a strike price of the maturity value of the bond and an expiry date that is the date on which the bond matures.

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Lease Finance and Investment Banking More subtly, the value of a bond that is redeemable at the option of the issuer, has an embedded short position in a call option. The holder has effectively written a call option to the issuer. The value of the bond is the value of an equivalent bond that cannot be redeemed early, less the value of a call option over the bond. Even ordinary shares in a company that has debt may be viewed as options to purchase the company free of debt by paying off the debt. This is not an approach that is often used, but it is theoretically correct.

Adjustable-rate mortgage A variable-rate mortgage, adjustable-rate mortgage (ARM), or tracker mortgage is a mortgage loan with the interest rate on the note periodically adjusted based on an index which reflects the cost to the lender of borrowing on the credit markets. The loan may be offered at the lender's standard variable rate/base rate. There may be a direct and legally-defined link to the underlying index, but where the lender offers no specific link to the underlying market or index the rate can be changed at the lender's discretion. The term "variable-rate mortgage" is most common outside the United States, whilst in the United States, "adjustable-rate mortgage" is most common, and implies a mortgage regulated by the Federal government, with caps on charges. In many countries, adjustable rate mortgages are the norm, and in such places, may simply be referred to as mortgages. A type of mortgage in which the interest rate paid on the outstanding balance varies according to a specific benchmark. The initial interest rate is normally fixed for a period of time after which it is reset periodically, often every month. The interest rate paid by the borrower will be based on a benchmark plus an additional spread, called an ARM margin. Adjustable rates transfer part of the interest rate risk from the lender to the borrower. They can be used where unpredictable interest rates make fixed rate loans difficult to obtain. The borrower benefits if the interest rate falls but loses if the interest rate increases. The borrower benefits from reduced margins to the underlying cost of borrowing compared to fixed or capped rate mortgages.

Accrual Bond A bond that does not pay periodic interest payments. Instead, interest is added to the principal balance of the bond and is either paid at maturity or, at some point, the bond begins to pay both principal and interest based on the accrued principal and interest to that point. An accrual bond is a fixed-interest bond that is issued at its face value and repaid at the end of the maturity period together with the accrued interest. In Germany, the accrued interest is compounded. In contrast to zero-coupon bonds, accrual bonds have a clearly stated coupon rate.

Mortgage Derivatives Mortgage derivatives are investment securities developed by the financial industry to provide different risk and interest-rate profiles from pools of mortgages. Abuses in mortgage derivatives are given part of the blame for the global financial crisis of 2007 and 2008. Another term used for mortgage derivatives is collateralized mortgage obligations, or CMOs. Mortgage derivative, any of several types of securities that pay their investors with cash flows generated by the payments of principal and interest to an underlying pool of mortgages. Mortgage Jagannath University

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Lease Finance and Investment Banking derivative products include collateralized mortgage obligations (CMOs), real estate mortgage investment conduits (REMICs), stripped mortgage-backed securities such as interest-only securities (IOs) and principal-only securities (POs), and pass-through mortgage-backed securities with senior/subordinated structures.

Prepayment Risk The risk associated with the early unscheduled return of principal on a fixed-income security. Some fixed-income securities, such as mortgage-backed securities, have embedded call options which may be exercised by the issuer, or in the case of a mortgage-backed security, the borrower. The yield-to-maturity of such securities cannot be known for certain at the time of purchase since the cash flows are not known. When principal is returned early, future interest payments will not be paid on that part of the principal. If the bond was purchased at a premium (a price greater than 100) the bond‘s yield will be less than what was estimated at the time of purchase.

Targeted Amortization Class - TAC A type of credit derivative that is similar to a planned amortization class (PAC) in that it protects investors from prepayment; however, it is structured differently than a PAC. TACs protect investors from a rise in the prepayment rate or a fall in interest rates. They do not protect from a fall in the prepayment rate like PACs. The TAC is essentially a bond under a collateralized mortgage obligation (CMO). Under a TAC, the principal is paid on a predetermined schedule. Any prepayment that occurs is amortized in order to maintain the schedule. TACs are inferior to PACs because they only provide one-sided prepayment protection.

Companion Bond A class of tranche found in a planned amortization class (PAC) bond that is responsible for protecting the PAC tranche from both contraction and extension risk. The companion bond is designed to absorb excess principal payments during times of high prepayment speeds and defer receiving principal payments during times of low prepayment speeds. Also known as a "support tranche" or "companion tranche" More specifically, in situations of high prepayment speeds, the companion bond takes as much of the excess prepayments from the PAC tranche as possible and uses them to repay its own principal amount. Once its portion of the principal is completely paid off, all excess principle payments go back to the PAC bond. Conversely, in situations of low prepayment speeds, the companion bond defers the reception of any payments. The principal payments then go toward paying off the PAC bond. As long as the prepayment speed stays within the designated upper and lower PAC collars, the companion bond will be able to operate as designed.

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Lease Finance and Investment Banking

Interest-only loan An interest-only loan is a loan in which, for a set term, the borrower pays only the interest on the principal balance, with the principal balance unchanged. At the end of the interest-only term the borrower may enter an interest-only mortgage, pay the principal, or (with some lenders) convert the loan to a principal and interest payment (or amortized) loan at his/her option.

Principal-only (PO) A mortgage-backed security (MBS) whose holder receives only principal cash flows on the underlying mortgage pool. All the principal distribution due from the underlying collateral pool is paid to the registered holder of the stripped MBS on the basis of the current face value of the underlying collateral pool.

Option-adjusted spread Option adjusted spread (OAS) is the flat spread which has to be added to the treasury yield curve in a pricing model (that accounts for embedded options) to discount a security payment to match its market price. OAS is hence model dependent. This concept can be applied to a mortgage-backed security (MBS), option, bond and any other interest rate derivative. In the context of an MBS, the option relates to the right of property owners, whose mortgages back the MBS, to prepay the full mortgage amount.

Effective spread The spread actually paid by investors whose orders are routed to a particular market. The gross underwriting spread adjusted for the impact that a common stock offering's announcement has on the firm's share price.

Asset-backed security An asset-backed security is a security whose value and income payments are derived from and collateralized (or "backed") by a specified pool of underlying assets. The pool of assets is typically a group of small and illiquid assets that are unable to be sold individually. Pooling the assets into financial instruments allows them to be sold to general investors, a process called securitization, and allows the risk of investing in the underlying assets to be diversified because each security will represent a fraction of the total value of the diverse pool of underlying assets. The pools of underlying assets can include common payments from credit cards, auto loans, and mortgage loans, to esoteric cash flows from aircraft leases, royalty payments and movie revenues.

Prepared By Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University. Email:[email protected] Mobile: 01198150195 Jagannath University

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Financial Engineering: Derivatives Instruments Inroduction Derivatives are products whose value is derived from one or more basic variables called underlying assets or base. In simpler form, derivatives are financial security such as an option or future whose value is derived in part from the value and characteristics of another an underlying asset. The primary objectives of any investor are to bring an element of certainty to returns and minimize risks. Derivatives are contracts that originated from the need to limit risk. Derivative contracts can be standardized and traded on the stock exchange. Such derivatives are called exchange-traded derivatives. Or they can be customized as per the needs of the user by negotiating with the other party involved. Such derivatives are called over-the-counter (OTC) derivatives. Derivatives A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. A financial instrument whose characteristics and value depend upon the characteristics and value of an underlier, typically a commodity, bond, equity or currency. Most derivatives are characterized by high leverage. Examples of derivatives include futures and options. Advanced investors sometimes purchase or sell derivatives to manage the risk associated with the underlying security, to protect against fluctuations in value, or to profit from periods of inactivity or decline. These techniques can be quite complicated and quite risky. A Derivative includes:  a security derived from a debt instrument, share, loan, whether secured or unsecured, risk instrument or contract for differences or any other form of security ;  a contract which derives its value from the prices, or index of prices, of underlying securities. Types of Derivatives: 1. Over the Counter Derivatives: Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, exotic options - and other exotic derivatives - are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. 2. Exchange-traded derivative contracts (ETD): Exchange-traded derivative contracts (ETD) are those derivatives instruments that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange is a market where individual‘s trade standardized contracts that have been defined by the exchange. A derivatives exchange acts as an intermediary to all related transactions, and takes initial margin from both sides of the trade to act as a guarantee. The world's largest[16] derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), and CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade and the 2008 acquisition of the New York Mercantile Exchange).

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Lease Finance and Investment Banking Plain Vanilla The most basic or standard version of a financial instrument, usually options, bonds, futures and swaps. Plain vanilla is the opposite of an exotic instrument, which alters the components of a traditional financial instrument, resulting in a more complex security. For example, a plain vanilla option is the standard type of option, one with a simple expiration date and strike price and no additional features. With an exotic option, such as a knock-in option, an additional contingency is added so that the option only becomes active once the underlying stock hits a set price point. Plain vanilla is an adjective describing the simplest version of something, without any optional extras, by analogy with vanilla ice cream, the default flavour. Some Financial instruments like put options or call options are often described as plain vanilla options. Exotic Option An option that differs from common American or European options in terms of the underlying asset or the calculation of how or when the investor receives a certain payoff. These options are more complex than options that trade on an exchange, and generally trade over the counter. For example, one type of exotic option is known as a chooser option. This instrument allows an investor to choose whether the options is a put or call at a certain point during the option's life. Because this type of option can change over the holding period, it is not be found on a regular exchange, which is why it is classified as an exotic option. Other types of exotic options include: barrier options, Asian options, digital options and compound options, among others.

Swaps Swaps are private agreements between two parties to exchange cash flows in the future according to a prearranged formula. They can be regarded as portfolios of forward contracts. The two commonly used swaps are interest rate swaps and currency swaps. A swap can be described as a series of forward contracts. It‘s a contract between a buyer and a seller to enter multiple cash flow exchanges to be executed at preset future dates. Typically the value of these cash flows is determined by a dynamic metric such as an interest rate. However, one side of the transaction can be fixed cash flow agreement as well. The cash flows are calculated over a notional principal amount. Contrary to a future, a forward or an option, the notional amount is usually not exchanged between counterparties. Consequently, swaps can be in cash or collateral. These rates are quoted by the market and will be almost identical to the rate used for the swaps, minus any premiums added. For example: 1) The interest rate associated with the fixed portion of an interest rate swap. 2) The exchange rate associated with the fixed portion of a currency swap.

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Lease Finance and Investment Banking The main difference here is that a forward is a one-time deliverable contract, but a swap is made up of multiple predetermined trades. Notional Principal Amount In an interest rate swap, the predetermined dollar amounts on which the exchanged interest payments are based. Notional principal never changes hands in the transaction, which is why it is considered notional, or theoretical. Neither party pays or receives the notional principal amount at any time; only interest rate payments change hands. For example, two companies might enter into an interest rate swap contract as follows: -For three years, Company A pays Company B 5% interest per year on a notional principal amount of $10 million. -For the same three years, Company B pays Company A the one-year LIBOR rate on the same notional principal amount of $10 million. This would be considered a plain vanilla interest rate swap because one party pays interest at a fixed rate on the notional principal amount and the other party pays interest at a floating rate on the same notional principal amount. Zero Coupon Swap An exchange of income streams in which the stream of floating interest-rate payments is made periodically, as it would be in a plain vanilla swap, but the stream of fixed-rate payments is made as one lump-sum payment when the swap reaches maturity instead of periodically over the life of the swap. The amount of the fixed-rate payment is based on the swap's zero coupon rate.

Different Types of Swaps Interest rate swaps An agreement between two parties (known as counterparties) where one stream of future interest payments is exchanged for another based on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an interest rate (most often the LIBOR). A company will typically use interest rate swaps to limit or manage exposure to fluctuations in interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the swap. These involve swapping only the interest related cash flows between the parties in the same currency. Interest rate swaps are simply the exchange of one set of cash flows (based on interest rate specifications) for another. Because they trade OTC, they are really just contracts set up between two or more parties, and thus can be customized in any number of ways. Currency Swap A swap that involves the exchange of principal and interest in one currency for the same in another currency. It is considered to be a foreign exchange transaction and is not required by law to be shown on a company's balance sheet. Jagannath University

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Lease Finance and Investment Banking A currency swap is a foreign-exchange agreement between two parties to exchange aspects (namely the principal and/or interest payments) of a loan in one currency for equivalent aspects of an equal in net present value loan in another currency; see foreign exchange derivative. Currency swaps are motivated by comparative advantage. A currency swap should be distinguished from a central bank liquidity swap. For example, suppose Bangladeshi Beximco Company needs to acquire US Dollar and a US-based company needs to acquire Bangladeshi Taka. These two companies could arrange to swap currencies by establishing an interest rate, an agreed upon amount and a common maturity date for the exchange. Currency swap maturities are negotiable for at least 10 years, making them a very flexible method of foreign exchange. Currency swaps were originally done to get around exchange controls. Commodity Swap A commodity swap is an agreement whereby a floating (or market or spot) price based on an underlying commodity is traded for a fixed price over a specified period. A swap in which exchanged cash flows are dependent on the price of an underlying commodity. A commodity swap is usually used to hedge against the price of a commodity. A Commodity swap is similar to a Fixed-Floating Interest rate swap. The difference is that in an Interest rate swap the floating leg is based on standard Interest rates like LIBOR, EURIBOR etc. but in a commodity swap the floating leg is based on the price of underlying commodity like Oil, Sugar etc. No Commodities are exchanged during the trade. The vast majority of commodity swaps involve oil. So, for example, a company that uses a lot of oil might use a commodity swap to secure a maximum price for oil. In return, the company receives payments based on the market price (usually an oil price index). On the other side, if a producer of oil wishes to fix its income, it would agree to pay the market price to a financial institution in return for receiving fixed payments for the commodity. There are two main types of commodity swaps:  Fixed-floating commodity swaps: Fixed-floating commodity swaps are similar to the interest rate fixed-floating swaps except that both legs are commodity based. These are used by commodity producers and consumers to lock in commodity prices.  Commodity for interest swaps: Commodity for interest swaps are similar to equity swaps, in which a total return on the commodity is exchanged for some money market rate (plus or minus a spread).

Equity Swap An exchange of cash flows between two parties that allows each party to diversify its income, while still holding its original assets. The two sets of nominally equal cash flows are exchanged as per the terms of the swap, which may involve an equity-based cash flow (such as from a stock asset) that is traded for a fixed-income cash flow (such as a benchmark rate), but this is not necessarily the case. Besides diversification and tax benefits, equity swaps also allow large institutions to hedge specific assets or positions in their portfolios.

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Lease Finance and Investment Banking An equity swap is a financial derivative contract (a swap) where a set of future cash flows are agreed to be exchanged between two counterparties at set dates in the future. An equity swap involves a notional principal, a specified tenor and predetermined payment intervals. Most equity swaps today are conducted between large financing firms such as auto financiers, investment banks and capital lending institutions. LIBOR rates are a common benchmark for the fixed income portion of equity swaps, which also tend to be held at intervals of one year or less, much like commercial paper. Libor The London Interbank Offered Rate is the average interest rate estimated by leading banks in London that they would be charged if borrowing from other banks. The LIBOR is the world's most widely used benchmark for short-term interest rates. An interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. The LIBOR is fixed on a daily basis by the British Bankers' Association. The LIBOR is derived from a filtered average of the world's most creditworthy banks' interbank deposit rates for larger loans with maturities between overnight and one full year. Libor rates are calculated for ten currencies and 15 borrowing periods ranging from overnight to one year and are published daily at 11:30 am (London time) by Thomson Reuters. Many financial institutions, mortgage lenders and credit card agencies set their own rates relative to it. At least $350 trillion in derivatives and other financial products are tied to the Libor. Roles for Swap Dealers  monitor trading to prevent violations of applicable position limits;  establish risk management procedures adequate for managing the day-to-day business of the swap dealer or major swap participant;  disclose to the Commission and to other financial regulators general information relating to swaps trading, practices, and financial integrity;  establish internal procedures to come to compliance with Commission regulations;  implement conflict of interest procedures; and  not engage in any action that would result in an unreasonable restraint of trade or impose a material anticompetitive burden on trading or clearing. Options: An option is a derivative financial instrument that specifies a contract between two parties for a future transaction on an asset at a reference price (the strike). The buyer of the option gains the right, but not the obligation, to engage in that transaction, while the seller incurs the corresponding obligation to fulfill the transaction. The price of an option derives from the difference between the reference price and the value of the underlying asset (commonly a stock, a bond, a currency or a futures contract) plus a premium based on the time remaining until the expiration of the option. Other types of options exist, and options can in principle be created for any type of valuable asset. Options are extremely versatile securities that can be used in many different ways. Traders use options to speculate, which is a relatively risky practice, while hedgers use options to reduce the risk of holding an asset. Jagannath University

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Calls and Puts The two types of options are calls and puts: A call gives the holder the right to buy an asset at a certain price within a specific period of time. Calls are similar to having a long position on a stock. Buyers of calls hope that the stock will increase substantially before the option expires. A put gives the holder the right to sell an asset at a certain price within a specific period of time. Puts are very similar to having a short position on a stock. Buyers of puts hope that the price of the stock will fall before the option expires.

Structured Note A debt obligation that also contains an embedded derivative component with characteristics that adjust the security's risk/return profile. The return performance of a structured note will track that of the underlying debt obligation and the derivative embedded within it. A structured note is a hybrid security that attempts to change its profile by including additional modifying structures. A simple example would be a five-year bond tied together with an option contract. This structure would work to increase the bond's returns. Interest rate cap An interest rate cap is a derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. An example of a cap would be an agreement to receive a payment for each month the LIBOR rate exceeds 2.5%. An interest-rate cap is an OTC derivative that protects the holder from rises in short-term interest rates by making a payment to the holder when an underlying interest rate (the "index" or "reference" interest rate) exceeds a specified strike rate (the "cap rate"). Caps are purchased for a premium and typically have expirations between 1 and 7 years. They may make payments to the holder on a monthly, quarterly or semiannual basis, with the period generally set equal to the maturity of the index interest rate. If a payment is due on a USD Libor cap, it is calculated as 𝑖𝑛𝑑𝑒𝑥 𝑟𝑎𝑡𝑒 − 𝑐𝑎𝑝 𝑟𝑎𝑡𝑒

𝑎𝑐𝑡𝑢𝑎𝑙 𝑑𝑎𝑦𝑠 (𝑛𝑜𝑡𝑖𝑜𝑛𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡) 360

Caps can be used to hedge against interest rate fluctuations. For example a borrower who is paying the LIBOR rate on a loan can protect himself against a rise in rates by buying a cap at 2.5%. If the interest rate exceeds 2.5% in a given period the payment received from the derivative can be used to help make the interest payment for that period, thus the interest payments are effectively "capped" at 2.5% from the borrowers point of view.

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Lease Finance and Investment Banking Interest Rate Floor An interest rate floor is a derivative contract in which the buyer receives payments at the end of each period in which the interest rate is below the agreed strike price. An over-the-counter investment instrument that protects the floor buyer from losses resulting from a decrease in interest rates. The floor seller compensates the buyer with a payoff when the reference interest rate falls below the floor's strike rate. For example, assume that an investor is securing a floating rate loan and is looking for protection against lost income that would arise if interest rates were to decline. Suppose the floor rate is 8% and that on a particular day, the rate on the investor's floating-rate loan of $1 million is 7%. The floor provides a payoff of $10,000 (($1 million *.08) - ($1 million*.07)).

Interest Rate Ceiling The maximum interest rate that a financial institution can charge a borrower for an adjustable rate mortgage or loan according to the contractual terms of the mortgage or loan. This interest rate is expressed as an absolute percentage. For example, the terms of the loan might state that the interest rate can never exceed 19%. An interest rate ceiling is sometimes used interchangeably with the term "lifetime interest rate cap". However, an interest rate cap is usually expressed as a maximum change allowed in an initial interest rate. For example, a 5% interest rate cap would suggest that the interest rate on the borrower's loan can fluctuate within a 5% range during any specific rate adjustment period. Interest Rate Collar An investment strategy that uses derivatives to hedge an investor's exposure to interest rate fluctuations. The investor purchases an interest rate ceiling for a premium, which is offset by selling an interest rate floor. This strategy protects the investor by capping the maximum interest rate paid at the collar's ceiling, but sacrifices the profitability of interest rate drops. An interest rate collar can be an effective way of hedging interest rate risk associated with holding bonds. Since a bond's price falls when interest rates go up, the interest rate cap can guarantee a maximum decline in the bond's value. While interest rate floor does limit the potential appreciation of a bond given a decrease in rates, it provides upfront cash to help pay for the cost of the ceiling. Let's say an investor enters a collar by purchasing a ceiling with a rate of 10% and sells a floor at 8%. Whenever the interest rate is above 10%, the investor will receive a payment from whoever sold the ceiling. If the interest rate drops to 7%, which is under the floor, the investor must now make a payment to the party that bought the floor.

Swaption (Swap Option) The option to enter into an interest rate swap. In exchange for an option premium, the buyer gains the right but not the obligation to enter into a specified swap agreement with the issuer on a specified future date.

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Lease Finance and Investment Banking The agreement will specify whether the buyer of the swaption will be a fixed-rate receiver (like a call option on a bond) or a fixed-rate payer (like a put option on a bond). There are two types of swaption contracts: 

A payer swaption gives the owner of the swaption the right to enter into a swap where they pay the fixed leg and receive the floating leg.  A receiver swaption gives the owner of the swaption the right to enter into a swap in which they will receive the fixed leg, and pay the floating leg. Asian Option An option whose payoff depends on the average price of the underlying asset over a certain period of time as opposed to at maturity. Also known as an average option. Asian options are thus one of the basic forms of exotic options. This type of option contract is attractive because it tends to cost less than regular American options. An Asian option can protect an investor from the volatility risk that comes with the market. One advantage of Asian options is that these reduce the risk of market manipulation of the underlying instrument at maturity. Another advantage of Asian options involves the relative cost of Asian options compared to European or American options. Because of the averaging feature, Asian options reduce the volatility inherent in the option; therefore, Asian options are typically cheaper than European or American options

Prepared By Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University. Email:[email protected] Mobile: 01198150195 Jagannath University

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Chapter 14: Merchant Banking in Bangladesh Merchant Banking Merchant Banking refers to negotiated private equity investment by financial institutions in the unregistered securities of either privately or publicly held companies. A bank that offers these services is called a merchant bank. Both commercial and investment banks may engage in merchant banking activities. The original purpose of merchant banks was to facilitate and/or finance production and trade of commodities and hence the name "merchant" Merchant banks invest their own capital into corporate clients. A merchant bank will assess the value of a company and invest its money into it, sometimes taking a very large ownership interest in the company. Merchant banks specialize in international finance. Multinational corporations use this expertise to facilitate their international transactions. Merchant banking can be called "very personal banking"; ‗Investment Banking is an American synonym of merchant banking. Investment banks provide advice on mergers and acquisitions and are involved in financing industrial corporations through buying shares and selling them in relatively small lots to investors. In the context of Bangladesh, merchant banking includes all financial institutions that combine the functions of both development banking and investment banking.

Difference between Investment and Merchant Banking Even though, a fine line separates a Merchant bank from an investment bank, there are some differences between them.  Traditional investment banks only engage in the underwriting of shares and issuance of shares, whereas merchant banks involve in international financial activities.  While traditional investment banks assist companies in the acquisition and merges, merchant banks are not.  Normally investment banks focus on share issuance of large private and public companies, whereas merchant banks look after small scale companies.  While merchant banks still offer trade financing to their clients, investment banks rarely offer this service.  Investment banks offer advisory services for acquisition and mergers, whereas a merchant bank provides little or no of such services. Neither merchant nor investment banks serve the general public. Instead, both serve publicly and privately held corporations. Both merchant and investment banks perform underwriting functions for their corporate clients.

Jagannath University

Department of Finance

Md. Mazharul Islam Jony

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Merchant Banking in Bangladesh: Merchant banks were allowed to operate with the hope of playing a meaningful role in salvaging the country's limping stock market, by generating fresh funds, following the 1996 stock market crash. So far, a total of 31 companies received merchant banking licenses from the Securities and Exchange Commission. The registered merchant banks are: Janata Bank Limited, BRAC Bank Limited, City Bank Limited, Premier Bank Limited, Mutual Trust Bank Limited, Industrial Development Leasing Company of Bangladesh Ltd, Uttara Finance and Investment Limited, BancoTrans World (Bangladesh) Limited, Fidelity Assets and Securities Company Ltd., N DB Capital Ltd., Bay Leasing and Investment Limited, Alliance Financial Services Ltd., Business and Management Co. Ltd., Swadesh Investment Management Limited, LankaBangla Finance Limited, Grameen Capital Management Limited, South Asia Capital Ltd., Prime Finance & Investment Ltd., EC Securities Ltd., Mercantile Securities Limited, GSP Finance Company (Bangladesh) Ltd., Bangladesh Mutual Securities Ltd., BRAC EPL Investment Ltd, Prime Bank Limited, Arab Bangladesh Bank Ltd., ICB Capital Management Ltd., Export Import Bank of Bangladesh Ltd.(EXIM Bank), Union Capital Limited , AAA Consultants and Financial Advisers, Citigroup Global Markets Bangladesh Private Limited, Trust Bank Ltd, Southeast Bank Ltd, Standard Bank Ltd, Sonali Bank Limited and Agrani Bank Limited. Of them, a total of 29 companies received merchant banking licenses from the commission between January 1998 and April 2002. The Citigroup Global Markets Bangladesh Private obtained the license in the year of 2007 and the Trust Bank in the year of 2008. Six more FIs are going to be approved by the SEC. The SEC on September 7, 2008 cancelled the merchant banking license of the Equity Valuation Research and Distribution Ltd. The Securities and Exchange Commission on October, 2008 cancelled merchant banking licenses of the First Securities Services Ltd and the Raspit Securities and Management Limited with immediate effect since they remained inactive for years together. The First Securities Services was given license to act as issue manager while the Raspit Securities and Management as full-fledged merchant bank, which was allowed to perform as issue and portfolio manager as well as underwriter for clients. In the year of 2009, of the then 28 merchant banks, 23 had full-fledged merchant banking license, while four had only issue management license and one had only portfolio management licence. The central bank of Bangladesh asked the commercial banks to run their merchant banking business through separately formed subsidiary companies, officials and bankers. Under those new regulations, the banks had to convert their existing merchant banking wing or department into a separate subsidiary company by January31, 2010. It helped to ensure transparency of the merchant banking business. Recently, securities regulators gave its go-ahead to six more financial institutions (FIs) to operate merchant banking. Because, analysts questioned their expertise and financial base. The Securities and Exchange Commission (SEC) also approved rights offer of Bay Leasing and Investment Ltd. The six financial institutions are Jamuna Bank, Mutual Trust Bank Ltd, TheCity Bank, Summit Group's Cosmopolitan Traders Private Ltd, Green Delta Insurance and Alpha Capital Management Ltd, a unit of Progressive Life Insurance. According to the SEC officials, the approval will bring the total number of merchant banking at 37. By giving nod to the six FIs to operate as merchant banks, theSEC has increased maximum limit of the merchant banking operation in the stock market to 50 from 35. But, although 31 merchant banks are operating, only a few(only some) are active while the performance of the rest is "far from being satisfactory.""The merchant banks should focus on forming their own portfolios in making the market sustainable," An analyst saw no strong case for the SEC motive, saying it would be of no use unless the companies have professionalism and strong financial base

Jagannath University

Department of Finance

Md. Mazharul Islam Jony

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Lease Finance and Investment Banking So far, the commission has scrapped six licenses of merchant banks including First Securities Services Ltd, Prime Securities and Financial Services Ltd, and Mercantile Securities Ltd. Bay Leasing and Investment Ltd will issue one rights share against one existing share to bolster its capital base and to raise the capacity of SME credit to meet Bangladesh Bank's directive. It will float 30,60,000 ordinary shares as rights offer of Tk. 100.00 each at an issue price of Tk 350.00 per share (including a premium of Tk 250.00 each). Merchant Banking Operations in Bangladesh: Although in the U.S., merchant banks offer a wide range of activities, including portfolio management, credit syndication, acceptance credit, counsel on mergers and acquisitions, insurance, etc, in case of our country, these services may differ. In Bangladesh, a merchant bank can perform multiple operations including underwriting, issue management, portfolio management, merger & acquisition etc. The merchant banking activities were largely fostered by two distinct developments: Merger &acquisition activities and increased demand for venture capital. 1. Underwriting: Underwriting operation is one of the important functions of a merchant banker by which it can increases the supply of stock/shares and debentures in the market. It is an arrangement whereby the underwriter undertakes to subscribe the unsubscribed portion of shares/debentures offered by any public limited company. This encourages the prospective issuers to offer shares/debentures to the public for subscription and they can raise funds from the public. One or more investment banking firms may underwrite public offerings. The underwriters have the responsibility of pricing new shares and selling them to investors. The company pays the underwriters a fee. Underwriter also provides advice to a company issuing securities or to an issue manager. ³Before granting authority to17 non-bank financial institutions in 1997 to conduct merchant banking business in Bangladesh under the Securities and Exchange (Merchant Bankers and Portfolio Manager) Regulations 1995, specialized financial institutions, and the nationalized commercial banks and insurance companies were the key underwriters in the country‘s securities market.´ 2. Issue Management: Issue Management function of merchant Banking helps capital market to increase the supply of securities. Being a Issue Manager these FIs provide assistance to the Private Limited Companies intended to be converted into Public Limited Companies by way of obtaining necessary permission from the relevant authorities, preparing prospectus for public issue of shares and debentures, involving itself in the collection of application money, scrutiny of applications, arranging for lottery relating to allotment, if required, allotment of shares and debentures, refund of application money etc. 3. Portfolio Investment Management Services: Portfolio means a collection of investments owned by an investor, an institution or a mutual fund and portfolio manager means the entity responsible for investing a mutual fund's assets, mapping out its investment strategy and managing day-to-day securities trading´. Portfolio management is the process of building, managing and assessing an inventory of company products and projects.´ One of the most important functions of merchant banking is to provide Portfolio Management service to the customer. Basically, Portfolio Management Services program has four different wings to provide portfolio investment management services. The SEC allowed banks to launch merchant banking operation through opening of separate wing mainly to deal in portfolio investment on behalf of clients' account in order to channel pool of investors' fund into the stock market in an organized manner. 4. Merger and Acquisition:The phrase mergers and acquisitions (abbreviated M&A) refers to the aspect of corporate strategy, corporate finance and management dealing with the buying, selling and combining of different companies that can aid, finance, or help a growing company in a given industry grow rapidly without having to create another business entity.´ Jagannath University

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Lease Finance and Investment Banking Merchant banking helps to negotiate companies in this case, Other functions that differ from FIs to FIs are Factoring, Asset Securitization, OTC Market, Capital Re-Structuring etc. In addition these FIs can also perform the activities of: Project counseling Lending to stock investors Pre-Investment Studies, etc

Laws and Regulations: The SEC granted authority to 17 non-bank financial institutions in 1997 to conduct merchant banking business in Bangladesh under the Securities and Exchange(Merchant Bankers and Portfolio Manager) Regulations 1995,The Securities and Exchange Commission (SEC), invited letters of intent from14 institutions for the registration of merchant banks based on SRO No. 59 of 24 April1996, and a decision taken by it on 17 August 1997. Prior to this decision, seven (7)institutions submitted such letters of intent and SEC gave registration to a total of 19.Under the SEC merchant banker licensing rules, a merchant bank working only as issue manager has to submit at least a documented proposal for an initial public offer of a company, while a merchant bank licensed to act only as portfolio manager has to form at least five new portfolios of its clients besides its own, and a merchant bank working as a full-fledged merchant bank has to manage one IPO, to be underwriter of two issues and form five new portfolios of its clients besides its own in a calendar year. A full-fledged merchant bank has to perform at least two operations among the three including managing portfolio in a calendar year.

Customers of Merchant banking: In our country, the customers of merchant banking are as follows in general: 1. Any Bangladeshi over 18 years of age 2. Any Corporate body (ies) 3. NRB (s) through NITA Account

The Role of Merchant Banking in Bangladesh: If FIs get the license, apart from merchant banking, these will be able to ensure huge liquidity supply to the stock market. The capital market has been in a liquidity crisis since the introduction of direct listing rules in 2006, as five state-owned enterprises and two privately-run companies raised thousands of crores of taka from the market, according to experts. ³To face such a crisis, more merchant bankers should be allowed to operate in the market,´ said an expert. The necessity of issuing merchant banking license by the Securities and Exchange Commission (SEC) is also seen by some experts as an option to lessen the alleged dominance of the existing merchant banks in the stock market. This will also be very helpful for the investors and firms.

Prepared By Md. Mazharul Islam (Jony) ID no:091541, 3rd Batch. Department of Finance. Jagannath University. Email:[email protected] Mobile: 01198150195 Jagannath University

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Ending “Mending Mending, Slow Motion. Picking Picking, Information. Building Building, Our Nation. Ending Ending, Conclusion.” By Md. Mazharul Islam Jony

Jagannath University

Department of Finance

Md. Mazharul Islam Jony

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