Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy
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Chapter 15 Short- and medium-term finance 395
a two-year annuity of £5 million and add the undiscounted first payment of million,
yielding a total of:
Table 15.3 shows the behaviour of a loan of this amount, serviced by the same pro-
file of payments as required by the lease itself.
All we have done here is to express the calculation in a different way. We have
found that the equivalent loan is million, while the lease itself provides the abil-
ity to acquire an asset whose price is million, i.e. for the same profile of pay-
ments, the lease allows the firm to ‘borrow’ an extra million, which is precisely
the NAL. We can now see that the lease evaluation effectively involves computing a
loan equivalent. A lease is worthwhile if the required payment of cash flows could
service a loan higher than the outlay required to undertake the project.
In other words, a lease is worthwhile if the effective financing obtained is higher
than the equivalent loan. Many writers and analysts prefer to evaluate leases in terms
of equivalent loans, but, in more realistic cases, the phasing of rental payments, inter-
mingled with tax complications, can make the computation of an equivalent loan
highly complex. Generally, we favour the incremental cash flow approach.
■ Leasing as a financing decision: the three-stage approach
In this section, we offer a note of warning. In the Hardup example, we found leasing
was preferable to borrowing-to-buy. However, in many companies, the analysis might
not have got this far. For example, had the underlying project (the acquisition of the jet),
been revealed as unattractive, the financial manager might not have bothered to under-
take a financing analysis. In other words, firms may evaluate decisions in two stages:
first, to assess the basic desirability of the activity; and second, if the project is deemed
acceptable, to assess the optimal form of financing. The danger in this sequence is that
some projects that might be rendered worthwhile by especially favourable financing
packages could be rejected. It may make more sense to evaluate projects as linked invest-
ment and financing packages. To explore further this interaction between investment and
financing, we need to explain the three-stage approach.
In analysing Hardup’s jet acquisition, it was assumed that the investment was
inherently worthwhile, and that the remaining issue was how best to finance it. Let us
now examine the underlying investment decision. Imagine that Hardup is all-equity
financed and that its shareholders require a return of 15 per cent. Assume further that
acquisition of the jet would result in annual benefits (such as savings in executive time
and in travel expenses, and income from hiring) of £6 million p.a. for three years, treat-
ed as year-end lump-sum payments, and which, while uncertain, are no more risky
than existing company operations. The NPV of the jet purchase is:
The project would be (just) rejected on the NPV criterion and the issue of how best
to finance it might never arise (unless there were non-financial motives, such as cor-
porate prestige, to justify it).
NPV £13.75 m £6 m 1PVIFA
115,32
2 £13.75 m £13.70 m £0.05 m
£0.30
£13.75
£13.45
PV £5 m £5 m 1PVIFA
112,22
2 1£5 m £8.45 m2 £13.45 m
£5
Table 15.3
The behaviour of the
equivalent loan 1£m2
Year 0 1 2 3
1 Balance of loan at start of year 13.45 8.45 4.46 0
2 Payments, of which: 5.00 5.00 5.00 –
3 Interest at 12% – 1.01 0.54 –
4 Capital 5.00 3.99 4.46 –
5 Balance of loan at end of year (1–4) 8.45 4.46 0 –
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396 Part IV Short-term financing and policies
However, it could be acceptable using other methods of finance, such as borrowing
or leasing. Of these, lease financing is the most attractive because we know the NAL
is £0.30 million. In this example, the acquisition should be undertaken, since the NAL
exceeds the negative NPV anticipated from all-equity financing. This suggests how
and why a three-stage analysis should be applied. The three stages are as follows:
1 Determine whether the project is inherently attractive.
2 Even if the NPV is negative, evaluate the NAL to assess whether to lease or borrow-
to-buy.
3 Assess the value of the project with the chosen financing method.
(N.B. Stage 2 could precede stage 1, of course, but all three should be undertaken.)
To examine stage 3, we compare the benefits anticipated from the project, discount-
ed at the ‘risky’ rate of 15 per cent, with the costs associated with the cheapest financ-
ing method, in this case, the stream of rental payments.
As found earlier, the present value of project benefits is million. Now apply-
ing the 12 per cent cost of debt finance to the rental stream, we have:
Since the project benefits exceed the costs associated with the cheapest financ-
ing method, the overall investment-cum-financing package is worthwhile. This is an
important result. When judged on its intrinsic merits, and evaluated using ‘normal’
criteria, the project reduces shareholder wealth by million. Yet when evaluated
using alternative financing methods, it becomes worthwhile.
Thus we find:
This equals the NPV of the basic project plus the NAL
Not all marginal investment decisions can be turned around by clever financing
decisions, but a three-stage approach can help to avoid rejecting some projects that
might be worth undertaking if financed in particular ways. Sometimes, the lease may
yield net benefits due to the preferential borrowing ability of the lessor (e.g. a bank),
which is passed on to the lessor. Alternatively, it is possible to exploit tax advantages
for the mutual benefit of the two parties. Finally, in some cases, the lessor may have
bulk-buying advantages not possessed by the lessee.
We will continue to assume that projects are worthwhile in their own right when
their benefits are discounted at the appropriate risk-adjusted rate, although it is
implicit that a full three-stage analysis has been undertaken.
1£0.30 m2.1£0.05 m2
NPV of project if leased £0.25 m
PV of lease rentals 1£13.45 m2
PV of project cash flows £13.70 m
£0.05
PV of rentals £5 m £5 m 1PVIFA
112,22
2 £13.75 m
£13.70
15.9 MOTIVES FOR LEASING
Some writers suggest that leasing is undertaken primarily to exploit tax advantages.
Large numbers of firms in the 1970s and early 1980s found that their desired capital
expenditures exceeded their taxable earnings, and as a result they could not take
advantage of the 100 per cent First Year Allowances then available, at least until their
Self-assessment activity 15.7
What are the main differences between an operating lease (OL) and a finance lease (FL)?
(Answer in Appendix A at the back of the book)
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Chapter 15 Short- and medium-term finance 397
profitability had recovered. Under these circumstances, leasing was often a more cost-
effective form of asset finance than borrowing-to-buy.
Many firms possessing taxable capacity set up leasing subsidiaries in order to shel-
ter their own profits from tax by purchasing capital equipment on behalf of tax-
exhausted firms. As a result, the list of active lessors included such odd-looking
bedfellows as Tesco, Mothercare, Ladbrokes and Marks & Spencer, all highly prof-
itable companies during this period. Such companies were able to obtain the tax ben-
efits from equipment purchase considerably earlier than their tax-exhausted clients
could expect to. In effect, lessors bought equipment on behalf of clients, took the tax
benefits and passed these on to clients in the form of reduced rentals.
The extent to which tax benefits are actually passed on depends on the state of com-
petition in the market for leasing and how near to the end of the lessor’s tax year the
negotiations take place. Sometimes, very attractive lease terms can be obtained from a
lessor anxious to qualify for tax reliefs as soon as possible. In these cases, the lessor can
profit from the contract, and the lessee may find leasing more attractive than outright
purchase. Therefore, both parties can gain from the arrangement at the expense of the
taxpayer.
While tax breaks have been important in explaining the rise of leasing, they do not
account for the continuing popularity of leasing after the phased abolition of First Year
Allowances between 1984 and 1986. Beyond the tax system, a variety of reasons have
been proposed to explain the continuing popularity of leasing.
■ ‘Leasing offers an attractive alternative source of funds’
For firms subject to capital rationing, leasing may offer an attractive means to access
capital markets. This applies especially to small, growing businesses that lack a suffi-
ciently impressive track record to satisfy lenders, or possess inadequate assets upon
which to secure a loan. With a lease, no security is required, since if the lessee defaults,
the owner simply repossesses the asset and looks for another client. For this reason, it
is unusual to find restrictive clauses in lease contracts, in contrast to debt covenants
where the lender may stipulate, for example, that the borrower should not exceed a
specified gearing ratio. In addition, few lenders will offer 100 per cent debt financing.
They prefer instead to see the client inject a significant amount of equity. This is not the
case with a lease contract, which may thus be seen as a ‘back-door’ method of obtain-
ing total debt financing for the equipment needs of a project.
Some organisations, such as local authorities and government departments,
persistently suffer from constraints on capital expenditure and may find leasing
an appealing device. In such organisations, there is often a rigid distinction between
‘revenue’ budgets and ‘capital’ budgets, which can be exploited by managers aware of
the leasing alternative. Equipment may be acquired not by using the tightly controlled
capital budget, but by undertaking a lease contract where the rentals are paid out of
the revenue budget. Indeed, in the short term, leasing may even be presented as a way
of ‘saving money’. In 1979, the ability of lessors to obtain tax relief on equipment pur-
chase, regardless of the tax status of the lessee, was removed. Since then, tax relief has
been available only in cases where the lessee is normally liable for Corporation Tax,
even if, perhaps temporarily, tax-exhausted. However, the public sector remains an
important source of leasing business.
■ ‘Leasing has cash flow planning advantages’
Leasing removes the need for a substantial cash outlay at the outset of a project in
return for a series of contractually agreed, predictable cash flows over the term of the
lease contract. A lease thus has the effect of smoothing out cash flows, which facilitates
budgetary planning. However, this is a rather spurious argument as the same effect
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398 Part IV Short-term financing and policies
could be achieved with a bank loan. So this argument only applies if a bank loan is not
available. This would of course render the ‘lease vs. borrow-to-buy’ mode of evaluation
redundant.
■ ‘Leasing provides off-Balance Sheet financing’
Until SSAP 21 made capitalisation of leases mandatory, companies were not required to
show lease obligations in published accounts. This had the effect of disguising their
indebtedness by lowering the recorded gearing ratio, and also raising the return on cap-
ital employed. However, lease obligations had to be mentioned in the notes to the
accounts, but it may have been fanciful to imagine that lenders (perhaps with their own
leasing subsidiaries) were unaware of this form of window-dressing when assessing
corporate performance and borrowing levels. However, this argument does apply for
operating leases.
■ ‘Leasing is cheaper than other forms of finance’
As well as its pragmatic attractions, leasing is often a more cost-effective way of acquir-
ing an asset. We have seen how leasing can be a profitable alternative to bank bor-
rowing under certain conditions. This is equivalent to saying that the effective rate of
interest on a lease contract is lower than that on a bank loan. Indeed, many firms eval-
uate leases by comparing the bank’s effective lending rate with the rate of interest
implicit in the lease contract, i.e. the internal rate of return on the profile of lease pay-
ments, including the ‘up-front’ financing. Of particular interest is the case of an ‘end-
year lease’, written on or just before the end of the lessor’s tax year. At this juncture, the
lessor is anxious to get the contract drawn up so as to claim the tax relief in the year just
ending, rather than having to wait a further year before reaping the tax advantage.
Many lessors have borrowing advantages owing to their size, which they may pass on
to lessees in the form of lower rental charges.
A survey of quoted UK companies by Drury and Braund (1990) found that the cost
of leasing, Corporation Tax considerations and, to a lesser extent, conservation of work-
ing capital were the most important factors in the lease or borrow-to-buy decision.
15.10 ALLOWING FOR CORPORATION TAX IN LEASE EVALUATION
The Hardup example omitted the impact of taxation. Lease rentals qualify for tax relief,
as do interest payments on loans, while expenditures to purchase capital equipment
generally attract capital allowances against Corporation Tax. To include tax is particu-
larly important, since the UK tax system was widely believed to be largely responsible
for the original upsurge in leasing activity in the UK.
Retaining the figures from the Hardup example, we now assume Corporation Tax is
paid at 30 per cent with no delay, and the availability of a 25 per cent writing-down
allowance (WDA). A firm with sufficiently high taxable profits can set off 25 per cent of
its outlay on capital equipment against profits in the year of expenditure, and in each
subsequent year, based on a reducing balance. Consequently, by careful timing of expen-
ditures, a company with sufficient taxable capacity can enjoy significant tax savings.
Assuming that Hardup is not tax-exhausted, it can shelter its profits from tax by
acquiring the aircraft. In effect, the taxpayer subsidises the required outlay, making
equipment purchase a more attractive proposition for the tax-paying enterprise.
Conversely, tax relief on rental payments lowers their effective cost. (For exposition,
we assume that all of the rental is wholly tax-allowable as a normal business expense.
However, the regulations in this area were changed in 1991, as explained in the next
section.) The final tax adjustment is to the discount rate.
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Chapter 15 Short- and medium-term finance 399
The after-tax cost of borrowing
When interest payments qualify for tax relief, the effective rate of interest, , is deflat-
ed by the rate of Corporation Tax (T):
where r is the nominal or quoted pre-tax interest rate.
For Hardup, facing a pre-tax borrowing rate of 12 per cent, this produces a tax-
adjusted effective interest rate of about 8.4 per cent, i.e.
Retaining our previous incremental format, and allowing for the various tax com-
plications, Table 15.4 shows the relevant cash flows.
The figures indicate that the lease is still worthwhile for the lessee. We could have
undertaken a parallel analysis from the lessor’s standpoint to examine whether it was
worthwhile for it to purchase the asset for leasing to Hardup. In fact, the computation
has effectively been done for us, because all the cash flows have the same numerical
values, except that their signs are reversed. As a result, the NPV of the project to
Moneybags is million (assuming that both firms could obtain capital at 12 per
cent pre-tax). On this basis, a leasing contract between tax-paying companies is a zero-
sum game. In reality, however, the lessor is likely to have special advantages, like
access to cheaper finance, reducing its required return to below that of the lessee,
and preferential buying terms. Economies of bulk purchase are common for lessors of
motor cars, with 40 per cent discounts on list price not unknown.
The relative desirability of leasing and borrowing-to-buy depends largely on the tax
regime. If the company is in a non-tax-paying situation (and expects to be so indefi-
nitely), the lease evaluation should be conducted on a pre-tax basis.
£0.12
r* 0.12 11 0.302 0.084 8.4%
r* r11 T2
r*
Table 15.4
Hardup’s leasing
decision with tax
Year
Item of cash flow ( ) 0 1 2 3
Lease:
Rental –
Tax saving at 30%
Net lease cash flows (L)
Borrow-to-buy:
Outlay
Tax saving
Net purchase cash flows (B)
Net incremental cash flows
Present value at 8.4%
Net present value
Tax savings on the rentals are actually delayed by a year owing to the timing of the rental pay-
ments, i.e. on the first day of each of Years 1, 2 and 3.
The profile of tax savings is based on setting the allowable expenditure against profits in Year 0
and in three subsequent years. The undepreciated balance is set against profits in the last year.
No salvage value is assumed. Insurance and maintenance costs are also ignored.
2
1
0.121NAL2
0.193.473.947.72
0.244.084.277.721L B2
1.740.580.7712.72
1.740.580.771.03
2
13.75
1.503.503.505.00
1.501.501.50
1
5.005.005.00
£m
Self-assessment activity 15.8
What is the tax-adjusted interest rate when the nominal rate is 9 per cent for:
(i) a small firm paying tax at 10 per cent?
(ii) a tax-exhausted firm?
(Answer in Appendix A at the back of the book)
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400 Part IV Short-term financing and policies
■ The current tax treatment of lease rentals
In the Hardup example, we treated the rental payment as wholly tax-allowable. In 1991,
the UK tax authorities made the rules more complex, to bring the tax treatment of leases
into line with SSAP 21. This dictates that finance leases be stated on the Balance Sheet
and depreciated accordingly. For leases taken out after April 1991, the Inland Revenue
requires a separate treatment for the implicit finance charge and the implicit capital
charge. The former depends on the interest rate implicit in the lease contract, and is tax-
allowable in full in the relevant accounting period. The capital repayment element is
derived by spreading the total capital charge – normally the asset’s cash price – over its
useful life. In other words, the depreciation charge in the accounts becomes the tax-
allowable figure, dependent on the method of depreciation used and its acceptability to
the Inland Revenue. An example should clarify this.
Example
Consider the case of a four-year lease contract to finance acquisition of an asset costing
million. The rental is million p.a., paid at each year-end. The effective interest
rate is the solution rate in the IRR expression formed by setting the finance raised equal
to the sum of discounted payments:
R is exactly 10 per cent. The annual interest charge can now be found by analysing the
implicit loan of million as shown in Table 15.5.
Applying straight-line depreciation to the asset cost, the annual charge is £10 m/4
= £2.5 m. This is fully allowable against tax in each of the four years. Table 15.6 compares
the profiles of tax-allowable expenditures, and thus the impact of the 1991 changes. The
present system accelerates the tax relief, and reduces the effective cost of the lease (for the
tax-paying company).
£10
£10 m
£3.15 m
11 R2
£3.15 m
11 R2
2
£3.15 m
11 R2
3
£3.15 m
11 R2
4
£3.15£10
Table 15.5 Interest charges on a lease contract (figures in £m)
Opening Interest End of Closing
Year balance @ 10% year debt Repayment balance
10.00 1.00 11.00 3.15 7.85
7.85 0.78 8.63 3.15 5.48
5.48 0.55 6.03 3.15 2.88
2.88 0.29 3.17 3.15 0.02*
*Rounding errors prevent this reducing exactly to zero.
Table 15.6 Changes in tax-allowable lease costs (figures in £m)
Then Now
Year Rental
1 3.15
2 3.15
3 3.15
4 3.15
Totals 12.60 *
*Rounding error.
12.6210.002.62
2.792.500.29
3.052.500.55
3.282.500.78
3.502.501.00
Interest capital charge Total
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Chapter 15 Short- and medium-term finance 401
■
Policy implications: when should firms lease?
There are two lessons to be drawn from this analysis of leasing decisions:
1 Lease evaluation involves analysing a financing decision, as borne out by the three-
stage analysis. Sometimes, especially favourable financing arrangements, available
via a lease contract, may tip the balance between project rejection and acceptance.
But these cases are rare and the margin of acceptance offered by attractive financ-
ing will probably be fairly narrow. If the project is worthwhile only because of the
financing package, this should be explicitly recognised and the concessionary
finance regarded as a ‘one-off’, which may not be repeated in other cases. It seems
unduly purist to argue that, if the financing deal is all that makes the project
acceptable, then it should be rejected. Few financial managers would pass up an
attractive financing opportunity. However, policy is more profitably directed at finding
genuinely worthwhile projects, rather than diverting resources to obtaining marginal
financing advantages.
2 The analysis enables us to pinpoint the factors that suggest the relative attractive-
ness of leasing as compared to other financing arrangements. We now list the fac-
tors that impact on the leasing decision, but note that these are mainly ‘other things
being equal’ prognoses. ‘Look before you lease’ is a sensible motto.
Taxable capacity
Leasing is a means whereby lessors can exploit their own taxable capacity and pass on
any tax savings to firms in less favourable tax positions. Hence, the greater the taxable
capacity of would-be lessors and the lower that of users of capital equipment, the
greater the attractions of leasing.
Competition among lessors
A major factor in the development of the UK leasing market was the entry of new
players, eager to exploit their taxable capacity and thus shelter their profits from
Corporation Tax. This had the effect of increasing competition for available leasing
business and reducing the general level of lease rentals. Therefore, the greater the com-
petition among lessors, the greater the attractiveness of leasing.
Investment incentives
Another major factor in the growth of the leasing industry was the availability of
especially generous inducements to encourage firms to acquire plant, machinery and
industrial buildings. Although UK incentives are now less attractive than those
existing prior to 1984, there was no fall-off in leasing after the removal of First Year
Allowances, probably owing to the other attractions of leasing. However, it seems
reasonable to argue that, the greater the generosity of the tax authorities, the greater
the attractiveness of leasing because tax-breaks lower the effective cost of equipment
purchase for lessors, which may then pass on the benefits to lessees, whether or not
they are tax-exhausted.
Corporation tax
Investment incentives are most valuable when high rates of Corporation Tax raise the
value of the tax savings. Until 1984, with 100 per cent First Year Allowances, the total
(undiscounted) tax saving with Corporation Tax payable at 52 per cent for a million
investment would have been million. This falls to million with the present tax
rate of 30 per cent and, when discounted, even lower with 25 per cent annual WDAs.
The higher the rate of corporate profits tax, the more attractive leasing becomes,
because lessors can shelter their profits to a greater extent.
£3£5.2
£10
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402 Part IV Short-term financing and policies
Inflation
Rising price levels reduce the real value of future payments, such as a series of fixed
rental payments. Therefore, we suggest that the higher the expected rate of inflation,
the greater the appeal of leasing. However, the inflation effect will benefit the lessee
only if it correctly anticipates a higher rate of inflation than the lessor. As in all con-
tractual arrangements, unanticipated inflation is what does the damage, and it is by no
means certain that the lessee will be more successful than the lessor in forecasting infla-
tion. If lessors feel confident in their ability to predict inflation, if the rentals they set
incorporate their expectations, and if they are more or less correct, the benefits expect-
ed by lessees will evaporate. In addition, lease contracts may incorporate some form of
inflation adjustment.
Interest rates
The relevant rate of discount in lease evaluation is the rate applicable to the best alter-
native bank loan. The higher the rate of interest, the greater the discounting effect on
future contractual lease obligations. Generally, therefore, the higher the interest rate, the
more attractive a lease appears, since the present value of a given set of rentals will
become lower. However, this effect may be diluted by the impact of lessors applying
higher rentals in order to cover their own increased borrowing costs. If there is any ten-
dency for the spread of interest rates to widen at higher levels of interest rates, this
effect may still operate, since lessors usually have access to borrowed capital at more
advantageous rates than lessees.
15.11 FINANCING INTERNATIONAL TRADE
Obviously, it takes two parties to trade across country borders, the importer and the
exporter, but here, we adopt the perspective of the exporter. Exporting carries particu-
lar risks, e.g. the risk of slow (or even non-) payment by customers and the risk of
adverse currency movements. Hence, export finance is rather more complex than the
finance of domestic trade. The banking system, both domestic and foreign, usually has
a pivotal part to play both in arranging contract terms and making arrangements for
the exporter to be paid.
The simplest basis of trading is open account where the parties simply make a ‘gen-
tleman’s agreement’ about the settlement date, prior to which the goods are shipped,
received by the importer and used for production or sale. The exporter thus loses con-
trol over the goods and has recourse to the legal system if the importer fails to pay. Open
account is thus confined to deals involving established, reliable and highly credit-
worthy customers located in countries that have rapid, fair and reliable payment and
legal procedures. Much of the trade involving large UK firms with large EU-based
firms is conducted on open account. The advent of the euro as the common currency of
the EU is likely to increase the proportion of intra-EU trade conducted on open account.
With less reliable, or new, customers based in other parts of the world, more formal
procedures are required. As a first requisite, to overcome the fear of non-payment by
a customer in a foreign country, the exporter enlists the help of a well-respected bank
to act as intermediary. Using the reputation and good offices of the bank, the trade-
cum-financing package typically works as follows:
■ the importer secures the promise of the bank to pay on its behalf;
■ the bank promises the exporter to pay on behalf of the importer;
■ the exporter ships the goods, trusting to the bank’s promise to pay;
■ the bank pays the exporter at a pre-agreed juncture;
■ the bank passes title to goods to the importer;
■ the importer pays the bank, often using the sale proceeds of the goods shipped.
open account
Where trading partners agree
settlement terms with no for-
mal contract.
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■ Trade documents
Most export deals involve three key documents:
■ the bank’s promise to pay is called a Letter of Credit.
■ when the exporter ships the goods to the importer’s location, title to the goods is
conveyed to the bank by a Bill of Lading.
■ When the exporter seeks payment from the bank, it presents a ’sight draft’. When the
bank has paid the exporter, title to ownership of the goods passes to the importer
which duly pays the bank.
There is obvious potential for delay in these procedures, e.g. in trans-shipment of
goods, in inspecting the goods, in acceptance of the documents, etc. Hence the bank
plays a key role in ‘holding the ring’ between importer and exporter and providing a
source of short-term finance. The three documents help protect the two parties from the
risk of non-completion of the contract.
We now pay particular attention to the Letter of Credit, as this represents the bank’s
promise to pay.
■ Letters of Credit (LOC)
An LOC, or documentary letter of credit (DLOC), is a document drawn up by an
importer giving its bank detailed instructions as to the circumstances in which the cred-
it can be honoured by the importer’s bank (the ‘opening bank’) in favour of the exporter.
It details the nature of the goods, their quality and price and the dates between which
the LOC is valid. A DLOC enables the exporter to receive payment for goods in its coun-
try of location once shipment has taken place. The burden of financing is thus on the
importer who gains the comfort of knowing a definite date by which the exporter must
ship the goods. The exporter’s risk is reduced insofar as the credit-worthiness of the
involved banks is substituted for that of the buyer.
There are two types of DLOC. An Irrevocable DLOC is a written authority from the
opening bank to its correspondent bank in the exporter’s country (the ‘advising
bank’) to make specified payments provided that the documents specified are pre-
sented between the specified dates. If requested, the advising bank will add its own
undertaking to that of the opening bank by confirming the DLOC, which becomes a
‘Confirmed DLOC.’ This type of DLOC is legally binding and thus cannot be modified
or cancelled except with the consent of all parties involved.
Conversely, a Revocable DLOC can be altered or cancelled at any time without hav-
ing to give prior notice to the beneficiary, i.e. the exporter. It cannot be confirmed and
is not legally binding.
Drawbacks with letters of credit
DLOCs are not problem-free:
■ They can be expensive. The importer is likely to demand a lower price if it uses a
DLOC, as insurance against potential hitches in the transaction, removing the need
for the exporter to build these into the price.
■ The advising bank has to check that the documents presented exactly conform to
the specifications stipulated. If they do not, payment will be refused.
■ Banks do not accept responsibility for the goods shipped. A DLOC arrangement is
simply about transferring documents at arm’s length from the trading activity. If the
documents are in order, the credit will be honoured.
■ The opening bank bears a credit risk while the credit is open. It may thus demand
a cash deposit or lower the importer’s other borrowing facilities.
Other methods of financing international trade are: Bills of Exchange, documentary col-
lections, forfaiting and export factoring.
Chapter 15 Short- and medium-term finance 403
sight draft
A document presented to a
bank by an exporter seeking
payment for an export deal
Irrevocable DLOC
A written authority for a bank
to make specified payments to
an exporter, whose terms can-
not be varied
Revocable DLOC
A Letter of Credit whose terms
can be varied without consult-
ing the exporter
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404 Part IV Short-term financing and policies
■ Bills of Exchange in export trade
The use of Bills of Exchange in export trade is similar in essence to their domestic use.
An exporter can send a Bill of Exchange for the value of goods shipped through the
banking system for payment by a foreign buyer when presented. The exporter usually
prepares the bill, drawn on the foreign-based importer, for the amount specified in the
export contract.
Using the bill along with the other shipping documents via the banking system, the
exporter retains greater control over the goods because, until the bill is paid or accept-
ed by the foreign buyer, they cannot be released. The importer acknowledges his
agreement to pay on the due date by writing an acceptance on the bill, but does not
have to pay, or agree to pay, until delivery of the goods by the exporter.
The exporter may pass the bill to a domestic bank, which forwards it to a foreign
branch of the same bank or to a correspondent bank in the importer’s country. The so-
called ‘collecting bank’ presents the bill to whoever it is drawn upon, either for imme-
diate payment, if it is a ‘sight draft’, or for acceptance, if it is a ‘term draft’, payable
after a specified credit term. Where no shipping documents are required, this is called
a ‘clean bill collection’.
Where the importer’s financial standing is doubtful, the bill may be used in a ‘doc-
umentary credit collection’, The exporter sends the bill to its bank which in turn sends
it to its foreign-based correspondent, along with the shipping documents, including
the title to the goods, represented by the Bill of Lading. The bank releases the docu-
ments to the importer only on payment or acceptance of the bill by the foreign buyer.
In this way, greater control of the goods is achieved.
Bills of Exchange have several advantages:
■ They are cheaper than Letters of Credit.
■ Because the title documents can only be released on payment, the exporter has a
stronger position than in open account trades.
■ The bills can be discounted via the banking system to release finance for other uses.
Effectively, the bank buys the customer’s account payable, represented by the pro-
ceeds of the export deal at the time that the collection is remitted abroad.
■ Banks may also give an advance based on an outward collection of Bills of Exchange,
i.e. the anticipated payment.
■ Bills of Exchange reduce the risk of non-payment, given that banks do not want to
be associated with clients of poor credit standing.
■ Forfaiting
Forfaiting is a form of medium-term export financing that involves the purchase by a
bank (the ‘forfaiter’) of a series of promissory notes, usually due at six-month intervals
over perhaps three to four years, signed by an importer in favour of an exporter. The
notes are usually guaranteed (‘avalised’) by the importer’s bank and then sold by the
exporter to the forfaiting bank at a discount. The bank pays the exporter, allowing it to
finance the production of the goods destined for export, and enabling the importer to
settle later. The promissory notes are held by the forfaiter for collection as they mature,
on a without-recourse basis, thus the exporter is not liable in case of default by the
importer.
The rate of discount applied in forfaiting depends on the terms of the notes, the
currencies of denomination, the credit ratings of the importer and of the bank that
guarantees the notes, as well as the country risk of the importer’s base. Because the
forfaiting bank will quote a discount rate on demand, the exporter is able to quote a
selling price to foreign customers that allows for financing costs.
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