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UNIT III

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LEASING AND HIRE PURCHASE

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LEASING

Leasing concept & classification

Evolution of Indian leasing Industry Presentation

Product profile

Legal (regulatory aspects of leasing in India), tax & accounting aspects of leasing

Funding of leasing in India.

Financial evaluation of leasing

HIRE PURCHASE Concept and characteristics

Legal & tax frame work, mathematics

Financial evaluation of hire purchase deals-

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LEASING

Owner of an asset grants theright

Use the asset to other partyReceiver of the services of asset

Under lease contract

Individual,company,firmPeriodic payment- lease rental

lessor lessee

Contractual agreement

Leaserenting of an asset for some specified period

Seller, supplier, fin co, manuClaims depreciation on the asset

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MEANING - LEASING

Divorce of ownership from the economic

use of an asset/equipment

Device of financing(money lending) thecost of an asset/capital asset

Fund based service

Lending of funds/finance/credit

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CONCEPT OF LEASE

JAMES C.VAN HORNE DEFINED:

Lease is a contract whereby the owner of anasset (lessor)grants to another party (lessee)

the exclusive right to use the asset usually foran agreed period of time in return for thepayment of rent.

LEASING

Is a process by which a firm canobtain the use of certain fixed asset for whichit must make a series of contractual periodictax-deductible payment (lease rentals)

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ESSENTIAL ELEMENTS OF LEASING

Parties to the contract-lease financier, lessor, broker,

lessee

Asset: asset, property or equipment

Ownership separated from the user

Term of the lease

Lease Rentals

Modes of terminating lease

At the end of the lease period the asset reverts back to the

lessor unless there is a provision for the renewal of contract.

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STEPS INVOLVED IN LEASING

TRANSACTION Lessee decide asset req & supplier

Lessee enters lease agreement lessor

Basic lease period Timing and amount of periodical rental payment

Option details renew/purchase

Payment details maintenance, repairs, taxes,

insurance & other expenses

Lessor contacts manufacturer supply

makes payment after asset delivered &

accepted by lessee.

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CLASSIFICATION OF

LEASING Financial Lease & Operating Lease

Sale & Leaseback & Direct Lease

Single investor Lease & Leveraged

lease

Domestic Lease & International LeaseBased on risks & rewards, parties involved

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FINANCIAL LEASE

The lessor transfers to the lessee,substantially all the risks & rewards

incidental to the ownership of theasset whether or not the title iseventually transferred.- IAS -17

Also known as Capital lease, long term lease,net lease and close lease, Full payout leases

Approach to economic life

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The salient features of a lease are:A financial lease is a long-term, non-cancelable

lease.

The lessee has the option to purchase the assetat a price - sufficiently lower than the fair marketvalue .

The lease term - major part of the useful life of theasset.

The lessee is responsible - maintenance of the

asset - for insuring it against accidental damage orloss.

The risk of Damage is shifted from the lessor tothe lessee.

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OPERATING LEASE

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 & rewards

incidental to the ownership of the asset.The lessor provides all the services

attached to the leased asset.Also known as Service lease, Short term lease or True lease

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Features: The lease term is significantly less than

the economic life of the equipment.

The lease is usually cancelled at a short

notice.

The lessor is responsible for theinsurance & maintenance of the asset.

The lessor bears the risk of economic &functional obsolescence of the asset.

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DISTINCTION BETWEEN A

FINANCIAL LEASE & OPERATING

LEASE FINANCIAL Installment loan

Taxes & maintenancelessee

Risk of obsolescencelessee

Contract period medium long term

Contract non-cancellable

Air crafts, land , building..

Lessor fulfills financialfunction

OPERATING LEASE Rental agreement

Taxes & maintenance

lessor Risk of obsolescence

Lessor

Ranges formintermediate short term

Cancellable Computers, officeequipment,Taxi,mobilecranes

Service function

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SALE & LEASEBACK

The owner of an equipment/asset sells

(Mkt value)it to a leasing company

(lessor) which leases it back to theowner (lessee).

The leaseback arrangement - in theform of a finance lease or an operating

lease.Retail stores, office buildings, multipurpose industrial building,

shopping centre

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DIRECT LEASE

TWO TYPES:

BIPARTITE LEASE equipment

supplier cum lessor & lessee (operatinglease) upgrade lease, swap lease

TRIPARTITE LEASE: equip supplier,

lessor, lessee sales aid lease

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SINGLE INVESTOR LEASE

(Two parties) The leasing company (lessor) funds the

entire investment by raising.

The debt funds raised by the leasingcompany are without recourse to the

lessee.

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Leveraged Lease (3 parties)

borrowing a large chunk of the

investment with full recourse to the

lessee & without any recourse to it.

Lessor

Loan participant

Trustee LesseeLeases the

Equipment

HUGE CAPITAL LAYOUT & ECONOMIC LIFE - 10 YRS OR MORE

Equity investor

lender

Aircraft, ships etc..

LEASING COMPANY

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Domestic Lease VS International Lease

Domestic lease :All the parties to thetransaction are domiciled in the same

country.

International lease: All parties to the leasetransaction are domiciled in different

countries.

IMPORT LEASE- Lessor and lesseedomiciled in samecountry, supplier in different country

CROSS-BORDER LEASE: Lessor and lessee are domiciled

in different countries, supplier in any country

- Involve Country risk & currency risk

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LEASE RELATED RISKS

(Borne by the lessor) Default risk

Residual value risk

Interest rate risk

Purchasing Power risk

Currency & Cross-border risk

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ADVANTAGES OF LEASING

To the lessee:

1. 100% Financing of Capital Good2. Flexibility & convenience - structuring of rentals, terminating

3. Avoids conditionality's

4. Simplicity

5. Tax Benefits revenue expense

6. Permit alternative use of funds7. Boon to small firm

8. Protection against obsolescence

9. Conserving borrowing capacity/Facilities additional borrowings

10. Faster and cheaper credit

11.High growth potential/return on capital employed12. Enhanced liquidity

13. No floatation costs

14. No disposal problem

15. Lesser administrative and maintenance costs

16. Off the balance sheet transaction

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ADVANTAGES

To the Lessor:

1. Full security

2. Tax Benefit depreciation-reduce tax

liabilities

3. High Profitability

4. Quick returns

5. Increased sales

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LIMITATIONS

Lessee:

Higher cost

Risk of being deprived of the use of asset

No alteration or change in asset

Loss of ownership incentives

Penalties on termination of lease

Restrictions on use of equipment

Loss of residual/salvage value

Cost of financing generally higher than debtfinancing

Understatement of lessee's asset

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LIMITATIONS

Lessor:

High risk of obsolescence

Competitive market price

Price-level changes

Management of cash flows

Increased cost due to loss of use benefits Long term investment

Double sales tax.

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FACTORS CONSIDERED

BUY/LEASE

Availability of funds

Financial evaluation

Possession of asset Cost of Borrowing

Depreciation

Taxes

Salvage Value

Risk

Maintenance

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PROFILE/STRUCTURING OF

LEASING IN INDIA PRIVATE SECTOR:

Pure leasing companies/Independent

Hire Purchase and Finance companies: tax adv

Subsidiaries of manufacturing group companiesVendor

leasing, in-house leasing/captive

PUBLIC SECTOR:

Leasing divisions of financial institutions: IFCI,ICICIallindia, state level

Subsidiaries of public sector banks: Commercial banks94-95year onwards

Other public sector leasing organisation: Bharat electronicsltd, Hindustan packaging company limited, ECILsell

equipment through leasing

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SOME OF THE LEASING

COMPANIES

First leasing company of India ltd.

Sundaram finance ltd.

Kotak Mahindra Finance ltd

20th century finance corporation ltd.

CEAT Financial services ltd

Ashok Leyland Finance Ltd.

Escorts Financial services ltd

Motor & General Finance Ltd

Anagram Finance ltd.

Rockland leasing ltd

ILFS Infrastructure leasing & financing services

1987

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PRODUCT PROFILE

(lease structures in India) The category of Finance Lease. The lease agreements do not provide for

transfer of ownership to the lessee. The lease rentals are structured so as to

recover the entire investment cost during

the primary period.

The lease rentals are payable generally in

EMIs at the beginning of every month.

CONTD.

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Sale & Lease back type of transactionsare rare. Most of them are direct lease

Equipment leasing covers a wide range ofequipments from industrial plant &machinery, office equipments, vehicles

etc. - standby finance.-

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Legal Aspects/regulatory aspects

There is no legislation that exclusively

governs equipment leasing transactions in

India. CONTRACT ACT:

Law of contract :Two provisions- specifically

applicable to leasing transactions.

General provisions: contract: legal obligation,lawful consideration, competent parties, free

consent, not expressly void, discharge of

contracts: performance, frustration, mutual

agreement , operation of law, remission

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SPECIAL PROVISIONS: The provisions

of the Indian Contract Act, 1872

SECTION 148, relating to bailment areapplicable to leasing transactions

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Leasing as a Bailment Agreement

There are two parties to a bailment

agreement, ie, bailor who delivers the

goods & bailee to whom the goods aredelivered for use.

There is delivery of transfer of goods

from the bailor(lessor) to bailee(lessee).The ownership of the goods continues

with the bailor (lessor).

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The goods in bailment should be

transferred for a specific purpose under a

contract. purpose to make use ofeconomic life of asset.

When the purpose is accomplished, the

goods are to be returned to the bailor ordisposed off acc. to his directions

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Liabilities of lessee/bailee

Reasonable care

Not to make unauthorized use

To return the goods

Not to set up an adverse title

To pay the lease rental

To insure and repair the goods

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REMEDIES FOR BREACH

Remedies to lessor: Forfeiture,

damages, repossession

Remedies to the lessee:claim damages- termination

MOTOR VEHICLES ACT, 1988- SECTION 146-INSURANCE

RBI NBFCs directonsOther act/laws indian stamp act

Lease documentation and agreement

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FINANCIAL EVALUATION

OF LEASING

The objective of evaluation is:

To identify

Lessee - The source of finance &

Lessor - Better investment alternative .

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Lessees Perspective

LEASE Evaluation

Investment decision Financing decision

Purchase the asset

1. Should the asset be funded with

debt?2. Should the asset be funded with

debt & equity?3. Should it be leased?

o ce etween

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o ce etweenDebt Financing/ borrowing Vs Lease

Financing

Since lease rentals are similar to

payment of interest on debt, leasing

in essence is an alternative to

borrowing.

PROCEDURE FOLLOWED: The

decision criterion used is NPV/NAL.If the NPV/NAL is +ve, the leasing alternative should be used,otherwise the borrowing alternative would be preferable.

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PROCEDURES

NPV/NAL

PV OF CASH OUTFLOWS

BERL

GROSS YIELD

ADD-ON YIELD

IRR BASED PRICING

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Computation of NPV(L)/NAL(net

Adv. of leasing)Initial Investment/investment cost- PV of lease rentals(kd)

- Management fee+ PV (tax shield on lease rentals)

+ PV (tax shield on Mgt. fee)

- PV (tax shield on Depreciation)- PV (Net salvage value)

Lease the equipment if NAL is +veBuy the equipment if NAL is -Ve

Kd pre-tax cost of long term debt

Kc - post tax marginal cost of capital

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BREAKEVEN LEASE

RENTAL The BELR is the rental at which lessee

is indifferent between lease

financing/borrowing & buying.

BELR has NAL as zero. It reflects themaximum level of rental which the

lessee would be willing to pay.

If the BELR exceeds the actual lease rental, the lease

proposal, would be accepted, otherwise rejected.

LESSEE

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LESSORS VIEWPOINT

Accept a lease proposal /choose from

alternative proposal

BELR represents the minimum (floor)lease rental which he can accept. The

NAL at this level is zero.

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The NAL to a lessor:

PV of Cash Inflows PV of Cash Outflows

CASH OUTFLOWS:Initial InvestmentIncome tax on lease rentalsSales-tax on lease transactions

Administration expenses CASH INFLOWS:

Lease rentalsManagement fee

Tax shield on depreciationResidual value

Security deposit if any

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NEGOTIATING LEASE

RENTALS The BELRs of the lessor & the lessee

represents the range of acceptable level

of rentals. The BELR of the lessor sets

the lower limit, while the BELR of thelessee sets the upper limit of the range.

The actual rental has to be negotiated

within the range.A rental within the range implies a

+ve NAL both for the lessor & the lessee.

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ADD-ON YIELD

A variant of gross yield. The add-on yield, akin to flat rate of

interest assumes that the investment in

the lease remains constant over thelease period.

The add-on yield is not a true measure.

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IRR BASED PRICING

IRR internal rate of return rate of

discount at which present value of

cash-inflows = PV of cash outflows The IRR of a lease investment is that

rate of interest at which NAL is equal

to zero.The lease investment is accepted if & only ifthe IRR exceeds the required rate of return.

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TAX ASPECTS

Income tax provisions:

Lessee : lease rentals as tax- deductible

expenses Lessor:

Lease rental are taxableProfits &

gains of business or profession

investment allowance/depreciation on

the investment

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SALES TAX PROVISIONS

The lessor is not entitled confessional

rate CST use/resale

46th amendment act (Under purview ofsale ) - ST

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ACCOUNTING TREATMENT OF

LEASE

Lessor :

The leased asset is shown on the balance

sheet Depreciation and other tax shields

Lease rentalincome lessor

Lessee: Lease rental - expenseIAS International accounting standard, 17- 1982

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PRESENTATION

N. JOHN

History of hire-purchasing

Concept Stipulations,modus operandi,Features

Legal framework

Financial evaluation

SOWJANYA:

Hire Purchase Vs Installment

Hire Purchase Vs Leasing

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HIRE-

PURCHASING

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Evolution U.K, Henry moore- paino maker 1846

U.S.A furniture dealer 1807 In India for more than 6 decades. Thefirst hire-purchase company is

believed to be Commercial Credit

Corporation. - Madras Motor and General Finance and

Instalment Supply Company werebased in North India.

investments supply ltd. National small industries corporation

supplies machinery ssi

These companies were set up in the 1920s

and 1930s.

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Development of Hire-purchase - two forms:

Consumer durables and

Automobiles Consumer durables hire-purchase was

promoted by the dealers in the respective

equipment.

Singer Sewing Machine company, orMurphy radio dealers - instalment facilities

on hire-purchase basis

Hire-purchase of commercial

vehicles developed very fast.

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UNTING

ASPECTS

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TAXATION ASPECTS

INCOME TAX HIRER: CB of direct taxes 1943- Entitled to

the tax shield on depreciation.

Tax shield on consideration for hire i.e,finance charge (hire charges).

INCOME TAX HIRE VENDOR:

The hire charges - is liable to tax underthe head profits & gains of business &

profession.

SALES TAX:

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SALES-TAX:

Hire-purchase transactions are liable to

sales tax. The sales tax is payable oncethe goods are delivered by the owner to

the hirer.

INTEREST-TAX:

The hire-purchase finance companies,

have to pay interest-tax under the

Interest-Tax Act, 1974. According to this

Act, interest tax is payable on the total

amount of interest earned.

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ACCOUNTING & REPORTING

ASPECTS OF HIRING

Risks & rewards are transferred to the

hirer at the inception of the transaction

No accounting standard/guidelines notefor accounting treatment in india/no law

/regulation to govern HP Contracts

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IN THE BOOKS OF THE

HIRER Depreciation claim based on cash

purchase price - policy

Cash purchase price of the asset is

capitalized ---cpp - down paymentliability

Total charge for credit is allocated over the

hire-period effective rate of interestmethod, sum-of the years-digitsmethod/straight line method.

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IN THE BOOKS OF HIRE-

VENDOR(FIN CO)

HP installment as current asset (stock on

hire) & unearned fin component of these

installments as current liability unmatched

finance charges

End of each accounting period appropriate

part of Unmatured finance income

recognised as current income Direct costs structuring of the transaction

expensed immediately/allocated against

finance income over the hire-period

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HIREPURCHASE - concept

Hire-purchase agreement is defined aspeculiar kind of transaction in which

goods are let on hire with an option to

the hirer to purchase them. The purchase price is to be paid in

installments can purchase by paying

all the installments.

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Stipulations

Payment to be made in installments over aspecified period.

The possession is delivered to the hirer at the

time of entering into the contract.

The property in the goods passes to the hirer on

payment of the last instalment.

If default is made in payment of any instalment,

the seller becomes entitled to take away thegoods.

The hirer is free to return the goods without

being required to pay any further installments.

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MODUS OPERANDI

The finance (hire-purchase) companypurchases the equipment from the

equipment supplier and lets it on hire to

the hirer.

The hirer is required to make a down

payment of, say 20-25% of the cost &

pay balance with interest in EMIs.

Alternatively, the hirer has to invest an

equivalent amount on fixed deposits

with the finance company.

L Fi i

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Lease Financing

Vs Hire-purchase Financing

Ownership

Depreciation

Magnitude

Extent of financing

Maintenance

Tax Benefits

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LEGAL FRAMEWORK

There is no exclusive legislationdealing with hire-purchase

transactions in India. The Hire-Purchase Act was passed in

1972, however, the Act has not beenenforced so far.

In the absence of any specific law,the hire-purchase transactions aregoverned by the provisions of the

Indian Contract Act & the Sales of

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The hire-purchase transaction has two

aspects:

An aspect of bailment of goods which iscovered by the Contract Act.

An element of sale when the option of

purchase is exercised by the hirer whichis covered by the Sales of Goods Act.

FINANCIAL EVALUATION

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FINANCIAL EVALUATION

OF HIRE-PURCHASE

POINT OF VIEW OF THE HIRER:

The evaluation of hire-purchase

transaction from the hirers angle, has tobe done in relation to leasing alternative.

Decision-Criterion:

The decision-criterion from the point ofview of a hirer is the cost hire-purchasevis-a-vis the cost of leasing.

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COST OF HIRE-PURCHASE COST OF

LEASING

Down payment Lease Mgt Fee

+ Service charges + Lease payments

+PV hire charges - PV of tax shield on - PV of depreciation lease payments

tax shield - PV of tax

- PV of net salvage shield on expenses

value

F th Vi i t f Hi

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From the Viewpoint of Hire-

Vendor

Hire-purchase & leasing represent twoalternative investment decisions of ahire-vendor.

The decision-criterion, is based on acomparison of the NPVs of twoalternatives.

The alternative with a higher NPV wouldbe selected.

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NPV OF LEASE PLAN

PV of lease rentals

+ Lease Mgt Fee

+ PV of tax shield on depreciation + PV of net salvage value

- Initial Investment

- Initial Direct costs - PV of tax liability on lease rentals &

lease Mgt fee

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END OF UNIT III

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REEFERENCES

Financial services : M Y KHAN

Emerging Scenario of Financial services

: GORDON AND NATARAJAN http://www.firstleasingindia.com/ourhisto

ry.asp

EVOLUTION OF

http://www.firstleasingindia.com/ourhistory.asphttp://www.firstleasingindia.com/ourhistory.asphttp://www.firstleasingindia.com/ourhistory.asphttp://www.firstleasingindia.com/ourhistory.asp

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EVOLUTION OF

LEASING

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EVOLUTION OF LEASING

1. LEASING ACTIVITY WAS INITIATEDIN INDIA IN 1973.

2. THE FIRST LEASING COMPANY OFINDIA, NAMED FRIST LEASINGCOMPANY OF INDIA LTD. WAS SET

UP IN THAT YEAR BY FAROUK IRANI,WITH INDUSTRIALIST A C MUTHIA.

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Contd

3. FOR SEVERAL YEARS, THIS COMPANYREMAINED THE ONLY COMPANY IN THECOUNTRY UNTIL 20th CENTURY FINANCE

CORPORATION WAS SET UP- THIS WASAROUND 1980.4. FROM 1981, THE TRICLE STARTED AND

SHETTY INVESTMENT ANDFINANCE,JAYABHARAT CREDIT AND INVESTMENT,

MOTOR & GENARAL FINANCE, ANDSUNDARAM FINANCE ETC. JOINED THELEASING GAME.

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Contd.

5. THE INDUSTRY ENTERED THE THIRDSTAGE IN THE GROWTH PHASE IN LATE1982, WHEN NUMEROUS FINANCEAL

INSTITUTIONS AND COMMERCIAL BANKSEITHER STARTED LEASING OR

ANNOUNCED PLAN TO DO SO. ICICI,PROMINT AMONG FINANCIAL

INSTITUTIONS, ENTERED THE INDUSTRYIN 1983 GIVING A BOOST TO THECONCEPT OF LEASING.

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Contd..

6. INTERNATIONAL FINANCECORPORATION ANNOUNCED ITS

DECISION TO OPEN FOUR LEASINGJOINT VENTURES IN INDIA.

7. BANKS THEMSELVES WERE ALLOWED

TO OFFER LEASING FACILITIES MUCHLATER IN 1994.

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THANK YOU