Hire Purchase System

Introduction

Definition
J.R.Batliboi : Under the hire purchase

system, goods are delivered to a person, who agrees to pay the owners by equal periodical installments, such installments to be treated as hire of those goods, until a certain fixed amount has been paid, when these goods become the property of the hirer.

Features of Hire Purchase

Payment is made in installments.

Right to use the goods by buyer.

Seller remains the owner of the goods. Default made in payment of installments.

Right to recover the goods.

Forfeiture of installment made. Right to sue for the O/S installment. Duty to take reasonable care of goods delivered. Better title.

Advantages of Hire Purchase

Advantages to hirer Use of expensive goods possible, easy payment, encouragement to saving, Facility of free repairs

To seller Increase in sale, possibility of sale of other goods, facility of getting capital at lower rate.

Disadvantages
To hirer Costly, risky for hirer, no right to sale the goods. To seller Large capital, difficulty in repossession of goods, more expenses for accounting, loss on sale of goods.

Financial Evaluation
From the view point of hirer In a hire purchase deal, the hirer is entitled to claim depriciation and the deduction for the finance charges (interest) component of the hire installment. Decision criteria Hire purchase and lease financing

Cost of leasing and Hire Purchasing

Cost of H.P.
1.
2. 3. 4. 5.

Down payment Plus service charges Plus P.V of hire purchase payment Minus P.V of depriciation tax shield Minus P.V of net salvage value

Cost of Leasing
1. 2.

3.

Lease management fee Plus P.V of lease payment Less P.V of tax shield on lease payment and lease management

From View Point of Hire Vendor

NPV of Hire Purchase Plan
1. 2.

3.
4. 5.

6.
7.

P.V of H.P installment Plus documentation and service fee Plus P.V of tax shield on initial direct cost Less loan amount Less initial cost Less P.V of income tax on finance income (interest) Less P.V of income tax on documentation and service fee

NPV of Lease Plan

1. P.V of lease rental

2. Plus lease mgt fee

3. Plus P.V of tax shield on initial direct cost

4.
5. 6. 7.

and depriciation Plus P.V of net salvage value Less initial investment Less initial direct cost Less P.V of tax liability on lease rental and lease management fee.

Taxation Aspects
Three aspects of H.P transactions

Income tax, sales tax, interest tax

1.

Assessment of hire purchaser

Tax shield on depriciation calculated with reference to cash purchase price Tax shield on the consideration for hire.

2.

Assessment of hire vendor

The consideration for hire / income received by the hire vendor is liable to tax under the head profit and gains of business and profession.

Sales Tax and Interest Tax

Sales Tax
H.P though not sale in true sense, is deemed to be sale. Such

transaction are per se liable to sale tax. The sale tax is payable once the goods are delivered by the owner to the hirer even If the transaction does not covert into a sale. There is no provision of refund of sale tax on the unpaid installments. A hire purchase deal is regarded as sale immediately the goods are delivered and not on the transfer of the title to the goods.

Interest tax
Interest tax is payable under the interest tax act, 1974.

Interest tax is payable on the total amount of interest earned less bad

debts in the provision year @ 2%.

Problem
A ltd. Company is interested in acquiring the use

of an asset costing Rs. 1 Lakh. It has two option to purchase the asset on hire purchase basis at 20% cash down payment and remaining amount in 4 equal installments with 10% interest or to take on lease the asset for a period of 5 yrs at the year end rental of Rs. 30000. The tax is 50% and the depreciation is allowed on original cost basis at 20%. The asset will have Rs. 40000 salvage value at the end of 5th year.
You are required to advise the company about lease or buy decision.

Note
The present value of Rs. 1 at 10% discount

factor is : 1st year 2nd year 3rd year 4th year 5th year

.909 .826 .751 .683 .621