Lease purchase and Hire purchase

Presented by:Group 5- 411,412,413,516,517,518

Lease purchase
Rental agreement extending for year and more and has series of fixed payments. Alternative to buying Involves two parties-Lessee-user Lessor-owner (IBM)

Lessors-banks, Leasing companies(GE capital aviation services)

Lease contract
Legal contract enforceable to both the parties. Names of the parties of the agreement. The starting date and duration of the agreement. Identifies the specific object being leased.

Specifies payment patterns

Provides options-purchase or take out new lease

Types of leases
Operating lease Financial lease types

Rental lease(full service)

Net lease

Direct lease

Sale and lease back

Leveraged lease

Advantages of lease
Leasing balances usage and cost Leasing provides fixed rate financing

Leasing increases purchasing power

Tax shields can be used. Leasing provides options

Disadvantages of lease
No Ownership

Long Term Expense

Maintenance

FINANCIAL LEASE

A finance lease or capital lease is a commercial arrangement where: the lessee (customer or borrower) will select an asset (equipment, vehicle, software); the lessor (finance company) will purchase that asset; the lessee will have use of that asset during the lease; the lessee will pay a series of rentals or instalments for the use of that asset; the lessor will recover a large part or all of the cost of the asset plus earn interest from the rentals paid by the lessee; the lessee has the option to acquire ownership of the asset (e.g. paying the last rental, or bargain option purchase price)

Impact on accounting
working capital decreases, but the debt/equity ratio increases, creating additional leverage.
In a statement of cash flows, part of the lease payments are reported under operating cash flow but part under financing cash flow. Therefore, operating cash flow increases.

EXAMPLE
Blueline Bus Lines is considering a lease. Your operating manager wants to buy a new bus for Rs.46 lakhs. The bus has an 8 year life. The Bus Saleswoman says she will lease Blueline the bus for 8 years at Rs.7.83 lakhs per year, but Blueline assumes all operating and maintenance costs. Should Blueline Buy or Lease the bus?

Cash flow consequence of the lease contract offered to Blueline Bus:

 Blueline Bus can borrow at 10%, thus the value of the lease should be discounted at: .10 x (1-.3366)= 6.634%.

Blueline Bus Lines lease cash flows can also be thought of as loan equivalent cash flows.

NPV= 40.80-40.86 = -0.06 lakhs

Value of lease for lessor

906.53 809.76 737.18 NPV lease = 4080.56 2 1.06634 (1.06634) (1.06634)3 682.75 641.92 611.3 795.02 (1.06634) 4 (1.06634)5 (1.06634)6 (1.06634)7 6.24 or Rs.6.24 thousands

The lessor can only win on lessee expense

Other Types of leases

Capital Lease

(a) ownership at the end of the lease term; (b) the asset at a bargain price; (c) the lease term is equal to 75% or more of the estimated economic life of the property (d) the present value of minimum lease rental payments is equal to 90 % or more of the fair market value of the leased asset less related investment tax credits retained by the lessor.

 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.

Full payment 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 equipments future residual value.

 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.

Trac 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.

Blueline pays no tax

cost of new bus lease payment cash flow from lease 0 4600 -783 3817 1 -783 -783
7

2 -783 -783

3 -783 -783

4 -783 -783

5 -783 -783

6 -783 -783

7 -783 -783

783 Value of lease = +4600 - (1.1) t t=1 4600 - 4594.97 = +5.03, or Rs.5.03 thousands

Operating Lease

Operating Lease
An operating lease is similar to rent: it is for a stated portion of time (less than the useful life)

no ownership occurs from the relationship

rental costs are not directly associated with the acquisition cost of an asset

 Usually not fully amortized. This means that the payments required under the terms of the lease are not enough to recover the full cost of the asset for the lessor. Usually require the lessor to maintain and insure the asset. Term: operating lease term is significantly less than the economic life of equipment. Lessee enjoys a cancellation option. This option gives the lessee the right to cancel the lease contract before the expiration date.

Variety of lease plans

Variety of lease plans with differing add-ons or leave-outs by different lessors but broadly falling into two categories: Short term rentals . Long term cancellable leases. Full service leases Net, but cancellable leases

Features of an operating lease

Operating leases may not allow the asset to be virtually exhausted by the same lessee. Operating leases do not put the lessee in the position of a virtual owner. The lease is either fully cancellable or partly non-cancellable and partly cancellable. Operating leases are non-full-payout. The lessor may provide any services relating to the asset, such as maintenance, or operations. In such case, the lease is wet lease.

Example Page 706 Sriram Companys

Cost of vehicle (Limo) Other costs (op., insurance, maintenance etc) Useful life Net salvage value Depreciation rate Marginal tax rate Cost of capital Annual lease rental 3450 552

6 years 0 15% 33.66% 7% ?

Cash flows

All the figures are in thousands

Annual lease rental

1. Calculate the Present value of post tax cash flows =
NPV= CF0 + CF1/(1+r) +CF2/(1+r)^2 +CF3/(1+r)^3 CF4/(1+r)^4 + CF5/(1+r)^5+CF6/(1+r)^6 NPV= Rs 46.77 Lakhs

 Now Calculating the annual lease rental:

44.77= x + x/(1+0.07) +x/(1+.07)^2 +x/(1+0.07)^3 x/(1+0.07)^4 + x/(1+0.07)^5+x/(1+0.07)^6

X= Rs 9.17

Operating Vs. Finance Lease

HIRE PURCHASE

WHAT IS HIRE PURCHASE?

Hire purchase is a type of installment credit under which the hire purchaser, called the hirer, agrees to take the goods on hire at a stated rental, which is inclusive of the repayment of principal as well as interest, with an option to purchase.

What are the income tax implications in the case of a hire purchase?
In the hire purchase the hirer carrying business or profession gets benefit of depreciation. He can also claim deduction on the interest paid on hire charges, in his income tax assessment.

INDIAN CONTEXT- HIRE PURCHASE ACT 1972

1) The owner delivers possession of goods thereof to a person on condition that such person pays the agreed amount in periodic installments. 2) The property in the goods is to pass to such person on the payment of the last of such installments, and 3) Such person has a right to terminate the agreement at any time before the property so passes.

SC ARTICLE 7
SC=(NC*R*T)/100 NC (Net cash) R (Rate 18%or less) T (time between the date agreement is signed and last payment is due

SOLUTION
SC=(NC*R*T)/100 = (50000*18*5)/100=45000 HIRE PURCHASE CHARGES = 65000 + 45000 = 1,10000 BALANCE = 1,10000-15000 =95000

ARTICLE 9- When Hirer tenders a contract

R =(SC*M*(M+1))/(N*(N+1)) M= No Of Complete Months still remaining N=Total Number of months in the period R=Rebate SC=Statutory Cash Prize

SOLUTION
R =(SC*M*(M+1))/(N*(N+1)) R=(45000*24*25)/(60*61) 7377.05 Rs.

In case of breach
SC is hire purchase price is <5000 SC is 5000<HPP<15000 SC>= HPP>15000

Accounting treatment
At the inception of the transaction, the finance company should record the hire purchase installments receivables as current asset (i.e. stock on hire) the unearned finance income component of these installments as a current liability under the head unmatched finance charges

After end of Accounting Period

The hire purchase price less the installments received should be shown as receivable / stock on hire The finance income component of these installment should be shown as current liability / unmatched finance charge. The direct costs associated with structuring the transactions / deal should be either expensed immediately or allocated against the finance income over the hire period.

Cost Of Hire Purchase - HIRER

1. Down payment 2. + Service Charges 3. +Present value ofhirepurchasepaymentsdiscountedby the cost of debt. 4. Present value of depreciation tax shield discounted by cot of capital. 5. Presentvalueofnetsalvagevaluediscountedbycostof capital.

The NPV of HPP consist of

PVofhirepurchaseinstallments +Documentationandservicefee. +PVoftaxshieldoninitialdirectcost Loan amount Initial cost. PVofinteresttaxonfinanceincome(interest) PVofincometaxonfinanceincomemetedforinterest tax PVofincometaxondocumentationandservicefee.

HIRE PURCHASE & CONSUMER CREDIT

Consumer Credit
Includes all asset based financing plans offered to individuals. (eg. Cars, scooters,VCRs, TVs, Refrigerators, washing machines etc., personal computers.). Main supplier of consumer credit are Multinational Banks, commercial banks, Finance cos..etc

Consumer Credit...
Salient Features

Parties to the transaction : Bipartite arrangement - two parties viz borrower/consumer and dealer/financier. Tripartite Transaction - dealer, financier, and customer. The dealer arranges the credit from the financier. Structure of the transaction : Hire-Purchase , Conditional Sale , Credit Sale . Hire Purchase - Most tripartite consumer credit transactions are of this type. Customer option to purchase the asset on completion of the pay back period.

Consumer Credit ...

Conditional Sale : Ownership not transferred until full payment of purchase price, including the credit charge. The customer cannot terminate the agreement. Credit Sale : Ownership transferred to the customer on first instalment payment. But the agreement cannot be cancelled. Payment Period and ROI : Payment period - 12 -60 months. ROI - generally flat rate. Effective Rates generally not disclosed. Sometimes in place of ROI, the EMI for different payment periods is mentioned.

Consumer Credit ...

Security : First charge on assets. The consumer cannot sell the hypothecated asset. Evaluation Can be made with Effective Rate of Interest and rebates for early repayments.

Installment Credit Systems

A system of customer financing, whereby the payments of the purchase price is deferred, to be paid in reasonable installments is known as installment credit systems. Features: An ordinary sale of goods with easy payment system The buyer obtains ownership and possession on payment of the first installment Payment is made through a number of installment No possibilities of the article sold being returned to the seller, since sale is complete immediately after the execution of the agreement

Hire Purchase and installment system

Similarities: 1. They are forms of consumer finance for the sale of expensive and durable goods 2. They are recognized by the Indian sale of goods act 3. Recovery of the price is through installments spread over a fixed period of time Suitability: 1. Separate identity or individuality to facilitate their recovery when there is a default. 2. Durability to sustain the long period of installments and facilitate repossession in the event of a default 3. High enough value to justify a hire purchase agreement 4. Standard specifications to facilitate reselling , if necessary

Example: Sum of the Years Digits

Nidhi finance offers a hire purchase proposal to one of its customers, synthetic Chemicals, which requires an equipment costing Rs. 1 million on the following: 1. 2. A flat interest rate of 14% A hire purchase period of 36 months (3 Years)

 The total interest burden: Rs 1000000 * 0.14 * 3 = Rs. 420000 Total amount: Rs 1000000 + Rs. 420000 = Rs. 1420000 Monthly hire purchase installment (Rs.1000000 + Rs. 420000) / 36 = Rs. 39444 Every Year :
1420000 / 3 = Rs.473333

Allocating the interest burden of Rs 420000 over the three years as per the Sum Of The Years Digit Method.
1st Year: Interest: (12+11+10+..+1) / (36+35+34++1) = 78 / 666 = (78 / 666) * 420000 = Rs.49189

Principal Repayment : Rs.473333 49189 = Rs. 424144

2nd Year: Interest: (24+23+22++13 ) / (36+35+34++1)

=222/ 666 = (222 / 666) * 420000 = Rs.140000 Principal Repayment : Rs.473333 140000 = Rs. 333333

3rd Year: Interest: (36+35+34+..+25) / (36+35+34++1)

= 366 / 666 = (366 / 666) * 420000 = Rs.230811

Principal Repayment : Rs.473333 230811= Rs. 242522

Year

Hire purchase installment (Rs)

Interest (Rs)

Principal Payment (Rs)

1.
2. 3.

473,333
473,333 473,333

49,189
140,000 230,811

424,144
333,333 242,522

Lease vs. Hire

Basis
Meaning

Lease Financing
Commercial Arrangement, whereby an equipment, owner or manufacturer, conveys to the equipment user the right to the use equipment in return for a rental.

Hire Purchase
Type of instalment credit under which the hire purchaser agrees to take the goods on hire at a stated rental, which is inclusive of the repayment of principal as well as interest, with an option to purchase

Option to user Nature of expenditure Components

No option is provided to the Option is provided to the hirer lessee (user) to purchase the (user). goods. Lease rentals paid by the lessee Only interest element included in are entirely revenue expenditure the HP instalments is revenue of the lessee. expenditure by nature. Lease rentals comprise of HP instalments comprise 2 elements (1) finance of 3 elements (1) normal charge and (2) capital recovery. trading profit (2) finance charge and (3) recovery of cost of goods/assets.

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