UNIT III

LEASING AND HIRE PURCHASE

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-

LEASING
Contractual agreement Owner of an asset grants the right Use the asset to other party Receiver of the services of asset Under lease contract

lessor
Seller, supplier, fin co, manu Claims depreciation on the asset

lessee
Individual,company,firm Periodic payment- lease rental

Lease renting of an asset for some specified period

MEANING - LEASING
Divorce of ownership from the economic use of an asset/equipment Device of financing(money lending) the cost of an asset/capital asset Fund based service Lending of funds/finance/credit

CONCEPT OF LEASE

JAMES C.VAN HORNE DEFINED: Lease is a contract whereby the owner of an asset (lessor)grants to another party (lessee) the exclusive right to use the asset usually for an agreed period of time in return for the payment of rent. LEASING Is a process by which a firm can obtain the use of certain fixed asset for which it must make a series of contractual periodic tax-deductible payment (lease rentals)

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.

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.

CLASSIFICATION OF LEASING

Financial Lease & Operating Lease

Sale & Leaseback & Direct Lease Single investor Lease & Leveraged lease Lease

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

FINANCIAL LEASE

The lessor transfers to the lessee, substantially all the risks & rewards incidental to the ownership of the asset whether or not the title is eventually transferred.- IAS -17

Also known as Capital lease, long term lease, net lease and close lease, Full payout leases Approach to economic life

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 asset at a price - sufficiently lower than the fair market value . The lease term - major part of the useful life of the asset. The lessee is responsible - maintenance of the asset - for insuring it against accidental damage or loss. The risk of Damage is shifted from the lessor to the lessee.

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

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

DISTINCTION BETWEEN A FINANCIAL LEASE & OPERATING LEASE FINANCIAL

Installment loan Taxes & maintenance lessee Risk of obsolescence lessee Contract period medium long term Contract non-cancellable Air crafts, land , building..
Lessor fulfills financial function

OPERATING LEASE
Rental agreement Taxes & maintenance lessor Risk of obsolescence Lessor Ranges form intermediate short term Cancellable Computers, office equipment,Taxi,mobile cranes Service function

SALE & LEASEBACK

The owner of an equipment/asset sells (Mkt value)it to a leasing company (lessor) which leases it back to the owner (lessee).

The leaseback arrangement - in the form of buildings, a finance lease or industrial an operating Retail stores, office multipurpose building, shopping centre lease.

DIRECT LEASE
TWO TYPES: BIPARTITE LEASE equipment supplier cum lessor & lessee (operating lease) upgrade lease, swap lease TRIPARTITE LEASE: equip supplier, lessor, lessee sales aid lease

SINGLE INVESTOR LEASE (Two parties)

The leasing company (lessor) funds the entire investment by raising. The debt funds raised by the leasing company are without recourse to the lessee.

Leveraged Lease (3 parties)

HUGE CAPITAL LAYOUT & ECONOMIC LIFE - 10 YRS OR MORE

borrowing a large chunk of the investment with full recourse to the lessee & without any recourse to it.
LEASING COMPANY

Lessor
Equity investor

Trustee

Leases the Equipment

Lessee

Loan participant

Aircraft, ships etc..

Domestic Lease VS International Lease

Domestic lease :All the parties to the transaction are domiciled in the same country. International lease: All parties to the lease transaction are domiciled in different countries.

IMPORT LEASE- Lessor and lessee domiciled in same country, supplier in different country CROSS-BORDER LEASE: Lessor and lessee are domiciled in different countries, supplier in any country - Involve Country risk & currency risk

LEASE RELATED RISKS

(Borne by the lessor)
Default risk Residual value risk Interest rate risk Purchasing Power risk Currency & Cross-border risk

ADVANTAGES OF LEASING
To the lessee: 1. 100% Financing of Capital Good 2. Flexibility & convenience - structuring of rentals, terminating 3. Avoids conditionality's 4. Simplicity 5. Tax Benefits revenue expense 6. Permit alternative use of funds 7. 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 employed 12. Enhanced liquidity 13. No floatation costs 14. No disposal problem 15. Lesser administrative and maintenance costs 16. Off the balance sheet transaction

ADVANTAGES
To
1. Full

the Lessor:

security 2. Tax Benefit depreciation-reduce tax liabilities 3. High Profitability 4. Quick returns 5. Increased sales

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 debt financing Understatement of lessee's asset

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.

FACTORS CONSIDERED BUY/LEASE

Availability of funds Financial evaluation Possession of asset Cost of Borrowing Depreciation Taxes Salvage Value Risk Maintenance

PRIVATE SECTOR: Pure leasing companies/Independent Hire Purchase and Finance companies: tax adv Subsidiaries of manufacturing group companies Vendor leasing, in-house leasing/captive PUBLIC SECTOR: Leasing divisions of financial institutions: IFCI,ICICI all india, state level Subsidiaries of public sector banks: Commercial banks 94-95year onwards Other public sector leasing organisation: Bharat electronics ltd, Hindustan packaging company limited, ECIL sell equipment through leasing

PROFILE/STRUCTURING OF LEASING IN INDIA

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

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.

Sale & Lease back type of transactions are rare. Most of them are direct lease Equipment leasing covers a wide range of equipments from industrial plant & machinery, office equipments, vehicles etc. - standby finance.- <100 lakhs Project leasing is being attempted only on a limited scale exclusively by ILFS. Cross-border are not popular

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

SPECIAL PROVISIONS: The provisions of the Indian Contract Act, 1872 SECTION 148, relating to bailment are applicable to leasing transactions

Leasing as a Bailment Agreement

There are two parties to a bailment agreement, ie, bailor who delivers the goods & bailee to whom the goods are delivered 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).

The goods in bailment should be transferred for a specific purpose under a contract. purpose to make use of economic life of asset. When the purpose is accomplished, the goods are to be returned to the bailor or disposed off acc. to his directions

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

LIABILITIES OF LESSOR/BAILOR
Delivery of goods Peaceful possession Fitness of goods To disclose all defects

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 directons Other act/laws indian stamp act Lease documentation and agreement

FINANCIAL EVALUATION OF LEASING

The objective of evaluation is:

To identify

Lessee - The source of finance &

Lessor - Better investment alternative .

Lessees Perspective
LEASE Evaluation

Investment decision Purchase the asset

Financing decision 1. Should the asset be funded with debt? 2. Should the asset be funded with debt & equity? 3. Should it be leased?

Choice between Debt 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 isshould NPV/NAL. If the NPV/NAL is +ve, the leasing alternative be used,

otherwise the borrowing alternative would be preferable.

PROCEDURES
NPV/NAL PV OF CASH OUTFLOWS BERL GROSS YIELD ADD-ON YIELD IRR BASED PRICING

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)

Computation of NPV(L)/NAL(net Adv. of leasing)

Lease the equipment if NAL is +ve Buy the equipment if NAL is -Ve
Kd pre-tax cost of long term debt Kc - post tax marginal cost of capital

ALTERNATIVE APPROACH BUY/LEASING

To determine the PV of the cash outflows after taxes under the leasing & the borrowing alternatives.

The decision criterion: Select the alternative with the lower PV of cash outflows.

BREAK EVEN LEASE RENTAL

The BELR is the rental at which lessee is indifferent between lease financing/borrowing & buying. BELR has NAL as zero. It reflects the maximum level of rental which the lessee would be willing to pay.

LESSEE

If the BELR exceeds the actual lease rental, the lease proposal, would be accepted, otherwise rejected.

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.

The NAL to a lessor: PV of Cash Inflows PV of Cash Outflows

CASH OUTFLOWS: Initial Investment Income tax on lease rentals Sales-tax on lease transactions Administration expenses CASH INFLOWS: Lease rentals Management fee Tax shield on depreciation Residual value Security deposit if any

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 the lessee sets the upper limit of the range. The actual rental has to be negotiated within the range.

NEGOTIATING LEASE RENTALS

A rental within the range implies a +ve NAL both for the lessor & the lessee.

GROSS YIELD
Used as the basis for pricing a lease. The gross yield of a lease can be defined as the compound rate of return that equates PV (lease rentals) + PV (Residual value) to investment cost.

If gross yield is higher than the required yield, the lessor can consider accepting the proposal

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 the lease period. The add-on yield is not a true measure.

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 if the IRR exceeds the required rate of return.

TAX ASPECTS

Income tax provisions:

Lessee : lease rentals as tax- deductible expenses Lessor: Lease rental are taxable Profits & gains of business or profession investment allowance/depreciation on the investment

SALES TAX PROVISIONS

The lessor is not entitled confessional rate CST use/resale 46th amendment act (Under purview of sale ) - ST

ACCOUNTING TREATMENT OF LEASE

Lessor :
The leased asset is shown on the balance sheet Depreciation and other tax shields Lease rental income lessor

Lessee: Lease rental - expense

IAS International accounting standard, 17- 1982

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

HISTORY OF HIREPURCHASING

Evolution

U.K, Henry moore- paino maker 1846 U.S.A furniture dealer 1807 In India for more than 6 decades. The first hire-purchase company is believed to be Commercial Credit Corporation. - Madras Motor and General Finance and Instalment Supply Company were based in North India. investments supply ltd. National small industries corporation supplies machinery ssi

These companies were set up in the 1920s and 1930s.

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, or Murphy radio dealers - instalment facilities on hire-purchase basis

Hire-purchase of commercial vehicles developed very fast

TAXATION,ACCO UNTING ASPECTS

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 under the head profits & gains of business & profession.

SALES-TAX: Hire-purchase transactions are liable to sales tax. The sales tax is payable once the 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.

ACCOUNTING & REPORTING ASPECTS OF HIRING

Risks & rewards are transferred to the hirer at the inception of the transaction No accounting standard/guidelines note for accounting treatment in india/no law /regulation to govern HP Contracts

IN THE BOOKS OF THE HIRER

Depreciation claim based on cash purchase price - policy Cash purchase price of the asset is capitalized ---cpp - down payment liability Total charge for credit is allocated over the hire-period effective rate of interest method, sum-of the years-digits method/straight line method.

IN THE BOOKS OF HIREVENDOR(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

HIRE PURCHASE - concept

Hire-purchase agreement is defined as peculiar 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.

Stipulations

Payment to be made in installments over a specified 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 the goods. The hirer is free to return the goods without being required to pay any further installments.

MODUS OPERANDI
The finance (hire-purchase) company purchases 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.

Lease Financing Vs Hire-purchase Financing

Ownership Depreciation Magnitude Extent of financing Maintenance Tax Benefits

LEGAL FRAMEWORK
There is no exclusive legislation dealing with hire-purchase transactions in India. The Hire-Purchase Act was passed in 1972, however, the Act has not been enforced so far. In the absence of any specific law, the hire-purchase transactions are governed by the provisions of the Indian Contract Act & the Sales of

The hire-purchase transaction has two aspects: An aspect of bailment of goods which is covered by the Contract Act. An element of sale when the option of purchase is exercised by the hirer which is covered by the Sales of Goods Act.

FINANCIAL EVALUATION OF HIRE-PURCHASE

POINT OF VIEW OF THE HIRER: The evaluation of hire-purchase transaction from the hirers angle, has to be done in relation to leasing alternative. Decision-Criterion: The decision-criterion from the point of view of a hirer is the cost hire-purchase vis-a-vis the cost of leasing.

COST OF HIRE-PURCHASE LEASING

COST OF

Down payment + Service charges +PV hire charges - PV of depreciation tax shield - PV of net salvage value

Lease Mgt Fee + Lease payments - PV of tax shield on lease payments - PV of tax shield on expenses

From the Viewpoint of HireVendor

Hire-purchase & leasing represent two alternative investment decisions of a hire-vendor. The decision-criterion, is based on a comparison of the NPVs of two alternatives. The alternative with a higher NPV would be selected.

NPV of Hire-Purchase
PV of hire-purchase installments + Documentation & service fee + PV of tax shield on initial direct costs - Loan Amount - Initial Cost - PV of interest tax on interest

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

END OF UNIT III

REEFERENCES
Financial services : M Y KHAN Emerging Scenario of Financial services : GORDON AND NATARAJAN http://www.firstleasingindia.com/ourhisto ry.asp

EVOLUTION OF LEASING

EVOLUTION OF LEASING
1.

2.

LEASING ACTIVITY WAS INITIATED IN INDIA IN 1973. THE FIRST LEASING COMPANY OF INDIA, NAMED FRIST LEASING COMPANY OF INDIA LTD. WAS SET UP IN THAT YEAR BY FAROUK IRANI, WITH INDUSTRIALIST A C MUTHIA.

Contd
3.

4.

FOR SEVERAL YEARS, THIS COMPANY REMAINED THE ONLY COMPANY IN THE COUNTRY UNTIL 20th CENTURY FINANCE CORPORATION WAS SET UP- THIS WAS AROUND 1980. FROM 1981, THE TRICLE STARTED AND SHETTY INVESTMENT ANDFINANCE, JAYABHARAT CREDIT AND INVESTMENT, MOTOR & GENARAL FINANCE, AND SUNDARAM FINANCE ETC. JOINED THE LEASING GAME.

Contd.
5. THE INDUSTRY ENTERED THE THIRD STAGE IN THE GROWTH PHASE IN LATE 1982, WHEN NUMEROUS FINANCEAL INSTITUTIONS AND COMMERCIAL BANKS EITHER STARTED LEASING OR ANNOUNCED PLAN TO DO SO. ICICI, PROMINT AMONG FINANCIAL INSTITUTIONS, ENTERED THE INDUSTRY IN 1983 GIVING A BOOST TO THE CONCEPT OF LEASING.

Contd..
6.

7.

INTERNATIONAL FINANCE CORPORATION ANNOUNCED ITS DECISION TO OPEN FOUR LEASING JOINT VENTURES IN INDIA. BANKS THEMSELVES WERE ALLOWED TO OFFER LEASING FACILITIES MUCH LATER IN 1994.

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