LEASE AND HIRE-LEASE AND HIRE-PURCHASE FINANCEPURCHASE FINANCE

LEARNING OBJECTIVESLEARNING OBJECTIVES• Trace leasing industry evoluation• Give the nature of leasing and elements of leasing• Explain the Mechanism of leasing• Explain the different types of leasing• Distinguish between financial lease and operating lease• List advantages of leasing• Discuss aspects of leasing• Know evaluation of lease proposal• Give the nature of hire puchase• Give the contents of HP agreement• Distinguish between HP and leasing• Know evaluation of HP proposal

Leasing IndustryLeasing Industry• Originated in Western Countries• USA is the 3rd largest country with 1/3 of business investment• Leasing activity in India was initiated in 1973• In 1973 “First Leasing Company of India Ltd.” established, by

Farock Irani• Second stage started in 1981• Third stage started in 1982• On 31.3.1986 there were 399 equipment leasing companies

Meaning and Essential Elements of Meaning and Essential Elements of LeasingLeasing

Lease: A contract where lessor provides asset and gives the right to use asset to lessee, in return for a number of specified payments

• Essential Elements:

– Two parties

– Period of lease

– Asset

– Lease rent

Mechanics of Lease

Types of LeasesTypes of Leases

Distinguish between Financial and Distinguish between Financial and Operating LeaseOperating Lease

Point of Difference Financial lease Operating lease

1. Term

2. Cancelability

3. Lease period

4. Transfer of all risks and returns

5. Maintenance Insurance and taxes

6. Asset selection

7. Lease capitalization

Long-Term

Non-cancelable

Equals t life of the asset

Substantially transfers

Payable by lessee

Selected by lessee

In the books of lessee

Short-Term

Cancelable

Less than the life of the asset

Does not transfer substantially

Payable by lessor

Selected by lessor

In the books of lessor

Advantages of Lease FinanceAdvantages of Lease Finance•Conserve capital•100 per cent finance•Free up capital•Saves Bank line of credit•Benefit of tax shield•Convenience•Custom tailored to lessee needs•Low risk of obsolescence•Expeditious implementation•No ownership dilution

Lease AgreementLease Agreement

• Lease agreement has to fulfill the requirements of agreement

Tax provisionsTax provisions

• Lease attracts sales tax

• Lessor eligible to claim depreciation

• Entire lease rent is taxable for lessor

• Lessee can show lease rent as expense in P&L Account

Accounting Treatment of Lease Accounting Treatment of Lease [operating lease][operating lease]

• In Lessor Books: Asset shown in asset side; lease rent treated as income; depreciation claimed by lessor

• In Lessee Books: Asset is off-balance sheet; not eligible to deduct depreciation; lease rent is shown as expense in P&L Account

Accounting Treatment of Lease Accounting Treatment of Lease [Financial lease][Financial lease]

• In Lessee Books: Asset is shown in lessee balance sheet; lease rent is split into principal and interest; asset is depreciated in the books of lessee

• In Lessor Books: Asset is not shown in lessor books, only lease rent is shown as income

Lease Evaluation [Lessor’s view pointLease Evaluation [Lessor’s view point]]

I. Based on NPVII. Based on IRR

Lease Rent DeterminationLease Rent Determination

Minimum Cost need to be ered

PVIFA k n

Recov

.

Post Tax Equivalent Annual Cost

Tax Rate1

1. Calculation of cash outflows (Cost of asset)2. Calculation of benefits (cash inflows) arising from ownership of an asset.3. Computation of PV of benefits calculated in step 1.4. Calculation of minimum cost (amount) to be recovered through lease rentals (i.e cost of asset less benefits computed in step 1.)5. Calculation of post tax equivalent annual cost

6. Adjust post tax equivalent annual cost for the tax factor [i.e., tax need to be paid on receipt lease rental]

The last step gives the lumpsum amount of lease rental need to be collected. But some times lease rentals may be expressed per thousand basis.

Lease Evaluation [Lessee’s view point]

• The lease-versus-buying decision involves use of capital budgeting techniques. Evaluation of lease proposal as a financing decision involves the following four steps:Step 1: Calculation of after – tax cash outflows for each year under lease

option;Step 2: Calculation of after – tax cash outflows for each year under buying

option;Step 3: Calculation of PV of cash outflows of lease (step 1) option and buying (step 2) optionStep 4: Select an option which is coming with less PV of cash outflows.

• Decision Rule:Buy the Asset: If PV of cash outflows of buying option is less than leasing option.Lease the Asset: If PV of cash outflows of buying option is higher than leasing option.

Equivalent Loan MethodEquivalent Loan Method

• Equivalent Loan Method: Amount of loan can be served with lease cash outflows

Hire-purchase Finance EvolutionHire-purchase Finance Evolution

• Developed in UK

• Now found in India; Australia; New Zealand

• Commercial Credit Corporation is first company in India

Meaning and Essentials of HPMeaning and Essentials of HP

• Hire purchase is a conditional sale of contract.

• Essentials:

– Owner (hirer)

– User (hirer)

– Asset

– HP installment

Contents of Valid HP agreement

• A clear description of the goods

• The cash price of the goods

• The HP price

• The deposit

• The monthly installments

• Comprehensive statement of the parties rights

Hirer’s Rights and ObligationsHirer’s Rights and ObligationsRights: • To buy goods at any time by giving notice• To return the goods to the buyer• With consent of owner assign burden and benefit to third party• Recover the goods plus damages for loss if owner wrongfully

repossesses the goodsObligations:• To pay the hire installments• To take reasonable care of the goods• To inform the owner where the goods will be kept

Owner’s RightsOwner’s Rights

• To forfeit the deposit• To retain the installments already paid and recover the balance

due• To repossess the goods• To claim damages for any loss suffered

Distinguish between HP and Lease

Point of Difference HP Lease

Ownership transfer Transferred after the payment of last installment

Never transferred

Depreciation claim for tax purpose Hirer entitled to claim depreciation for tax purpose

Complete lease rent is allowed for tax deduction

Tax benefit Only interest component in Hire purchase installment is allowed tax deduction and not portion of principle amount

Complete lease rent is allowed for tax deduction

Benefit of scrap value Hirer can enjoy the benefit of scrap value

Lessee cannot enjoy the benefit of scrap value, because he/she is not the owner of asset

Amount of finance Relative low when compared to leasing Huge amount is involved

Maintenance of the asset Hirer has to spent money on maintenance

If the lease is finance lease, lessee pays maintenance cost, otherwise lesser pays maintenance cost

Tax and Accounting Treatment of HPTax and Accounting Treatment of HP

HP transactions are attracted to sales tax Accounting treatmentHirer Books: • The asset part on balance sheet• The liability on the liability side• HP installment-interest component is shown is expense in P&L Account• Principal amount deducted from asset• Hirer is allowed to enjoy tax benefit on depreciationHiree Books:• Interest charge is shown as income• Amount spent on HP agreement is treated as expense

Determination of HP InstallmentDetermination of HP Installment• HP installment: Equals to principal amount plus

total interest dividend by number of installments

Pr incipal Amount Total Interest Over Installment Period at Flat Rate

Number of Installments

HPI =

Split of HP Installment into interest and Split of HP Installment into interest and principal amountprincipal amount

• There are three methods available in vogue:1. Straight line splitting [equally on the tenure of hire)2. Sum-of-Digits or Sum-of-Values-Digits [in proportion to the

number of installments or the value of installments (unequal installment are) outstanding

3. Capital Recovery Method (Repayment of a part of capital)

Leasing vs. HPLeasing vs. HP

• For evaluation of leasing and HP option companies (user of asset) need to calculate PV of net cash outflows, and decide the option that involves less net cash out flow. Thus there are three steps involved in evaluation of Lease vs HP

1. Estimation of post tax cash flows associated with leasing as well as HP option

Leasing: Post Tax Cast Flows = Post Tax Lease Rental : Lease Rent (1-tax rate)HP: Post Tax Cash Flows = Post – Tax Interest + Principal Amount – Tax Benefit on Differentiation

: I(1-t) – PRt + Dt(t) 2. Calculation of PV of post tax cash associated with leasing as well as

HP: Here companies need to use cost of debt (Kd) as discounting rate. 3. Choose the option which has a lower PV of cash outflows.