29423156 leasing and hire purchasing

7/28/2019 29423156 Leasing and Hire Purchasing

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Leasing and Hire PurchasingRashmi Mehta 208

Ishan Modi 210Anshum Kawatra 308

Arpan Mehra - 309


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Leasing as Source of Finance

Leasing company finance for:Modernization of Business

Balancing equipmentCars, scooters and other vehicles anddurables

Items entitled to 100% of 50% depreciationoAssets which are not being financed by FIs.


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Types of Lease

Financial LeaseOperating Lease

Leverage LeaseSale and Lease backCross Border Lease


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Advantages of Lease

Permit alternative use of fundsFaster and cheaper credit

FlexibilityFacilitate additional borrowingProtection against obsolescence

Hundred percent financingBoon to small firm


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Financial Lease

Irrevocable and non-cancellable contractualagreement.

Lessee uses the asset exclusively for a relativelylonger period, maintains it, insures and avails of the after sales service and warranty backing it.

Lessee bears the risk of obsolescence as it standscommitted to pay for entire lease period.


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Contd .

Financial lease with the purchase option,where at the end of pre-determined period,the lessee has the option to buy theequipment / asset at a pre-determined value.

The leasing company / lessor charges nominalservice charges to lessee towards legal andother costs.


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Operating Lease

Contractual period between lessor and lessee isless than full economic life of equipment i.e.short-term in nature.

The lease is terminable by giving stipulated noticeas per the agreement.

The risk of obsolescence is enforced on the lessorwho will also bear the cost of maintenance and

other relevant expenses.


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Leverage Lease

Arrangement for assets of huge capital outlay.

Parties involved are (a) Lessor (Max. 20 50%stake) (b) Lessee (As in operational lease) (c)Lenders (Rest stake holders)

Lessor acquires the asset with maximum

contribution upto 50% and rest is financed bylenders secured by mortgage of the asset besidesassignment of leased rental payments.


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Sale and Lease Back

Arrangement where a firm which has an assetsells it to leasing company / lessor and gets itback on lease.

Lessee gets the sale price in the market value andgets the right to use the asset during the leaseperiod. T itle of the asset remains with the lessor.

Lease back agreements are on net basis i.e.lessee pays the maintenance, property tax andinsurance premium.


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Cross Border Lease

It is international leasing and is referredotherwise as transactional leasing.

Relates to lease transaction between differenta lessor and lessee domiciled in differentcountries.

Illustration:- Leasing company in USA makesavailable Air Bus on lease to Air India.


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D isadvantages of Leasing

Lease rentals are payable soon after enteringinto lease agreement while in new projectscash generation may start after gestationperiod.The cost of financing is higher than debtfinancing.

If the lessee defaults in payment, lessorwould suffer a loss.


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Legal Aspects of Leasing

Under Section 148 of Indian Contract Act leasingis executed.

The lessor has the duty to deliver the asset tolessee, legally authorizes lessee to use the asset.

The lessee has the obligation to pay the lease

rentals as per lease agreement, to protect lessor stitle, to take reasonable care of the asset, and toreturn the leased asset on the expiry of leaseperiod.


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Income Tax Provisions Relating toLeasing

The lessee can claim lease rentals as tax -deductible expenses.

The lease rentals received by lessor are taxableunder the head of Profits and Gains of Businessor Profession

The lessor can claim investment allowance anddepreciation on the investment made in leased

assets.


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Accounting Treatment of Lease

The leased asset is shown on the balancesheet of the lessor.

D epreciation and other tax shields associatedwith leased asset are claimed by the lessor.The entire lease rental is treated as an incomein the books of the lessor and expense in thebooks of lessee.


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Problems of Leasing

Unhealthy CompetitionLack of qualified personnel

Tax ConsiderationsStamp D utyD elayed Payments and Bad D ebts


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Calculation of Lease Payments

E.g. ABC leasing company is in the business of providing automobiles on wet lease to corporateclients. Centaur is considering a new model of Honda for which a serious enquiry has come fromXYZ enterprises. The vehicle cost is 1.2 million. It soperating maintenance and other cost is expectedto be 0.2 million. The car is expected to have auseful life of 5 years after which it will fetch a

salvage value of 0.4 million after that.T

hedepreciation rate is 40 % and marginal tax rate is35%. Centaurs cost of capital is 11%.


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Calculation ProcedureCalculate the present value of post-tax cash flows associated withthe cash flows associated with the ownership and operation of thecar. The post-tax cash flows associated with the car are shown intable. The present value of cash flows is Rs. 1.204 million.

Convert the present value obtained in step 1 into post taxequivalent annual cost (EAC). the post- tax EAC works out to:

PV of costs = 1.204 = Rs. 0.326 millionPVIFA 3.696

Adjust post tax EAC for tax factor to g et lease rentalLease rental = Post-tax EAC = 0.326 = Rs. 0.502 million

Tax rate 1 - 0.35


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0 1 2 3 4 5

Initial Cost -1.2Operating and other costs

- 0.2 -0.216 -0.233 -0.252 -0.272

Depreciation 0.48 0.288 0.173 0.104 0.062Tax shield on operatingcosts and depreciation 0.238 0.176 0.142 0.125 0.117

Net salvage value 0.400Post-tax cash flow

(1+2+4+5) -1.2 0.038 -0.04 -0.091 -0.127 0.245

Discount factor (at 11 %)1 0.901 0.812 0.731 0.659 0.593

Present Value -1.2 0.034 -0.032 -0.067 -0.084 0.145


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Other Considerations

ABC of course will have to charge an annuallease rental more than 0.502 million to cover

Cost of negotiating and administering the lease

contract periodically It as to forgo the revenues wen car is idle and off-

lease It as to bear the risk of diminishing appeal of the

car over a period of time


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Leasing v/s Buying

BUY asset if post-tax EAC of ownership andoperation is less than post-tax lease rentalLEASE asset if post-tax EAC of ownership andoperation is more than post-tax lease rentalIf you need the asset for a shot period - leaseit. On the other hand, if you need the asset fora long time buy itException - Lease for a longer period Economies of scale


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An operating lease offers valuable options to thelessee. For e. g. suppose ABC offers XYZ two proposals:

A one year lease for Rs. 0.520 million

A 5-year lease for Rs. 0.540 million with the option tocancel the lease any time after 1 year

Although the second proposal is costlier, it has someattractive features, if lease rates increase after oneyear, XYZ can continue at the old rate and if the leaserates decline, XYZ can cancel the lease and get a betterrate.


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Lease v/s Borrowed funds

Vitex ltd. has decided to go for a forklift forinternal transportation. It costs 10 million and hasan economic life of 6 years at the end of which itwill fetch a salvage value of Rs. 1 million. Theforklift will be depreciated at 40% and marginaltax rate is 35%. Vitex can borrow Rs. 10 million at15.4 % to buy the forklift. As a financial managerof vitex you have approached by anupam leasing

company who is willing to lease the forklift for Rs.2.4 million per year payable in arrear. Vitex willbear all the operating, maintainance, andinsurance expenses.


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If Vitex leases the fork lift the financial implications areas follows:

Vitex saves Rs. 10 million, the cost of the forklift. This isequivalent to cash inflow at the end of year 0.

Vitex not being owner of the forklift cannot claimdepreciation on it. Hence it loses the depreciation taxshield. Further Vitex does not get the salvage value at theend of 6 years.

Vitex must pay Rs. 2.4 million per year to Anupam leasing ,the first payment is due at the end of year 1.

T he lease payment of Rs. 2.4 million per year represents atax deductible expense generating a tax shield of Rs. 0.96million per year.


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0 1 2 3 4 5 6Initial Cost 10

Depreciation 4 2.4 1.44 0.86 0.52 0.31Loss of Tax shield

on depreciation

-1.4 -0.84 -0.5 -0.3 -0.18 -0.11

Lease Payment -2.4 -2.4 2-.4 -2.4 -2.4 -2.4Tax Shield on

lease payment0.84 0.84 0.84 0.84 0.84 0.84

Loss of salvage

value

-1.0

Cash flow 10 -2.96 -2.40 -2.06 -1.86 -1.74 -2.67

T he post-tax borrowing for Vitrex is equal to 15.4 x (1- 0.35) = 10%


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N PV, IRR and ELA

IRR

Since the lease has a negative N PV Vitex is better of buying the forklift from apurely financial point of view.

T herefore irr = 10.2 %

Since this figure is higher than the post-tax cost of debt (10 %) leasing is a costlier option.


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Equivalent Loan Amount


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HIRE-PURCHASE MET

HOD


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D efinition

Hire purchase is a type of instalment creditunder which the hire purchaser, called thehirer , agrees to take the goods on hire at astated rental , which is inclusive of therepayment of principal as well as interest ,with an option to purchase.


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FEA TURES

Hire Purchase is an agreement to hire an asset over a predefined

period with an option to purchase as the end of the agreement.

After all the payments have been made, the business customer

becomes the owner of the equipment.

Under hire purchase system, the buyer takes possession of goods

immediately & agrees to pay the total hire purchase price in

instalmentsIn case the buyer makes any default in payments of any instalments

the seller has right to repose the goods.


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FIN AN CIAL EVALUAT ION

STEPS involved in choosing between leasing and Hire-Purchase options are:-

1. Estimate the post tax cash flows associated with eachoption

a) Leasing- LRn(1-Tc)

a) Hire Purchase- In(1-Tc) PR n + D n(Tc) + N SVn

2. Calculate the present value of cash flows associated withthe two options. Choose the option which has lowerpresent value.


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FIN AN CIAL EVALUAT ION

COST of HIRIN G

- D own payment + service charges+ PV of hirepurchasepayments

PV of depreciation tax

shield

- PV of net

salvage value

COST of LEASIN G

- Lease managementfee

+ PV of leasepayments

PV of taxshield on lease

payments

+ PV of interesttax shield onhire purchase


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EXAMPLEQ. N armada finance offers a Hire purchase plan for corporate

borrowers

Rate of interest 13 % flat

Repayment 3 years monthly in arrear

D own payment 20 %

Calculate A PR (annual percentage rate) by trial error &approximation approach.

What would be the answer if payment is in advance.


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SOLUT ION

Amount of loan 800Total charge for credit 800 * 0.13 * 3 = 312Monthly installment (800 + 312) / 36 = 30.89(30.89 * 12 ) * PVIFA p (i,3) = 800

i / i12

* PVIFA (i,3) = 2.158

For i= 24 LHS = 2.191For i= 26 LHS = 2.143

i= 25.38

Approximate formula36/37 * 2 * 13 = 25.3%


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Solution Contd.

(30.89 * 12 ) * PVIFA p (i,3) = 800i / d 12 * PVIFA (i,3) = 2.158For i= 26 LHS = 2.185For i= 28 LHS = 2.141

i= 27.23%

Approximate formula36/35 * 2 * 13 = 26.74%


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LEA SE versus

HIRE PURCHA SE


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When Is Leasing A Good Option?

Leasing is a good option for businesses that needequipment for short periods of time.

For instance, you may require a special machine for a project.After the project, you will have no need for the machine.

In such cases, it would be more cost effective to lease themachine for the duration of the project instead of purchasing it.

Increasingly, many small businesses are beginning to leasecomputers, photocopiers and fax machines.N ot only does it help to reduce the upfront cash needed topurchase these items, but it also shifts the responsibilityand cost of maintenance and servicing to the supplier.


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When Is Hire Purchase A BetterOption?

Hire purchase is a better option when you needto use the equipment or asset frequently e.g.delivery vans.Hire purchase allows you to eventually own theequipment as opposed to purely renting theequipment.

In leasing, you can only rent the item if it isavailable. If your business depends on anequipment or asset, you cannot afford to lease.


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How Does A Lease Or Hire PurchaseA

ffect Taxes?When you lease , the costs of rental can be treated as businessexpenses.

When you take up a hire purchase , you are effectively purchasingthe asset. It is treated as a capital expenditure.

Both finance methods provide savings to offset against year-endtaxable profits. With HP , we can claim 25% of the equipment cash

price in the first year, then 25% of the balance in the second yearand this continues on a reducing balance basis each year.

With leasing , all the lease payments you make in the financial yearcan be offset against your taxable profits for that year


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D IFFEREN CEHIRE PURCHA SE LEA SE F INA NCE

SA LE

T he hirer has the option to purchase the goodsanytime during the term of the agreement. He also

has the right to terminate the agreement at anytimebefore payment of the last instalment.

SA LE

T he sale has already taken place, the goods havealready been delivered to the owner and the buyer

is bound to pay the full price.

OWN E RSHIPa) Ownership is passed to the hirer only if he

exercises the option to purchase.b) T he ownership of the equipment passes to the

hirer on payment of the last instalment.c) T he lessee, not being the owner of the asset,

does not enjoy the salvage value of the asset.

OWN E RSHIPa) Ownership is transferred to the purchaser on

payment of the first instalment.b) T he lessor company is the owner and the

lessee is entitled only to the use of theleased equipment.

c) T he hirer, being the owner of the asset, enjoysthe salvage value of the asset.

TAX BE NEF ITSHirer is allowed the depreciation claim

and finance charge and the seller may depreciationand lessee is allowed to claim rentals andmaintenance cost acquire the asset for tax

purposes.

TAX BE NEF ITST he lessor is allowed to claim depreciation and

lessee is allowed to claim any interest on borrowedfunds to claim rentals and maintenance cost.

Against taxable income.


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D IFFEREN CEHIRE PURCHA SE LEA SE F INA NCE

MA INTENA NCE

Cost of maintaining the hired equipment is tobe borne by the Lender.

MAINT EN AN CEM aintenance of the leased asset is the

responsibility of the lesse.

EX TENT20-25% of the cost of the equipment

is required to be paid by the hirer as downpayment.

EX TENTN o down payment is required from the lessee.

MA GNITUDET he magnitude of funds involved is relatively

low as compared to buying the asset.

MA GNITUDET he magnitude of funds involved is very

small.EXAM PLES

Automobiles, generators,office equipment etc. are usually

hire purchased.

EXAM PLE

Aircrafts, ships, machinery are taken onfinancial lease.


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When is it best to purchase a capitalasset by paying cash or by getting a

bank loan or by leasing?

DECIDE

(1) the type of asset the company needs(2) whether it is new or used(3) the purchase cost

(4) the amount of the down payment, if any(5) the length of finance term(6) the payment method/procedure/preference.


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If you are thinking about buying anasset with

A vailable cash , you should consider the availability of cash opportunity cost other investments available, tax benefits

obsolescence of the asset.Borrow to purchase the asset , you should consider

the amount of cash needed interest rate, term of a loan the tax benefits from interest and depreciation

Lease , you should consider the lease term interest rate change in technology residual value


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Procedure for choosing between hire

purchase and leasingStep 1 Estimate the post-tax cash flowsassociated with both the options

Step 2 Calculate the present value of cashflows associated with both the options andchoose the option which has a lower presentvalue.


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EXAMPLEN idhi finance in addition to hire purchase proposal, offersa lease proposalAsset value Rs. 1 millionPrimary lease period 5 yearsLease rentals Rs. 300 per 1,000 per yearSecondary lease period 5 yearsLease rental Rs. 12,000N et salvage value of the asset after 10 years Rs. 100,000

Post tax cost of debt 8%Tax rate 50 %D epreciation 33.5 %


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29423156 leasing and hire purchasing

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