Leasing and Hire Purchasing

Rashmi Mehta – 208Ishan Modi – 210

Anshum Kawatra – 308Arpan Mehra - 309

Leasing as Source of Finance

Leasing company finance for:• Modernization of Business• Balancing equipment• Cars, scooters and other vehicles and

durables• Items entitled to 100% of 50% depreciation• oAssets which are not being financed by FIs.

Types of Lease

• Financial Lease• Operating Lease• Leverage Lease• Sale and Lease back• Cross Border Lease

Advantages of Lease

• Permit alternative use of funds• Faster and cheaper credit• Flexibility• Facilitate additional borrowing• Protection against obsolescence• Hundred percent financing• Boon to small firm

Financial Lease

• Irrevocable and non-cancellable contractual agreement.

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

• Lessee bears the risk of obsolescence as it stands committed to pay for entire lease period.

Contd….

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

• The leasing company / lessor charges nominal service charges to lessee towards legal and other costs.

Operating Lease

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

• The lease is terminable by giving stipulated notice as per the agreement.

• The risk of obsolescence is enforced on the lessor who will also bear the cost of maintenance and other relevant expenses.

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 by lenders secured by mortgage of the asset besides assignment of leased rental payments.

Sale and Lease Back

• Arrangement where a firm which has an asset sells it to leasing company / lessor and gets it back on lease.

• Lessee gets the sale price in the market value and gets the right to use the asset during the lease period. Title of the asset remains with the lessor.

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

Cross Border Lease

• It is international leasing and is referred otherwise as transactional leasing.

• Relates to lease transaction between different a lessor and lessee domiciled in different countries.

• Illustration:- Leasing company in USA makes available Air Bus on lease to Air India.

Disadvantages of Leasing

• Lease rentals are payable soon after entering into lease agreement while in new projects cash generation may start after gestation period.

• The cost of financing is higher than debt financing.

• If the lessee defaults in payment, lessor would suffer a loss.

Legal Aspects of Leasing

• Under Section 148 of Indian Contract Act leasing is executed.

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

• The lessee has the obligation to pay the lease rentals as per lease agreement, to protect lessor’s title, to take reasonable care of the asset, and to return the leased asset on the expiry of lease period.

Income Tax Provisions Relating to Leasing

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

• The lease rentals received by lessor are taxable under the head of “Profits and Gains of Business or Profession”

• The lessor can claim investment allowance and depreciation on the investment made in leased assets.

Accounting Treatment of Lease

• The leased asset is shown on the balance sheet of the lessor.• Depreciation and other tax shields associated

with leased asset are claimed by the lessor.• The entire lease rental is treated as an income

in the books of the lessor and expense in the books of lessee.

Problems of Leasing

• Unhealthy Competition• Lack of qualified personnel• Tax Considerations• Stamp Duty• Delayed Payments and Bad Debts

Calculation of Lease Payments

E.g. ABC leasing company is in the business of providing automobiles on wet lease to corporate clients. Centaur is considering a new model of Honda for which a serious enquiry has come from XYZ enterprises. The vehicle cost is 1.2 million. It’s operating maintenance and other cost is expected to be 0.2 million. The car is expected to have a useful life of 5 years after which it will fetch a salvage value of 0.4 million after that. The depreciation rate is 40 % and marginal tax rate is 35%. Centaurs cost of capital is 11%.

Calculation Procedure• Calculate the present value of post-tax cash flows associated with the

cash flows associated with the ownership and operation of the car. The post-tax cash flows associated with the car are shown in table. The present value of cash flows is – Rs. 1.204 million.

• Convert the present value obtained in step 1 into post tax equivalent 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

0 1 2 3 4 5

Initial Cost -1.2 Operating 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 operating costs 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

Other Considerations

• ABC of course will have to charge an annual lease 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

Leasing v/s Buying

• BUY asset if post-tax EAC of ownership and operation is less than post-tax lease rental

• LEASE asset if post-tax EAC of ownership and operation is more than post-tax lease rental

• If you need the asset for a shot period - lease it. On the other hand, if you need the asset for a long time – buy it

• Exception - Lease for a longer period – Economies of scale

• An operating lease offers valuable options to the lessee. 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 to cancel

the lease any time after 1 year

• Although the second proposal is costlier, it has some attractive features, if lease rates increase after one year, XYZ can continue at the old rate and if the lease rates decline, XYZ can cancel the lease and get a better rate.

Lease v/s Borrowed funds

• Vitex ltd. has decided to go for a forklift for internal transportation. It costs 10 million and has an economic life of 6 years at the end of which it will fetch a salvage value of Rs. 1 million. The forklift will be depreciated at 40% and marginal tax rate is 35%. Vitex can borrow Rs. 10 million at 15.4 % to buy the forklift. As a financial manager of 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 will bear all the operating, maintainance, and insurance expenses.

• If Vitex leases the fork lift the financial implications are as follows:– Vitex saves Rs. 10 million, the cost of the forklift. This is

equivalent to cash inflow at the end of year 0.– Vitex not being owner of the forklift cannot claim depreciation

on it. Hence it loses the depreciation tax shield. Further Vitex does not get the salvage value at the end 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.

– The lease payment of Rs. 2.4 million per year represents a tax deductible expense generating a tax shield of Rs. 0.96 million per year.

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 payment 0.84 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

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

NPV, IRR and ELA

IRR

Since the lease has a negative NPV Vitex is better of buying the forklift from a purely financial point of view.

Therefore irr = 10.2 %

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

Equivalent Loan Amount• The loan that will entail the same debt service

burden is called equivalent loan amount.

• = =Rs. 10.16 million

• Thus, a loan of 10.16 million can be serviced with the lease cash flows

HIRE-PURCHASE METHOD

Definition

Hire purchase is a type of instalment 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.

FEATURES

• 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 instalments

• In case the buyer makes any default in payments of any instalments the

seller has right to repose the goods.

FINANCIAL EVALUATION

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

1. Estimate the post tax cash flows associated with each optiona) Leasing

- LRn(1-Tc)

b) Hire Purchase- In(1-Tc) – PRn + Dn(Tc) + NSVn

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

FINANCIAL EVALUATION

COST of HIRING

- Down payment + service charges + PV of hire

purchase payments

– PV of depreciation tax

shield

- PV of net salvage value

COST of LEASING

- Lease management fee

+ PV of lease payments

– PV of tax shield on lease

payments

+ PV of interest tax shield on hire purchase

EXAMPLEQ. Narmada finance offers a Hire purchase plan for corporate borrowers

• Rate of interest 13 % flat

• Repayment 3 years monthly in arrear

• Down payment 20 %

• Calculate APR (annual percentage rate) by trial error & approximation approach.

• What would be the answer if payment is in advance.

SOLUTION• Amount of loan 800• Total charge for credit 800 * 0.13 * 3 = 312• Monthly installment (800 + 312) / 36 = 30.89• (30.89 * 12 ) * PVIFA p (i,3) = 800• i / i 12 * PVIFA (i,3) = 2.158

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

– i= 25.38

• Approximate formula36/37 * 2 * 13 = 25.3%

Solution Contd.

• (30.89 * 12 ) * PVIFA p (i,3) = 800• i / d 12 * PVIFA (i,3) = 2.158• For i= 26 LHS = 2.185• For i= 28 LHS = 2.141– i= 27.23%

• Approximate formula36/35 * 2 * 13 = 26.74%

LEASE versus

HIRE PURCHASE

When Is Leasing A Good Option?

• Leasing is a good option for businesses that need equipment 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 the machine for the duration of the project instead of purchasing it.

• Increasingly, many small businesses are beginning to lease computers, photocopiers and fax machines.

• Not only does it help to reduce the upfront cash needed to purchase these items, but it also shifts the responsibility and cost of maintenance and servicing to the supplier.

When Is Hire Purchase A Better Option?

• Hire purchase is a better option when you need to use the equipment or asset frequently e.g. delivery vans.

• Hire purchase allows you to eventually own the equipment as opposed to purely renting the equipment.

• In leasing, you can only rent the item if it is available. If your business depends on an equipment or asset, you cannot afford to lease.

How Does A Lease Or Hire Purchase Affect Taxes?

• When you lease, the costs of rental can be treated as business expenses.

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

• Both finance methods provide savings to offset against year-end taxable profits. With HP, we can claim 25% of the equipment cash price in the first year, then 25% of the balance in the second year and this continues on a reducing balance basis each year.

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

DIFFERENCEHIRE PURCHASE LEASE FINANCE

SALEThe hirer has the option to purchase the goods

anytime during the term of the agreement. He also has the right to terminate the agreement at anytime

before payment of the last instalment.

SALEThe sale has already taken place, the goods have

already been delivered to the owner and the buyer is bound to pay the full price.

OWNERSHIPa) Ownership is passed to the hirer only if he

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

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

does not enjoy the salvage value of the asset.

OWNERSHIPa) Ownership is transferred to the purchaser on

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

lessee is entitled only to the use of the leased equipment.

c) The hirer, being the owner of the asset, enjoys the salvage value of the asset.

TAX BENEFITSHirer is allowed the depreciation claim

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

purposes.

TAX BENEFITSThe lessor is allowed to claim depreciation and

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

Against taxable income.

DIFFERENCEHIRE PURCHASE LEASE FINANCE

MAINTENANCECost of maintaining the hired equipment is to

be borne by the Lender.

MAINTENANCEMaintenance of the leased asset is the

responsibility of the lesse.

EXTENT20-25% of the cost of the equipment

is required to be paid by the hirer as down payment.

EXTENTNo down payment is required from the lessee.

MAGNITUDEThe magnitude of funds involved is relatively

low as compared to buying the asset.

MAGNITUDEThe magnitude of funds involved is very

small.

EXAMPLESAutomobiles, generators,

office equipment etc. are usuallyhire purchased.

EXAMPLEAircrafts, ships, machinery are taken on

financial lease.

When is it best to purchase a capital asset 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.

If you are thinking about buying an asset with

• Available 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

Procedure for choosing between hire purchase and leasing

• Step 1 – Estimate the post-tax cash flows associated with both the options

• Step 2 – Calculate the present value of cash flows associated with both the options and choose the option which has a lower present value.

EXAMPLE• Nidhi finance in addition to hire purchase proposal, offers a

lease proposal• Asset value – Rs. 1 million• Primary lease period – 5 years• Lease rentals – Rs. 300 per 1,000 per year• Secondary lease period – 5 years• Lease rental – Rs. 12,000• Net salvage value of the asset after 10 years – Rs. 100,000• Post tax cost of debt – 8%• Tax rate – 50 %• Depreciation – 33.5 %