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Chapter 14 LEASE AND HIREPURCHASE FINANCE

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LEARNING 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

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Leasing 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

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Meaning and Essential Elements of Leasing 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 5

Mechanics of Lease

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Types of Leases

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Distinguish between Financial and Operating Lease Point of Difference

Financial lease

1. 2. 3.

Term Cancelability Lease period

4.

Long-Term Short-Term Non-cancelable Cancelable Equals t life of the asset Less than the life of the asset Substantially transfers Does not transfer substantially Payable by lessor Payable by lessee

Transfer of all risks and returns Maintenance Insurance and taxes Asset selection Selected by lessee Lease capitalization In the books of lessee

5. 6. 7.

Operating lease

Selected by lessor In the books of lessor

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Advantages 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 •Avoids restrictive covenants •Low risk of obsolescence risk •Expeditious implementation •No ownership dilution 9

Lease Agreement • Lease agreement has to fulfill the requirements of agreement

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Tax 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

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Accounting Treatment of 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

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Accounting Treatment of 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

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Lease Evaluation [Lessor’s view point] I. Based on NPV II. Based on IRR

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Lease Rent Determination 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 annual cost Minimum Cost need to be equivalent Recov ered PVIFA k .n

6. Adjust post tax equivalent annual cost for the tax factor [i.e., tax need to be paid on receipt lease rental] Post Tax Equivalent Annual Cost 1 − Tax Rate

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. 15

Lease Evaluation [Lessee’s view point] •

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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) option Step 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. 16

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

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Hire-purchase Finance Evolution • Developed in UK • Now found in India; Australia; New Zealand • Commercial Credit Corporation is first company in India

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Meaning and Essentials of HP • Hire purchase is a conditional sale of contract. • Essentials: – Owner (hirer) – User (hirer) – Asset – HP installment

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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

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Hirer’s Rights and Obligations Rights: • 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 goods Obligations: • To pay the hire installments • To take reasonable care of the goods • To inform the owner where the goods will be kept 21

Owner’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

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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 Complete lease rent is allowed for purpose tax deduction

Tax benefit

Only interest component in Hire purchase Complete lease rent is allowed for installment is allowed tax deduction and tax deduction not portion of principle amount

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

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

Huge amount is involved

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Tax and Accounting Treatment of HP HP transactions are attracted to sales tax Accounting treatment Hirer 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 depreciation Hiree Books: • Interest charge is shown as income • Amount spent on HP agreement is treated as expense

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Determination of HP Installment • HP installment: Equals to principal amount plus total interest dividend by number of installments

HPI =

Pr incipal Amount + Total Interest Over Installment Period at Flat Rate Number of Installments

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Split of HP Installment into interest and principal 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)

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Leasing 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.

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