Leasing and Hire Purchasing

Rashmi Mehta – 208

Ishan Modi – 210
Anshum Kawatra – 308
Arpan 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 million
PVIFA 3.696

• Adjust post tax EAC for tax factor to g et lease rental

Lease 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 0.062
Tax shield on operating
costs and depreciation
  0.238 0.176 0.142 0.125 0.117

Net salvage value           0.400

Post-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 6
Initial Cost 10            
Depreciation   4 2.4 1.44 0.86 0.52 0.31
Loss of Tax shield   -1.4 -0.84 -0.5 -0.3 -0.18 -0.11
on depreciation

Lease Payment   -2.4 -2.4 2-.4 -2.4 -2.4 -2.4

Tax Shield on   0.84 0.84 0.84 0.84 0.84 0.84
lease payment
Loss of salvage             -1.0
value
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

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

IRR

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 option
a) 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

+ PV of hire – PV of
- PV of net
- Down payment + service charges purchase depreciation tax
salvage value
payments shield

COST of LEASING

– PV of tax + PV of interest
- Lease management + PV of lease
shield on lease tax shield on
fee payments
payments hire purchase
 EXAMPLE
Q. 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 formula
36/37 * 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 formula
36/35 * 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
 DIFFERENCE
HIRE PURCHASE LEASE FINANCE
SALE SALE
The hirer has the option to purchase the goods The sale has already taken place, the goods have
anytime during the term of the agreement. He also already been delivered to the owner and the buyer
has the right to terminate the agreement at anytime is bound to pay the full price.
before payment of the last instalment.

OWNERSHIP OWNERSHIP
a) Ownership is passed to the hirer only if he a) Ownership is transferred to the purchaser on
exercises the option to purchase. payment of the first instalment.
b) The ownership of the equipment passes to the b) The lessor company is the owner and the
hirer on payment of the last instalment. lessee is entitled only to the use of the
c) The lessee, not being the owner of the asset, leased equipment.
does not enjoy the salvage value of the asset. c) The hirer, being the owner of the asset, enjoys
the salvage value of the asset.

TAX BENEFITS TAX BENEFITS

Hirer is allowed the depreciation claim The lessor is allowed to claim depreciation and
and finance charge and the seller may depreciation lessee is allowed to claim any interest on borrowed
and lessee is allowed to claim rentals and funds to claim rentals and maintenance cost.
maintenance cost acquire the asset for tax Against taxable income.
purposes.
 DIFFERENCE
HIRE PURCHASE LEASE FINANCE

MAINTENANCE MAINTENANCE
Cost of maintaining the hired equipment is to Maintenance of the leased asset is the
be borne by the Lender. responsibility of the lesse.

EXTENT EXTENT
20-25% of the cost of the equipment No down payment is required from the lessee.
is required to be paid by the hirer as down
payment.

MAGNITUDE MAGNITUDE
The magnitude of funds involved is relatively The magnitude of funds involved is very
low as compared to buying the asset. small.

EXAMPLES EXAMPLE
Automobiles, generators, Aircrafts, ships, machinery are taken on
office equipment etc. are usually financial lease.
hire purchased.
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 %