Module-F Leasing and Hire Purchase 1. Meanin Meaning g of of Hire Hire Purcha Purchase se In general, a lease is a contractual arrangement under which the owner of an asset (called the lessor) agrees to allow the use of his asset by another party (lessee) in exchange of periodic payments (lease rents) for a specified period. The lessee pays the lease rent as a regular fixed payments over a period of time at the beginning or at the end of a month, month, quarte quarter, r, half-yea half-yearr or year year. ltho lthough ugh general generally ly fixed, fixed, lease lease rents rents can be tailored both in terms of amount and timing to the profits and cash flow position of the lessee. t the end of the lease contract the asset reverts bac! to the real owner, i.e., the lessor. "owever, in long-term lease contracts, the lessee is generally given the option to buy or renew the lease.
2. Types ypes or or Form Formss of Leasin Leasing g There are several types of leases prevalent in financial mar!ets. The ma#or ones are discussed below$ i.
Operating Lease
n operating lease is an agreement in which the lessee acquires the use of an asset on a period-to-period basis. That is, instead of ta!ing an asset on long-term basis at one point of time lessee prefers the system of hiring an asset for each period (say a year, half-year, quarter or even month) with the option of renewing the same after its expiration date. ii.
Financial Le Lease
%inancial lease differs from operating lease in important respects. %irst, in contrast to opera operati ting ng leas lease, e, fina financ ncia iall (cap (capit ital al)) leas leasee invo involv lves es a rela relati tivel vely y long longer er-t -ter erm m commitment on the part of the lessee. They are non-cancelable, in the sense that the lessee lessee is contrac contractua tually lly oblige obliged d to ma!e ma!e lease lease paymen payments ts during during the entire entire period period specified in the contract. &econd, the financial lease is less expensive relative to operating lease from the point of view of the lessor as the maintenance and service costs are generally borne by the lessee. %inancial leases are commonly used for leasing land, buildings and large pieces of fixed-equipments. iii.
Sale and Lease ac!
s the name suggests, under this form of lease arrangement, the firm sells an asset, already owned by it to another firm'party and hires it bac! from the buyer. The lessor
is ordinarily a financial institution such as commercial ban!, development ban!, insurance company or leasing company. sale-lease bac! arrangement is normally initiated'preferred by a firm that is suffering from the shortage of funds for its operations or is faced with liquidity crisis. i".
#irect Lease
nder direct leasing, the lessee does not already own the equipment. "e acquires it either from the manufacturing company directly (say ta!ing computers form I*) or arranges the desired equipment to be purchased by the leasing company. ".
Le"eraged Lease
leveraged lease or third party lease is one that involves a third party who is lender, in addition to the lessor and lessee. nder the arrangement, the lessor borrows funds from the lender and himself acts as an equity participant. +ormally the equipment borrowed is substantial vis-a-vis the funds provided by the lessor himself. The lessor services the debt out of lease rents received. Typically, such types of leases are popular in structuring leases of very expensive assets such as the lease of a plane or ship. The third party usually involved in financing the transaction is a financial institution li!e commercial ban!s, insurance company etc. "i.
Primary and Secondary Lease
The lease contract is sometimes divided into two parts, namely, primary lease and secondary lease. The primary lease provides for the recovery of the cost of the asset and profit through lease rentals during the initial years (say to years) of lease contract followed by the secondary'perpetual lease at nominal lease rents.
$. Financial %"aluation of Lease The evaluation of lease financing from the view point of lessee involves the following steps$ i.
etermine the after tax cash outflows for each year under the lease alternative. This is arrived at by multiplying the lease rental payment (/) by (0 1 Tax rate, t). ii. etermine the after-tax cash outflows for each year under the buying alternative based on borrowing. The amount is equal to$ /oan instalment (2ross cash outflows, 234) /ess tax (t) advantage on interest, r i.e. (05t) /ess tax shield due to depreciation () llowance ( 5 t) iii. 3ompare the present value (pv) of the cash flows associated with leasing (step 0) and buying (step 6) alternative by employing after tax cost of debt (! d) as the discount rate for the purpose.
iv.
&elect the alternative with the lower present value of cash outflows. Thus, the decision criterion is$
a. 78 of cash outflows under leasing 9 alternative
78 of cash outflows as per buying alternative
uy the asset
b. 78 of cash outflows : under leasing alternative
78 of cash outflows as per buying alternative
/ease the asset
&. %conomics of Leasing There are several qualitative considerations which ma!e leasing an attractive proposition. &ome of the commonly cited advantages of leasing are$ i. ii. iii. iv. v. vi. vii.
&hifting the ;is! of Technological 4bsolescence
#isad"antages There are certain disadvantages of leasing. The important on e are$ i. ii. iii.
;is! of being eprived of the se of
Pro'lem( 1
3 *achine Tool 3ompany is considering the acquisition of a large equipment to set up its factory in bac!ward region for T!. 06, >>,>>>. The equipment is expected to have economic useful life of ? years. The equipment can be financed either within an eightyear term loan at 0@ interest, repayable in equal installments of T!. 6, ?,ABA per year or by an equivalent amount of lease rent (T!. 6, ?,ABA) per year. In both the cases, payments are due at the end of the year. The equipment is sub#ect to straight line method of depreciation. ssuming no salvage value, >@ corporate tax rate, which of the financing alternative it should selectC Pro'lem( 2
5DE uilders F 3ompany needs to acquire the use of a crane for construction business and is considering whether buy or lease. The crane costs T!. 0>, >>,>>> and is sub#ect to straight-line method of depreciation to a =ero salvage value at the end of years. In contrast, the lease rent is T!. 6, 6>,>>> per year to be paid in advance each year of years. The 5DE uilders can raise debt at 0@ payable in equal annual installments, each installment becoming due at the beginning of the year. It is in >@ tax brac!et. dvise the company.
). Hire Purchase *greements hire purchase agreement is one under which a person ta!es delivery of goods promising to pay the price by a certain number of installments and, until full payment is made, to pay hire charges for using the goods. nder hire purchase agreement goods are let on hire and under which the hire has an option to purchase them in accordance with the terms of the agreement and includes a agreement under which, 7ossession of goods is delivered by the owner thereof to a person on condition • that such person pays the agreed amount in periodical instalments, and The property of the goods is to pass to such person on the payment of the last of • such instalment, and &uch person has a right to terminate the agreement at any time before the property • so passes.
