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UNIT III

UNIT III. LEASING AND HIRE PURCHASE. LEASING. Leasing – concept & classification Evolution of Indian leasing Industry – Presentation Product profile Legal (regulatory aspects of leasing in India), tax & accounting aspects of leasing Funding of leasing in India.

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UNIT III

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  1. UNIT III

  2. LEASING AND HIRE PURCHASE

  3. LEASING • Leasing – concept & classification • Evolution of Indian leasing Industry – Presentation • Product profile • Legal (regulatory aspects of leasing in India), tax & • accounting aspects of leasing • Funding of leasing in India. • Financial evaluation of leasing • HIRE PURCHASE • Concept and characteristics • Legal & tax frame work, mathematics • Financial evaluation of hire purchase deals-

  4. LEASING Contractual agreement Owner of an asset grants the right Use the asset to other party Receiver of the services of asset Under lease contract lessor lessee Seller, supplier, fin co, manu Claims depreciation on the asset Individual,company,firm Periodic payment- lease rental Lease – renting of an asset for some specified period

  5. MEANING - LEASING • Divorce of ownership from the economic use of an asset/equipment • Device of financing(money lending) the cost of an asset/capital asset • Fund based service • Lending of funds/finance/credit

  6. CONCEPT OF LEASE • JAMES C.VAN HORNE DEFINED: Lease is a contract whereby the owner of an asset (lessor)grants to another party (lessee) the exclusive right to use the asset usually for an agreed period of time in return for the payment of rent. • LEASING – Is a process by which a firm can obtain the use of certain fixed asset for which it must make a series of contractual periodic tax-deductible payment (lease rentals)

  7. ESSENTIAL ELEMENTS OF LEASING • Parties to the contract-lease financier, lessor, broker, lessee • Asset: asset, property or equipment • Ownership separated from the user • Term of the lease • Lease Rentals • Modes of terminating lease At the end of the lease period the asset reverts back to the lessor unless there is a provision for the renewal of contract.

  8. STEPS INVOLVED IN LEASING TRANSACTION • Lessee – decide asset req & supplier • Lessee enters – lease agreement – lessor • Basic lease period • Timing and amount of periodical rental payment • Option details – renew/purchase • Payment details – maintenance, repairs, taxes, insurance & other expenses • Lessor contacts manufacturer – supply – makes payment after asset delivered & accepted by lessee.

  9. CLASSIFICATION OF LEASING • Financial Lease & Operating Lease • Sale & Leaseback & Direct Lease • Single investor Lease & Leveraged lease • Domestic Lease & International Lease Based on risks & rewards, parties involved

  10. FINANCIAL LEASE • The lessor transfers to the lessee, substantially all the risks & rewards incidental to the ownership of the asset whether or not the title is eventually transferred.- IAS -17 Also known as Capital lease, long term lease, net lease and close lease, Full payout leases Approach to economic life

  11. The salient features of a lease are: • A financial lease is a long-term, non-cancelable lease. • The lessee has the option to purchase the asset at a price - sufficiently lower than the fair market value . • The lease term - major part of the useful life of the asset. • The lessee is responsible - maintenance of the asset - for insuring it against accidental damage or loss. • The risk of Damage is shifted from the lessor to the lessee.

  12. OPERATING LEASE • According to the IAS-17, an operating lease is one which is not a finance lease. • In an operating lease the lessor does not transfer all the risks & rewards incidental to the ownership of the asset. The lessor provides all the services attached to the leased asset. Also known as Service lease, Short term lease or True lease

  13. Features: • The lease term is significantly less than the economic life of the equipment. • The lease is usually cancelled at a short notice. • The lessor is responsible for the insurance & maintenance of the asset. • The lessor bears the risk of economic & functional obsolescence of the asset.

  14. FINANCIAL Installment loan Taxes & maintenance – lessee Risk of obsolescence – lessee Contract period – medium – long term Contract non-cancellable Air crafts, land , building.. Lessor – fulfills financial function OPERATING LEASE Rental agreement Taxes & maintenance –lessor Risk of obsolescence – Lessor Ranges form intermediate – short term Cancellable Computers, office equipment,Taxi,mobile cranes Service function DISTINCTION BETWEEN A FINANCIAL LEASE & OPERATING LEASE

  15. SALE & LEASEBACK • The owner of an equipment/asset sells (Mkt value)it to a leasing company (lessor) which leases it back to the owner (lessee). • The leaseback arrangement - in the form of a ‘finance lease’ or an ‘operating lease’. Retail stores, office buildings, multipurpose industrial building, shopping centre

  16. DIRECT LEASE TWO TYPES: • BIPARTITE LEASE – equipment supplier cum lessor & lessee (operating lease) – upgrade lease, swap lease • TRIPARTITE LEASE: equip supplier, lessor, lessee – sales – aid lease

  17. SINGLE INVESTOR LEASE(Two parties) • The leasing company (lessor) funds the entire investment by raising. • The debt funds raised by the leasing company are without recourse to the lessee.

  18. Leveraged Lease (3 parties) HUGE CAPITAL LAYOUT & ECONOMIC LIFE - 10 YRS OR MORE borrowing a large chunk of the investment with full recourse to the lessee & without any recourse to it. LEASING COMPANY Lessor Leases the Lessee Trustee Equity investor Equipment Loan participant Aircraft, ships etc….. lender

  19. Domestic Lease VS International Lease • Domestic lease :All the parties to the transaction are domiciled in the same country. • International lease: All parties to the lease transaction are domiciled in different countries. IMPORT LEASE- Lessor and lessee – domiciled in same country, supplier in different country CROSS-BORDER LEASE: Lessor and lessee are domiciled in different countries, supplier in any country - Involve Country risk & currency risk

  20. LEASE RELATED RISKS(Borne by the lessor) • Default risk • Residual value risk • Interest rate risk • Purchasing Power risk • Currency & Cross-border risk

  21. ADVANTAGES OF LEASING To the lessee: • 100% Financing of Capital Good • Flexibility & convenience - structuring of rentals, terminating • Avoids conditionality's • Simplicity • Tax Benefits – revenue expense • Permit alternative use of funds • Boon to small firm • Protection against obsolescence • Conserving borrowing capacity/Facilities additional borrowings • Faster and cheaper credit • High growth potential/return on capital employed • Enhanced liquidity • No floatation costs • No disposal problem • Lesser administrative and maintenance costs • Off the balance sheet transaction

  22. ADVANTAGES • To the Lessor: • Full security • Tax Benefit – depreciation-reduce tax liabilities • High Profitability • Quick returns • Increased sales

  23. LIMITATIONS Lessee: • Higher cost • Risk of being deprived of the use of asset • No alteration or change in asset • Loss of ownership incentives • Penalties on termination of lease • Restrictions on use of equipment • Loss of residual/salvage value • Cost of financing generally higher than debt financing • Understatement of lessee's asset

  24. LIMITATIONS • Lessor: • High risk of obsolescence • Competitive market price • Price-level changes • Management of cash flows • Increased cost due to loss of use benefits • Long – term investment • Double sales – tax.

  25. FACTORS CONSIDERED – BUY/LEASE • Availability of funds • Financial evaluation • Possession of asset • Cost of Borrowing • Depreciation • Taxes • Salvage Value • Risk • Maintenance

  26. PROFILE/STRUCTURING OF LEASING IN INDIA • PRIVATE SECTOR: • Pure leasing companies/Independent • Hire Purchase and Finance companies: tax adv • Subsidiaries of manufacturing group companies – Vendor leasing, in-house leasing/captive • PUBLIC SECTOR: • Leasing divisions of financial institutions: IFCI,ICICI – all –india, state level • Subsidiaries of public sector banks: Commercial banks – 94-95year onwards • Other public sector leasing organisation: Bharat electronics ltd, Hindustan packaging company limited, ECIL – sell equipment through leasing

  27. SOME OF THE LEASING COMPANIES • First leasing company of India ltd. • Sundaram finance ltd. • Kotak Mahindra Finance ltd • 20th century finance corporation ltd. • CEAT Financial services ltd • Ashok Leyland Finance Ltd. • Escorts Financial services ltd • Motor & General Finance Ltd • Anagram Finance ltd. • Rockland leasing ltd • ILFS – Infrastructure leasing & financing services – 1987

  28. PRODUCT PROFILE(lease structures in India) • The category of ‘Finance Lease’. • The lease agreements do not provide for transfer of ownership to the lessee. • The lease rentals are structured so as to recover the entire investment cost during the primary period. • The lease rentals are payable generally in EMIs at the beginning of every month. CONTD…….

  29. Sale & Lease back type of transactions are rare. – Most of them are direct lease • Equipment leasing covers a wide range of equipments from industrial plant & machinery, office equipments, vehicles etc. - standby finance.- <100 lakhs • Project leasing is being attempted only on a limited scale exclusively by ILFS. • Cross-border are not popular

  30. Legal Aspects/regulatory aspects • There is no legislation that exclusively governs equipment leasing transactions in India. • CONTRACT ACT: • Law of contract :Two provisions- specifically applicable to leasing transactions. • General provisions: contract: legal obligation, lawful consideration, competent parties, free consent, not expressly void, discharge of contracts: performance, frustration, mutual agreement , operation of law, remission

  31. SPECIAL PROVISIONS: The provisions of the Indian Contract Act, 1872 – SECTION 148, relating to bailment are applicable to leasing transactions

  32. Leasing as a Bailment Agreement • There are two parties to a bailment agreement, ie, bailor who delivers the goods & bailee to whom the goods are delivered for use. • There is delivery of transfer of goods from the bailor(lessor) to bailee(lessee). The ownership of the goods continues with the bailor (lessor).

  33. The goods in bailment should be transferred for a specific purpose under a contract. – purpose – to make use of economic life of asset. • When the purpose is accomplished, the goods are to be returned to the bailor or disposed off acc. to his directions

  34. Liabilities of lessee/bailee • Reasonable care • Not to make unauthorized use • To return the goods • Not to set up an adverse title • To pay the lease rental • To insure and repair the goods

  35. LIABILITIES OF LESSOR/BAILOR • Delivery of goods • Peaceful possession • Fitness of goods • To disclose all defects

  36. REMEDIES FOR BREACH • Remedies to lessor: Forfeiture, damages, repossession • Remedies to the lessee:claim damages - termination MOTOR VEHICLES ACT, 1988- SECTION 146-INSURANCE RBI NBFCs directons Other act/laws – indian stamp act Lease documentation and agreement

  37. FINANCIAL EVALUATION OF LEASING The objective of evaluation is: To identify • Lessee - The source of finance & • Lessor - Better investment alternative .

  38. Lessee’s Perspective LEASE Evaluation Investment decision Financing decision • Should the asset be funded with debt? • Should the asset be funded with debt & equity? • Should it be leased? Purchase the asset

  39. Choice between Debt Financing/ borrowing Vs Lease Financing • Since lease rentals are similar to payment of interest on debt, leasing in essence is an alternative to borrowing. • PROCEDURE FOLLOWED: The decision criterion used is NPV/NAL. If the NPV/NAL is +ve, the leasing alternative should be used, otherwise the borrowing alternative would be preferable.

  40. PROCEDURES • NPV/NAL • PV OF CASH OUTFLOWS • BERL • GROSS YIELD • ADD-ON YIELD • IRR BASED PRICING

  41. Computation of NPV(L)/NAL(net Adv. of leasing) Initial Investment/investment cost - PV of lease rentals(kd) - Management fee+ PV (tax shield on lease rentals)+ PV (tax shield on Mgt. fee) - PV (tax shield on Depreciation) - PV (Net salvage value) Lease the equipment if NAL is +veBuy the equipment if NAL is -Ve Kd – pre-tax cost of long term debt Kc - post – tax marginal cost of capital

  42. ALTERNATIVE APPROACH – BUY/LEASING • To determine the PV of the cash outflows after taxes under the leasing & the borrowing alternatives. The decision – criterion: Select the alternative with the lower PV of cash outflows.

  43. BREAK – EVEN LEASE RENTAL • The BELR is the rental at which lessee is indifferent between lease financing/borrowing & buying. • BELR has NAL as zero. It reflects the maximum level of rental which the lessee would be willing to pay. LESSEE If the BELR exceeds the actual lease rental, the lease proposal, would be accepted, otherwise rejected.

  44. LESSOR’S VIEWPOINT • Accept a lease proposal /choose from alternative proposal • BELR represents the minimum (floor) lease rental which he can accept. The NAL at this level is zero.

  45. The NAL to a lessor: PV of Cash Inflows – PV of Cash Outflows • CASH OUTFLOWS:Initial InvestmentIncome tax on lease rentalsSales-tax on lease transactionsAdministration expenses • CASH INFLOWS: Lease rentalsManagement feeTax shield on depreciationResidual value Security deposit if any

  46. NEGOTIATING LEASE RENTALS • The BELRs of the lessor & the lessee represents the range of acceptable level of rentals. The BELR of the lessor sets the lower limit, while the BELR of the lessee sets the upper limit of the range. • The actual rental has to be negotiated within the range. A rental within the range implies a +ve NAL both for the lessor & the lessee.

  47. GROSS YIELD • Used as the basis for pricing a lease. • The gross yield of a lease can be defined as the compound rate of return that equates PV (lease rentals) + PV (Residual value) to investment cost. If gross yield is higher than the required yield, the lessor can consider accepting the proposal

  48. ADD-ON YIELD • A variant of gross yield. • The add-on yield, akin to flat rate of interest assumes that the investment in the lease remains constant over the lease period. • The add-on yield is not a true measure.

  49. IRR BASED PRICING • IRR – internal rate of return – rate of discount at which present value of cash-inflows = PV of cash outflows • The IRR of a lease investment is that rate of interest at which NAL is equal to zero. The lease investment is accepted if & only if the IRR exceeds the required rate of return.

  50. TAX ASPECTS • Income tax provisions: • Lessee : lease rentals as tax- deductible expenses • Lessor: • Lease rental are taxable – “Profits & gains of business or profession” • investment allowance/depreciation on the investment

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