Professional Documents
Culture Documents
Hire Purchase
Hire Purchase
CONCEPTUAL FRAMEWORK
Hire-purchase is a mode of financing the price of goods to be sold on a future date. Hire purchase is a type of instalment credit under which the hire-purchaser agrees to take goods on hire at a stated rental with an option to purchase the goods
It is an agreement relating to a transaction in which goods are let on hire, the purchase price is to be paid in installments and the hirer is allowed the option to purchase the goods paying all the installments. Though the option to purchase the goods/assets is allowed in the very beginning, it can be exercised only at the end of the agreement.
CONCEPTUAL FRAMEWORK
The essence of the agreement is that the property in the goods does not pass at the time of the agreement but remains in the intending seller (hire-vendor) and only passes when the option is exercised by the hirer (intending hire-purchaser). In contrast, in installment sale the ownership in the goods passes on to the purchaser simultaneously with the payment of the initial/first installment. The hire-purchase also differs from the installment sale in terms of the call option and right of termination.
Conceptual Framework
Under the down payment plan of hire-purchase, the hirer has to make a down payment of 20-25 per cent of the cost and pay the balance in equated monthly installments (EMIs).
As an alternative, under a deposit-linked plan the hirer has to invest a specified amount in the fixed deposit of the finance company which is returned together with interest after the payment of the last EMI by the hirer.
The interest component is based on a flat rate of interest while effective rate is applied to the declining balance of the original amount to determine the interest component of each installment. For a given flat rate interest , the equivalent effective rate of interest is higher
During the hire-period, the hirer can opt for early repayment/purchase of the equipment/asset by paying the remaining installments minus an interest rebate. The hirer has the right to terminate the contract after giving due notice.
Consumer credit
Consumer credit includes all asset-based financing plans offered to primarily individuals to acquire durable consumer goods. In a typical consumer credit deal, the customer pays a fraction of the cash purchase price on delivery of the goods and the balance is paid together with interest over a specified period of time. Salient Features: Parties to the transaction(Bipartite or tripartite)
Consumer credit
Modes of Payment:The consumer credit plans/schemes can be down payment type or deposit-linked type.
Illustration 5.5 (Flat and Effective Rates of Interest) The Hypothetical Consumer Finance Ltd (HCFL) has structured a consumer credit deal for Rs 4,00,000 on the following basis: _______________________________________________________________________________________________ Monthly repayment period Equated monthly installment _______________________________________________________________________________________________ 12 Rs 38,000 24 Rs 21,400 _______________________________________________________________________________________________ Required: Compute the flat and effective rates of interest for each alternative/option. Solution Flat and Effective Rates of Interest _______________________________________________________________________________________________ Repayment period (months) _______________________________________________________________________________________________ 12 24 _______________________________________________________________________________________________ Total charge for credit Rs 56,000 Rs 56,800 Flat rate of interest (%) 0.14 0.142 Effective rate of interest (%) 0.2585 0.2726 _______________________________________________________________________________________________
Working Notes 1. Total annual charge for credit = (Rs 38,000 x 12) Rs 4,00,000 = Rs 56,000 Rs 56,000 = ------------------- x 100 = 0.14 Rs 4.00,,000 n = -------- x 2 F n+1 = [Rs 21,400 x 24) (Rs 4,00,000)] 2 = Rs 56,800 Rs 56,000 = ------------------ x 100 = 0.142 Rs 4.00,000 n = ---------- x 2F n+1
2.
3.
In words,
Bank will charge 1.5% interest each month on your unpaid balance, if you borrowed money You will earn 1.5% interest each month on your remaining balance, if you deposited money
= 1.5%
ia (1 r / M ) 1
M
r = nominal interest rate per year ia = effective annual interest rate M = number of interest periods per year
18%
: 1.5%
=
19.56 % compounded annually
Practice Problem
Suppose your savings account pays 9% interest compounded quarterly. If you deposit $10,000 for one year, how much would you have?
First leasing company offers an asset on hire purchase to Indian Breweries on the following: Cost =Rs. 0.1 million Rate of interest =10% (flat) Hire purchase period = 4 years Payment in yearly installments in arrear Down payment =20% Tax =30% The asset has 4 years life with zero salvage value.what is the effective interest rate.
Example
Solution
Amt of loan = Rs .1 million Rs ..02 million = Rs .8 million Interest at flat rate =Rs 3,20,000 Annual equated installment = (8,00,000+3,20,000)/4 Amount of interest each year
Year 1 2 3 4
Interest 3,20,000*4/10= Rs 128000 3,20,000*3/10 =Rs 96,000 3,20,000*2/10= Rs 64,000 3,20,000*1/10= Rs. 32000
Illustration
Following details pertain to a company manufacturing air bags required for the luxury cars. Cost of equipment =Rs 5,00,000 Down payment =25% of cost price Number of installments =4 (arrears) Flat rate of interest14% p.a. Disc rate 18% Annual lease rentals = Rs 1,00,000 and lease period =5 years Tax rate 50% Depreciation=SLM and salvage value =Rs 40000 The company is examining two financing alternatives.HP and leasing.You are required to give your opinion about the choice of financing to be adopted by the firm.Also determine interest under three methods.
Solution
Flat rate of interest =14% Cost of equipment =Rs 5,00,000 Down payment 25% = Rs 1,25,000 HP principal amount =Rs 375000 HP interest = 3,75,000*14%*4=Rs 2,10,000 Total HP amount =Rs 3,75,000+2,10,000 =Rs 5,85,000 Annual instalment amount =5,85,000/4 = Rs 1,46,250
Year
ERI (interest)
Annual interest
SOYD (interest) SLM (interest ) ERI (Principal paid) 84,000 52,500 69,375
3,75,000
76,875
62,250
93,750
3,05,625
62,653
63,000
52,500
83,597
83,250
93,750
1,46,250
2,22,028
45,516
42,000
52,500
1,00,734
1,04,250
93,750
1,46,250
121,294
24,865
21,000
52,500
1,21,294
1,25,250
93,750
1,46,250
3 4 5 6 7 8
Depreciation 1,15,000 1,15,000 1,15,000 1,15,000 1,91,875 1,77,653 1,60,516 1,39,865 88,827 80,258 69,933 40,000 50,312 .847 57,423 .718 65,992 .609 36,317 .516 .437
Tax shield 95,938 (col.4 *50%) Salvage value Net cost of HP (1-5-6) PVF 18%
PV of salvage value 17480 Net cash flow under HP = 1,42,809- 17480=125329 Under leasing =1,56,350
Modalities (contd..)
The Finance company signs the document and sends a copy to hirer The dealer delivers the good The hirer makes the payment periodically On completion of hire term property in good passes to him
Legal Framework
There is no exclusive legislation dealing with hire purchase transactions in India. The Hire-Purchase Act was passed in 1972. A bill was introduced in 1989 to amend some of the provisions of the Act. However, the Act has not been enforced so far. In the absence of any specific law, the hire-purchase transactions are governed by the general laws. The hire-purchase transaction has two aspects: (i) an aspect of bailment of goods which is covered by the Indian Contract Act, (ii) an element of sale when the option to purchase is exercised by the hirer which is covered by the Indian Sales of Goods Act.
TAXATION ASPECTS
There are three aspects of taxation of hire-purchase deals: (i) income-tax, (ii) sales tax and, (iii) interest tax. Though the hirer is not the owner of the asset, he is entitled to claim depreciation as a deduction on the entire purchase price. He can also claim deduction on account of consideration for hire, that is, finance charge. The amount of finance charge to be deducted each year is to be spread evenly over the term of the agreement on the basis of a method chosen from amongst the alternatives: SOYD, ERI, SLM.
TAXATION ASPECTS
The hire-purchase transaction can be used as a tax planning device in two ways: (i) by inflating the net income (finance income interest on borrowings by the finance company) at the rear-end of the deal and (ii) by using hire-purchase as a bridge between the lessor and the lessee, that is, introduction of an intermediate financer
TAXATION ASPECTS
Hire purchase deemed to be sales, are liable to sales tax. There is no provision of refund of sales tax on unpaid installment However, hire-purchase transaction structured by finance companies (which are not hire-vendors), being essentially a financing arrangement, do not attract sales tax. Delivery Vs Transfer of property:Taxable event. The sales tax is levied on full amount payable without any deduction of hire charges The sales tax rates vary from state to state Salestax is not levied if goods are delivered in the state with single point levy system
Taxation aspects
An interest tax has to be paid on the interest earned less bad debts. The tax is treated as a tax-deductible expense for the purpose of computing the taxable income under the Income-Tax Act.
Solution
Interest for five years at 18% p.a = RS 13,50,000 Instalment = 15,00,000+13,50,000/5 = Rs 5,70,000 The amount of inteerst is distributed according the SOYD method according the amount of each year is as shown
Year 1
Interest 4,50,000
2 3 4 5
5,70,000
1,20,000
3,60,000
1,57,500
1,05,000
3,07,500
5,70,000
2,10,000
2,70,000
1,26,000
1,05,000
339,000
5,70,000
3,00,000
180,000
73,500
1,05,000
3,70,500
5,70,000
3,90,000
90,000
63000
1,05,000
4,02,000
5,70,000
4,80,000
31500
1,05,000
4,33,000
At the end of each accounting period ,an appropriate part of unmatured finance income should be recognized as current income for the period. The direct costs are expensed immediately/amortised over the accounting period.
Illustration 5.1 Under a hire-purchase deal structured by the Hypothetical Finance Ltd (HFL) for the Hypothetical Industries Ltd (HIL), the HFL has offered to finance the purchase of an equipment costing Rs 150 lakh. The (flat) rate of interest would be 13 per cent. The amount would have to be repaid in 48 equated monthly installments in advance. The HIL is required to make a cash down payment of 25 per cent. It uses WDV method of depreciation @ 30 per cent on similar assets.
From the foregoing information, you are required to show: (A) the allocation of total charge for credit (finance charge), on the basis of (1) effective rate of interest (ERI)/annual percentage rate (APR) method, (ii) sum-of-years-digits (SOYD) method and (iii) straight line method (SLM) of depreciation; (B) how the deal will be recorded in the financial statements (profit and loss account and balance sheet) of the hirer (HIL) in the first two years. You can make, if necessary, your assumptions.
Solution (A) (i) Allocation of Total Charge for Credit: ERI/APR Method (Rs lakh) _______________________________________________________________________________________________ Year Outstanding amount Interest content Capital content/ Annual installment at the beginning recovery (3.5625 x 12) _______________________________________________________________________________________________ 1 112.50 23.54 19.21 42.75 2 93.29 18.52 24.22 42.75 3 69.06 12.20 30.55 42.75 4 38.52 4.22 38.53 42.75 _______________________________________________________________________________________________
Working Notes 1. Computation of ERI/APR: Total charge for credit = Rs 112.50 [Rs 150 lakh down payment (Rs 37.50 lakh)] x 0.13 x 4 = Rs 58.50 lakh Monthly installment = (Rs 112.50 lakh + Rs 58.50 lakh) / 48 = Rs 3.5625 lakh Annual installment = Rs 3.5625 lakh * 12 = Rs 42.75 lakh The ERI per annum, I, is given by equation: N/N-1 *2F = 48 /47 *2*13 =26.55% Assumption: Salvage value after 4 years, nil.
(A) (ii) Allocation of Total Charge for Credit: SOYD Method (Rs lakh) _______________________________________________________________________________________________ Year Annual installment Finance charge Capital recovery (3.5625 x 12) _______________________________________________________________________________________________ 1 42.75 25.42 17.33 2 42.75 18.21 24.55 3 42.75 11.04 31.71 4 42.75 3.83 38.92 _______________________________________________________________________________________________ Working Notes Finance charge (Rs lakh) 48 + 47 + + 37 Year 1 = ----------------------- x Rs 58.50 lakh = Rs 25.42 lakh 48 + 47 + + 1 36 + 35 + + 25 2 = ----------------------- x Rs 58.50 lakh = Rs 18.21 lakh 48 + 47 + + 1 24 + 23 + + 13 3 = ----------------------- x Rs 58.50 lakh = Rs 11.04 lakh 48 + 47 + + 1 12 + 11 + + 1 4 = ----------------------- x Rs 58.50 lakh = Rs 3.831 lakh 48 + 47 + + 1
(A) (iii) Equated Annual Finance Charge: SLM Rs 58.50 lakh 4 = Rs 14.62 lakh (B) Financial Statements Income Statement (Rs lakh) _______________________________________________________________________________________________ Expenses Year 1 Year 2 _______________________________________________________________________________________________ Depreciation (150 x 0.30) 45.00 (105 x 0.30) 31.50 Finance charge 23.54 18.52 _______________________________________________________________________________________________ Balance Sheet (Rs lakh) _______________________________________________________________________________________________ Liabilities Amount Assets Amount ____________ ___________________ Year 1 Year 2 Year 1 Year 2 _______________________________________________________________________________________________ Secured loans: Fixed assets: Hire-purchase outstanding 69.06 38.51 Equipment on hire purchase: 150.00 150.00 (due after one year) Gross Block 45.00 76.50(45+31.5) Current liabilities: Less: Accumulated depreciation _____ _____ Hire-purchase outstanding 24.22 30.50 Net block 105.00 73.50 (due within one year) _______________________________________________________________________________________________
Illustration 5.2 For the Hypothetical Finance Ltd (HFL) in Illustration 5.1, assume that the initial cost of structuring the deal is Rs 1.2 lakh. Using the effective rate of interest method for allocating finance income, show how the transaction will appear in the books of the HFL. You can make other assumptions, if necessary. Solution Allocation of Unearned Finance Income (ERI: 26.1%) (Rs lakh) _______________________________________________________________________________________________ Year Outstanding amount Installment Interest component Capital recovery at the beginning _______________________________________________________________________________________________ 1 112.50 42.75 23.54 19.21 2 93.29 42.75 18.52 24.22 3 69.06 42.75 12.22 30.55 4 38.52 42.75 4.22 38.53 _______________________________________________________________________________________________ Record in Financial Statements: Income Statement (Rs lakh) _______________________________________________________________________________________________ Expenses Amount Income Amount ________________ ___________________________ Year 1 Year 2 Year 1 Year 2 _______________________________________________________________________________________________ Direct costs 1.2 Hire finance income 23.54 18.52 _______________________________________________________________________________________________
Balance Sheet (Rs lakh) _______________________________________________________________________________________________ Liabilities Amount Assets Amount ________________ ______________ Year 1 Year 2 Year 1 Year 2 _______________________________________________________________________________________________ Current liabilities: Current assets: Finance income/charge Stock on hire (agreement (unmatured/unearned) 34.95 16.42 value less amount/installment received) 128.24 85.49 _______________________________________________________________________________________________