UNIT - 2

HIRE PURCHASE
 HIRE PURCHASE
Meaning and concept
The concept of hire purchase involves hiring of an
asset for a specified period of time. At the end of such
period, the asset is purchased. Under this arrangement,
the hirer acquires the possession and the right to use the
asset. Hire Purchase system can be used for financing
capital assets as well as consumer goods.
E.g., : Hypothecating the vehicle
 EVALUATION OF HIRE PURCHASE PROPOSALS

From the viewpoint of the Hirer From the viewpoint of

Finance company
• FROM THE VIEWPOINT OF THE HIRER
The hire purchaser generally makes the decision regarding hire purchase program in
comparison to leasing agreement. The purchaser whichever agreement is cheaper in cost.
1) Cost of Hire Purchase: Following are the main components of cost of hire purchase:
i) Down Payment
ii) Plus Service Charges
iii) Plus Present value of hire purchase payments discounted by the cost of debt.
iv) Minus Present value of depreciation tax shield discounted by the cost of capital.
v) Minus Present value of net salvage value discounted by the cost of capital.
FROM THE VIEWPOINT OF FINANCE COMPANY
The firms go with the plan which offers higher net present value.
1) Net Present Value of Hire-Purchase Plan : Following are the main components of the
NPV
i) Present value of hire-purchase instalments.

ii) Add: Documentation and other service fee.

iii) Add: Present value of tax shield availed on original direct cost.

iv) Less: the Loan amount availed

v) Less: Initial cost.

vi) Less: Present value of interest tax on finance income i.e. interest

vii) Less: Present value of income tax on finance income (interest) meted for interest tax.

viii) Less: Present value of income tax on documentation and service fee.
 LEASING: OVERVIEW
In simple terms, a lease financing may be defined as:
"A contractual arrangement (lease agreement) in which a party
owning an asset/equipment (lessor) allows its use to another
(transfer the right to use the equipment) party (lessee) for an
agreed period of time for the consideration of periodic payment
(lease rentals) with or without a further payment (premium)".
At the end of the period of contract (lease period), the leased
asset/equipment reverts back to the lessor, provided there is no
provision for the renewal of the lease agreement.
 TAX ASPECTS OF LEASING
INCOME TAX CONSIDERATIONS
.Leasing may help people in saving taxes by deferring or reducing
them. In this manner, leasing can be used as a method for managing tax
liability.
1)Income Tax Consideration for Lessor:
Leasing allows the lessor to claim a depreciation deduction for calculating
their income tax liability. While these provisions may differ from company
to company, there are several tools available for this purpose.
Taxability of Lease Rental: Income Tax Act, 1961 is applicable for the
purpose of calculating tax liability of the businesses. The computation is
done under various heads and then is aggregated. Such aggregate is
reduced by the deductions available under income tax provisions.
 Deductibility of Expenses: Following expenses are allowed as deduction under income tax provisions.
• Depreciation
• Various rent, rates, taxes and repairs expenses paid. If the lessor pays insurance, then such
expenditure is also deductible.
• Interest paid on debts.
• Expenses made for improving business.
• Entertainment expenses up to a certain extent.
• Travelling expenses as per provisions.
2) Income Tax Consideration for Lessee: Following are the main points concerning the income tax from
the point of view of the lessee:
 Allowability of Lease Rentals: Income tax allows the lease to be deducted as normal business
expenditure. However, such expenditure should not be of capital nature or a personal expenditure.
 Deductibility of Incidental Expenses: The lesses is required to pay for the expenses required for
leasing the assets. Some of these expenses are repairs and maintenance, insurance and finance charges.
 Tax Planning: Leasing is helpful in tax planning as well. Depreciation is a tax-deductible expenditure
for the lessor. The lessee may also reduce their tax bill by claiming deductibility of their lease rental
payments.
SALES TAX ASPECTS
• Purchase of equipments: If the asset purchase involves inter-state sale,
Central Sales Tax may be applicable to such transactions.
• Lease Rentals : Until 1982, lease rental did not attract any sales tax. The
Constitution (Forty Sixth Amendment) Act, 1982 extended the scope of sales
tax to bring lease rentals under its ambit. The lease by the STAs and the CST.
• Sale of Asset: Lease rentals are not eligible for second sale exemption which
is generally applied to second sale transactions in the same state.
The transaction occurring between the leasing company and the
equipment suppliers is known as the first sales. Such sale is covered under the
local sales tax. The transaction between the lessor and the lessee is a deemed
sales and is known as second sale. Such second sale is exempt from sales tax in
many cases, but not in the case of lease transactions.
 TYPES OF LEASING
1. Operating or service lease
2. Sale and lease back
3. Single investor lease
4. Domestic lease
5. Financial lease
6. Direct lease
7. Leveraged lease
8. International lease
1. Operating or service lease
An operating lease is one which is not a finance lease. It is a contract
wherein the owner, called the Lessor, permit the user, called the Leesee, to use
an asset for a particular period which is shorter than the economic life of the
asset without any transfer of ownership rights.
2. Sale and Lease Back
A Firm/company (lessee) sell an asset already owned by it to another
party and lease it back from the buyer (lessor).
3. Single Investor Lease
The lessor and the lessee are the two parties involved in the lease
transaction. The third party, i.e., the supplier is missing. Supplier’s role is
played by the lessor, who takes the responsibility of funding the entire
investment through a suitable mix of debt and equity finance.
4. Domestic Lease
A lease transaction in which all the involved parties , viz. lessee, lessor and
supplier happen to be the resident of the same country is known as ‘Domestic
Lease’.
5. Financial Lease
In financial lease, the lessee, who is the customer or borrower, identifies a
given asset which is purchased by the lessor (the financier) and given to the lessee
for use throughout the leasing period, as agreed between both the parties. The
lessee pays a series of rentals or instalments. At the end of the leasing period, the
lessor is able to recover a large portion (or all) of the cost of the identified asset,
in addition to interests earned from the rentals or instalments paid by the lessee.
Generally, in India financial leases are used for leasing land and building,
machinery and fixed equipments, etc.
6. Direct Lease
A direct lease is the simplest form of leasing. The lessee and the owner of the equipment are two
parties. It may be of two types: 'Bipartite Lease' and 'Tripartite Lease’ .
i) Bipartite Lease: In this lease transaction, two parties are involved, viz.:
• Equipment supplier cum lessor
• Lessee
The assets are maintained by the lessor and, if required, they are replaced with similar assets in
working conditions.
ii)Tripartite Lease: In such type of lease, the supplier of the equipment and lessor are two different parties.
Thus, the Tripartite Lease involves three different parties in the lease agreement:
• Equipment supplier.
• Lessor and
• Lessee
The equipment supplier facilitates lease finance in the following manner.
a) Giving reference in respect of a customer to the leasing company;
b) Acting as an agent of the leasing company in
 negotiating the terms and conditions of lease with the customer, and
 completing all other formalities on behalf of the leasing company:
7.Leaveraged Lease
The leveraged lease is partially financed by the lessor through a third-
party financial institution. The lending company holds the title to the leased
asset, while the lessor creates the agreement with the lessee and collects the
payment. The payments are then passed on to the lender. Thus, in a leveraged
lease, three parties, viz. lessor, lessee, and financer are involved.

Sells Asset Leases asset

Manufacturer Lessor Lessee

Lender
8. International Lease:
A lease transaction, in which all the involved parties belong to
two different countries, is known as an 'International Lease'. This
type of lease is further sub-classified into:
i) Import Lease:
In this lease, the lessor and the lessee are from the same country
but the equipment supplier is belonging to different country.
Equipments are imported by the lessor and are leased to the lessee.
ii) Cross-Border Lease:
In this type of lease, both parties, i.e. the lessor and the lessee
are from two different nations. The domicile of the third party, i.e.
supplier does not matter.
 RIGHTS AND LIABILITIES OF LESSOR AND LESSEE:
The following are the elements which governs the Rights and Liabilities of a
Lessor and Lessee:
1.Any contract between the parties
2.Local custom or usage
3.Provisions of section 108 of the Transfer of Property Act, 1882.

RIGHTS OF THE LESSOR ARE AS FOLLOWS:

Section 108 of the Act does not provide for any specific right of the Lessor. The
liabilities of Lessee as given in section 108, would thereby mean identical to the
rights of the Lessor.
The Lessor has the right to collect rent or any form of consideration as mentioned in
the terms and conditions of the contract from the tenant without any form of
interruptions.
The Lessor has right to take back the possession of his property from the Lessee, if
the Lessee commits any breach of condition.
The Lessor has right to take back the possession of his property from the
Lessee on the termination of the lease term prescribed in the agreement or if
the Lessee commits any breach of condition.
The Lessor has right to recover the amount of damages from the Lessee if
there is any damage done to the property.

Liabilities of the Lessor are as follows:

It is the duty of the Lessor to not cause any form of interruptions during the
tenancy period.
The Lessor must give possession of the property to the Lessee on Lessee’s
request. However, this liability only arises when there is a request on behalf of
the Lessee.
The Lessor is bound to disclose any form of a material defect in the property.
 RIGHTS OF THE LESSEE:
The Lessee has the right to avoid the lease in case of any destruction of property by
fire or flood, or violence of an army or of a mob, or other irresistible force.
The Lessee has right to repair the property when Lessor fails to do so and to deduct
the cost of repairs from the rent.
The Lessee has right to make such payments which are obligatory on the Lessor
and to deduct that amount from the rent.
The Lessee has right to enjoy the accretions to the leased property.
The Lessee has right to remove the fixtures made by him during the tenancy.
He has right to enjoy the benefit of crops growing on the land sown or planted by
the Lessor.
The Lessee can sub-lease the property or the Lessee can absolutely transfer his
interests. However, if the lease deed restricts a Lessee to assign his interest then the
Lessee is prohibited to do so and even after the transfer of his rights, the Lessee is
still subject to all the liabilities related to the lease deed.
Liabilities Of The Lessee:
The Lessee is bound to pay the rent or the premium to the Lessor or his agent in the
proper time and proper place as decided by the lease deed.
If the Lessee becomes aware that any person has tried or is trying to damage the
rights of the Lessor or the title of the Lessor is endangered then, in that case, the
Lessee must give notice to the Lessor.
The Lessee has duty to use the property in a manner as if it was his/her own
property.
The Lessee is bound to inform the Lessor of any material fact which the Lessee is
aware of and the Lessor is not. In case the Lessee does not disclose such fact and the
Lessor suffers any loss then the Lessee is bound to compensate the Lessor.
If Lessee gets to know about any proceedings relating to the property or any
encroachment or any interference, then Lessee is under an obligation to give notice
to the Lessor.
The Lessee has duty to not to erect on the property any permanent structure without
Lessor’s consent.
 EVALUATION OF LEASING
i) Lessee’s Point of view
The evaluation of the option may be made using different
techniques such as cashflow technique, using Net present value
method. Following are the main steps involved in the process:
• Determine the present value of the cashflows for each buying
alternative.
• Determine the present value of cashflows associated with the
leasing alternatives.
• Compare the NPV under each alternative to determine the most
viable option.
ii) Lessor’s point of view
From the point of view of the lessor, the prospects of leasing out an asset should be
made out in the following manner:

1) Present Value Method: Following are the main steps involved in this method:

i) Find the cash outflows by deducting the tax incentive of owning the assets. Such
incentives include investment allowance and such other perks.

ii) Calculate the cash inflows after tax.

iii) Calculate the present value of cash outflows as well as the cash inflows after tax. This is
done by discounting the weighted average cost of capital of the lessor.

iv) The present value of cash inflows should be compared with the present value of cash
outflows. The asset should be leased out if the present value of cash inflows is higher than
the present value of the cash outflows and vice versa.
2) Internal Rate of Return Method: IRR refers to the discount rate
which equates the present value of cash inflows with the present
value of cash outflows:
i) Internal Rate of Return (IRR) needs to be computed by using
present value tables. Following are the main steps involved in this
process:
Find the future net cash flows for the duration of the lease.
Find the rate of discount which equates the present value of cash
inflows with the present value of cash outflows.