Leasing and Hire Purchase - Comprehensive Notes | MODULE D: FINANCIAL PRODUCTS AND SERVICES
Leasing and Hire Purchase - Complete Study Notes
Lease Finance
Lease finance is an arrangement where one party (lessor) provides an asset for use to another party (lessee) for a specified period in exchange for periodic payments called lease rentals. It allows businesses to use expensive equipment without purchasing them outright, preserving working capital.
Mathematical Example:
Suppose a machine costs ₹10,00,000 and is leased for 5 years at an annual lease rental of ₹2,50,000. Find the Net Present Value (NPV) of leasing at a discount rate of 10%.
NPV = Σ [Lease Rental / (1 + r)^t]
= (2,50,000 / 1.1) + (2,50,000 / 1.1²) + (2,50,000 / 1.1³) + (2,50,000 / 1.1⁴) + (2,50,000 / 1.1⁵)
= ₹9,47,808.24
Evolution of Leasing in India
Leasing was formally introduced in India in the late 1970s. Financial institutions like First Leasing Company of India pioneered the leasing industry. Over time, regulatory reforms, entry of banks into leasing, and NBFCs (Non-Banking Financial Companies) fueled growth.
Types of Leasing
- Operating Lease: Short-term, cancellable lease.
- Financial Lease: Long-term, non-cancellable lease transferring risks and rewards to lessee.
- Sale and Leaseback: Owner sells asset and leases it back for continued use.
- Leveraged Lease: Multiple parties involved; debt financing is significant.
Advantages and Disadvantages of Lease Finance
Advantages
- Preservation of working capital
- Tax benefits (lease payments are tax deductible)
- Flexibility in financing
Disadvantages
- High overall cost due to periodic payments
- No ownership benefits
- Obligations remain even if the asset becomes obsolete
Market Share of Various Leased Asset Classes
In India, leasing majorly covers commercial vehicles, industrial equipment, aircraft, and IT equipment. Commercial vehicle leasing alone accounts for over 50% of the leasing market.
Impact of Leasing on Financial Ratios
Leasing affects key financial ratios such as:
- Debt-Equity Ratio: Off-balance sheet leases may hide actual liabilities.
- Return on Assets (ROA): Lower assets improve ROA artificially.
- Interest Coverage Ratio: Lower interest burden compared to debt financing.
Mathematical Example:
If Company A has total debt ₹50 lakh and equity ₹1 crore, and additionally takes lease obligations of ₹20 lakh:
Without Lease: Debt-Equity Ratio = 50,00,000 / 1,00,00,000 = 0.5
With Lease: (50,00,000 + 20,00,000) / 1,00,00,000 = 0.7
Legal Aspects of Leasing
Lease agreements are governed by the Indian Contract Act, 1872. The Transfer of Property Act, 1882 also applies to leases involving immovable properties. Key legal components include lease period, lease rentals, maintenance responsibilities, and termination clauses.
Regulatory Aspects of Leasing Activities
The Reserve Bank of India (RBI) regulates NBFCs involved in leasing. Companies must maintain a prescribed capital adequacy ratio and follow KYC (Know Your Customer) norms. Disclosure norms are aligned with accounting standards such as AS-19 on Leases.
Hire Purchase
Hire Purchase (HP) is an arrangement where the buyer takes possession of the asset immediately and pays in installments. Ownership transfers after the last payment. It is commonly used for vehicles and consumer goods financing.
Mathematical Example:
Price of car: ₹5,00,000; Down Payment: ₹1,00,000; Remaining to be paid in 4 annual installments at 12% p.a.
Installment = Principal / n + (Principal * Interest Rate)
First Installment = 4,00,000/4 + (4,00,000 × 0.12) = ₹1,00,000 + ₹48,000 = ₹1,48,000
Evolution of Hire Purchase in India
Hire purchase in India began in the 1930s, primarily for consumer durables and automobiles. Post-1991 liberalization, financial institutions expanded HP services across industrial equipment and real estate sectors.
Legal Aspects of Hire Purchase
Governed primarily by the Hire Purchase Act, 1972 (now repealed but influences current practices) and the Indian Contract Act. The terms include conditions for repossession, rights of the hirer and owner, and penalty clauses for defaults.
Parties to a Hire Purchase Contract
- Owner: Retains ownership until full payment.
- Hirer: Gains possession, but ownership only after completing all payments.
- Guarantor: Provides guarantee for payment (optional).
Leasing and Hire Purchase Compared
| Aspect | Leasing | Hire Purchase |
|---|---|---|
| Ownership | Remains with lessor | Transfers to hirer after final payment |
| Risk and Rewards | Depends on lease type | Transferred to hirer |
| Accounting Treatment | Expense (Operating Lease) or Asset (Financial Lease) | Asset shown in balance sheet with liability |
| Tax Benefit | Lease rental deduction | Depreciation + Interest deduction |
Chapter List: MODULE D: FINANCIAL PRODUCTS AND SERVICES
- Overview of Financial Markets
- Money Markets and Capital Markets
- Fixed Income Markets - Debt / Bond Markets
- Forex Markets
- Interconnection of various markets/Market Dynamics
- Merchant Banking Services
- Derivatives Market including Credit Default Swaps
- Factoring, forfaiting & Trade Receivables Discounting System (TReDS)
- Venture capital
- Leasing and Hire Purchase
- Credit Rating agencies & their functions
- Mutual Funds
- Insurance Products
- Pension Funds (include APY, NPS)
- Guidelines on Para Banking & Financial Services provided by Banks
- Real Estate Investment Funds / Infrastructure Investment Fund (concept)
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