FM3
UNIT IVLease and Hire Purchase Financing Q1) Write the meaning and types of lease?A1) A “lease” is defined as a contract between a lessor and a lessee for the hire of a specific asset for a specific period on payment of specified rentals.The maximum period of lease according to law is for 99 years. Previously land or real estate, mines and quarries were taken on lease. But now a day’s plant and equipment, modem civil aircraft and ships are taken(i) Lessor:The party who is the owner of the equipment permitting the use of the same by the other party on payment of a periodical amount.(ii) Lessee:The party who acquires the right to use equipment for which he pays periodically.Lease Rentals:This refers to the consideration received by the lessor in respect of a transaction and includes:(i) Interest on the lessor’s investment;(ii) Charges borne by the lessor. Such as repairs, maintenance, insurance, etc;(iii) Depreciation;(iv) Servicing charges. Types of Leases:The different types of leases are discussed below:1. Financial Lease:This type of lease which is for a long period provides for the use of asset during the primary lease period which devotes almost the entire life of the asset. The lessor assumes the role of a financier and hence services of repairs, maintenance etc., are not provided by him. The legal title is retained by the lessor who has no option to terminate the lease agreement.The principal and interest of the lessor is recouped by him during the desired playback period in the form of lease rentals. The finance lease is also called capital lease is a loan in disguise. The lessor thus is typically a financial institution and does not render specialized service in connection with the asset. 2. Operating Lease:It is where the asset is not wholly amortized during the non-cancellable period, if any, of the lease and where the lessor does not rely for is profit on the rentals in the non- cancellable period. In this type of lease, the lessor who bears the cost of insurance, machinery, maintenance, repair costs, etc. is unable to realize the full cost of equipment and other incidental charges during the initial period of lease.The lessee uses the asset for a specified time. The lessor bears the risk of obsolescence and incidental risks. Either party to the lease may termite the lease after giving due notice of the same since the asset may be leased out to other willing leases. 3. Sale and Lease Back Leasing:To raise funds a company may-sell an asset which belongs to the lessor with whom the ownership vests from there on. Subsequently, the lessor leases the same asset to the company (the lessee) who uses it. The asset thus remains with the lessee with the change in title to the lessor thus enabling the company to procure the much needed finance. 4. Sales Aid Lease:Under this arrangement the lessor agrees with the manufacturer to market his product through his leasing operations, in return for which the manufacturer agrees to pay him a commission.5. Specialized Service Lease:In this type of agreement, the lessor provides specialized personal services in addition to providing its use. 6. Small Ticket and Big Ticket Leases:The lease of assets in smaller value is generally called as small ticket leases and larger value assets are called big ticket leases. 7. Cross Border Lease:Lease across the national frontiers is called cross broker leasing. The recent development in economic liberalization, the cross border leasing is gaining greater importance in areas like aviation, shipping and other costly assets which base likely to become absolute due to technological changes. Q2) Write a note: Hire Purchase.A2) Hire Purchase is defined as an agreement in which the owner of the assets lets them on hire for regular installments paid by the hirer. The hirer has the option to purchase and own the asset once all the agreed payments have been made. These periodic payments also include an interest component paid towards the use of the asset apart from the price of the asset.The term ‘Hire-Purchase’ is a UK term and is synonymous to ‘rent-to-own’ or ‘installment plan’ in various other countries. Owning goods through hire and purchase lets companies improve their earnings performance. Not just beneficial to the hirer, this system is also the most effective and secure form of credit sales for the current owner of the asset.Hire purchase is a method of purchasing or financing capital goods whereby the goods are accessible for use almost instantaneously but the payment is made in smaller parts over an agreed period. The ownership is transferred only after the paying all installments. Technically speaking, it is an agreement between the buyer (or user) of the asset and the financing company whereby the financing company purchases the asset on behalf of the buyer and the buyer utilized it for business purpose and pays back to the financing company in small installments called hire charges.In other words, hire purchase can be defined as an option of financing or acquiring an asset for use whereby the financing company let the goods on hire to the buyer against small installments called hire charges and the buyer gets the right to use the asset with an option to purchase the asset by paying all such installments spread over a period of time. Hire purchase was very prominent for vehicle financing whether that is a personal car, commercial vehicle etc but now equipment, machinery etc are also financed with hire purchase method Q3) What is the Need and Importance of Hire Purchase?A3) Hire purchase is a typical transaction in which the assets are allowed to be hired and the hirer is provided an option to later purchase the same assets.
Following are the features of a regular hire purchase transaction:Rental payments are paid in installments over the period of the agreement. Each rental payment is considered as a charge for hiring the asset. This means that, if the hirer defaults on any payment, the seller has all the rights to take back the assets. All the required terms and conditions between both the parties involved are documented in a contract called Hire-Purchase agreement. The frequency of the installments may be annual, half-yearly, quarterly, monthly, etc. according to the terms of the agreement. Assets are instantly delivered to the hirer as soon as the agreement is signed. If the hirer uses the option to purchase, the assets are passed to him after the last installment is paid. If the hirer does not want to own the asset, he can return the assets any time and is not required to pay any installment that falls due after the return. However, once the hirer returns the assets, he cannot claim back any payments already paid as they are the charges towards the hire and use of the assets. The hirer cannot pledge, sell or mortgage the assets as he is not the owner of the assets till the last payment is made. The hirer, usually, pays a certain amount as an initial deposit / down payment while signing the agreement. Generally, the hirer can terminate the hire purchase agreement any time before the ownership rights pass to him. Immediate use of assets without paying the entire amount. Expensive assets can be utilized as the payment is spread over a period of time. Fixed rental payments make budgeting easier as all the expenditures are known in advance. Easy accessibility as it is a secured financing. No need to worry about the asset depreciating quickly in value as there is no obligation to buy the asset. Q4) Elaborate the Calculation of Cash flows of a finance lease.A4) Lessee’s Point of View:Once a firm has evaluated the economic viability of an asset as an investment and accepted/selected the proposal, it has to consider alternate methods of financing the investment. However, in making an investment, the firm need not own the asset. It is basically interested in acquiring the use of the asset.Thus, the firm may consider leasing of the asset rather than buying it. In comparing leasing with buying, the cost of leasing the asset should be compared with the cost of financing the asset through normal sources of financing, i.e., debt and equity.Since, payment of lease rentals is similar to payment of interest on borrowings and lease financing is equivalent to debt financing, financial analysts argue that the only appropriate comparison is to compare the cost of leasing with that of cost of borrowing. Hence, lease financing decisions relating to leasing or buying options primarily involve comparison between the cost of debt-financing and lease financing. The evaluation of lease financing decisions from the point of view of the lessee involves the following steps:(i) Calculate the present value of net-cash flow of the buying option, called NPV (B).(ii) Calculate the present value of net cash flow of the leasing option, called NPV (L)(iii) Decide whether to buy or lease the asset or reject the proposal altogether by applying the following criterion:(a) If NPV (B) is positive and greater than the NPV (L), purchase the asset.(b) If NPV (L) is positive and greater than the NPV (B), lease the asset.(c) If NPV (B) as well as NPV (L) are both negative, reject the proposal altogether.Since many financial analysts argue that the lease financing decisions arise only after the firm has made an accept-reject decision about the investment; it is only the comparison of cost of leasing and borrowing options. The following steps are involved in such an analysis:(i) Determine the present value of after-tax cash outflows under the leasing option.(ii) Determine the present value of after-tax cash outflows under the buying or borrowing option.(iii) Compare the present value of cash outflows from leasing option with that of buying/borrowing option.(iv) Select the option with lower presented value of after-tax cash outflows.
Following are the features of a regular hire purchase transaction:
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