Module-F

Leasing and Hire Purchase

1. Meaning of Hire Purchase
In general, a lease is a contractual arrangement under which the owner of an asset
(called the lessor) agrees to allow the use of his asset by another party (lessee) in
exchange of periodic payments (lease rents) for a specified period. The lessee pays the
lease rent as a regular fixed payments over a period of time at the beginning or at the end
of a month, quarter, half-year or year. Although generally fixed, lease rents can be
tailored both in terms of amount and timing to the profits and cash flow position of the
lessee. At the end of the lease contract the asset reverts back to the real owner, i.e., the
lessor. However, in long-term lease contracts, the lessee is generally given the option to
buy or renew the lease.

2. Types or Forms of Leasing

There are several types of leases prevalent in financial markets. The major ones are
discussed below:
i.

Operating Lease
An operating lease is an agreement in which the lessee acquires the use of an asset on
a period-to-period basis. That is, instead of taking an asset on long-term basis at one
point of time lessee prefers the system of hiring an asset for each period (say a year,
half-year, quarter or even month) with the option of renewing the same after its
expiration date.

ii.

Financial Lease
Financial lease differs from operating lease in important respects. First, in contrast to
operating lease, financial (capital) lease involves a relatively longer-term
commitment on the part of the lessee. They are non-cancelable, in the sense that the
lessee is contractually obliged to make lease payments during the entire period
specified in the contract. Second, the financial lease is less expensive relative to
operating lease from the point of view of the lessor as the maintenance and service
costs are generally borne by the lessee. Financial leases are commonly used for
leasing land, buildings and large pieces of fixed-equipments.

iii.

Sale and Lease Back

As the name suggests, under this form of lease arrangement, the firm sells an asset,
already owned by it to another firm/party and hires it back from the buyer. The lessor

is ordinarily a financial institution such as commercial bank, development bank,

insurance company or leasing company.
A sale-lease back arrangement is normally initiated/preferred by a firm that is
suffering from the shortage of funds for its operations or is faced with liquidity crisis.
iv.

Direct Lease

Under direct leasing, the lessee does not already own the equipment. He acquires it
either from the manufacturing company directly (say taking computers form IBM) or
arranges the desired equipment to be purchased by the leasing company.
v.

Leveraged Lease

A leveraged lease or third party lease is one that involves a third party who is lender,
in addition to the lessor and lessee. Under the arrangement, the lessor borrows funds
from the lender and himself acts as an equity participant. Normally the equipment
borrowed is substantial vis-a-vis the funds provided by the lessor himself. The lessor
services the debt out of lease rents received. Typically, such types of leases are
popular in structuring leases of very expensive assets such as the lease of a plane or
ship. The third party usually involved in financing the transaction is a financial
institution like commercial banks, insurance company etc.
vi.

Primary and Secondary Lease

The lease contract is sometimes divided into two parts, namely, primary lease and
secondary lease. The primary lease provides for the recovery of the cost of the asset
and profit through lease rentals during the initial years (say 4 to 5 years) of lease
contract followed by the secondary/perpetual lease at nominal lease rents.

3. Financial Evaluation of Lease

The evaluation of lease financing from the view point of lessee involves the following
steps:
i.

Determine the after tax cash outflows for each year under the lease alternative.
This is arrived at by multiplying the lease rental payment (L) by (1 Tax rate,
t).
ii.
Determine the after-tax cash outflows for each year under the buying
alternative based on borrowing. The amount is equal to:
Loan instalment (Gross cash outflows, GCO)
Less tax (t) advantage on interest, r i.e. (1Xt)
Less tax shield due to depreciation (D) Allowance (D X t)
iii.
Compare the present value (pv) of the cash flows associated with leasing (step
1) and buying (step 2) alternative by employing after tax cost of debt (kd) as
the discount rate for the purpose.

iv.

Select the alternative with the lower present value of cash outflows. Thus, the
decision criterion is:

a. PV of cash outflows
under
leasing >
alternative

PV of cash outflows as per

buying alternative

Buy the asset

b. PV of cash outflows <

under
leasing
alternative

PV of cash outflows as per

buying alternative

Lease the asset

4. Economics of Leasing
There are several qualitative considerations which make leasing an attractive
proposition. Some of the commonly cited advantages of leasing are:
i.
ii.
iii.
iv.
v.
vi.
vii.

Shifting the Risk of Technological Obsolescence

Easy Source of Finance
Conversion of Borrowing Capacity through off-the Balance-sheet Financing
Improved Performance
Convenience and Flexibility
Maintenance and Specialized Services
Lower Administrative Cost

Disadvantages
There are certain disadvantages of leasing. The important one are:
i.
ii.
iii.

Risk of being Deprived of the Use of Equipment

Alteration/Changes in the Asset
Terminal Value of the Asset.

Problem: 1
ABC Machine Tool Company is considering the acquisition of a large equipment to set
up its factory in backward region for Tk. 12, 00,000. The equipment is expected to have
economic useful life of 8 years. The equipment can be financed either within an eightyear term loan at 14% interest, repayable in equal installments of Tk. 2, 58,676 per year
or by an equivalent amount of lease rent (Tk. 2, 58,676) per year. In both the cases,
payments are due at the end of the year. The equipment is subject to straight line method
of depreciation. Assuming no salvage value, 50% corporate tax rate, which of the
financing alternative it should select?
Problem: 2

XYZ Builders & Company needs to acquire the use of a crane for construction business
and is considering whether buy or lease. The crane costs Tk. 10, 00,000 and is subject to
straight-line method of depreciation to a zero salvage value at the end of 5 years. In
contrast, the lease rent is Tk. 2, 20,000 per year to be paid in advance each year of 5
years. The XYZ Builders can raise debt at 14% payable in 5 equal annual installments,
each installment becoming due at the beginning of the year. It is in 50% tax bracket.
Advise the company.

5. Hire Purchase Agreements

A hire purchase agreement is one under which a person takes delivery of goods promising
to pay the price by a certain number of installments and, until full payment is made, to
pay hire charges for using the goods.
Under hire purchase agreement goods are let on hire and under which the hire has an
option to purchase them in accordance with the terms of the agreement and includes a
agreement under which,
Possession of goods is delivered by the owner thereof to a person on condition
that such person pays the agreed amount in periodical instalments, and
The property of the goods is to pass to such person on the payment of the last of
such instalment, and
Such person has a right to terminate the agreement at any time before the property
so passes.