Leasing & Hire Purchase

All about Leasing & HP

Its Contribution to Economic
Development

Rajendra Adsul
Maneesh Agrawal
Kumar Chitalia
Sameer Pandit
Ranjita Sahu
Kinjal Shah
Agenda
• Leasing defined
• Overview of the leasing industry worldwide
• Why has leasing grown so fast
• Impact of leasing
– Economic development
• Micro, Small and Medium Sized Enterprises (MSMEs)
– Financial sector development
• Role of the Regulator / Enabling environment
• Trends in Leasing Industry
• Conclusions
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Introduction

 Leases and hp contracts are means by which companies

obtain the right to use or purchase fixed assets.

Avoids having to raise the cash up front.

The substance of the transaction is very similar to

purchasing an asset through a loan.
SOME BASIC TERMS

• LEASE is a contract between a lessor and a lessee for

the hire of a specific asset. The lessor retains the
ownership of the asset but conveys the right to use the
asset to the lessee for an agreed period of time in return
for specific rentals.
• LESSOR is the legal owner of the asset. Lessor rents
out the asset to a lessee and receives income
• LESSEE pays rents in accordance with the terms of the
lease; receives economic benefits associated with the
asset and also incurs future obligations.
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Leases
• No legal title passes, but lessee is given the right
to use the asset for a designated period of time.
• Capital allowances are not available to the lessee
• If a finance lease, depreciation and interest are
charged against profit over the assets useful
economic life.
• Machinery is leased from a company with the
intention of keeping it for the majority of it’s
useful life. The lessee is responsible for insuring
it, maintaining it and servicing it.
 Types of Leases

OPERATING LEASES
• Relatively short term agreement: akin to hiring an asset
e.g. a taxi, car for holidays
• Easily cancellable arrangement
• Risk/rewards do not usually pass to the lessee.
• Lessor remains responsible for repairs and
maintenance.
• Payments by the lessee to the lessor are charged to P/L
account on a straight line basis
• Receipts are shown as revenue in the P/L account of the
lessor on a straight line basis.
• Note to the accounts if amounts are material
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 FINANCE LEASE

• Long term arrangement. Covers most of the asset life. Lessee

responsible for risk of technological obsolescence
• Generally non-cancellable
• Transfers risk/reward of ownership to lessee. The lessee
responsible for maintenance and insurance.
• Lessee pays full cost of asset plus a return on finance provided
by lessor
• Minimum Lease Payment by the lessee = 90% of the fair value
of the asset.
• Assets specifically manufactured may be treated as finance
leases
• Technically, the lessor has legal ownership of asset, but in
reality the transaction is very similar to outright purchase,
financed by a loan repayable in instalments. 7
Financial Leasing

• A contractual arrangement that allows one party (the lessee) to

use an asset owned by the leasing company (the lessor) in
exchange for specific periodic payments. This requires:

– Separation of legal ownership from economic use

– Credit analysis focuses on lessor’s cash generation capacity
to finance lease payments rather than relying on credit
history
– Security is the asset itself
• As such, this product is particularly suitable for new Micro,
Small or Medium Sized Enterprises
(MSMEs) without a long credit history of
financial statements.
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Common Terms

• Leveraged lease: lessor 25%, lessee, financer 75%

(loan)
• Sale & Lease-back: lessee sells pre-owned asset to
lessor & leases it back
• Cross border: International lease between parties in
two or more countries; if between 3 parties –
manufacturer/vendor, lessor, lessee in 3 countries it
is called foreign-to-foreign lease
• Sale & Lease-back: User sells existing asset to
lessor and leases it back
Common Terms

• Closed-ended lease: asset transferred to lessor at

end of lease; risk of obsolescence, residual value,
etc. his problem
• Open-ended lease: lessee has option to purchase
asset at end of lease
• Direct lease: mix of operating & financial lease;
provides purchase option to lessee at end of lease
Common Terms

• Master lease: for a period longer than asset life;

lessor responsible for providing asset in good
condition
• Percentage lease: fixed rent + % of previous year’s
gross revenue to be paid by lessee to lessor;
protects against inflation
• Wet & Dry lease: aircraft industry; financing +
servicing + fuel
Common Terms

• Net net net lease: triple net lease lessee takes care
of maintenance, taxes, & insurance of equipment

• Update lease: protects lessee aginst obsolescence.

Lessor agrees to replace obsolete equipment with
new asset at specified rent
Benefits of Leasing

• Bank (lessor) ‘buys’ asset (and gets benefit of tax allowance)

because it is awash with cash
• Bank post tax cash flow is improved because it receives tax
allowances
• Bank can offer reduced interest rate (which benefits manufacturer)
• Bank (lessor) leases asset to manufacturer (lessee) who may not
have adequate taxable profits. Thus leasing results in smaller charge
against P&L compared to outright purchase
• Inland Revenue had no problem with these arrangements

• Now more sophisticated forms to improve balance sheets.

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 IMPACT OF LEASING

• ASSETS/LIABILITIES UNDERSTATED
• ROCE DISTORTED
• GEARING DISTORTED
• FINANCIAL RISK MAY BE MIS-SPECIFIED
• COST OF CAPITAL MISPRICED
• MARKETS MISLED, RESOURCES MISALLOCATED
Hire Purchase

• Hirer may acquire legal title (upon payment of

agreed number of instalments).

• Capital allowances are available to hirer.

• If of a financing nature, depreciation (calculated

over useful life) and interest are charged against
profit.
• HP- Financing Arrangement
• A vehicle is acquired under an HP agreement from a garage
with the intention that ownership will change hands. The
purchaser being responsible for taxing it, insuring it,
maintaining it and servicing it.
• HP - Operating Arrangement
• Car hire for a month or two from a rental company.

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 LEASE V HIRE PURCHASSE (HP)

LEASE HP / HL

• Main objective is ‘usage’ • Ultimate objective is

and not ‘ownership’. ownership.

• Tax element plays a crucial • Interest rate is the key

role. factor.

• Ownership benefits to the • Ownership benefits to the

financier. borrower.

• Concept of residual value. • No concept of residual

value 17
Overview of the Leasing Industry

• Historically, leasing dates back to thousands of years –

where the industry has developed from being a
manufacturer’s selling technique to a stand-alone
specialized financial service industry.
• First leasing firms started in the US in 50’s; then in
Europe and Japan in the 60’s; and since the 70’s, leasing
has been spreading to many developing nations
• In 2001, over US$476 billion of new vehicles, plant,
machinery and equipment were financed
through leasing.

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Overview (Cont’d)

• Africa region accounted for US$3.8 bn less than 1% of total

volume

• The top four countries in leasing volume are U.S., Japan,

Germany, and the U.K.

• South Africa remains the largest leasing market in the Africa

region with a volume of US$2.79 bn

• Substantial scope for future growth – globally, annual leasing

volumes as a percentage of GDP average about 1.5% (U.S.
2.3%).
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Leasing Industry
in the Developing Countries

• Since the late 70’s, many developing nations have been

developing their leasing industries.

• The most spectacular increases being in Asia, led by Korea

– In 1994, South Korea’s leasing market was 5th largest in

the World – an industry which was started in 1975 with
IFC’s investment in Korea’s first leasing firm.

• Growth of leasing in Africa, Asia and S. America exploded

in the early 90’s but stagnated over the last 5 years.

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Why has Leasing Grown so Fast

• Leasing has filled the gap for financing the un-met

demand for a key sector in any Economy

• MSE are mostly shunned out from the formal banking

sector due to high transactions costs, and as well as
other considerations.

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Evolution phases in India

Pre 1970 1970-1995 1995-2004

- Only HP companies - Entry into equipment - Exit of large no. of

 
finance through: companies:
- Automobile
* Leasing * Small & Large
financing mainly for
commercial vehicles * Hire Purchase
 
* Indian & Foreign
 

- Fixed Deposit: main - Commencement of car - Regulation by RBI

source of funds finance
  - Few companies
- Access to Capital Markets diversified into
related financial
 

- Funds from FDs and services

Banks
Why has Leasing Grown so Fast
Beneficial to both lessee and lessor:
For Lessee:
• Fewer requirements about balance sheets.
• Leasing may be the only source of financing
• No outside security/collateral needed
• Low documentation cost
• Leasing can finance a higher % of equipment than bank
loans
• Governments allow lessees to deduct full lease payments
from their income before tax.
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Why has Leasing Grown so Fast
Beneficial to both lessee and lessor:
For Lessor:
• Ownership of asset
• Transaction costs lower
• Lighter regulations, because they are not deposit taking
institutions.
• Tax incentives, although they are eroding.
• Better control on utilization of funds.

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Why has Leasing Grown so Fast
Beneficial to both lessee and lessor:
For Lessee: For Lessor:
• Fewer requirements about balance • Ownership of asset
sheets.
• Leasing may be the only source of
• Transaction costs lower
financing • Lighter regulations, because
• No outside security/collateral they are not deposit taking
needed institutions.
• Low documentation cost • Tax incentives, although they
• Leasing can finance a higher % of are eroding.
equipment than bank loans
• Better control on utilization of
• Governments allow lessees to
deduct full lease payments from funds.
their income before tax.

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Impact of Leasing (Cont’d)

• Impact on Broadening the Financial Sector Development:

Leasing companies have helped develop capital markets by
increasing financing options for segments of the market
which previously relied on informal financing, supplier credit,
and internal cash generation – Filled the gap left by banks

• Impact on Capital Markets: As leasing firms grow, their

needs for diversified funding sources becomes eminent –
leading to the use of securitization, issuances of bonds and
other capital instruments.

• Increased Competition: The entry of leasing firms in

financing the MSME has encouraged competition in many
markets, whereby some of the banks started to go down-
market in order to serve the smaller clients.
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Present industry order

Only few major players exist

 SREI International Finance  Shriram Finance

 Sundaram Finance
 Tata Finance

 Cholamandalam Finance
 Countrywide Finance
 Mahindra & Mahindra
 Citicorp
 GE Capital
Challenges before the Industry
 Funding and regulatory issues

 Poor availability of medium and long term funding

 Although right of repossession of assets recognised there are

impediments in implementation

 Multiplicity of taxes - Sales tax / Service tax / Entry tax on lease

transactions

 Multiple Regulators - Lack of Comprehensive Legislation

Opportunities for the Industry
 Huge leasing opportunity
Large Potential
 Outstanding lease & hire purchase assets around Rs 20,000 crores
 Large variety of user segment
 High growth potential in Vehicle Finance
 Commercial Transportation – Govt. support, Diverse products
 Personal Transportation – Wide Variety, Low finance costs, Increasing
Propensity for credit purchase, Huge used car finance market
 New Products - Dealer Finance, Working Capital Finance, Personal Loans
 Low lease penetration ratio
 Around 1.5% as a % of Gross Domestic Capital Formation
 Very low in sectors like equipment & infrastructure
 Substantial upside possible

Expansion Opportunity
 Huge infrastructure spending in next 5yrs (apprx Rs 3,60,000 crores)
 Steadily rising disposable income – Generating huge demand for
consumer goods
With growth ingredients in place

 Global opportunities – Cross-Border Leases allowed

 Substantially reduced dependence on public deposits

as a source of fund - Out of a total asset base of Rs
40,050 crores, public deposits account for Rs 5,850
crores as against NOF Rs 4,500 crores

 Comparatively Low Default Rate – Particularly in

consumer loans and vehicles financing as compared to
many other markets
Future Strategy
Innovation to address evolving consumer needs

 Operating Leases

 Leveraged Leases

 Residual value products

 Using Depreciation & Tax Shields for structuring

Shift focus from customer to product / asset
 Develop strong asset management capabilities including repossession
& remarketing
 Long term mutually beneficial vendor relationships

Cross selling
 Distribution of Financial Products
 Distribution of Insurance Products

Securitisation
 Strong liability product
Importance of Leasing

• Leasing may be the only source of financing as

access to capital markets or bank loans is difficult
given the small size of these companies and/or
their unproven track record.

• Government support of leasing industry is thus an

indirect support of MSMEs. Also, increases
competition in financial services.

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Challenges Facing
the Leasing Industry
• Funding – Leasing companies are not deposit-taking
institutions and access to long-term funding is a critical
success factor
• Eroding tax benefits – the tax benefits of leasing are gradually
eroding, opening the industry to strong competition from the
banking sector.
• Regulatory environment changes – While the leasing industry
typically has less stringent regulation, changes in law impact
operations substantially.
• Lack of deep pocketed shareholders in the absence of capital
markets.
• Too much concentration in a sector
• Lack of a robust secondary market for certain equipments.
• Risk management not managed. 37
Enabling Environment:
Legal and Regulatory Aspects
• Strengthening Leasing Laws
– Lessor’s ownership over the assets funded must be
clearly stipulated with simple, effective and timely
procedures for repossession if lessee defaults
– Lessee and possession rights – to ensure
uninterrupted use for the length of the lease
– Central Registry of charges
• Supervision and Regulation
– Restrict leasing to Licensed operators
– Prudential Requirements – less strict than
for deposit-taking institutions 38
Enabling Environment:
Tax and Accounting

• Lessor – Lessors can typically take the benefit of

depreciation expense as a shield against taxes. This
advantage has been eroding in the recent past.
• Lessee – Lessees can offset their full lease payments
against income before tax
• Sales Tax – Post contract sale of assets is typically
exempt from sales tax
• Accounting – Accounting for Leases is done
under IAS 17 internationally
• Cross Border Issues
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Trends in Leasing Industry

• Customers: • Leasing Companies:

– Smarter – Specialization
– Diverse – Diversification
– Seek more Alternatives – Consolidation
– Service Conscience – Globalization
– Understand Asset – Branding, Relationship,
Management Image Building
– Trending to Technology
• Products: • Rules and Regulations
– Assume/Manage more Risk – Distinction Between Lease
– Solution Packages and Loans
– Leases with Other – Expanded Public Official
Financing Packages Understanding
– Venture Leasing – Global Harmonization of
Accounting

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Conclusions

• Leasing is an important source of funding for MSEs,

which are key drivers of economic development in
developing countries.
• There is substantial scope for future growth in the
industry, particularly in developing countries.
• However, the industry faces financial and regulatory
challenges which must be addressed to promote its
growth.
• Leasing is instrumental in assisting the
development of the financial sector,
and of the economy as a whole.
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