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UNIT III
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LEASING AND HIRE PURCHASE
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LEASING
Leasing concept & classification
Evolution of Indian leasing Industry Presentation
Product profile
Legal (regulatory aspects of leasing in India), tax & accounting aspects of leasing
Funding of leasing in India.
Financial evaluation of leasing
HIRE PURCHASE Concept and characteristics
Legal & tax frame work, mathematics
Financial evaluation of hire purchase deals-
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LEASING
Owner of an asset grants theright
Use the asset to other partyReceiver of the services of asset
Under lease contract
Individual,company,firmPeriodic payment- lease rental
lessor lessee
Contractual agreement
Leaserenting of an asset for some specified period
Seller, supplier, fin co, manuClaims depreciation on the asset
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MEANING - LEASING
Divorce of ownership from the economic
use of an asset/equipment
Device of financing(money lending) thecost of an asset/capital asset
Fund based service
Lending of funds/finance/credit
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CONCEPT OF LEASE
JAMES C.VAN HORNE DEFINED:
Lease is a contract whereby the owner of anasset (lessor)grants to another party (lessee)
the exclusive right to use the asset usually foran agreed period of time in return for thepayment of rent.
LEASING
Is a process by which a firm canobtain the use of certain fixed asset for whichit must make a series of contractual periodictax-deductible payment (lease rentals)
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ESSENTIAL ELEMENTS OF LEASING
Parties to the contract-lease financier, lessor, broker,
lessee
Asset: asset, property or equipment
Ownership separated from the user
Term of the lease
Lease Rentals
Modes of terminating lease
At the end of the lease period the asset reverts back to the
lessor unless there is a provision for the renewal of contract.
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STEPS INVOLVED IN LEASING
TRANSACTION Lessee decide asset req & supplier
Lessee enters lease agreement lessor
Basic lease period Timing and amount of periodical rental payment
Option details renew/purchase
Payment details maintenance, repairs, taxes,
insurance & other expenses
Lessor contacts manufacturer supply
makes payment after asset delivered &
accepted by lessee.
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CLASSIFICATION OF
LEASING Financial Lease & Operating Lease
Sale & Leaseback & Direct Lease
Single investor Lease & Leveraged
lease
Domestic Lease & International LeaseBased on risks & rewards, parties involved
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FINANCIAL LEASE
The lessor transfers to the lessee,substantially all the risks & rewards
incidental to the ownership of theasset whether or not the title iseventually transferred.- IAS -17
Also known as Capital lease, long term lease,net lease and close lease, Full payout leases
Approach to economic life
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The salient features of a lease are:A financial lease is a long-term, non-cancelable
lease.
The lessee has the option to purchase the assetat a price - sufficiently lower than the fair marketvalue .
The lease term - major part of the useful life of theasset.
The lessee is responsible - maintenance of the
asset - for insuring it against accidental damage orloss.
The risk of Damage is shifted from the lessor tothe lessee.
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OPERATING LEASE
According to the IAS-17, an operating
lease is one which is not a finance
lease. In an operating lease the lessor does
not transfer all the risks & rewards
incidental to the ownership of the asset.The lessor provides all the services
attached to the leased asset.Also known as Service lease, Short term lease or True lease
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Features: The lease term is significantly less than
the economic life of the equipment.
The lease is usually cancelled at a short
notice.
The lessor is responsible for theinsurance & maintenance of the asset.
The lessor bears the risk of economic &functional obsolescence of the asset.
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DISTINCTION BETWEEN A
FINANCIAL LEASE & OPERATING
LEASE FINANCIAL Installment loan
Taxes & maintenancelessee
Risk of obsolescencelessee
Contract period medium long term
Contract non-cancellable
Air crafts, land , building..
Lessor fulfills financialfunction
OPERATING LEASE Rental agreement
Taxes & maintenance
lessor Risk of obsolescence
Lessor
Ranges formintermediate short term
Cancellable Computers, officeequipment,Taxi,mobilecranes
Service function
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SALE & LEASEBACK
The owner of an equipment/asset sells
(Mkt value)it to a leasing company
(lessor) which leases it back to theowner (lessee).
The leaseback arrangement - in theform of a finance lease or an operating
lease.Retail stores, office buildings, multipurpose industrial building,
shopping centre
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DIRECT LEASE
TWO TYPES:
BIPARTITE LEASE equipment
supplier cum lessor & lessee (operatinglease) upgrade lease, swap lease
TRIPARTITE LEASE: equip supplier,
lessor, lessee sales aid lease
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SINGLE INVESTOR LEASE
(Two parties) The leasing company (lessor) funds the
entire investment by raising.
The debt funds raised by the leasingcompany are without recourse to the
lessee.
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Leveraged Lease (3 parties)
borrowing a large chunk of the
investment with full recourse to the
lessee & without any recourse to it.
Lessor
Loan participant
Trustee LesseeLeases the
Equipment
HUGE CAPITAL LAYOUT & ECONOMIC LIFE - 10 YRS OR MORE
Equity investor
lender
Aircraft, ships etc..
LEASING COMPANY
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Domestic Lease VS International Lease
Domestic lease :All the parties to thetransaction are domiciled in the same
country.
International lease: All parties to the leasetransaction are domiciled in different
countries.
IMPORT LEASE- Lessor and lesseedomiciled in samecountry, supplier in different country
CROSS-BORDER LEASE: Lessor and lessee are domiciled
in different countries, supplier in any country
- Involve Country risk & currency risk
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LEASE RELATED RISKS
(Borne by the lessor) Default risk
Residual value risk
Interest rate risk
Purchasing Power risk
Currency & Cross-border risk
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ADVANTAGES OF LEASING
To the lessee:
1. 100% Financing of Capital Good2. Flexibility & convenience - structuring of rentals, terminating
3. Avoids conditionality's
4. Simplicity
5. Tax Benefits revenue expense
6. Permit alternative use of funds7. Boon to small firm
8. Protection against obsolescence
9. Conserving borrowing capacity/Facilities additional borrowings
10. Faster and cheaper credit
11.High growth potential/return on capital employed12. Enhanced liquidity
13. No floatation costs
14. No disposal problem
15. Lesser administrative and maintenance costs
16. Off the balance sheet transaction
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ADVANTAGES
To the Lessor:
1. Full security
2. Tax Benefit depreciation-reduce tax
liabilities
3. High Profitability
4. Quick returns
5. Increased sales
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LIMITATIONS
Lessee:
Higher cost
Risk of being deprived of the use of asset
No alteration or change in asset
Loss of ownership incentives
Penalties on termination of lease
Restrictions on use of equipment
Loss of residual/salvage value
Cost of financing generally higher than debtfinancing
Understatement of lessee's asset
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LIMITATIONS
Lessor:
High risk of obsolescence
Competitive market price
Price-level changes
Management of cash flows
Increased cost due to loss of use benefits Long term investment
Double sales tax.
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FACTORS CONSIDERED
BUY/LEASE
Availability of funds
Financial evaluation
Possession of asset Cost of Borrowing
Depreciation
Taxes
Salvage Value
Risk
Maintenance
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PROFILE/STRUCTURING OF
LEASING IN INDIA PRIVATE SECTOR:
Pure leasing companies/Independent
Hire Purchase and Finance companies: tax adv
Subsidiaries of manufacturing group companiesVendor
leasing, in-house leasing/captive
PUBLIC SECTOR:
Leasing divisions of financial institutions: IFCI,ICICIallindia, state level
Subsidiaries of public sector banks: Commercial banks94-95year onwards
Other public sector leasing organisation: Bharat electronicsltd, Hindustan packaging company limited, ECILsell
equipment through leasing
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SOME OF THE LEASING
COMPANIES
First leasing company of India ltd.
Sundaram finance ltd.
Kotak Mahindra Finance ltd
20th century finance corporation ltd.
CEAT Financial services ltd
Ashok Leyland Finance Ltd.
Escorts Financial services ltd
Motor & General Finance Ltd
Anagram Finance ltd.
Rockland leasing ltd
ILFS Infrastructure leasing & financing services
1987
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PRODUCT PROFILE
(lease structures in India) The category of Finance Lease. The lease agreements do not provide for
transfer of ownership to the lessee. The lease rentals are structured so as to
recover the entire investment cost during
the primary period.
The lease rentals are payable generally in
EMIs at the beginning of every month.
CONTD.
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Sale & Lease back type of transactionsare rare. Most of them are direct lease
Equipment leasing covers a wide range ofequipments from industrial plant &machinery, office equipments, vehicles
etc. - standby finance.-
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Legal Aspects/regulatory aspects
There is no legislation that exclusively
governs equipment leasing transactions in
India. CONTRACT ACT:
Law of contract :Two provisions- specifically
applicable to leasing transactions.
General provisions: contract: legal obligation,lawful consideration, competent parties, free
consent, not expressly void, discharge of
contracts: performance, frustration, mutual
agreement , operation of law, remission
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SPECIAL PROVISIONS: The provisions
of the Indian Contract Act, 1872
SECTION 148, relating to bailment areapplicable to leasing transactions
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Leasing as a Bailment Agreement
There are two parties to a bailment
agreement, ie, bailor who delivers the
goods & bailee to whom the goods aredelivered for use.
There is delivery of transfer of goods
from the bailor(lessor) to bailee(lessee).The ownership of the goods continues
with the bailor (lessor).
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The goods in bailment should be
transferred for a specific purpose under a
contract. purpose to make use ofeconomic life of asset.
When the purpose is accomplished, the
goods are to be returned to the bailor ordisposed off acc. to his directions
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Liabilities of lessee/bailee
Reasonable care
Not to make unauthorized use
To return the goods
Not to set up an adverse title
To pay the lease rental
To insure and repair the goods
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REMEDIES FOR BREACH
Remedies to lessor: Forfeiture,
damages, repossession
Remedies to the lessee:claim damages- termination
MOTOR VEHICLES ACT, 1988- SECTION 146-INSURANCE
RBI NBFCs directonsOther act/laws indian stamp act
Lease documentation and agreement
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FINANCIAL EVALUATION
OF LEASING
The objective of evaluation is:
To identify
Lessee - The source of finance &
Lessor - Better investment alternative .
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Lessees Perspective
LEASE Evaluation
Investment decision Financing decision
Purchase the asset
1. Should the asset be funded with
debt?2. Should the asset be funded with
debt & equity?3. Should it be leased?
o ce etween
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o ce etweenDebt Financing/ borrowing Vs Lease
Financing
Since lease rentals are similar to
payment of interest on debt, leasing
in essence is an alternative to
borrowing.
PROCEDURE FOLLOWED: The
decision criterion used is NPV/NAL.If the NPV/NAL is +ve, the leasing alternative should be used,otherwise the borrowing alternative would be preferable.
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PROCEDURES
NPV/NAL
PV OF CASH OUTFLOWS
BERL
GROSS YIELD
ADD-ON YIELD
IRR BASED PRICING
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Computation of NPV(L)/NAL(net
Adv. of leasing)Initial Investment/investment cost- PV of lease rentals(kd)
- Management fee+ PV (tax shield on lease rentals)
+ PV (tax shield on Mgt. fee)
- PV (tax shield on Depreciation)- PV (Net salvage value)
Lease the equipment if NAL is +veBuy the equipment if NAL is -Ve
Kd pre-tax cost of long term debt
Kc - post tax marginal cost of capital
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BREAKEVEN LEASE
RENTAL The BELR is the rental at which lessee
is indifferent between lease
financing/borrowing & buying.
BELR has NAL as zero. It reflects themaximum level of rental which the
lessee would be willing to pay.
If the BELR exceeds the actual lease rental, the lease
proposal, would be accepted, otherwise rejected.
LESSEE
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LESSORS VIEWPOINT
Accept a lease proposal /choose from
alternative proposal
BELR represents the minimum (floor)lease rental which he can accept. The
NAL at this level is zero.
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The NAL to a lessor:
PV of Cash Inflows PV of Cash Outflows
CASH OUTFLOWS:Initial InvestmentIncome tax on lease rentalsSales-tax on lease transactions
Administration expenses CASH INFLOWS:
Lease rentalsManagement fee
Tax shield on depreciationResidual value
Security deposit if any
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NEGOTIATING LEASE
RENTALS The BELRs of the lessor & the lessee
represents the range of acceptable level
of rentals. The BELR of the lessor sets
the lower limit, while the BELR of thelessee sets the upper limit of the range.
The actual rental has to be negotiated
within the range.A rental within the range implies a
+ve NAL both for the lessor & the lessee.
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ADD-ON YIELD
A variant of gross yield. The add-on yield, akin to flat rate of
interest assumes that the investment in
the lease remains constant over thelease period.
The add-on yield is not a true measure.
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IRR BASED PRICING
IRR internal rate of return rate of
discount at which present value of
cash-inflows = PV of cash outflows The IRR of a lease investment is that
rate of interest at which NAL is equal
to zero.The lease investment is accepted if & only ifthe IRR exceeds the required rate of return.
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TAX ASPECTS
Income tax provisions:
Lessee : lease rentals as tax- deductible
expenses Lessor:
Lease rental are taxableProfits &
gains of business or profession
investment allowance/depreciation on
the investment
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SALES TAX PROVISIONS
The lessor is not entitled confessional
rate CST use/resale
46th amendment act (Under purview ofsale ) - ST
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ACCOUNTING TREATMENT OF
LEASE
Lessor :
The leased asset is shown on the balance
sheet Depreciation and other tax shields
Lease rentalincome lessor
Lessee: Lease rental - expenseIAS International accounting standard, 17- 1982
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PRESENTATION
N. JOHN
History of hire-purchasing
Concept Stipulations,modus operandi,Features
Legal framework
Financial evaluation
SOWJANYA:
Hire Purchase Vs Installment
Hire Purchase Vs Leasing
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HIRE-
PURCHASING
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Evolution U.K, Henry moore- paino maker 1846
U.S.A furniture dealer 1807 In India for more than 6 decades. Thefirst hire-purchase company is
believed to be Commercial Credit
Corporation. - Madras Motor and General Finance and
Instalment Supply Company werebased in North India.
investments supply ltd. National small industries corporation
supplies machinery ssi
These companies were set up in the 1920s
and 1930s.
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Development of Hire-purchase - two forms:
Consumer durables and
Automobiles Consumer durables hire-purchase was
promoted by the dealers in the respective
equipment.
Singer Sewing Machine company, orMurphy radio dealers - instalment facilities
on hire-purchase basis
Hire-purchase of commercial
vehicles developed very fast.
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UNTING
ASPECTS
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TAXATION ASPECTS
INCOME TAX HIRER: CB of direct taxes 1943- Entitled to
the tax shield on depreciation.
Tax shield on consideration for hire i.e,finance charge (hire charges).
INCOME TAX HIRE VENDOR:
The hire charges - is liable to tax underthe head profits & gains of business &
profession.
SALES TAX:
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SALES-TAX:
Hire-purchase transactions are liable to
sales tax. The sales tax is payable oncethe goods are delivered by the owner to
the hirer.
INTEREST-TAX:
The hire-purchase finance companies,
have to pay interest-tax under the
Interest-Tax Act, 1974. According to this
Act, interest tax is payable on the total
amount of interest earned.
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ACCOUNTING & REPORTING
ASPECTS OF HIRING
Risks & rewards are transferred to the
hirer at the inception of the transaction
No accounting standard/guidelines notefor accounting treatment in india/no law
/regulation to govern HP Contracts
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IN THE BOOKS OF THE
HIRER Depreciation claim based on cash
purchase price - policy
Cash purchase price of the asset is
capitalized ---cpp - down paymentliability
Total charge for credit is allocated over the
hire-period effective rate of interestmethod, sum-of the years-digitsmethod/straight line method.
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IN THE BOOKS OF HIRE-
VENDOR(FIN CO)
HP installment as current asset (stock on
hire) & unearned fin component of these
installments as current liability unmatched
finance charges
End of each accounting period appropriate
part of Unmatured finance income
recognised as current income Direct costs structuring of the transaction
expensed immediately/allocated against
finance income over the hire-period
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HIREPURCHASE - concept
Hire-purchase agreement is defined aspeculiar kind of transaction in which
goods are let on hire with an option to
the hirer to purchase them. The purchase price is to be paid in
installments can purchase by paying
all the installments.
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Stipulations
Payment to be made in installments over aspecified period.
The possession is delivered to the hirer at the
time of entering into the contract.
The property in the goods passes to the hirer on
payment of the last instalment.
If default is made in payment of any instalment,
the seller becomes entitled to take away thegoods.
The hirer is free to return the goods without
being required to pay any further installments.
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MODUS OPERANDI
The finance (hire-purchase) companypurchases the equipment from the
equipment supplier and lets it on hire to
the hirer.
The hirer is required to make a down
payment of, say 20-25% of the cost &
pay balance with interest in EMIs.
Alternatively, the hirer has to invest an
equivalent amount on fixed deposits
with the finance company.
L Fi i
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Lease Financing
Vs Hire-purchase Financing
Ownership
Depreciation
Magnitude
Extent of financing
Maintenance
Tax Benefits
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LEGAL FRAMEWORK
There is no exclusive legislationdealing with hire-purchase
transactions in India. The Hire-Purchase Act was passed in
1972, however, the Act has not beenenforced so far.
In the absence of any specific law,the hire-purchase transactions aregoverned by the provisions of the
Indian Contract Act & the Sales of
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The hire-purchase transaction has two
aspects:
An aspect of bailment of goods which iscovered by the Contract Act.
An element of sale when the option of
purchase is exercised by the hirer whichis covered by the Sales of Goods Act.
FINANCIAL EVALUATION
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FINANCIAL EVALUATION
OF HIRE-PURCHASE
POINT OF VIEW OF THE HIRER:
The evaluation of hire-purchase
transaction from the hirers angle, has tobe done in relation to leasing alternative.
Decision-Criterion:
The decision-criterion from the point ofview of a hirer is the cost hire-purchasevis-a-vis the cost of leasing.
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COST OF HIRE-PURCHASE COST OF
LEASING
Down payment Lease Mgt Fee
+ Service charges + Lease payments
+PV hire charges - PV of tax shield on - PV of depreciation lease payments
tax shield - PV of tax
- PV of net salvage shield on expenses
value
F th Vi i t f Hi
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From the Viewpoint of Hire-
Vendor
Hire-purchase & leasing represent twoalternative investment decisions of ahire-vendor.
The decision-criterion, is based on acomparison of the NPVs of twoalternatives.
The alternative with a higher NPV wouldbe selected.
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NPV OF LEASE PLAN
PV of lease rentals
+ Lease Mgt Fee
+ PV of tax shield on depreciation + PV of net salvage value
- Initial Investment
- Initial Direct costs - PV of tax liability on lease rentals &
lease Mgt fee
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END OF UNIT III
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REEFERENCES
Financial services : M Y KHAN
Emerging Scenario of Financial services
: GORDON AND NATARAJAN http://www.firstleasingindia.com/ourhisto
ry.asp
EVOLUTION OF
http://www.firstleasingindia.com/ourhistory.asphttp://www.firstleasingindia.com/ourhistory.asphttp://www.firstleasingindia.com/ourhistory.asphttp://www.firstleasingindia.com/ourhistory.asp -
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EVOLUTION OF
LEASING
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EVOLUTION OF LEASING
1. LEASING ACTIVITY WAS INITIATEDIN INDIA IN 1973.
2. THE FIRST LEASING COMPANY OFINDIA, NAMED FRIST LEASINGCOMPANY OF INDIA LTD. WAS SET
UP IN THAT YEAR BY FAROUK IRANI,WITH INDUSTRIALIST A C MUTHIA.
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Contd
3. FOR SEVERAL YEARS, THIS COMPANYREMAINED THE ONLY COMPANY IN THECOUNTRY UNTIL 20th CENTURY FINANCE
CORPORATION WAS SET UP- THIS WASAROUND 1980.4. FROM 1981, THE TRICLE STARTED AND
SHETTY INVESTMENT ANDFINANCE,JAYABHARAT CREDIT AND INVESTMENT,
MOTOR & GENARAL FINANCE, ANDSUNDARAM FINANCE ETC. JOINED THELEASING GAME.
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Contd.
5. THE INDUSTRY ENTERED THE THIRDSTAGE IN THE GROWTH PHASE IN LATE1982, WHEN NUMEROUS FINANCEAL
INSTITUTIONS AND COMMERCIAL BANKSEITHER STARTED LEASING OR
ANNOUNCED PLAN TO DO SO. ICICI,PROMINT AMONG FINANCIAL
INSTITUTIONS, ENTERED THE INDUSTRYIN 1983 GIVING A BOOST TO THECONCEPT OF LEASING.
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Contd..
6. INTERNATIONAL FINANCECORPORATION ANNOUNCED ITS
DECISION TO OPEN FOUR LEASINGJOINT VENTURES IN INDIA.
7. BANKS THEMSELVES WERE ALLOWED
TO OFFER LEASING FACILITIES MUCHLATER IN 1994.
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THANK YOU