Merchant banking and financial services unit 4 notes for mba

Merchant Banking and Financial Services

Semester III

UNIT – IV FUND BASED FINANCIAL SERVICES

Leasing and Hire Purchasing – Basics of Leasing and Hire Purchasing – Financial Evaluation

LEASING AND HIRE PURCHASING

LEASINGAccording to the Institute of Chartered Accountants of India, “A lease is an agreement whereby the lessor conveys to the lessee, in return for rent, the right to use an asset for an agreed period of time. Lessor is a person who conveys to another person (lessee) the right to use an asset in consideration of payment of periodical rental, under a lease agreement. Lessee is a person who obtains from the lessor, the right to use the asset for a periodical rental payment for an agreed period of time”.

A financing arrangement that provides a firm with the advantage of using an asset without owing, it may be termed as ‘leasing’.

Leasing: It is a contract by which one party conveys land, property, services etc., to another for a specified time.

Definition: The Transfer of Property Act, 1882 (as amended in 1952) describes Lease as follows “A Lease of the movable property is a transfer of a right to enjoy such property, made for a certain time, express of implied, or in perpetuity, inconsideration of a price paid or promised or of money, a share of crops, service or any other things of value, to be rendered periodically or on specified occasions to the transferor by the transferee, who accepts the transfer on such terms.”

o The transferor is called the lessoro The transferee is called the lesseeo The price is called the premium o The money, share, service or other thing to be rendered is called the rent.

Definition: Section 105 of the above Act defines a lease as follows: “A Lease is a transfer of a right to enjoy the property. The consideration may be a price or a rent. The rent may be either money, or share of crops, service of anything of value, to be rendered periodically by the transferee to the transferor.”

HIRE PURCHASINGA transaction of finance whereby goods are bought and sold as per the terms and conditions specified below is known as ‘hire purchase finance’.

a. Payment of periodic installmentsb. Immediate possession of goods by the buyer

S.N.Selvaraj, M.B.A., M.Phil., Assistant Professor, Email: [email protected]

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c. Ownership of goods remaining with the vendor until the payment of the last installment

d. Vendor’s right to repossess the goods in the event of default committed by the buyer

e. Treatment of each installment as hire charge till the payment of the last installment

According to Hire Purchase Act of 1972, the term ‘hire purchase’ is defined as “an agreement under which goods are let on hire and under which the hirer has an option to purchase them in accordance with the terms of the agreement and includes an agreement under which:

i. Possession of goods is delivered by the owner thereof to a person on the condition that such person pays the agreed amount in periodic payments

ii. The property of the goods is to pass to such a person on the payment of the last of such installment

iii. Such a person has a right to terminate the agreement any time before the property so passes.”

BASICS OF LEASING AND HIRE PURCHASING

BASICS OF LEASINGParticipants in Leasing: There are number of players present in the leasing industry. These players are below:

The players in the name of Lessors: There are different kinds of lessors. They are specialized leasing companies, one-off lessors, manufacturer-lessor and bank-sponsored leasing companies.

Specialized leasing companies One-off lessors Manufacturer-lessors Bank-sponsored leasing companies Financial institutions

The players in the name of Lessees: The lessees constitute a wide range of companies, from blue chip companies to small units, which avail the financial services from the lessor companies.

Lease brokers Lease Financiers

Advantages of LeasingLeasing as a financial service offers the following potential advantages both to the lessor and lessee.

Advantages to Lessor1. Stable business 2. Wider distribution




3. Sale of supplies 4. Second-hand market 5. Tax-benefits 6. Absorbing obsolescence risks 7. Fillip to capital market 8. Easy finance

Advantages to Lessee1. Efficient use of funds 2. Cheaper source 3. Flexible source 4. Enhanced borrowing capacity 5. Off-balance sheet financing 6. Tax benefits 7. Favourable terms 8. Guards against obsolescence 9. Avoidance of initial cash outlay 10. Better liquidity

Classification of Leasing:1. Finance Lease and Operating Lease 2. Sale and Lease Back and Direct Lease 3. Single Investor Lease and Leveraged Lease 4. Domestic Lease and International Lease

Finance Lease: A lease is defined as a finance lease if it transfers a substantial part of the risks and rewards associated with ownership from the lessor to the lessee.

Operating Lease: The International Accounting Standard Committee defines operating lease as “any lease other than a finance lease”.

Sale and Lease Back: In the case of sale and lease back, the owner of equipment sells it to a leasing company, which, in turn, lease it back to the seller of the equipment, who then becomes the lessee. The Lease Back‘ arrangement in this transaction can be in the form of either a finance lease or an operating lease e.g., the sale and lease back of safe deposit vaults practiced by commercial banks.

Direct Lease: It is defined as any lease, which is not a sale and lease back transaction. A direct lease can be of two types: (i) Bipartite lease, and (ii) Tripartite Lease.

Single Investor Lease: The entire investment is funded by the lessor by arriving at a judicious mix of debt and equity. The debt funds raised by the leasing company are without recourse to the lessee, i.e., in the event of the default by the leasing company on its debt-servicing obligation, the lender cannot demand payment from the lessee.




Leveraged Lease: It is a lease which is leveraged through a trustee. The leasing company invests in equipment by borrowing large investments with full recourse to the lessee without any recourse to it. The lender (loan participant) gets an assignment of the lease and enjoys benefit of the rentals to be paid by the lessee and a first mortgage on the leased assets. This transaction is routed through the trustee to take care of the lender and the lessee.

Domestic Lease and International Lease: In domestic lease, all the parties to the lease transaction i.e., the equipment supplier, lessor and lessee are domiciled in the same country. An international lease transaction pre-supposes: An understanding of the political and economic climate; and As a result international lease is exposed to country risk and currency risk.

Financial Lease Vs Operating LeaseCharacteristics Financial Lease Operating Lease

Specificity The asset leased out is use-specific for the lessee

The asset leased out may be used commonly by a number of users in sequence

Ownership Risks The lessee bears the risks and rewards associated with the use of the asset leased; the lessor is simply the legal owner of the asset

The risks and rewards associated with the use of the asset leased is borne by the lessor and the lessee is simply provided with the use of the asset for a certain period time

Obsolescence Risk The lessee bears the risks of obsolescence

The lessor bears the risks of obsolescence

Cancelability The lease cannot be cancelled by either of the parties. The lessor is rather interested in rental and not in the asset

The lease can be cancelled at the option of the lessee and the lessor does not have the difficulty of leasing the same asset to other willing lessees

Lease Period The lease period usually coincides with the life of the asset and may be broken into primary and secondary period

Lease period is generally small, as the lessor intends to lease the same asset several times to various users

Maintenance The cost of repairs and maintenance are borne by the lessee; the lessor is merely a financier with the lease.

The cost of repairs and maintenance are borne by the lessor.

Lessor’s Service As the lessor is just a financial institution, it does not render any specialized service in connection with the lease

The lessor is specialized in handling and operating the particular asset and usually provides specialized services

Pay-out It is a full pay-out lease, where a single lease repays the cost of the asset, together with the interest

It is usually a non-pay out lease, as the lessor is in the business of leasing the asset t various users several times




Lease Market in India: Lease market in India may be in the form of: (a) Formal Market: The formal players in the market are the financial institutions, commercial banks, foreign financial institutions, manufacturers and non-banking financial companies (NBFCs).(b) Informal Market: Individuals and families handle leasing in the informal market.

Regulatory Authority: No specific Act or Authority regulates leasing in India. Some of the Acts which indirectly governs are:

Income Tax Act, 1962 Indian Contract Act, 1872 Indian Stamp Act, 1899 Manufacturing and Other Companies (Auditor‘s Report) Order, 1988 Motor vehicles Act, 1988 Recovery of Debts due to Bank and Financial Institutions Act, 1993 Registration Act, 1908 Reserve Bank of India Act, 1934 Sale of Goods Act, 1930 Sick Industrial Companies (Special Provisions) Act, 1985 Transfer of Property Act, 1882 Companies Act, 1956 Consumer Protection Act, 1986 Easements Act, 1882 Foreign Exchange Management Act, 2000 Hire Purchase Act, 1972

TYPES OF LEASES

Lease is of different types as mentioned below:

Financial Lease: A financial lease, also called ‘capital lease’ is a contract involving payment over an obligatory period, of specified sums sufficient in total to amortize the capital outlay, besides giving some profit to the lessor. According to the International Accounting Standard (IAS) No.17, “a financial lease is a lease that transfers substantially all the risks and rewards incident to ownership of an asset.” Title may or may not eventually be transferred.”

According to the Institute of Chartered Accountants of India, “financial lease is a lease under which the present value of the minimum lease payments at the inception of the lease exceeds or is equal to substantially the whole of the fair value of the leased asset.”

Variants of financial lease include full payout lease and true lease.1. Full Payout Lease2. True Lease:




Operating Lease: An operating lease is any other type of lease whereby the asset is not fully amortized during the non-cancelable period of the lease and where the lessor does not rely on the lease rentals for profits. It is basically an economic service. It is a short-term lease on period-to-period basis, the period of lease being less than the useful life of the asset.

Net Lease: A variant of operating lease is net lease. A type of lease where the lessor is not concerned with the repairs and maintenance of the leased asset is known as ‘net lease’. The only function of the lessor is to provide a financial service.

Conveyance-type Lease: It is a very long tenure lease applicable to immovable properties. The intention of the lease is to convey title in property. Such leases are entered into for periods which may be as long as 99 years or 999 years.

Leveraged Lease: When a part or whole of the financial requirement involved in a lease are arranged with the help of a financier, it takes the form of leveraged lease. This type of lease is resorted to in cases where the value of the leased asset is very high. In this type of lease, the lessor, who is also a financier, involves one more financier, who may hold a charge over the leased asset, over and above a part of lease rentals.

Sale and Leaseback: Under this type of lease, the owner of an asset sells it to the lessor, and gets asset back under the lease agreement. The ownership of the asset changes hands from the original owner to the lessor, who in turn leases out the asset, back to the original owner. This paper exchange of title has the effect of providing immediate free finance to the selling company, the lessee. This transaction also helps the release of funds tied up in that particular asset.

Partial Pay-out Lease: It is a type of lease whereby the lessor obtains full payment of the lease in several leases. This broadly falls under the category of operating lease.

Consumer Leasing: Leasing of consumer durables such as televisions, refrigerators, etc. is called consumer leasing. It has assumed popularity with the rapid increase in the quantum of consumer credit.

Balloon Lease: A type of lease, which has zero residual value at the end of the lease period, is called ‘balloon lease’. It also means a kind of lease where the lease rentals are low at the inception, high during the mid-years and low again during the end of the lease.

Close-end Leasing: A leasing arrangement whereby the asset leased out is reverted to the lessor is known as ‘close-end leasing’. It is also called ‘walk-away’ lease.

Open-end Leasing: A term commonly used in automobile leasing in the USA, it means a lease agreement where the lessee guarantees that the lessor will realize a minimum value from the sale of the asset at the end of the lease period.




Swap Leasing: In swap leasing, the lessee is allowed to exchange equipment leased out whenever the original asset has to be sent to the lessor for some repair or maintenance.

Wrap Leasing: When the lessee further sub-leases the asset to the end-user, retaining a fee and a share of the residual value, it is called wrap leasing. Normally, the term of the first lease is longer than the second, in order to maximize the first leassor’s tax deductions. It is also called because the first lease wraps the second lease.

Import Leasing: The leasing of imported capital goods is known as ‘import leasing’. It is beneficial to the lessee because arranging any other source of funding may take a long time, during which the prices of the importable item, as also the rates of exchange, may change.

Cross-border Leasing: A type of lease where the lessor in one country leases out assets to a lessee to another country is known as cross-border leasing. The jurisdiction of lessor and lessee are in two different countries. Cross-border leasing originated in the 1970s in the US.

Double-dip: According to the concept of double-dip, it is possible to have the advantage of depreciation tax benefits twice, depending on the prevalence of different tax laws in two different countries.

Triple-dip: Where the benefit of depreciation tax allowances is available in three different jurisdictions for a single asset leased out, it is a case of triple-dip. Accordingly, benefits are available for hire purchase, true lease and capital lease.

Japanese Cross-border Leasing: The Japanese leasing falls broadly under three categories namely samurai leasing, shogun leasing and mushashi leasing.

International Leasing: When a leasing company operates in different countries through its branches, it is a case of international leasing. International leasing is active in countries such as US, Japan and Hong Kong. ‘US Leasing International’ started the first international leasing company in the year 1959, in Canada.

BASICS OF HIRE PURCHASINGHire purchase finance refers to a transaction of finance, whereby goods are bought and sold under certain terms and conditions, such as payment of periodic installments, immediate possession of goods to the buyer, etc. The terms of agreement are drawn in accordance with the Hire Purchase Act of 1972. The Act provides certain rights to the hirer, such as, it is not possible for the hire vendor to terminate the hire purchase agreement on account of default in payment of hire charges by the hirer or due to unauthorized act or breach of express conditions, unless the hire vendor gives a notice in writing in this regard to the hirer.




Hire Purchase It is the purchase of goods on hire The buyer makes payment for goods on a monthly installment basis and at the

same time is allowed to be used by the buyer The buyer becomes the owner of the goods only on the payment of the last

installment. Till such time, the amount paid by the buyer is treated as hiring charges. If the buyer fails to pay any installment, the goods will be seized for non-

payment of the installment amount.

According to the Hire Purchase Act of 1972, the term ‘Hire Purchase’ is defined as, “An agreement under which goods are let on hire and under which the hirer has an option to purchase them in accordance with the terms of the agreement, and includes an agreement under which

(a) Possession of goods is delivered by the owner thereof to a person on the condition that such person pays the agreed amount in periodic payments (b) The property of the goods is to pass to such a person on the payment of the last of such installment c. Such a person has a right to terminate the agreement any time before the property so passes”.

All Hire purchase finance companies are controlled by the Hire Purchase Act, 1972.

A Hire purchase transaction has two elements, (1) Bailment which is governed by the Indian Contract Act, 1872 and (2) Sale under the Sale of Goods Act, 1930.

Hire Purchase Agreement o A Hire Purchase Agreement is an agreement between the seller and the buyer,

where the ownership of goods does not pass to the buyer until he pays the last installment. There are two parties to the hire purchase agreement.

o The hire vendor, who is the seller and the other, is the hire purchaser, the buyer.

o The purchaser has to make a down payment of 20 to 25% of the cost and the remaining amount has to be paid in equal monthly installments.

o In the case of a Deposit linked plan, the hire purchaser has to invest a fixed amount as fixed deposits in the finance company which is returned together with interest after the payment of the last installment.

Parties to the Hire Purchase Contract There are two parties in a hire purchase contract:

1) The intending seller2) The intending purchaser or the hirer

Tripartite Agreement: (1) Seller (2) Financier (3) Hirer/Purchaser




Rights of HirerThe Hire Purchase Act of 1972 provides the following rights to the hirer:

Right to Protection Right to Notice Right to Repossession Right of Statement Right to Excess Amount

Rights of InterestThe type of interest rates popularly used in hire purchase financing is as follows:

Add-on Rate of Interest Flat Rate of Interest Effective Rate of Interest

Difference between Leasing and Hire Purchase: S.No. Characteristics Lease Financing* HP Financing

1 Ownership Ownership of the property lies with the finance company, the lessor and it is never transferred to the lessee, the user

Ownership of the property is transferred to the hirer on the payment of the last installment

2 Depreciation Lessor and not the lessee, is entitled to claim depreciation tax shield

The hirer (owner) is entitled to claim depreciation tax shield

3 Capitalization Capitalization of the asset is done in the books of the lessor, the leasing company

Capitalization of the asset is done in the books of the hirer

4 Payments The entire lease payments are eligible for tax computation in the books of the lessee

Only the hire-interest is eligible for tax computation in the books of the hirer

5 Salvage Value The lessor and not the lessee, has the right to claim the benefit of salvage value

The hirer can claim benefit of salvage value as the prospective owner of the asset

6 Magnitude Leasing is used as a source of finance, usually for acquiring high cost assets such as machinery, ships airplanes, etc.

Hire purchase is used as a source of finance, usually for acquiring relatively low cost assets such as automobiles, office equipment, etc.

7 Down Payment No down payment is required for acquiring the use of leased assets

Down payment is required to be made for acquiring the asset and there is a margin maintained to the extent of 20-25 percent

8 Reporting In the books of the lessee, leased assets are disclosed by way of a note only

The asset bought on hire purchase will be shown as an asset, and the amount of installments payable to the




lessor as a liability9 Maintenance of

AssetWhereas the lessee has to maintain the lease asset in the case of financial lease, upkeep is the responsibility of the lessor in the case of operating lease

It is the hirer’s responsibility to ensure the maintenance of the asset bought

10 Suitability It is not suitable for the low-capital enterprises which desire to show a strong asset position in their balance sheets

It is highly suitable for the low-capital enterprises which need to show a strong asset position in their balance sheets

11 Nature of Asset An asset given on lease by a leasing company is considered as the fixed asset of the lessor

The hire vendor normally shows the asset let under HP either stock in trade or as receivables

12 Receipts All receipts from the lessee is taken into the lessor’s profit & loss account

Only the interest portion is taken into the hire-vendor’s profit & loss account

13 Income Lessor’s income declines as the investment outstanding in the lease declines

In the case of HP transactions, finance charges are allocated to the HP period equally

* With reference to ‘operating lease’.

FINANCIAL EVALUATION

Financial Evaluation is an evaluation by the hirer of the desirability for lease and hire purchase. The hirer makes decision based on the Present Value of Net Cash Outflow. The decision is considered favourable when the PV of Net Cash Outflow under Hire Purchase is less than the PV of Net cash Outflow under leasing.

Lease Vs. Hire Purchase Evaluation: The hirer makes the evaluation on the desirability for lease and HP. The considered hire makes a decision based on the PV of net cash outflow. The decision for HP is considered favourable where the PV of net cash outflow under HP is less than the PV of net cash under leasing.

Following are the steps involved:Step 1: Calculate annual interest amountStep 2: Find Principal amount outstanding at the beginning of each year

= Total outstanding principal – principal paid in the previous yearStep 3: Find Principal paid the previous year = Annual installment amount – Annual

interestStep 4: Find Annual ITS = Annual interest × Tax rateStep 5: Find Depreciation Step 6: Find Annual DTS = Annual depreciation × Tax rateStep 7: Find Total TS = Step 4 + Step 6Step 8: Find Annual installment amount = Total HP amount + [HP amount× Flat rate

of interest] ÷ No of HP yearsStep 9: Find PV of salvage value of asset = SV × PVF




ty = Terminal year ; k = Cost of capitalStep 10: Find Net cash flow of HP = Step 8 – Step 7 Step 11: Find PV of net cash outflow of HP at the appropriate discount rateStep 12: Find Total PV net cash outflow of HP = Step 11 – Step 9Step 13: Find Tax shield on annual lease rentals = Annual Lease rental × Tax rate Step 14: Find Net cash outflow of Leasing = [Annual lease rental – Step 13]Step 15: Find Total PV of net cash outflow of Leasing at the appropriate discount rate

= Net cash outflow of Leasing × PVAFnk = number of lease years at a ‘K’ interest rate

Step 16: Make a decision: HP is desirable if total PV of net cash outflow of HP is less than that of leasing

Tax Implication Tax Benefits in Hire purchase transaction. A hire purchaser can claim the benefits by claiming depreciation on the goods which are used in his business. Such tax benefits are applicable to sole trader, partnership firms, as well as Joint Hindu firms. Depreciation can be claimed on the entire purchase price.

1) Income Tax: Deductions could be made on account of interest charged e.g. In the purchase of house on hire purchase basis, the initial payment of interest charges will be totally waived form income tax as per the new regulations. Even the principal amount is entitled for 20% deduction under Section 80(C) of the Income Tax Act.

2) Sales Tax: Sales Tax is levied on the total value of the goods and not on the installment payment. The respective State is benefited when there are more sales under hire purchase transactions as they get more revenue. HP Transactions Benefits in Income Tax Benefits in Sales Tax Benefits in interest Tax

3) Interest Tax: It is the tax payable by the Hire Purchase Companies on Interest under the Interest Tax Act 1974. However the tax is treated as a tax deductible expense for the purpose of computing taxable income under the Income Tax Act.

Overall Financial Implications: Lease transactions would have accounting and financial implications for both the lessors and the lessee as detailed below:

For Lessee Tax shield on lease rentals is available as business expenditure Depreciation tax shield is not available Tax shield on lease rentals represents a cash inflow Tax shield on depreciation represents cash outflow (cash inflow

foregone) For Lessor

Depreciation tax shield is available Tax shield on lease rentals is not available as business expenditure Tax shield on depreciation represents cash inflow




Tax shield on lease rentals represents cash outflow (cash inflow foregone)

Evaluation of Hire Purchase ProposalsIn the comparative evaluation between leasing and hire purchase, calculation of interest and the split of the installment amount into ‘interest and principal’ components assume importance, especially where the flat rate of interest only is available in the problem. Interest amount is calculated by applying a rate of interest on the principal amount outstanding at the beginning of each period. The principal amount is determined as the difference between ‘installment amount per period and the interest amount per period.’

Methods of Interest Calculation(All methods assume annual payment at the end of the year)

a) Effective rate of interest or annual percentage rate method b) Sum-of-years digits methodc) Straight-line method

Effective Rate of Interest (ERI): Effective Rate of Interest (ERI) method, also known as Annual Percentage rate Method, is a method of interest calculation where the effective rate of interest is determined by the popular ‘IRR’ technique. Accordingly, effective rate of interest is that rate of interest, which equates the PV of all future annual instalment payments, with the HP principal payable at the beginning of the hire purchase contract. The HP principal payable is the excess of the cost of the asset hire-purchased, over and above the down payment made.

Following are the steps involved in the determination of ERI:Step 1: Find HP Principal = Cost of Asset – Down PaymentStep 2: Find Total Interest Amount for the HP Period

= [HP principal × Flat rate of interest × HP period of years]Step 3: Find HP Amount = Step 1 + Step 2Step 4: Find Annual Instalment Amount = (Step 3 ÷ No. of Instalments)Step 5: Find Effective Rate of Interest (ERI)

Rate of Interest: → PV of Future Annual Instalments = PV of HP principal amount payable

Step 6: Find Annual Interest Amount = Total Principal Outstanding at the beginning × ERI

Sum-of-years Digits Method: Under this method, the annual amount of interest is determined as follows:

Annual amount of interest = [Number of years of remaining HP period including the current year ÷ Total of all digits representing the period of HP] × Total amount of interest for HP period.Where,

Total amount of interest for HP period = Total amount payable × Flat rate of interest.




Straight-Line Method: Under this method, the annual amount of interest is determined as an equated annual financial charge as follows:

Annual amount of interest = Total amount of interest for HP period ÷ No. of HP periods

Evaluation of Leasing ProposalsLeases are evaluated by both the lessee and the lessor. The lessee must determine whether leasing an asset is less costly than buying the asset. The lessor has to determine the appropriate lease rent that should be fixed so as to achieve the required rate of return.

A decision can be made by evaluating both the leasing and buying alternatives. These are referred to as ‘lease or buy’ decisions. The lease-buy decisions are the most common decisions confronting the business firms. The main advantage of leasing is that the initial cash outlay is not true. Unlike bank borrowings, where margin money is insisted, leasing does not involve such payment. In practice, advance lease rentals are required from the lessee. However, the amount involved is not as high as margin money.

Various models are applied in evaluation of a lease. The Weigngartner Model adopts the Net Present Value (NPV) concept to evaluate the lease Vs buy alternatives. The model basically considers leasing as an investment decision. There are other models such as Equivalent Loan Model, Bower Model, etc. and these models evaluate the lease as a financing alternative.

Lease Vs. Buy Decisions by using NPV The NPV concept is a fundamental valuation concept in financial management. It is widely followed in capital budgeting decisions. The basic philosophy of the concept is to compare the expected benefits with the investment outlay and see whether the NPV of the benefit are greater than the cost. The method uses discounted cash flow to arrive at the NPV. Normally, the weighted average cost of the firm is used as a discounting rate to compute the present values.

Lease Evaluation: Lessor’s Point of ViewGenerally, the lessors are the financial institutions, banks, NBFCs and specialized leasing companies. Sometimes manufacturers like IBM, themselves become the lessor. For the lessors, leasing business is an investment of funds and therefore they expect a fair return on the funds invested. He must ensure whether the return on the lease exceeds the cost of capital. Further, pricing the lease is a crucial issue.The major concerns of lessors are:

Fixing the break-even lease rental that sets the floor price of a lease Assessing the extent of lease-related risks such as default risk, residual value

risk, interest rate risk, etc.




Loan Repayment ScheduleIt is a schedule that shows the calculations regarding annual installments, annual principal repaid and the annual interest paid by the lessor. In order to evaluate the desirability of leasing option, leasing is compared with borrowing option. It is therefore important that necessary calculations are learnt regarding the methods of repayment of loan. The different methods of determining the ‘annual total amount repaid’ or annual installments under a loan scheme are discussed below.

Steady Principal Reduction (SPR) MethodUnder this method, the total payment of the installment amount will keep diminishing every year. The principal amount reduced in equal amounts each year and the interest is calculated at the end of each year on the balance of principal amount outstanding at the beginning of that year.

Annual Installment Amount = Fixed equal principal amount+

Interest on outstanding principal Where,Fixed equal principal amount = Cost of asset – Down payment

Number of installmentsInterest = Principal O/S at the end of previous year × Interest Rate

Steady Payment Method / Annual Net Equivalent Cash Outflow MethodUnder this method, the Annual Installment amount is determined as follows:

= Amount Borrowed Relevant Annuity Factor

Where,Amount borrowed = Purchase price – Down paymentAnnual principal amount = Annual installment – Annual interestInterest is calculated on the balance of principal amount outstanding at the beginning of each year.

Balloon Payment MethodUnder this method, firms pay smaller amounts at the beginning and progressively larger amounts or balloon payments, in the later stages of the loan period. Interest is calculated on the principal amount outstanding at the beginning of each year. The interest rate for this method is usually higher than the other methods.

Annual installment amount = Annual principal amount + Interest on outstanding principal

Annual principal amount = Annual installment – Annual interest

The Level-Rental Plan




It is a straight lease which obligates a firm to make a series of identical payments over the service life of the asset. The amount of annual is determined as follows:

= Asset Cost Relevant Annuity Factor

Steps for Constructing Loan Repayment ScheduleStep 1 Find down paymentStep 2 Find annual principal paidStep 3 Find annual principal outstanding at the beginning of each year.Step 4 Find annual interest paid

Part ‘A’ Questions1. Define lease.2. What is financial lease?3. What is meant by operating lease?4. What is sale and lease back?5. Define hire purchase.6. What is cross border lease?7. What is swap leasing?8. What is ‘Japanese cross border leasing’? 9. What do you mean by ‘International leasing’?10.What is hire-purchase agreement?

Part ‘B’ Questions1. Explain the advantages of leasing in terms of lessee and lessor.2. Enumerate the rights of hirer and the interest of hirer.3. Distinguish the characteristics between financial lease and operating lease.4. Explain the characteristics of Lease financing and HP financing.5. Discuss the lease evaluation in the lessor’s point of view.

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Text Books & References1. M.Y.Khan, “Financial Services”, Tata McGraw Hill Education Pvt. Ltd., New

Delhi, 12th Edition, 2012.2. Nalini Prava Tripathy, “Financial Services”, Prentice Hall of India, New

Delhi, 2nd Edition, 2008.3. Machiraju, “Indian Financial System”, Vikas Publishing House, 2nd Edition,

2010.4. Dr.S.Gurusamy, “Merchant Banking and Financial Services”, Tata McGraw

Hill Education Pvt. Ltd., New Delhi, 3rd Edition, 2009.5. Website of SEBI.



Merchant banking and financial services unit 4 notes for mba

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Transcript of Merchant banking and financial services unit 4 notes for mba