Hire purchase as a financial service.pptx

Hire Purchase Finance
Dr.R.K.Sudhamathi, Associate Professor, MBA, NGPiTech 1

Hire Purchase - Meaning
• Hire purchase is an arrangement for buying expensive goods, where
the buyer makes an initial down payment and pays the balance plus
interest in installments.
• The term hire purchase is commonly used in the United Kingdom and
it's more commonly known as an installment plan in the United
States.

Hire Purchase - Meaning
• 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.
• The property of the goods is to pass to such a person on the payment of
the last of such instalment
• Such a person has a right to terminate the agreement any time before the
property so passes.”

Features of Hire Purchase
• The asset ownership is transferred to the buyer only after the final
installment is paid.
• Buyer pays for the asset in regular installments, which includes both
the principal amount and the interest.
• Asset itself serves as security. In case the buyer fails to pay
installments, the seller can repossess the asset.
• The buyer has the option to buy the asset at any time by paying the
remaining installments in one go.

Features of Hire Purchase
• Interest is charged over unpaid balance instead of the original price of
the asset.
• Until the final payment is made, the maintenance of asset remains
the responsibility of the buyer, not the seller.
• Buyer can terminate agreements at any time before taking ownership
of the asset.

Rights of Hirer
• The hire purchase act of 1972, provides the following rights to the
hirer
• Rights of Protection
• 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 notice in writing to the hirer in this
regard.

Rights of Hirer
• Right of Notice
• When the hire charges are weekly, or for a period less than that, one
week notice is to be given, and in all other cases a two weeks notice is
to be given.

Rights of Hirer
• Right of Repossession:
• The right of repossession is not available to the hire vendor, unless
sanctioned by the court in the following cases:
• 1. one half of the price has been paid where the hire purchase price is
less than Rs. 15,000 (Rs. 5,000 in the case of motor vehicles).
• 2. Three fourth of the price has been paid where the hire purchase
price is not less than Rs. 15,000 (Rs. 5,000 in the case of motor
vehicles).
• Three fourth or such higher proportion, not exceeding nine—tenth,
where the hire purchase price is not less than Rs. 15,000

Rights of Hirer
• Right of Statement
• The hirer has the right to obtain a statement on payment of Re.1,
containing details such as the amount paid by the hirer, the amount
and the date upon which the instalment becomes due but not been
paid, the amount of instalment, which will become payble etc.

Rights of Hirer
• Right to excess Amount
• The hirer has the right to obtain any amount in excess of the value of
goods repossessed, over and above the amount of instalments which
will become payable etc.

Type of interest rate used in Hire purchase
Financing
• Add-On rate of interest
• Add-on rate of interest refers to that rate of interest which is
chargeable in hire purchase as a percent of the original cash price of
the asset.
• In other words, the hire purchase agreement will not specify a rate,
but will only specify the total quantum of interest.

Financing
• Flat rate of interest
• It is the discount rate applied to a figure from which the amount of
discount is deducted at the outset.

Financing
• Effective Rate of Interest
• Effective rate of interest, also known as true rate of interest, arrived at
by trial and error, at which the total present value of the stream of
instalments is equal to the cash price of the asset bought on hire
purchase.

Difference Between Leasing and Hire
Purchase

Purchase
Feature Hire Purchase Leasing
Ownership
The asset ownership is
transferred to the hirer at
the end of the payment term
upon completion of all
installments.
The asset ownership remains
with the lessor throughout the
lease term.
Payment
Structure
The cost of the asset is
divided into equal
installments, including
interest, that hirer pays over
a specific period.
The lessee makes periodic
payments for the use of the
asset without any intention of
ownership transfer.
Duration
The payment term is
relatively longer and can
range from months to years.
The lease term is usually
shorter and can be customized
according to the lessee’s
requirements.

Purchase
Upfront Cost
The hirer typically pays a
down payment upfront,
which is a percentage of
the asset’s total cost.
Leasing may require a smaller
upfront payment compared to hire
purchase.
Maintenance
The hirer is responsible
for the maintenance and
repairs of the asset.
The lessor often retains
responsibility for the maintenance
and repairs of the leased asset.
Risk and
Ownership
Transfer
The hirer assumes the
risk of asset ownership,
including depreciation and
obsolescence.
The lessor retains ownership and
assumes the risk associated with
the asset, reducing the lessee’s
risk exposure.

Purchase
Return or
Upgrade
The hirer can return the
asset if they can no
longer make payments
or choose to upgrade to
a different asset by
entering into a new
agreement.
The lessee has options to return
the asset, extend the lease,
purchase the asset at a
predetermined price, or lease a
new upgraded asset.
Tax Benefits
The hirer may be eligible
for tax benefits such as
depreciation and interest
deductions.
The lessor may be eligible for tax
benefits, and the lessee may have
the advantage of deducting lease
payments as operating expenses.
Financing
Hire purchase is a form
of financing where the
hirer gradually pays for
the asset over time.
Leasing is a contractual
arrangement for the use of an
asset without ownership transfer.

Purchase
Depreciation
The hirer(Owner) is
entitled to claim
depreciation tax shield
Lessor, and not the lessee, is
entitled to claim depreciation tax
shield
Capitalization
Capitalization of the
asset is done in the
books of the hirer
Capitalization of the asset is done
in the books of the lessor, the
leasing company
Salvage Value
The hire can claim
benefit of salvage value
as the prospective owner
of the asset.
The lessor, and not the lessee,
has the right to claim the benefit of
salvage value

Purchase
Reporting
The asset bought on hire
purchase will be shown as
an asset, and amount of
instalments payable to the
hire purchase vendor as a
liability
In the books of lessee, leased
asset are disclosed by way of note
only
Suitability
It is highly suitable for the
low-capital enterprises
which need to show a
strong asset position in their
balance sheets.
It is not suitable for the low-capital
enterprises which need to show a
strong asset position in their
balance sheets.

Purchase
Nature of the
asset
The hire vendor normally
shows the asset let
under HP either as stock
in trade or as
receivables
An asset given on lease by a
leasing company is considered as
the fixed asset of the lessor
Receipts
Only the interest portion
is taken into the hire
vendors profit and loss
account
All receipts from the lessee is
taken into the lessors profit and
loss account

Method of Reporting Hire Purchase
• Disclosure in Hirer Books:
• 1. The annual interest and depreciation charge must be debited to
the profit and loss account every year, until the loan is paid off.
• 2. The principal component of outstanding hire purchase each year
must be shown in the balance sheet by way of current liability of hire
purchase outstanding within one year, and by way of secured loan of
hire purchase outstanding for periods more than one year.

• Disclosure in Hire Vendor books
• 1. Cost of HP deal shall be debited to P & L account
• 2.The interest received from the hirer each year constitutes finance
income, and shall be credited to P&L account.

Methods of Interest Calculation
• Effective Rate of Interest ( ERI)
• The effective rate of interest method, also known as annual
percentage method, is a method of interest calculation where the
effective rate of interest is determined by the IRR technique.
• ERI is the 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.

• Step 1= Find HP principal = cost of asset – down payment
• Step 2 = Find total interest amount of the HP period =( HP principal *
flat rate of interest*HP period of years)
• Step 3 = Find total HP amount = ( step 1 + step 2)
• Step 4 = Find annual instalment amount = step 3 / no of instalments
• Step 5 = Find effective 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 methods:
• 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.
• 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.

References
• Dr.S. Gurusamy, Merchant Banking and Financial Services, New Delhi:
Tata McGraw Hill
• M.Y. Khan, Financial Services, New Delhi: Tata McGraw Hill

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