Hire Purchase

Hire-Purchase Finance Hire-Purchase Finance and Consumer Creditand Consumer Credit

CONCEPTUAL FRAMEWORKCONCEPTUAL FRAMEWORK

Hire-purchase is a mode of financing the price of goods Hire-purchase is a mode of financing the price of goods to be sold on a future date.to be sold on a future date.

Hire purchase is a type of instalment credit under which the hire-purchaser agrees to take goods on hire at a stated rental with an option to purchase the goods

It is an agreement relating to a transaction in which It is an agreement relating to a transaction in which goods are let on hire, the purchase price is to be paid in goods are let on hire, the purchase price is to be paid in installments and the hirer is allowed the option to installments and the hirer is allowed the option to purchase the goods paying all the installments. purchase the goods paying all the installments.

Though the option to purchase the goods/assets is Though the option to purchase the goods/assets is allowed in the very beginning, it can be exercised only at allowed in the very beginning, it can be exercised only at the end of the agreement.the end of the agreement.

CONCEPTUAL FRAMEWORKCONCEPTUAL FRAMEWORK The essence of the agreement is that the property in the The essence of the agreement is that the property in the

goods does not pass at the time of the agreement but goods does not pass at the time of the agreement but remains in the intending seller (hire-vendor) and only remains in the intending seller (hire-vendor) and only passes when the option is exercised by the hirer (intending passes when the option is exercised by the hirer (intending hire-purchaser).hire-purchaser).

In contrast, in installment sale the ownership in the goods In contrast, in installment sale the ownership in the goods passes on to the purchaser simultaneously with the passes on to the purchaser simultaneously with the payment of the initial/first installment. payment of the initial/first installment.

The hire-purchase also differs from the installment sale The hire-purchase also differs from the installment sale in terms of the call option and right of termination.in terms of the call option and right of termination.

Conceptual Framework

Under the down payment plan of hire-purchase, Under the down payment plan of hire-purchase, the hirer has to make a down payment of 20-25 the hirer has to make a down payment of 20-25 per cent of the cost and pay the balance in per cent of the cost and pay the balance in equated monthly installments (EMIs). equated monthly installments (EMIs).

As an alternative, under a deposit-linked plan As an alternative, under a deposit-linked plan the hirer has to invest a specified amount in the the hirer has to invest a specified amount in the fixed deposit of the finance company which is fixed deposit of the finance company which is returned together with interest after the payment returned together with interest after the payment of the last EMI by the hirer. of the last EMI by the hirer.

Leasing Vs Hire purchase Leasing Vs Hire purchase Similarly, hire-purchase and leasing as modes of financing are Similarly, hire-purchase and leasing as modes of financing are

also differentiated in several respects such as: also differentiated in several respects such as:

Ownership of the asset/equipment and its capitalisation, Ownership of the asset/equipment and its capitalisation,

Depreciation chargeDepreciation charge

MagnitudeMagnitude

Extent of financing Extent of financing

MaintenanceMaintenance

Tax benefitsTax benefits

The RBI treats lease and hire purchase on a par and stopped The RBI treats lease and hire purchase on a par and stopped the distinctive classification of leasing and hire purchase the distinctive classification of leasing and hire purchase companies as the factors for which leasing was used for P& M companies as the factors for which leasing was used for P& M and hire purchase for vehicles have vanished over timeand hire purchase for vehicles have vanished over time

Hire purchase Installment The hire-purchase installment has two components: (i) The hire-purchase installment has two components: (i)

interest/finance charge and (ii) recovery of principal. interest/finance charge and (ii) recovery of principal.

• The interest component is based on a flat rate of interest while The interest component is based on a flat rate of interest while effective rate is applied to the declining balance of the original effective rate is applied to the declining balance of the original amount to determine the interest component of each amount to determine the interest component of each installment.installment.

• For a given flat rate interest , the equivalent effective rate of interest is higher

• During the hire-period, the hirer can opt for early During the hire-period, the hirer can opt for early repayment/purchase of the equip ment/asset by paying the repayment/purchase of the equip ment/asset by paying the remaining installments minus an remaining installments minus an interest rebateinterest rebate. The hirer has . The hirer has the right to terminate the contract after giving due notice. the right to terminate the contract after giving due notice.

Flat rate Vs Effective rate of interest /Annual percentage rate• Approximation approach• Trial and error approach• Computation of APR /ERI (payment in arrear)• I= N/N+1 *2F• Computation of APR /ERI (Payment in advance)• I =N/N-1*2F

Where I = APR /ERIs

N=Number of repayments

F = Flat rate of interest per unit

Consumer credit• Consumer credit includes all asset-based financing plans Consumer credit includes all asset-based financing plans

offered to primarily individuals to acquire durable consumer offered to primarily individuals to acquire durable consumer goods. goods.

• In a typical consumer credit deal, the customer pays a In a typical consumer credit deal, the customer pays a fraction of the cash purchase price on delivery of the goods fraction of the cash purchase price on delivery of the goods and the balance is paid together with interest over a specified and the balance is paid together with interest over a specified period of time. period of time.

Salient Features:Salient Features:

Parties to the transaction(Bipartite or tripartite)Parties to the transaction(Bipartite or tripartite)

Structure of transaction (Hire purchase /Conditional sale/Credit Structure of transaction (Hire purchase /Conditional sale/Credit sale)sale)

Consumer credit• Modes of Payment:The consumer credit plans/schemes can Modes of Payment:The consumer credit plans/schemes can

be down payment type or deposit-linked type. be down payment type or deposit-linked type.

• Payment period and Rate of Interest (12- 60 monthly Payment period and Rate of Interest (12- 60 monthly installments)installments)

• Security :The loan is secured by a first charge on the The loan is secured by a first charge on the concerned equipment.concerned equipment.

• Evaluation:Can be made with reference to effective rate of Evaluation:Can be made with reference to effective rate of interest, rebate for early prepayments and charge for delayed interest, rebate for early prepayments and charge for delayed payments.payments.

Illustration 5.5Illustration 5.5 (Flat and Effective Rates of Interest) (Flat and Effective Rates of Interest)

The Hypothetical Consumer Finance Ltd (HCFL) has structured a consumer credit deal for Rs 4,00,000 on the The Hypothetical Consumer Finance Ltd (HCFL) has structured a consumer credit deal for Rs 4,00,000 on the following basis:following basis:

______________________________________________________________________________________________________________________________________________________________________________________________

Monthly repayment periodMonthly repayment period Equated monthly installment Equated monthly installment

______________________________________________________________________________________________________________________________________________________________________________________________

1212 Rs 38,000Rs 38,000

2424 Rs 21,400Rs 21,400

______________________________________________________________________________________________________________________________________________________________________________________________

Required: Compute the flat and effective rates of interest for each alternative/option.Required: Compute the flat and effective rates of interest for each alternative/option.

SolutionSolution

Flat and Effective Rates of InterestFlat and Effective Rates of Interest

______________________________________________________________________________________________________________________________________________________________________________________________

Repayment period (months)Repayment period (months)

______________________________________________________________________________________________________________________________________________________________________________________________

1212 24 24

______________________________________________________________________________________________________________________________________________________________________________________________

Total charge for creditTotal charge for credit Rs 56,000Rs 56,000 Rs 56,800Rs 56,800

Flat rate of interest (%)Flat rate of interest (%) 0.14 0.14 0.142 0.142

Effective rate of interest (%)Effective rate of interest (%) 0.2585 0.2585 0.2726 0.2726

______________________________________________________________________________________________________________________________________________________________________________________________

Working NotesWorking Notes

1.1. Total annual charge for credit = (Rs 38,000 x 12) –Total annual charge for credit = (Rs 38,000 x 12) – = [Rs 21,400 x 24) –= [Rs 21,400 x 24) –

Rs 4,00,000Rs 4,00,000 (Rs 4,00,000)] ÷ 2 (Rs 4,00,000)] ÷ 2

= Rs 56,000= Rs 56,000 = Rs 56,800 = Rs 56,800

Rs 56,000 Rs 56,000 Rs 56,000 Rs 56,000

2.2. Flat rate of interest = ------------------- x 100 = 0.14 = ------------------ x 100 = 0.142Flat rate of interest = ------------------- x 100 = 0.14 = ------------------ x 100 = 0.142

Rs 4.00,,000 Rs 4.00,000Rs 4.00,,000 Rs 4.00,000

nn n n

3.3. Effective rate of interestEffective rate of interest = -------- x 2 F = -------- x 2 F = ---------- x 2F = ---------- x 2F

n + 1n + 1 n + 1 n + 1

12 12 24 24

= ----- x 28 = 25.85 per cent = ----- x 28.4 = 27.26 per cent= ----- x 28 = 25.85 per cent = ----- x 28.4 = 27.26 per cent

1313 25 25

Nominal Versus Effective Interest Rates

Nominal Interest Rate:

Interest rate quoted based on an annual period

Effective Interest Rate:Actual interest earned or paid in a year or some other time period

18% Compounded Monthly

• What It Really Means?– Interest rate per month (i) = 18%/12 = 1.5%– Number of interest periods per year (N) = 12

• In words,– Bank will charge 1.5% interest each month on

your unpaid balance, if you borrowed money – You will earn 1.5% interest each month on

your remaining balance, if you deposited money

18% compounded monthly

Question: Suppose that you invest $1 for 1 year at 18% compounded monthly. How much interest would you earn?

Solution:

ai

iF 1212 )015.01(1$)1(1$

= $1.1956

0.1956 or 19.56%

= 1.5%

18%

Effective Annual Interest Rate (Yield)

r = nominal interest rate per yearia = effective annual interest rateM = number of interest periods per

year

1)/1( Ma Mri

: 1.5%

18%

18% compounded monthly or

1.5% per month for 12 months

=

19.56 % compounded annually

Practice Problem

• Suppose your savings account pays 9% interest compounded quarterly. If you deposit $10,000 for one year, how much would you have?

Example• First leasing company offers an asset on hire purchase

to Indian Breweries on the following:• Cost =Rs. 0.1 million• Rate of interest =10% (flat)• Hire purchase period = 4 years• Payment in yearly installments in arrear• Down payment =20%• Tax =30%• The asset has 4 years life with zero salvage value.what

is the effective interest rate.

Solution• Amt of loan = Rs .1 million – Rs ..02 million = Rs .8

million• Interest at flat rate =Rs 3,20,000• Annual equated installment = (8,00,000+3,20,000)/4• Amount of interest each year

Year Interest

1 3,20,000*4/10= Rs 128000

2 3,20,000*3/10 =Rs 96,000

3 3,20,000*2/10= Rs 64,000

4 3,20,000*1/10= Rs. 32000

The implied interest rate calculation

Year Principal amount Installment Interest paid Principal repaid

Outstanding amount

0 10,00,000 2,00,000 8,00,000

1 2,80,000 128,000 152,000 6,48,000

2 2,80,000 96,000 184,000 4,64,000

3 2,80,000 64,000 216,000 2,48,000

4 2,80,000 32,000 2,48,000

Implied interest for whole period: 8,00,000 = Ʃ n=1to 4 2,80,000/ (I+r)n

By interpolation r =15% approx

Illustration• Following details pertain to a company manufacturing air bags

required for the luxury cars.• Cost of equipment =Rs 5,00,000• Down payment =25% of cost price• Number of installments =4 (arrears)• Flat rate of interest14% p.a.• Disc rate 18%• Annual lease rentals = Rs 1,00,000 and lease period =5 years• Tax rate 50%• Depreciation=SLM and salvage value =Rs 40000 • The company is examining two financing alternatives.HP and

leasing.You are required to give your opinion about the choice of financing to be adopted by the firm.Also determine interest under three methods.

Solution

• Flat rate of interest =14%• Cost of equipment =Rs 5,00,000• Down payment 25% = Rs 1,25,000• HP principal amount =Rs 375000• HP interest = 3,75,000*14%*4=Rs 2,10,000• Total HP amount =Rs 3,75,000+2,10,000 =Rs

5,85,000• Annual instalment amount =5,85,000/4 = Rs

1,46,250

ERI by trial and errors amount Trial I –20%

PVIF

PV

Trial II –21%

PVIF

PV

1,46250 .833 1,21,826 .826 1,20,803

1,46250 .694 1,01,498 .683 99,889

1,46250 .579 84,679 .564 82,485

1,46250 .482 70,493 .467 68,299

Total 3,78,496 3,71,476

=20% +[3,75,000 – 3,71,476 ] /3,78,496 –3,71,476 = 20.50%

Annual interest under SOYD

• Year 1 = 2,10,000*4/10 =Rs 84,000

• Year 2 = 2,10,000*3/10 =Rs. 63,000

• Year 3 = 2,10,000*2/10=Rs 42000

• Year 4= 2,10,000*1/10=Rs21000

• Annual interest under SLM

• For all years = 2,10,000 /4 = 52,500

Annual interestYear O/s

principal ERI

ERI

(interest)

SOYD

(interest)

SLM

(interest)

ERI

(Principal paid)

SOYD

(Principal paid)

SLM

(Principal paid)

Annual installment (ERI/SOYD/SLM)

1 3,75,000 76,875 84,000 52,500 69,375 62,250 93,750 1,46,250

2 3,05,625 62,653 63,000 52,500 83,597 83,250 93,750 1,46,250

3 2,22,028 45,516 42,000 52,500 1,00,734 1,04,250 93,750 1,46,250

4 121,294 24,865 21,000 52,500 1,21,294 1,25,250 93,750 1,46,250

Analysis table (using ERI)S.no. Particulars Year 1 2 3 4 5

1 Annual Instalment

1,46,250 1,46,250 1,46,250 1,46,250

2 Annual interest- 20.5%

76,875 62,653 45,516 24,865

3 Depreciation 1,15,000 1,15,000 1,15,000 1,15,000

4 Cost of HP (2+3)

1,91,875 1,77,653 1,60,516 1,39,865

5 Tax shield (col.4 *50%)

95,938 88,827 80,258 69,933

6 Salvage value

40,000

7 Net cost of HP (1-5-6)

50,312 57,423 65,992 36,317

8 PVF –18% .847 .718 .609 .516 .437

Analysis table (using ERI)S.no. Particulars Year 1 2 3 4 5

9 PV of net cost of HP

42,614 41,230 40,189 18,776

10 Annual lease rental

1,00,000 1,00,000 1,00,000 1,00,000 1,00,000

11 Tax shield on lease rentals

50,000 50,000 50,000 50,000 50,000

12 Net cost of leasing (10-11)

50,000 50,000 50,000 50,000 50,000

13 Pv of leasing 43,250 35,900 30,450 25,800 21,850

PV of salvage value 17480 Net cash flow under HP = 1,42,809- 17480=125329Under leasing =1,56,350

Parties to hire purchase agreement

• Two parties• Sale element of hire purchase contract has been

divorced from finance element (tripartite deal)• Modalities:The dealer contracts a finance company to finance

hire purchase dealsDealer arranges full documents to be completed to

make a hire purchase deal.The customer makes the cash down payment which

is retained by the dealerDealer sends the document and finance company

purchases the asset.

Modalities (contd..)

• The Finance company signs the document and sends a copy to hirer

• The dealer delivers the good

• The hirer makes the payment periodically

• On completion of hire term property in good passes to him

Legal FrameworkThere is no exclusive legislation dealing with hire There is no exclusive legislation dealing with hire

purchase transactions in India. The purchase transactions in India. The Hire-Purchase Hire-Purchase Act Act was passed in 1972. A bill was introduced in was passed in 1972. A bill was introduced in 1989 to amend some of the provisions of the Act. 1989 to amend some of the provisions of the Act. However, the Act has not been enforced so far. However, the Act has not been enforced so far.

In the absence of any specific law, the hire-purchase In the absence of any specific law, the hire-purchase transactions are governed by the general laws. The transactions are governed by the general laws. The hire-purchase transaction has two aspects: (i) an hire-purchase transaction has two aspects: (i) an aspect of bailment of goods which is covered by aspect of bailment of goods which is covered by the the Indian Contract ActIndian Contract Act, (ii) an element of sale when , (ii) an element of sale when the option to purchase is exercised by the hirer the option to purchase is exercised by the hirer which is covered by the which is covered by the Indian Sales of Goods ActIndian Sales of Goods Act. .

Hire purchase agreement• Nature of agreement• Delivery of equipment• Location• Inspection• Hire charges• Repairs• Alteration• Termination• Risk• Registration and fees• Schedule of hire charges and equipments

TAXATION ASPECTSTAXATION ASPECTSThere are three aspects of taxation of hire-purchase There are three aspects of taxation of hire-purchase

deals: (i) income-tax, (ii) sales tax and, (iii) interest deals: (i) income-tax, (ii) sales tax and, (iii) interest tax. tax.

• Though the hirer is not the owner of the asset, he is Though the hirer is not the owner of the asset, he is entitled to claim depreciation as a deduction on the entitled to claim depreciation as a deduction on the entire purchase price.entire purchase price.

• He can also claim deduction on account of He can also claim deduction on account of consideration for hire, that is, finance charge. consideration for hire, that is, finance charge.

• The amount of finance charge to be deducted each The amount of finance charge to be deducted each year is to be spread evenly over the term of year is to be spread evenly over the term of the agreement on the basis of a method chosen the agreement on the basis of a method chosen from amongst the alternatives: SOYD, ERI, SLM. from amongst the alternatives: SOYD, ERI, SLM.

Assessment of Owner (hire vendor)

• Income is liable to tax under Income from business profession otherwise income from other sources.

TAXATION ASPECTSTAXATION ASPECTS

The hire-purchase transaction can be used as a tax The hire-purchase transaction can be used as a tax planning device in two ways: planning device in two ways:

(i) by inflating the net income (finance income — (i) by inflating the net income (finance income — interest on borrowings by the finance company) at interest on borrowings by the finance company) at the rear-end of the deal and the rear-end of the deal and

(ii) by using hire-purchase as a bridge between the (ii) by using hire-purchase as a bridge between the lessor and the lessee, that is, introduction of lessor and the lessee, that is, introduction of an intermediate financer an intermediate financer

TAXATION ASPECTSTAXATION ASPECTS

• Hire purchase deemed to be sales, are liable to sales tax. Hire purchase deemed to be sales, are liable to sales tax.

• There is no provision of refund of sales tax on unpaid There is no provision of refund of sales tax on unpaid installmentinstallment

• However, hire-purchase transaction structured by finance However, hire-purchase transaction structured by finance companies (which are not hire-vendors), being essentially a companies (which are not hire-vendors), being essentially a financing arrangement, do not attract sales tax. financing arrangement, do not attract sales tax.

• Delivery Vs Transfer of property:Taxable event.Delivery Vs Transfer of property:Taxable event.

• The sales tax is levied on full amount payable without any The sales tax is levied on full amount payable without any deduction of hire chargesdeduction of hire charges

• The sales tax rates vary from state to stateThe sales tax rates vary from state to state

• Salestax is not levied if goods are delivered in the state with Salestax is not levied if goods are delivered in the state with single point levy systemsingle point levy system

Taxation aspects

• An interest tax has to be paid on the interest An interest tax has to be paid on the interest earned less bad debts. The tax is treated as a earned less bad debts. The tax is treated as a tax-deductible expense for the purpose of tax-deductible expense for the purpose of computing the taxable income under the computing the taxable income under the Income-Tax ActIncome-Tax Act..

Evaluation of hire purchase• Sriram leasing and hire purchase company

offers equipment costing Rs 1.5 million on hire purchase to Britannia industries .The hire purchase installments will be paid annually for five years.The hiree calculates interest at a flat rate of 18%.Britannia Industries will depreciate the asset for five years and the asset has no salvage value.The corporate tax rate is 35%.Evaluate the hire purchase offer.Britannia industries is also offered the same asset on lease.How much lease rental is the company prepared pay?

Solution• Interest for five years at 18% p.a = RS 13,50,000• Instalment = 15,00,000+13,50,000/5 = Rs 5,70,000• The amount of inteerst is distributed according the

SOYD method according the amount of each year is as shown

Year Interest

1 4,50,000

2 3,60,000

3 2,70,000

4 180,000

5 90,000

After tax cost of hire purchaseYear Purchase

price avoided

Installment amount

Principal repaid

Interest Interest tax shield

Depreciation tax shield

Net Cash flows

0 15,00,000 4,50,000 15,00,000

1 5,70,000 1,20,000 3,60,000 1,57,500 1,05,000 3,07,500

2 5,70,000 2,10,000 2,70,000 1,26,000 1,05,000 339,000

3 5,70,000 3,00,000 180,000 73,500 1,05,000 3,70,500

4 5,70,000 3,90,000 90,000 63000 1,05,000 4,02,000

5 5,70,000 4,80,000 31500 1,05,000 4,33,000

After tax cost of hire purchase

• 15,00,000 = 3,07,500/(1+r) + 3,39,000/(1+r)2 + 3,70,500/(1+r) 3+ 4,02,000/(1+r)4 + 4,33,000/(1+r)5

• R= 7% approx• Lease rentals that Britannia industry is prepared to

pay is as follows:• 15,00,000 = Ʃ t=1to 5 L(1-t)/ (I+.07)t

• 15,00,000 = 4.1 (.65)L= 2.6665L• Lease rentals = 562,852• Thus Britannia Industries will be indifferent between lease

financing and hire purchase financing if lease rentals are Rs 562,852

ACCOUNTING AND REPORTINGACCOUNTING AND REPORTING• There was no accounting standard/guidance There was no accounting standard/guidance

note for accounting treatment of hire-purchase note for accounting treatment of hire-purchase in India. in India.

• According to the current reporting practices, in According to the current reporting practices, in the books of the the books of the hirerhirer, the cash purchase price , the cash purchase price of the equipment is of the equipment is capitalisedcapitalised and an and an equal equal amount less down payment,amount less down payment, if any, is recorded if any, is recorded as a liability. as a liability.

• The depreciation is charged on the cash The depreciation is charged on the cash purchase price in conformity with the general purchase price in conformity with the general depreciation policy for similar depreciation policy for similar assets. assets.

ACCOUNTING AND REPORTINGACCOUNTING AND REPORTING• The total charge for credit is spread over hire-term The total charge for credit is spread over hire-term

according to one of the alternative methods: ERI, SOYD, according to one of the alternative methods: ERI, SOYD, SLM.SLM.

• As far as the finance company(hiree) is concerned, the hire As far as the finance company(hiree) is concerned, the hire installment receivable is shown as a current asset under the installment receivable is shown as a current asset under the head head stock on hirestock on hire and the and the finance incomefinance income element of the element of the installment is recorded as a current installment is recorded as a current liabilityliability under the head under the head unmatured/unearned finance charge and is spread over the unmatured/unearned finance charge and is spread over the accounting period (hire-term). accounting period (hire-term).

• At the end of each accounting period ,an appropriate part of At the end of each accounting period ,an appropriate part of unmatured finance income should be recognized as current unmatured finance income should be recognized as current income for the period.income for the period.

• The direct costs are expensed immediately/amortised over The direct costs are expensed immediately/amortised over the accounting period. the accounting period.

Illustration 5.1Illustration 5.1

Under a hire-purchase deal structured by the Hypothetical Finance Ltd (HFL) for the Hypothetical Industries Under a hire-purchase deal structured by the Hypothetical Finance Ltd (HFL) for the Hypothetical Industries Ltd (HIL), the HFL has offered to finance the purchase of an equipment costing Rs 150 lakh. The (flat) rate of Ltd (HIL), the HFL has offered to finance the purchase of an equipment costing Rs 150 lakh. The (flat) rate of interest would be 13 per cent. The amount would have to be repaid in 48 equated monthly installments in interest would be 13 per cent. The amount would have to be repaid in 48 equated monthly installments in advance. The HIL is required to make a cash down payment of 25 per cent. It uses WDV method of advance. The HIL is required to make a cash down payment of 25 per cent. It uses WDV method of depreciation @ 30 per cent on similar assets. depreciation @ 30 per cent on similar assets.

From the foregoing information, you are required to show: (A) the allocation of total charge for From the foregoing information, you are required to show: (A) the allocation of total charge for credit (finance charge), on the basis of (1) effective rate of interest (ERI)/annual percentage rate (APR) method, credit (finance charge), on the basis of (1) effective rate of interest (ERI)/annual percentage rate (APR) method, (ii) sum-of-year’s-digits (SOYD) method and (iii) straight line method (SLM) of depreciation; (B) how the deal (ii) sum-of-year’s-digits (SOYD) method and (iii) straight line method (SLM) of depreciation; (B) how the deal will be recorded in the financial statements (profit and loss account and balance sheet) of the hirer (HIL) in the will be recorded in the financial statements (profit and loss account and balance sheet) of the hirer (HIL) in the first two years. You can make, if necessary, your assumptions.first two years. You can make, if necessary, your assumptions.

SolutionSolution

(A)(A) (i) Allocation of Total Charge for Credit: ERI/APR Method(i) Allocation of Total Charge for Credit: ERI/APR Method (Rs lakh)(Rs lakh)

______________________________________________________________________________________________________________________________________________________________________________________________

YearYear Outstanding amount Outstanding amount Interest contentInterest content Capital content/ Capital content/ Annual installment Annual installment

at the beginningat the beginning recovery recovery (3.5625 x 12) (3.5625 x 12)

______________________________________________________________________________________________________________________________________________________________________________________________

11 112.50112.50 23.5423.54 19.2119.21 42.7542.75

22 93.29 93.29 18.5218.52 24.2224.22 42.7542.75

33 69.06 69.06 12.2012.20 30.5530.55 42.7542.75

44 38.52 38.52 4.22 4.22 38.5338.53 42.7542.75

______________________________________________________________________________________________________________________________________________________________________________________________


1.1. Computation of ERI/APR:Computation of ERI/APR:

Total charge for credit = Rs 112.50 [Rs 150 lakh Total charge for credit = Rs 112.50 [Rs 150 lakh – down payment (Rs 37.50 lakh)] x 0.13 x 4 =– down payment (Rs 37.50 lakh)] x 0.13 x 4 =

Rs 58.50 lakhRs 58.50 lakh

Monthly installment = (Rs 112.50 lakh + Rs 58.50 Monthly installment = (Rs 112.50 lakh + Rs 58.50 lakh) / 48 = Rs 3.5625 lakhlakh) / 48 = Rs 3.5625 lakh

Annual installment = Rs 3.5625 lakh * 12 = Rs Annual installment = Rs 3.5625 lakh * 12 = Rs 42.75 lakh42.75 lakh

The ERI per annum, I, is given by equation:The ERI per annum, I, is given by equation:

N/N-1 *2F N/N-1 *2F

= 48 /47 *2*13= 48 /47 *2*13

=26.55%=26.55%

Assumption: Salvage value after 4 years, nil.Assumption: Salvage value after 4 years, nil.

(A)(A) (ii) Allocation of Total Charge for Credit: SOYD Method(ii) Allocation of Total Charge for Credit: SOYD Method (Rs lakh)(Rs lakh)

______________________________________________________________________________________________________________________________________________________________________________________________

Year Annual installment Finance chargeYear Annual installment Finance charge Capital recovery Capital recovery

(3.5625 x 12)(3.5625 x 12)

______________________________________________________________________________________________________________________________________________________________________________________________

11 42.7542.75 25.4225.42 17.3317.33

22 42.7542.75 18.2118.21 24.5524.55

33 42.7542.75 11.0411.04 31.7131.71

44 42.7542.75 3.83 3.83 38.9238.92

______________________________________________________________________________________________________________________________________________________________________________________________


Finance charge (Rs lakh)Finance charge (Rs lakh)

48 + 47 + … + 3748 + 47 + … + 37

YearYear 1 = ----------------------- x Rs 58.50 lakh = Rs 25.42 lakh1 = ----------------------- x Rs 58.50 lakh = Rs 25.42 lakh

48 + 47 + … + 148 + 47 + … + 1

36 + 35 + … + 2536 + 35 + … + 25

2 = ----------------------- x Rs 58.50 lakh = Rs 18.21 lakh2 = ----------------------- x Rs 58.50 lakh = Rs 18.21 lakh

48 + 47 + … + 148 + 47 + … + 1

24 + 23 + … + 1324 + 23 + … + 13


48 + 47 + … + 148 + 47 + … + 1

12 + 11 + … + 112 + 11 + … + 1


48 + 47 + … + 148 + 47 + … + 1

(A) (iii) Equated Annual Finance Charge: SLM(A) (iii) Equated Annual Finance Charge: SLM

Rs 58.50 lakh ÷ 4 = Rs 14.62 lakhRs 58.50 lakh ÷ 4 = Rs 14.62 lakh

(B) Financial Statements(B) Financial Statements

Income StatementIncome Statement (Rs lakh)(Rs lakh)

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Expenses Expenses Year 1Year 1 Year 2Year 2

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Depreciation (150 x 0.30)Depreciation (150 x 0.30) 45.0045.00 — —

(105 x 0.30)(105 x 0.30) — — 31.50 31.50

Finance chargeFinance charge 23.5423.54 18.5218.52

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Balance SheetBalance Sheet (Rs lakh)(Rs lakh)

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LiabilitiesLiabilities AmountAmount AssetsAssets Amount Amount

________________________ ___________________ ___________________

Year 1 Year 2Year 1 Year 2 Year 1 Year 1 Year 2Year 2

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Secured loans:Secured loans: Fixed assets: Fixed assets:

Hire-purchase outstanding 69.06 38.51Hire-purchase outstanding 69.06 38.51 Equipment on hire purchase: 150.00 Equipment on hire purchase: 150.00 150.00150.00

(due after one year)(due after one year) Gross BlockGross Block 45.00 45.00 76.50(45+31.5) 76.50(45+31.5)

Current liabilities:Current liabilities: Less: Less: Accumulated depreciation _____ Accumulated depreciation _____ __________

Hire-purchase outstanding 24.22 30.50Hire-purchase outstanding 24.22 30.50 Net block Net block 105.00 105.00 73.50 73.50

(due within one year)(due within one year)

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Illustration 5.2Illustration 5.2

For the Hypothetical Finance Ltd (HFL) in Illustration 5.1, assume that the initial cost of structuring the deal is For the Hypothetical Finance Ltd (HFL) in Illustration 5.1, assume that the initial cost of structuring the deal is Rs 1.2 lakh. Using the effective rate of interest method for allocating finance income, show how the Rs 1.2 lakh. Using the effective rate of interest method for allocating finance income, show how the transaction will appear in the books of the HFL. You can make other assumptions, if necessary. transaction will appear in the books of the HFL. You can make other assumptions, if necessary.

SolutionSolution

Allocation of Unearned Finance Income (ERI: 26.1%)Allocation of Unearned Finance Income (ERI: 26.1%) (Rs lakh)(Rs lakh)

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YearYear Outstanding amount Installment Outstanding amount Installment Interest component Interest component Capital recovery Capital recovery

at the beginningat the beginning

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11 112.50112.50 42.7542.75 23.5423.54 19.2119.21

22 93.29 93.29 42.7542.75 18.5218.52 24.2224.22

33 69.06 69.06 42.7542.75 12.2212.22 30.5530.55

44 38.52 38.52 42.7542.75 4.22 4.22 38.5338.53

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Record in Financial Statements:Record in Financial Statements:

Income StatementIncome Statement (Rs lakh)(Rs lakh)

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ExpensesExpenses Amount Amount IncomeIncome Amount Amount

________________________________ ______________________________________________________

Year 1Year 1 Year 2Year 2 Year 1Year 1 Year 2Year 2

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Direct costsDirect costs 1.2 1.2 — — Hire finance income Hire finance income 23.5423.54 18.5218.52

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Balance SheetBalance Sheet (Rs (Rs lakh)lakh)

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LiabilitiesLiabilities Amount Amount AssetsAssets Amount Amount

________________________________ ____________________________

Year 1Year 1 Year 2Year 2 Year 1 Year 1 Year 2Year 2

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Current liabilities:Current liabilities: Current assets:Current assets:

Finance income/charge Finance income/charge Stock on hire (agreement Stock on hire (agreement

(unmatured/unearned)(unmatured/unearned) 34.9534.95 16.4216.42 value less amount/installment value less amount/installment

received)received) 128.24 128.24 85.4985.49

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Hire Purchase

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