A lease is an agreement whereby the lessor (owner of property) allows the lessee use of the property in exchange for lease payments. Operating leases give the lessee the use of property without ownership. Operating leases are sometimes used to initiate off-balance-sheet financing of assets. Capital or Financing leases transfer ownership from lessor to lessee. Under capital leases, the lessee will record the asset at the present value of lease payments not to exceed the fair market value of the asset. The following examples will illustrate certain basic calculations in valuing leases. You will need to refer to present value tables to understand the source of present value factors.
Example 1. What is the value of the leased asset?
Annual lease rental payments are $ 10,000 under a 5 year lease. The financing rate for this lease is 12% and payments are made at the beginning of the year. Since payments are made at the beginning of the year, we will use a present value factor for an annuity due. Remember that many present value tables are
based on year-end payments.
Step 1: Determine the present value factor to use, 4 years (n-1) and 12% gives us 3.0373 + 1.0000 = 4.0373 present value for annuity due at 12% for 5 years.
Step 2: Calculate the present value of cash flows associated with the lease.
$ 10,000 x 4.0373 = $ 40,373 Value of Leased Asset.
Example 2. What is the annual payment for a lease?
We will lease an asset that has a value of $ 50,000 over 10 years. Payments will be made at year-end with an interest rate of 14%.
Step 1: Determine the present value factor to use, 10 years and 14% gives us 5.2161
Step 2: Calculate the annual lease payments, $ 50,000 / 5.2161 = $ 9,586
Lease calculations are important when making a decision to buy or lease assets. Leases can help preserve cash flows, but leases carry higher costs over the long-run than outright purchasing of assets.
Written by: Matt H. Evans, CPA, CMA, CFM | Email: firstname.lastname@example.org | Phone: 1-877-807-8756