Lease payments refer to the payments where the lessee under the lease agreement has to pay monthly fixed rental for using the asset to the lessor being the owner of such asset and asset is generally taken back by the owner after the expiration of lease term.
What is Lease Payment?
The term “Lease Payment” is analogous to rental payment and it refers to the payment made as per the contract agreed between the lessor and the lessee for granting use of an asset, which may include real estate, equipment or other fixed assets, for a specific period of time.
Components of Lease Payment
The calculation of lease payment is dependent on three components, which are depreciation fee, finance fee, and sales tax. Now, let us have a look at each of the components separately:
#1 – Depreciation Fee
The depreciation fee is analogous to principal payment of a loan. It is what the lessee pays the lessor for the loss in value of the asset, which is spread over the period of lease or the time for which the asset will be used by the lessee. The depreciation fee is expressed as equal periodic payment which is derived by dividing the total depreciation by the term of the lease as shown below,
- Net Capitalized Cost is the addition of the selling price, any additional dealer fees, taxes which are not paid up-front and outstanding loan balances (if any) minus any down payment and rebates.
- Residual value is the resale value of the asset at the end of the lease.
- Term of lease is the length of the lease contract (usually in months).
#2 – Finance Fee
The finance fee is analogous to the interest payment on loans and it is what the lessee pays the lessor for using their money. It is to be kept in mind that the finance charges are paid on the total of depreciation and residual value. The finance fee is mathematically represented as below,
The money factor can be calculated on the basis of the interest rate mentioned in the lease agreement which is mathematically expressed as shown below,
#3 – Sales Tax
It is the state or local tax charged on the sale price. It is usually paid at the time of signing the lease contract as part of the “due at lease signing” amount. It is mathematically expressed as below,
Lease Payment Formula
The formula for Lease Payment is derived by adding the depreciation fee, finance fee and sales tax which is mathematically represented as,
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Calculation of Lease Payment with Examples
Let’s see some simple examples of the lease payment to understand it better.
Let us take the example of John who is planning to buy a car on lease. The lease will be for a period of 36 months and charged an annual interest rate of 6%. John managed to negotiate the selling price to be $26,000 with a down payment of $4,000 and an outstanding loan balance of $5,000. The car is expected to have a residual value of $16,500 at the end of 36 months from now. The applicable sales tax rate is 5%. Determine the monthly lease payment for John.
Net Capitalized Cost
The net capitalized cost can be calculated using the below formula as,
Net Capitalized Cost = Negotiated Selling Price – Down Payment + Outstanding loan
= $26,000 – $4,000 + $5,000
Net Capitalized Cost = $27,000
Depreciation Fee
Depreciation fee = (Net capitalized cost – Residual value) / Term of lease
= ($27,000 – $16,500) / 36
Depreciation Fee = $291.67
Money Factor
Money Factor = Interest rate / 24
= 6% / 24
Money Factor = 0.0025
Financing Fee
Financing fee = (Net Capitalized Cost + Residual value) * Money factor
= ($27,000 + $16,500) * 0.0025
Financing Fee = $108.75
Sales Tax
Sales tax = (Depreciation fee + Finance fee) * Sales tax rate
= ($291.67 + $108.75) * 5%
Sales Tax = $20.02
Monthly Lease Payment
Therefore, Calculation of Monthly lease payment can be done using below formula as,
Monthly lease payment Calculation = Depreciation fee + Finance fee + Sales tax
= $291.67 + $108.75 + $20.02
Monthly Lease Payment = $420.44
Therefore, John has to pay monthly lease payment of $420.44.
Advantages
Now, let us have a look at some of the advantages of Lease Payment:
- The cash outflow or the lease payments are spread across the term of the lease agreement, which eliminates the burden of one-time substantial cash pay-out. This immensely helps the liquidity position of a business and eases the pressure on the cash flow profile.
- By choosing leasing over-investment in an asset, a company releases the capital which can be used to fund other business needs.
- In an operating lease, the lease is treated differently from debt as it is classified as an off-balance sheet liability and as such doesn’t appear in the balance sheet. However, the financial lease doesn’t offer this advantage.
- Leasing can be a viable option for businesses operating in industries which are vulnerable to the risk of technology obsolescence. By leasing, a company basically safeguards itself from the risk of investing in a technology that is likely to become obsolete.
Disadvantages
Now, let us have a look at some of the disadvantages of Lease Payment:
- In the case of a lease agreement for assets such as land, the business is deprived of the benefit from any appreciation in the value of the asset.
- The lease expenses shrink the net income of a company without any appreciation in value, which eventually results in limited returns for the equity shareholders.
- In case of an operating lease, the lease is not captured as part of the balance sheet of a company. However, most investors deem it to be a long-term debt and as such adjust the valuation of the business accordingly.
- In case of an operating lease, the lessee doesn’t have the option of owning the asset at the end of the leasing period despite. However, in case of financial lease, the lessee is given the option to purchase the asset subject to payment of the residual value.
Conclusion
So, it can be concluded that lease financing is appropriate for business that doesn’t intend to fund their asset purchase through debt or term loan to reduce the burden of capex. Further, the lease payments work best for companies in industries that are susceptible to technology obsolescence. On the other hand, it is also beneficial for investors who want to invest their money efficiently without participating in the business and earn interest.
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