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Lease Payments
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Definitions
Lease Amount This is the presumed value of the asset being leased, at the time that the lease is signed. It is the present value of the future payments on the lease, including the residual value. Residual Value This is the assumed value of the asset at the end of the life of the lease. Often, as is the case for auto loans, the lessee has the option of purchasing the asset for this price when the lease is up. For example, an auto lease may specify a residual value of $15,000 when the lease is up in 3 years. At that time, the lessee has the right, but usually not the obligation, to purchase the vehicle for $15,000. If the lessee chooses not to exercise that option, then the vehicle will be turned over to the lessor. In this example, the lease has a built-in call option with a strike price equal to the residual value. Advance Payments Sometimes the lease terms call for a number of payments to be paid in advance, when the lease is signed. The number of advance payments could be 0, 1, 2, or more. For example, suppose that a lease calls for a $300 monthly payment with 2 advance payments. Then, when the lease is signed, you would pay $600 (2 payments) and the first regular payment of $300 would be due in one month.
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Note that I have compressed the time line for space considerations. The principle of value additivity states that the present value (lease amount) is equal to the present value of the monthly payments (an annuity) plus the present value of the residual value (a lump sum). Therefore, we have the following formula as our starting point:
We already know the PV (that is, the lease amount) and the FV (the residual value), and we want to solve the above equation for the monthly payment amount. This requires a minor amount of algebra to rearrange the equation, and the result is:
An Example
Imagine that you are considering an equipment lease (rather than a purchase) of a computer for your office. The lease terms call for a lease amount of $3,500, a residual value of $1,000 and 24 monthly payments. The lease carries an interest rate of 9% per year. How much would your monthly payments be? Using our formula from above, and converting the annual rate to a monthly rate (0.09/12 = 0.0075) we can calculate the monthly payment amount as follows:
So, the monthly payment would be $121.71. Note that you can easily find this same answer using a financial calculator. Simply enter 24 into N, 9/12 into i, -3500 into PV, and 1000 into FV. Solve for the PMT and you will get the same answer.
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The result is that you monthly payment would be $119.13. Note that you would make three payments at signing, so you would have to immediately write a check for $357.40. Your last payment would be made 3 months earlier than if you hadn't made the advance payments. One final note: If the number of advance payments equals 1, then the problem is greatly simplified because the monthly payment can be treated as an annuity due. This calculation can be done in a financial calculator just put the calculator into Begin mode. However, if the number of advance payments is 2 or more, then the above formula must be used. I hope that you have found this tutorial useful. I also have an Excel spreadsheet to calculate lease payments (Excel 2003 version) available. For more information regarding the leasing business, please visit the non-profit Equipment Leasing and Finance Foundation.
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