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Today I’m going to show you how to calculate the implicit rate of interest on lease by using a loan amortization program.
The program that I use is called T-Value, and can be purchased at www.timevalue.com for about $150. Before running the program, you need to determine the dates and amounts of all payments. This includes the initial deposit payment (which is usually first and last), the amount of each monthly payment, the lease termination charge at the end of the lease, and any other scheduled payments. If there is a purchase option at the end of the lease that can be determined, you will want to run a separate iteration to cover that possibility as well.
In this example we are assuming the following facts:
* Date of Purchase = 1/1/2011
* Lease term = 60 months
* FMV of equipment = $40,000
* Monthly payment = $1,000
* Due on signing = First and last = $2,000
* Monthly payment of $1,000 for 58 months
* Lease termination fee = $500
First, we give the schedule a name: Lease #1. Input the compounding period as monthly, which we can be entered from the drop down menu. For Nominal Annual Rate, enter “Unknown.” This is amount will be eventually be calculated by the program, and is the implicit rate in the lease.
Next, put in our cash flow. On line 1 we call the event a “Loan” and enter the date of purchase as January 1, 2011, along with the FMV of the equipment, which is the same as the cash purchase price. In this case the FMV is $40,000.
On line 1 we enter our first cash payment, which in this example is first and last payment, totaling $2,000. This happens at the inception of the lease, so the date is also January 1, 2011.
On line 3 we enter the monthly payments and the fact that there will be 58 of them, starting on February 1, 2011. Remember, there is a total 60 payments of $1,000, and the first two were made at the inception of the lease. So payment #1 and #60 have already been made.
On line 4 we enter the lease termination charge of $800, and the date of the termination of the lease, which is January 1, 2016.
Now that all of cash flow information is entered, we click the calculate button. The program now tells us that the implicit rate is just over 19%.
If you intend to purchase the asset at the end of the lease, this may be a problem in trying to determine the implicit rate. This won’t be a problem if the purchase option has a fixed dollar amount. All you do then is simply add the purchase option price to the termination fee, then click calculate to determine implicit rate. But if the lease says that you may purchase for FMV, you will have to estimate this amount, and understand that if you’re wrong, it will affect the implicit rate. But some leases give no criteria as to how to determine this amount, other than stating that it will be determined by the lessor. Understand that if this is the case, you are completely at lessor’s mercy.
To learn more, visit our video library at www.cfooutsource.com. Also, to see a video demonstration of the use of the T-Value program, click here.