Question

i. Explain how the cost of debt and the resale value of leased asset affect the lease rate?

ii. Maintenance costs can make the lease analysis a complicated affair. Explain how maintenance affects financial lease calculations.

Answer 1

i) Explain how the cost of debt and the resale value of leased asset affect the lease rate?

The lease rate is worked out so as to get 0 NPV with the applicable discount rate.

The equation for the lease rent would be:

Cost of asset = PV of after tax lease rent+PV of depreciation tax shield on the asset+PV of after tax resale value-PV of insurance, maintenance etc. (if to be borne by the lessor)ter

As the after tax cost of debt is used as the discount rate, to work out the lease rent that can be charged, the cost of debt becomes relevant. Further, as the PV of the after tax resale value of the asset is also counted, that too becomes relevant.

ii. Maintenance costs can make the lease analysis a complicated affair. Explain how maintenance affects financial lease calculations.

Maintenance costs affect the lease rate if the lessor is to bear it. The lease rent should cover the after tax maintenance costs also.

From the lessee's point of view also, the maintenance costs are vital if the lessee is to bear it. NPV of lease should be worked out by considering after tax maintenance costs.