Interest rate charged by a financial institution for a lease or loan

Cash flows before, during, and after equipment use; positive number = cash outflow

The cash flow chart depicts total annual cash flows for every equipment acquisition option. These cash flows are nominal cash flows, i.e., before discounting. They are visual representations of the total cash flows from the cash flow details tables.

Equipment delivery, installation, and any other out-of-pocket expenses, such as software or training

Number of years the equipment will be depreciated for accounting and tax purposes (this tool uses the straight-line depreciation method)

Rate of return to calculate the present value of future cash flows

The discount rate, also referred to as rate of return, hurdle rate, or opportunity cost of capital, is a proxy for the financial risk associated with any investment. This opportunity cost is the return forgone by investing in a specific project rather than in comparable investment alternatives. The discount rate is determined based on the first basic principle of finance that a dollar today is worth more than a dollar tomorrow and based on the second basic finance principle that a safe dollar is worth more than a risky dollar.

In lease-buy decisions most of the investment characteristics are set in stone once the decision is made, leading to very predictable future cash flows such as monthly payments or tax advantages. Hence, lease-buy decisions can be considered low risk. The function of the discount rate is then to appropriately value cash flows in different time periods and discount them to today's dollars.

Because of the usually low financial risk associated with a lease-buy decision, the discount rate needs to reflect this low risk. This can be accomplished by choosing a discount rate that is close to a risk-free rate of return expected for example from short-term (3-month) U.S. Treasury bills. But many times companies determine a weighted average cost of capital (WACC) for the company and use it for all investment decisions. By doing this though companies treat low risk investments, such as capital purchase, the same way as high risk investments, such as bringing new technology to a new market. Hence, FinanceIsland recommends using a risk-free rate for the lease-buy analysis.

You can find more information about choosing an appropriate discount rate for various investment projects in FinanceIsland's tutorial on risk and the Capital Asset Pricing Model.

Fee that may be set by the leasing company to compensate for the expenses of selling or otherwise disposing the equipment at the end of the lease

Payment made usually at the time of equipment possession that reduces the amount to be financed

Company's effective tax rate based on the federal tax rate and potentially adjusted for state or local taxes

The effective tax rate is used to calculate tax deductions and after-tax cash flows. According to the guidelines on deductible business expenses from U.S.' Internal Revenue Service (IRS), this tool calculates tax deductions and after-tax cash flows for the following business expenses:

• lease: down payment, lease payments, and disposition fee
• financed purchase: loan interest payments, equipment depreciation, and taxes on equipment sale
• cash purchase: equipment depreciation and taxes on equipment sale

Should other tax regulations apply to your business, please set the effective tax rate to zero. By doing so, calculations of total costs will exclude taxes on equipment sale and all tax deductions. The tool will recommend then the least expensive lease-buy option before taxes. In this case we recommend though consulting with your trusted financial advisor to determine any tax impact from each lease-buy option.

Depreciation of the capital equipment that can be tax deducted

Depreciation is an income tax deduction that allows a business to recover the cost of tangible property such as capital equipment. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property. According to the Publication 946, How To Depreciate Property from U.S.' Internal Revenue Service (IRS), there are several depreciation methods that can be used to calculate this tax deduction including straight-line depreciation and accelerated depreciation. FinanceIsland's lease-buy tool uses the straight-line depreciation method to calculate the equipment depreciation tax deduction.

Should other tax regulations apply to your business, please set the effective tax rate to zero. By doing so, calculations of total costs will exclude taxes on equipment sale and all tax deductions. The tool will recommend then the least expensive lease-buy option before taxes. In this case we recommend though consulting with your trusted financial advisor to determine any tax impact from each lease-buy option.

Price of the capital equipment to be leased or purchased

Expected sales price of the capital equipment

Sum of the annual depreciation fee and the annual lease financing fee

Tax deduction on the lease payment

FinanceIsland's lease-buy tool takes into account tax deduction on the lease payment according to the guidelines on deductible business expenses from U.S.' Internal Revenue Service (IRS). Should other tax regulations apply to your business, please set the effective tax rate to zero. By doing so, calculations of total costs will exclude taxes on equipment sale and all tax deductions. The tool will recommend then the least expensive lease-buy option before taxes. In this case we recommend though consulting with your trusted financial advisor to determine any tax impact from each lease-buy option.

Tax deduction on the interest portion of the loan payment

FinanceIsland's lease-buy tool takes into account tax deduction on the interest portion of the loan payment according to the guidelines on deductible business expenses from U.S.' Internal Revenue Service (IRS). Should other tax regulations apply to your business, please set the effective tax rate to zero. By doing so, calculations of total costs will exclude taxes on equipment sale and all tax deductions. The tool will recommend then the least expensive lease-buy option before taxes. In this case we recommend though consulting with your trusted financial advisor to determine any tax impact from each lease-buy option.

Annual loan payment

Another representation of the interest rate in a lease

The money factor may be used by leasing companies to simplify the calculation of the monthly lease financing fee. The money factor equals annual interest rate times 100 and divided by 2400. For more details, please see definition of the monthly lease financing fee below.

Part of the monthly lease payment that covers the depreciation of the equipment

The monthly lease payment consists of two components: depreciation fee and lease financing fee. The depreciation fee covers the loss of value of the equipment during the lease duration. The monthly depreciation fee is calculated as:

Part of the monthly lease payment that covers finance charges

The monthly lease payment consists of two components: depreciation fee and lease financing fee. The lease financing fee is the finance charge to pay the leasing company for the use of its money. It corresponds to the interest payment in a loan. The monthly lease financing fee can be approximated based on the average amount to be financed and based on the monthly interest rate as described in the formula below. The leasing company may simplify the calculation by using the money factor.

Sum of the monthly depreciation fee and the monthly lease financing fee

The monthly lease payment is calculated in FinanceIsland's lease-buy tool based on the approximation of the monthly depreciation fee and the monthly lease financing fee as described in their definitions above. This approximation was chosen to illustrate the two components of a lease payment: depreciation fee and lease financing fee. The true lease payment formula wouldn't distinguish these two components. Using that true formula though the resulting monthly lease payment would be slightly higher. For leases with annual interest rates under 10% and terms of 60 months or less the difference would be less than 2%.

Monthly payment to pay off the loan

The calculation of the monthly loan payment is based on the assumption that the payment occurs at the end of the month. Should the payment occur at the beginning of the month, the monthly loan payment would be slightly lower. For typical loans with annual interest rates under 10% the difference between the monthly loan payments would be less than 1%.

Net present value = sum of discounted cash flows

Discounted cash flows are present values of cash flows, whether in- or outflows. Since the three options to acquire capital equipment, i.e., lease, financed purchase, and cash purchase, lead to varying levels of cash flows in varying time periods, NPV is the best measure to compare these options. Together with the appropriate discount rate, NPV provides one financial measure for each option, which takes into account the total cost before, during, and after the equipment use. In the case of a lease-buy analysis, where positive numbers are cash outflows, the option with the lowest NPV makes the most financial sense and should be selected to acquire the capital equipment.

FinanceIsland's lease-buy tool calculates annual cash flows first and then discounts them on an annual basis. Cash flows from down payment, security deposit, and total cash outlay are treated as cash flows in period 0 and are not discounted. Cash flows from lease or loan payments and tax deductions during the equipment use are discounted annually starting with the first year of equipment use. Cash flows after the equipment use, i.e., security deposit refund, disposition fee, and equipment sale, are discounted in the last year that includes the last month of usage duration.

Net present value comparison of all options based on the usage duration; option with the lowest NPV should be selected

The NPV chart shows net present values of the three lease-buy options as a function of usage duration. It allows for a quick sensitivity analysis of the usage duration to understand if shorter or longer equipment use would change the preferred acquisition option.

Expected market value of the equipment at which it can be sold on the market after its use

Remaining value of the equipment at the end of the lease that is determined by or negotiated with the leasing company

Security deposit that may be charged by the leasing company

The security deposit is usually fully refunded at the end of the lease if the equipment condition is within the normal wear and tear. FinanceIsland's lease-buy tool assumes a full refund of the security deposit.

Taxes to be paid on the gain from the equipment sale

When selling depreciable equipment and calculating any gain to be treated as ordinary income, companies have to take into account the depreciation allowed during the equipment use. According to the Publication 544, Sales and Other Dispositions of Assets from U.S.' Internal Revenue Service (IRS), that gain is the lesser of the depreciation allowed on the equipment and the gain realized on the disposition. This gain has to be taxed accordingly. FinanceIsland's lease-buy tool uses the calculation method described in this IRS publication to determine taxes on equipment sale.

Should other tax regulations apply to your business, please set the effective tax rate to zero. By doing so, calculations of total costs will exclude taxes on equipment sale and all tax deductions. The tool will recommend then the least expensive lease-buy option before taxes. In this case we recommend though consulting with your trusted financial advisor to determine any tax impact from each lease-buy option.

Total cash paid to acquire the equipment including delivery and installation fees (equals total cost)

Total cost consisting of the equipment price and any fees

Total amount to be financed through a lease or loan after any down payments

Number of months the equipment will be used (in case of leasing or loan financing equals duration or term of the lease or loan)