Finance Leasing Manual - FLM6.14

'Net present value'

Assume market interest rates are 10% a year payable annually in arrear. This means a sum of £1,000 today will be worth £1,100 in a year's time. So, ignoring questions of security, profit margin etc, you should be able to sell your entitlement to a sum of £1,100 in a year's time for £1,000 today. Put another way, the 'present value' of that future entitlement to £1,100 is £1,000.

On the same assumptions, £1,000 today will be worth £1,210 in two years' time, assuming that the interest earned in the first year itself earns interest in the second. That is, the capital earns interest of 10% which compounds at annual rests: applying a 10% interest rate to the £1,100 accumulated at the end of the first year produces £1,210 by the end of the second year. Interest is earned on the interest previously earned so that the second year's interest is £110 and not just a £100. Thus, the 'present value' of that entitlement to £1,210 in two years is also £1,000.

The intervals at which compounding of interest occurs can have a significant effect. Interest at 12% calculated at monthly rests is worth more than interest at 12% calculated at annual rests. Interest is earned on interest earlier in the monthly case.

These simple examples of the 'time-value-of-money' illustrate the principles which lie at the heart of leasing calculations. The lessor's upfront tax losses save tax (or generate repayments) in the early part of the lease. In due course the lessor will have to pay tax on his profit. The tax on later rentals receivable (capital plus interest) should be more than the tax saved upfront (because earnings exceed expenses overall). But the upfront tax can be worth more (have a greater present value) than the larger amount of tax the lessor eventually has to pay on the profits in the future.