Having spent a number of yearsboth in the equipment-leasing industry and as a corporatetreasurer, I am still surprised by how often companies appear tojust enter into lease transactions with no more foresight than thestroke of a pen. In many cases, they enter a deal worth hundreds ofthousands, or even millions, of dollars over multiple years aftervery little review or analysis of the lease transaction's terms andtrue costs over time.

Most of the corporate lease-procurement effort revolves aroundnegotiation of the equipment's purchase price at the beginning ofthe lease. When that is completed, the supplier's captive leaserepresentative steps in with a lease contract, which the buyerimmediately accepts without any meaningful review or pushback.

Such an approach may leave a considerable amount of money on thetable. Quite often, lessees negotiate a good cash purchaseprice, only to relinquish much of those savings in the leasefinancing. The lessee's finance staff don't do an adequate analysisbecause they don't have the time or expertise, which enables thevendor to recapture margin it forfeited in price negotiations.

So, how can a treasury or finance team know whether a lease isgood or bad?

There are two parts of a lease transaction to consider inanswering this question: the total lease price that the lessoroffers up as part of the deal, and the terms and conditions of thelease contract. This article will focus on the leasepricing; we will subsequently publish a separate article aboutanalysis of the lease contract itself.

Fair Market Value

We will focus on a fair market value (FMV) lease, as this is thetypical lease structure for most equipment. Pricing on anequipment lease transaction is usually quoted using a lease ratefactor, or LRF. Arriving at the LRF is a simplecalculation. The periodic lease payment is divided by the initialcost of the equipment; the resulting percentage is the LRF.

The LRF is a well-established standard across the leasingindustry. The beauty of the LRF is that a company can apply thepercentage to different equipment options and very quickly figureout how much it would need to pay every month orquarter. The downside is that's all the information theLRF provides.

When a lessor provides a price quote for an FMV lease, its LRFis driven by three main components: the length of the lease term;the implied cost of money the lessor is receiving over time ratherthan at the outset of the lease; and the lessor's estimate of howmuch residual value the asset(s) will retain at the end of thelease term. In most cases, the lessor is not going to wantto disclose how it arrives at the LRF it quotes. The good news isthat a corporate finance team can easily deconstruct the LRF to geta sense for where the numbers come from.

In fact, dissecting every lease quote is a best practice forcompanies that engage in equipment leasing. The PMT formula inMicrosoft Excel can provide a very good understanding of how thelessor arrived at its LRF, or the lease's periodic payment. Theformula looks like this:

=PMT(rate,nper,pv,fv,type)

where

• PMT is the amount of each periodic payment. (Note thatit is a negative value in the Excel formula; think of it asnegative because the cash is leaving you.)
• rate is the interest rate driving the periodicpayment. (Note that it must reflect the frequency of payment—sorate for a monthly payment would be the annual interestrate divided by 12.)
• nper is the number of periodic payments in the leasetransaction.
• pv is the initial cost of equipment in the lease.
• fv is the expected residual value of the equipment atthe end of the lease term. (Note that fv is also anegative value in the Excel PMT formula.)
• type is determined by whether payments are made inadvance or arrears. (If the payment period is monthly, an advancepayment for January would be due on January 1, while an arrearspayment would be due January 31.)

Here's how the calculation would work. Suppose you werelooking to lease a forklift and a prospective lessor gave you a bidwith these features:

• Initial purchase price of the forklift(pv)—$25,000
• LRF—2.87%
• Term of the lease (nper)—36 months, with one paymentper month
• Payment timing (type)—advance

To determine whether this is a good deal, you can back into themissing numbers.

You don't know what the lessor used for the implied cost offunds or the residual value of the forklift, so you need to makesome assumptions. When I am performing this calculationfor my company, I estimate a reasonable cost of funds for myorganization based on our current credit profile.

Because the lease term in this example is 36 months, thequestion you would ask is: What interest rate would we have to payif we went to the debt market today and borrowed $25,000? If yourcurrent interest rate for 36-month debt is 5 percent, you couldreasonably estimate that your annual interest rate in the PMTformula should be 5 percent. Then, because you will be makingpayments once a month, you need to divide the annual interest rateby 12 to reach the rate number for your monthly payment.This does not yield a perfect analysis; nevertheless, it providesimportant insights into the economics underlying a particular leasetransaction's LRF.

With rate determined, the only variable still missingin the Excel PMT formula is the residual value. The PMT formulalooks like:

=PMT(.05/12,36,25000,fv,1)

where

• rate =  5% (i.e., .05) divided by 12
• nper =  36
• pv =  $25,000
• type =  advance, which is represented by a 1in Excel (arrears would be represented by 0)

The good news is that because you have the purchase price andthe LRF, you can calculate the PMT value, the monthlypayment implied in the quote. Just multiply the 2.87 percent LRF bythe $25,000 pv, and you find that you will be paying$717.50 every month for the next 36 months. Having the correctanswer to the payment amount means you can test different valuesfor any variables you are missing, and can determine whether aparticular calculation of the PMT formula is correct.

For example, if you guess that the residual value of yourforklift after 36 months will be 10 percent of its purchase priceat the beginning of the lease contract, or $2,500, you can enter-2500 for fv in the Excel PMT formula (remember that thefv value in Excel is a negative amount). Running the PMTformula with these values—

=PMT(.05/12,36,25000,-2500,1)

—results in a PMT value of -681.92, which is equivalentto a monthly payment of $681.92. This is lower than the actualmonthly payment of $717.50.

From here, you can use Excel's "Goal Seek" function on the Toolsmenu to find the fv value that will result in a monthlypayment of $717.50. Goal Seek is a great function; it canquickly run through thousands of numbers to find the rightone. In this example, you can specify that you want theGoal Seek function to modify the fv number so that the PMTformula results in a value of -717.50.

Note that you will need to set up two separate cells in Excelfor this to work. One cell should hold the actual number for theresidual value (-717.50); the PMT function requires the dollaramount. The other cell should hold residual value as a percentageof the equipment's original value (.10); the Goal Seek functionrequires a percentage.

With all these considerations, the Goal Seek formula would looklike this before running the analysis:

Cell B12 is the calculated payment that we want to become-$717.50 to match the monthly payment amount offered by the lessor.We get to the right monthly payment by modifying cell B9, theexpected residual value expressed as a percentage of the originalpurchase cost.

After the "OK" button is pressed to run the Goal Seek function,the numbers look like this:

As you can see, the result of this calculation is veryinteresting. If we're correct about the lessor's impliedinterest rate of 5 percent, the residual value built into the LRFis only $1,115.43, or 4.46 percent of the original purchase price.That seems like a low value for a $25,000 forklift after just threeyears. This is a red flag that the lessor may not be offering agood deal on the lease.

When you see this type of red flag, you may want to continueanalyzing the deal by changing other variables that you estimated.In this example, it would make sense to re-run the calculationswith a different interest rate. Doing so could provide asensitivity analysis showing how the residual value would changeunder different interest rate assumptions.

See also:

• Lease Modification Rising Due to EconomicUncertainty

One more idea for tightening up the estimate of the cost offunds the lessor is including in the LRF is to ask the prospectivelessor for two LRFs—one for an FMV lease and one for a full-payout("dollar buyout") lease. The full-payout lease, by definition, iscalculated such that the equipment has a residual value of $1 atthe end of the lease term. A corporate finance team evaluating afull-payout lease can use the PMT formula to definitively solve forthe cost of funds that the lessor has priced into the full-payoutLRF. They can then plug this realistic ratefigure into the analysis of pricing on the FMV lease to solve forthat lease's residual value. An unreasonably high interestrate is another potential red flag that a lease offer is not a gooddeal.

How to Use What You Learn

A finance team that finds a pricing red flag on a lease they areconsidering should show their analysis to the lessor and push for alower LRF (i.e., lower monthly payment) for the deal. Thesecalculations are a great negotiation tool, and that's not theironly use. My advice is for companies to evaluate every lease inthis way, to make sure they are always getting a good price—notonly on the equipment, but also on the lease.

Ultimately, the best mechanismfor negotiating a good lease is to competitively bid thetransaction among a variety of lessors. An investment-grade companywhose assets aren't particularly specialized should have no troublefinding lessors to compete for its lease business. Broad-basedcompetition is the only way to ensure that the resulting deal isthe best available. And the bigger the deal, the harder lessorswill fight to win.

A finance team can run this competitive process in-house orleverage an online leasing marketplace, such as theLeaseAccelerator Sourcing platform. Either way, getting multiplebids will give decision-makers a clear picture of the currentmarket price for a particular lease given the company's creditrating. They can measure the value of competing leases bycomparing the LRF of the lowest bid against the LRF of the averagebid.

It's a good idea to save leasing bids indefinitely to retain apermanent, long-term view of the company's lease-biddingexperience, in order to track performance over time. In my opinion,this is a leasing best practice. Finance managers, and their seniormanagement team, can rest assured that they are doing everythingwithin their power to enter into fair leasetransactions. They have the audit trail for everytransaction and market data to support their decisions.

Data is crucial in negotiating equipment leases. The companiesoffering the leases engage in these transactions every day.Compared with the corporate finance teams entering transactions aslessees, the lessors will always have the upper hand in terms ofexperience and expertise. That said, treasury and finance groupswho understand the different inputs that each lessor is using todetermine the LRF it offers will know that no lessor can takeadvantage of their organization. They will have the supportinganalytics for every transaction.

Ingemar Lanevi isvice president and general manager of global lease sourcingsolutions at LeaseAccelerator. He has more than 25 years ofexperience leading finance, treasury, leasing, and strategyfunctions. He also has extensive experience in structuring complexfinancial transactions, financial and fiscal planning, capitalmarket fundraising, budgeting and forecasting, strategic businessdevelopment, IT system implementations, and merger and acquisition(M&A) funding.