Taxation of leases that are not long funding leases: net present value and calculating rents: importance of 'net present value' in leasing
Guidance on the meaning of net present value is at BLM11210.
Assume market interest rates are 10% a year payable annually in arrear. This means a sumof £1000 today will be worth £1100 in a year’s time. So, ignoring questions of credit risk and profit margin etc, you should be able to sell your entitlement to a sum of £1100in a year’s time for £1000 today. Put another way, the ‘present value’ of that future entitlement to £1100 is £1000. Similarly, the present value of an entitlement to £1210in two years is also £1000 (because £1000 compounded at 10% is £1210).
The intervals at which compounding of interest occurs can have a significant effect. Interest at 10% calculated at monthly rests is worth more than interest at 10% 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 taxon their profit. The tax on later rentals receivable should be more than the tax saved upfront (because earnings exceed expenses overall). But the upfront tax saved 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.