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Strategic Financial Management · Leasing Decisions

Lease Evaluation from the Lessor's Perspective: NPV, IRR and Minimum Rental

Updated 11 October 2026 · Fact-checked

A lessor treats a lease as an investment. The outflow is the asset cost. The inflows are after-tax rentals, the depreciation tax shield and the residual value. Discount them at the lessor's required post-tax return. If NPV is positive, or IRR is above the required return, the lease is acceptable. The minimum rental is the one that makes NPV zero.

Understand Lease Evaluation from the Lessor's Perspective

A lessor buys an asset and lets someone else use it for rentals. So the lessor's question is simple: does the money I put in earn at least my required return? That makes lease evaluation a normal capital budgeting problem.

The outflow is the cost of the asset at time zero, plus any initial costs the question gives. The inflows are the lease rentals, the tax saved on depreciation, and the residual (salvage) value when the lease ends. Rentals are taxable income, so you use rental × (1 − tax rate). Depreciation is not a cash flow, but it reduces tax. So the cash gain is depreciation × tax rate. This is the depreciation tax shield.

Discount all inflows at the lessor's required rate of return. Use a post-tax rate, because the cash flows are post-tax. If the question gives only a pre-tax rate, convert it as pre-tax rate × (1 − t), unless the question says otherwise. NPV is the present value of inflows minus the asset cost. A positive NPV means the lessor earns more than required. The IRR is the discount rate at which NPV is zero. This is the lessor's yield on the lease.

The minimum (break-even) lease rental is the lowest rental at which the lessor just earns the required return, that is, NPV = 0. Any rental above it adds value for the lessor. The lessee compares the same rental with its own alternatives, so the lessor's minimum is the floor in negotiation.

The depreciation method and the residual value change the answer, so read them carefully. Depreciation follows the tax rule or method the question states. If the question does not say, state your assumption clearly before you start.

Key rules to remember

Net outflow at time zero
Outflow = Cost of asset + initial expenses (if given)
Treat it as a cash outflow at year 0. Ignore it if the question gives no initial expenses.
After-tax rental
After-tax rental = Rental × (1 − t)
t is the lessor's tax rate. Rentals are taxable income.
Depreciation tax shield
Tax shield = Depreciation × t
Use the depreciation method and rate stated in the question. It is a tax saving, not depreciation itself.
Lessor's NPV
NPV = Σ [Rental × (1 − t) + Depreciation × t] ÷ (1 + k)^n + PV of residual value − Cost of asset
k is the post-tax required return. Tax on residual value applies only if the question or tax rules give it. Add tax effects only where the problem supports them.
Lessor's IRR (yield)
IRR is the k at which NPV = 0
Find it by trial at two rates and interpolate: IRR ≈ L + NPV(L) ÷ [NPV(L) − NPV(H)] × (H − L).
Break-even (minimum) rental
After-tax rental = [Cost − PV of tax shield − PV of residual value] ÷ PV annuity factor; Pre-tax rental = After-tax rental ÷ (1 − t)
Valid when rentals are level. If rentals fall at the beginning of each year, use the matching factors.

How to solve Lease Evaluation from the Lessor's Perspective questions

Use this order for any lessor-side question. It works for NPV, IRR and minimum rental.

  1. 1Write the facts: asset cost, lease period, rental and its timing (start or end of year), tax rate, depreciation method, residual value and required rate of return.
  2. 2Fix the discount rate. Use the post-tax required return. If only a pre-tax rate is given, convert it as pre-tax × (1 − t), unless told otherwise.
  3. 3Prepare the depreciation schedule for each year of the lease. Then work out the tax shield as depreciation × t.
  4. 4Compute the annual after-tax rental as rental × (1 − t). Add the tax shield to get the net annual inflow.
  5. 5Add the residual value in the final year. Adjust for tax only if the question provides the facts.
  6. 6Discount all inflows with the right factors. Subtract the asset cost to get NPV. Accept the lease if NPV is positive.
  7. 7For IRR, compute NPV at two rates, one positive and one negative, and interpolate. For minimum rental, set NPV = 0 and solve for the rental.
  8. 8State the conclusion in one line: accept or reject, or the minimum rental to quote.

Quickest way: Solve for rental per ₹1 of lease first

When to use it: Use it when the question asks for minimum rental, or when you must test several rentals. It avoids repeating the whole table.

  1. Compute the PV of the depreciation tax shield and the PV of the residual value. These do not depend on the rental.
  2. Required PV of after-tax rentals = Cost − PV of tax shield − PV of residual value.
  3. Divide by the annuity factor to get the after-tax rental. Then divide by (1 − t) to get the pre-tax rental.
  4. To test any other rental, use NPV = NPV at a known rental + (new rental − old rental) × (1 − t) × annuity factor. This changes only the rental part.

Common mistakes in Lease Evaluation from the Lessor's Perspective

  • Discounting at a pre-tax rate while using after-tax cash flows.

    The question gives one rate and students use it without checking whether it is pre-tax or post-tax.

    Fix: Check the rate. Post-tax flows need a post-tax rate. Convert as pre-tax × (1 − t) if the question gives only a pre-tax rate.

  • Treating the full depreciation as a cash inflow.

    Depreciation appears in the schedule and looks like a flow.

    Fix: Only the tax saved is a cash inflow: depreciation × t. Depreciation itself is non-cash.

  • Taxing the rental twice or not at all.

    Students forget that rentals are taxable income for the lessor.

    Fix: Always convert rentals to rental × (1 − t) before discounting.

  • Ignoring the residual value or placing it in the wrong year.

    It appears as a single line in the problem and is easy to miss.

    Fix: List it in your fact table. Receive it at the end of the final year of the lease and discount with that year's factor.

  • Giving the post-tax rental as the minimum rental.

    Students stop after solving the equation for the after-tax rental.

    Fix: Divide the after-tax rental by (1 − t) to get the pre-tax rental the lessor must charge.

  • Using end-of-year factors when rentals are paid at the start of each year.

    The rental timing is mentioned in one phrase and is missed.

    Fix: Mark the timing in your fact table. For beginning-of-year rentals, discount the first rental at year 0 and shift each rental one period earlier.

Worked examples

Example 1

A lessor buys equipment for ₹10,00,000 and leases it for 4 years at an annual rental of ₹3,50,000, payable at the end of each year. Depreciation is ₹2,50,000 a year for 4 years (asset written down to nil). Tax rate is 30%. The equipment is expected to be sold for ₹1,00,000 at the end of year 4; treat this as received net of tax. The lessor's post-tax required return is 10%. (a) Compute NPV and advise. (b) Estimate the lessor's IRR. PV factors at 10%: 0.9091, 0.8264, 0.7513, 0.6830 (sum 3.1698).

Show the solution
  1. After-tax rental = 3,50,000 × (1 − 0.30) = ₹2,45,000.
  2. Depreciation tax shield = 2,50,000 × 0.30 = ₹75,000 a year.
  3. Net annual inflow = 2,45,000 + 75,000 = ₹3,20,000.
  4. PV of annual inflows at 10% = 3,20,000 × 3.1698 = ₹10,14,336.
  5. PV of residual value = 1,00,000 × 0.6830 = ₹68,300.
  6. Total PV of inflows = 10,14,336 + 68,300 = ₹10,82,636.
  7. NPV = 10,82,636 − 10,00,000 = ₹82,636. It is positive, so the lease is acceptable.
  8. For IRR, try 13%: factors 0.8850, 0.7831, 0.6931, 0.6133 (sum 2.9745). PV = 3,20,000 × 2.9745 = 9,51,840, plus 1,00,000 × 0.6133 = 61,330, total 10,13,170. NPV = +13,170.
  9. Try 14%: factors 0.8772, 0.7695, 0.6750, 0.5921 (sum 2.9137). PV = 3,20,000 × 2.9137 = 9,32,384, plus 59,210, total 9,91,594. NPV = −8,406.
  10. Interpolate: IRR = 13% + 13,170 ÷ (13,170 + 8,406) × 1% = 13% + 0.61% ≈ 13.6%.

Answer: NPV = ₹82,636 (positive), so accept the lease. The lessor's IRR is about 13.6%, which is above the required 10%.

Example 2

Using the same data as above (cost ₹10,00,000; 4 years; end-of-year rentals; depreciation ₹2,50,000 a year; tax 30%; residual value ₹1,00,000 net of tax at the end of year 4; required return 10%), find the minimum annual lease rental the lessor should charge.

Show the solution
  1. Depreciation tax shield = ₹75,000 a year. PV = 75,000 × 3.1698 = ₹2,37,735.
  2. PV of residual value = 1,00,000 × 0.6830 = ₹68,300.
  3. Required PV of after-tax rentals = 10,00,000 − 2,37,735 − 68,300 = ₹6,93,965.
  4. After-tax rental = 6,93,965 ÷ 3.1698 ≈ ₹2,18,930.
  5. Pre-tax rental = 2,18,930 ÷ (1 − 0.30) = 2,18,930 ÷ 0.70 ≈ ₹3,12,757.
  6. Check: at a rental of ₹3,50,000 the NPV was ₹82,636. Each extra ₹1 of rental adds 0.70 × 3.1698 = 2.21886 of PV. So the rental that gives NPV zero is 3,50,000 − 82,636 ÷ 2.21886 = 3,50,000 − 37,243 = ₹3,12,757. This matches.

Answer: The minimum annual lease rental is about ₹3,12,757. Any rental above this gives the lessor a positive NPV.

Exam tips

  • Write a short fact table first: cost, period, rental timing, tax rate, depreciation, residual value, discount rate. Most lost marks come from missing one item.
  • State your assumption when the question is silent, for example on depreciation or tax on residual value. State it in one line and use it consistently.
  • For minimum rental, show the PV of the tax shield and residual value separately. Then compute the after-tax rental and the pre-tax rental as separate lines.
  • Always end with a recommendation: accept or reject, or the rental to quote. In case-based questions this line carries marks.
  • In MCQs, check the discount rate and rental timing before calculating. Wrong options are often built from a common slip such as using the pre-tax rate or ignoring tax on rentals.

Practice questions from Leasing Decisions

Lease Evaluation from the Lessor's Perspective: frequently asked questions

How do you calculate the minimum lease rental for a lessor?

Set the lessor's NPV to zero. Subtract the PV of the depreciation tax shield and the PV of the residual value from the asset cost. Divide the balance by the annuity factor to get the after-tax rental. Then divide by (1 − tax rate) to get the pre-tax rental.

What is the lessor's yield on a lease?

It is the IRR of the lessor's cash flows. The outflow is the asset cost. The inflows are the after-tax rentals, the depreciation tax shield and the residual value. Compare this yield with the required return. If the yield is higher, the lease is acceptable.

Is depreciation a cash flow in lessor evaluation?

No. Depreciation is non-cash. Only the tax it saves, depreciation × tax rate, is a cash inflow for the lessor.

Which discount rate should the lessor use?

Use the lessor's required rate of return after tax, because the cash flows are post-tax. If the question gives only a pre-tax rate, convert it as pre-tax rate × (1 − tax rate) unless the question says otherwise.