Copyright © 2008, The McGraw-Hill Companies, Inc.
Before moving on, we should note that the method for calculating lease payments that
we are using here is a theoretical one. Just as with the rent on an apartment or anything else
for that matter, the amount of a lease payment will be largely influenced by what the market
will bear. In an earlier example, we calculated Jessie’s lease payment to be $362.68. While
this is a theoretically correct lease payment based on the prices and interest rates used, the
rates a leasing company will actually charge will be strongly affected by rates accepted in
the market. If the market would bear lease payments of $375, the leasing company will
most likely move the rate up. On the other hand, if this rate is too high relative to what
people are willing to pay, the rate may require a downward adjustment, say to $350.00. It
should be clearly understood that lease payments as calculated in this section provide a
guideline, but they are not written in stone.Mileage Limits
In order for leasing to work out well financially for the leasing company, the residual value
used in determining the payment is critical. The lease payments need to cover the interest
on both the residual and the loss in value, so where the line is drawn between these two
is not all that important for the portion of the payments that go to interest. However, the
payments also must cover the loss in value itself. If the residual value is overestimated, the
loss in value will be underestimated, and so the lease payments will not fully cover the loss
in value.
There are several reasons why the residual value might be overestimated. If the leasing
company misjudged the used car market and wrongly expected the car’s value to be more
than it really turns out to be, that is unfortunate for the leasing company, but not a problem
for the lessee. The lease terms were set in advance, and it is not the lessee’s responsibility to
make sure that the leasing company is not being overly optimistic about the residual value.
If the residual value is lower than it should be at the end of the lease because things the
lessee did with the car, though, that is another story. If the car is returned with serious paint
scratches, upholstery stains, damage due to negligent maintenance, or other problems with
the vehicle that go beyond what would be expected from normal wear and tear, the lessee
is responsible for paying for those damages. The leasing contract will usually spell out the
details of this responsibility.
Without doing any explicit damage, though, the lessee can also reduce the value of the
car by putting too many miles on it. A 3-year-old car with 80,000 miles is naturally worth
much less than one with 30,000 miles, even if both cars have been properly maintained. For
this reason, leasing contracts almost always specify some limits on the number of miles the
car can be driven. If the car is returned with mileage that exceeds this limit, the lessee must
compensate the leasing company for this. This is usually based on a predetermined penalty
per mile over the limit. The following example will illustrate how this works.Example 10.4.4 The terms of Ajay’s 2-year lease allow for 12,500 miles per year,
with a 32 cents per mile charge for any overages. How much will Ajay have to pay as a
penalty if at the end of the lease his mileage is (a) 16,500 miles, (b) 28,743 miles, or
(c) 72,400 miles?The total miles allowed over the course of the lease is (2 years)(12,500 miles per year)
25,000 miles.(a) Since 16,500 is less than the allowed 25,000, Ajay does not owe any penalty. (Sorry,
Ajay, there is no rebate for being below the limit.)(b) 28,743 25,000 3,743 miles over. (3,743 miles)($0.32 per mile) $1,197.76.(c) 72,400 25,000 47,400 miles over. (47,400 miles)($0.32 per mile) $15,168.The fee in (c) above may seem outrageous, but on the other hand Ajay has dramatically
reduced the car’s resale value by putting such enormous mileage on it. Even if he agrees the
fee is fair, though, it certainly poses a problem for him. Most leases contain a provision that
allows the lessee to buy the car at the end of the lease for the assumed residual value. If you10.4 Leasing 461