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Financing – Debt finance

3.4 Allocating interest – actuarial method and sum of digits method

In the above example, to simplify the calculations, we were told
specifically that the full lease payment was to be treated as a tax
deductible expense. In reality, it will usually be just the interest element
of the lease payment which is tax deductible. In this case, the first step
is to calculate the interest element, using either the actuarial method, or
the sum of digits method.

Assume that KL Co has the option to buy an asset for USD100,000,
or to lease it under a finance lease by paying USD29,500 per year in
arrears for 4 years. Clearly, the interest element in the lease amounts
to (4 × USD29,500) – USD100,000 = USD18,000 in total.

Sum of digits method

This is the simpler way of allocating interest, based on the “sum of digits”
formula:

n(n+1)/2

In this example, the lease payments are to be made over 4 periods, so the “sum
of digits” is 10 (working: 4 × 5 /2 = 10)

Hence, the interest allocation is:

Year 1: 4/10 × 18,000 = USD7,200

Year 2: 3/10 × 18,000 = USD5,400

Year 3: 2/10 × 18,000 = USD3,600

Year 4: 1/10 × 18,000 = USD1,800

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