When operating a successful business, it is important to consider operating costs and expenses related to producing or being able to provide a certain good or service. In some cases, it is more beneficial for a business to lease equipment needed for production or manufacturing and in other instances it is financially favorable to purchase equipment. This paper will compare the factors involved in deciding whether to purchase or lease equipment.
Types of Leases
The term “lease” is essentially the same as the term “rent”, as both have identical meanings. There are two different types of leases, an operating lease and a financial lease. Both types provide the use of an asset, but with some very different rules. An operating lease is typically used for equipment or vehicles and can be cancelled by the lessee with proper notice. The timeframe of the lease is usually less than the expected life of the item, and will sometimes include a maintenance contract built in. The lessor hopes to either sell the asset or release it at the end of the initial lease. A financial lease, aka a capital lease, cannot be terminated early. Financial leases also do not include maintenance contracts, and are usually set for the life expectancy of the item. The purpose for the lessor is to gain their initial investment plus a return on the asset, and is thus like debt financing.
Lease vs. Purchase
If a company wants to obtain the usage of an asset such as cash, plant or equipment, without the obligation of purchasing the item, then a lease is the best option. Leases can be classified as short term or long-term debt just depending on the amount of time contracted. The key considerations a company must consider when trying to decided whether to purchase or lease an asset is the net present value of purchasing versus leasing. The factors that affect the value are depreciation, taxes, length of lease payments, life span of asset, and any residual or salvage value of the asset. Leases are accounted for on a company’s balance sheet as long as one of the following occurs; the lease transfers ownership at the expiration, the lessee may buy the asset below its value at the expiration, length of lease is more then 75 percent of the expected life span, or the present lease payments exceeds 90 percent of the fair market value of the property (Mayo, 2012).
Financial leases though, must be capitalized where as operating leases may not have to be placed on the balance sheet, but should be noted in the footnotes. Even though financial leasing may sound similar to debt financing of an asset, keep in mind that the lessor will obtain any residual value of the asset, whereas if purchased, the salvage value would remain with the purchaser. Leasing offers higher tax deductions, but potentially understates a companies assets. Purchasing usually requires a higher initial cash outlay (Newman, 2006), but may offer higher assets and better return on investment in the long run. Determining which option of leasing or buying is better will ultimately depend on the time value of money (Mayo, 2012). Application of Time Value/Money Concepts in Evaluating Lease vs. Purchase Decisions When deciding on whether on whether to lease or purchase assets for your company, there are a few different factors to consider.
One of those important factors is the time value of money. According to “Financial Dictionary” the time value of money can be defined as “the idea that a dollar today is worth more than a dollar in the future, because the dollar received today can earn interest up until the time the future dollar is received” (2015). To determine which option, leasing or purchasing, would be financially beneficial for the business, the present value of each should be calculated. The present value formula will give you the cash flows associated with leasing or purchasing the asset (Mayo, 2012). To calculate the present value of a single sum of money one would divide the Future Value (FV) by (1 + i)n where i is the interest rate per compounding period and n are the number of compounding periods (“Present Value Of A Single Sum Of Money”, 2013).
There are many factors and applications to consider when making the decision between leasing and purchasing. Factors such as the assets life expectancy, company’s tax bracket, and payment schedule are just a few to be considered when determining which option is best for a company. Understanding the time value of money, is just one of the few considerations a company must review so that its financial officers can make educated business decisions.
Financial Dictionary. (2015). Retrieved from http://financial-dictionary.thefreedictionary.com Mayo, H. B. (2012). Basic finance: An introduction to financial institutions, investments, and management (10th ed.). Mason, OH: South-Western. Newman, P. (2006). Leasing vs Buying: Which is Best for You?. Retrieved from http://www.entrepreneur.com/article/169332 Present Value of a Single Sum of Money. (2013). Retrieved from http://accountingexplained.com/misc/tvm/pv-single-sum