Lease versus Buy Essay
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When an individual is trying to decide whether or not to lease or buy, he or she needs to know the purchase cost, the lease cost, as well as the interest rate of a loan that will be used to purchase the item. The residual value of the item also must be known up front to help determine if leasing is the better option. When determining whether to lease or buy, the cash flow for both should be compared so the best decision can be made.
Below is a chart on lease vs buy. (www.smartcomputing.com; Retrieved November 6, 2006)
Cash Flow – Usually better from a short-term cash flow perspective. Frees up cash for other purposes while you generate income to pay the leases. You pay less overall but need to have available cash. Financing as an alternative costs more than a lease.
Tax Treatment – If properly structured, a lease may give your company a larger expense write-off than a purchase. Consult your tax advisor. Depreciation write-off is based on IRS rules for the type of equipment that you are buying. Consult your tax advisor.
Upgrades- Many lease companies let you upgrade to newer equipment during the term of the lease without renegotiating.
If you need newer equipment, you are on your own. However, simple upgrades (RAM, hard drive, etc.) cost you only whatever the upgrade is.
Equity- At the end of a lease, you don’t own the property, and you will need to replace it or buy it from the lease company.You own the equipment and can do with it whatever the needs of your business dictate.
Disposal – The lessor is responsible for whatever it costs to dispose of the equipment. You are on to your next set of computers. You can use the equipment for a different purpose within your company, sell it, or pay someone to recycle it for you, but disposal is up to the owner of the equipment.
The first scenario is an organization called Bonnesante Research based out of Irvine, California. Bonnesante is set up with Venture Capitalist (VC) Funding. Bonnesante major focus is asset acquisition, which is why the Chief Financial Officer has to weigh the pros and cons of leasing vs buying. Bonnesante’s is trying to determine if purchasing or leasing is the better option for a mainframe computer. I chose to lease the mainframe computer because the loan options have a higher outflow whereas the lease option of 18 months with no down payment has the lowest present value of cash outflows.
Because the Mainframe would not be used through its entire economic life, it was better for the organization to lease the mainframe. If a loan was acquired to purchase the mainframe, the organization would have to record the purchase on the balance sheet and the depreciation and the interest payments would be recorded as expenses. If the organization was taxed then purchasing the mainframe would be beneficial because the depreciation and the interest payment would lower the outflows.
In the second scenario Bonnesante Research is tasked with finding the best option to acquire a spectrometer. The options Bonnesante Research is faced with are:
– Operating Lease
– Capital Lease
After evaluating all the information, buying the spectrometer would be the best option for Bonnesante. Buying the spectrometer is beneficial because it is considered to be a long term asset with no threat of becoming obsolete. The spectrometer can be used for its entire economic life. An operating lease would not be beneficial because an operating lease is considered when equipment is to be acquired on a short term basis. The capital lease was another option but was not chosen because the 60 month capital lease would have cost more in present value terms than what the loan amount would have been to purchase the spectrometer. If the organization had cash flow issues, then the capital lease might have been a better option. Whether the company pursued a capital lease or received a loan to purchase the spectrometer, both options can be recorded on the balance sheet so the organization can reap the benefits of depreciation.
The final scenario is Bonnesante Research has been in operation for 6 years and wants to acquire a manufacturing facility. Bonnesante Research already has a facility in mind but that facility will require an upgrade. Bonnesante Research has the options of a capital lease or Bonnesante can purchase the facility by obtaining a loan. Also, Bonnesante Research has to keep in mind the organization is having a cash flow crisis that needs to be resolved. The challenge Bonnesante was faced with was to acquire the facility at the lowest cost possible and to resolve the cash flow shortage. Although the buy option was more expensive than the lease option, it gave Bonnesante more flexibility to upgrade the facility and to carry out a sale and leaseback transaction.
Due to the leaseback transaction, Bonnesante was able to resolve the cash flow crisis. The leaseback option was more beneficial to Bonnesante rather than the bridge loan. The bridge loan is a short-term loan with a higher interest rate compared to long term borrowing. A bridge loan would have been more costly to Bonnesante Research and the organization could not afford to go with this type of loan. A sale and leaseback is beneficial to any organization that has a cash flow shortage. Selling the asset can bring forth a large amount of cash and the organization can retain use of the asset by leasing it back hence the name sale and leaseback.
The risks involved with lease vs buying depends on an organizations financial status. Whether or not an organization decides to lease or buy is determined by what option is more beneficial to the organization. An organizations attitude toward acquiring assets and financial strength all affect the decision on leasing vs buying. Whether an organization leases or buys, the organization needs to make sure the asset that is being acquired will add value to the organizations capital budget.
“The advantage of computing present value considers all factors such as inflation and forgone interest on money. That is, account must be taken of the fact that utilizing capital in ‘investing’ in equipment could result in the loss of income that would have been earned if it were invested elsewhere. To properly evaluate the alternative cash flows, it is necessary to discount them and express them in terms of their present values, to determine their net present values. In summary the Net Present Value calculation determines today’s value of future cash flows.” (www.pngbd.com Retrieved November 6, 2006).
When determining when to lease vs buy, an organization should take into account the financial and non-financial issues. When considering the financial aspect, it should include the cost to acquire an asset; if there will be a tax advantage, cash flow, and the benefits to the organizations balance sheet. The non-financial issues that should be considered are asset-management and the cost to dispose of obsolete equipment.
In conclusion, under certain circumstance leasing is the better way to go rather than purchasing a capital item outright and vice versa. By leasing, it gives an organization a way to acquire up-to-date equipment while maintaining cash flow. By maintaining cash flow through leasing, an organization can use the cash flow for more pertinent renovations such as office expansion or research and development. Leasing has less of an impact on an organizations budget whereas purchasing an item outright has more of an impact on an organizations budget. Overall, leasing is a way for an organization to recognize operational savings and production improvements in a timely manner.
Smart Computing; Lease vs Buy; Executive Decisions; March 2004, Vol. 8 Issue 2 Page(s) 55-57. (www.smartcomputing.com)
Papua New Guinea Business & Tourism; Making Capital Expenditure Decisions-Leasing vs Buying vs Borrowing; (www.pngbd.com Retrieved November 6, 2006).