The choice to lease versus purchase is a crucial financial consideration for businesses of all sizes. When comparing the factors involved in deciding whether to purchase or lease equipment for a firm, one must first have a clear understanding of the value in making a purchase verses a lease. In order to make the ideal decision, it is imperative for the firm to analyze the tax savings and the time value of money (TVM) principle on future cash flows. This decision is made by evaluating the time value of money for said equipment for the allotted period of time. With this information a firm can make the best choice when deciding to borrow and purchase or lease. Factors Involved
Most companies starting out probably do not have as much capital as a well-established company. A brand new company just starting up may be faced with the decision of purchasing or leasing property, equipment, or anything else needed. There are several calculations that can be used to assist a company on deciding which route is best for them. When assessing whether to buy or lease property, equipment, or anything else needed for your operations, you will want to understand the factors affecting the economics as well as compare the financial aspects of each option.
There are several different variables to consider when making a purchase on items. These include the firm’s tax bracket, the terms of the lease, the asset’s anticipated residual value, and the cost of obtaining funds to buy the asset (Mayo, 2012). Once all the variables are identified a company can determine if the investment in new equipment will be cost efficient and if the value is lower than leasing. Some advantages of buying equipment include: owned equipment may be easily replaced or sold at the owner’s discretion while replacing leased equipment may be more difficult; owned equipment has asset value and may be used as collateral against other loans; purchases do not require security deposits, although down payments to secure financing may be higher; purchased equipment has no use limitations while some leases specify the number of hours a machine may be used before a penalty is imposed; and increased asset value on the balance sheet.
In the case a company is on the fence of leasing, the company will need to identify some of the same variables to determine if leasing is on the table. Leasing seems to offer more benefits like maintenance cost, upgradeable equipment; you can choice who you want to lease from on new contracts, and the ability to make payments over time. Depreciation, taxation, the timing of lease payments, the timing of interest and principal repayments, and the residual or salvage value of the asset affect the present value of the cash outflows and thus affect the decision to lease or to borrow and purchase. (Mayo, 2012) Some advantages of leasing equipment include: lower up-front, down payment costs compared to purchasing; payments often are less than traditional loan payments; less liability on the balance sheet; equipment available for short-term needs; access to and use of latest technology; and lease payments are considered production expenses for tax purposes.
Time Value of Money Concepts
The Time Value of Money is the idea that money available now is worth more today than the same amount in the future. With that being said, when a firm calculates the present value of cash outflows/inflows from owning equipment as $101,281 and $90,892 from leasing equipment; the better choice in regards to cost after the allotted three years would be to lease. The depreciation of the equipment over time will cost the firm more when using the option to purchase over leasing because the value of the equipment will not be the same upon resale which will cause a loss to the firm.
Present value of the cost of leasing (using the 10 percent interest rate): $39,000(0.909) + 28,600(0.826) + 56,200(0.751) = $101,281
Knowing the Time Value of Money in regards to making a decision on leasing or purchasing equipment is very valuable if a firm wants to make the most of every dime invested in its success. Deciding whether to buy or lease equipment requires that you understand some base characteristics and how they affect cash flow and asset management. The value or depreciation of the equipment in the above scenario would make the firm take a loss when deciding to purchase over leasing.
Mayo, H. B. (2012). Basic Finance. An Introduction to Financial Institutions, Investments, and Management, Tenth Edition. Cengage Learning.