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Tutorial:
LEASE OR BUY
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Companies have usually several options when acquiring capital equipment. There are at least three possibilities:
- lease
- buy and finance through a loan
- buy with cash on hand
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Each of these options leads to different costs at the time of equipment acquisition, during its use, and at the end of its use. Although it's easy to focus
on month-to-month payments, companies should take the total costs into account and consider the different cash flow impact from these three options.
Cash flows of these three options are driven by several components including interest and discount rates, effective tax rate, number of depreciable years
for tax purposes, how long the equipment will be used, and the salvage value at the end of its use.
FinanceIsland's lease-or-buy calculator
takes into account all these relevant cash flow drivers and also displays the cash flows visually (see chart example on the right). The tool even allows
for a quick sensitivity analysis of some of these cash flow components.
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Net present value
Simply comparing different cash flows in different time periods may not be practical in order to arrive at a capital investment decision. Hence there is a
need for a metric that can accurately summarize these cash flows for each investment option.
Net present value (NPV) is such a metric. NPV is calculated as the sum of present values of current and future cash flows. The focus on NPV forces companies
to identify all cash flows from these three lease-or-buy options, which ensures that not only the month-to-month payments are considered.
FinanceIsland's lease-or-buy calculator treats cash outflows as positive and cash inflows as negative. Hence, from a purely financial point of view,
companies should acquire capital equipment based on the option with the lowest NPV.
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Options
Which option has the lowest NPV, i.e., the lowest total cost, depends on many factors. Leasing for example makes financial sense most of
the time if the company always needs up-to-date equipment and replaces it very often. The chart below shows an example where leasing has the lowest NPV,
i.e., is the least expensive option, for usage durations under four years.
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By leasing, the company can use its cash for investments in its core business rather than in the infrastructure required to run it. Equipment that is
often leased includes computers and peripherals, office furniture, manufacturing and construction equipment, and commercial vehicles. A lease can even
include installation, freight, and training expenses.
Between leasing and financing, leasing usually offers the lowest month-to-month payments. But there are also other costs associated with a lease,
especially the residual value of the equipment and the buyout price agreed with the leasing company upfront.
Some lessees make the mistake of focusing on the low monthly payments and don't consider also the choices that they will need to make at the end of
the lease.
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Lessees should keep in mind, for example, that they may need to continue using the equipment, which may require extending the lease or
buying out the equipment. Both choices may generate additional costs.
Financing the purchase through a loan may make more sense if the company needs to use the equipment longer than just few years.
In the example above, financed purchase becomes the preferred choice if the equipment will be used more than four years. In this example, leasing would
still provide the lowest monthly payments even for usage durations above four years. However, other factors such as tax deduction on equipment
depreciation or sale of the equipment at the end of its use make financed purchase the least expensive option for longer use.
Cash purchase could be the preferred option, on the other hand, if the equipment is needed for longer period of time and the interest
rate of the lease or loan significantly exceeds company's cost of capital. In the example above, cash purchase never becomes the preferred choice since
the cost of capital is not significantly lower than the interest rate of the lease or loan. In other words, the company can use its cash to get better
returns from other investments and should either lease the equipment or finance the equipment purchase.
On the other hand, if the company had plenty of cash on hand, which were held in low-return accounts, buying the equipment with the available cash could
be the least expensive alternative. Keeping low debt and avoiding taking on additional loans is another situation where cash purchase could be the preferred
option.
There are many scenarios to consider before choosing the method to acquire capital equipment. But as long as all cash flow drivers are taken into account,
you should feel comfortable making these decisions.
FinanceIsland's lease-or-buy calculator
takes into account all relevant cash flow drivers and helps you to model some of these scenarios to arrive at the best lease-or-buy decision.
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