Lease vs. Purchase Considerations

To lease or to purchase—that is the question. And it is a question that business owners and managers ask themselves each day.

Before you make a decision regarding the acquisition of capital equipment, you may want to perform some calculations.

You can analyze the costs of a lease versus a purchase through discounted cash flow analysis. This analysis compares the cost of each alternative by considering the timing of the payments, the tax benefits, the interest rate on a loan, the lease rate and other financial arrangements.
To make the analysis, you must first make certain assumptions about the economic life of the equipment, salvage value and depreciation.

To evaluate a lease, you must first find the net cash outlay in each year of the lease term. You find these amounts by subtracting the tax savings from the lease payment. This calculation gives you the net cash outlay for each year of the lease.

Each year's net cash outlay must next be discounted to take into account the time value of money. This discounting gives you the present value of each of the amounts.

Fortunately, there are tables, which provide the discount factors for present value calculations. There are also relatively inexpensive special purpose pocket calculators programmed to make these calculations. And better yet, most spreadsheets such as Excel, Lotus123 or QuattroPro have present value calculations built in and even have templates to use in making such a comparison.

Why bother with making these present value calculations? You've got to make them to compare the actual cash flows over the time periods. You can't realistically compare methods of financing without taking into account the time value of money.

The sum of the discounted cash flows is called the net present value of the cost of leasing. It is this figure that will be compared with the final sum of the discounted cash flows for the loan and purchase alternative.

Evaluation of the lease versus purchase option is a little more complicated because of the tax benefits that go with ownership through the investment tax credit, loan interest deductions and depreciation. The interest portion of each loan payment is found by multiplying the loan interest rate by the outstanding loan balance for the preceding period.

As noted earlier, the salvage value is one of the advantages of ownership. It must be considered in making the comparison; however, it is discounted at a higher rate. This rate is used because the salvage value is not known with any certainty.

The major difference in cost, of course, comes from the salvage value. If you ignore that value, these two alternatives may be very close in their net present value of costs. Naturally, it's possible that salvage costs for each asset could be very high or be next to nothing. Salvage value assumptions need to be made carefully.

While this sort of analysis is useful, you can't make a lease versus purchase decision solely on cost analysis figures. There may be other factors that will outweigh the differences in cost, especially if costs are reasonably close. Other factors to consider include the availability of capital. One may have operating funds but no capital funds for the purchase of new equipment.

Another important factor to consider is the useful life of the equipment. One way this can be determined is by looking at the application life. How long will the equipment be used? If the period of use will be relatively short, leasing may be preferred over purchase. One should also consider the technological life. When will the equipment become obsolete? Leasing may be advisable when equipment becomes obsolete quickly. Also, consider the physical life of the equipment. When will the equipment be worn out? You may be better off to lease if the total cost of the lease for the application life or the technological life is less than the purchase price.

Once you have made these calculations and taken the other factors into consideration, you will be better able to make a sound decision about which method to use when adding new equipment.

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Authored by: Rick Sparks, Business and Industry Specialist, University of Missouri Extension
Source: Creating Quality Newsletter, Volume 12, Number 2, February 2003

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