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Leasing versus buying
For many small businesses, leasing is a viable financing alternative to buying with a loan. Leasing may allow your young enterprise to conserve cash. It may also allow you to avoid buying equipment you may not want for long.
Companies routinely use leasing for some of their financing. Airlines lease their airplanes. Car-rental companies lease their fleets of rental vehicles. Most companies lease some or all of their office, warehousing, and retailing space.
A lease is a contract that obligates your business (the lessee) to make periodic payments to the lessor over the span of a lease term.
In the start-up or growth stage of your business, you may need to keep your cash expenditures as low as possible. You may also wish to avoid owning equipment in the early stages of your enterprise. Leasing helps your business to accomplish these goals.
Leasing services for businesses falls into two major categories:
- Equipment leasing. Equipment leasing finances everything from the manufacturing equipment to the personal computers, desks, and chairs used by you and your employees.
- Real estate leasing. Real estate leasing finances everything from office and retail space to warehouses and parking lots. Real estate leasing also includes sale-and-leasebacks. A sale-and-leaseback occurs when a company sells real estate and leases it back from the new owner.
The two major types of business leases are operating leases and capital leases:
- Operating leases. An operating lease is a lease that often allows the lessee to make smaller periodic payments than with a term loan. Smaller lease payments are the result of the lease not being fully amortized over the lease term. As a result, the leased equipment has a residual value at the end of the lease term.
An operating lease requires the lessor to service and maintain the equipment. Costs for these services are added to the lease payments. An operating lease also allows the lessee to cancel before the end of the lease term.
- Capital leases. A capital lease amortizes the lease over the span of the lease term. The lessee receives the tax benefits of a capital lease, such as the tax savings earned on the depreciation expense of the equipment. At the end of the lease term, the lessee owns the equipment or faces a much smaller residual value. Since capital leases are considered equivalent to loans, you are required to show any capital leases on your balance sheet.
Lease payments on a capital lease are larger than payments on an operating lease. In fact, capital-lease payments are comparable to loan payments. As a result, a lease-versus-buy analysis is more appropriate when evaluating operating leases.
While equipment leasing and real estate leasing have their respective unique terms (triple net in real estate leasing, for instance), operating leases have similar features, including:
- Lower payments. Since operating leases only partially amortize a lease, monthly payments are generally lower than payments on a term loan, which fully amortizes the loan.
- Residual value. At the end of a lease or loan term, the asset is likely to have some resale value. This value is called the residual, or salvage, value. If the lessee renews the lease, the residual value will be the amount that is renewed.
- Purchase option. Instead of renewing a lease or walking away, a lessee may decide to exercise the option to purchase the equipment at the residual value. A purchase option is a standard feature of an operating lease.
Leasing offers certain advantages over buying. There are certain trade-offs with either decision. With leasing, we discussed the benefit of smaller payments and flexibility that comes with not owning the equipment for any longer than you wish. However, buying (using a loan to supplement any cash down payment) has advantages that come with ownership.
As a result, the lease-versus-buy decision can be a complex one. At a minimum, you should use a discounted cash flow (DCF) analysis to show expected
cash inflows and outflows of either financing decision.
The following example shows a lease-versus-buy analysis. The first table assumes you buy equipment for $700,000 using a loan, making a down payment of $200,000 today (period 0). You borrow $500,000 for four years at 10%, making yearly payments of $157,735. The example assumes an income tax rate of 40%, an inflation rate of 3%, and a five-year MACRS life for the property.
In addition to the operating expenses you pay, you also realize tax savings from the related depreciation and interest expense. These savings lower your net cash outflows each year. If you sell the equipment at the end of the loan term for $100,000, your net present value is a net cash outflow of $547,967 (Earnings that the equipment generates are ignored):
| Borrow: |
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| Year |
0 |
1 |
2 |
3 |
4 |
| Payment |
($200,000) |
($157,735) |
($157,735) |
($157,735) |
($157,735) |
| Operating expenses |
-- |
($50,000) |
($51,500) |
($53,045) |
($54,636) |
| Tax savings |
-- |
$96,000 |
$125,891 |
$85,928 |
$59,846 |
| Salvage value |
-- |
-- |
-- |
-- |
$100,000 |
| Net cash flow |
($200,000) |
($111,735) |
($83,345) |
($124,852) |
($52,525) |
| Discount factor |
1.000 |
1.030 |
1.061 |
1.093 |
1.126 |
| Present value |
($200,000) |
($108,481) |
($78,560) |
($114,257) |
($46,668) |
| NPV |
($547,967) |
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Next, compare your net cash flow to a decision to lease. With an upfront security deposit of $50,000, lease payments of $125,000 at the end of each year, and a purchase option on a residual value of $375,000, the net present value of leasing is $617,541 in net cash outflows. Inflation rate of 3% and income tax rate of 40% are assumed. (Earnings that the equipment generates are ignored):
| Lease: |
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| Year |
0 |
1 |
2 |
3 |
4 |
| Payment |
($50,000) |
($125,000) |
($125,000) |
($125,000) |
($75,000) |
| Tax savings |
$0 |
$50,000 |
$50,000 |
$50,000 |
$50,000 |
| Residual value |
-- |
-- |
-- |
-- |
($375,000) |
| Net cash flow |
($50,000) |
($75,000) |
($75,000) |
($75,000) |
($400,000) |
| Discount factor |
1.000 |
1.030 |
1.061 |
1.093 |
1.126 |
| Present value |
($50,000) |
($72,816) |
($70,695) |
($68,636) |
($355,395) |
| NPV |
($617,541) |
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Since net present value of the purchasing decision is smaller (both have net cash outflows), purchasing is the cheaper alternative. You may also have noticed that you can calculate a break-even point for the lease-versus-buy decision.
The example simplifies some assumptions, including a decision to exercise the purchase option, but it gives you an idea of the kind of analysis needed to compare trade-offs in leasing and buying.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.
Next Topic: Capital budgeting
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