Often in business, you need one piece of equipment or another. Perhaps it’s as small as a computer or as hugh as a multi-million dollar production line. Whatever item you need, you are often faced with a decision: to buy or lease the asset. This can be one of the more important decisions you make since it will directly affect the cash flow of your business and, as discussed in the past, cash is king.
So how do you decide what route to take? Let’s look at a few quantitative and qualitative factors to take into account.
The Theory of Relativity
Don’t worry; we’re not getting into a physics discussion. Rather, when we speak of relativity, we speak of what effect a purchase will have on your present cash flow. It’s a lot easier to simply purchase a $10,000 copy machine if you generally have $1 million in cash at any given time than if your bank account runs more often in the double digits at times. Your first and most important consideration, then, should be what your bank account will look like after you negotiate a deal rather than immediately before you cut a big check.
Planned Obsolescence/The Pack Rat Syndrome
Years ago, the rule of thumb was that you should expect to replace your computers once every three years. Then, the time frame shrunk to 18 months as the rate of technological innovation increased. This presented a real challenge to corporate buyers. If a firm was committed to replacing it’s equipment on a three-year basis, did it make sense to sink a ton of money into equipment that would be obsolete in a year or two or would the best bang for the buck come from leasing the equipment and trading up every few years to get the latest and greatest hardware?
On the other side of the spectrum are those buyers/companies that tend to draw every drop of usefulness out of a piece of equipment before relegating it to the junk heap. Again, using the computer as an example, there are instances where the latest and greatest would be nice to own, but if all you are doing is typing letters on your desktop, do you really need the latest graphics and speed enhancements? Assuming you plan on keeping your equipment for an extended period of time, buying could really make a lot of sense.
The Numbers - What to Consider
In making an informed decision about the financial aspect of the lease or buy question, you will need some information. Here is what you will generally need to know for your comparison:
- Monthly lease payment
- Any required deposits - do you pay the last month’s rent at the beginning of the lease?
- Lease term or, if buying and financing, term of note.
- Sales tax rate on lease payments - in many places, not only do you make a monthly lease payment, but you also pay sales tax on it.
- The guaranteed residual value of the equipment at the end of the lease.
- Cost of equipment, if you buy - when calculating this cost, be sure to include any taxes that might be due.
- Allowable depreciation if you buy the asset.
- Borrowing costs (i.e. fees and interest rates).
- Down payment if purchasing the asset.
- Your average, or perhaps assumed average, investment return on idle funds.
- The estimated salvage value of the equipment at the end of the lease term.
- Your tax rate.
Once you have this information, it’s time to crunch the numbers. In general, here’s what you are looking at. You will make two calculations that give you the net cash out over the time you own or lease the equipment. While this may seem fairly simple to do, to get a true picture of what the options will cost, you have to take into account what you will lose as well as what the actual cash cost. This is the reason you need to know the rate of return on your idle cash. Each alternative will give you a different amount of cash to invest at a point in time. Lost interest may be significant if you are talking about a significant investment.
Another big factor in calculating cash flow is the tax effect of your decision. If you buy a piece of equipment, the IRS will require you to deduct the cost of the equipment over time through an annual depreciation allowance. If you lease the asset, the rent payments are generally deductible as they are paid. Over time, the tax effects may equal out, but using the theory that a dollar today is worth more than a dollar tomorrow, tax deductibility is a significant consideration.
Does all of this sound a bit complicated? Don’t worry, there are numerous free calculators on the market to help you figure the cash flows. This web site has such a calculator, but it doesn’t take the tax effects into account. If you think the tax effects could be significant, a web search will yield a calculator that takes these into effect, or simply give us a call. We have the experience and tools to assist you in making your decision.
Happy 4th of July. Remember to celebrate safely.