Financial Aspects of the Analysis
Outright purchase implies a heavy initial financial burden. The cost of the equipment or asset must be paid in full at the very time of purchase. While it may not be a problem for most well established firms, entrepreneurial ventures usually find it difficult to amass bigger sums and invest them all on a single asset. Thus, if your business doesn’t have enough ready cash available to fund the purchase or if hoarding all your cash reserves for a single asset disrupts the normal cash flow of your business, a lease contract is the way to go. The initial security deposit for a lease is comparatively much lower and is not likely to strain your business finances too much.
Depreciation and Appreciation
The next important financial consideration is the depreciation on the asset. In the case of a lease contract the loss in value due to depreciation doesn’t go into your account, while in the case of purchase this loss will be all yours. While most equipment will depreciate in value, there are assets like property and real estate which usually appreciate in value. Accordingly, taking such assets on lease will deprive you of the value appreciation benefit.
Interest on Capital
Here the advantage again lies in procuring assets through lease. That’s because with a lease agreement you will be paying only monthly installments, and the balance money that you would have otherwise spent on purchasing an asset will keep on earning interest for you, as long as you hold it in your bank account.
How do you determine whether you should lease or buy a piece of equipment for your business? Let's assume you're faced with the following lease-or-buy decision:
You can purchase a $50,000 piece of equipment by putting 25 percent down and paying off the balance at 10 percent interest with four annual installments of $11,830. The equipment will be used in your business for eight years, after which it can be sold for scrap for $2,500.
The alternative is that you can lease the same equipment for eight years at an annual rent of $8,500, the first payment of which is due on delivery. You'll be responsible for the equipment's maintenance costs during the lease.
You expect that your combined federal and state income tax rate will be 40 percent for the entire period at issue. You further assume that your cost of capital is 6 percent (the 10 percent financing rate adjusted by your tax rate).
The following tables demonstrate how you can use a cash flow analysis to assist you with a lease-or-buy decision. In this case, if cost were the sole criterion for the decision, you would be inclined to purchase the asset because in current dollars, the cost of purchasing is $32,204, while the cost of leasing is $34,838. Even if cost isn't your sole criterion, a cash flow analysis is useful because it can show you how much you're paying for non-cost factors that may dictate your decision to lease.
Cash Flow Analysis of Purchase
This analysis assumes the financed purchase of a $50,000 piece of equipment for 25 percent down, interest at 10 percent, and four annual payments of $11,830 (all payments are made on the first day of the year).
Interest is deemed to accrue on the outstanding balance of the loan at the end of each year and is computed as follows (the last column shows the portion of each annual payment that goes to principal and that reduces the outstanding loan):
|Year End||Outstanding Loan||Interest||Principal|
Depreciation is computed on the basis of the 200 percent declining balance method.
|Year||Cash Payments||Prior Year's Interest||Prior Year's Depreciation||Tax Savings [40% x (C + D)]||Net Cash Flow [B - E]||Discount Factor (6% Cost of Cap.||Present Value|
[F x G]
|Net Cash Flow||32,204|
Cash Flow Analysis of Leasing
This analysis assumes that equipment costing $50,000 will be leased for eight years for an annual rent of $8,500, with the first payment being due on delivery and the following payments being due on the first day of each subsequent year. The business is assumed to have a combined federal and state income tax rate of 40 percent (tax benefits are computed as of the first day of year following the year for which the rental deduction was claimed) and a 6 percent cost of capital.
|Year||Lease Payment||Prior Year's Tax Savings [40% x B]||Net Cash Flow [B - C]||Discount Factor (6% Cost of Capital)||Present Value [D x E]|
|Net Cash Flow||34,838|
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