There are many factors to consider when acquiring capital assets and one of the first considerations is whether to lease or purchase. There are advantages and disadvantages but ultimately the decision is based, in large part, on the particular business situation. In order to determine whether a lease or purchase offers the most value, companies should not only consider situational factors but also evaluate the costs. By taking the time to carefully review operational conditions and financial capacities, companies will be able to make a sound decision of whether to purchase or lease an asset or assets. Consideration Factors for Lease vs. Purchase
Some of the factors to consider when evaluating whether to purchase an asset consist of source of money and related costs of using the money, tax deductions, depreciation expenses, amortization expenses, useful life, residual value, and long-term savings. One of the advantages of purchasing an asset includes ownership that allows the asset to be easily replaced if needed. It also allows owners use the asset as collateral against other loans. There is also an advantage of increased asset value on the balance sheet. However the disadvantages include a higher initial cost, depreciation, and the risk of obsolete assets due to rapid technological changes (“Business Equipment: Buying Vs. Leasing”, n.d.).
Some of the factors to consider when evaluating whether to lease an asset consist of current cash flow conditions, owner’s credit rating, how long the asset will be used, purchase options, whether maintenance is the responsibility of the lessor or the lessee, and tax deductions. The advantages of leasing include lower initial costs, lower payments, less liability on the balance sheet, access to and use of latest technology, and lease payments which are considered expenses for tax purposes. However, the disadvantages are higher overall costs, lack of ownership or control, and the obligation to pay over the full term which results in inflexibility (“Factors To Consider: Lease Or Purchase Of A Facility”, n.d.).
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Evaluation of Costs for Lease vs. Purchase
Identifying the lease and purchase factors alone will not provide a clear picture on whether one option is more beneficial over the other. The data gathered through the consideration of purchase and lease factors can be used to calculate financial advantages or disadvantage of an investment project. Analysis of the costs of a lease versus a purchase can be accomplished through discounted cash flow analysis. Discounted cash flow analysis uses future free cash flow projections and reduces, or discounts, them to identify their present value (PV).
The weighted average cost of capital is the most commonly used formula for determining the amount of discount.
If the result of the discounted flow analysis is higher than the current cost of the investment, the opportunity may be a good one (“Business Equipment: Buying Vs. Leasing”, n.d.).
However, a second calculation involving time value of money will result in added value to the decision. The internal rate of return (IRR) can be used in combination with PV determination to provide the optimum level of assurance regarding a purchase or lease option. The IRR is the discount rate at which the PV of anticipated cash inflows is equal to the PV of anticipated total cash outflows. An IRR that is higher than the minimum acceptable rate of return would indicate that the investment project is considered desirable (“What Is Discounted Cash-Flow”, n.d.).
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Conclusion
The decision between leasing versus purchase or loan of an asset is worth taking some time to consider. Using cost analysis tools involving the time value of money can assist in the decision making process however, a decision cannot be made solely on cost analysis. There may be other factors that outweigh the differences in cost, especially if costs are reasonably close, and each will be unique to each business situation.
References
Business equipment: buying vs. leasing. (n.d.).
Retrieved from http://www.nolo.com/legal-encyclopedia/business-equipment-buying-vs-leasing-29714.html What is discounted cash-flow. (n.d.).
Retrieved from http://www.businessdictionary.com/definition/discounted-cash-flow-DCF.html
