Comparing the advantages and disadvantages of leasing or purchasing shop equipment. February 6, 2010
Question I just finished a three week summer class here at Boise State University. I now have completed all requirements for a minor in Business. By the May of 2010 I will graduate from the Construction management Program. I am still interested in the fields of the Architectural Mill Works Industry.
Something I have read here at the Business Forum is people asking about leasing or buying different equipment for their shop. In all the posting there has not been one person pointing out that says you need to evaluate the Internal Rate of Return (IRR) versus the cost of raising the capital for that piece of equipment.
Most people say just buy all you can afford. Which there is truth in that, but as a business form we need to look at other factors, such as the Net Present Value (NPV) or the IRR of the equipment. There are many online financial calculators that will help in finding both the IRR and NPV. All you need is to know the cash flow for that piece of equipment. If the IRR percentage is greater than the percentage it would cost to raise the capital then you should buy it.
Forum Responses (Business and Management Forum)
From contributor G: The only issue I have with leasing equipment is at the end of the lease you have paid all that money and you have nothing. Like my dad use to tell me, don't buy ice. It just melts and you have nothing. You lease when you cannot afford the machine you want, which falls into the typical American thought process of instant gratification. Live within your means goes a long way. Don't buy something you cannot afford. I guess you can see my view on leasing equipment.
From contributor U: This is an interesting thread in light of the current economic climate. How would you have determined IRR 12 months ago vs. now on a new machine, or a plant full of machinery? Even an ongoing contract isn't worth anything if the buyer goes bankrupt. Judging by the current glut of repossessed equipment on the market, there were a lot of rosy forecasts and optimistic business plans. Investing your own money into equipment that increases your income may be a very conservative position, but it does make you think long and hard about making a wise decision.
From contributor Z:
You can put all the fancy nomenclature NVP, IRR etc. It all looks good or bad on paper but what’s on paper does not pay the bills. Leasing equipment is a crap shoot in my opinion. When times are good it works. When times are bad it’s a noose around your neck that will slowly kill you. On the other hand if you buy it when times are good you can pay for it. Then when times get bad it costs little or nothing to sit idle. Leasing is good for the lessor always. Good for the leasee sometimes.
From contributor P: If you do a lease to buy (the only way to do a lease), then the expense you have for the lease does not take from the capital you can borrow. Your ability to borrow is not decreased by the lease amount. The lease is also an asset - but is also taxed in most areas/leases. A loan is looked at differently by a lender, and will figure into the formula for computing your ability to borrow.
This you would typically do only in a growth situation where you need a capital loan to expand, buy equipment, etc. A lease is just another tool to get what you need. Growth and borrowing is not for everyone - many will advise against borrowing, etc for your business.
There are also online calculators to discover if you are better off leasing vs. borrowing. If you going into business find a competent accountant you can talk to, and develop a relationship with him/her. This will be your best chance ongoing to have access to reasonable advice with someone that knows your business. Do not ever lease without buying - otherwise you are just renting and not increasing capital. Increasing capital is the goal of your business.
From contributor R: I'm assuming when you people say "buying" you mean buying without borrowing money. I may not be a good businessman, and I maybe could make more money somehow, but I've leaned heavily to the buy with cash philosophy; and I'm sure glad at this point. We have moderate amount of work, and I'm not laying awake at night worrying about excess debt load.
From the original questioner: I think it is good advice to talk to an accountant is a good idea after the finals numbers are on paper. Leasing to own is a great way to go if you can do it. The lease would be a tax deduction for the business. These formulas are used to help you not to have the accountant as the educated one.
The NPV or the IRR are Financial terms that are used to help evaluate the feasibility from that piece of equipment. You talk about what would be the NPV 12 month ago versus today’s market. The Net Present Value is a method of ranking investments which equals future cash flows discounted to the present value. By having the future cash flows discounted to the present value will help you evaluate if the investment is worth taking.
From contributor O: IRR has some assumptions built in, a form of leverage if you will against future expectations. (My rate of return will increase because I can make more widgets.) In a period of recession you need to be more than normally careful about those underlying assumptions. Survival mode requires minimalization of overhead. Unless you are very sure that new machinery will allow growth that is reasonably certain, or will allow cuts in labor costs, then this is a poor time to take on extra overhead. (The expected IRR is low).
From contributor Z: I am aware of what they stand for and what they are. I still say leasing is a crap shoot, especially now. You are making educated guesses on future cash flow on orders you may not ever get, using the hopes of projected income to justify the lease payment in the future. It is obvious in many segments of our present economy, including this one that past models don't work very well anymore. There are loads of repo'd equipment out there that looked good on paper at the time to all concerned. Leasing equals extra payment for more capacity but that capacity has to be use to its max for the through put of product to return not only the lease payment but more money for you. If the leased equipment just pays for itself then it is of no real value.
From contributor R: I don't know much. I might as well say it up front as you'll find out soon enough. But for argument's (scholarly) sake, let's assume the machine costs $5000. Whether I plunk down cold hard cash, borrow from the bank or borrow as a lease, I still need a return on my investment. I could have that money sitting in the bank making a couple of percent or whatever it is now, so I need to at least have a rate of return from buying that piece to match that. Of course we all know for risk, etc, the rate of return should be higher. So, how it's financed shouldn't make a difference as far as getting a return on the investment. Now, what is being factored in as a rate of return and how optimistic one is on future business, you'll have no argument from me there. I'm like you, I'd rather miss out on some possible returns by not borrowing or leasing and paying cash than having debt over my head and lose something.
From contributor S: Forget all the fancy terms. Leasing is a credit card for the firm that has no capital to invest. A lease usually requires less down payment than a purchase. It is a loan, it will count as a monthly obligation of the company in any future evaluation for credit. If you don't lease to own, it's just like a auto lease. You pay monthly, you pay the upkeep and repair, and at the end of the lease you give it back and own nothing; you just rented.
Even if you "lease to buy", you will be paying the property tax on the equipment, but you won't own a thing (balance sheet) till the final payment, yet you will have a contractual liability - monthly payment. Leasing does allow you to recapture costs by writing off the entire payment on your income tax annually, while a purchase has a slower write off. That is the only advantage I have ever seen to a lease. Example: The IRS only allows a $3000 per year depreciation on a vehicle. A $60 K car would take 20 years to write off. By leasing, you can write off the entire $10000 a year lease cost as expense. You get the same write off, just faster. The question is how much more do you want to pay for the tax deduction. Never buy or lease anything you don't already have the work to keep busy. Adding capacity doesn't equal additional sales.
Personally I have not bought other than for cold hard cash in the last 25 years. Most of us here seem to own small businesses. We all work with dangerous equipment where an accident could maim for life, and or prevent us forever working again. The past year had shown us what the bad times look like. If you paid for that shiny new hammer with cash, you can feed your family in the lean times and not have a payment, lease or buy, to worry about. No one ever knows what tomorrow may bring. Some figures look better on paper than they do in real life.
From contributor T: The first, most important thing a piece of equipment needs to do for me is reduce labor costs. If it can do that, then the next issue is to how best to pay for it. I'll pay cash if I can but lease if I must. One thing is for sure - by law, payroll happens on a regular basis. I'd rather peel off some of that payroll disbursement and pay on a machine.
What would a machine be worth to you if it could reduce your workforce by one man? Do you know your costs well enough to determine the true cost of one employee? Do you know the true cost of "overtime" hours worked? (I my case I always found, for example, four men working 50 hours per week cost a lot less than five men working 40 hours per week).
From contributor F: When we have used leasing we have always used leases with $1 buy outs and capitalized them just like a loan, the only real difference is how you structure the lease, our bank used to do zero down on equipment loans (in the mid 90's) so it was always about the rate and total cost of the acquisition. We are at the beginning of major manufacturer's starting to expand for the recovery, although we all need to be cautious it is time to look forward and plan.
