Comparison between leasing and purchasing

Comparison between leasing, Renting and purchasing

Advantages of Purchasing

1. Use and possession: The owner has absolute control of the use and disposition of the equipment.
2. Flexibility: The owner can sell the equipment, trade it, or use it until it is not economical to repair without having to respond to any creditor. Ownership gives the user complete flexibility regarding servicing, maintaining, and insuring the equipment.
3. Price: The buyer with cash is usually able to get better discounts due to a stronger financial position in the deal.
4. Tax benefits: The owner can take advantage of depreciation and interest tax benefits associated with equipment ownership.
5. Pride of ownership: Ownership can lead to better care and maintenance.

Disadvantages of Purchasing

The purchase option for equipment acquisition generally becomes more economically attractive if there is a high utilization rate throughout the useful life of the equipment. This point is extremely important, because the inability to use the machine enough to pay for its cost is the greatest risk and disadvantage of purchasing. Whether the equipment is working or not, the owner’s financial obligation to the lender continues. Borrowing large sums of money is sometimes necessary to purchase large heavy equipment tying up company capital and borrowing power. If the machine’s working capabilities are limited, the types of work activities that can be undertaken by the machine are limited. This is not necessarily a disadvantage, but a limitation. Many construction activities are redundant and similar each time therefore the same machine can be used. Other responsibilities (not necessarily disadvantages, unless mismanaged) of owning include licenses, proper registration, all associated paperwork, insurance, maintenance, transport, storage, and provision of a qualified operator. All of these requirements of equipment ownership have to be managed, tracked, and con-trolled. The administration of equipment management costs should be included in the charge for use of the equipment.

Advantages of Leasing

1. Lower rates and lessee cannot claim tax benefits. When the lessee cannot take advantage of tax benefits associated with equipment ownership, such as depreciation and interest, the leasing is more attractive. The lessor can purchase the equipment, claim the tax benefits, and lease the equipment to the lessee. The tax benefits are passed to the lessee in the form of lower lease rates.
2. Cash flow improvement. Compared with a loan, a lease typically gives the lessee a more favorable cash flow, especially during the first years of use.
3. Carry on off-balance sheet for financial accounting purposes. The lessor assumes title to the equipment with interest expense capitalized into the lease when the equipment is delivered and accepted by the lessee.
4. Impact on lessee’s income. During the early years of a properly structured lease usually there is less effect on income depreciation and interest payments related to the purchase of the equipment.
5. Fixed-rate lease payments. The lessee can know the exact amount of future payments and avoid the risks inherent in fluctuations in the cost of funds. By knowing this amount information, the lessee can predict future financing equipment costs and cash needs more accurately.
6. Faster amortization of the equipment. The lessee under an operating lease may be able to amortize the cost of the equipment faster through tax-deductible rentals than through depreciation and after tax cash flow.
7. Hedge against inflation. Future lease rentals are paid in inflated currency. The lessor (bank) can borrow long to minimize the effect of inflation and pass on this protection to the lessee in the form of long-term level lease payments.
8. Payments coordinated with lessee’s cash flow. Payment schedules can be coordinated with earnings generated from the use of the equipment by the lessee. This flexibility may not be available with other financing methods.
9. Long-term financial availability. Leases can be structured for most of the useful life of the equipment. The lease contract can exceed the period of time normally available on a term loan. Lessors can offer lease terms due to faster return of capital from cash flow generated by tax benefits.
10. Convenience. For leasing contracts below $5 million, documentation may be simpler and more flexible than other sources of financing.
11. Full financing. Leasing can provide the lessee 100% financing. The amount can include shipping and installation charges. A typical equipment loan may require an initial down payment.
12. Earnings from the retained capital. A lease allows retentions of lessee’s capital that can be used elsewhere in the lessee’s business.
13. Obsolescence. Leasing avoids equipment obsolescence for the lessee. If equipment becomes obsolete faster than its depreciation life, leasing may be more attractive.
14. Uncertain residual value. The more risk associated with the residual value of the equipment, the more attractive leasing becomes.

Disadvantages of Leasing

Leasing is ideal for acquisition of equipment for long-term use and ultimate purchase. Disadvantages are limited. The reputation and the reliability of the lessor and terms of the lease agreement should be verified prior to entering into a lease. There are many types of leases and conditions can vary based on the market or the lessor. In some instances the total sum of all leasing rates can reach a total amount greater than the cost of the new equipment.

Advantages of Renting

1. Minimum equipment for the job. Equipment ownership becomes particularly expensive when the equipment is idle and not utilized. When ownership of the basic equipment is combined with rental as needed, idle time is minimized.
2. Right equipment for the job. Ownership encourages inefficiency through use of wrong size or type of equipment for a given job. Renting can minimize this hidden cost.
3. Warehousing or storage. Warehousing facilities are seldom needed for rental equipment, thus reducing overhead.
4. Breakdowns. The rental service will typically replace equipment if there is a break-down, thus minimizing downtime due to repairs.
5. Maintenance. Full maintenance is covered on a day-to-day basis. The user needs no repair shop, no spare parts supply, no mechanics, and no maintenance records.
6. Equipment obsolescence. The rental service may provide the latest types and models of equipment that are faster and more productive than the older models.
7. Disposal cost. Selling used and obsolete equipment is not required.
8. Cost control. Cost is easier to monitor and control with rented equipment. The true cost of an owned equipment is often difficult to determine.
9. Inventory control. Contractors have less inventory loss when equipment is rented. The presence of continuous billing on any rented item tends to establish accountability for that item.
10. Taxes and licenses. Personal property taxes and license costs are eliminated on rented equipment. Leasing cost is 100% deductible.
11. Conservation of capital. The lessees’ capital is available for other uses or investment. Contractors should analyze cash requirements and consider renting equipment as a method of conserving working capital.
12. Increase in borrowing capacity. Rented equipment does not result in a liability on the balance sheet. Debt ratios will improve, making the lessee firm seem stronger financially.
13. Cost estimating and bid preparation. Renting can increase estimating accuracy because all repair and downtime costs become more predictable.
14. Short-term jobs. Renting is the most economical solution for short-term and specialty jobs.
15. Transportation costs. Renting is the best way to avoid transporting equipment from project to project, thus reducing transportation costs. This is especially beneficial when dealing with heavy equipment requiring special hauling equipment.
16. Equipment testing. Allows use of equipment in the field without purchase, leading to a better understanding of equipment capabilities and suitability for the work.

Disadvantages of Renting

The greatest disadvantage of renting is the resultant higher unit cost to perform the work. Typically the hourly rental rate is more than the lease or ownership rate. Higher unit cost will typically result in a less competitive estimate when bidding against someone who owns their equipment.

THE BUY, LEASE, OR RENT DECISION

Table shown below is adapted from Coombs and Palmer’s book, Construction Accounting and Financial Management. The table suggests the optimal approach for equipment acquisition based on customer needs or criteria.

As stated before, the buy, lease, or rent decision is most influenced by how long the equipment is needed. A short period of utilization favors renting and a longer period favors leasing or purchase. Along with the discussed financial analysis and comparison there are many non-quantitative areas to be considered prior to the decision:

• Work volume
• Nature and types of construction projects
• Client requirements and expectations
• Reputation and company perception to potential clients
• Funding capabilities
• Long-term financial goals
• Relationship with equipment supplier
• Company ownership policy

A study of the acquisition and finance alternatives comes after identification of the need for a piece of equipment. This evaluation is a key component in the financial planning of the construction firm.

References

1. Technical book, “Construction Machinery Training”, Instate, Imlambad
2. Harris, F. and McCaffer, “Management of Construction Equipment”, Macmillan Education Ltd. London, UK.
3. Erich J. Schulz, “Diesel Equipment I and II”, Mcgraw-Hill book co.
4. Frank Harries, Ronald McCaffer, “Construction of Plant Excavating and Material Handling”, Granda Publishing.
5. SAE Handbook Volume 4
6. “Caterpillar performance Handbook”, Edition 33, Caterpillar Inc, Peoria, Illinois, USA.