The question of whether to buy an asset or to lease an asset is quite complex. Indeed, the answer is not always a black and white, straight response. Often, there is a grey area when researching whether to purchase or lease. For instance, if one wishes to purchase a house and live within the residence for two years, the residence can then be rented out and considered an investment home. Additionally, one can carry a mortgage on a house and live on one of the floors or in the basement. The rest of the quarters may be rented as a means to obtain cash flow.
The purchase of a car is somewhat less complex yet has an array of options that may be intriguing to the consumer. Generally speaking, you do not buy an expensive new car due to the depreciation that is applied as soon as the car is driven off of the lot. The car is no longer priced as a pristine, new asset and therefore the depreciation is considerable once driven. A car has the highest 'premium' purchase value of any 'everyday' asset.
This is to say, the consumer is paying a premium to purchase the car as brand new. Brand new is special and therefore the price is reflected accordingly. The price is likely to be reduced by three to four thousand dollars if the car has only a few thousand miles of wear and tear. Therefore, those whom choose to purchase a brand new and expensive luxury car tend to make the purchase either with cash or as a business asset that can be written-off of the income derived from business activities.
Many financial advisors will advise the purchaser to pursue a lease option on a new or used vehicle. The advantage to leasing is the ability to pay low monthly installments and to not own or to pay capital on a depreciating asset. The lease allows one to 'rent' the vehicle for a specified period of time. Additionally, the likelihood of vehicle malfunction is reduced when considering the lifespan of the lease and the typical number of miles on the car when a lease is undertaken.
A simpler example of the purchasing vs. leasing quandary can be described by Berst (1983). According to Berst, "There is no one answer to the question of whether buying computer equipment is better than leasing. Each case must be considered individually. Advantages of buying include: 1. Control of ownership, modification, and maintenance, 2. The option to sell when desired, and 3. Its financial advantage compared to leasing, especially in the area of tax benefits. If money is no problem, buying is the best approach to financing computer equipment. Leasing provides the advantage of stretching a company's cash without tying up funds that could be used in other areas." (Berst, 1983)
Purchasing an asset is ostensibly how a sole proprietor or a corporate entity will build equity and grow its wealth. Inherently, this is where the question of whether to buy or lease becomes tricky. For any asset, the idea is for the asset to generate a cash flow, or for the asset to appreciate in equity as well as derive some consideration of cash flow. If the asset is not linked to generating a cash flow, then the asset in question is not an asset.
Property, Plant, and Equipment are assets because essentially these items comprise the factors of production. The means to generate income to pay for the cost of each asset and to facilitate profit generation is the functional value of Property, Plant, and Equipment. The question of whether to purchase the Property, Plant, and Equipment is answered based on the cash flow that is generated by the assets in use. Once the asset generates cash flow sufficient to switch from leasing to owning, the optimal decision is to purchase the asset.
According to Weiss (2003), "When a company buys equipment with cash, the asset side of the balance sheet exhibits a reduction in cash and an increase in "property, plant and equipment.." The money disappears from the balance sheet contemporaneously with the purchase. A purchase in which debt is incurred to buy the item of equipment leaves some of that cash on the balance sheet, but the debt balance, of course, is recorded as an increase in liabilities. In either example, there may be adverse consequences resulting from diminished liquidity ratios or increased leveraged ratios." (Weiss, 2003)
Additionally, the issue of interest accrual on the debt issued to purchase the asset must be less than the rate of return on the asset being purchased. If the interest rate on the debt exceeds the rate of return on the asset purchased, the likelihood of the debt defaulting is positive and likely to increase as a function of the lack of cash flow from the asset to cover the expenses incurred from issuing the debt.
According to Weiss, "For decades, the lease vs. purchase decision has been among the most complex analyses in modern finance. The net effect of balance sheet and income statement management, tax results, "fleet flexibility," and cash cost considerations is difficult to assess. Yet recent accounting and tax law interpretations highlight some near-term opportunities for companies deciding how to acquire equipment." (Weiss, 2003)
When the firm is cash rich, the notion to purchase a leased asset makes more sense as the cash flow is not as important as when the firm is not cash rich. Ostensibly, the cash outflow from leasing can now be turned into the ownership of an asset that generates cash flow. Most assets are depreciating, and often to not appreciate in value. Many have now come to realize, in sheer terror, that the housing market does not always go in one direction, upward. Many consumers were under the guise that a house is an asset that appreciates in value over the long-term.
Therefore, a house purchased at time zero and held for ten years until t=10, in many consumers mind, would generate an asset appreciation value and perhaps a cash flow if the house is rented. However, houses are a function of supply and demand, and a large supply of cookie cutter houses will not outpace the S&P500 over the same period when considering year over year growth. The houses that tend to appreciate and hold significant value are in areas where the median income is above the national mean, in locations where there are good schools, and where the land is considered 'viable'.
Modern homes with modern fixtures on land with natural beauty and attraction remain critical components to determining the market value of a home. A home on the top of a hill, for instance, will command a higher asking price for the home than a similar model built and situated at the bottom of the same hill. Such a house, if possible, should be purchased. Ideally, one should purchase a house in which to live. If you can answer the question of whether you can live at a potential home for ten years with Yes, then perhaps the decision to purchase is an intelligent one. But purchasing a home with the sole intention of using the home as an investable asset and as a means to derive a cash flow can indeed backfire, horrendously.
According to the Small Business Link (2007), "One of the most important benefits of leasing vs. owning is the use of the equipment necessary to [keep] your business current in a changing world. Operating profits come from the use of equipment, not ownership of it. Today, the way to [expand] is by preserving your bank lines of credit and cash for operating expenses. Leasing allows valuable working capital for the day-in-and-day-out operations of the business, says Kim Manke of Lakeland, Fl." (Small Business Link, 2007)
As Manke points out, the ability for a proprietor or a corporation to harness the available working capital to pay for daily business operations is the difference between leasing and purchasing. Leasing is considered to be less expensive overall over the course of using the asset to generate returns. For instance, if a young person does opt to lease a new car rather than purchase one to obtain transportation to a job where the salary after taxes are deducted is $25,000, the decision is intelligent and correct.
The decision to lease in this case is a function of the annual after tax income of $25,000. Indeed, should the individual choose to purchase a car, the amount is tax deductible however without a savings account that is at least 50% of the value of the car, the notion of purchasing a new car and making payments along with insurance and the gasoline required will likely intrude onto the budgeted areas where the $25,000 has already been allocated to pay for other costs.
According to Alexander (1999), "Another GAAP rule that affects IT managers is FASB 13 lease capitalization…