Capital Budgeting Decision Leasing vs.

Capital Budgeting Decision

Leasing vs. buying: Capital budgeting in organizations for individuals

In the field of managerial accounting, a 'make-or-buy' decision is defined as the question of whether an organization should make some parts and components in-house or subcontract the manufacture of those parts to an outsider. A similar question involves outsourcing, or purchasing a product, part, component, or service from an outside supplier instead of manufacturing it in-house (Atkinson 2001, et al., Slide 12). The costs of manufacturing in-house, including the opportunity costs of the resources devoted to manufacturing the parts or providing the service, are calculated vs. The competitive purchase price of the item, when making the decision to make or buy.

Debating the question of whether to lease or buy new equipment or other aspects of the organization classified under the designation of capital budgeting are slightly different than the 'make or buy' debate. Other costs, such as depreciation of the asset must be considered when contemplating a purchase of new equipment vs. A lease on the equipment. In the short-term, leasing an asset provides an enterprise with more available capital to spend on possibly more attractive options that may arise in the future, as the initial cash outlay is smaller with leasing than with buying. As with a 'make-or-buy' decision the opportunity cost and revenue derived from the extra cash spent upon a purchase must be considered. The interest rate upon the loan necessary to buy or lease the item must also be factored into the monthly cost of operating the item and the tabulation of the overall, long-term costs of leasing or buying.

Leasing also means that there is a 'trial period,' whereby an organization can test out the compatibility of the item to their methods of production. For some items, like computer software and office equipment, the lender may provide technical or maintenance support. For items with a quick turn over in terms of technical obsolescence, leasing may be the better option as it is easier to upgrade the system. There is also no need to resell the item -- although there is also no profit gained from an item with good resale value (Should I buy or lease an asset, 2008, 360 Degrees Financial Literacy).

The general rule of thumb is to buy an asset if it appreciates in its value over time and it will be kept for more five years. Buying an asset provides the organization with a source of equity. Another rule of thumb is that "you will likely spend more dollars by leasing over the life of the asset than you would with a purchase, even if you consider the interest payments on a loan. This is particularly true with real estate. The interest you pay on loans to acquire real property may be tax deductible as a business expense, as may maintenance costs and depreciation on the asset. Also, even though most lease payments are fully deductible as business expenses for tax purposes, your purchase of the asset may provide greater tax relief in the long-term" (Should I buy or lease an asset, 2008, 360 Degrees Financial Literacy).

However, every item must be considered individually when debating whether to lease or buy an item. For example, even though the real estate market is depressed, owning vs. renting property is considered the superior option, given real estate's likelihood of appreciating in the very long-term, and the dangers of being reliant upon the whims of a landlord to renew or not to renew a lease. Some people compare buying a car to renting an apartment: "you pay a monthly fee to use it but don't own it -- and aren't making payments toward ownership. The leased vehicle remains the property of the lessor -- the company that issued the lease" (Peters 2009). However, cars depreciate rather than appreciate in value, unlike real estate. Monthly lease payments are cheaper than payments on a new car, a lease is generally of shorter duration than a car loan. "Another nice thing about car leasing is that you're always driving a new or nearly new vehicle. And of course you don't have to worry about the potentially expensive repair and/or maintenance problems that inevitably crop up as a car ages -- and gets out of warranty" (Peters 2009) the leased car will be under factory warranty for the duration of a standard two-year lease and may even cover routine maintenance, such as oil changes.

But at the end of the lease, the renter is that much the poorer, with no asset in exchange for the 'rent' he or she was paying to the lender. A car owner making car payments still has the equity, and can use or sell the car. "Though it will continue to depreciate with each passing year, so long as it's still serviceable transportation, it will always be worth something. That value can be used as a trade-in; or the vehicle can be sold privately to help raise money to pay for a new one -- or for some other need" (Peters 2009).