Lease vs. Buy Capital Expenditure

Lease vs. Buy

Capital expenditure is an outlay of cash for a project that is expected to produce a cash inflow over a period of time exceeding one year. This can, however, be costly for the firm and can greatly affect their financial performance. So a process called capital budgeting was developed to help determine whether or not the projects that entails capital expenditure are worthwhile. Examples the investments are property, plant and equipment, research and development projects.

There are several methods in capital budgeting namely the Net Present Value (NPV), Internal Rate of Return (IRR), Discounted Cash Flow (DCF), and Payback Period. Net Present Value is the present value of the inflows of cash minus the present value of the outflows of cash and is a method to evaluate whether the project or investment is profitable or not. Meanwhile, Internal Rate of Return is a method zero out the net present value of all cash flows for a certain project. Another method is Discounted Cash Flow that determines whether an investment is attractive or not. Lastly, Payback period is a method that tells us the time period to return the investments costs (Dictionary, n.d.).

Despite the methods provided, the company is still faced with different risks and uncertainties as a small corporation. It may be a difficult decision then whether or not it be worth to buy into an investment or to lease it instead. When a lease is made, then the business needs to change its operations significantly, it may be costly or hard to terminate a lease before the term ends. In such events, the business may have not recovered the original costs of the original lease. On the other hand, when a lease is made, then the business has succeeded its operations, they may pay for higher rental payments when the contract of the lease is renewed.

There may be several things the firm may look into when making a buy or a lease decision. Some may want to investment in projects that will produce immediate cash inflows; others may want those that would affect a long-term growth in the company. Yet, most of the firms want to maximize the present shareholder value. This goal implies that the prospective project should result in more present value of the expected cash inflow than the needed capital expenditure. This is why computing present value of cash outflows is also significant.

Furthermore, if leasing is considered, there are two ways of accounting for lease. These are also considered long-term financing programs designed for one year of more projects and investments. The first one is an operating lease. It is an operating lease when "the lessor (or owner) transfers only the use the property to the lessee and at the end of the lease period, the lessee returns the property to the lessor" (Operating vs. Capital Leases, n.d.). On the other hand, it is a capital lease when it meets one or more of the following criteria: "the lease life exceeds 75% of the life of the asset; there is a transfer of ownership to the lessee at the end of the lease term; there is an option to purchase the asset at a "bargain price" at the end of the lease term; the present value of the lease payments, discounted at an appropriate discount rate, exceeds 90% of the fair market value of the asset" (Operating vs. Capital Leases, n.d.).

These two have significant impacts on the balance sheet and income statement of the firm. In the balance sheet, the operating lease has no effect while the capital lease shows interest receivable and capital asset with depreciation on the asset side and debt on the liability. In the income statement, both the operating lease and capital lease records an operating expense; the latter also shows interest as revenue. (Operating vs. Capital Leases, n.d.).

Furthermore, capital lease provides more benefits than buying an asset. First, and probably the most important, is cash flow. Capital lease offers a great alternative in preserving the cash flow. It allows the company to have a working asset like equipment by leasing than making an outright purchase. Usually a minimum down payment is required. With a monthly payment of lease, the company has now machinery that can be utilized to increase production and quality of a product while some costs like labor is decreased. Then in the end of the lease, there is an option to return the equipment to the lessor or to buy it. Opting to buy could be beneficial because the company now clearly owns the machinery. Another benefit of leasing is the mitigation of technology risk. When there is growth or change in the business, it may need to add or upgrade its equipment. This allows the company to update the equipment through a favorable strategy; thus, lowering the risk of obsolescence due to change in technology. Leasing may also provide favorable tax implications. Lease payments are accounted as expenses to offset revenue when the taxable profit is computed in the fiscal or calendar year.