The effect of leasing versus buying assets on return and cost effectiveness

¶ … leasing assets vs. buying.

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)

Why Buy?

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.

Why Lease?

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 from the Financial Accounting Standards Board (FASB.) It defines ways of handling computer equipment leases, says Greg Uchimura, manager of cost accounting at GTE Data Services in Temple Terrace, Fla." (Alexander, 1999)

Additionally, the question of leasing vs. buying or owning is different based on the country one is engaging. For instance, in Sweden, according to Lind, Lundstrom, (2010), "During especially the last two decades, there has been a more intense discussion about owning vs. leasing in all three levels of the public in Sweden: the central government, the regional authorities (county councils) that are responsible for health care in Sweden and the local authorities (municipalities) that, for example, are responsible for day-care centers, schools and homes for the elderly." (Lind, Lundstrom, 2010)

Additionally, when speaking with regard to owning vs. leasing real estate, Lind & Lundstrom say the following. "A good overview of the general arguments for real estate leasing vs. owning can be found in Benjamin et al. (1988). The starting point for their argument is that owning should be more efficient as it is difficult to create strong incentives for a tenant to take good care of a leased property." (Lind, Lundstrom, 2010)

Additionally, Lind & Lundstrom point to the following as the parameters to determine whether to lease or buy a property. These include, "transaction costs, differential access to credit markets, risk shifting, comparative advantage in asset disposal, asymmetric information, economies of scale in management, and accounting and tax aspects." (Lind, Lundstrom, 2010)

The transaction costs can be a barrier such that high transaction costs to buy or sell an asset may make more sense to lease the asset rather than take ownership. Differential access to credit markets is applicable to the cost of borrowing funds in the credit markets to pay for the procurement of assets. Again, the idea is to have the asset generate a return that is greater than the cost of the credit or debt obligation.

According to Kuzeljevich (2001), "The most obvious benefit of full-service leasing is the ability to concentrate on core operations outside of running the fleet. Leasing can provide fixed, predictable payments rather than variable rate financing as occurs on some purchasing. Under a lease, your statement can show operating lease payments as a monthly expense rather than long-term debt on the balance sheet. "Some customers don't twig to the financial benefits of full-service leasing. They may be of the mindset that owning equipment (is an asset). Leasing really does free up your capital within the company so you can reinvest within the facility, or wherever. In a great sense, it also eliminates the obsolescence of the equipment," says Steve nash, general manager of Provincial Trailer Rentals." (Kuzeljevich, 2001)

According to Solender (1998), "If lease rates are low, you can benefit from a long-term lease with a fixed rate or moderate, staged increases during the term of the lease. When the market has rapidly increasing lease rates, you should consider ownership, especially if you require substantial space. Owning a facility may be more cost-effective than you think. Even if you must borrow part of the funds necessary to buy a facility, your debt payments will be fixed and probably less than escalating rent payments. By owning your facility, you will avoid paying property and sales taxes on utilities that are part of rent to a landlord." (Solender, 1998)

Additionally, according to Solender, "Another good reason to buy rather than lease is that you have the option of holding a capital campaign to raise money to purchase a facility. You may be more successful holding such a campaign than trying to raise money for your operating budget to pay increasing annual rents." (Solender, 1998)

Leasing is the alternative that frees up cash flow and working capital to either the individual or the business to enable such profitability ratios including the working capital ratio and the quick ratio to remain competitive and viable (at least, above 1), which enables the business to meet its short-term liability obligation. Whether one leases as opposed to owning is also a function of the balance sheet and whether the firm wants to accept more debt to finance its assets or whether the firm can better utilize its cash flow to acquire an asset to not pay the taxes on the rental property to the landlord.

According to Deierlein (2006), "Many fleet managers make the mistake of thinking that the "to lease or not to lease" you do a thorough analysis each year, as your operating needs and leasing costs can change over time. Don't think that a leasing decision you made three years ago is automatically the right one for you today; you may require more or less service or realize that capital you spent buying trucks in your last vehicle acquisition could now be better spent elsewhere." (Deierlein, 2006)

Conclusion

Leasing appears to be the optimal choice regarding the decision to purchase the asset. According to Lyon (2010), "The value of reflecting leases on the balance sheet can be determined by close analysis of the work of Lasfer and other proponents of the advice that leasing real estate is better than owning it. Leasing is an activity whereby the use of an asset is separated from the ownership of the asset. A lease would appear to fall into both liability and asset categories." (Lyon, 2010)