The advantages of buying or leasing major equipment purchases.
By Vince Cahill
When a business owner makes a capital equipment purchase, the decision to buy or lease may be as complicated as selecting which piece of equipment to buy. Some owners prefer to pay cash and would not miss the liquidity that having cash affords. Financing the purchase is an option if credit is available and a financial institution or angel investor is willing to provide a loan. State or local business development programs may also be a source of low-interest loans or possible investments in your business. Leasing is a third alternative.
The best choice for financing a large capital expenditure depends on business philosophy, circumstances, and the costs associated with each course of action. In some cases, purchasing equipment will prove the better course; under other conditions, leasing will be the better choice. In order to choose the best path, a business owner must examine the advantages and disadvantages, benefits and costs of leasing and purchasing with and without financing. An accountant or financial adviser can review the tax implications associated with each option.
If cash is the preferred payment option, consider what continuing to hold on to it is worth. If funds in a bank are earning four percent interest, using those resources will not only cost the amount of the purchase, but also the interest on the money.
Accountants call the percentage lost either discount for present value or investment rate of return. In calculating the cost of a lease or bank financing versus cash payment, deduct the interest that is not earned from the lease and finance costs. Add it, however, for the cash amount of a loan down payment or lease up front payment or security deposit. In paying cash, consider the impact that spending the money would have on liquidity. A business with cyclical sales may want to have funds available for months with leaner revenue streams.
Ownership certainly offers advantages over other acquisition methods, including the ability to modify the equipment to fit the shop’s needs. Leases typically restrict the leaseholder from modifying leased equipment, which is, in effect, rented. Banks also may impose some restrictions on modification to the equipment that they are financing and holding as collateral. Ownership also removes the burden of a monthly payment to a leasing company or bank. Many businesses seek freedom from debt and always pay cash and follow a pay-as-you-go discipline. Businesses following this approach may not grow as fast as those in debt, but they do not have the burden of repayment to worry about.
Banks offer both fixed-rate and adjustable-rate loans. During periods of declining interest rates, adjustable-rate financing can save money, but when rates are rising, the increase can siphon away a business’s cash and retard business growth. Generally, adjustable-rate financing will carry a lower interest rate than fixed-rate financing. Changing a loan from a variable to a fixed-rate loan involves reapplying and incurring application and other charges.
The leasing option
Approximately 80 percent of all businesses in the United States will lease equipment at some time. Leasing provides a viable way for most businesses to acquire needed equipment and ancillary products and services. Leasing companies usually will permit a business to bundle the acquisition of software, consumables, installation, transportation, and other charges into a lease. Equipment leasing companies will underwrite the complete bundle without a down payment. Banks also may allow a leaseholder to cover some of these items, but will more likely exclude those that are not readily identified as collateral and will often require a down payment and a lien on other company assets. The expense of a loan also would include the cost of filing the lien at the county courthouse. Some leasing companies work cooperatively with equipment sales organizations. Some leasers will pay equipment companies a fee for their referrals, while others will not.
While leasing companies will investigate a customer’s credit worthiness, they are less intrusive than banks and will not demand that a business owner supply tax returns and annual reports for the term of the lease, items that banks often will require for the term of a loan. Many leasing companies offer leasing contracts that they tailor to the business needs of their customers. Some banks also offer such custom financing, but the loan process usually is more complicated and time consuming.
The cost of money from a bank will depend on a business’s credit standing. Very large corporations often can negotiate loans below the prime rate, while small businesses typically have to pay a few percentage points above prime. The cost of bank financing typically will be somewhat less that that of leasing. A lease will, however, use part of an owner’s allowable credit in acquiring a bank loan, but will not do so in obtaining equipment through a lease. Banks will be reluctant to lend money for equipment with which they are not familiar or consider as collateral. They will often require that a business maintain an amount on deposit with them. Banks also can help in the funding of projects that receive state or area development authority funding.
Equipment leases differ from automotive leases, since many automotive leaseholders will not want to own the vehicle at the end of lease, and most companies with equipment leases prefer to retain and acquire the equipment. Also, most state governments tax automotive purchases, but usually do not tax manufacturing equipment. Equipment leases generally are designed so that at the end of the lease term, the company that is leasing the equipment ends up owning it. Leases can offer a variety of options. At the time when the lease is negotiated, the leaseholder can typically choose either a $1 buyout or a buyout for 10 percent of fair market value. Most opt for the $1 buyout.
Some leasing companies offer flexible payment plans, including set-period, fixed-payment plans for monthly, quarterly, semi-annual, or annual fixed payments. Initial deferred-payment plans allow the leaseholder to pay smaller payments during the beginning three or six months of a lease. This type of plan can particularly help small and new businesses during the training for using the new equipment and the ramping up for production period.
Seasonal payment plans match the cycles of a business. Multiple-purchase, master lease contracts enable businesses to secure approval at a set discount rate at one time for leasing multiple pieces of equipment, which would be acquired over a set period of time. This type of plan enables new businesses with the need to acquire multiple pieces of equipment during a startup to plan and shop for the best buy and solution.
Step-up payment plans increase over the term of the contract to match business growth that the equipment should generate. These contracts typically cost more over the term of their contracts than other plans, but they also enable a company to have its payments match anticipated increases in revenue from leased equipment production.
Step-down payment plans, in contrast to step-up plans, involve higher initial payments that progressively lower over the life of the contract. These plans yield lower finance charges than most other plans.
Federal law allows businesses to expense some equipment purchases up to $125,000 for the year in which you purchase them. Otherwise, tax law requires a business to depreciate an equipment purchase over the standard life of the item. A business will be able to deduct loan financing interest payments and lease payments as business expenses from taxable income if there is any. Consult with an accountant or tax adviser to determine if expense deductions or depreciation provide the greater advantage.
The Internet provides tools for comparing leasing with bank financing and cash payment. The Web site of New England Business Services Inc. (www.nebs.com) offers a number of free business tools. Other sites are KJE Computer Solutions LLC (www.dinkytown.net) and the Bloomberg Web site (www.bloomberg.com).