Should I lease or should I buy? How many of us have asked this question and pondered which was better? How often have we asked this question and received different answers? In this article we’ll briefly explore the ‘lease versus buy’ question.
Let’s begin with a brief review of how a lease is calculated. Assume, for example, that the total value of a machine is $100,000. It has a residual value of $55,000. This means that you are paying $45,000 for the use of the machine for a fixed term (i.e. five years) – the $55,000 is the asset value at the end of your lease which you do not have to pay for as you do not own the asset. (When the lease term is completed you typically have the option to purchase the machine for its residual value.)
A lease payment is comprised of interest and principle amounts. The interest portion is based upon the entire value of the machine ($100,000) whereas the principle portion is calculated solely upon the value of the machine used ($45,000). By contrast, to buy the machine using a loan, the payments (based on interest and principle calculations) would be derived from the full asset value ($100,000).
BUY VS. LEASE: KEY FACTORS TO CONSIDER
Not everyone operates their greenhouse in the same manner. It is recommended that you discuss any lease arrangements with your tax advisor early in the process, as your tax situation can have a significant impact on your lease vs. buy decision.
Some key considerations are as follows:
Cash Flow: In general, leasing usually requires less cash flow. Recall the previously noted example about what it is that you are actually paying for. Leases are usually more flexible and the regular lease payments are normally less than loan payments for the same piece of equipment. Can the extra cash flow from leasing be used to generate more money elsewhere in your operation than the cost saving from purchasing? Knowing the return on assets for your business is important in answering this question.
Tax: There are advantages to both options: under an operating lease, the entire lease payment is tax deductible (capital leases have different tax treatments than operating leases); if the asset is purchased, you can claim the Capital Cost Allowance (CCA) and the interest on any borrowed money. Consult a tax professional to determine which option is best for you.
Asset turnover/replacement: Greenhouses that need to replace their equipment more frequently may benefit from leasing. Equipment that tends to last longer may be better purchased.
Impact on your balance sheet: Unlike purchased capital assets, assets that are secured through operating leases do not appear on your balance sheet as a capital asset. (Unlike operating leases, capital leases are recognized as if they were purchased assets. They therefore are treated as if the asset was purchased).
What this means is that your current ratio and working capital are not impacted. Lenders like to see these metrics maintained within certain limits – choosing to lease vs. buy may help you maintain these targets while still owning the same asset(s).
BUY VS. LEASE EXAMPLE
Let’s continue with our machine example, which had a price tag of $100,000. The other relevant information we will need to make our decision:
• The interest rate on the loan is 6.5 per cent.
• We can sell this machine at the end four years for the residual value of $55,000.
• Discount rate on cash flow is five per cent.
• Our greenhouse pays tax at the low corporate rate of 19 per cent.
If the machine was leased, our annual payments would be $16,380 per year. We would save about $3,112 per year on taxes at the low corporate tax rate. This results in a cash outflow of $13,268 per year.
If we purchased the machine, the annual loan payments would be $28,458. The taxes recovered for the interest component and the CCA would be $3,958. This results in a net cash outflow of about $24,500 in Year One and similar cash outflow in the remaining four years. The machine is then sold at the very beginning of Year Five for $55,000, resulting in taxes recovered of $4,911.
The net present value of the above example results in each of these options being essentially the same ($47,276 to purchase vs. $47,047 to lease). So in this particular case, it wouldn’t matter whether you leased or purchased. However, it is unlikely that you would be selling this machine as soon as you finished paying for it … and at 55 per cent of the original purchase.
Our example was done to illustrate that in the short term, leasing requires less cash flow, so that what is saved from leasing can be used in another part of the operation.
In conclusion, there are many decisions that go into evaluating a lease vs. buy decision. However, the time and effort spent in comparing the two options is worthwhile. Talk to your business and tax advisor.
David Tonin is an associate partner with the Burlington office of Deloitte.
TIME TO BUY … OR TIME TO LEASE?
Your tax situation can have a significant impact on your lease vs. buy decision. Greenhouses that need to replace their equipment more frequently may benefit from leasing.
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