Lease Versus Purchase

The question of when to lease and when to purchase equipment becomes very complex at times, and all aspects must be considered. Following are some facts to note before purchasing equipment.

1. The effect of the added capital assets on the tax structure of the corporation must be determined, as well as the additional bookkeeping necessary to calculate depreciation, and so on, when the assets are acquired.

2. Records of maintenance and efficiency of the different types of equipment must be maintained so that the time of replacement can be determined and provided for in the budget.

3. Storage and repair facilities must be provided for the equipment and the repair parts. The availability of trained maintenance personnel must be evaluated and the time they will be required must be determined.

4. One of the most important considerations must be to determine how frequently the equipment will be employed in the normal working year. This would include evaluating the mobility of the equipment and the ability to utilize the equipment in other locations of the mill or at other plant sites, and how the charges for the equipment would be distributed.

5. Security requirements in the areas in which the equipment or repair parts and tools are stored can be an important consideration.

6. If the equipment is available on the site when required, a move-in/ move-out charge is eliminated.

Before leasing equipment, one should consider the following:

1. No capital assets are added to affect the tax structure of the corporation, and bookkeeping is not increased to calculate depreciation, and so on; maintenance of records is minimized.

2. No formal records are needed for normal maintenance and efficiency determination.

3. Storage and repair facilities need not be provided; trained maintenance personnel may not be needed.

4. If a type of equipment is not employed frequently or for long periods of time, the equipment rental will cease when the equipment is released from the project. Also the charge for the equipment can be transferred by the contractor to another project with ease. If the equipment is owned, internal bookkeeping and agreement on the amount of charges are required.

5. Security of the equipment must be maintained only when the equipment is utilized since the equipment is on site only when required.

6. Availability of the equipment and the distance of the haul must be considered. A contractor who can furnish the required equipment with reasonable move-in/move-out charges must be selected.

Example 4.11 Lease vs. Purchase

A new welding machine (gasoline/electric) has been leased for $300 per month, and a new machine can be purchased for $2500. We must decide whether to purchase a new machine or to continue to lease a machine. The data are as follows:

Solution The leasing cost can be written off at once for tax purposes and after taxes is

$3600(1-0:34)=$2376

The new machine generates a depreciation expense of $2500/8=$312.50 which, after taxes, becomes

$312.50(1–0.34)=$206.25

The extra cash flow by purchasing is $-2500 at zero time

and there is a savings over leasing at the end of each of the 8 years amounting to

$2376+$206.25=$2582.25

A year-by-year tabulation is not necessary in this particular example but is used here as a guide to the general procedure. The discounted cash flow for the extra cash flow generated by purchase of the machine is:

By interpolation of the discount rates to a net cash flow of $0, the discounted cash flow rate of return is about 86.7% in favor of purchasing a new machine. 4.2.4 Economics for Capital Projects or Replacements

Economic justification for construction or replacement of a project should be viewed from the impact of the cost of the project on the method of obtaining revenue as well as from other aspects. Since most corporations obtain revenue from the sales of products, the impact of the cost on sales revenue must be considered.

When calculating discounted cash flows, the cost of money, profit, depreciation, and so on, must be established to a high degree of accuracy. These figures can then be applied in other methods of calculating risk and the profitability of projects.

One of the first steps in determining profitability in the impact on sales method is to examine the present percentage of net profit to sales. This can be done by dividing the net profit for the year by the sales volume in dollars for the year. If we assume the sales volume to be $184,300,000 and the net profit to be $18,280,000, we find the percentage to be

By applying this percentage, the amount of sales required to offset the expenditure can be found. For each dollar expended, the amount of sales required is found to be

This calculation illustrates the importance of the corporation saving comparatively small amounts of money as well as saving larger amounts. When viewed from the evaluation aspect and applied to the project, several determinations must be made:

1. The amount of sales volume in dollars per year that will be generated 2. The amount of net profit realized from the additional sales volume 3. The amount of operating expense to be eliminated by more efficient

operations

4. The duration in time of the increase in production or duration in time of the savings in expense

5. The amount of sales volume in dollars per year required to offset the expenditure

When the discounted cash flow method is applied using the same 10% factor to determine if the project is feasible, we find:

As shown above, the project would earn the required 10% profit and recover the capital investment in 13 years, with $1,260,241 or 2.8% of the initial $45,000,000 investment as a surplus. If the calculation is completed through the sixteenth year, when the project has been totally depreciated, the 10%

When viewed using the calculation above, we find the sales required to offset the additional expenditure are $1,650,000. When this is applied to a corporation earning 10% on sales of $182,800,000 or $18,280,000, the impact of the expenditure becomes:

profit would be earned and the initial investment recaptured with a $5,951,195 surplus.

The example above illustrates a good investment. However, if money were expended but contributed nothing to the profit or did not reduce operating expenses, we would have a different situation.

Example 4.13

When this example is viewed in terms of the effect on sales, profit, and the loss of revenue that could have been realized if the profit had been invested in a project yielding 10% profit, an even greater impact on earnings is noted.

where 0.009 equals approximately 1% of the total net profit of the corporation. The ratio of the smaller gain in sales can present another picture, as can be seen above: $1,650,000 of the sales revenue must be expended for the $150,000 spent. This represents

where 0.075 equals 7.5% of the net gain in sales.

This would for all practical purposes reduce the net gain in sales to 11% ($20,108,000) from the 12% ($21,936,000) gain, as 7.5% of the additional sales would be offset by the nonproductive expenditure.

The examples above illustrate the importance of the evaluation of all projects to be undertaken by corporations. The examples also illustrate the importance of efficient operations and budget planning when the impact on sales ratio of profits and the impact on net profits from a comparatively small unnecessary expenditure are noted.

When considering the growth of a corporation, a 12% increase in sales appears to be a healthy rate of growth. However, when $150,000 of unnecessary expenditures can lower 1% of the sales growth and $21,936,000×10%=$2,193,600 can negate the entire growth in sales, the careful evaluation of expenditures can be seen as being of great importance.

The importance of implementing more efficient conditions or methods wherever possible can be seen readily by the fact that a saving of $150,000 in operating expense is the equivalent of a 1% growth in sales for a corporation with a sales volume of $182,800,000. This becomes even more significant if the operating expenses are average, or approximately 85% of sales or revenue.

0.85%×$182,800,000=$155,380,000

When the realization that, with a comparatively small savings,

(0.009 equals approximately 1/10 of 1% of operating expense), the equivalent of a 1% growth in sales is realized, and the savings become even more important.