Should I buy or lease equipment?

This calculator compares a term loan and lease to obtain business equipment. To compare the value of payments over time for the lease-or-loan option, the calculator shows payments in present value

A term loan helps you to buy the equipment. While your business pays all expenses, it realizes substantial tax savings from these expenses. However, loan financing crimps your cash flows: a down payment is a large initial expenditure, and your monthly payments are larger to include repayment of loan principal. If your business is a young enterprise, you may not have the level of cash necessary to sustain high debt payments.

A lease lets you obtain business equipment at a cost that is generally less than loan financing. Using an operating lease, your monthly lease payments will be lower than loan payments. You also avoid a down payment. Instead, you pay a security deposit that is much smaller than a down payment on a purchase.

When the lease term expires, you have more flexibility than with a loan. You can renew the lease, exercise a purchase option, or, in most cases, walk away. Leasing may also be advantageous if the equipment becomes obsolete fairly quickly.

Key assumptions of this calculator include:

Depreciation. The calculator uses double-declining balance (DDB) method and MACRS to depreciate equipment. It switches to straight-line depreciation in the year that depreciation expense under that method is greater. The half-year convention is used to calculate depreciation expense for the first year, regardless of purchase date.

Recharacterization:The two main types of leases are operating and capital leases. Operating leases are not recorded on a company's balance sheet; capital leases are. If the IRS determines that a lease transaction resembles a capital lease, it will require the lessee to reclassify, or recharacterize, the lease. As a result, the company is required to show the lease on its balance sheet.

Term loan:A term loan is a loan whose principal is repaid, or amortized, over a fixed term. Banks sometimes call these bullet loans. A common term for term loans is three to five years.

Salvage value:Salvage value is the value of a depreciated or leased asset at the end of its depreciable life or lease life. Salvage value is referred to as scrap, or residual, value. Scrap value is an alternative term for value of fully depreciated equipment. Residual value is an alternative term for value of equipment at the end of the lease life.

Down payment:A down payment is the cash you deposit towards the purchase of equipment, or commercial vehicle. The larger the down payment, the less you are required to borrow. For equipment loans, a down payment of 20% of the equipment purchase price is generally required. The value of a trade-in can be used instead of a down payment when purchasing replacement equipment.

Net present value (NPV):Net present value is a method of determining the value of an investment in today's dollars. To calculate net present value, you discount future cash flows at the appropriate interest rate. You subtract your cash outlay from the sum of the present value of your cash inflows to determine your net present value. As a general rule, if net present value is positive, the investment should be made.

Straight-line depreciation:Straight-line depreciation is the simplest depreciation method. To use, take the depreciable basis of the asset and subtract salvage value. For example, you may decide to depreciate a $1 million asset that has an estimated salvage value of $100,000 in 10 years. Divide the difference in depreciable basis and salvage value by the number of years to calculate annual depreciation expense. In this case, if your annual depreciation expense would be $90,000 ($900,000 / 10).

Tax savings:Tax savings are the amount you may save in taxes from a tax deduction or tax credit. Tax savings are also called a tax shield. To calculate tax savings from a deduction, multiply the amount of the deduction by your marginal income tax rate. For businesses, tax savings are realized on such deductible expenses as lease payments, interest on loan payments, and depreciation expense. Example: At a marginal business income tax rate of 25%, an increase of $2,000 in depreciation expense may save you $500 in taxes or $10,000 in operating lease payments may save you $2,500. You may wish to consult a financial or tax adviser.

Double-declining balance method:Double-declining balance (DDB) method is a depreciation method that accelerates depreciation expense for equipment. To calculate, divide depreciable base of the equipment (after subtracting salvage value) by number of depreciation years. The IRS' MACRS depreciation schedule shows the number of depreciation years. Then, double that amount. This process is repeated until the depreciation expense using the straight-line method is greater than the expense calculated using the DDB method. In that year, companies routinely switch to straight-line depreciation to depreciate the remaining value of the equipment.

Tax-deductible:A tax-deductible expense or contribution reduces your taxable income. To calculate the worth of a tax deduction, multiply the deduction by your income tax rate. For example, if you deduct $10,000 in mortgage interest expense and are in the 25% income-tax bracket, the tax deduction is worth $2,500. If you deduct $1,000 in contributions to a charity, the tax deduction is worth $250.

Useful life:Useful life refers to the number of years that a business asset can be used for depreciation purposes.

Lease:A lease is a contract between two parties, a lessor and lessee. Under the terms of the lease agreement, the lessee makes periodic payments to the lessor. Ownership of the equipment at the end of the lease term, as well as which side receives the tax benefits from the related depreciation expense, depends on the type of lease.

Cost of capital:Cost of capital: 1) the weighted-average cost of debt and equity financing; 2) the required rate of return a business expects to earn on its investments. Cost of capital is used to discount future cash flows to present value. Which cost of capital to use to discount future cash flows depends on the transaction. If financing a project, the appropriate cost of capital is the cost of debt and equity financing. If the business uses only debt to finance the project, the after-tax interest rate is the cost of capital. If investing in a project, the appropriate cost of capital is the rate of return a business requires on its investment elsewhere. This rate of return is also called the opportunity cost of capital since it is the rate of return the business earns if investing elsewhere.

MACRS:MACRS is an acronym for Modified Accelerated Cost Recovery System. MACRS is the depreciation schedule that businesses use to depreciate business equipment, buildings, and other real estate improvements over the useful life of the assets. Raw land is not depreciable. The number of years that you elect to depreciate a building may depend on the industry in which the building is used. For more on MACRS, see IRS Pub. 946 at the IRS Web site (http://www.irs.gov).

Auto lease purchase option:A purchase option gives you the right to buy leased equipment at the end of the lease term. The purchase price is called the residual value, which is close to the book value of the asset. In a lease transaction, the party that leases the equipment (the lessor) retains ownership of the asset and takes depreciation expense.

Residual value:Residual value is the value of a leased vehicle or other equipment at the end of the lease term. Residual value is the fair market value of the leased equipment. It is the price the lessee pays to buy the equipment if they exercise the purchase option.

Operating lease:An operating lease is one of the two major types of equipment leases (the other type is a capital lease). An operating lease is a contract that requires the lessee (the party that uses the equipment) to make periodic payments to the lessor (the party that retains ownership of the equipment) over the length of the lease term. Operating leases allow lessees to conserve cash and avoid buying too much equipment. Operating leases have a cancellation provision in case the lessee wants to stop making payments. At the end of the lease term, the leased equipment may be leased again or sold to the lessee for the residual value of the equipment.

Discount rate:The discount rate is the interest rate the Federal Reserve, the U.S. central bank, charges banks on loans the Fed makes at its discount window. Banks seldom borrow at the discount window, since the Fed is considered a lender of last resort. The discount rate is important, however, in that it is routinely used as an index rate by the lenders to set interest rates on a range of consumer loans. This includes auto, credit card, and home equity loans. As a general rule, the Fed lowers the discount rate when it changes its target for the fed funds rate.

Fair market value:Fair market value (FMV) is the value or price at which a commodity would change hands, assuming a willing buyer and a willing seller and no duress. In the absence of an arms-length transaction, fair market value is used as a proxy for sale price. Fair market value is often used to calculate the basis of a capital asset.

Depreciation:Depreciation is the systematic reduction of book value over time due to wear and tear and obsolescence. Some equipment types depreciate faster than others. If a piece of equipment has a longer useful life, it suggests that its depreciation rate is lower than one with a shorter useful life. Depreciation is also used to calculate the residual value of leased equipment. Depreciation expense is a non-cash expense that creates tax savings.

Present value:Present value is the value of a future payment, or series of payments, discounted at the appropriate interest rate to determine the value in today's dollars. For example, if you were given the choice of $100 today or a year from now, you would choose to take it now. You can invest or spend it. If you could invest it at 10%, you would have $110 a year from today ($110/$100). In other words, the present value of $110 a year from today is $100 if the discount rate is 10%. The discount rate should be at least equal to the inflation rate, which has averaged about 3% a year over the last decade. As a result, $103 a year from now has a present value of $100 ($103/1.03).