Acquiring capital assets like equipment, vehicles or real estate requires companies to make a fundamental choice: lease or buy? The decision goes beyond simple monthly payment comparisons; it requires a thorough understanding of the financial implications, accounting treatments and strategic considerations of both options.

Whether you’re expanding operations, upgrading technology or managing your real estate footprint, knowing when to lease and when to buy can significantly impact your company's financial flexibility and bottom line.

What does it mean to lease capital assets?

Leasing enables companies to access capital assets without committing to ownership and adding them to the balance sheet. A lease establishes a contract between the lessor, who owns and provides the asset, and the lessee, who gains the right to use that asset for a specific time period in exchange for payment.

This is particularly helpful for companies that need operational flexibility to use assets but still “walk away” if market conditions are unfavorable at lease end, or have investors who prioritize return on capital metrics. From a financial management perspective, leasing offers a viable alternative to debt financing for asset acquisition.

The pros and cons of leasing

There are a number of strategic advantages to leasing. In terms of taxes, both parties can receive favorable treatment, and short-term leases can provide an additional advantage: off-balance sheet financing. Leasing can also serve as a great alternative to traditional debt financing for companies that have limited credit access or are trying to avoid restrictive loan covenants.

Additionally, leasing allows for a “balance sheet-lite” strategy, in which payments come from operating expenses instead of capital expenses. Generally, this lowers earnings while enhancing return on equity calculations due to reduced assets.

The operational flexibility in leasing arrangements allows companies to better manage their technological obsolescence risk, particularly when it comes to assets such as computers and medical equipment. Additionally, startups and companies exploring new markets can leverage lease cancellation provisions to mitigate demand uncertainty.

Furthermore, leasing outsources asset management, allowing companies to focus on their core competencies. For example, a food distributor could lease and maintain a delivery fleet through an outside vendor rather than having to purchase and maintain a fleet of vehicles, hire the staff to maintain the vehicles, etc.

The cons of leasing include long-term cost implications and the potential value that asset ownership affords, particularly when comparing residual value to the flexibility of walking away at the end of the lease. Also, adding leases to financial statements could adversely impact ratios between earnings, assets and liabilities, which could lead to a potential debt covenant violation.

Types of leases

There are two primary types of leases: operating and finance. The main differences between the two include the length of the lease, who is responsible for maintenance and upkeep of the asset, the residual value of the asset, the relevant tax treatment and who retains the asset at the end of the lease.

Operating lease

With an operating lease, ownership remains with the lessor beyond the lease term, and maintenance is often included as part of the agreement. In 2019, a significant regulatory shift occurred when ASC Topic 842 and IFRS 16 were implemented, mandating that operating leases with terms in excess of one year must be recorded on the lessee’s balance sheet and simultaneously appear as an expense on the income statement. Prior, they could be maintained off-balance-sheet.

Operating leases are typically shorter than the asset’s useful life — three to five years for equipment and up to 20 years for real estate. Because of the shorter duration, lease payments generally do not cover the asset’s full cost, resulting in a residual value when the lease ends. Financial professionals evaluating operating leases should pay particular attention to cancellation policies as the terms can impact the lease’s flexibility and financial implications.

Finance lease

Finance leases offer an alternative to traditional debt financing for purchasing assets. Under IFRS 16, lessees must record both the right of use of an asset and the corresponding lease payment obligations on their balance sheets, with limited exemptions for short-term and low-value leases. Meanwhile, US GAAP (ASC Topic 842) provides specific criteria for classifying a lease as a finance lease, including lease duration relative to asset life, ownership transfer provisions, bargain purchase options, payment present value and asset specialization.

The financial structure and accounting treatment of finance leases closely mirror those of long-term debt financing. Responsibilities typically associated with ownership are assumed by the lessee, including maintenance, taxes and insurance, and lease payments are calculated using the asset's residual value.

Under ASC Topic 842, finance leases must be recorded on the balance sheet, showing both the right-of-use (ROU) asset and the corresponding lease liability, similar to traditional loan agreements. This means that finance leases can effectively serve as a substitute for long-term debt financing, despite their different legal structure.

What does it mean to buy capital assets?

Buying a capital asset gives the company full ownership, as well as the responsibilities associated with it, such as maintenance, depreciation and disposal. The asset can be purchased with cash or with debt financing. While a company is making loan payments, the balance sheet would show both an asset and a liability, reflecting the full purchase price and outstanding loan balance.

The pros and cons of buying

The pros of buying a capital asset include the opportunity to build equity, have complete operational control, and gain potential tax advantages through interest deductions and depreciation. Additionally, companies can benefit from any appreciation in the asset's value and have the flexibility to modify or customize it to their needs. The absence of end-of-term negotiations or renewal concerns that accompany leases also provides greater long-term certainty.

There are also cons to this approach. It requires a larger upfront investment than leasing, which could strain cash reserves. If the purchase is made with debt financing, the company's borrowing capacity could be impacted. Additionally, companies assume all risks associated with ownership, including maintenance costs, obsolescence risk and potential market value fluctuations. Furthermore, the long-term commitment can negatively affect operational flexibility, especially for industries that change rapidly and require frequent updates.

While the arrangement is straightforward, the impact on financial ratios and debt covenants warrants consideration in the decision-making process.

The formula to help make your decision

Deciding whether to lease or buy involves weighing the present value of leasing costs against the present value of ownership costs. It’s important to remember that the cost of debt — not the weighted average cost of capital (WACC) — is used as the discount rate because debt financing represents a viable alternative to leasing.

At the end of the day, the goal is to choose the option that adds the most value to your company. This may mean taking the route that offers the lowest present value cost. Think of it as looking for the best deal.

Calculation example

• Cost of new piece of machinery: $50,000
• Time needed: 3 years
• Residual value: $20,000
• Interest rate on loan: 6% (annual interest payments required, plus a final principal repayment at the end of the three years)
• Marginal tax rate: 30%
• Depreciation:
• Year 1: $10,000
• Year 2: $16,000
• Year 3: $6,000
• Annual Maintenance: $5,000

Alternatively, the machine can be leased for $16,000/year for three years. The payment is due at the beginning of each year. There is no maintenance expense, and the machine is returned to the lessor at the end of the lease term.

To calculate the cost of owning the equipment, use the following:

NPV of owning at 6%: –$2600/(1+0.06)¹ + –$800/(1+0.06)² + –$34,400/(1+0.06)³ = –$32,048

To calculate the cost of leasing the equipment, use the following:

NPV of leasing at 6%: –$11,200/(1+0.06)¹ + –$11,200/(1+0.06)² + –$11,200/(1+0.06)³ = –$31,734

Since lease payments are made at the beginning of the year instead of the end, the first payment is made immediately, i.e., Year 0.

$32,048 – $31,734 = $314

Leasing the machine would save the company $314, as well as the time and effort involved in reselling the machine.

However, this calculation is not the only consideration when deciding whether to lease or buy. Additional internal teams, such as legal, tax and accounting, as well as possibly an external auditor, should be consulted to avoid making any adverse assumptions.

Operational and strategic considerations

The decision to lease or buy goes beyond examining the clear-cut costs of each option. Mario Vasquez, FPAC, Finance Executive and AFP Board Member, explained that in the over nine years he spent analyzing broadcast tower leases, he learned that “the real story lies beyond the numbers.”

In Vasquez’s case, signal coverage was paramount in his decision-making. By partnering with the engineering team, he was able to map signal strength and reach from each potential location. “A cheaper lease in a less advantageous spot could mean sacrificing valuable viewership,” he said.

Additionally, the company’s negotiation power with landlords played a significant role. “Concentrated leases with a single landlord originally limited our negotiating power,” he explained. Even when some individual location analyses determined that staying was the best decision, moving proved to be beneficial to the company’s strategic position.

The tower infrastructure itself also mattered to the decision. “Locations requiring us to perform tower work could quickly inflate expenses, making shared antenna options at new sites very attractive for cost control,” he said.

Ultimately, making the best lease vs. buy decision requires balancing financial, operational and strategic considerations.

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