A Lease To A Purchase

Lease, Custom Hire, Rent or Purchase Farm Machinery: Evaluating the Options Jeff Williams and Terry Kastens Revised September 1998 Presented at the Department of Agricultural Economics Risk and Profit Conference, Kansas State University, August 20-21, 1998. Jeff Williams is a Professor and Terry Kastens is an Assistant Professor and Crop and Farm Management Extension Specialist in the Department of Agricultural Economics, Kansas State University. Lease, Custom Hire, Rent or Purchase Farm Machinery: Evaluating the Options Introduction Machinery and equipment expense represents a major category of cost in crop production. A comparison of machinery costs to total crop costs on Kansas Farm Management Association crop farms indicates machinery costs range from 38.3 to 47.4 percent of total crop production costs (Langemeier and Taylor, 1997). Purchasing equipment with the use of loans from financial institutions or equipment manufacturers has been the typical method of obtaining machinery services for most farm operations. Producers are increasingly considering other options for obtaining machinery services due to increasing equipment costs, obsolescence of owned equipment and limited sources of outside debt capital. This paper focuses on how to evaluate the costs of alternative ways of obtaining machinery services. These include the traditional method of purchasing equipment, as well as leasing equipment, renting equipment, and obtaining machinery services from custom operators. A demonstration of the appropriate economic analysis that can be completed with the use of a spreadsheet is provided using a combine example. A method of estimating machinery costs over several time periods in current dollars is needed to compare the options of leasing, using custom hire services, renting machinery or purchasing equipment. To accurately evaluate the options, Net Present Value Analysis will be used. Net present value analysis procedures use discounted cash flows. This method is desirable because it accounts for the time value of money or opportunity cost of having funds tied up in capital items such as machinery. It also can incorporate the effects of all applicable income tax deductions, and market depreciation on the decision. The traditional DIRTI (annual depreciation, interest, fixed repairs, taxes, and insurance) formula used to calculate ownership costs for enterprise budgets and partial budgeting is not suitable because it can’t account for both income tax depreciation and market depreciation, income taxes, the time value of money, and the timing of cash flows for fixed and variable cost components, which can be different from option to option. Analysis of discounted cash flows can account for both components of machinery costs, housing, and the ownership or fixed costs which include depreciation, interest and insurance, and the variable costs which include labor, fuel, oil and repairs. The analysis method also includes the income tax consequences, which affect after tax costs of owning and operating machinery or obtaining machinery services by leasing, renting or hiring custom work. Procedures for estimating market value of machinery and repair costs are referred to as well. Net Present Cost or Discounted Cash Flows A comparison of the costs of alternative options for obtaining machinery services requires comparing costs over several years due to multiple year lease payments or loan payments and income tax consequences of the options. A problem exists in that $1,000 of cost today does not have the same value as $1,000 of cost 5 years from now. Discounting accounts for or adjusts for this problem. The basic concept of the discounted cash flow (net present cost) procedure is that a dollar received or paid today is worth more than a dollar to be received or paid sometime in the future because today’s dollar can be invested to generate earnings. Likewise, a $1,000 of cost 5 years from now is “cheaper” than 1 $1,000 of cost today. Delaying payment of a fixed dollar amount into the future reduces costs. Therefore, financing arrangements which have different payment requirements at different times affect today’s cost. In short, funds invested in machinery or other capital items have opportunity costs because they could be earning a return in another investment. Therefore, a discounting procedure is applied to the cash flows. This discounting procedure converts the cash flow which occurs over a period of future years into a single current value so that alternative options can be compared on the basis of a single value. For machinery, that single value is the net present cost of machinery services. Investing $1,000 today at a simple interest rate of 10% yields $1,100 at the end of one year. This can be calculated using the compounding formula presented in equation (1). (1) where: FV = PV = i= n= future value present value interest rate year for i = .10 and n = 1 $1,000 * (1.10)1 = $1,100 The compounding formula can be reversed to form the discounting formula, equation (2). (2) One should be indifferent about receiving $1,100 one year from now or $1,000 today because What is $1,000 received a year from today worth today? What is $1,000 received two years from today worth today? Today’s value of $1,000 received in the future depends upon when it is received and the discount factor (i). To illustrate the present value computation or discounting in more detail consider the example in Table 1. Assume a farm manager has agreed to pay $1,000 a year at the end of each year for the next five years for the use of his retired neighbor’s machine shop. 2 Table 1. Present Value of $1,000 Costs over Five Years using a Discount Rate of 10%. Year Cash Flow * Discount Factor = Present Value or Cost 1 $1,000 .909 $909 2 $1,000 .826 $826 3 $1,000 .751 $751 4 $1,000 .683 $683 5 $1,000 .621 $621 Total $3,7091 1 This calculation can be operationalized in most spreadsheets using the built in NPV function. NPV(Discount Rate, Beginning Cell:Ending Cell). The cell range is the cash flow over all years to be discounted. The total present value or cost of these services is actually $3,790 at the beginning of year 1 and not $5,000 because in each year the cost of $1,000 is valued less. Another way of looking at this is that $3,790 today invested at 10% per year is equal to $6,104 at the end of 5 years: $3790 * (1.10)5 = $6,104. This is equal to receiving $1,000 at the end of each year and investing the $1,000 each year at 10%. Year 1 $1,000 * (1.10)4 = Year 2 1,000 * (1.10)3 = Year 3 1,000 * (1.10)2 = Year 4 1,000 * (1.10)1 = Year 5 1,000 * (1.10)0 = Total = $1,464 1,330 1,210 1,100 1,000 $6,104 Conversely, the $6,104 at the end of year 5 is equal to $3,790 today. Choosing a Discount Rate An appropriate discount rate must be selected to reflect the time value of money. As illustrated, the discount rate is used to adjust future value of cash flow to the present. The higher the discount rate the smaller the present value. The discount rate chosen should reflect the minimum acceptable rate of return for an investment (Boehlje and Eidman 1988). If the investment is 100% financed with debt capital, then the minimum rate of return is the interest rate on the loan since the loan must be repaid. Because farms typically operate with both debt and equity, usually the objective is to evaluate investment alternatives based on the optimal long-run combination of debt and equity (Boehlje and Eidman 1988). To do this a long-run weighted cost of capital is used. The cost of debt funds and cost of equity funds must be weighted by the long-run proportion of borrowed funds and funds from equity. Therefore, the discount rate should be calculated as in equation (3). 3 (3) i = (% e * re) + (% d * rd) where: i = discount rate (weighted cost of capital) %e = percent funds used from equity re = return on equity %d = percent funds used from debt rd = interest rate on debt The rate of return to equity is the cash return from using the assets plus any return in the form of capital gain from holding the asset. Casler, Anderson, and Aplin (1984) state that the average cost of capital for a farm declines as debt funds are substituted for equity sources of capital up to a point. However, beyond the point which is the optimal proportion of debt to equity, or the firm’s lowest cost of capital, the use of additional debt raises the cost of capital. We are assuming that the firm is optimally financed such that cost of debt equals the return on equity. Normally, you should expect your rate of return on equity to be at least equal to your cost of debt in the long-run or you will continue to make debt payments from returns on equity or equity. Historical data indicate that long-run returns to equity are marginally greater than debt costs. For our purposes we will assume that in the long-run re and rd in equation (3) are equivalent. That is, little harm is done if machinery decisions are made using a discount rate set equal to the typical interest rate on the machinery loan or farm loans. The discount rate must also be adjusted to an after tax to account for the impact of interest deduction on after tax interest costs or taxes on a rate of return used to calculate the discount rate. The after tax discount rate can be determined using equation (4). (4) r = i * (1 - MTR), where: r = i = MTR = after tax discount rate before tax discount rate marginal tax rate The marginal tax rate is the sum of the marginal federal income tax rate, state income tax rate, and self employment tax rate. Most producers who are married and file a joint return are in either the 15% (taxable income up to $42,350 in 1998) or 28% federal income tax bracket. The Kansas marginal income tax rate for these producers would be approximately 5-6%. The self employment tax rate is 15.3% up to $68,000 in income in 1998. Therefore, the marginal tax rate for a producer in the 15% federal income tax bracket would be approximately 35-36%. Defining the Options We define four options for obtaining machinery services: 1) lease, 2) custom hire, 3) rental arrangement, or 4) purchase. These options may mean different things to different managers; there are no standard definitions in the industry. Therefore, it is important that we define what we consider to be the specific characteristics of each option because analysis of each requires somewhat different data and is treated differently for tax purposes. Additional discussion of similar alternatives can also be 4 found in Hinman and Willett (1991). Lease. We define a lease as a long term contract. These contracts normally are for 3 to 5 years. The machinery dealer essentially provides financing for machinery services to the person leasing the machine, but retains ownership. This form of a lease is not what some refer to as an operating lease. The farm manager leasing the equipment is responsible for insurance payments, taxes, and repairs not covered by warranty just as if the equipment had been purchased. The responsibilities for operating costs including maintenance fall on the farm manager just as they would if the machine had been purchased. The manager provides the labor for operating the machinery. The main differences are that the financing is done with specified lease payments instead of a loan and the title to the equipment remains with the equipment dealer. At the end of the lease the equipment is owned by the equipment dealer and not the farm manager. This type of lease generally may not be canceled without penalty. Rent. This option involves the use of a short term contract which is based upon a short time period such as a few days, or a harvest period such as a few weeks or a few months. The farm manager rents the machinery by the hour, day, week, month or other arrangement. The owner of the equipment is responsible for all ownership costs including insurance, taxes, and major repairs. The farm manager pays for variable expenses such as labor, fuel, oil, and routine maintenance. This type of an arrangement may occasionally be referred to as an operating lease. Custom Hire. This option is also a short term agreement, but the fees are normally for a specific amount of work to be done. Fees may be based on the number of acres covered or bushels per acre harvested. Generally, a custom operator provides the machinery, machine operator, and pays for all ownership and operating costs. Purchase. This option is the traditional method where the farm manager buys a machine from a dealer with the use of equity and or a loan from the dealer or financial institution. Ownership of the machine is transferred to the farm manager who is responsible for making loan payments, insurance payments, taxes, and repairs not covered by warranty. The owner also provides the labor or hires it and pays for all variable or operating cost such as fuel, lubricants and routine maintenance. Costs, Income Tax Implications and other Characteristics of the Options Table 2 displays the characteristics and income tax implications that must be considered in evaluating the options. Several are discussed briefly. Leasing, renting or custom hiring machinery services generally does not require a down payment. A lease or rental agreement may require a refundable or non-refundable deposit. A lease or rental agreement will likely call for payments at the beginning of the lease or rental period. Custom hiring specialty operations, or operations which you require the least frequently, may be a way of avoiding large ownership costs for equipment used infrequently. Farm managers who lease equipment incur the same variable costs as those who purchase equipment, such as labor, fuel, and repair costs. They generally incur the same insurance and housing costs. However, the operators who 5 rent or custom hire the equipment may not pay all variable costs or taxes, insurance, and housing costs. In the case of purchasing custom hire services they “pay” none. These differences are important to recognize in the analysis of the options. However, the manager should keep in mind that the costs of operating and maintaining the equipment are paid in one form or another (actual costs are often near custom rates). So, if the analysis indicates one alternative is dramatically less expensive, the analysis should be reviewed to be sure some costs were not overlooked. Differences in overall costs may vary due to the risk associated with the options. Tax treatment or income tax deductions vary by option. In a true lease agreement the entire lease payment is deductible. A lease deposit is also deductible, but the deduction must be amortized (spread over) the life of the lease. Depreciation and interest deductions are not used. Custom hire and rental payments are fully deductible just as are other operating costs. With a purchase the machinery is set up on a depreciation schedule and depreciation deductions used. If the machine is financed with a loan the interest component of a payment is also deductible. In addition, you can expense up to $18,500 of section 179 property on 1998 federal income tax returns. If this expensing option has not been used up by other capital purchases this can be deducted in the first year of ownership. It can be claimed only during the first year of ownership. The limit on section 179 property expensing increases to $25,000 by 2003. Variable costs of any of the options such as labor, fuel, and repairs as well as insurance payments are tax deductible. Custom hire and rental options offer substantial flexibility, but also offer the farm manager the least amount of control of the machinery. Ownership offers the most control because all decisions are made by the owner. For example, one important disadvantage to custom hiring or short term rental of machinery is it may not be available for use at the optimal time it is needed. On the other hand, machinery owners who lack sufficient operating labor may view custom hire as providing increased flexibility. 6 Table 2. Characteristics of Lease, Custom Hire, Purchase or Rent Options. Characteristics Lease Custom Hire Rent Costs Down Payment/Deposit Labor Fuel/Oil Maintenance Major Repairs Insurance Housing Property Taxes Income Tax Deductions Depreciation Deduction Section 179 Expensing Interest Deduction Variable Cost Deduction Lease Payment Deduction Rent Payment Deduction Custom Fee Deduction Purchase Yes/Smaller Y Y Y Y/Warranty Y Y Y if applies ? N N N N N N N Yes/Smaller Y Y ? N N N N Yes/Larger Y Y Y Y/Warranty Y Y Y if applies N N N Y Y --- N N N None --Y N N N Y -Y -- Y Y Y Y ---- Other Long Term Agreement Y N N Control Most Least Limited Availability Readily For typical operations Limited Risk of Obsolescence Limited None None Y indicates yes or in the case of costs that are the responsibility of the farm manager. N indicates no or in the case of costs that are not the responsibility of the farm manager. Y Most Readily Most The Procedure The following outlines the general calculation of costs that are made to evaluate the four options. Detailed equations are presented in the Technical Appendix. Hinman and Willett (1991) provide an alternative procedure and software that will yield equivalent results. Lease + + + Lease Deposit Lease Payment Deposit Deduction Effect Lease Payment Deduction Effect After Tax Variable Costs 7 + = After Tax Taxes, Insurance, and Housing Costs After Tax Cash Flow Custom Hire + Custom Hire Fees Custom Hire Fee Deduction Effect = After Tax Cash Flow Rent + + + = Purchase + + + + + = Rent Payments Rent Payment Deduction Effect After Tax Variable Costs After Tax Taxes, Insurance, and Housing Costs After Tax Cash Flow Down Payment Loan Payment Depreciation Deduction Effect Interest Deduction Effect After Tax Variable Cost After Tax Taxes, Insurance, and Housing Costs Salvage Value Balancing Charge (Depreciation Recapture) After Tax Cash Flow The meaning of some of these variables such as the lease payment, loan payment, rental fee, custom hire charge and salvage value are straight forward. Others require further explanation which are presented below. Deposit Deduction Effect = (Deposit/Length of Lease in Years) * Marginal Tax Rate (MTR) Lease Payment Deduction Effect = Lease Payments * MTR After Tax Variable Costs = Variable Costs * (1 - MTR) After Tax Fixed Costs = Fixed Costs * (1 - MTR) Custom Hire Fee Deduction Effect = Custom Hire Fees * MTR Rental Fee Deduction Effect = Rental Fees * MTR Depreciation Deduction Effect = Depreciation * MTR Interest Deduction Effect = Interest Payment * MTR Balancing Charge = (Salvage Value - Book Value) * (MTR - Self Employment Tax Rate) Some additional explanation of those variables labeled Deduction Effect is also necessary. The deduction effect is the amount by which the deduction reduces costs on an after tax basis. After Tax Cost = Before Tax Cost * (1 - MTR) After Tax Cost = Before Tax Cost - Deduction Effect 8 Setting the two equal to each of other and solving for the Deduction Effect results in the following. Before Tax Cost * (1 - MTR) = Before Tax Cost - Deduction Effect Deduction Effect = Before Tax Cost * MTR Although repair and maintenance cost estimates and an estimate of salvage value are important for the analysis, it is not the intent of this paper to discuss the alternatives for determining these values. Kastens (1997) provides a detailed review of procedures and examples for calculating repair costs and salvage values. An Example An example of leasing, custom hiring, renting or purchasing a combine is used to demonstrate how the options are evaluated (Table 3). The combine is assumed to be operated in years 1 through 5. Values shown in year 0 are considered to take place at the end of year 0 or at the beginning of year 1. The values used for the evaluation are presented below. Annual Lease Payment Lease Deposit Length of Lease (years) Custom Hire Charge ($/acre) Acres Custom Hire Inflation Rental Charge ($/hour) Hours to harvest 1,000 acres Rental Rate Inflation (%/year) Purchase Price Down Payment Depreciable Basis Salvage Value at end of 5 years Interest Rate of Loan Length of Loan (years) Loan Payment ($/year) Marginal Income Tax Rate After Tax Interest Rate on Loan Annual Fuel, Oil, and Labor Inflation Rate $23,152 $0 5 $17.82 1,000 3% $160 135 3% $140,000 $19,331 $140,000 $77,638 9.65% 5 $31,548 35% 6.27% [(1-.35) * 9.65%] 3% The values for repairs, labor, fuel, and oil are found directly in the example because they are different each year. Labor, fuel, and oil costs total $4.36/acre in the first year. Operating costs are equivalent for the lease and the purchase. These costs are somewhat smaller in the rental example because all repairs are assumed to be made by the owner and not the manager who is renting the equipment. There are no operating expenses in addition to the custom hire charge. Depreciation for tax purposes is based upon the MACRS 150% double declining balance for 7 year property. 9 Table 3. NPV of Cashflows Calculations for Lease Custom Hire Rent and Purchase. Lease Lease Deposit or Deposit Payment After Tax After Tax Lease Deduction Deduction Variable Taxes, Insurance Year Payment Effect Effect Costs Housing Deposit 0 $0.00 0 $23,152.00 1 $23,152.00 $0.00 $8,103.20 $2,889.66 $0.00 2 $23,152.00 $0.00 $8,103.20 $3,107.94 $0.00 3 $23,152.00 $0.00 $8,103.20 $3,349.41 $0.00 4 $23,152.00 $0.00 $8,103.20 $3,611.00 $0.00 5 $0.00 $8,103.20 $3,892.18 $0.00 + + + After Tax Cashflow $0.00 $23,152.00 $17,938.46 $18,156.74 $18,398.21 $18,659.80 ($4,211.02) Present Value >>> $82,960.02 Custom Hire Year 0 1 2 3 4 5 Custom Fee Payment $17,815.00 $18,349.45 $18,899.93 $19,466.93 $20,050.94 + Custom Fee Deduction Effect $6,235.25 $6,422.31 $6,614.98 $6,813.43 $7,017.83 Present Value >>> $51,227.80 After Tax Cashflow $0.00 $11,579.75 $11,927.14 $12,284.96 $12,653.51 $13,033.11 10 Table 3. NPV of Cashflows Calculations for Lease Custom Hire Rent and Purchase (continued). Rent Rent Fee After Tax After Tax Rent Deduction Variable Taxes, Insurance Year Payment Effect Costs Housing 0 $21,600.00 1 $22,248.00 $7,560.00 $2,834.00 $0.00 2 $22,915.44 $7,786.80 $2,919.02 $0.00 3 $23,602.90 $8,020.40 $3,006.59 $0.00 4 $24,310.99 $8,261.02 $3,096.79 $0.00 5 $0.00 $8,508.85 $3,189.69 $0.00 + + + After Tax Cashflow $21,600.00 $17,522.00 $18,047.66 $18,589.09 $19,146.76 ($5,319.15) Present Value >>> $80,642.88 Purchase Down Payment or Loan Payment $19,331.00 $31,548.06 $31,548.06 $31,548.06 $31,548.06 $31,548.06 + Depreciation Deduction Effect $5,247.90 $9,373.70 $7,364.70 $6,002.50 $6,002.50 Interest Deduction $4,075.60 $3,403.35 $2,666.24 $1,858.00 $971.76 After Tax Variable Costs $2,889.66 $3,107.94 $3,349.41 $3,611.00 $3,892.18 + After Tax Taxes, Insurance Housing $0.00 $0.00 $0.00 $0.00 $0.00 + Salvage Value Balancing Charge After Tax Cashflow $19,331.00 $25,114.22 $21,878.94 $24,866.52 $27,298.55 ($42,220.82) $73,308.24 Year 0 1 2 3 4 5 $77,638.00 $6,951.20 + Present Value >>> 11 Table 4: Summary of Example Results. Lease Custom Hire Rent Purchase Net Present Cost $82,960.02 $51,227.80 $80,642.88 $73,308.34 Annualized $19,840.63 $12,251.59 $19,286.47 $17,532.32 A summary of the results of the analysis is presented in Table 4. The column labeled Net Present Cost is the present value of the total after tax costs over the period of analysis for each option. This example indicates that custom hire is the least costly, followed by the purchase alternative, rent alternative, and lease alternative. The second column reports the annualized costs. These values represent the average cost incurred in each year of the analysis (years of machinery services) which is equal to the Net Present Cost. This is an average annual cost adjusted for the time value of money. The amortized value is calculated using equation (5). (5) where: N = total years in analysis (length of ownership) r = discount rate PV = present value Most spreadsheet software have a built in function to calculate the amortized value which is usually called PMT which takes the form PMT(r, N, PV). One assumption made in the analysis is that the lease payment deduction occurs one year after the initial lease payment. The deduction for depreciation and interest occurs much closer to the time of actual payment because loan payments are made at the end of the period, but lease payments are normally made at the beginning of the period. If we make the simplifying assumption that the difference in time between the lease payments and the lease payment deduction, and the loan payments and the interest and depreciation deductions associated with a purchase does not matter, then the after tax lease payment (Lease Payment * (1 - MTR)) could be directly compared to the annualized purchase cost. This would be similar to assuming the lease payment was made at the end of the period. In this case, the annual after tax cost of the lease is $15,048 or [$23,153 * (1 - .35)]. The loan payment for the purchase cannot be treated in such a straight forward manner for comparison. The after tax annualized value of the purchase must be calculated. Table 5 presents the net present cost of the purchase without operating costs, taxes, insurance, and housing costs. This assumes there is no difference between operating costs, taxes, insurance, and housing costs of the two alternatives which in most cases will be true. The net present cost of $59,344.21 is then annualized using equation (5) as demonstrated below. The $14,189 after tax annualize cost of the purchase is slightly less than the annual cost of the lease of $15,048. This comparison cannot be made for other alternatives without similar assumptions and, therefore, will only be feasible for comparing a lease to a purchase option. 12 Table 5. NPV of Cashflow Calculation for Purchase without Variable Costs. Down Payment or Depreciation Interest After Tax Loan Deduction Deduction Variable Year Payment Effect Effect Costs 0 1 2 3 4 5 $19,331.00 $31,548.06 $31,548.06 $31,548.06 $31,548.06 $31,548.06 + $5,247.90 $9,373.70 $7,364.70 $6,002.50 $6,002.50 $4,075.60 $3,403.35 $2,666.24 $1,858.00 $971.76 $0.00 $0.00 $0.00 $0.00 $0.00 + + After Tax Taxes, Insurance Housing $0.00 $0.00 $0.00 $0.00 $0.00 Salvage Value Balancing Charge After Tax Cashflow $19,331.00 $22,224.56 $18,771.00 $21,517.12 $23,687.56 ($46,113.00) $59,344.21 $77,638.00 $6,951.20 + Present Value >>> 13 When is a Lease not a Lease? If a lease is actually a conditional sales contract it must be treated as a purchase. Depreciation and interest deductions must be used for tax purposes rather than the “lease” payments. The cost of the equipment for depreciation is determined by calculating the present value of lease payments and the option price at the end of the lease. This could be to the disadvantage of the “purchaser.” The Internal Revenue Service says a lease agreement should be treated as a conditional sales contract if any of the following is true. (IRS, 1997) 1. The agreement applies part of each payment toward an equity interest you will receive. 2. You receive title to the property after you pay a stated amount of required payments. 3. You must pay, over a short period of time, an amount that represents a large part of the price you would pay to buy the property. 4. You pay much more than the current fair rental value of the property. 5. You have an option to buy the property at a small price compared to the value of the property at the time you can exercise the option. Determine this value at the time you enter into the agreement. 6. You have an option to buy the property at a small price compared to the total amount you pay under the lease. 7. The lease designates some part of the payment as interest or part of the payments are easily recognizable as interest. An example of a lease and a buyout at the end of the lease with the use of a loan is provided in Table 6. The basic information in this example is the same as that used in the previous example. The major exceptions are that the length of “ownership” is for 10 years instead of 5 and a 5 year loan is used to buy the leased machine at the end of year 5 (beginning of year 6) for the salvage value. For simplicity, the operating costs, taxes, insurance, and housing costs are assumed to be equal and left out of the analysis. For the first 5 years the analysis treats the cash flow like a lease and treats the second 5 year period like a purchase. An outright purchase using a 5 year loan with the intention of owning the machine for 10 years is used for comparison. In addition, a Conditional Sales Contract or Capital Lease Analysis is provided for comparison. Under a conditional sales contract or capital lease the general approach to calculation of the costs are outlined below. Conditional Sales Contract or Capital Lease + Lease Deposit + Lease Payment Depreciation Deduction Effect Interest Deduction Effect + After Tax Variable Cost + After Tax Taxes, Insurance, and Housing Costs Salvage Value + Balancing Charge (Depreciation Recapture) = After Tax Cash Flow 14 Table 6. Analysis of Lease/Buyout, Capital Lease, and Purchase. Lease Lease/Buyout Lease Deposit or Deposit Payment After Tax Lease Deduction Deduction Variable Year Payment Effect Effect Costs 0 $0.00 0 $23,152.00 1 $23,152.00 $0.00 $8,103.20 $0.00 2 $23,152.00 $0.00 $8,103.20 $0.00 3 $23,152.00 $0.00 $8,103.20 $0.00 4 $23,152.00 $0.00 $8,103.20 $0.00 5 $0.00 $0.00 $8,103.20 $0.00 + + After Tax Taxes, Insurance Housing $0.00 $0.00 $0.00 $0.00 $0.00 + Lease Present Value >>> After Tax Cashflow $0.00 $23,152.00 $15,048.80 $15,048.80 $15,048.80 $15,048.80 ($8,103.20) $68,996.00 Buyout Lease/Buyout Down Payment or Loan Year Payment 0 0 0 0 0 $16,089.20 6 $16,825.63 7 $16,825.63 8 $16,825.63 9 $16,825.63 10 $16,825.63 + Total Lease/Buyout Depreciation Deduction Effect Interest Deduction Effect After Tax Variable Costs After Tax Taxes, Insurance Housing Salvage Value Balancing Charge $3,015.52 $5,386.26 $4,231.86 $3,449.12 $3,449.12 - $2,173.65 $1,815.12 $1,422.00 $990.93 $518.27 + $0.00 $0.00 $0.00 $0.00 $0.00 + $0.00 $0.00 $0.00 $0.00 $0.00 Buyout Lease/Buyout $53,686.00 $5,809.08 Present Value >>> Present Value >>> After Tax Cashflow $0.00 $0.00 $0.00 $0.00 $0.00 $11,636.46 $9,624.25 $11,171.77 $12,385.58 ($35,018.69) $9,336.28 $78,332.27 15 Table 6. Analysis of Lease/Buyout, Capital Lease and Purchase (continued). Capital Lease - Must find present value of lease payments and treat as interest and depreciation deductions instead of lease deductions. Deposit or Lease After Tax Payment or After Tax Taxes, Insurance Option Depreciation Interest Variable Housing Salvage Balancing Year Payment Deduction Deduction Costs Value Charge 0 $0.00 0 $23,152.00 1 $23,152.00 $5,542.28 $4,211.78 $0.00 $0.00 2 $23,152.00 $9,899.51 $3,836.26 $0.00 $0.00 3 $23,152.00 $7,777.82 $3,424.50 $0.00 $0.00 4 $23,152.00 $6,339.20 $2,973.01 $0.00 $0.00 5 $16,089.20 $6,339.20 $2,477.94 $0.00 $0.00 6 $16,825.63 $6,339.20 $2,173.65 $0.00 $0.00 7 $16,825.63 $6,339.20 $1,815.12 $0.00 $0.00 8 $16,825.63 $3,172.19 $1,422.00 $0.00 $0.00 9 $16,825.63 $0.00 $990.93 $0.00 $0.00 10 $16,825.63 $0.00 $518.27 $0.00 $0.00 $53,686.00 $10,737.20 + + + + Present Value >>> After Tax Cashflow $0.00 $23,152.00 $13,397.94 $9,416.23 $11,949.68 $13,839.79 $7,272.05 $8,312.78 $8,671.30 $12,231.45 $15,834.70 ($26,641.44) $83,880.06 16 Table 6. Analysis of Lease/Buyout, Capital Lease and Purchase (continued). Purchase Down Payment or Depreciation Interest After Tax After Tax Loan Deduction Deduction Variable Taxes, Insurance Year Payment Effect Effect Costs Housing 0 $19,331.00 1 $31,548.06 $5,247.90 $4,075.60 $0.00 $0.00 2 $31,548.06 $9,373.70 $3,403.35 $0.00 $0.00 3 $31,548.06 $7,364.70 $2,666.24 $0.00 $0.00 4 $31,548.06 $6,002.50 $1,858.00 $0.00 $0.00 5 $31,548.06 $6,002.50 $971.76 $0.00 $0.00 6 $0.00 $6,002.50 $0.00 $0.00 $0.00 7 $0.00 $6,002.50 $0.00 $0.00 $0.00 8 $0.00 $3,003.70 $0.00 $0.00 $0.00 9 $0.00 $0.00 $0.00 $0.00 $0.00 10 $0.00 $0.00 $0.00 $0.00 $0.00 + + + Salvage Value Balancing Charge After Tax Cashflow $19,331.00 $22,224.56 $18,771.00 $21,517.12 $23,687.56 $24,573.80 ($6,002.50) ($6,002.50) ($3,003.70) $0.00 ($42,948.80) $53,686.00 $10,737.20 + Present Value >>> $78,183.28 17 Table 7. Summary of Lease/Buyout, Capital Lease and Purchase. Net Present Cost Lease/Buyout $78,332.27 Capital Lease $83,880.06 Purchase $78,183.28 Annualized $10,780.67 $11,544.20 $10,760.17 In the example, the purchase is slightly less expensive than a capital lease or the lease with a buyout at the end. It would be appropriate to consult your tax advisor before entering into a lease agreement. The Spreadsheet A spreadsheet is available for a charge of $5.00 which is designed to perform the calculations presented in this paper. The spreadsheet file is LCRPOPT.XLS. The spreadsheet has 5 worksheets. A brief description of each is listed below. Sheet A Sheet B Sheet C Sheet D Sheet E Contains basic data for the net present cost calculations. Illustrates the annual costs and compares the net present cost and annualized cost of the options. Supplementary worksheet calculates repairs, salvage value and net present cost and annualized cost of owning a machine different lengths of time. Supplementary worksheet for estimating salvage value of a machine based on accumulated hours of use. Supplementary worksheet calculates repair and maintenance costs of a machine. The example in the spreadsheet matches the example presented in the paper. The spreadsheet is setup for a five year analysis. It would need to be modified for a shorter or longer analysis. A file called LEABOUT.XLS is also included. This spreadsheet illustrates the Lease/Buyout and Conditional Sales Contract or Capital Lease example. This software is provided on an “as is” basis, without warranty. Kansas State University and the authors of this software will have no liability or responsibility to the cooperator or any other person or entity with respect to any liability, loss, or damage caused, or alleged to be caused, directly or indirectly by programs sold or given away by Kansas State University or the authors. This includes, but is not limited to, any interruption of service, loss of business or anticipatory profits, or consequential damages resulting from user or operation, and in no event will Kansas State University or the authors be liable for loss of profits or indirect, special, or consequential damages arising from the use of the software provided by Kansas State University or the authors. The software is provided without technical support. 18 References Boehlje, Michael D. and Vernon R. Eidman. 1984. Farm Management. John Wiley and Sons, Inc. New York, NY. Casler, George L., Bruce L. Anderson, and Richard D. Aplin. 1984. Capital Investment Analysis: Using Discounted Cash Flows. 3rd Edition. Grid Publishing, Inc., Columbus, Ohio. Hinman, Herbert R. and Gayle S. Willett. 1991. BUY OR LEASE: A Microcomputer Program to Analyze the Economics of Alternative Methods of Financing Farm Machinery.” MCP 0015. Washington State University, Cooperative Extension Service. December. Information for ordering this software is available at http://farm.mngt.wsu.edu/software.htm Internal Revenue Service. 1997. Farmer’s Tax Guide. Publication 225. Department of Treasury. Washington, D.C. Kastens, Terry. 1997. “Farm Machinery Operation Cost Calculations.” MF-2244. Kansas State University, Agricultural Experiment Station and Cooperative Extension Service, May. Kastens, Terry. 1997. Machinery Costs: Economics of Size and Selected Topics. Kastens, Terry. 1997. Machinery Costs: Selected Topics Presented at the School of Rural Banking, Wichita, KS, June 4. Langemeier, Larry N. and Randal K. Taylor. 1997. “A Look at Machinery Cost.” KSU Farm Management Guide MF-842. Kansas State University, Agricultural Experiment Station and Cooperative Extension Service. October. Langemeier, Larry N. and Kim Witt. 1991. “Crop Machinery Investment, Repair and Fuel-Oil Requirement for Irrigated and Dryland Crops in Kansas.” Report of Progress 613. Kansas State University, Agricultural Experiment Station and Cooperative Extension Service. December. Lee, Warren F., Michael D. Boehlje, Aaron G. Nelson, and William G. Murray. 1988 Agricultural Finance. Iowa State University Press. Ames, Iowa. 19 Technical Appendix Equations for Calculation of Net Present Value of After Tax Cash Flows Purchase (Refer to equation (A5) for an alternative method) (A1) NPC t i k N DP0 LPk VCk FCk Dk Ik SVN BCN ts = = = = = = = = = = = = = = net present cost of cash flows marginal income tax rate (federal + state + self employment) after tax discount rate, i = loan rate * (1 - t) 1 to N periods (years) terminal year down payment in period 0 loan payment variable costs (labor, fuel, repairs) taxes, insurance, housing costs depreciation deduction interest deduction market salvage value balancing charge = depreciation recapture = (market salvage - book value) marginal income tax rate minus self employment tax rate (t - self employment tax rate) Reflects the amount that the depreciation deduction reduces after tax costs. Reflects the amount that the interest deduction reduces after tax costs. 20 Reflects the after tax variable costs. Reflects the after tax fixed costs. Reflects cash from re-sale. Reflects recapture of depreciation due to re-sale value above book value. Lease (A2) (Refer to note on next page about the above two terms.*) DEP0 = LPYk = Rent (A3) lease deposit (cost must be deducted over life of lease) lease payment (Refer to note below about the above two terms.*) 21 RP Custom Hire (A4) = rental payment CH = custom hire charge * Notice the authors have not collapsed the lease and rental payments to because of the longer delay in getting the tax credit for lease, and rental payments compared to using depreciation and interest deduction with a loan or the custom hire cost deduction. We are assuming an estimate of lease and rent charges are paid up front and the custom hire payments are made at harvest and the loan payments including interest are made at the end of the year so the credits come closer to the actual payments than the lease and rental payments. Purchase Alternative (A5) NPC t i k N C0 DP0 LPk VCk FCk Dk Ik = = = = = = = = = = = = net present cost of cash flows marginal income tax rate (federal + state + self employment) after tax discount rate, i = loan rate * (1 - t) 1 to N periods (years) terminal year purchase cost down payment in period 0 loan payment variable costs (labor, fuel, repairs) taxes, insurance, housing costs depreciation deduction interest deduction 22 SVN = BCN = ts = Note: market salvage value balancing charge = depreciation recapture = (market salvage - book value) marginal income tax rate minus self employment tax rate (t - self employment tax rate) is replaced by C0. is removed. Equation (A5) could replace equation (A1) because the result is equivalent. However, including the loan payments and the interest deduction in the analysis may be easier to understand. 23