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A Lease To A Purchase

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					                               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 =    future value
                        PV =    present value
                          i=    interest rate
                          n=    year

        $1,000 * (1.10)1 = $1,100       for i = .10 and n = 1

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 =      $1,464
Year 2 1,000 * (1.10)3 =        1,330
Year 3 1,000 * (1.10)2 =        1,210
Year 4 1,000 * (1.10)1 =        1,100
Year 5 1,000 * (1.10)0 =        1,000
Total                    =      $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 =        after tax discount rate
                      i =        before tax discount rate
                  MTR =          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                 Purchase

 Costs
 Down Payment/Deposit            Yes/Smaller                ?               Yes/Smaller        Yes/Larger
 Labor                                Y                     N                   Y                   Y
 Fuel/Oil                             Y                     N                   Y                   Y
 Maintenance                          Y                     N                    ?                  Y
 Major Repairs                   Y/Warranty                 N                   N              Y/Warranty
 Insurance                            Y                     N                   N                   Y
 Housing                              Y                     N                   N                   Y
 Property Taxes                  Y if applies               N                   N              Y if applies

 Income Tax Deductions
 Depreciation Deduction                N                   N                     N                 Y
 Section 179 Expensing                 N                   N                     N                 Y
 Interest Deduction                    N                   N                     N                 Y
 Variable Cost Deduction               Y                  None                   Y                 Y
 Lease Payment Deduction               Y                   --                    --                --
 Rent Payment Deduction                --                  --                    Y                 --
 Custom Fee Deduction                  --                  Y                     --                --

 Other
 Long Term Agreement                   Y                     N                     N               Y
 Control                             Most                   Least                Limited          Most
 Availability                       Readily        For typical operations        Limited         Readily
 Risk of Obsolescence               Limited                 None                  None            Most
 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.


                                             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
       +       Rent Payments
       -       Rent Payment Deduction Effect
       +       After Tax Variable Costs
       +       After Tax Taxes, Insurance, and Housing Costs
       =       After Tax Cash Flow

Purchase
      +        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                                    $23,152
 Lease Deposit                                                $0
 Length of Lease (years)                                       5
 Custom Hire Charge ($/acre)                              $17.82
 Acres                                                     1,000
 Custom Hire Inflation                                       3%
 Rental Charge ($/hour)                                     $160
 Hours to harvest 1,000 acres                                135
 Rental Rate Inflation (%/year)                              3%
 Purchase Price                                         $140,000
 Down Payment                                            $19,331
 Depreciable Basis                                      $140,000
 Salvage Value at end of 5 years                         $77,638
 Interest Rate of Loan                                    9.65%
 Length of Loan (years)                                        5
 Loan Payment ($/year)                                   $31,548
 Marginal Income Tax Rate                                   35%
 After Tax Interest Rate on Loan                          6.27% [(1-.35) * 9.65%]
 Annual Fuel, Oil, and Labor Inflation Rate                  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                       After Tax
          Year     Payment          Effect           Effect        Costs          Housing                            Cashflow
Deposit    0           $0.00                                                                                            $0.00
           0     $23,152.00                                                                                        $23,152.00
           1     $23,152.00           $0.00       $8,103.20     $2,889.66          $0.00                           $17,938.46
           2     $23,152.00           $0.00       $8,103.20     $3,107.94          $0.00                           $18,156.74
           3     $23,152.00           $0.00       $8,103.20     $3,349.41          $0.00                           $18,398.21
           4     $23,152.00           $0.00       $8,103.20     $3,611.00          $0.00                           $18,659.80
           5                          $0.00       $8,103.20     $3,892.18          $0.00                           ($4,211.02)
                 +             -                -               +            +
                                                                                                 Present Value >>> $82,960.02


Custom Hire
                                    Custom Fee
                  Custom Fee         Deduction                                                                      After Tax
          Year     Payment            Effect                                                                         Cashflow
           0                                                                                                            $0.00
           1     $17,815.00         $6,235.25                                                                      $11,579.75
           2     $18,349.45         $6,422.31                                                                      $11,927.14
           3     $18,899.93         $6,614.98                                                                      $12,284.96
           4     $19,466.93         $6,813.43                                                                      $12,653.51
           5     $20,050.94         $7,017.83                                                                      $13,033.11
                 +              -
                                                                                                 Present Value >>> $51,227.80




                                                                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                          After Tax
          Year     Payment          Effect                         Costs          Housing                               Cashflow
           0     $21,600.00                                                                                           $21,600.00
           1     $22,248.00      $7,560.00                      $2,834.00           $0.00                             $17,522.00
           2     $22,915.44      $7,786.80                      $2,919.02           $0.00                             $18,047.66
           3     $23,602.90      $8,020.40                      $3,006.59           $0.00                             $18,589.09
           4     $24,310.99      $8,261.02                      $3,096.79           $0.00                             $19,146.76
           5           $0.00     $8,508.85                      $3,189.69           $0.00                             ($5,319.15)
                 +             -                                +            +
                                                                                                    Present Value >>> $80,642.88



Purchase
                 Down                                                       After Tax
               Payment or     Depreciation                  After Tax         Taxes,
                  Loan         Deduction       Interest     Variable        Insurance     Salvage       Balancing     After Tax
       Year     Payment         Effect        Deduction      Costs           Housing       Value         Charge       Cashflow
        0     $19,331.00                                                                                             $19,331.00
        1     $31,548.06         $5,247.90   $4,075.60      $2,889.66        $0.00                                   $25,114.22
        2     $31,548.06         $9,373.70   $3,403.35      $3,107.94        $0.00                                   $21,878.94
        3     $31,548.06         $7,364.70   $2,666.24      $3,349.41        $0.00                                   $24,866.52
        4     $31,548.06         $6,002.50   $1,858.00      $3,611.00        $0.00                                   $27,298.55
        5     $31,548.06         $6,002.50     $971.76      $3,892.18        $0.00      $77,638.00 $6,951.20        ($42,220.82)
              +              -               -             +            +               -            +
                                                                                                Present Value >>>    $73,308.24




                                                                11
 Table 4: Summary of Example Results.
                                             Net Present Cost                       Annualized
 Lease                                         $82,960.02                           $19,840.63
 Custom Hire                                   $51,227.80                           $12,251.59
 Rent                                          $80,642.88                           $19,286.47
 Purchase                                      $73,308.34                           $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                                                           After Tax
               Payment or Depreciation          Interest     After Tax            Taxes,
                  Loan        Deduction        Deduction      Variable          Insurance    Salvage     Balancing     After Tax
         Year   Payment          Effect          Effect        Costs             Housing      Value       Charge       Cashflow

          0     $19,331.00                                                                                            $19,331.00
          1     $31,548.06        $5,247.90   $4,075.60          $0.00             $0.00                              $22,224.56
          2     $31,548.06        $9,373.70   $3,403.35          $0.00             $0.00                              $18,771.00
          3     $31,548.06        $7,364.70   $2,666.24          $0.00             $0.00                              $21,517.12
          4     $31,548.06        $6,002.50    $1,858.00         $0.00             $0.00                              $23,687.56
          5     $31,548.06        $6,002.50      $971.76         $0.00             $0.00    $77,638.00    $6,951.20   ($46,113.00)
                +             -               -              +              +               -           +
                                                                                                  Present Value >>>   $59,344.21




                                                                 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          After Tax
             Lease         Deduction        Deduction       Variable        Taxes, Insurance                                     After Tax
 Year       Payment          Effect           Effect         Costs              Housing                                          Cashflow
   0            $0.00                                                                                                                  $0.00
   0       $23,152.00                                                                                                            $23,152.00
   1       $23,152.00        $0.00          $8,103.20         $0.00              $0.00                                           $15,048.80
   2       $23,152.00        $0.00          $8,103.20         $0.00              $0.00                                           $15,048.80
   3       $23,152.00        $0.00          $8,103.20         $0.00              $0.00                                           $15,048.80
   4       $23,152.00        $0.00          $8,103.20         $0.00              $0.00                                           $15,048.80
   5            $0.00        $0.00          $8,103.20         $0.00              $0.00                                            ($8,103.20)
          +              -                -               +                +
                                                                                         Lease               Present Value >>>   $68,996.00

Buyout Lease/Buyout
           Down
        Payment or        Depreciation         Interest       After Tax        After Tax
           Loan            Deduction          Deduction       Variable      Taxes, Insurance       Salvage         Balancing     After Tax
 Year    Payment            Effect              Effect         Costs            Housing             Value           Charge       Cashflow
   0                                                                                                                                   $0.00
   0                                                                                                                                   $0.00
   0                                                                                                                                   $0.00
   0                                                                                                                                   $0.00
   0    $16,089.20                                                                                                                     $0.00
   6    $16,825.63       $3,015.52            $2,173.65         $0.00            $0.00                                            $11,636.46
   7    $16,825.63       $5,386.26            $1,815.12         $0.00            $0.00                                             $9,624.25
   8    $16,825.63       $4,231.86            $1,422.00         $0.00            $0.00                                            $11,171.77
   9    $16,825.63       $3,449.12              $990.93         $0.00            $0.00                                            $12,385.58
  10    $16,825.63       $3,449.12              $518.27         $0.00            $0.00            $53,686.00       $5,809.08     ($35,018.69)
       +                 -                -               +                +                     -
                                                                                     Buyout                Present Value >>>      $9,336.28
Total   Lease/Buyout                                                           Lease/Buyout                Present Value >>>     $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     After Tax
Year        Payment          Deduction           Deduction            Costs                                        Value             Charge       Cashflow
  0              $0.00                                                                                                                                  $0.00
  0        $23,152.00                                                                                                                             $23,152.00
  1        $23,152.00        $5,542.28           $4,211.78             $0.00                   $0.00                                              $13,397.94
  2        $23,152.00        $9,899.51           $3,836.26             $0.00                   $0.00                                               $9,416.23
  3        $23,152.00        $7,777.82           $3,424.50             $0.00                   $0.00                                              $11,949.68
  4        $23,152.00        $6,339.20           $2,973.01             $0.00                   $0.00                                              $13,839.79
  5        $16,089.20        $6,339.20           $2,477.94             $0.00                   $0.00                                               $7,272.05
  6        $16,825.63        $6,339.20           $2,173.65             $0.00                   $0.00                                               $8,312.78
  7        $16,825.63        $6,339.20           $1,815.12             $0.00                   $0.00                                               $8,671.30
  8        $16,825.63        $3,172.19           $1,422.00             $0.00                   $0.00                                              $12,231.45
  9        $16,825.63              $0.00           $990.93             $0.00                   $0.00                                              $15,834.70
 10        $16,825.63              $0.00           $518.27             $0.00                   $0.00           $53,686.00           $10,737.20   ($26,641.44)
        +                 -                    -                 +                   +                         -                 +
                                                                                                                            Present Value >>>    $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     Salvage      Balancing        After Tax
Year       Payment          Effect            Effect        Costs             Housing           Value        Charge          Cashflow
  0       $19,331.00                                                                                                        $19,331.00
  1       $31,548.06       $5,247.90        $4,075.60        $0.00              $0.00                                       $22,224.56
  2       $31,548.06       $9,373.70        $3,403.35        $0.00              $0.00                                       $18,771.00
  3       $31,548.06       $7,364.70        $2,666.24        $0.00              $0.00                                       $21,517.12
  4       $31,548.06       $6,002.50        $1,858.00        $0.00              $0.00                                       $23,687.56
  5       $31,548.06       $6,002.50          $971.76        $0.00              $0.00                                       $24,573.80
  6            $0.00       $6,002.50             $0.00       $0.00              $0.00                                       ($6,002.50)
  7            $0.00       $6,002.50             $0.00       $0.00              $0.00                                       ($6,002.50)
  8            $0.00       $3,003.70             $0.00       $0.00              $0.00                                       ($3,003.70)
  9            $0.00           $0.00             $0.00       $0.00              $0.00                                             $0.00
 10            $0.00           $0.00             $0.00       $0.00              $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                              Annualized
 Lease/Buyout                            $78,332.27                                 $10,780.67
 Capital Lease                           $83,880.06                                 $11,544.20
 Purchase                                $78,183.28                                 $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 -        Contains basic data for the net present cost calculations.
        Sheet B -        Illustrates the annual costs and compares the net present cost and annualized
                         cost of the options.
        Sheet C -        Supplementary worksheet calculates repairs, salvage value and net present cost
                         and annualized cost of owning a machine different lengths of time.
        Sheet D -        Supplementary worksheet for estimating salvage value of a machine based on
                         accumulated hours of use.
        Sheet E -        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      =      net present cost of cash flows
           t    =      marginal income tax rate (federal + state + self employment)
           i    =      after tax discount rate, i = loan rate * (1 - t)
           k    =      1 to N periods (years)
          N     =      terminal year
       DP0      =      down payment in period 0
       LPk      =      loan payment
       VCk      =      variable costs (labor, fuel, repairs)
       FCk      =      taxes, insurance, housing costs
       Dk       =      depreciation deduction
       Ik       =      interest deduction
       SVN      =      market salvage value
       BCN      =      balancing charge = depreciation recapture = (market salvage - book value)
           ts   =      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 =           lease deposit (cost must be deducted over life of lease)
        LPYk =           lease payment

Rent

(A3)


        (Refer to note below about the above two terms.*)




                                                    21
       RP      =       rental payment

Custom Hire

(A4)


       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     =       net present cost of cash flows
           t   =       marginal income tax rate (federal + state + self employment)
           i   =       after tax discount rate, i = loan rate * (1 - t)
           k   =       1 to N periods (years)
          N    =       terminal year
       C0      =       purchase cost
       DP0     =       down payment in period 0
       LPk     =       loan payment
       VCk     =       variable costs (labor, fuel, repairs)
       FCk     =       taxes, insurance, housing costs
       Dk      =       depreciation deduction
       Ik      =       interest deduction

                                                  22
       SVN =           market salvage value
       BCN =           balancing charge = depreciation recapture = (market salvage - book value)
          ts =         marginal income tax rate minus self employment tax rate
                       (t - self employment tax rate)
       Note:




       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

				
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