Lease or Buy Decisions

Most firms rent or lease a vehicle or a computer or plant and machinery. Rentals by and large, have traditionally been used for very short durations (e.g. hiring a car for a day etc.). For longer durations firms have traditionally preferred to buy the asset by either paying for it outright or through hire purchase ( A type of leasing agreement where ownership changes hands).

Assets that are are purchased outright, or in installments, are depreciated by the firm over a specified time horizon.

It is also possible to 'lease an asset' like a vehicle or a computer or even plant and machinery, and treat it as a business expense. In such leases the ownership remains with the lessor or the person or entity leasing the asset. These types of leases are offered as 'capital leases' or 'financial leases' over a fixed term (viz. they cannot be broken without heavy penalties), or as 'operating leases' where the lessee has the right to return the asset at anytime (subject to conditions agreed to between both parties).

Different countries use different descriptors to describe a lease. Standard descriptions have been used below.

Leasing an asset through an operating or capital Lease provides some clear advantages:

1. They do not require a company to raise the money to fund an asset outright, or up-front, but spread the cost over an agreed time horizon;
2. They permit the company to upgrade to a new technology at regular intervals;
3. They provide a tax benefit as they are charged off to tax (rather than being depreciated);
4. Operating leases in particular provide the firm with the flexibility to return an asset when it is no longer needed, or if the company wishes to terminate the lease for any reason. The actual terms and conditions for such eventualities are usually agreed in advance. .

Clearly companies need to weigh the benefits of 'leasing versus buying' an asset outright, or leasing versus buying an asset using loan financing.

A 'lease or buy' decision analysis evaluates the financial and non-financial benefits and costs of buying versus leasing, and makes the trade-off between one or the other, visible to the decision maker(s) of the company.

Allan Rodrigues of The Business Farm has developed several financial models for determining the optimum 'lease versus buy' decision under various conditions of risk and uncertainty.