Lease vs. Purchase of Ag. Equipment - Economic Evaluation

The basic tenet of leasing is to offer producers more value over purchasing. Leasing equipment allows dairy farmers to obtain equipment for lower upfront costs without the larger initial investment. This way producers can preserve working capital that can be diverted to other operating uses. Leases are flexible, and they can be for long or short terms. The goal is that lease payments should be less than loan payments. They are treated as a business expense and can be tax deductible. Leasing allows producers to have the most recent technology.

In contrast to a lease, when farm equipment is purchased, a deposit that can be sizable is usually required. It can be used as collateral against other loans if needed. Producers have complete control over it, use it without any limitations, and can customize it according to their needs. It can be sold or changed anytime without any penalty. Owning farm equipment is cost-effective in the long term, past the lease contract period. Depreciation, variable costs, and interest charged on a loan are tax deductible.

To find out which option will minimize costs during a given time, it is good to evaluate the economic costs associated with both options.

Any producer should consider three analytical steps to make sure that the lessor is transferring enough savings to make leasing more economically attractive than purchase.

These steps are:

1. compare lease payment to purchase price
2. compare income tax effects
3. compare present values

Here is an example where a producer needs a new skid steer. The purchase price is $50,000, the lease payment is $10,500 per year for five years, and there is an option to purchase the skid steer for a salvage value of $5,000 at the end of the lease. The basic layout of these costs for both lease and purchase options is in the left part of Table 1.

Both the purchase price of $50,000 and the first lease payment of $10,500 in the Today row, suggest that it has to be paid today, upon delivery. For the purchase, the producer can either use cash reserves or borrow money from a lender. The lease payment does not require a large sum of money to be paid upfront and likely the farm’s cash reserves can be used.

The option to purchase the skid steer after the lease expires, or the skid steer’s salvage value of $5,000, is the '5 years from now' row. This is important as the producer would not incur this cost if the skid steer was purchased. To make a fair economic decision, a producer needs to include this cost in the comparison. In this example, the after-the-lease purchase value is specified, but many times it can be stated as 'fair market value'. The advantage of the lease is that the final purchased value is determined at the beginning of the lease agreement and is not subject to market changes.

The income tax effect comparison is perhaps the most important as it varies among agriculture businesses and individual farms. Thus, the assessment of tax benefits on an individual basis is imperative.

In the purchase option, a producer can use a tax deduction in the form of equipment depreciation. Depreciation reduces the tax owed only for each year it is allowed. The tax deduction amount depends on the marginal tax rate which is the amount of taxes paid for every additional dollar earned.

It has been estimated that 97% of all farms are taxed under individual income tax rather than corporate tax, and most of the farms would fit into the marginal average income tax rate of 14% (OECD Library, 2024). At the 14% marginal rate, a $10,000 tax deduction would be worth $1,400.

Depreciation of the skid steer is taken over 7 years. It can be taken as a straight line or accelerated method. A straight line is used in this example. Assuming that the skid steer purchase is financed, it is recommended to elect out the full depreciation and match up the annual depreciation amounts with the loan payments.

For a skid steer with a base value of $50,000 and a salvage value of $5,000, annual depreciation for 7 years is $6,429 annually. At a marginal tax rate of 14%, the tax saving is $900 per year of the annual depreciation amount (Table 2).

In the lease option, the tax savings of a 14% marginal tax rate would be calculated for each of the annual payments of $10,500, or $1,470 per year. The after-tax payment per year would be $9,030 ($10,500 - $1,470 = $9,030) and the salvage value would be $4,300 (Table 2).

The lease payments decrease from $10,500 to $9,030, and the final purchase price from $5,000 to $4,300 (Table 2). The total lease cost after the tax rate is $49,450.

The purchase option includes the depreciation of -$900 per year (Table 2), decreasing the total costs to $43,700. At this point, the skid steer purchase appears as a much better option as opposed to the lease.

However, one last step that needs to be done is to compare the values of payments, depreciation, and salvage value at the time when they incur.

The present value of money needs to be included to make a true economic comparison and place all costs on the same time scale. This is an important step as it affects leasing or buying because it determines how many dollars are needed today to pay costs that come due in the future and it also assesses which option is less expensive.

The basic concept of the present value of money is that a dollar earned today is worth more than a dollar earned in the future, for example, five years from now. On the other hand, a dollar in five years will be less than a dollar today. The value of the dollar is determined by the interest rate – either for money borrowed or invested.

The preset value is calculated as:

Present value of money = the future sum of money/(1+interest rate)ⁿ

Where: ⁿ = number of years

Present value factors for different interest rates and years are in Table 3.

In our example, a producer can borrow money at 7.25%, and after taking out the after-tax rate of 14%, it is about 6%. The present value factors are used in the table below to find the present values for payments, depreciation, and salvage value.

The lease would appear as a better option by $1,141 in today's dollars; $43,533 as opposed to $44,674 for buying (Table 2). It is important to note that these values are just a snapshot in time.

During volatile and uncertain markets, the resulting present value costs can change relatively quickly. For example, if the interest rate used to calculate the present value costs would increase to 7% and 8%, assuming that the rest remains unchanged, the lease would show as an even better option by $992 and by $1,934, an increase from $1,141 to $2,133 and $3,075, respectively.

On the other hand, should the interest rate decrease to 5% or even 4%, the lease would be better only for the interest of 5% by only $113, $44,419 vs $44,532, and the purchase would be better by $960 at an interest rate of 4%, from $45,342 to $44,382 total present value costs.

Searching for better interest rates is crucial as they can have a significant impact on the final decision.

Other Factors that Need to be Considered

Economic evaluation of lease versus purchase is the basic step to assess the total costs. When the lease costs are lower than the purchase, it would be deemed reasonable to exercise the lease. However, sometimes the cost difference between lease and purchase is low. In our example, when the interest rate drops to 5%, the difference in costs is only $113, which is negligible over the course of five years.

There can be other conditions in the lease agreement that could make a small, or even large lease cost saving meaningless. A potential special requirement of the lease could increase the overall costs. Here are some additional things to consider:

• What are the terms of the equipment maintenance?
• Who is doing and paying for the maintenance?
• Do I need to take the equipment to a specialized shop and if so is that shop far away from my farm?
• Are the maintenance costs smaller or identical whether leased or purchased?
• Are there any limits on the use of the equipment?
• Are there any other fees involved? Do I have to pay a security deposit at the beginning of the lease and get it refunded at the end of the lease? This is an interest-free loan to the lessor and could tie up the producer's cash for a long time.
• What are the penalties to get out of the lease contract earlier?

Deciding to purchase or lease farm equipment is a big decision and many elements should be considered. Each farm has a unique situation and thus legal, accounting, and business circumstances need to be factored into the final decision.

References

Lemmons T. Leasing Vs. Buying Ag. Machinery: Factors to Assess. 2009. Institute of Ag. and Natural Resources. University of Nebraska.

Levins R. The Economics of Leasing Versus Buying Farm Equipment. 2003 Maryland Extension, University of Maryland.

OECD Library, 2024, Taxation in Agriculture.