The decision to buy or lease capital equipment is very complex, involving not only quantitative data but also qualitative issues. A traditional lease vs buy analysis compares an operating lease to a capital purchase, and the objective is to quantify the acquisition method that minimizes cost.
For the decision to make sense, the lease vs buy model must be based on realistic and complete information. Determining if your information is reliable is key to developing a cost-effective capital acquisition.
Many factors influence the choice of the acquisition method and should be considered before using any quantitative model. A lease vs buy model depends on judgments and assumptions that are qualitative in nature. It reduces the decision to the method, lease, or purchase that produces the lowest net present value of required cash outflows.
The Conventional Quantitative Model
Understanding the key data used in the lease vs buy model is important to assessing its relevance to your decision process. The lease vs buy formula is a mathematical model that compares the costs of two different acquisition choices through a technique called the discounted cash-flow analysis. The model requires the following data as inputs to determine the present value.
Useful Life
The useful life of an asset is based on an estimate. If this is wrong, the analysis is inaccurate. If you assume that older technology will be redeployed during its functional life and you have no process for redeployment, the model is using the wrong useful life.
Direct Costs
Direct costs are equipment cost, sales tax, interest rate, depreciation rate, fees, transportation, and maintenance. There generally is little chance for error in this area.
Indirect Costs
Administrative costs, installation, overhead, and income tax rates and tax preference almost always are estimates provided by the finance department.
Cost of Capital
Your company’s incremental or average cost of capital can be the cost to borrow or a blended rate that includes the cost of equity. The method chosen by financial management has significant influence on the lease vs buy model. The lower the rate, the greater the likelihood that the result will favor purchase.
Many companies incorrectly use the short-term borrowing rate from their bank. The more accurate rate should reflect the cost to acquire capital for a period equal to the useful life of the equipment, which generally is a higher interest rate.
Residual Value
The greatest errors in running a true lease vs buy model occur here. If an organization has no process of selling equipment at the end of the estimated useful life, then this number should be zero.
Most test users are good at bringing equipment into the company but have no process for recycling assets. If you are not prepared to sell it, then you cannot fairly project a residual value. Residual estimates often are “plugged” by financial analysts who are not knowledgeable at remarketing test equipment, making the number a guess at best.
Qualitative Issues
Although it is tempting to merely rely on a purely mathematical model, qualitative issues can override or invalidate the quantitative conclusions of the lease vs buy model. Here are several qualitative issues that are material in determining whether a lease vs buy analysis is appropriate for your acquisition decision.
Technology Risk Management
Many labs and production lines require the latest test technology to develop and produce competitive products. This is particularly true in the telecommunications industry today.
The rate of new test-product introductions and upgrades is increasing, reducing the useful life of the asset at your company. Examples are the oscilloscope and logic analyzer markets where competing manufacturers are leapfrogging each other at a rapid pace.
Financial Management Objectives
Credit availability, cash flow, and financial performance criteria, such as return on net assets or leverage ratios, may require the use of off balance-sheet financing. All purchases must be shown in the asset section of the balance sheet, and all loans must be shown as a liability. Leases and rentals are not reported on the balance sheet as either an asset or a liability.
A requirement for off balance-sheet reporting eliminates the need to do a lease vs buy analysis.
Service and Support
The need for services such as calibration, maintenance, extended warranties, downtime protection, and loaners influences the decisions about which vendor and acquisition method to use. The services required may only be available for leased or rented equipment, precluding purchasing as an alternative.
Priorities
In any complex decision process, establishing priorities is critical to identifying a solution. Prioritizing cash flow over cost minimization or avoiding obsolescence over asset ownership will lead to different acquisition plans. The lease vs buy model does not accurately incorporate these priorities.
Asset Management
The maturity and reliability of your company’s asset-management procedures should have a significant impact on the acquisition decision. It should influence the lease vs buy model as well.
Asset management requires accurate forecasting, active management of utilization, and recycling of test assets. Lack of a reliable process in any of these areas negatively impacts the validity of any lease vs buy analysis because the model relies on accurate forecasts and assumes full utilization.
Remember that the model assumes the equipment will be in productive service; that is, fully utilized during the useful life of the asset. Test equipment, particularly a benchtop asset, is characterized by usage, which often is periodic. Usage declines in subsequent years as new models arrive.
Frequently, there is duplication of test sets between labs because of the fragmented acquisition channels. Since few companies have effective redeployment systems or test-asset pools, it is hard to justify full utilization for all the test assets you own.
My favorite example of what can happen with a flawed model is from a manager at an electronics company who divided the number of test assets owned by the number of engineers on staff. There were more than 60 assets available for use per engineer. This company relied on a lease vs buy model that always said buy because of unreliable input. What is your level of confidence with the traditional lease vs buy model in your acquisition decisions?
There is a growing trend among large users of general-purpose test equipment to create test-asset management centers. These centers would provide engineers with the assets they need while increasing utilization and reducing capital expenditures and expenses. Looking at test assets as a managed portfolio emphasizes qualitative judgment vs the quantitative nature of the lease vs buy model.
In a test pool, asset managers purchase certain quantities based on a sustaining need for each type and model, and then lease and rent the remainder to meet variable demand. Leasing and renting test assets allow pool managers to easily acquire and return them to cost-effectively meet the demand for equipment. A well-managed test-equipment pool delivers what the engineers need at a significant reduction in the total cost to the organization.
Conclusion
While the lease vs buy model is very effective for large capital projects and acquisitions of individual assets, it is not well suited for projects that have large quantities of similar assets and fluctuating utilization. Purchasing all your test assets is a luxury if you have unlimited capital and are not concerned about financial efficiency.
The traditional lease vs buy analysis used by most companies for general-purpose test equipment is flawed as a result of the unreliable quality of the information on which it is based. A well-designed acquisition program for test equipment uses a mix of purchases—new and refurbished, leases, and rentals.
Effective test-asset management includes managing portfolio utilization through redeployment and disposition to maximize the return and minimize the costs. In test- equipment management, there is no model that replaces common sense and good business judgment.
About the Author
Tevis Martin is vice president and general manager of the Leasing Division at Telogy. Before joining the company, he was vice president of a major lessor, distributor, and remarketer of computer systems and a vice president in commercial lending and leasing for a major California bank. Mr. Martin is a graduate of the University of California, Berkeley, and earned an M.B.A. from the University of San Francisco. Telogy, 3885 Bohannon Dr., Menlo Park, CA 94025, (800) 835-6494.
Copyright 1999 Nelson Publishing Inc.
April 1999