Leasing of machinery, buildings, equipment and even livestock provides agribusiness an option to ownership of assets. Leasing gives operators a way to gain the use of assets without major capital investment. An agribusiness manager needs to understand the advantages and disadvantages of leasing and must know how to evaluate a lease-or-buy decision. A lease is a contract between someone who owns an asset but sells the right to use it to someone else. The lessor is the one that owns the asset. The lessee is the user of the leased asset.
Types of Leases
Three general types of leases are commonly used in agribusiness. Each offers the lessee and lessor a set of advantages and disadvantages that both parties must weigh when selecting the best type of lease and whether leasing is the right choice.
(i) Operating Leases: An operating lease is a contract, generally written for short periods, that is based on a set charge per hour, week, or month. Typically, the lessor pays the cost of maintenance and taxes. This type of lease is most commonly used with machinery and equipment rentals.
(ii) Financial Leases: A financial lease is a long-term contract where the lessee acquires sole use of the equipment or machinery in return for lease payments. Typically, the lessee pays the cost of maintenance, insurance, and taxes, while the lessor retains ownership of the item and takes the depreciation and any other tax deductions that are available. Lease payments are a tax-deductible business expense for the lessee in most situations.
(iii) Lease-Purchase Options: In most cases, a lease with a purchase option is similar to a financial lease. The major difference is that the lease agreement contains a provision for the lessee to buy the equipment at the end of the lease period for a prearranged price. This type of lease may not be tax deductible.
Advantages of Leasing
Leasing can provide an agribusiness a number of advantages over buying. A lease agreement may call for the lessor to periodically upgrade the item at the lessor’s expense so a piece of machinery of equipment remains on the cutting edge of technology and efficiency. This may be important in areas of rapid technological change because it removes this risk from the lessee. Also the lease payments are often lower than loan payment. This is especially true in the early years of a lease because the payment normally cover a longer period then loan payments.
Many leases require a down payment that is less then what would be required to purchase the item with a loan. Leasing can reduce the capital investment needed to acquire an asset, keep its technology up to date, and reduce the monthly cash outflows needed to acquire it. These are important considerations to a business, especially one just starting.
Advantages of Ownership
In a true lease, the lessor retains ownership of the item. Many leasing companies seek only to recover 10 to 30 percent of the original value of the item by the end of the contract. The ability to anticipate and evaluate what will happen at the expiration of the lease can be the most important consideration when deciding whether to lease or buy.
If the residual value of the equipment is low because it is worn out or obsolete there is no advantage to taking ownership at the end of the lease. However, if the equipment has a physical life, that is longer than the leasing period and the end-or-lease purchase price is reasonable, having a lease with a purchase clause can be worthwhile.
NB: The decision between leasing, buying or borrowing is a capital budgeting decision because it often involves large amounts of money, can affect long term profitability of the firm, and is non-reversible once it is made. The NPV procedure is the most appropriate decision making method.
Lease Rates and Terms: Leasing firms typically figure lease payments on a percentage basis, like loans. The lease payment can vary between leasing firms depend on their costs, taxes, and profit goals. The length of the lease also can affect the lease payment. It pays to shop for the best rates and terms.
Insurance: The lessee is responsible for damage to leased equipment. When damage occurs, the lessee is responsible for repairs and is still liable for the remaining lease payments. Many leasing firms insist that the lessee have insurance to cover this possibility.
Repairs and Taxes: Usually a financial lease requires the costs of repairs and sales taxes to be paid by the lessee. New equipment usually comes with warranties to cover repair costs in the early years of a lease. Dealers may be more interested than an outside leasing firm in including a warranty and repair service in a lease.
Terminating the Lease: Most leases obligate the lessee to make lease payments for the entire life of the lease. Circumstances can develop where the lessee would want to terminate the lease before its scheduled date. The lease agreement should specify the conditions and procedures for early lease termination. Some lessors are willing to sell the equipment before the end of the lease. In this case, the lessee is often obligated to reimburse the lessor for any unrecovered cost lost by the sale and early termination. It is important to understand the procedure and cost of quitting a lease before entering a lease agreement.
Expiration of the Lease: Many things take place at the end of a lease that could affect a leasing decision. A manager needs to anticipate and evaluate those costs prior to entering into a lease. For example, who pays for dismantling leased property when the lease expires? If the lease states that the lessee is responsible, this will be an added expense. It also puts the lessee in a weaker bargaining position for negotiating the purchase of the equipment when the lease ends.