Equipment purchase vs leasing

Introduction

Purchasing mining equipment is very capital intensive, especially as equipment costs are constantly increasing. Once the decision to acquire new equipment is made the decision on how to finance the transaction needs to be determined. There are three ways to finance the purchase of new equipment which include; buying the equipment, hire purchase or lease the equipment.

Purchasing

Buying the equipment increases capital costs which can be acquired through existing cash on hand, borrowing against the company’s line of credit, or other direct loans. One of the benefits of buying is getting to deduct the depreciation. If the money is from a loan than the interest is also deducted. When the decision is made to purchase the equipment there are two equations used to determine the operating costs from that purchase.

Equivalent lease cost 

The equivalent lease cost is a method used to determine the ownership cost annually or per hour. An alternative and preferred method is to treat the plant as if it were being leased. This calculation includes all of the factors considered in the average investment method but they more correctly account for the higher interest component of the cost earlier in the equipment life.

• The primary inputs are:
• Required return on investment, i
• Initial investment, PV
• Machine life, n

Example 1:

Determine the average hourly ownership cost using the equivalent lease cost method for a dozer that operates for 4,000 hours per year and has an expected life of 20,000 hours with an initial capital cost of $ 1million. The company seeks a 15% return on the investment.

n = (20,000) / 4,000 = 5years 

CRF = [i(1 + i)]ⁿ / ([(1 + i)]ⁿ − 1) = [0.15(1 + 0.15)]⁵ / ([(1 + 0.15)]⁵ − 1) = 0.2983

PV = $1 million

 i = 15%

Equivalent annual payment = PV x CRF = $1,000,000 x 0.2983 = $298,300 / year

Ownership cost per operating hour = $298,300/4000 = $74.58/operating hour

Discounted average cost 

The discounted average cost method can be used to determine ownership cost for a piece of equipment. This method assumes operating costs are zero and an “operating hour” is the unit of production therefore applying to the capital components of an equipment purchase. This method is more difficult to apply than the previous mentioned method but it has the following advantages:

• The timing of capital payments can be accounted for
• Include the impact of tax on the ownership cost
• Adjustments can be made for salvage value. Allows the equivalent capital cost of long-life equipment to be accounted for even when it is to be used for a fraction of its technical life. The salvage value can be used as transfer value to another project in the company.
• Irregular annual usage rates can be accounted for

When the capital component is ignored in calculating the hourly operating cost there is a risk of estimating completely in error. The discounted average cost method allows direct comparison between purchasing equipment and hired equipment. If a contractor will place a $1 million machine on hire for $150/hour then the equivalent cost is the operating cost per hour plus the discounted average cost determined by the discounted average cost method.

Hire Purchase

Hire purchase is a method of buying goods through making several installments over time. The buyer is leasing the equipment but does not own it until the full amount of the contract is paid off. At the end of the hire period the user has the option to purchase the equipment. The user agrees to take the equipment on hire at a stated rental which includes the repayment of principal and interest.

In the hire purchase agreement the following terms apply:

• The owner delivers the asset on condition that the person pays the agreed amount in periodic installments
• The rights to the asset are passed to the user after the last payment is made, and
• Such person has the right to terminate the agreement at any time before the last payment is due

Rent to hire is a viable option when:

• Want to evaluate equipment from month-month before making a purchase or signing a lease
• Need quick access to equipment during shortage bites
• Need to reduce investments in fixed assets
• Need to acquire equipment while preserving credit lines
• Want purchase and upgrade options

Leasing

A lease is a contract between the owner of the equipment (lessor) and its user (the lessee) for the right to use the asset. The period of time is specified and a mutually accepted amount and frequency of payment is determined. The user does not own the equipment and in turn it’s not included on the financial spreadsheet which frees up capital.There are two important categories of leasing: operating leases and financial leases.

Operating leases are short term and favourable for equipment that is susceptible to the risk of obsolescence. These leases can be cancelled at any time and the risk of obsolescence is taken on by the lessor. The lessor is responsible for the upkeep and maintenance of the asset and there is no incentive given to purchase at the end of the lease term.

Financial leases are long-term, non-cancellable and any risk in the use of the asset is taken on by the lessee. In this lease the lessor agrees to transfer the title for the asset at the end of the lease term for a nominal price. The lessor recovers 90% of the fair value of the asset as lease rentals and the lease period is 75% of the economic life of the asset. The agreement is irrevocable and the lessee takes on maintenance, insurance and repairs. Only the title deeds remain with the lessor.

Leasing is a viable option when:

• Risk of technological obsolescence
• Interest rate for leasing given by manufacturer is lower than interest rate on loan
• Need to spread payments over a longer term usually with a lower interest rate than a loan
• Typically no down payment Need to save on capital costs
• Need flexibility and convenience
• Planning cash flows
• Want to improve Liquidity
• Equipment is only required for less than 2 years
• User needs to defer a sales-tax payment
• The user cannot afford the capital outlay, or needs to improve financial ratios

Once it has reached the end of the lease period, the company has the option of:

• Buy the equipment for fair market value or predetermined price
• Renew the lease for a specific period of time
• Upgrade to new model and renew lease agreement

Case study

In this example an Atlas Copco MT 4368 is considered for purchase at a capital cost of $685,000.00. Here, the net present value of the residual cost was subtracted from the total cost of buying a new machine. This residual value was fixed at 17% of the original truck value, and was discounted at 10% for every year the truck was owned. The effect of this was that the total cost of buying the truck increased with each year that the residual value was discounted. This can be seen as an upward sloping line in Figure 1.

To obtain the monthly values of leasing the machine, an example was followed in the ‘Equipment Cost’ excel. The constants needed to calculate a constant, monthly lease value are listed below in Table 1 and were found using the ‘Equipment cost’ document.

Table 1: Lease calculation constants

Lease Duration (years)	Multiplier
1	0.070719
2	0.036619
3	0.024686
5	0.015489

These constants were multiplied into the total cost of the truck to obtain a monthly lease rate. This monthly lease rate could be used to calculate annual costs associated with the lease. Such costs as well as the capital and residual costs are summarized in Table 2 below.

Table 2 Buying costs versus leasing cost.

Inflation rate	10%
Buying
Capital Cost	$685,000
Residual	$116,450
Annual leasing Rate
Year 1	$581,000.00
Year 2	$297,490.02
Year 3	$202,918.92
Year 5	$127,319.58

The annual costs could then be discounted at 10% annually and summed together to botain a net present value (NPV) for the leased truck. The effect of discounting the monthly payments, on an annual basis, meant that future payments were worth less than present day dollars. Therefore, as the lease period grew, the net present cost associated with the vehicle lease decreaed. This trend can be seen wiht the orange data in Figure 1.

Figure 1: Depicts the net present cost associated with either buying or leasing a particular piece of equipment with respect to the number of years the equipment is ‘owned’.

Conclusions

Three types of organizations providing equipment financing:

• Equipment manufacturers
• Various types of financial intermediary and law firms
• National and International agencies

Table 3: Difference between lease financing and hire purchase

The significant different between hire purchase and leasing is the tax consequences. A lease is a commercial arrangement whereby the owner of the equipment manufacturer gives the right for the user to use their equipment.

Table 4: Difference between purchase and lease 

In the end owning equipment doesn’t make you money, using the equipment does. The cheapest way you can get the equipment for longest term is the most cost-effective choice.