I see an increasing trend toward leasing. It may or may not be the right thing to do.
This is the time of year when you make many decisions on buying or trading equipment. The most common question we get is, “Should I buy or lease machinery?”
Leasing is generally the best decision when you have significant tax liability, have used all your Section 179 expensing for the year or you're making the decision late in the year and can't depreciate the purchase but can write off the lease payment.
Let's look at the issues and some examples.
There are definite advantages to leasing. The most obvious is that it requires no down payment, which would reduce your cash flow the first year.
This causes less demand on your working capital, which is the greatest area of weakness I see in farm financial statements. The first-year lease payment often is required up front. But that may still be less cash than a down payment.
Secondly, if you've already used all of your Section 179 expensing, writing the whole lease payment off as an operating expense can save you tax dollars. Section 179 expensing, sometimes called “expense method depreciation,” allows you to deduct a certain amount of the purchase cost of depreciable assets in the year of purchase. This was $20,000 in 2000 and will increase to $24,000 in 2001 and 2002, and to $25,000 after 2002.
Most equipment items are acquired by an operating lease in which fixed payments are made for the term of the lease. Then the machine can be returned to the dealer or leasing company, or purchased for the residual buy-out value. All lease payments are tax deductible as ordinary operating expense.
A disadvantage of leasing is that, at the end of the agreement, the operator has built up no equity interest in the equipment. Look at all the angles, though, and be creative.
I just worked with a Minnesota farmer who had a year left on his combine lease and wanted to switch to a different-colored machine. The new dealer waited until fall and bought the old combine for the residual value (through the farmer). The farmer ended up realizing equity in the leased one by the deal he made on the new one. In this case, he ended up with equity out of a lease plus enjoyed the advantages of a lease for two years.
Another way of buying machinery is the rollover purchase plan. The operator buys a new or used piece of equipment from a dealer with the expectation that it will be returned for another model after one year. Often the purchase is financed with the dealer and accrues no interest or only several months' interest during the year. Again, there's no equity at the end of the agreement other than the down payment.
Every situation is different. The right choice depends on the lease or rollover payments, the residual buy-out value, the amount of acres or hours the equipment is used, the salvage value, depreciation and tax issues, interest rates and terms of the loan.
I got tired of figuring them all out so I built three Excel spreadsheets — one to evaluate purchase, one to evaluate lease and one for the rollover purchase plan. I use the spreadsheets to compare the net present value and internal-rate of return for each of the options. This puts them all on an equal basis in figuring the best return on investment.
This can be quite revealing. For example, I worked with an Iowa farmer who leased a tractor for three years with a 600-hour-per-year use term. But he only put 400 hours per year on the tractor. When we ran it through the spreadsheet, the net present value was negative. He in essence was paying for 600 hours and only getting 400 hours of value.
He would've been far better off owning.
Moe Russell is president of Russell Consulting Group, Panora, IA. Russell previously spent 26 years with Farm Credit Services as a division president. For more risk management tips, check his Web site (www.russellconsulting.net) or call toll-free 877-333-6135.