1997 Acta Structilia Vol 4 No 1 Contractor's plant: Whether to buy or to lease? Marius H Muller Summary This article comments on the concepts of buying versus leasing in terms of decision-making theory regarding the procurement of contractor's plant. It was found that leasing offered the better option in the worked example presented herein, but that every plant buying or lease decision would have to be made individually on proven calculation and on merit. Keywords: Plant, purchasing, leasing, hiring. KONTRAKTEURSTOERUSTING: KOOP OF HUUR? Opsomming In hierdie artikel word die bestaande opsies behandel waarvoor die boukontrakteur te staan kom wanneer hy toerusting aanskaf. Die vraag is: moet hy huur of koop. Uit die voorbeeld wat hier aangehaal word blyk dit dot huur 'n beter opsie bied. Dit is egter ook baie duidelik dot elke geval meriete het en dus individueel bekyk moet word. Kostes moet teen mekaar opgeweeg word, veral met die kontrakteur se doelwit voor oe. Sleutelwoorde: Toerusting, boukontrakteur, aankope, huur, verhuring. Marius H Muller, B Sc (QS) (UCT} MAQS, MSAIB Dr Muller is a property researcher. Muller/ Contractor's Plant: Whether to Buy or to Lease? T his article investigqtes the options available to the contractor for obtaining plant, either by buying or leasing it. The concepts of buying and leasing are first presented; the theory relating to these concepts is then put forward: following this is a worked example containing explanatory notes concerning decision making. Finally, conclusions are drawn and recommendations are made with regard to the contents of the article. Concepts of leasing and buying Buying will be understood to mean the instance whereby the contractor acquires plant by his personal action in re­ turn for an agreed payment in monetary value, as op­ posed to inheriting it. In turn, leasing will be understood to mean the temporary procurement of plant in return for an agreed payment in monetary value (Barber, 1973). A lease is defined by Ferrara ( 19 79), as a contractual agree­ ment between a lessee and lessor, where the lessee is the user of the equipment and the lessor is the supplier of the equipment. Table 1 Differences in leases (after Ross & Westerfield, 1990) Operating lease Financial lease 1. Is a short-tenn lease, usually less 1. Is a long-tenn lease, usually more than live years than live years 2. Is not lully amortised 2. Is lully amortised 3. Lessor provides maintenance 3. Lessee provides maintenance 4. Has a cancellation option 4. No cancellation option Leasing can be sub-divided into two types, viz. operating and financial leases. The operating lease is also known as a 18 ., 1997 Acta Structilia Vol 4 No 1 maintenance or service lease. The financial lease is also called a capital lease. The most significant difference be­ tween the two are listed in Table 1. As the contractor may hire plant for one week or in excess of five years for one particular project, no further distinction will be made between the two types of leases. At this stage we will briefly consider the different leasing categories (IDC (SA), 199-). They are: 1. Direct lease. The lessee contracts a leasing company and obtains the sue of an asset that it did not previ­ ously own. 2. Sales and lease back. The lessee sells an asset he owns to another firm and immediately leases it back. 3. Leveraged lease. This is a three-sided deal among the lessee, the lessor and the lenders. For now, it suffices to say that for tax purposes and lower rental costs, the leveraged lease is the most advantageous. Figure 1 is a schematic comparison which highlights the dif­ ferences between buying and leasing. Theory of buying and leasing It is important to know when tendering for a job whether one should opt to buy or hire plant. At this stage one should not only consider the specific contract at hand but also rationally consider future contracts and their de­ mands on plant resources. Nevitt and Fabozzi ( 1988), and Brealey and Myers ( 1991 ) , list four sources of supply for contracting plant, viz.: a) Direct leasing from manufacturers / suppliers b) Leverage leasing through plant hire organisations 19 Muller/ Contractor's Plant: Whether to Buy or to Lease? Figure 1 Buying versus leasing (after Bierman, 1982) BUY Firm U buys asset and uses asset; financing raised by debt and equity Manufacturer/ Supplier of asset Q Firm U buys assets from Manufacturer 0 Firm U: 1. Uses asset 2. owns asset Q Creditors and equity shareholders supply financing to Firm U 0 () LEASE Firm U leases asset from lessor; the lessor owns the asset Lessor: Manufacturer I Supplier of asset Q Lessor buys asset 0 1. owns asset /-'\ 2. Does not '-r-1 use asset Q Creditors and equity shareholders supply financing to lessor Lessee: (Firm U) 1. Uses asset 2. Does not own asset 0 () I Equity shareholder I I Creditors I J Equity shareholders I [cfe;;J c) Acquisition of new plant or second-hand plant d) Employing existing owned plant. The contractor, when considering his tender price and op­ tions available for plant usage must remember that the cost involved with this plant is very similar to that of a leasing company. It thus comes down to employing financial cal­ culations to see which option is the best, not only for the present, but for the future as well. According to Harris & McCaffer (1986), facts to consider about the plant expen­ diture include: 20 1997 Acta Structilia Vol 4 No 1 1 . Initial capital cost and residual value 2. Interest and service charges on the investment 3. Monetary policy, including investment. initial and an­ nual tax allowances 4. Maintenance and repair costs 5. Cost of administration. insurance, licensing and legal documentation 6. Cost of fuel and other consumable items 7. Cost of operating and supervisory personnel. If a contractor opts to purchase plant, he has further issues to consider. One of them is overhead costs. These have to be borne whether or not the machines are being used. The objective is to minimise these costs so as to reduce the unit costs of the plant. This can be best achieved by having the highest possible utilisation of each item of plant and a sup­ portive maintenance team. A further matter for consideration is obsolescence and after-sales service. With improved technology and design, manufacturers are updating and upgrading plant continuously, and plant that seems effective and efficient today may prove to be less productive tomorrow. Although after-sales service may be of an acceptable standard, it is also an object of uncer­ tainty to the plant owner. Also, how it is decided and who decides what type of plant is required, what size fleet will be purchased. and, if this size is determined on projected future demands, how accurate are those projections? If plant is purchased it will also be necessary to have vehicles available to transport the plant to different building sites. In addition to this, the mechanical and spare-parts workshop will also have to be moved to the different building sites. These can of course be hired. 21 Muller/ Contractor's Plant: Whether to Buy or to Lease? A further headache the future plant owner has to consider. is what the residual value of the plant will be, if any, and whether there will be a demand for the plant on a second­ hand market. Once the plant has been purchased the contractor will re­ quire skilled operators who in turn may have to be trained. It will be beneficial to the contractor to employ skilled opera­ tors so as to obtain maximum benefit from the plant. The opposite of this scenario is that of leasing plant with a hire­ driver who is already familiar with the plant. Another positive factor in favour of leasing is tax (only appli­ cable in certain countries) and inflation benefits. While us­ ing leased plant. the contractor can claim tax rebates for his costs. This is usually as a trade-off against depreciation rebates he would have received had he purchased the plant. Leasing could also evade inflation in that it may not have escalation clauses written into the contract. This stands opposed to loans which in this case may have been taken to purchase plant. Although the text thus far has been biased towards leasing, it is necessary to note that at times the contractor may have no other option than to hire plant. for example, when the deadline has been shortened. Conversely, he may pre­ fer to hire, but if no plant is available, he will have to pur­ chase plant. Mead and Mitchell ( 1971) found that in the United King­ dom, contractor's plant constituted two-thirds purchased and one-third hired plant. This high purchasing ratio of two­ thirds is acceptable if the plant will be continually used throughout its economic life. Also. if the contractor is in­ volved in specialised works, for example pile driving and fi­ nally if the two-third comprises mostly small plant. for example excavators. dumpers, etc. 22 1997 Acta Structilia Vol 4 No 1 Decision making about leasing and buying a worked example Consider the decision confronting MHM Construction Com­ pany. They have determined that they need a new exca­ vating machine. NLC makes an excavating machine that can be purchased for R 10 OOO MHM will save R6 OOO per year in reduced labour costs for the next 5 years if it uses the machine. MHM has a company tax rate of 34% and a 5 year fully amortised straight line depreciation policy. How­ ever, the leasing corporation has offered to lease the same machine to MHM for lease payments of R2 500 per year for 5 years. With the lease, MHM would remain responsible for maintenance, insurance and operating expenses. The following assumptions are applicable to the calcula­ tions: 1. The stated company will realise sufficient profit during the five years period to effect viable tax benefits to the company. 2. The tax benefits are due in the same year as the ex­ penses are incurred. 3. The rate of inflation and the prime rate do not change significantly during the five years period. 4. Lease payments are due annually at the end of each year. 5. The scrap value of plant after year five is taken as nil. 23 Muller/ Contractor's Plant: Whether to Buy or to Lease? Calculations 1 ) Depreciation tax benefit = tax rate x depreciation ex­ pense per year R680 = 0,34 X (10�00) 2) After-tax cash flows: Buy = Lease = 6 000 x { l - 0,34) + (0,34) (2 OOO) = 6 000 x { l - 0,34) + (0,34) (2 500) - R2 500 = R4 640 R2 310 Table 2 shows the direct cash flow consequences of buying the machine and also signing the lease agreement Table 2 Cash flows to MHM for using NLC excavating machine: BUY versus LEASE YEAR 0 1 2 3 4 5 Cost of machine (10 OOO) After-tax operating savings 3 960 3 960 3 960 3 960 3 960 Depreciation tax benefit 680 680 680 680 680 TOTAL (10 OOO) 4640 4640 4640 4 640 4640 LEASE Lease payments (2 500) (2 500) (2 500) (2500) (2 500) Tax benefit of lease 850 850 850 850 850payments After-tax operating savings 3 960 3 960 3 960 3960 3 960 TOTAL 2 310 2 310 2 310 2310 2 310 Table 3 (on page 25) subtracts the direct cash flows of buy­ ing the excavator from those leasing it. What can be concluded from the analysis in Tables 2 and 3 are listed below Table 3. 24 1997 Acta Structilia Vol 4 No 1 Table 3 Direct incremental cash flow consequences for MHM for the lease offered by leasing corporation YEAR 0 1 2 3 4 5 LEASE minus BUY LEASE Lease payment (2 500) (2 500) (2 500) (2 500) (2 500) Tax benefits of lease pay- 850 850 850 850 850 ments BUY (minus) cost of ma- chine (10 OOO) Lost depreciation tax benefit 680 680 680 680 680 TOTAL (10 OOO) (2 330) (2 330) (2 330) (2330) (2 330) a Operating costs are not affected directly by leasing. Whether buying or leasing, MHM will always have an after-tax saving of R3 960 a If MHM leases, it will save R 10 OOO in year 0 a If MHM leases, it will have to give up its depreciation tax benefits a If MHM leases, it must pay R2 500 for 5 years. This means an after-tax lease payment of R 1 650 per year a Leasing Corporation's position is exactly the opposite. An initial cash outflow of R 10 OOO, but an inflow in years 1 to 5 of R 1 650 + R680 depreciation tax benefit. So far it has been found that the net cash flow of leasing versus buying for years O to 5 is: 0 1 2 3 4 5 R10 OOO (R2 330) (R2 330) (R2 330) (R2 330) (R2 330) 25 Muller/ Contractor's Plant: Whether to Buy or to Lease? If the discount rate = 7,58%; the Net Present Value (NPVJ can be calculated as: NPV R10 OOO = R593,09 f 2330 1=1 (\0758)' It appears that the lease is a good deal; but this conclusion may be premature. However, company tax is 34%, the cor­ rect discount rate= 7,58 ( 1 - 0,34) = 5%. The correct NPV is thus: NPV R10 OOO = (R87,68) � 2330 1=1 (t05)' Analysing this we find that leasing is not such a good idea. Furthermore, MHM could purchase the excavator at RlO OOO+ R87,68 = RlO 087,68. This means that MHM would have R87,68 available to re-invest elsewhere. If they decide to lease, the extra R87,68 would have to be used to finance the leasing agreement. Conclusions Leasing in theoretical as well as practical terms has been discussed. The former proved to be in favour of leasing and the latter 'in favour of buying. The greatest factor in favour of buying is that the depreciation tax rebate is lost in the form of opportunity costs when leasing (Posner, 1990). Leasing, on the other hand, in countering this drawback does have other cost re-imbursements. The first is tax shield­ ing. When the leasing company is in a high tax bracket, it re­ ceives a higher depreciation tax return. The company can therefore forward this benefit to the lessee in the form of lower leasing costs. Secondly, a lease contract increases the value of a firm in that it transfers the risk of uncertainty of 26 1997 Acta Structilia Vol 4 No 1 the residual value of the plant to the lessor. Thirdly, transac­ tion costs can be lower for a lease contract than for buying the asset and financing it with debt or equity. Other benefits of leasing are that the balance sheet and in­ come statements of a company will look different as it em­ ploys less capital if it does not purchase the equipment. Also, leasing can provide 100% financing on condition that no advance lease down-payment needs to be made. Fi­ nally, leasing can be used to circumvent capital expendi­ ture control systems set up by bureaucratic firms. This simply means that. so as not to be held up by management deci­ sions as to whether an expensive machine should be pur­ chased or not, the leasing arrangement can be written off as an expense. Recommendations A careful comparison is normally required to decide be­ tween leasing and purchasing. Purchasing equipment will also depend on whether the cash is available or whether a loan can be raised. If you lease you also do not have maintenance costs or administration, insurance or licens­ ing costs connected with the ownership of these items of plant (Wall, 1978). The plant hire company's decisions about buying is very dif­ ferent from that of the construction company, because the hire company makes its profits from hiring the equipment it owns to the hirer, while the construction company uses equipment it owns or that it hires or leases to do work from which they make their profits. Even if the construction company loses money on owning equipment it can still make a profit from using it correctly. The opposite is also true, namely that the company can "make" a profit on its plant and lose it on construction. A good balance is required such that the correct plant rates are charged to ensure that the construction com- 27 Muller/ Contractor's Plant: Whether to Buy or to Lease? pany makes a profit and gets enough work, rather than making money on its plant but not getting sufficient work because its plant rates are too high to be competitive in the market. In general terms, plant is one of the resources available to the construction company; the others being labour, materi­ als, money and management. As such the construction company must maximise its use of these resources to maxi­ mise its return on its investment in the long-term. 1 . Based on facts, figures and views contained in this ex­ ercise, leasing should be opted for over buying. 2. It should, however, not be used where the NPV is so much below zero that the respective finance could be re-invested at a better rate of return. 3. If the NPV is not too far below zero, the company concerned should use its economic intuition as to whether it would prefer the extra funding, meaning that they would have to buy a plant and would then be responsible for all the acquired responsibilities, for example, drivers, mechanics, workshops etc. or whether they would rather lease and thereby have more resources available for resource demand as and when needed. Bibliography BARBER, G. 1973. Builder's Plants and Equipment, London: Newnes-Butterworths. BIERMAN, H. 1982. The Lease versus Buy Decision, Englewood Cliffs, NJ: Prentice Hall. BREALEY, R.A. & MYERS, s.c. 1991. Principles of Corporate Fi­ nance, McGraw-Hill, Inc. FERRARA, W. L. 1979. The Lease-Purchase Decision, New York: Na­ tional Association of Accountants. 28 1997 Acta Structilia Vol 4 No 1 HARRIS, F. & McCAFFER, R. 1986. Management and Investment Decision - Construction Plant, E. & F. N. Spon Ltd. Industrial Development Corporation (S.A.) (199-) Standard Lease Buildings: Why Lease? Sandton: The Corporation. MEAD, M.T. & MITCHELL, G.L. 1971. Plant Hire for Building and Construction, London: Newnes-Butterworths. NEVITT, P.K. & FABOZZI, F.J. 1988. Equipment Leasing, Dow Jones­ Irwin, Inc., Homewood, Ill. POSNER, W.H. 1990. The Leasing Process: A Guide for the Com­ mercial Tenant, Ontario: Captus Press. Ross, S. & WESTERFIELD, R. 1990. Corporate Finance, McGraw-Hill, Inc. WALL, R.D. 1978. Lease and Rental Services - South Africa, Cape Town: George Warman. 29