Lease, Custom Hire, Rent or PurchaseFarm Machinery: Evaluating the Options

Jeff Williams and Terry Kastens

Revised September 1998

Presented at the Department of Agricultural Economics Risk and Profit Conference, Kansas StateUniversity, August 20-21, 1998.

Jeff Williams is a Professor and Terry Kastens is an Assistant Professor and Crop and FarmManagement Extension Specialist in the Department of Agricultural Economics, Kansas StateUniversity.

1

Lease, Custom Hire, Rent or PurchaseFarm Machinery: Evaluating the Options

Introduction

Machinery and equipment expense represents a major category of cost in crop production. Acomparison of machinery costs to total crop costs on Kansas Farm Management Association cropfarms indicates machinery costs range from 38.3 to 47.4 percent of total crop production costs(Langemeier and Taylor, 1997). Purchasing equipment with the use of loans from financial institutionsor equipment manufacturers has been the typical method of obtaining machinery services for most farmoperations. Producers are increasingly considering other options for obtaining machinery services dueto increasing equipment costs, obsolescence of owned equipment and limited sources of outside debtcapital. This paper focuses on how to evaluate the costs of alternative ways of obtaining machineryservices. These include the traditional method of purchasing equipment, as well as leasing equipment,renting equipment, and obtaining machinery services from custom operators. A demonstration of theappropriate economic analysis that can be completed with the use of a spreadsheet is provided using acombine example.

A method of estimating machinery costs over several time periods in current dollars is neededto compare the options of leasing, using custom hire services, renting machinery or purchasingequipment. To accurately evaluate the options, Net Present Value Analysis will be used. Net presentvalue analysis procedures use discounted cash flows. This method is desirable because it accounts forthe time value of money or opportunity cost of having funds tied up in capital items such as machinery. It also can incorporate the effects of all applicable income tax deductions, and market depreciation onthe decision. The traditional DIRTI (annual depreciation, interest, fixed repairs, taxes, and insurance)formula used to calculate ownership costs for enterprise budgets and partial budgeting is not suitablebecause it can’t account for both income tax depreciation and market depreciation, income taxes, thetime value of money, and the timing of cash flows for fixed and variable cost components, which can bedifferent from option to option. Analysis of discounted cash flows can account for both components ofmachinery costs, housing, and the ownership or fixed costs which include depreciation, interest andinsurance, and the variable costs which include labor, fuel, oil and repairs. The analysis method alsoincludes the income tax consequences, which affect after tax costs of owning and operating machineryor obtaining machinery services by leasing, renting or hiring custom work. Procedures for estimatingmarket value of machinery and repair costs are referred to as well.

Net Present Cost or Discounted Cash Flows

A comparison of the costs of alternative options for obtaining machinery services requires comparingcosts over several years due to multiple year lease payments or loan payments and income taxconsequences of the options. A problem exists in that $1,000 of cost today does not have the samevalue as $1,000 of cost 5 years from now. Discounting accounts for or adjusts for this problem. Thebasic concept of the discounted cash flow (net present cost) procedure is that a dollar received or paidtoday is worth more than a dollar to be received or paid sometime in the future because today’s dollarcan be invested to generate earnings. Likewise, a $1,000 of cost 5 years from now is “cheaper” than

2

$1,000 of cost today. Delaying payment of a fixed dollar amount into the future reduces costs. Therefore, financing arrangements which have different payment requirements at different times affecttoday’s cost.

In short, funds invested in machinery or other capital items have opportunity costs because theycould be earning a return in another investment. Therefore, a discounting procedure is applied to thecash flows. This discounting procedure converts the cash flow which occurs over a period of futureyears into a single current value so that alternative options can be compared on the basis of a singlevalue. For machinery, that single value is the net present cost of machinery services.

Investing $1,000 today at a simple interest rate of 10% yields $1,100 at the end of one year. This can be calculated using the compounding formula presented in equation (1).

(1)

where: FV = future valuePV = present value i = interest rate n = year

$1,000 * (1.10)1 = $1,100 for i = .10 and n = 1

The compounding formula can be reversed to form the discounting formula, equation (2).

(2)

One should be indifferent about receiving $1,100 one year from now or $1,000 today because

What is $1,000 received a year from today worth today?

What is $1,000 received two years from today worth today?

Today’s value of $1,000 received in the future depends upon when it is received and the discountfactor (i).

To illustrate the present value computation or discounting in more detail consider the examplein Table 1. Assume a farm manager has agreed to pay $1,000 a year at the end of each year for thenext five years for the use of his retired neighbor’s machine shop.

3

Table 1. Present Value of $1,000 Costs over Five Years using a Discount Rate of 10%.Year Cash Flow * Discount Factor = Present Value or Cost

1 $1,000 .909 $9092 $1,000 .826 $8263 $1,000 .751 $7514 $1,000 .683 $6835 $1,000 .621 $621

Total $3,7091

1 This calculation can be operationalized in most spreadsheets using the built in NPV function. NPV(Discount Rate, Beginning Cell:Ending Cell). The cell range is the cash flow over all years to bediscounted.

The total present value or cost of these services is actually $3,790 at the beginning of year 1 and not$5,000 because in each year the cost of $1,000 is valued less.

Another way of looking at this is that $3,790 today invested at 10% per year is equal to $6,104at the end of 5 years: $3790 * (1.10)5 = $6,104. This is equal to receiving $1,000 at the end of eachyear and investing the $1,000 each year at 10%.

Year 1 $1,000 * (1.10)4 = $1,464Year 2 1,000 * (1.10)3 = 1,330Year 3 1,000 * (1.10)2 = 1,210Year 4 1,000 * (1.10)1 = 1,100Year 5 1,000 * (1.10)0 = 1,000Total = $6,104

Conversely, the $6,104 at the end of year 5 is equal to $3,790 today.

Choosing a Discount Rate

An appropriate discount rate must be selected to reflect the time value of money. As illustrated, thediscount rate is used to adjust future value of cash flow to the present. The higher the discount rate thesmaller the present value. The discount rate chosen should reflect the minimum acceptable rate ofreturn for an investment (Boehlje and Eidman 1988). If the investment is 100% financed with debtcapital, then the minimum rate of return is the interest rate on the loan since the loan must be repaid. Because farms typically operate with both debt and equity, usually the objective is to evaluateinvestment alternatives based on the optimal long-run combination of debt and equity (Boehlje andEidman 1988). To do this a long-run weighted cost of capital is used. The cost of debt funds and costof equity funds must be weighted by the long-run proportion of borrowed funds and funds from equity. Therefore, the discount rate should be calculated as in equation (3).

4

(3) i = (% e * re) + (% d * rd)where:

i = discount rate (weighted cost of capital)%e = percent funds used from equity re = return on equity%d = percent funds used from debt rd = interest rate on debt

The rate of return to equity is the cash return from using the assets plus any return in the form ofcapital gain from holding the asset. Casler, Anderson, and Aplin (1984) state that the average cost ofcapital for a farm declines as debt funds are substituted for equity sources of capital up to a point. However, beyond the point which is the optimal proportion of debt to equity, or the firm’s lowest costof capital, the use of additional debt raises the cost of capital. We are assuming that the firm isoptimally financed such that cost of debt equals the return on equity. Normally, you should expect yourrate of return on equity to be at least equal to your cost of debt in the long-run or you will continue tomake debt payments from returns on equity or equity. Historical data indicate that long-run returns toequity are marginally greater than debt costs. For our purposes we will assume that in the long-run reand rd in equation (3) are equivalent. That is, little harm is done if machinery decisions are made usinga discount rate set equal to the typical interest rate on the machinery loan or farm loans.

The discount rate must also be adjusted to an after tax to account for the impact of interestdeduction on after tax interest costs or taxes on a rate of return used to calculate the discount rate. Theafter tax discount rate can be determined using equation (4).

(4) r = i * (1 - MTR),where:

r = after tax discount rate i = before tax discount rate MTR = marginal tax rate

The marginal tax rate is the sum of the marginal federal income tax rate, state income tax rate, and selfemployment tax rate. Most producers who are married and file a joint return are in either the 15%(taxable income up to $42,350 in 1998) or 28% federal income tax bracket. The Kansas marginalincome tax rate for these producers would be approximately 5-6%. The self employment tax rate is15.3% up to $68,000 in income in 1998. Therefore, the marginal tax rate for a producer in the 15%federal income tax bracket would be approximately 35-36%.

Defining the Options

We define four options for obtaining machinery services: 1) lease, 2) custom hire, 3) rentalarrangement, or 4) purchase. These options may mean different things to different managers; there areno standard definitions in the industry. Therefore, it is important that we define what we consider to bethe specific characteristics of each option because analysis of each requires somewhat different dataand is treated differently for tax purposes. Additional discussion of similar alternatives can also be

5

found in Hinman and Willett (1991).

Lease. We define a lease as a long term contract. These contracts normally are for 3 to 5years. The machinery dealer essentially provides financing for machinery services to the person leasingthe machine, but retains ownership. This form of a lease is not what some refer to as an operatinglease. The farm manager leasing the equipment is responsible for insurance payments, taxes, and repairsnot covered by warranty just as if the equipment had been purchased. The responsibilities for operatingcosts including maintenance fall on the farm manager just as they would if the machine had beenpurchased. The manager provides the labor for operating the machinery. The main differences are thatthe financing is done with specified lease payments instead of a loan and the title to the equipmentremains with the equipment dealer. At the end of the lease the equipment is owned by the equipmentdealer and not the farm manager. This type of lease generally may not be canceled without penalty.

Rent. This option involves the use of a short term contract which is based upon a short timeperiod such as a few days, or a harvest period such as a few weeks or a few months. The farmmanager rents the machinery by the hour, day, week, month or other arrangement. The owner of theequipment is responsible for all ownership costs including insurance, taxes, and major repairs. Thefarm manager pays for variable expenses such as labor, fuel, oil, and routine maintenance. This type ofan arrangement may occasionally be referred to as an operating lease.

Custom Hire . This option is also a short term agreement, but the fees are normally for aspecific amount of work to be done. Fees may be based on the number of acres covered or bushelsper acre harvested. Generally, a custom operator provides the machinery, machine operator, and paysfor all ownership and operating costs.

Purchase. This option is the traditional method where the farm manager buys a machine froma dealer with the use of equity and or a loan from the dealer or financial institution. Ownership of themachine is transferred to the farm manager who is responsible for making loan payments, insurancepayments, taxes, and repairs not covered by warranty. The owner also provides the labor or hires itand pays for all variable or operating cost such as fuel, lubricants and routine maintenance.

Costs, Income Tax Implications and other Characteristics of the Options

Table 2 displays the characteristics and income tax implications that must be considered inevaluating the options. Several are discussed briefly.

Leasing, renting or custom hiring machinery services generally does not require a downpayment. A lease or rental agreement may require a refundable or non-refundable deposit. A lease orrental agreement will likely call for payments at the beginning of the lease or rental period.

Custom hiring specialty operations, or operations which you require the least frequently, may bea way of avoiding large ownership costs for equipment used infrequently. Farm managers who leaseequipment incur the same variable costs as those who purchase equipment, such as labor, fuel, andrepair costs. They generally incur the same insurance and housing costs. However, the operators who

6

rent or custom hire the equipment may not pay all variable costs or taxes, insurance, and housing costs. In the case of purchasing custom hire services they “pay” none. These differences are important torecognize in the analysis of the options. However, the manager should keep in mind that the costs ofoperating and maintaining the equipment are paid in one form or another (actual costs are often nearcustom rates). So, if the analysis indicates one alternative is dramatically less expensive, the analysisshould be reviewed to be sure some costs were not overlooked. Differences in overall costs may varydue to the risk associated with the options.

Tax treatment or income tax deductions vary by option. In a true lease agreement the entirelease payment is deductible. A lease deposit is also deductible, but the deduction must be amortized(spread over) the life of the lease. Depreciation and interest deductions are not used. Custom hire andrental payments are fully deductible just as are other operating costs. With a purchase the machinery isset up on a depreciation schedule and depreciation deductions used. If the machine is financed with aloan the interest component of a payment is also deductible. In addition, you can expense up to$18,500 of section 179 property on 1998 federal income tax returns. If this expensing option has notbeen used up by other capital purchases this can be deducted in the first year of ownership. It can beclaimed only during the first year of ownership. The limit on section 179 property expensing increasesto $25,000 by 2003. Variable costs of any of the options such as labor, fuel, and repairs as well asinsurance payments are tax deductible.

Custom hire and rental options offer substantial flexibility, but also offer the farm manager theleast amount of control of the machinery. Ownership offers the most control because all decisions aremade by the owner. For example, one important disadvantage to custom hiring or short term rental ofmachinery is it may not be available for use at the optimal time it is needed. On the other hand,machinery owners who lack sufficient operating labor may view custom hire as providing increasedflexibility.

7

Table 2. Characteristics of Lease, Custom Hire, Purchase or Rent Options.Characteristics Lease Custom Hire Rent Purchase

CostsDown Payment/Deposit Yes/Smaller ? Yes/Smaller Yes/LargerLabor Y N Y YFuel/Oil Y N Y YMaintenance Y N ? YMajor Repairs Y/Warranty N N Y/WarrantyInsurance Y N N YHousing Y N N YProperty Taxes Y if applies N N Y if applies

Income Tax DeductionsDepreciation Deduction N N N YSection 179 Expensing N N N YInterest Deduction N N N YVariable Cost Deduction Y None Y YLease Payment Deduction Y -- -- --Rent Payment Deduction -- -- Y --Custom Fee Deduction -- Y -- --

OtherLong Term Agreement Y N N YControl Most Least Limited MostAvailability Readily For typical operations Limited ReadilyRisk of Obsolescence Limited None None MostY indicates yes or in the case of costs that are the responsibility of the farm manager.N indicates no or in the case of costs that are not the responsibility of the farm manager.

The Procedure

The following outlines the general calculation of costs that are made to evaluate the four options. Detailed equations are presented in the Technical Appendix. Hinman and Willett (1991) provide analternative procedure and software that will yield equivalent results.

Lease+ Lease Deposit+ Lease Payment- Deposit Deduction Effect- Lease Payment Deduction Effect+ After Tax Variable Costs

8

+ After Tax Taxes, Insurance, and Housing Costs= After Tax Cash Flow

Custom Hire+ Custom Hire Fees- Custom Hire Fee Deduction Effect= After Tax Cash Flow

Rent+ Rent Payments- Rent Payment Deduction Effect+ After Tax Variable Costs+ After Tax Taxes, Insurance, and Housing Costs= After Tax Cash Flow

Purchase+ Down Payment+ Loan Payment- Depreciation Deduction Effect- Interest Deduction Effect+ After Tax Variable Cost+ After Tax Taxes, Insurance, and Housing Costs- Salvage Value+ Balancing Charge (Depreciation Recapture)= After Tax Cash Flow

The meaning of some of these variables such as the lease payment, loan payment, rental fee,custom hire charge and salvage value are straight forward. Others require further explanation which arepresented below.

Deposit Deduction Effect = (Deposit/Length of Lease in Years) * Marginal Tax Rate (MTR)Lease Payment Deduction Effect = Lease Payments * MTRAfter Tax Variable Costs = Variable Costs * (1 - MTR)After Tax Fixed Costs = Fixed Costs * (1 - MTR)Custom Hire Fee Deduction Effect = Custom Hire Fees * MTRRental Fee Deduction Effect = Rental Fees * MTRDepreciation Deduction Effect = Depreciation * MTRInterest Deduction Effect = Interest Payment * MTRBalancing Charge = (Salvage Value - Book Value) * (MTR - Self Employment Tax Rate)

Some additional explanation of those variables labeled Deduction Effect is also necessary. The deduction effect is the amount by which the deduction reduces costs on an after tax basis.

After Tax Cost = Before Tax Cost * (1 - MTR)After Tax Cost = Before Tax Cost - Deduction Effect

9

Setting the two equal to each of other and solving for the Deduction Effect results in thefollowing.Before Tax Cost * (1 - MTR) = Before Tax Cost - Deduction EffectDeduction Effect = Before Tax Cost * MTR

Although repair and maintenance cost estimates and an estimate of salvage value are importantfor the analysis, it is not the intent of this paper to discuss the alternatives for determining these values. Kastens (1997) provides a detailed review of procedures and examples for calculating repair costs andsalvage values.

An ExampleAn example of leasing, custom hiring, renting or purchasing a combine is used to demonstrate how theoptions are evaluated (Table 3). The combine is assumed to be operated in years 1 through 5. Valuesshown in year 0 are considered to take place at the end of year 0 or at the beginning of year 1. Thevalues used for the evaluation are presented below.

Annual Lease Payment $23,152Lease Deposit $0Length of Lease (years) 5Custom Hire Charge ($/acre) $17.82Acres 1,000Custom Hire Inflation 3%Rental Charge ($/hour) $160Hours to harvest 1,000 acres 135Rental Rate Inflation (%/year) 3%Purchase Price $140,000Down Payment $19,331Depreciable Basis $140,000Salvage Value at end of 5 years $77,638Interest Rate of Loan 9.65%Length of Loan (years) 5Loan Payment ($/year) $31,548Marginal Income Tax Rate 35%After Tax Interest Rate on Loan 6.27% [(1-.35) * 9.65%]Annual Fuel, Oil, and Labor Inflation Rate 3%

The values for repairs, labor, fuel, and oil are found directly in the example because they aredifferent each year. Labor, fuel, and oil costs total $4.36/acre in the first year. Operating costs areequivalent for the lease and the purchase. These costs are somewhat smaller in the rental examplebecause all repairs are assumed to be made by the owner and not the manager who is renting theequipment. There are no operating expenses in addition to the custom hire charge. Depreciation fortax purposes is based upon the MACRS 150% double declining balance for 7 year property.

10

Table 3. NPV of Cashflows Calculations for Lease Custom Hire Rent and Purchase.Lease

Year

Deposit orLease

Payment

DepositDeduction

Effect

LeasePayment

DeductionEffect

After TaxVariableCosts

After TaxTaxes, Insurance

HousingAfter TaxCashflow

Deposit 0 $0.00 $0.000 $23,152.00 $23,152.001 $23,152.00 $0.00 $8,103.20 $2,889.66 $0.00 $17,938.462 $23,152.00 $0.00 $8,103.20 $3,107.94 $0.00 $18,156.743 $23,152.00 $0.00 $8,103.20 $3,349.41 $0.00 $18,398.214 $23,152.00 $0.00 $8,103.20 $3,611.00 $0.00 $18,659.805 $0.00 $8,103.20 $3,892.18 $0.00 ($4,211.02)

+ - - + +Present Value >>> $82,960.02

Custom Hire

YearCustom Fee

Payment

Custom FeeDeduction

Effect After TaxCashflow

0 $0.001 $17,815.00 $6,235.25 $11,579.752 $18,349.45 $6,422.31 $11,927.143 $18,899.93 $6,614.98 $12,284.964 $19,466.93 $6,813.43 $12,653.515 $20,050.94 $7,017.83 $13,033.11

+ -Present Value >>> $51,227.80

11

Table 3. NPV of Cashflows Calculations for Lease Custom Hire Rent and Purchase (continued).Rent

YearRent

Payment

Rent FeeDeduction

Effect

After TaxVariableCosts

After TaxTaxes, Insurance

HousingAfter TaxCashflow

0 $21,600.00 $21,600.001 $22,248.00 $7,560.00 $2,834.00 $0.00 $17,522.002 $22,915.44 $7,786.80 $2,919.02 $0.00 $18,047.663 $23,602.90 $8,020.40 $3,006.59 $0.00 $18,589.094 $24,310.99 $8,261.02 $3,096.79 $0.00 $19,146.765 $0.00 $8,508.85 $3,189.69 $0.00 ($5,319.15)

+ - + +Present Value >>> $80,642.88

Purchase

Year

DownPayment or

LoanPayment

DepreciationDeduction

EffectInterest

Deduction

After TaxVariableCosts

After TaxTaxes,

InsuranceHousing

SalvageValue

BalancingCharge

After TaxCashflow

0 $19,331.00 $19,331.001 $31,548.06 $5,247.90 $4,075.60 $2,889.66 $0.00 $25,114.222 $31,548.06 $9,373.70 $3,403.35 $3,107.94 $0.00 $21,878.943 $31,548.06 $7,364.70 $2,666.24 $3,349.41 $0.00 $24,866.524 $31,548.06 $6,002.50 $1,858.00 $3,611.00 $0.00 $27,298.555 $31,548.06 $6,002.50 $971.76 $3,892.18 $0.00 $77,638.00 $6,951.20 ($42,220.82)

+ - - + + - +Present Value >>> $73,308.24

12

Table 4: Summary of Example Results.Net Present Cost Annualized

Lease $82,960.02 $19,840.63Custom Hire $51,227.80 $12,251.59Rent $80,642.88 $19,286.47Purchase $73,308.34 $17,532.32

A summary of the results of the analysis is presented in Table 4. The column labeled NetPresent Cost is the present value of the total after tax costs over the period of analysis for each option. This example indicates that custom hire is the least costly, followed by the purchase alternative, rentalternative, and lease alternative. The second column reports the annualized costs. These valuesrepresent the average cost incurred in each year of the analysis (years of machinery services) which isequal to the Net Present Cost. This is an average annual cost adjusted for the time value of money. The amortized value is calculated using equation (5).

(5)

where: N = total years in analysis (length of ownership) r = discount ratePV = present value

Most spreadsheet software have a built in function to calculate the amortized value which is usuallycalled PMT which takes the form PMT(r, N, PV).

One assumption made in the analysis is that the lease payment deduction occurs one year afterthe initial lease payment. The deduction for depreciation and interest occurs much closer to the time ofactual payment because loan payments are made at the end of the period, but lease payments arenormally made at the beginning of the period. If we make the simplifying assumption that the differencein time between the lease payments and the lease payment deduction, and the loan payments and theinterest and depreciation deductions associated with a purchase does not matter, then the after tax leasepayment (Lease Payment * (1 - MTR)) could be directly compared to the annualized purchase cost. This would be similar to assuming the lease payment was made at the end of the period. In this case,the annual after tax cost of the lease is $15,048 or [$23,153 * (1 - .35)]. The loan payment for thepurchase cannot be treated in such a straight forward manner for comparison. The after tax annualizedvalue of the purchase must be calculated. Table 5 presents the net present cost of the purchase withoutoperating costs, taxes, insurance, and housing costs. This assumes there is no difference betweenoperating costs, taxes, insurance, and housing costs of the two alternatives which in most cases will betrue. The net present cost of $59,344.21 is then annualized using equation (5) as demonstrated below.

The $14,189 after tax annualize cost of the purchase is slightly less than the annual cost of the lease of$15,048. This comparison cannot be made for other alternatives without similar assumptions and,therefore, will only be feasible for comparing a lease to a purchase option.

13

Table 5. NPV of Cashflow Calculation for Purchase without Variable Costs.

Year

DownPayment or

LoanPayment

DepreciationDeduction

Effect

InterestDeduction

Effect

After TaxVariableCosts

After Tax Taxes,

InsuranceHousing

SalvageValue

BalancingCharge

After TaxCashflow

0 $19,331.00 $19,331.001 $31,548.06 $5,247.90 $4,075.60 $0.00 $0.00 $22,224.562 $31,548.06 $9,373.70 $3,403.35 $0.00 $0.00 $18,771.003 $31,548.06 $7,364.70 $2,666.24 $0.00 $0.00 $21,517.124 $31,548.06 $6,002.50 $1,858.00 $0.00 $0.00 $23,687.565 $31,548.06 $6,002.50 $971.76 $0.00 $0.00 $77,638.00 $6,951.20 ($46,113.00)

+ - - + + - +Present Value >>> $59,344.21

14

When is a Lease not a Lease?

If a lease is actually a conditional sales contract it must be treated as a purchase. Depreciationand interest deductions must be used for tax purposes rather than the “lease” payments. The cost of theequipment for depreciation is determined by calculating the present value of lease payments and theoption price at the end of the lease. This could be to the disadvantage of the “purchaser.”

The Internal Revenue Service says a lease agreement should be treated as a conditional salescontract if any of the following is true. (IRS, 1997)1. The agreement applies part of each payment toward an equity interest you will receive.2. You receive title to the property after you pay a stated amount of required payments.3. You must pay, over a short period of time, an amount that represents a large part of the price you

would pay to buy the property.4. You pay much more than the current fair rental value of the property.5. You have an option to buy the property at a small price compared to the value of the property at the

time you can exercise the option. Determine this value at the time you enter into the agreement.6. You have an option to buy the property at a small price compared to the total amount you pay

under the lease.7. The lease designates some part of the payment as interest or part of the payments are easily

recognizable as interest.

An example of a lease and a buyout at the end of the lease with the use of a loan is provided inTable 6. The basic information in this example is the same as that used in the previous example. Themajor exceptions are that the length of “ownership” is for 10 years instead of 5 and a 5 year loan isused to buy the leased machine at the end of year 5 (beginning of year 6) for the salvage value. Forsimplicity, the operating costs, taxes, insurance, and housing costs are assumed to be equal and left outof the analysis. For the first 5 years the analysis treats the cash flow like a lease and treats the second 5year period like a purchase. An outright purchase using a 5 year loan with the intention of owning themachine for 10 years is used for comparison. In addition, a Conditional Sales Contract or CapitalLease Analysis is provided for comparison.

Under a conditional sales contract or capital lease the general approach to calculation of thecosts are outlined below.

Conditional Sales Contract or Capital Lease+ Lease Deposit+ Lease Payment- Depreciation Deduction Effect- Interest Deduction Effect+ After Tax Variable Cost+ After Tax Taxes, Insurance, and Housing Costs- Salvage Value+ Balancing Charge (Depreciation Recapture)= After Tax Cash Flow

15

Table 6. Analysis of Lease/Buyout, Capital Lease, and Purchase.Lease Lease/Buyout

Year

Deposit orLease

Payment

DepositDeduction

Effect

LeasePayment

DeductionEffect

After TaxVariableCosts

After TaxTaxes, Insurance

HousingAfter TaxCashflow

0 $0.00 $0.000 $23,152.00 $23,152.001 $23,152.00 $0.00 $8,103.20 $0.00 $0.00 $15,048.802 $23,152.00 $0.00 $8,103.20 $0.00 $0.00 $15,048.803 $23,152.00 $0.00 $8,103.20 $0.00 $0.00 $15,048.804 $23,152.00 $0.00 $8,103.20 $0.00 $0.00 $15,048.805 $0.00 $0.00 $8,103.20 $0.00 $0.00 ($8,103.20)

+ - - + +Lease Present Value >>> $68,996.00

Buyout Lease/Buyout

Year

DownPayment or

LoanPayment

DepreciationDeduction

Effect

InterestDeduction

Effect

After TaxVariableCosts

After Tax Taxes, Insurance

HousingSalvageValue

BalancingCharge

After TaxCashflow

0 $0.000 $0.000 $0.000 $0.000 $16,089.20 $0.006 $16,825.63 $3,015.52 $2,173.65 $0.00 $0.00 $11,636.467 $16,825.63 $5,386.26 $1,815.12 $0.00 $0.00 $9,624.258 $16,825.63 $4,231.86 $1,422.00 $0.00 $0.00 $11,171.779 $16,825.63 $3,449.12 $990.93 $0.00 $0.00 $12,385.58

10 $16,825.63 $3,449.12 $518.27 $0.00 $0.00 $53,686.00 $5,809.08 ($35,018.69)+ - - + + -

Buyout Present Value >>> $9,336.28Total Lease/Buyout Lease/Buyout Present Value >>> $78,332.27

16

Table 6. Analysis of Lease/Buyout, Capital Lease and Purchase (continued).Capital Lease - Must find present value of lease payments and treat as interest and depreciation deductions instead of lease deductions.

Year

Deposit orLease

Payment orOption

PaymentDepreciationDeduction

InterestDeduction

After TaxVariableCosts

After TaxTaxes, Insurance

Housing SalvageValue

BalancingCharge

After TaxCashflow

0 $0.00 $0.000 $23,152.00 $23,152.001 $23,152.00 $5,542.28 $4,211.78 $0.00 $0.00 $13,397.942 $23,152.00 $9,899.51 $3,836.26 $0.00 $0.00 $9,416.233 $23,152.00 $7,777.82 $3,424.50 $0.00 $0.00 $11,949.684 $23,152.00 $6,339.20 $2,973.01 $0.00 $0.00 $13,839.795 $16,089.20 $6,339.20 $2,477.94 $0.00 $0.00 $7,272.056 $16,825.63 $6,339.20 $2,173.65 $0.00 $0.00 $8,312.787 $16,825.63 $6,339.20 $1,815.12 $0.00 $0.00 $8,671.308 $16,825.63 $3,172.19 $1,422.00 $0.00 $0.00 $12,231.459 $16,825.63 $0.00 $990.93 $0.00 $0.00 $15,834.70

10 $16,825.63 $0.00 $518.27 $0.00 $0.00 $53,686.00 $10,737.20 ($26,641.44)+ - - + + - +

Present Value >>> $83,880.06

17

Table 6. Analysis of Lease/Buyout, Capital Lease and Purchase (continued).Purchase

Year

DownPayment or

LoanPayment

DepreciationDeduction

Effect

InterestDeduction

Effect

After TaxVariableCosts

After Tax Taxes, Insurance

HousingSalvageValue

BalancingCharge

After TaxCashflow

0 $19,331.00 $19,331.001 $31,548.06 $5,247.90 $4,075.60 $0.00 $0.00 $22,224.562 $31,548.06 $9,373.70 $3,403.35 $0.00 $0.00 $18,771.003 $31,548.06 $7,364.70 $2,666.24 $0.00 $0.00 $21,517.124 $31,548.06 $6,002.50 $1,858.00 $0.00 $0.00 $23,687.565 $31,548.06 $6,002.50 $971.76 $0.00 $0.00 $24,573.806 $0.00 $6,002.50 $0.00 $0.00 $0.00 ($6,002.50)7 $0.00 $6,002.50 $0.00 $0.00 $0.00 ($6,002.50)8 $0.00 $3,003.70 $0.00 $0.00 $0.00 ($3,003.70)9 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00

10 $0.00 $0.00 $0.00 $0.00 $0.00 ($42,948.80)$53,686.00 $10,737.20

+ - - + + - +Present Value >>> $78,183.28

18

Table 7. Summary of Lease/Buyout, Capital Lease and Purchase.Net Present Cost Annualized

Lease/Buyout $78,332.27 $10,780.67Capital Lease $83,880.06 $11,544.20Purchase $78,183.28 $10,760.17

In the example, the purchase is slightly less expensive than a capital lease or the lease with a buyout atthe end. It would be appropriate to consult your tax advisor before entering into a lease agreement.

The Spreadsheet

A spreadsheet is available for a charge of $5.00 which is designed to perform the calculationspresented in this paper. The spreadsheet file is LCRPOPT.XLS. The spreadsheet has 5 worksheets. A brief description of each is listed below.

Sheet A - Contains basic data for the net present cost calculations.Sheet B - Illustrates the annual costs and compares the net present cost and annualized

cost of the options.Sheet C - Supplementary worksheet calculates repairs, salvage value and net present cost

and annualized cost of owning a machine different lengths of time.Sheet D - Supplementary worksheet for estimating salvage value of a machine based on

accumulated hours of use.Sheet E - Supplementary worksheet calculates repair and maintenance costs of a

machine.

The example in the spreadsheet matches the example presented in the paper. The spreadsheet is setupfor a five year analysis. It would need to be modified for a shorter or longer analysis. A file calledLEABOUT.XLS is also included. This spreadsheet illustrates the Lease/Buyout and Conditional SalesContract or Capital Lease example.

This software is provided on an “as is” basis, without warranty. Kansas State University andthe authors of this software will have no liability or responsibility to the cooperator or any other personor entity with respect to any liability, loss, or damage caused, or alleged to be caused, directly orindirectly by programs sold or given away by Kansas State University or the authors. This includes, butis not limited to, any interruption of service, loss of business or anticipatory profits, or consequentialdamages resulting from user or operation, and in no event will Kansas State University or the authorsbe liable for loss of profits or indirect, special, or consequential damages arising from the use of thesoftware provided by Kansas State University or the authors. The software is provided withouttechnical support.

19

References

Boehlje, Michael D. and Vernon R. Eidman. 1984. Farm Management. John Wiley and Sons, Inc. New York, NY.

Casler, George L., Bruce L. Anderson, and Richard D. Aplin. 1984. Capital Investment Analysis: Using Discounted Cash Flows. 3rd Edition. Grid Publishing, Inc., Columbus, Ohio.

Hinman, Herbert R. and Gayle S. Willett. 1991. BUY OR LEASE: A Microcomputer Program toAnalyze the Economics of Alternative Methods of Financing Farm Machinery.” MCP 0015. Washington State University, Cooperative Extension Service. December. Information forordering this software is available at http://farm.mngt.wsu.edu/software.htm

Internal Revenue Service. 1997. Farmer’s Tax Guide. Publication 225. Department of Treasury. Washington, D.C.

Kastens, Terry. 1997. “Farm Machinery Operation Cost Calculations.” MF-2244. Kansas StateUniversity, Agricultural Experiment Station and Cooperative Extension Service, May.

Kastens, Terry. 1997. Machinery Costs: Economics of Size and Selected Topics.

Kastens, Terry. 1997. Machinery Costs: Selected Topics Presented at the School of Rural Banking,Wichita, KS, June 4.

Langemeier, Larry N. and Randal K. Taylor. 1997. “A Look at Machinery Cost.” KSU FarmManagement Guide MF-842. Kansas State University, Agricultural Experiment Station andCooperative Extension Service. October.

Langemeier, Larry N. and Kim Witt. 1991. “Crop Machinery Investment, Repair and Fuel-OilRequirement for Irrigated and Dryland Crops in Kansas.” Report of Progress 613. KansasState University, Agricultural Experiment Station and Cooperative Extension Service. December.

Lee, Warren F., Michael D. Boehlje, Aaron G. Nelson, and William G. Murray. 1988 AgriculturalFinance. Iowa State University Press. Ames, Iowa.

20

Technical Appendix

Equations for Calculation of Net Present Value of After Tax Cash Flows

Purchase (Refer to equation (A5) for an alternative method)

(A1)

NPC = net present cost of cash flows t = marginal income tax rate (federal + state + self employment) i = after tax discount rate, i = loan rate * (1 - t) k = 1 to N periods (years) N = terminal yearDP0 = down payment in period 0LPk = loan paymentVCk = variable costs (labor, fuel, repairs)FCk = taxes, insurance, housing costsDk = depreciation deductionIk = interest deductionSVN = market salvage valueBCN = balancing charge = depreciation recapture = (market salvage - book value) ts = marginal income tax rate minus self employment tax rate

(t - self employment tax rate)

Reflects the amount that the depreciation deduction reduces after tax costs.

Reflects the amount that the interest deduction reduces after tax costs.

21

Reflects the after tax variable costs.

Reflects the after tax fixed costs.

Reflects cash from re-sale.

Reflects recapture of depreciation due to re-sale value above book value.

Lease

(A2)

(Refer to note on next page about the above two terms.*)

DEP0 = lease deposit (cost must be deducted over life of lease)LPYk = lease payment

Rent

(A3)

(Refer to note below about the above two terms.*)

22

RP = rental payment

Custom Hire

(A4)

CH = custom hire charge* Notice the authors have not collapsed the lease and rental payments

to

because of the longer delay in getting the tax credit for lease, and rental payments compared to usingdepreciation and interest deduction with a loan or the custom hire cost deduction. We are assuming anestimate of lease and rent charges are paid up front and the custom hire payments are made at harvestand the loan payments including interest are made at the end of the year so the credits come closer tothe actual payments than the lease and rental payments.

Purchase Alternative

(A5)

NPC = net present cost of cash flows t = marginal income tax rate (federal + state + self employment) i = after tax discount rate, i = loan rate * (1 - t) k = 1 to N periods (years) N = terminal yearC0 = purchase costDP0 = down payment in period 0LPk = loan paymentVCk = variable costs (labor, fuel, repairs)FCk = taxes, insurance, housing costsDk = depreciation deductionIk = interest deduction

23

SVN = market salvage valueBCN = balancing charge = depreciation recapture = (market salvage - book value) ts = marginal income tax rate minus self employment tax rate

(t - self employment tax rate)Note:

is replaced by C0.

is removed.

Equation (A5) could replace equation (A1) because the result is equivalent. However, including theloan payments and the interest deduction in the analysis may be easier to understand.