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Despite the fact that similar approaches are used in arriving at the optimum selection in both make or buy and lease or buy decisions, the two scenarios have distinct clear cut differences. In both scenarios, financial analysis tools including the weighted average cost of capital, payback period, net present value and internal rate of return are used owing to the fact that they both involve investment decisions (Graham & Harvey, 2001, p.187; Kierulff, 2008, p.321; Pierru, 2009, p.1481; Osborne, 2010, p.234). Notwithstanding, leasing and making are two entirely different phenomena. By definition, a lease is a contract that grants a lessor the occupation or use of property for a specified period in exchange for a specified sum of money, which is paid at given intervals. Making on the other hand involves the use of the factors of production that are available within the firm or purchased inventory for producing assets or in most cases, finished products, which are sold to consumers. Therefore, while making might involve production of finished products for resale, leasing only entails the purchase of capital goods and other non-current assets. Fundamentally, a make or buy decision mostly involves choosing whether to produce a particular product or outsource the production process to another producer (Moschuris, 2007, p.40). Lease or buy decisions on the other hand will mainly involve choosing whether to meet the total cost of an asset by purchasing it immediately or practically renting it for a given period of time, with or without the option of purchasing it when the period elapses (Barkham & Park, 2011, p.157).
Over the years, leasing has become quite popular as a method of acquiring capital goods and other non-current assets in most organizations. This is because, among other reasons, “Leasing offers greater operational, strategic and financial benefits than outright ownership” (Cahill, 2006, p.8). Through leasing, most businesses are in a position to acquire costly equipment without compromising their ability to meet other financial obligations as they fall due. Moreover, leasing frees up liquid assets and other financial resources, which can in turn be put to more productive and strategic business uses. Some of the major advantages of leasing include conversion of capital, greater flexibility in making payments, hedging against residual value risk, tax savings, and enhancing operational flexibility (Schallheim, 2009, p.c1)
In order to minimize default risk, most methods of financing require a firm to provide collateral or upfront commitment fees. Leasing on the other hand does not require collateral or a substantial amount of money to be paid as a deposit prior to the acquisition of a lease asset. For this reason, it frees the company’s assets to be invested in fluid financial instruments as opposed to non-current assets, which are more often than not illiquid. Leasing also facilitates expansion through the purchase of fixed assets while allowing the firm to retain most of its cash. Furthermore, financial resources, which would have otherwise been used to meet tax obligations and repair and maintenance costs for the firm’s assets, can be transferred to the lessor.
Leasing provides a great degree of flexibility to a firm when it comes to making payments. Most lease options are usually tailor made to meet the firm’s budgetary or cash flow requirements. For instance, payments can be made on a monthly basis, quarterly, semiannually or once a year, in arrears or in advance. Other than that, a lessor can allow a firm to make stepped payments either at an increasing or decreasing rate. Compared to purchasing, leasing has minimal financial requirements, which do not have significant implications on budgetary allocations. This allows a firm to make substantial savings and timely improvements in productivity.
Residual value risk occurs when an asset becomes obsolete hence rendering it impossible to dispose it off to a third party at the end of its useful life. Because lease contracts allow firms to return the asset to the lessor at the end of the lease period, they are able to get rid of obsolete assets when the contract is terminated. Moreover, the fact that the expenses incurred in repair and maintenance of leased assets could be transferred to the lessor enables firms to maximize the utility of the assets by avoiding unnecessarily high repair and maintenance costs. Another interesting phenomenon about lease financing is that in some instances, the total cost of the lease can actually be less than the cost of the equipment (Cahill, 2006, p.8). This is because, in such cases, the tax advantages associated with the lease payment significantly reduce the total cost of the leased asset to an extent that it becomes less that the cost of purchasing the asset.
Finally, leasing increases operational flexibility. While purchasing might limit the ability of a firm to upgrade or change from one piece of equipment to another when the need arises, lease contracts, especially for operating leases, can provide for a renewal option where the lessee is allowed to renew the contract periodically, say on an annual basis. Consequently, when an asset becomes obsolete, the lessee may opt not to renew the lease contract and acquire assets that match the prevailing technological requirements.
Barkham, R. & Park, A., 2011. Lease versus buy decision for corporate real estate in the UK. Journal of Corporate Real Estate, 13(3), pp.157-68.
Cahill, D., 2006. The advantages of leasing. Nursing Homes, 55(7), pp.8-9.
Graham, J.R. & Harvey, C.R., 2001. The theory and practice of corporate finance: evidence from the field. Journal of Financial Economics, 60, pp.187-243.
Kierulff, H., 2008. MIRR: A better measure. Business Horizons, 51, p.321—329.
Moschuris, S.J., 2007. Triggering Mechanisms in Make-or-Buy Decisions: An Empirical Analysis. Journal of Supply Chain Managemen, 43(1), pp. 40-49.
Osborne, M.J., 2010. A resolution to the NPV–IRR debate? The Quarterly Review of Economics and Finance , 50, pp.234–39.
Pierru, A., 2009. The weighted average cost of capital is not quite right”: A rejoinder. The Quarterly Review of Economics and Finance, 49 , pp.1481–84.
Schallheim, J., 2009. Evidence for the Leasing Value Proposition. The Journal of Equipment Lease Financing, 27(3), pp.C1-C7.