January 12, 2009

When assessing whether to buy or lease ag machinery for your operation, you'll want to understand the factors affecting the economics (see story) as well as compare the financial aspects of each option.

Evaluating these two options begs the question, does leasing offer enough value per acre over purchasing? Answering this question requires understanding the real cost of equipment purchases versus the cost of making a lease payment. We will first look at the characteristics of an equipment purchase, then the characteristics of a lease payment. We also will do a side-by-side comparison of the two options.

The Purchase Option Equation

Buying farm equipment requires calculating the overall yearly cost of ownership. Generally, when comparing the costs of leasing versus purchasing, some variable costs will be constant, such as repairs (in a lease, these are the responsibility of the lessee), fuel and lubrication, insurance, and housing; thus their effects may be negated.

To calculate the purchase price:

Financed Value = Asset Purchase Price (APP) - Down Payment (DP)

Most loans are calculated as a constant payment per period, with most of the initial payments going toward interest costs and most of the latter payments going toward the remaining principle. A simple loan may be calculated as follows or with spreadsheets. The loan is for a $150,000 tractor purchased with a $20,000 down payment at 6% interest for 10 years.

This loan requires semi-annual payments of $8,065.88 for a total of $153,251.81. The number of hours a particular piece of equipment is used for crop production depends on the individual farming practices and crop species. For the purpose of this document, we will assume that the farm is 1200 acres, bringing the annual tractor payment per acre to $13.44 per acre ($16,131.76 / 1,200 acres).

The Lease Option Equation

The second option would be to lease this equipment from the dealer. To calculate the payment:

Lease payment = Depreciation Fee + Finance Fee

Depreciation Fee = (Net Cap Cost - Residual) / Term

Net Cap = (Gross machine capital value + Remaining loan amounts + Add-on fees) - (Down payment + Trade-in + Discounts)

Residual is the equipment's value at the end of the lease. The ideal lease contract has the lowest negotiated Net Cap Cost and the Highest Residual Value.

Finance Fee = (Net Cap Cost + Residual) x Money Factor

The finance fee includes the fee on both the Net Capital Cost and the Residual Value. This is a simplified estimate of the finance cost without having to use complex business formulas.

Calculating the Money Factor

The term Interest Rate is the Annual Interest Rate / Number of Payments per Year. If the annual interest rate is 6% and payments are made semi-annually, the period interest rate is = 6%/2 or 3%. If the interest rate is 6% and payments are made quarterly, the period interest rate is 6% / 4 = 1.5%.

To calculate the money factor:

APR / (Periods x 200)

If the annual interest rate is 6% and payments are made semi-annually, the money factor is:

6 / (2 x 200) = .015

Sales tax is represented as a fee on the down payment. If you make a $5,000 down payment to initiate a lease, you will owe state taxes on that $5,000. If the state sales tax is 6.5%, you would owe $325 ($5,000 x .065 = $325). This is due at the time of the lease signing.

Scenario 1 - Calculating a Lease Payment

Assumptions

Tractor Price = $150,000
Negotiated Price = $140,000
Trade-in Value = $5,000
Down Payment = $6,000
Interest Rate = 6%
Money Factor = .015
Add-on Fees = $300
Term = 5 years with 10 semi-annual lease payments
Residual Value = $90,000

Net Cap Cost — $140,000 + $300 -($5,000 + $6,000) = $129,300

Depreciation Cost — ($129,300 - $90,000) / 10 = $3,930 per year

Finance Cost — ($129,300 + $90,000) x .015 = $3,289.50 per year

Semi-annual Leasing Fee — $3,930.00 + $3,289.50 = $7,219.50

Additional lease payments that must be considered are other one-time payments, including the security deposit (generally the value of one period payment), acquisition fees, and disposition fees. These are fees similar to those experienced when making an equipment purchase.

Scenario 2. Comparing the Lease Option to the Purchase Option

Assumptions

Tractor Price = $150,000
Negotiated Price = $140,000
Trade-in Value = $5,000
Down Payment = $6,000
Interest Rate = 6%
Money Factor = .015
Term Lease = 5 years, semi-annual
Purchase Option = 10 years, semi-annual
Lease Residual Value = $90,000

Purchase Price = $150,000 - $5,000 - $6,000 = $139,000
Amortized 10-Year Loan Amount = $18,685.97
Net Cap Cost = $140,000 - $5,000 - $6,000 = $129,000
Depreciation Fee = ($129,000 - $90,000) / 5 x 2 = $3,900
Finance Fee = ($129,000 + $90,000) x .015 = $3,450
Annual Lease = ($3,900 + $3,450) x 2 = $14,700

It is assumed that the fuel and lubrication, insurance, housing, and repair costs for the five-year period will be identical, whether it is purchased or leased.

Before making a final decision regarding the worth of a lease, it is necessary to consider the tax effect of leases versus purchasing of farm machinery.

Summary

Producers must carefully consider and weigh the advantages and disadvantages of the lease and purchase options when buying machinery, accounting for individual and operational cash flow and tax needs, the user's machinery aptitude and skills, and the goals and objectives of the farm. Leasing has been shown to be similar to buying as related to fuel and lube, maintenance and repair costs in the early periods, insurance costs, housing, and other variable costs. For the operator, there are categories where superior management ability offers advantages, specifically in machinery repair and operations. The individual producer should take this into consideration when comparing the overall costs of leasing and buying equipment.

New technologies and precision farming advantages may be part of your decision-making; however, remember that just owning the technology and having the information does not ensure economic advantage and cost savings. The impact of new technologies in a given operation will vary, depending on producer's skills.

Resources for Further Information

Machinery Cost Estimates, 2008, University of Minnesota-Extension, http://www.extension.umn.edu/distribution/businessmanagement/DF6696.pdf

Agricultural Statistics Board NASS. (2008).Farm production expenditures 2007 summary. United States Department of Agriculture. Washington, D.C.

Farm Machinery Operation Cost Calculations. Terry Kastens (1997). Kansas State University Cooperative Extension Service, http://www.agmanager.info/farmmgt/machinery/mf2244.pdf

Tim Lemmons, Extension Educator