Case Study: Case of Equipment Justification Part IV

Over the past three installments, we’ve explored equipment purchase decisions. First, we reviewed if you should gamble in the first place. Second, we covered the first half of the four-step payback formula and, third, we covered the last half. What’s left? Nothing but questions. Here I address the most common ones:

How do you handle a trade-in using payback?
If the trade-in is paid for, disregard it. That’s because giving it to the equipment dealer creates no change in your checkbook. If it’s not paid off, then the equipment dealer will usually add the unpaid balance to the new equipment which will increase the initial cost. If you must pay it off before you trade it in (uncommon), then add it to the cost of the investment in the calculation.

Is it better to pay in full or finance?
Paying $60,000 cash or making 60 payments of $1,274.82 for a total of $76,489.36? Paying cash will obviously cost less over time, but it could cost you the business if you pay down your current ratio and cash on hand too far. So, get your accountant involved. I recommend you maintain a 2:1 current ratio and maintain 30 days worth of cash on hand once you complete the deal. If you're unable to do this, then borrowing the money would be better, even if it costs you more over time.

Now, assume we borrow as most would do. How does that factor into payback?
Figure it the same. If you have a choice between leases or leases vs. a loan, multiply the payment by the number of payments and add any upfront payment or end of term buyout. If it’s a fair market lease with the purchase price computed at the end, use 10% of the total equipment price as an estimate. Then compare the total payout between the options. The one with the lowest total wins unless there is some other complication.

How much leverage do we give the vendor who is willing to make an appealing deal like waiving the first six months of payments?
None, unless you absolutely need six months up front without the obligation of payments. If so, ask everyone to quote you the same thing. And, you will find some will and some won’t.

How do you compare deals if some have a six-month grace period and some don’t?
Thank them and then ignore it for justification purposes. Treat it as if you begin paying in month one. Of course, don’t begin to pay until month six though.

What’s the difference between buying equipment and leasing it?
Not much other than technical issues. If you borrow money from the bank and buy equipment, you owe the bank the money. Bank doesn’t own the equipment and, often, won’t even take it as collateral for the loan. That’s under the assumption that your lender isn’t in the equipment business. 

With leasing, the leasing company maintains ownership of the equipment and essentially rents it to us for use under terms that simulate borrowing. Tax law changes categorize leases as operating or financing. A financing lease is another form of a “bank” loan. Operating leases are like a building lease where we pay rent each month and give the equipment back at the end with no expectation of ownership (also known as fair market leases), although there’s typically an opportunity to purchase the equipment at “fair market” value at the end. Tax changes require this fair market value to be at least 10% of the original value so that effectively ended the historic one-dollar buy-outs.