PRODUCTION SYSTEMS PIH-115
PURDUE UNIVERSITY. COOPERATIVE EXTENSION SERVICE.
WEST LAFAYETTE, INDIANA
Financial Leasing of Capital Assets in Pork Production
Authors
Chris Hurt, Purdue University
Allan E. Lines, Ohio State University
Gerry Schwab, Michigan State University
Reviewers
Danny Klinefelter, Texas A&M University
Matt Parsons, Hadley, Massachusetts
James S. Plaxico, Oklahoma State University
Tommy Reff, North Dakota State University
The U.S. pork production industry continues to move rapidly
towards fewer farms producing an increasing amount of the
nation's hogs. This movement toward fewer, but larger, producers
has been made possible by added capital investments for facili-
ties, equipment, and various production inputs which have
replaced, or have been substituted for, manual labor on many
farms.
Traditionally, producers needing funds for growth used their
own capital (equity) or borrowed capital (debt) to purchase the
assets needed. But, with the increased capital needs and the
changes in financial markets, producers are exploring leasing as
an alternative method to acquire assets. Increased use of debt
capital and interest rate variability have increased the finan-
cial risk-exposure for some producers. And, leasing may help
reduce some financial uncertainties. Another important reason to
consider leasing is that, in some cases, it may provide the
lowest cost method to acquire certain assets.
Leasing consists of paying a set fee for the use of a
durable asset owned by a party other than the user. The owner of
the asset is termed the lessor, and the user termed the lessee.
Since this arrangement can be viewed as an alternative way to
finance the use of an asset, it is called financial leasing.
The Financial Lease
Nearly any kind of asset used in pork production can be
leased. Common examples of leased assets include breeding stock,
production equipment, and buildings.
A financial lease is a contractual commitment that enables
the lessee to acquire the use of an asset in exchange for a
stipulated fixed payment to the asset owner, the lessor. The
lease is the contractual agreement to which both parties are
legally obligated during the lease period.
To clarify the positions of both the lessor and lessee and
to help avoid misunderstandings, the lease should be written. A
written lease should include:
1. description of the property by location and a list of
exactly what is included;
2. the expected and permitted use of the property;
3. provisions for termination of the lease;
4. timing and amount (or calculation method) of lease payments;
5. initial maintenance condition of the property;
6. rights and obligations of the lessor; for example, permis-
sion to enter the leased property premises and maintenance
obligations;
7. operating obligations of the lessee. Examples include, who
is responsible for repairs, insurance and property taxes;
8. terms of a buy-out option at end of the lease period or any
early buyout agreements; and
9. an arbitration procedure to settle disagreements that are
not resolved by mutual agreement.
Advantages and Disadvantages
Some advantages to the lessee are listed. They may not be
valid in all cases, but have the potential to be advantageous in
other cases:
1. Leasing may require fewer dollars up front than ownership.
Capital assets may be placed in service at an initial cost
that may be less than even the minimum 10% down payment com-
monly associated with ownership.
2. When credit limits are imposed by a producer's lender, leas-
ing may be a way to acquire additional assets. However, pro-
ducers should realize that financial leasing will affect
cash flow requirements and thus may affect credit limits
imposed by the primary lender. In any case, the primary
lender should be made aware when a producer is considering a
financial lease.
3. The lease payment schedule is often a fixed dollar amount
per time period. When this occurs, cash flow planning on the
outflow side may be more certain than with a variable
interest rate loan under the ownership alternative.
4. The entire lease payment is a tax-deductible expense for
federal income tax purposes for qualifying leases.
5. Leasing may provide more flexibility to match the payment
terms to the actual expected useful life of an asset. For
example, a lender may want a three-year-term note on an
asset which could have lease payments extended over its
five-year-useful life.
6. Leasing provides clear alternatives for disposing of the
capital asset at the completion date of the lease contract
since the asset can be returned to the lessor, or purchased
if there is a buy-out option.
7. Leasing may be less risky to the lessee than debt financed
ownership. With leasing, the only collateral required is
the actual capital asset being leased. With debt financing,
additional collateral may be required to obtain financing.
8. Leasing can be a lower cost method of obtaining an asset
than debt financing when the lessor is in a higher tax
bracket, and/or has a lower cost of capital, and is willing
to pass a portion of this advantage to the lessee.
Some disadvantages of leasing from the lessee's perspective
relative to ownership are:
1. Depreciation and interest expense cannot be claimed by the
lessee for tax deductions.
2. If the lease period is equal to, or shorter than, the time
period for financing the asset using the ownership option,
the before-tax cash flow requirement will most often be
higher for leasing.
3. The total cost associated with leasing will often be higher
than the total cost associated with debt-financing for the
ownership option.
4. The fixed dollar lease payment is often inflexible over the
life of the lease with few options to refinance or delay
lease payments.
5. If the primary lender is not consulted about the additional
cash flow requirements of a lease, this may erode the work-
ing relationship with the lender.
6. The lessee may make cash flow commitments that are greater
than the ability to make payments.
When considering expenses such as repairs, property taxes,
and insurance, there is generally little difference between own-
ership or leasing since these items are usually paid by the user
directly, under the ownership option, or indirectly with a higher
lease payment.
Income Tax Implications
Since the financial lease is similar to ownership under a
debt-purchase arrangement, questions have arisen about income tax
treatment. The tax laws on lease arrangements continue to evolve.
Congress specifically defined a qualifying financial lease in the
Tax Equity and Fiscal Responsibility Act of 1982. A detailed set
of guidelines had to be met by both the lessor and the lessee in
order to qualify as a financial lease. However, farm financial
leases for the first $150,000 cost basis of leased property dur-
ing a year were not subject to these guidelines and did qualify
as a farm financial lease. The category known as ``farm financial
leases'' expired at the end of 1987. Accordingly, farm property
leased after 1987 falls under the guidelines of regular leases
for tax treatment.
For qualified capital assets, the lessor (owner) is allowed
to take interest expense and depreciation as business expenses
and thereby reduce income tax liability. Pork producers who lease
the capital assets are able to take the lease payments as a
deductible business expense.
Since tax laws are subject to change, it is advisable to
check income tax guidelines before entering into a financial
lease. Sources of information on the income tax treatment of
financial leases include the Farmer's Tax Guide (IRS publica-
tion), CPA's, attorneys, and tax practitioners.
Comparison of Debt-Purchase with Financial Leasing
It is important to note that the evaluation of the type of
financing has little to do with whether the asset should be
acquired. Before analyzing the type of financing, an evaluation
of potential profitability should be made. If the asset cannot be
used profitably, the best financing decision will only moderate
total losses. Therefore, the first analysis should be a profita-
bility analysis. This is then followed by the financial analysis
which is shown here.
To understand the economic differences between using debt to
purchase an asset or financial leasing, check the following exam-
ple. The analysis involves computing the net cash outflow, or
cost, each year. The net cash outflow is simply the cash outflow
less the tax savings in that year. Tax savings become a critical
factor since the amount of tax savings will likely vary between
the two alternatives. Cash outflows occur over a series of years,
therefore it becomes necessary to make some adjustment for the
timing of cash outflows. We know for example, that when purchas-
ing an asset worth $1, it is generally preferable to pay the $1
next year rather than today. How much better depends upon the
cost of (borrowed) money, or upon the earning power of (saved)
money. At a 12% interest rate, 89.3 cents today is equal to $1 in
a year (see discount factors in Table 1). Because of this ``time
value'' of money, it is necessary to adjust (discount) each
year's cash outflow by the appropriate discount factor. By sum-
ming the annual discounted cash outflows over the years, the
net-present value of the cash outflows for each alternative can
be calculated. The net-present value of the cash outflows for
leasing is then compared with the debt-purchase alternative.
Debt-Purchase Financing Example
Assume a producer has made a decision to purchase $30,000 of
feedmill equipment under the following financial arrangements:
o Down payment is $6,000.
o Amount financed is $24,000 at a 12% interest rate.
o Payments are to be made in 5 equal yearly amounts of $6,658.
o Marginal income tax rate is 31%.
o Equipment is considered 7 year property, for tax purposes,
and is depreciated using the double-declining balance method
with a half-year convention under the Modified Accelerated
Cost Recovery System as specified by the Tax Reform Act of
1986.
o Equipment is sold after 7 years for the $3,000 salvage
value, which is considered ordinary income for tax purposes
because the asset was fully depreciated.
The financial analysis for this debt-purchase example is
shown in Table 2. Annual payments of $6,658 are divided between
the portion of the payment allocated to principal repayment
(column A) and to interest (column B). Depreciation is shown in
Column C. Column E and F compute the amount of annual income tax
savings, while Column G shows the annual cash outflows after tax
savings are subtracted. Finally the annual after tax outflows are
multiplied by the appropriate tax adjusted discount factor in
Column H to provide the annual discounted cash outflow shown in
Column I. The net-present value of the cash outflows is then com-
puted by adding the numbers in Column I. For the debt-purchase
financing alternative, the net-present value of the cash outflows
is $21,590 for this example.
Table 1 provides discount factors for various discount rates
and years. The discount rate should be the interest rate on bor-
rowed capital if debt is used or the rate of return that could
have been earned if equity capital is used. Commonly, producers
do not finance with 100% debt, or with 100% equity, but rather
with a combination of the two. In this case, it is appropriate to
use a discount rate which is a combination of the rates for
interest cost and expected return on equity. In this example, the
feedmill equipment was financed with $6,000 of equity and $24,000
of debt, or 20% equity and 80% debt. The discount factor to use
for the debt is the 12% interest rate, and let's assume the pro-
ducer required a return of 17% on the equity. Given these two
rates, a weighted cost of capital could be calculated by multi-
plying the rates by the respective amounts of capital used. In
this example, the weighted cost of capital is 13% and is calcu-
lated as (.20 x 17%) + (.80 x 12%) = 13%.
The weighted costs of capital should then be adjusted for
tax implications. This can be done by multiplying the weighted
cost of capital x (1 - tax rate). In the example used here, this
would be 13% (1 - .31) = 13% x .69 or about 9%. The 9% discount
factor is then used as the tax adjusted discount factor in the
example.
Financial Lease Alternative
This analysis assumes the pork producer acquires the same
$30,000 of feedmill equipment, but leases the equipment rather
than using debt to purchase. Leasing assumptions are:
1. The lease payment rate is 24% per year for five years, or
$7200 annually.
2. The first payment is due when the equipment is acquired with
subsequent annual payments.
3. 31% marginal tax rate,
4. Equipment is returned to lessor after 5 years.
The lease analysis is illustrated in Table 3. Annual lease
payments of $7,200 are tax deductible with the tax savings
assumed to be received in the year after the payment. Tax savings
each year is $2,232. This is the $7,200 lease payment times the
31% marginal tax rate and is shown in Column B. Column C shows
the tax adjusted cash outflow. These numbers are multiplied by
the appropriate tax adjusted discount factor in Column D so the
net-present value of the cash outflows can be calculated in
Column E.
The lease alternative, under the assumptions given, has an
adjusted cash outflow, or cost, of $21,840. This number is com-
pared with the purchase alternative with an adjusted cash outflow
of $21,590. Thus, from an economic viewpoint, the debt-purchase
alternative has a lower cost in this example.
Factors That Affect The Analysis
It is possible for leasing to be the lowest cost method to
acquire assets. While this is not always the case, the most
likely conditions under which leasing could be more economically
attractive in relation to purchasing could occur if: (1) the les-
see has a lower marginal tax rate than the lessor; (2) the lessor
can obtain capital at a lower cost than the lessee or has a rela-
tively low return on their own capital, such as Certificate of
Deposit rates; (3) the lease payments can be extended over a
longer period than the allowable depreciable life; or (4) the
lessee has a very limited amount of equity but has the opportun-
ity to earn a high rate of return on the equity.
Other Factors to Consider
The economic comparison of the financial lease versus owner-
ship with debt is an important analysis in decision making. How-
ever, other factors should also be considered. (1) Pride of own-
ership may be an important reason for owning rather than leasing.
(2) Ownership may allow more flexibility if one wants to sell the
asset due to going out of business or has the need to trade the
asset for a larger or more technologically advanced replacement.
(3) Leasing is sometimes considered a way to secure 100% financ-
ing without making a down payment out of equity funds. However,
the first lease payment, which is generally due when the asset is
acquired, may be near the size of a down payment. (4) Leasing may
require the pork producer to justify as much credit worthiness as
a lending institution would require for a purchase. (5) The deci-
sion to acquire an asset may change the marginal tax rate versus
not acquiring the asset. (6) When comparing lease or purchase
alternatives, the pork producer should realize that the variables
used in the analysis may be different than expected. For example,
the results may vary substantially if the producer expected a
marginal tax rate of 20% and it was actually 40% or if interest
rates were expected to be 10% but were actually 14%. Some recog-
nition of future uncertainty probably means the producer needs to
consider the impacts of a broader range of values for the key
variables.
Additional Information
Only one leasing situation has been evaluated in this
worksheet. Each potential leasing situation will be unique and
will need to be evaluated with the producer's own variables. To
help analyze these individual leasing situations, the attached
worksheet, identified as Tables 4 and 5, can be used. This
worksheet follows the format of the examples previously cited.
Another alternative is to evaluate financial leasing versus debt
purchase with the use of a microcomputer. Many leasing companies
will provide this analysis as part of their service. In addition,
the Cooperative Extension Service, in many states, has the capa-
city to provide this computer analysis. Having access to a micro-
computer program will also allow you to evaluate financing alter-
natives under different sets of assumptions. But before entering
any lease, read the provisions of the lease carefully and have a
clear understanding of your obligations.
Summary
Leasing is an alternative way for a pork producer to control
the use of an asset without owning the asset. The financial lease
allows a producer to use assets generally over a period of years
for a fixed fee. The cost of leasing assets can be compared to
the use of debt to purchase the assets by examination of the
alternative impacts upon annual cash flows. Financial leasing is
often not as economically attractive as ownership, but this is
not always the case. Pork producers who are most likely to use
leasing will tend to be in one or more of the following situa-
tions: they have low marginal tax rates; they have high interest
cost; they have the opportunity to earn high rates of return on
their equity; or they do not wish to borrow additional amounts
against limited equity.
NEW 6/88 (5M)
Table 1. Annual Discount Factors
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No. of
Years 6% 7% 8% 9% 10% 11% 12% 13% 14% 15%
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1 .943 .935.926 .917.909 .901.893 .885.877 .870
2 .890 .873.857 .842.826 .812.797 .783.769 .756
3 .840 .816.794 .772.751 .731.712 .693.675 .658
4 .792 .763.735 .708.683 .659.636 .613.592 .572
5 .747 .713.681 .650.621 .593.567 .543.519 .497
6 .705 .666.630 .596.564 .535.507 .480.456 .432
7 .665 .623.583 .547.513 .482.452 .425.400 .376
8 .627 .582.540 .502.467 .434.404 .376.351 .327
9 .592 .544.500 .460.424 .391.361 .333.308 .284
10 .558 .508.463 .422.386 .352.322 .295.270 .247
11 .527 .475.429 .388.351 .317.288 .261.237 .215
12 .497 .444.397 .356.319 .286.257 .213.208 .187
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Table 2. Debt-Purchase Analysis1
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(A) (B) (C) (D)
Principal Interest2 Depreciation3 Salvage4
Payments Payments Value
Year
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0 6,000
1 3,778 2,880 4,287
2 4,231 2,427 7,347
3 4,739 1,919 5,247
4 5,308 1,350 3,747
5 5,944 713 2,679
6 2,676
7 2,679
8 1,338 3,000
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Table 2. (Continue...)
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(E) (F) (G) (H) (I)
$Tax Tax Tax Adjusted Tax Adjusted Discounted
Deductible Savings Cash outflow Discount Factor Cash outflow
(B+C-D) (E x .31) (A+B-D-F) (9%) (GxH)
________________________________________________________________
6,000 1.0 6,000
7,167 2,222 4,436 .917 4,068
9,774 3,030 3,628 .842 3,055
7,166 2,221 4,437 .772 3,425
5,097 1,580 5,078 .708 3,595
3,392 1,052 5,605 .650 3,643
2,676 830 -830 .596 -495
2,679 830 -830 .547 -454
-1,662 -515 -2,485 .502 -1,247
Net Present Value of Cash Outflows $21,590
________________________________________________________________
1Based upon $30,000 purchase price with $6,000 down payment,
financed at 12% interest with 5 equal annual payments of $6,658
each, salvage value is $3,000. Numbers are rounded to the nearest
whole dollar amount.
2It is assumed that interest payments are made on the annual
anniversary of the loan and that the tax savings from the interest
occur in the same year. This assumption may vary in individual
cases.
3Depreciation is based upon the double declining balance method
with a half-year convention under the Modified Accelerated Cost
Recovery System as specified by the Tax Reform Act of 1986.
4Salvage value is assumed to be ordinary income since the asset was
fully depreciated.
Table 3. Lease Analysis1
______________________________________________________________________
(A) (B) (C) (D) (E)
Tax2 Tax Adjusted Tax Adjusted Discounted
Lease Savings Cash Outflow Discount Factor Cash Outflow
Year Payments (A x .31) (A-B) (9%) (C x D)
______________________________________________________________________
0 7,200 7,200 1.0 7,200
1 7,200 2,232 4,968 .9l7 4,556
2 7,200 2,232 4,968 .842 4,183
3 7,200 2,232 4,968 .772 3,835
4 7,200 2,232 4,968 .708 3,517
5 2,232 -2,232 .650 -1,451
$21,840
______________________________________________________________________
Net Present Value of Cash Outflows
1Based upon annual lease payments of $7,200 for 5
years on $30,000 worth of equipment.
2Marginal income tax rate.
Debt-Purchase Versus Lease Worksheet
Table 4. Debt-Purchase Analysis
____________________________________________________________________
(A) (B) (C) (D) (E) (F)
Principal Interest Depreciation Salvage $Tax Tax1
Year Payments Payments Value Deductible Savings
(B+C-D) (E x .__)
____________________________________________________________________
0
____________________________________________________________________
1
____________________________________________________________________
2
____________________________________________________________________
3
____________________________________________________________________
4
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5
____________________________________________________________________
6
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7
____________________________________________________________________
8
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9
____________________________________________________________________
10
____________________________________________________________________
Table 4: (Continue...)
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(G) (H) (I)
Tax Adjusted Tax Adjusted Discounted
Cash Outflow Discount Factor2 Cash Outflow
(A+B-D-F) (__%) (GxH)
_______________________________________________
0
_______________________________________________
1
_______________________________________________
2
_______________________________________________
3
_______________________________________________
4
_______________________________________________
5
_______________________________________________
6
_______________________________________________
7
_______________________________________________
8
_______________________________________________
9
_______________________________________________
10
_______________________________________________
Net Present Value of Cash Outflows
1Marginal income tax rate.
2Adjust discount rate by the marginal tax rate and use factors in
Table 1
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Table 5. Lease Analysis
_________________________________________________________________
(A) (B) (C) (D) (E)
Tax1 Tax Adjusted Tax Adjusted2 Discounted
Lease Savings Cash Outflow Discount Factor Cash Outflow
Year Payments (A x.___) (A-B) (___%) (C x D)
_________________________________________________________________
0
_________________________________________________________________
1
_________________________________________________________________
2
_________________________________________________________________
3
_________________________________________________________________
4
_________________________________________________________________
5
_________________________________________________________________
6
_________________________________________________________________
7
_________________________________________________________________
8
_________________________________________________________________
9
_________________________________________________________________
10
_________________________________________________________________
Net Present Value of Cash Outflows
________________________________________________________________
1Marginal income tax rate
2Adjust discount rate by the marginal tax rate and use factors in
Table 1
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