Lease or buy?

Cash flow screws up more small businesses than almost any problem. Startup capital is always hard to find, and lately it’s become even harder to get. For many entrepreneurs, avoiding large early expenses borders on religion. Leasing can look attractive because it will allow you to get the use of equipment without the large upfront cost of a purchase. And your equipment is less likely to become obsolete, at least during a short lease period.

But if you hold onto equipment long term, you’ll probably spend more on a lease than on a purchase. You get a tax break on capital purchases because of depreciation. You’ll get no such break on a lease. And at the end of a lease, you’re going to need to either buy equipment or sign another lease.

The decision of buying versus leasing is classic discounted cash flow analysis – judging the value of money in hand against money later. Short of financial Armageddon, money is always more valuable now than it is later. But how much more valuable? Dinkytown has a good calculator for making the buy/lease decision.

The calculation depends in part on your opinion of the rate of return you could earn from taking the down payment price of a piece of equipment and investing it over the term of a lease. That number is murderously difficult to predict. Historically, it’s been between 8 and 10 percent a year. But tell that to investors last year. Another way to look at that question would be to ask yourself how much money you would be able to earn by investing that money in your own business. If a dollar invested in your own company returns more than you would expect to see in the market, it increases the incentive to avoid large upfront costs.

You also need to know the rate of depreciation for your equipment. We have a section about how that works. Equipment that loses value rapidly like computers and cell phones will come with higher leasing costs. A purchase will give a more rapid tax advantage through depreciation. But you’re also going to be stuck with low-value gear in a few years.

And, you’re going to need to know your cost of capital – how much interest you’re being charged for business loans.