How to Produce a Lease vs. Buy Analysis
Fleet management is a multi-dimensional profession. It requires a broad, diverse skill set and brings with it an equally broad set of responsibilities. Some are management challenges and some involve communication, while still other challenges are purely analytical.
One of the more complex, and important, of the analytical challenges is the lease vs. buy analysis and decision. Beyond fleet, choosing between owning and leasing company vehicles impacts company cash flow, the income statement, and, most importantly, the balance sheet.
Is it, however, the singular responsibility of a fleet manager to provide the analysis and decision? Most often the answer is no, but a fleet manager will be intimately involved in the entire process.
Why Lease vs. Buy?
Before any data is gathered, it is important to understand the reason for the analysis. Why now? What has, or hasn’t, changed since it was conducted last? Who is requesting that it be done?
Some companies schedule the lease vs. buy analysis each year — some, whenever any current procurement contract is up for renewal; others, when there is a change in senior management. The fleet manager should know whether it is part of a standard, regularly scheduled review or a reaction to some change somewhere in the company (a change that can be operational, financial, or personnel related). The reason for the exercise may well have an impact on the ultimate decision.
For example, perhaps the CEO has tasked his or her financial team to focus on cash flow, asking for a project plan to squeeze every dollar out of operations as possible. Or, perhaps the team was tasked with an effort to strengthen the balance sheet, where reducing debt and corresponding assets or keeping debt-to-equity ratios within bank standards both can be impacted by how the company accounts for fleet vehicles. Even a change in the company’s tax position can not only initiate a lease vs. buy analysis, but also determine the final decision.
These and other reasons for the process can help a fleet manager better understand what the company is looking for.
The Fleet Manager’s Role
In general, the fleet manager’s role in the lease vs. own process is more that of a subject-matter expert than it is of analyst. The “grunt” work — that of building the financial model — is usually housed elsewhere in the company, such as finance or treasury management.
That said, the financial model is built using in no small part assumptions and data that are provided by the fleet manager. These include:
- Vehicle acquisition costs (cap cost for leased vehicles and purchase cost for owned fleets).
- Replacement criteria and projections.
- Lease rate factors, including how they break down between the depreciation reserve, cost of funds, and administrative fees.
These points, and any other appropriate information, would be supplied by the fleet manager and plugged into the financial model for analysis.
Understand Net Present Value
Due to inflation, a dollar spent (or received) today is worth more than a dollar spent or received in the future. The process of determining what that value will be is called net present value.
The cost of a fleet vehicle produces a flow of funds from the first day until the vehicle is sold. These flows are comprised of several components, such as lease payments or initial purchase costs (outflows), and tax deductions/credits and resale proceeds (inflows). These flows occur over a period of time, and when a company analyzes the lease vs. buy numbers, what is being analyzed is the net present value of the after-tax funds flow.
If the fleet is leased, using the typical fleet open-end terminal rental adjustment clause (TRAC) lease, the flows consist of a series of lease payments, which are partially offset by their deductibility for tax purposes, with a final flow of the TRAC adjustment, which can be either an inflow or outflow, depending upon the net of the proceeds against the unamortized book value.
Here is a simplified example:
- Lease payments: $300 year 1; $250 year 2
- TRAC adjustment: $500 (Credit to lessee)
- Discount rate: 2% annually
- Payment in advance (1st of the month) tax rate: 35%
In the example, there are 12 lease payments of $300, 12 more at $250, and the resale proceeds exceed the net book value by $500 (resulting in an inflow). We are discounting the payment stream at a 2 percent annual rate, compounded monthly, and the company pays the full corporate tax rate of 35 percent.
The deductibility of the lease payments as an expense results in a savings of $105 ($300 x 0.35) — that is, the company’s taxable income is reduced by $105 as each payment is made. For the second year, the benefit is $87.50 ($250 x 0.35).
This results in payment streams of $195 per month in year one, followed by $162.50 per month in year two. The final flow (inflow) is the $500 credit, which increases the company’s tax liability, netting out at $325.
Using one of the present value calculators readily available online, the after-tax lease payment streams for the two year term come to $3,479.25. The present value of the final TRAC adjustment inflow, received 24 months in the future, is $312.27 (using the same 2 percent rate). Thus, the overall net present value of the after tax cash flows for this example is $3,166.98 ($3,479 in payments, less the credit of $312.27).
Yes, all that arithmetic can seem complicated, and usually the fleet manager isn’t asked to actually create the model. But, what is important is that fleet managers know and understand the concept of present value, the impact of taxes on the funds flow, and how it all applies to the lease vs. buy analysis.
For an owned fleet, the flows are different: there is a one-time outflow of the purchase price, followed by the tax depreciation benefit, ending with the resale proceeds and “recapture” of any tax benefit taken due to the tax code.
Depreciation rules can be varied and complex, so space here does not permit a sample — for example, depreciation is limited by the so-called “luxury” limits, whereby a vehicle costing more than $15,800 cannot take full depreciation deductions. Suffice it to say, the present value concept is identical.
Other Financial Considerations
What do companies consider when the lease vs. buy decision is made? There are a number of reasons for both leasing and ownership. Here are some of them:
- Depreciating asset: Vehicles depreciate in value over time; the more they are used, the lower their value at any point in time. Some companies’ financial philosophies call for leasing depreciating assets, and owning those that appreciate.
- Balance sheet: When leases qualify as operating leases, lease payments can be treated as an expense on the company income statement and deducted with other expenses (such as rent, utilities, and salaries). Owned fleets require balance sheet entries — an asset offset by a corresponding liability (debt). If the fleet is of substantial size, the company may prefer to lease, which will keep vehicles off the balance sheet and eliminate any impact on financial ratios, which are important to banks and other creditors. If the fleet is smaller, ownership can be considered as such ratios won’t be materially impacted.
- Cash flow: If the company is looking for predictable, even cash flows, leasing fits the bill. Some open-end TRAC leases have even payments in annual increments; however, closed-end leases are even better, with equal payments for the entire lease term. Ownership has very different funds flows, but if cash flows aren’t an issue, and the net present value is stronger, buying works just fine.
- Simplicity: Leasing can be a hands-off transaction; the lessor handles ordering, delivery, incidentals (tag/title), and resale, all under a single master agreement. There are, however, some large national fleet dealers who can provide similar services, as well as purchase/disposal programs offered by fleet management companies.
These are considerations, not recommendations. There is no “right” decision to the lease vs. buy question. The final answer will depend upon these, and other, circumstances along with the net present value model results.
So far, based on what the analysis process involves and the considerations that drive the decision, it seems as though the fleet manager’s role in all this is simply to provide assumptions for the financial model. But, if the company is doing it right, nothing could be further from the truth.
One of the major considerations in the lease vs. buy decision is — or should be — the availability of fleet management services and the coordination of those services should multiple suppliers be necessary. This is where a fleet manager becomes indispensable to the entire process.
There is more to a fleet operation, and thus more to the lease vs. buy decision, than simple financial considerations. Fleet managers have a broad range of responsibilities beyond the cost and method of procurement of the vehicles they manage, including:
- Ensuring that vehicles are as safe as possible and that company drivers perform their jobs as safely as possible.
- Providing for, and managing, the regular preventive maintenance of those vehicles.
- Managing the purchase of tires and other repairs, both predictable and unpredictable.
- Overseeing the processes for drivers to report accidents, obtaining replacement transportation, managing and authorizing the repair, and authorizing subrogation recovery where possible.
- Arranging for the means by which drivers can buy fuel, and managing the resulting costs of that fuel, all the while tracking the fuel efficiency of the vehicles they drive.
- Having a process in place for vehicle administrative needs, such as license renewals and the payment of parking tickets.
There are more examples, but the picture is clear: With internal resources and staffing dear, a fleet manager’s responsibilities require suppliers who can act as the fleet department “back room,” while the fleet manager directs their performance and retains overall authority. Not a simple task — and it is one that can be impacted dramatically by the lease vs. buy choice.
Fleet lessors offer what is called a “bundled” program — that is, with a master lease agreement, they can tie in any or all of the previously mentioned fleet programs (e.g., maintenance and accident management, safety, fuel cards) into a single source. It is also possible for a company to opt to buy vehicles, and this can be done via these FMCs as well, using the bundled approach.
But, purchasing via a fleet dealer, for example, requires that a fleet manager use at least one second supplier for services. Either that, or choose the “best practices” route, where each service is outsourced to the best provider that can be found.
Some FMCs are happy to provide services absent a lease agreement, while some are not. And, further, keep in mind the pricing for everything in a bundled agreement is predicated on that bundling; in other words, an FMC will anticipate and factor revenues from all of the services when pricing the overall programs. Put simply, a company is more likely to get a lower price when it leases a vehicle than it is when it doesn’t.
These considerations are where the fleet manager, as subject-matter expert, is critical to the process, since he or she will have to live with the consequences resulting from the decision. Today, fleet managers often have very limited staff (if any at all) and the resources and programs suppliers bring to the table are critical to a successful fleet operation.
Deal with Unexpected Change
So far, the fleet manager has provided the input needed for the lease vs. buy model, finance or treasury has run the numbers, and, from a financial perspective, one of the two options is shown to be more cost effective.
The final decision seldom, if ever, is made by the fleet manager — it is typically made at more senior management levels.
What happens when the fleet manager learns the option they determined was the most cost effective is not the one being used now? Perhaps the owned fleet now must lease, or the leased fleet must now buy its vehicles.
Either change is a dramatic one, requiring a number of new processes, new supplier(s), and an entirely different way of managing the fleet. How does a fleet manager best cope with these changes?
From Lease to Ownership
If a fleet is leased, and now will move to ownership, change can be minimized if the company’s current FMC can offer them a purchase/disposal program, where they act as purchasing agent for the fleet, and sell the vehicles when they are taken out of service (for a fee, of course). This way, whatever services are currently tied to the lease can be continued under the new program.
But, there may be more cost-effective ways to transition from leasing to ownership. As previously mentioned, there are a number of large, national fleet dealers that have sophisticated ordering and delivery systems and networks in place, and can “mimic” what many FMCs do (indeed, it is probably the FMCs that mimic what fleet dealers have been doing for many decades) for customers who purchase vehicles.
Either way, one significant change will be in budgeting: The fleet manager will need to produce a capital budget for the fleet, rather than the expense budget a leased fleet requires.
Another change, should the ownership be provided by a fleet dealer, might be the application for and tracking of so-called “extended warranty” claims, where the fleet petitions the manufacturer for compensation for repairs performed out of warranty.
Administratively, there is the issue of title retention — it is an old adage in the used-vehicle business that you don’t sell cars, you sell titles. Owned fleets will need to store vehicle titles that previously were kept by a lessor. Additionally, registration renewals will also need to be handled in-house.
From Ownership to Lease
On the other hand, changing from an owned fleet to leasing requires some changes as well, many of which surround the outsourcing of clerical and administrative activities (such as title administration and tag renewals, as described above) that the owned fleet currently has set up internally. For example, titles won’t be a quick walk to a locking file cabinet, and the fleet manager will have to trust the company’s FMC to make certain that tag renewals are conducted promptly.
In most cases, both owned and leased fleets use some form or forms of other services, such as the management of maintenance and accident reporting/repair described earlier. That transition should go relatively smoothly.
On the used car side, since the widely used fleet open-end TRAC lease provides the fleet with the economics of ownership, there is not all that much difference between leasing vs. buying. That is, unless the fleet manager has (under ownership) been selling vehicles directly, as most FMCs will sell vehicles (usually via auction). It isn’t common, but in some cases leased fleet managers still handle resale in-house.
Navigating the Lease vs. Buy Maze