Lease or buy: optimizing capital equipment procurement

Healthcare Financial Management, August, 1997 by Mark E. Sedlmeier

Many physician group practices struggle over whether to buy or lease equipment. While purchasing has been the traditional method of acquiring equipment, leasing often can be more cost-effective. Conducting a lease-versus-purchase analysis can help group practices arrive at the most cost-effective decision. Careful consideration of the alternatives can lead to the best use of the group's resources to meet its financial goals.

Whether to lease or buy medical equipment is not always a clear-cut decision. Purchasing is the traditional method of equipment acquisition for most group practices, and many continue to use cash to acquire needed equipment.

The pressure to reduce healthcare delivery costs, however, has made more stringent reviews of capital equipment acquisitions imperative. As a result, more group practices are choosing to lease medical equipment. The advantages of leasing include flexibility, convenience, and protection against technological obsolescence. And, in many cases, leasing can be more affordable than purchasing.

Decision Factors

Analysis of major capital equipment acquisitions needs to go beyond a simple return on investment (ROI) or hurdle rate analysis and consider other factors, including the estimated technological life of the equipment and the group's financial position.

Technological life of the equipment. The equipment's useful technological life should be considered in light of the group's long-term goals. Equipment that is projected to become obsolete over an anticipated period of use is a good candidate for leasing. A properly structured lease allows the user to shift the risks of technological obsolescence to the lessor and acquire new technology at the end of the lease term. The lease also allows the user the flexibility to purchase the equipment or renew the lease if the group decides the equipment can continue to provide the required level of performance.

Financial position. A primary factor in determining whether to lease or buy capital equipment is allocation of capital within a provider organization. Because cash can be allocated to a number of different organizational projects, deciding when to purchase and when to lease may be daunting. For example, if a group is considering a merger, acquisition, or other form of formal integration, cash will likely be tied up funding the merger or acquisition and preclude equipment purchases.

Other financial factors can affect the lease-or-buy decision, including the following:

* Affordability;

* Effective use of the equipment during its anticipated life;

* Cash flow and ability to pay for the equipment from an operating budget;

* Maintenance of working capital credit lines;

* Flexible structuring options; and

* Salvage and disposal.

Lease-versus-Purchase Analysis

A number of methods can be used to determine whether to lease or purchase equipment, but the simplest is to calculate the present value (PV) of each capital acquisition alternative compared with investing cash. Every organization has an investment hurdle rate denoting the minimum internal rate of return that must be met before undertaking a capital investment. This rate can be set using one of the following indicators:

* The cost of comparable term debt;

* The expected return on equity;

* The weighted cost of capital, consisting of the weighted values of the cost of debt and return on equity; or

* The expected ROI for similar term investments.

Regardless of the hurdle rate used, the rate should be applied consistently throughout the analysis.

Once the hurdle rate is determined, the analyst needs additional information from the following three general categories:

* Equipment assumptions;

* Lease information; and

* Alternative investment (opportunity cost) information.

Equipment assumptions include the cost of the equipment, the expected use period of the equipment, the anticipated salvage value of the equipment at the end of the expected use period, and any costs associated with the installation of the equipment. Lease information includes the term of the lease, advance payments, interim rentals, refundable deposits, purchase options at the end of the lease term, closing or documentation fees, and any other costs associated with the lease. Alternative investment (opportunity cost) information comprises the expected return on capital if the equipment were not acquired.

Exhibit 1 compares the total cash flow and PV costs associated with a 60-month lease on a $1 million piece of equipment with a cash purchase. The analysis assumes the group will return or salvage the equipment at the end of the analysis period. Although the cash-flow analysis prior [TABULAR DATA FOR EXHIBIT 1 OMITTED] to consideration of indirect costs (Line I) indicates that the purchase option may be the better alternative, the inclusion of an opportunity cost of capital clearly shifts the analysis in favor of leasing.

Line A defines the lease advance payment(s) and the equipment purchase price. The subsequent payment on Line B is the sum of the remaining payments to be made under each alternative.