Other people’s money” is an economic phrase that goes all the way back to Adam Smith’s The Wealth of Nations and has long since entered into common usage. According to The Farlex Financial Dictionary, other people’s money is an “informal term for the use or investment of borrowed funds. For example, a bank uses OPM to lend to its borrowers as the money it uses for loans (theoretically) comes from its deposits.” The Complete Real Estate Encyclopedia refers to it as “a common expression used when talking about the multiplying effect of using borrowed funds to purchase property rather than paying all cash.”
That multiplying effect comes from leverage investing, a method that seeks higher profits by investing with money borrowed from other people. If the investment yields earning greater than the interest paid on the borrowed money, the result is profit. This is an idea most people associate with hedge funds, real estate developers, stock portfolios, and Wall Street bankers. But it is applicable to any kind of capital investment intended to yield a profit margin, such as construction equipment.
For example, a business owner invests $100,000 of his cash and borrows $200,000 to purchase capital equipment for a total cost of $300,000. The owner is using financial leverage to control $300,000 of land with only $100,000 of his own money. During the time of ownership, the capital equipment generates enough net profit (after operational costs and paying interest on the loans) from contract work and resale equal to 25% more than the initial purchase price, a total of $375,000. The owner will see a $25,000 gain on his initial $100,000 investment, a 25% return. But the overall net gain is $75,000, which gives the owner a 75% gain on his initial $100,000 investment; hence, the power of leverage if value and profits increase. However, should the value of a capital investment fall and/or the earnings derived from capital equipment not match interest charges, the multiplier effect can also magnify losses. Thus, the need for a solid business plan prior to making major capital purchases.
There are three main methods for an equipment fleet owner to use other people’s money to acquire equipment: financing of direct loans to pay for the purchase, leasing long-term use of the equipment, or renting the equipment short term. Each has its pros and cons, and each is suitable for a particular situation. There are upsides and downsides to each method depending on current market conditions that determine whether an equipment owner should buy, rent, or lease. The differences in the rental or leasing market will also impact the owner’s decision, as will the current economic and political climate for financing heavy equipment.
Current Market Trends
According to Charles Carter, vice president, Construction Equipment Sales at Volvo Financial Services USA, the current economic/political climate for financing heavy equipment is good but never easy. “The economic climate is generally positive at this point in the cycle. We see good trends in housing starts, construction spending, and employment which are typically indicators of continued economic growth. The extended length of the economic recovery from the Great Recession has benefited many customers’ balance sheets and most are significantly healthier today than they were five to seven years ago. Couple these conditions with lending institutions’ strong desire to put capital to work, and you have an excellent climate for customers to have numerous equipment financing options.”
According to Carter, the way that the rental and leasing markets fit into decision making is a matter of timing. “In today’s market, customers often look to match the length of the financing to that of specific jobs or contracts they have won. They can better manage their cash flow while ensuring they have the equipment they need on hand. Many customers will have a mix of needs that include rental, leasing, and traditional loan financing. Rental and leasing may also provide additional support in terms of equipment upkeep and maintenance which allows the customer to focus solely on completing the job at hand. Customers still remember the last downturn and often want options and flexibility with their equipment purchasing including short-term rentals, leases with early return provisions, or loans with balloons.”
As for the upside and downside of each financing option and the general conditions affecting whether a contractor should either finance, rent, or lease, “each product has specific strengths in certain areas. Finance provides ownership, an opportunity to build equity for the future, and depreciation benefits. Leasing usually provides lower monthly payments and is advantageous to the most cash-flow-minded customers that want an option to return the equipment after a set period of time or as a specific job is completed. Renting’s strength is immediate availability and flexibility related to extended use of the machine if needed while typically fully serviced by the dealer or rental house. Each customer’s scenario is unique and requires a careful assessment of multiple factors including things like the current backlog of work, expected completion dates of jobs, the liquidity of the business, other capital expenditure needs, tax opinions from company sourced experts, growth needs, and ability to maintain the equipment.”
What is Capital Equipment?
All the heavy earthmoving equipment utilized by a contractor qualifies as “capital equipment.” The IRS defines a capital asset as “an asset including land, structures, equipment, and intellectual property (including software) that has an estimated useful life of two or more years,” and an acquisition cost above a certain minimum (typically $1,000). Capital equipment is long-lasting goods that a contractor acquires, owns, and operates that are not consumed in the normal course of business. And it is not just heavy earthmoving equipment. Capital equipment can include assets such as computers, trucks, and even office furniture and site trailers. Many earthwork contractors are small businesses with “fewer than 500 employees for manufacturing businesses and less than $7.5 million in annual receipts for most non-manufacturing businesses.” Under IRS rules, businesses must record capital assets on their balance sheet as equipment, and cannot expense them on a profit and loss statement due to their useful life. The useful life of a piece of equipment is classified by the IRS as either three-year, five-year, seven-year, 10-year, 15-year, 20-year, 25-year, 27.5-year, or 39-year assets. Instead of being expensed, capital assets are depreciated over their useful lifetimes. For example, a typical depreciable lifetime for heavy trucks and earthmoving equipment is seven years. A new full-sized excavator can cost $100,000 to $500,000, so a mid-range excavator costing $350,000 would have an annual depreciation of $50,000 per year for seven years (using straight-line depreciation). Note that a depreciable lifetime is not the same as an operational lifetime, with most equipment still functioning long after its depreciation schedule has been completed.
Accounting for capital items is different than for non-capital items in the areas of acquisition, asset management, measurement of asset performance, valuation, and reporting. Unlike non-capital assets, business owners expect capital assets to generate revenue over extended periods of time. Capital purchases are typically one-time non-recurring purchases (unlike the restocking of office paper, for example). Most capital purchases require lead time and are often customized for specific applications. Capital expenditures also tend to be much larger than non-capital expenses, requiring more extensive purchase and acquisition procedures. This lead time requirement can create supply bottlenecks with competitors often bidding for the same equipment in anticipation of future work.
Capital equipment performance is tracked with financial tools such as the rate of return for assets (ROA, net company income divided by the value of its total assets) and total asset turnover (a ratio that measures the value of a company’s gross sales or revenues generated relative to the value of its associated assets). Accounting methods for tracking the process of capital asset acquisition are in part determined by local tax laws as well as internal management policies. A firm’s capital funding process is normally carried out at a company-wide basis with capital review and purchase approval based on a review of prioritized funding proposals from across the company. In other words, the various User Departments submit capital purchase requests to the Purchase Department for review, approval, and allocation of funds. In contrast, the purchase of non-capital assets is authorized independently by lower-level managers across a company organization.
Once acquired, a business will manage the new capital equipment under its life cycle management process. The capital asset management cycle is based on the equipment’s assumed operational lifetime (which, again, is not the same as its depreciable lifetime). The duration of the equipment’s operational lifetime is determined by how long it can remain productive—they generate more revenue for the owners than they cost to operate. However, these operational lifetimes can be cut short by many factors, such as accidental damage in the field that is prohibitively costly to repair or technological obsolescence making a piece of equipment relatively unproductive compared with newer models. Capital asset managers typically assess equipment performance annually, measuring its value by accounting metrics such as return on investments (ROI) and return on capital employed (ROCE) in addition to a return on assets (ROA) and total asset turnover.
Valuation, as opposed to performance, is also managed differently by the company accountants. The reported book value of a piece of equipment changes over its operational lifetimes as a result of accumulated annual depreciation expense and value adjustments allowed by local or state tax laws. The value of capital assets is shown in the company’s balance sheet in a separate Capital Assets part of the ledger. In addition to heavy equipment, this category can also include property and real estate, plant and equipment, long-term assets, and tangible assets.
The current book value of a piece of equipment is not the same as its current market value. As anyone who has tried to sell a used car can tell you, you rarely get blue book value for your vehicle. The same is true for heavy equipment. The process works in reverse since a contractor is not limited to the acquisition of only new equipment. There is always a strong market for well-maintained used equipment which can combine discounted prices with a still significant operational lifetime. However, since depreciation does not apply to used equipment older than its depreciable lifetime, the buyer has to carefully weigh the financial and tax advantages (and disadvantages) of acquiring used equipment. The decision to purchase old or new equipment is made in the larger context of whether equipment should be purchased, leased, or rented.
The Equipment Purchase or Lease Decision
Since all businesses are in business to make money, every business decision including equipment acquisition has to take into account its effect on an operator’s after-tax income. In other words, every equipment acquisition is a bottom-line decision. For a capital-intensive business such as earth moving, an owner has to make accurate, apples-to-apples comparisons utilizing estimates in outflows in current dollars in order to compare lease payments and purchase costs—and make a rational decision between the two.
The first difference between leasing and purchasing is that lease payments are tax-deductible expenses that appear on the operator’s income statement. Conversely, the lease payment received by the business leasing the equipment (aka the lessor) is treated as taxable income. Second, lease payments are made in advance (like rent paid to a landlord at the start of a month). Loans are made at the end of each period of the loan.
What the actual annual lease payment would be depends on the value of the equipment, the length of the lease, and the interest rate of return required by the lessor. These three factors are used to determine the annual lease payment:
P = (A * i) / (1 – 1 / (1 + i) n )
P = Periodic lease payment
A = Asset value to be financed
i = Lease interest rate per period
n = Number of lease payments required
As an example, assume the following:
A = $100,000
i = 6%
n = five years (or 60 months)
The resultant monthly payments would be $1,933 with annual lease payments of $23,199. The total lease payments over the five-year period would be $115,995—a profit of $15,997 to the lessor.
Calculating the after-tax cash outflows associated with lease payments is relatively straightforward. Outflow equals the lease payment less the tax savings that result from treating the lease payment as a tax-deductible expense:
O = P * (1 – t)
O = Cash outflow
P = Lease payment
T = Tax rate
So, for a company paying a 40% tax rate, the cash outflow would be equal to 60% of the annual lease payments. The tax benefit associated with the lease payment example above would be $9,279 (40% x $23,197 total annual lease payments). The annual cash outflow would $13,918 ($23,197 – $9,279). Table 1 sums up these calculations.
Determining the equivalent cash outflows associated with loan payments is more complicated. First, the owner has to determine the annual interest rate applied to each loan payment as calculated by standard loan payment formulas that show the proportion of each payment that goes to the loan principal or gets applied to interest charges. As with a mortgage, the amount of money from each payment that goes towards paying down the loan principal is a higher percentage with each payment period. Second, the owner needs to calculate the annual depreciation applied to the equipment being evaluated. The depreciation and the interest charges for each year can be deducted as an expense from annual income. As with lease payments, the total of the interest and depreciation expense can be deducted for the loan payment to calculate annual cash outflow from the loan. The inherent risk of a wrong analysis is minimized by the fact that these values are either known or can be accurately projected.
As with lease payments, loan repayments are a function of the initial value, interest rate applied to the loan, and the length of the loan (usually measured in months) and using the same formula for lease payments. This results in the same monthly payment of $1,933 and annual loan payments of $23,199. However, the interest payments on the loan and the depreciation costs are deductible, as shown in Table 2.
In either case, the resultant outflows projected into the future have to be converted into current dollars by a present value (PV) analysis. Present value is determined by the present value interest formula:
PVIF = 1 / (1 + r) n
PVIF = the present value interest factor applied to each future payment
r = the discount rate (the current after-tax cost of debt)
n = the number of years in the future for each payment
The results are shown in Table 3.
As can be seen in the table, the loan option saves the owner $6,091 ($64,491 – $58,400). All things being equal, the loan option will often be the preferred method of acquiring equipment. However, things are often not equal. The above analysis is simplified and does not take into account sales taxes, resale value, special deals, etc. Lease terms often do not coincide with the length of loan repayments. Loan interest rates may be higher than effective lease rates. An equipment owner has to deal with a mixed stream of equipment payments, each with their own duration and effective interest charges. The result is a complicated stream of highly variable cash outflows and tax benefits. All in all, the process for deciding between lease and loan options is more art than science.
As mentioned above, all businesses exist to make money. There are two broad strategies for accomplishing this goal: wealth maximization or profit maximization. The more traditional approach, wealth maximization seeks to maximize the value of the owner’s company over the long run, as expressed by its stock price. Under this strategy, long-term gains matter more than current earnings. By contrast, a profit maximization is a short-term approach. More in favor with today’s investors, it does not consider long-term risks or the timing of cash flows. In general, giving their different planning timelines, equipment loans and purchases fit best with wealth maximization while profit maximization can be best served by the lease option.
How does the third option, equipment rental, differ from equipment leasing? Both lease and rental agreements are legal and enforceable documents with specifics detailing the responsibilities of both parties. Both types of agreements have many similarities. The primary difference is that lease agreements are for long periods of at least 12 months in duration. During the duration of the lease, the agreement cannot change. At the end of the lease, both parties are free (but not obligated) to enter into a new lease agreement when the terms of the lease can be changed. Lease agreements provide stability and long-term cash flows to the owner while protecting the renter from sudden changes in rental amounts or other terms of the agreement.
Rental agreements, on the other hand, are short term and are usually enforced only on a month-to-month basis with either party able to end the rental agreement at any time. The terms of the rental agreement can be changed at the end of each month, at which time the renter is free to leave the rental agreement if the new terms are not satisfactory. Typically, the owner of the rented equipment has to give 30 days’ notice of either changing or ending the rental agreement. Rental agreements, since they are short term, protect the owner and are preferred by equipment owners when dealing with renters with substandard reputations or finances. The renter gains in operational flexibility and does not tie himself to a piece of equipment long term.
Volvo Financial Services (VFS) provides a full range of financial services in the US for the truck, construction equipment, and bus industries supporting Volvo Group brands, including Volvo Construction Equipment, Volvo Trucks, Prevost, and Mack Trucks. Volvo Construction Equipment (Volvo CE) is a major international company developing, manufacturing, and marketing equipment for construction and related industries. Its products and leaders in many world markets include a comprehensive range of wheel loaders, crawler excavators, wheeled excavators, demolition machines, articulated haulers, soil and asphalt compactors, pavers, skid-steer loaders, compact track loaders, and pipe layers. As the captive finance company supporting Volvo CE, VFS offers a range of leasing and financing offers for both used and new equipment. Current offers include special rates on select Volvo D-Series excavators and G-Series wheel loaders, as well as very competitive financing on current and used Volvo remarketing inventory.
When it comes to the rent-versus-buy decision, it’s all about the math, says United Rentals. The equipment rental leader has been advising contractors on rent-versus-buy for over 20 years. Their perspective is based on 3,400 classes of equipment: earth movers, industrial pumps, trench safety systems, and a host of other machines, including those used in heavy construction, infrastructure, municipal work, and utility maintenance. United Rentals advises contractors to evaluate its owned fleet unit-by-unit before making additional purchases. The goal is to get a true reading on total cost versus return on investment. When it comes to the staples used on most job sites—towable light towers, for example—the rent-versus-buy decision is often not “either/or,” but both. The magic number is 75%—United Rentals cautions that if owned equipment sits idle more than 25% of the time, the value is insufficient relative to the cost of ownership. In other words, your capital can be put to better use elsewhere. This strategy calls for owning just enough 6-inch vac-assist diesel pumps, for example, to keep those units active at least 75% of the time. Then use pump rentals to top off the owned fleet as the scope of the project warrants.This idea of balanced equipment consumption gets a big boost from technology. The United Rentals Total Control system is designed to help contractors reduce overall costs by optimizing the amount, length, and utilization of equipment on rent. The software tracks a contractor’s entire fleet in real time—rented and owned equipment, across multiple job sites—with detailed visibility and accountability. If the data points to underutilized equipment, those units can be moved to more useful locations rather than renting more. While it may seem counterintuitive for a rental company to help its customers rent less, United Rentals believes that a long-term partnership approach is the best way to establish trust. The company says that Total Control can help cut annual rental costs by up to a third by prioritizing the use of owned equipment before renting additional items, with total savings far exceeding the reduction in costs.