Leasing is an alternative to purchasing. Because the lessee is obligated to make a series of payments, a lease arrangement resembles a debt contract. Thus, the advantages cited for leasing are often based on a comparison between leasing and purchasing using borrowed funds.
This post reveals 7 intelligent reasons behind the decision to leasing. These reasons do not necessarily mean that leasing is always better than purchasing. Leasing could be not a right option for certain conditions. But the reasoning revealed here may enlighten to a better decision whether to lease or to purchase. Enjoy!
Reason 1: Cost
Many lessees find true leasing attractive because of its apparent low cost. This is particularly evident where a lessee cannot currently use tax benefit associated with equipment ownership due to such factors as lack of currently taxable income or net operating loss carryforwards.
If it were not for the different tax treatment for owning and leasing equipment, the costs would be identical in an efficient capital market. However, due to the different tax treatment as well as the diverse abilities of taxable entities to currently utilize the tax benefit associated with ownership, no set rule can be offered as to whether borrowing to buy or a true lease is the cheaper form of financing.
The cost of a true lease depends on the size of the transaction and whether the lease is tax-oriented or nontax-oriented. the equipment leasing market can be classified into the following three market sectors: (1) a small-ticket retail market with transactions in the $5,000 to $100,000 range, (2) a middle market with large-ticket items covering transactions between $100,000 and $5 million, and (3) a special-products market involving equipment cost in excess of $5 million.
Tax-oriented leases generally fall into the second and third markets. Most of the leveraged lease transactions are found in the third market and the upper range of the second market. the effective interest cost implied by these lease arrangements is considerably below prevailing interest rates that the same lessee would pay on borrowed funds. Even so, the potential lessee must weigh the lost economic benefit from owning the equipment against the economic benefit to be obtained from leasing.
Nontax-oriented leases fall primarily into the small-ticket retail market and the lower range of the second market. There is no real cost savings associated with these leases compared to traditional borrowing arrangements.
In most cases, however, cost is not the dominant motive of the firm that employs this method of financing.
From a tax perspective, leasing has advantages that lead to a reduction in cost for a company that is in a tax-loss-carryforward position and is consequently unable to claim tax benefit associated with equipment ownership currently or for several years in the future.
Reason 2: Conservation of Working Capital
The most frequent advantage of leasing cited by leasing company representatives and lessees is that it conserves working capital. The reasoning is as follows:
When a firm borrows money to purchase equipment, the lending institution rarely provides an amount equal to the entire price of the equipment to be financed. Instead, the lender requires the borrowing firm to take an equity position in the equipment by making a down payment. The amount of the down payment will depend on such factors as the type of equipment, the creditworthiness of the borrower, and prevailing economic conditions. Leasing, in contrast, typically provides 100% financing since it does not require the firm to make a down payment. Moreover, costs incurred to acquire the equipment, such as delivery and installation charges, are not usually covered by a loan agreement. They may, however, be structured into a lease agreement.
The validity of this argument for financially sound firms during normal economic conditions is questionable. Such firms can simply obtain a loan for 100% of the equipment or borrow the down payment from another source that provides unsecured credit. However, there is doubt that the funds needed by a small firm for a down payment can be borrowed, particularly during tight money periods. Also, some leases do, in fact, require a down payment in the form of advance lease payments or security deposits at the beginning of the lease term.
Reason 3: Preservation of Credit Capacity by Avoiding Capitalization
Current financial reporting standards for leases require a leasing obligation classified as a capital lease (discussed later) be capitalized as a liability and the equipment recorded as an asset on the balance sheet.
According to Financial accounting standards board (FASB) Statement No. 13, the principle for classifying a lease as a capital lease for financial reporting purposes is as follows:
A lease that transfers substantially all of the benefit and risks incident to ownership of property should be accounted for as the acquisition of an asset and the incurrence of an obligation by the lessee.
FASB statement No. 13 specifies four criteria for classifying a lease as a capital lease. Leases not classified as capital leases are considered operating leases. Unlike a capital lease, an operating lease is not capitalized. Instead, certain information regarding such leases must be disclosed in a footnote to the financial statement.
Many CFOs are of the opinion that avoiding capitalization of leases will enhance the financial image of their corporations. By allowing a company to avoid capitalization, an operating lease preserves credit capacity.
An operating lease—and particularly a leveraged lease enables a lessee to utilize institutional (lessor) equity as a source of funding somewhat like subordinated debt. Because there is generally ample room for designing lease arrangements so as to avoid having a lease classified as a capital lease, CFOs generally prefer that lease agreements be structured as operating leases.
As a practical matter, most long-term true leases (payout-type leases for the lessors) are structured to qualify as operating leases for financial accounting purposes for the lessees at the request of the lessees. Further, the reality is that credit rating services evaluate a company’s balance sheet by including the assets and liabilities of operating leases. Hence, structuring a lease as an operating lease does not, in practicality, remove it from consideration as a liability.
Reason 4: Risk of Obsolescence and Disposal of Equipment
When a firm owns equipment, it faces the possibility that at some future time the equipment may not be as efficient as more recently manufactured equipment. The owner may then elect to sell the original equipment and purchase the newer, more technologically efficient version. The sale of the equipment, however, may produce only a small fraction of its book value. By leasing, it is argued, the firm may avoid the risk of obsolescence and the problems of disposal of the equipment. The validity of this argument depends on the type of lease and the provisions therein.
With a cancelable operating lease, the lessee can avoid the risk of obsolescence by terminating the contract. However, the avoidance of risk is not without a cost since the lease payments under such lease arrangements reflect the risk of obsolescence perceived by the lessor. At the end of the lease term, the disposal of the obsolete equipment becomes the problem of the lessor. The risk of loss in residual value that the lessee passes on to the lessor is embodied in the cost of the lease.
The risk of disposal faced by some lessors, however, may not be as great as the risk that would be encountered by the lessee. Some lessors, for example, specialize in short-term operating leases of particular types of equipment, such as computers or construction equipment, and have the expertise to release or sell equipment coming off lease with substantial remaining useful life.
A manufacturer-lessor has less investment exposure since its manufacturing costs will be significantly less than the retail price. Also, it is often equipped to handle reconditioning and redesigning due to technological improvements. Moreover, the manufacturer-lessor will be more active in the resale market for the equipment and thus be in a better position to find users for equipment that may be obsolete to one firm but still satisfactory to another. IBM is the best example of a manufacturer-lessor that has combined its financing, manufacturing, and marketing talents to reduce the risk of disposal. This reduced risk of disposal, compared with that faced by the lessee, is presumably passed along to the lessee in the form of a reduced lease cost.
Nonetheless, financial institutions and other lessors are financing ever larger, more complex, and longer-lived assets, and uncertainty over the residual value of those assets is one of the biggest risks for lessors. A steel plant, for example, could have an estimated useful life of 30 years, but its actual useful life could be as short as 25 years or as long as 40 years. If the useful life of the plant turns out to be less than the lessor has projected, the lessor could suffer a loss on a lease that appeared profitable in the original analysis.
For some types of assets there is abundant data to support estimates of residual value and for other types of assets there is very little data—particularly for new, unique, complex, or infrequently traded assets. The primary factors that affect residual value are the three components of depreciation: useful life (deterioration), economic obsolescence, and technological obsolescence.
Rode, Fishbeck, and Dean suggest that lessors use the best information available to simulate the behavior of these three factors as well as the correlation among the three factors, based on probabilistic ranges of outcomes, to produce distributions of useful life curves, estimated values, and confidence intervals. Because conditions inevitably change over time, lessors should update their modeling frequently during the life of the equipment.
Reason 5: Restrictions on Management
When a lender provides funds to a firm for an extended period of time, provisions to protect the lender are included in the loan agreement. The purpose of protective provisions, or protective covenants, is to ensure that the borrower remains creditworthy during the period over which the funds are borrowed.
Protective provisions impose restrictions on the borrower. Failure to satisfy such a protective covenant usually creates an event of default that, if not cured upon notice, gives the lenders certain additional rights and remedies under the loan agreement, including the right to perfect a security agreement or to demand the immediate repayment of the principal. In practice, the remedy and ability to cure vary with the seriousness of the event of default.
An advantage of leasing is that a lease agreement typically does not impose financial covenants and restrictions on management as does a loan agreement used to finance the purchase of equipment. The historical reason for this in true leases is that the internal revenue service discouraged true leases from having attributes of loan agreements. Leases, however, may contain restrictions as to location of the property and additional investments by the lessee in the leased equipment in order to ensure compliance with tax laws.
Reason 6: Impact on Cash Flow and Book Earnings
In a properly structured true lease arrangement, the lower lease payment from leasing rather than borrowing can provide a lessee with a superior cash flow. Whether the cash low on an after-tax basis after taking the residual value of the equipment into account is superior on a present value basis must be ascertained.
Leasing versus buying has a different effect on book earnings. Lease payments under a true lease will usually have less impact on book earnings during the early years of the lease than will depreciation and interest payments associated with the purchase of the same equipment.