Marsh Business Advisors, LLC
"CAPITAL"
Benefits Of Leasing Often Beat Buying Or Borrowing
By: Stuart Wm. Marsh
President, Genesee Capital, Inc.
November 3, 1995
Last week, this burning question was posed: If your company can borrow money from a bank to fund the equipment, why would you consider leasing the equipment?
For the answer, I spoke with William Jones, Chief Operating Officer of Patora Leasing, Inc. Because Bill has spent his entire career in both banking and leasing, I considered him the best equipped to compare a loan to a lease.
He summed it up succinctly: Buy assets that appreciate; lease assets that depreciate.
A lease is a contractual agreement between a lessor and a lessee that conveys to the lessee the right to use specific property, owned by the lessor, for a specific period of time in return for stipulated, and generally periodic, cash payments.
Bill discussed the following advantages of leasing:
~ Leasing permits 100 percent financing vs. 60 percent to 90 percent under borrowing. This conserves cash and working capital.
~ Leasing permits rapid changes in equipment, reduces the risk of obsolescence, and in many cases passes the risk in residual value to the lessor.
~ Leasing has certain tax advantages.
~ Leasing may be more flexible because typically lease agreements may contain less restrictive provisions than do other debt agreements.
~ And leasing may not add debt to the balance sheet--therefore not affecting financial ratios--and hence may add to borrowing capacity.
A cancelable lease is one the lessee can cancel at any time. Very often this type of lease is what comes to mind when a businessperson contemplates leasing a piece of equipment. A cancelable lease has all the characteristics of renting a piece of equipment, and if the lessee experiences financial difficulties, the equipment can be returned to the lessor on extremely short notice.
For the sake of this column, let's make a distinction between a lease and a rental. Let's refer to a cancelable lease as an equipment rental, and due to its very high costs, only a short-term option - often daily, weekly or monthly.
A non-cancelable lease requires payments from the lessee for the life of the lease. Non-cancelable leases usually have lives measured in years rather than weeks or months. Depending upon the specific terms and conditions of the lease, long-term non-cancelable leases are classified either as capital leases or as operating leases.
If at the inception of the lease agreement the lessee is party to a non-cancelable lease that meets one or more of the following four criteria, the lessee must account for the lease as a capital lease:
1) The lease transfers ownership of the property to the lessee.
2) The lease contains a bargain purchase option.
3) The lease term is equal to 75 percent or more of the estimated economic life of the leased property.
4) The present value of the minimum lease payments (excluding executory costs) equals or exceeds 90 percent of the fair value of the leased property.
A capital lease often is referred to as a "finance'' lease. Although the legal documents call it a lease, meeting any of the four criteria above qualifies it as more of a loan than a lease.
Leases that do not meet any of the four criteria are classified and accounted for by the lessee as operating leases, which often are referred to as "true'' leases.
These two different methods of accounting for leases can have a big impact on your business. If the lease is treated as a capital lease, then the leased asset and the lease obligation will appear on your company's balance sheet. The lease obligation is treated as a liability, and will increase the total debt reported on your balance sheet. Without a corresponding increase in your company's equity, this will serve to increase your firm's leverage. This often serves to decrease your firm's chance of borrowing more money from your friendly banker.
If the lease is treated as an operating lease, then the leased asset and the lease obligation will not appear on the balance sheet. This "off-balance-sheet financing'' may be a major advantage because it may enable your firm to borrow more money than if the leased asset were to appear on the balance sheet.
Quite often a company obtains all its short-term and long-term debt from one financial institution, typically a bank. The bank usually requires a comprehensive loan agreement that permits the company to do certain things, and prohibits the company from doing other things.
Another advantage to leasing is flexibility, in that the lessor may not require a restrictive borrowing agreement.
Leasing also may have tax advantages, which typically result from timing differences. Under an operating lease, the periodic lease payments are expensed in full. Under a loan, the interest portion of the loan payment is expensed, and the asset is depreciated for tax purposes in accordance with Internal Revenue Service regulations.
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Another good thing about leasing is that it permits 100 percent financing, whereas a company typically is able to finance only 60 percent to 90 percent of the equipment cost from a bank. This means the company must invest 10 percent to 40 percent of its equity in the equipment.
Leasing also can reduce the risk of obsolescence. When a company buys a piece of equipment, and finances it with a loan, the term of the loan is several years less than the economic life of the equipment. A lease often works exactly the same way: The term of the lease is several years less than the economic life of the equipment.
However, with a loan you pay for 100 percent of the cost of the equipment in a period less than the economic life of the equipment; a lease, meanwhile, often amortizes less than 100 percent of the equipment cost. In other words, you pay for only what you use, and you do not build up equity in a piece of equipment.
Remember Bill Jones' advice: Buy assets that appreciate; lease assets that depreciate.
Here is an example: Let's assume your company needs to acquire a new $100,000 1995 Super-D-Lux Framisator, which (according to the Super-D-Lux salesman), when operating at just over 92 percent of capacity "should make you just about as rich as Bill Gates.'' ("Honest.'')
Framisators are extremely well made, and typically last for seven to 10 years, at which point they become worthless. Your banker is willing to lend you 75 percent of the cost on a five-year term loan at a fixed interest rate of 10 percent. Your monthly loan payment for 60 months is $1,593.53.
In the past, this would be a no-brainer. But something is troubling you. Framisators are evolving technologically. Nowadays, Framisators are coming equipped with more and more microprocessors, and the pace of their obsolescence is quickening. Further, the Super-D-Lux salesman proudly mentioned that his company was working on the next generation of Framisators, which were being designed to interface with "Windows 2000.''
If the Super-D-Lux salesman is telling the truth (which, from past experience, seems, ah, doubtful), then just when you've finished paying off the loan, and are expecting two to five years of "free'' use of the Framisator, it might be obsolete.
You contact a leasing company, which then offers the following: It will lease the Framisator to you for 60 months for $1,899.34 per month. At the end of the 60 months you can buy the Framisator for its then fair market value, or return it to the leasing company.
At first glance, there is virtually no decision to be made. The monthly loan payment for 60 months is $1,593.53 and the lease payment, $1,899.34. The lease costs $305.81 more.
But the bank will require your company to come up with 25 percent of the Framisator's cost. This is $25,000 you could use elsewhere in your company. The leasing company, meanwhile, is not requiring a down payment.
If your company's after-tax cost of equity is 15 percent, and after-tax cost of debt is 7.5 percent (pretax cost of debt is 10 percent, with a 25 percent marginal tax rate), then the weighted-average cost of financing the Framisator with the help of a bank loan is 9.375 percent (or 25 percent of 15 percent, plus 75 percent of 7.5 percent).
How do you know what the interest rate is on the lease? Every time you ask the leasing company for the interest rate, they just mumble something about "lease factors'' and claim that "there is no interest rate in a lease.''
You get together with the Super-D-Lux salesman and the leasing representative. A couple of well-timed questions are asked during a couple of well-timed cocktails. You discover that the leasing company is taking a residual risk of 25 percent; that is, when the original lease term of 60 months is over, only 75 percent of the equipment cost has been amortized. You also find out that the interest rate the leasing company is using is 12 percent, which is higher than the 10 percent your banker is charging.
Later on you find out that the reason you can't get the leasing rep's numbers to work is because you've forgotten that lease payments are made in advance (for the coming month, like an apartment rent), whereas loan payments are made in arrears (for the prior month, like a home mortgage).
Since the proposed terms of this lease will enable you to treat it as a true lease, you will be able to expense the full amount of each lease payment. Since your firm is in the 25 percent marginal tax bracket, the 12 percent interest rate implicit in the lease has an after-tax cost of 9 percent. That is cheaper than the 9.375 percent after-tax weighted-average cost of borrowing 75 percent of the equipment cost from a bank and putting up a down payment of 25 percent.
But there is something else of value in this lease. You have reduced your risk - the risk of obsolescence. If Super-D-Lux does introduce a new generation of Framisators five years from now that run on Windows 2000, your 1995 Framisator may be obsolete. But it won't matter. You'll just call your friendly lease rep and say: "Where would you like me to deliver your Framisator?''
Leasing has many advantages over borrowing or buying. Consider leasing the next time your company needs a piece of equipment. Weigh all the factors carefully. Your decision will affect only your wealth and that of your shareholders.