WHY COMPANIES LEASE EQUIPMENT

Equipment Leasing is the single largest external source of capital for acquiring equipment in today’s economy and the demand continues to grow.  All types of assets are being leased and several thousand leasing companies, varying in size, type and market focus, have emerged to meet the diverse financial needs of lessees.  “High Tech” products present as good an opportunity for leasing as any equipment segment due to the high degree of soft costs that may be included in an acquisition, along with the technological obsolescence factor.  The reasons for leasing are numerous.  Following is a categorical presentation of many of the motivations to lease.

Technological Considerations

• A Natural Obsolescence Hedge - Perhaps one of the strongest reasons for acquiring the use of equipment through leasing, as opposed to purchasing, is that leasing helps lessees avoid many of the risks of ownership.  One of the key risks of ownership is obsolescence.  The inherent risk of owning technologically sensitive equipment is that the equipment may become economically useless to the company owning it much earlier than expected, and long before the obligations incurred to acquire the equipment have been satisfied.  If a lessor, such as Solarcom Capital, is willing to assign a residual value to the leased equipment, the lessee benefits by paying back less than 100% of the equipment cost and the residual becomes the lessor’s risk.  Secondly, Solarcom Capital’s equipment knowledge, combined with its greater access to secondary equipment markets, may cause the equipment to be more valuable in the hands of the lessor than the lessee.

• Takeouts, Rollovers and Upgrades - Takeouts, rollovers and upgrades also give the lessee flexibility during the lease term should the leased equipment become obsolete prior to termination of the lease.  This flexibility would not be available if the lessee purchased the equipment, without the lessee potentially incurring a book loss.

Financial Reporting Reasons

• Off Balance Sheet Financing - When a company purchases equipment it must capitalize the equipment on its balance sheet by showing it as an asset, along with a corresponding liability for any loans used to finance the equipment’s purchase.  Since the cost of the capitalized equipment must be amortized over its economic life, depreciation and interest expense (if financed) will appear on the company’s income statement.  If a lease is classified as an operating lease for the lessee’s financial reporting purposes, however, it is not required to be capitalized in the financial statements.  Furthermore, the only expense appearing on the lessee’s income statement that is attributable to the lease would be the lease rental payment.  The use of operating leases can reduce the amount of leverage reflected on financial statements.  Many, if not all, of the company’s financial ratios and measurements are improved, at least initially, so the company appears to be stronger, more liquid and more profitable.

• Increased Return On Assets - Due to its effects of lowering a lessee’s asset base, as well as increasing the lessee’s reported earnings, an operating lease helps a lessee to report a higher return on assets (ROA).  Many managers are sensitive to the level of the reported ROA, as oftentimes bonus arrangements are tied to the ROA attained by the division or company. Companies, especially public companies, are constantly striving to have their financial statements look as strong and healthy as possible to shareholders and lenders and operating leases can help accomplish that goal.

• Lower-Level Decision Maker - Managers of all levels who wish to acquire the use of equipment, but who do not have the appropriate authority to expend the necessary level of funds, find leasing to be a convenient method of acquiring the equipment’s use.  Through the use of a lease they are able to pay monthly lease rentals out of the department’s or division’s operating budget, as the amount of the monthly lease payment oftentimes falls within their spending authority guidelines.

Cash Management Considerations

• Affordability To Lessees - The acquisition of assets through leasing, as opposed to purchasing, becomes even more desirable as the cost of equipment rises.  First, as a general rule, leasing companies require lower down payments than other financial institutions.  Leasing companies may require multiple lease payments up front; however, that still normally equates to much less than the standard 20% down payment required by most banks.  Secondly, other incidental costs of acquiring the asset, such as sales tax, installation charges and delivery charges, can be included as part of the lease, rather than being paid up front, along with the large down payment.  This allows a company to employ cash savings for other more profitable working capital requirements.  Frequently, the opportunity cost of tying up cash in equipment acquisitions almost necessitates leasing as an alternative, especially for rapidly growing companies whose available cash is invested in highly profitable inventory and receivables.  Firms oftentimes mistakenly use funds earmarked for short-term working capital needs to purchase long-term assets, thereby hindering the company’s day-to-day operations, as well as its ability to meet short-term credit obligations.  Leasing helps a company to conserve working capital for its intended purpose.  A lease alternative also may be more affordable to a company than a conventional loan due to potentially lower monthly payments impacted by residual values or tax benefits.

• Improved Cash Forecasting - The fixed contractual nature of a lease eliminates any uncertainties regarding the future cost of the equipment.  This enables companies to prepare more accurate cash forecasts and plans.

• Circumventing Capital Budget Constraints - Many large and profitable firms choose to lease for one very real reason - to circumvent various capital budget constraints.  A division or department of a large firm may have sufficient funds to purchase a new piece of equipment outright.  However, if the division or department has already fully utilized its capital equipment budget, it most likely will be precluded from purchasing the equipment.  Such a department or division could lease the necessary equipment and pay for the lease rentals out of its operating budget instead of the capital budget. As previously mentioned, a lease structured as an operating lease for financial reporting purposes appears as a periodic expense on the lessee’s income statement, is not reflected on the lessee’s balance sheet and is paid for out of its operating budget.

• Reimbursement Policies - Companies operating in certain regulated industries, as well as private contractors for the federal government, are reimbursed in various ways for the expenses they have incurred, depending upon the nature of the expense.  Oftentimes, lease expense can be recovered more quickly than depreciation and interest expense incurred in purchasing an asset.  In many cases lease expense is viewed as an expense tied to a certain project or time period, whereas interest and depreciation for a long-term asset may not be accepted as a project expense and, therefore, may not be immediately reimbursable.

Income Tax Motivations

• Deductibility Of Rentals - Lease payments in a tax lease are fully deductible for federal income tax purposes.  While the user will not receive any accelerated depreciation benefits, the deductibility of the payments provides a clear tax benefit for the lessee.  In regard to this deductibility of lease payments, short-term leases provide an even greater tax incentive to lease.  When leases are written for terms shorter than the equipment’s MACRS class-life, an incremental tax advantage is created to the degree that the deductible lease payments exceed the expenses plus MACRS deductions that would have been available to the user had the equipment been purchased.  A computer system is a perfect example.  Our leases are typically 36 months, while the MACRS class-life for computer equipment is 5 years.  Therefore, there may be an incremental tax benefit in expensing the lease payments over the 36 month term instead of depreciating the asset over 5 years.  (Not even considering the risk of obsolescence and potential book loss if the equipment is not held for the entire 5 years.)

• Negative Impact of Additional Purchases/AMT - Companies either facing or approaching the alternative minimum tax (AMT) or the midquarter depreciation convention will be penalized when purchasing new equipment by having to pay more taxes, due to a loss or reduction in value of certain tax benefits.  For a company that is approaching or is in an AMT position it makes more sense for them to lease the equipment than to purchase, because a purchase may cause them to pay additional taxes, whereas, a lease will not.  In addition, a company that is in need of new equipment in the fourth quarter of its fiscal year may fall subject to the midquarter depreciation convention.  If  more than 40% of all personal property placed in service during the year is placed in service in the last 3 months of the taxable year, all MACRS recovery property placed in service during the entire year is subject to the midquarter convention.  The bottom line is this could cause the company to pay additional tax, whereas, if they leased the equipment, this problem could be eliminated.

 
Ownership Aspects

• Use Versus Ownership - Enlightened business people realize the use of a piece of equipment is far more important to the production of income than a piece of paper conveying title to the equipment, as it is the use of equipment that produces profit, not ownership.  For example, ownership of the equipment may not be as important to a company as acquiring the use of the equipment for the lowest possible cost, or with the least expense.  Obtaining the use of equipment through leasing may result in lower acquisition costs, which in turn implies greater profitability.

• Avoiding Stranded Assets - For financial reporting purposes, a piece of equipment that has been capitalized on a company’s balance sheet is depreciated over its estimated economic life.  If equipment is deemed obsolete before the end of its depreciable life, the company would then own a worthless asset that is not fully depreciated on its books.  The company will likely record a book loss on the sale of the asset, thus negatively impacting earnings.  If the company holds the asset just for the sake of depreciation, this is called a “stranded asset”.  To avoid this scenario, the company could lease the equipment over a shorter term and ask for renewal terms in the event they are not certain as to how long they will need the use of the equipment.

Flexibility and Convenience

• Convenience to Lessee - Leasing through Solarcom Capital can be one stop shopping for a company, which can be a tremendous convenience.  A company can also find convenience in not having to capitalize and depreciate a piece of equipment on their books if they purchase it.  Instead they simply expense the payment, which is far less cumbersome to monitor.  As discussed previously, leasing helps in the budgeting or cash flow projection process, because the payments for most leases are fixed periodic payments, which are easy to budget for.  Furthermore, oftentimes companies do not require the same lengthy analysis for leasing equipment where payments are coming from an operating budget, as they would in analyzing an acquisition through their capital budget.

• Flexibility In Lease Structuring - Leasing, unlike conventional financing, sometimes can be as flexible as a Lessor’s imagination.  For example, if you have a customer that has seasonality in their cash flow, why not suggest a structure that matches their lease payments with their cash flow.  Another flexible structure may be a step payment structure.  If you find that your customer has excess budget money they need to spend this year, you may suggest a step down payment structure that increases their payments in the early part of the lease and reduces the payments in later months.  Or vice versa, if they are looking to have reduced payments initially and then increase payments in subsequent months, you may suggest a step up payment structure.  This scenario may occur if your customer is looking to the equipment as a revenue enhancer and is trying to match payments to the equipment’s revenue production.  (Be aware that this is usually available for only solid credit risks.)  The list goes on, but the point being leasing is much more flexible than conventional financing.

• Bundled Services - Usually, the subject of a lease is tangible personal property. However, in our case bundled services is more the norm than the exception.  Bundling software, services, etc. into a full-service lease can be a tremendous convenience to a lessee and probably less expensive that if they had to purchase the same equipment and services separately.

• Planned Replacement Of Equipment - Many managers prefer to lease equipment because leasing facilitates the planned replacement of existing equipment with new technology.  If the equipment had been purchased, no outside forces exist that would compel the company to replace its existing equipment, short of market conditions.  A manager’s intent to replace equipment at a certain point easily could be side-tracked by a temporary corporate freeze on capital expenditures; whereas, in a lease scenario, he could replace the equipment and simply continue to make lease payments from the operating budget that may even be less than the prior lease payments.

• Priority Delivery - When a company realizes an immediate need for new equipment, delivery delays might cost it a great deal in terms of lost sales, customer goodwill and incremental profits. From time to time, a certain piece of equipment may be in such high demand that a long lead time is required between order and delivery.  If the company has little clout with the manufacturer, they may look to someone like Solarcom Capital who may be able to shorten the delivery time because of our inventory or clout with the manufacturer in securing a shorter lead time and delivery.  Leasing, therefore, may be the company’s answer to a speedier delivery of equipment, thereby preserving potentially lost sales, profits and goodwill.

Economic Reasons

• Diversification of Financing Sources - The US economy has seen several swings in the availability of conventional bank financing.  Many businesses are acutely aware of the dangers of depending solely upon conventional sources.  Diversification of financing sources makes good business sense whether credit is in short supply or not.  It is also important to note that federally chartered banks have, by regulatory law, built-in limits on the availability of loanable funds to any single customer.

• Additional Source of Debt Financing - Over the years during periods of capital shortages stemming from numerous underlying economic factors, leasing’s popularity was enhanced by its capacity to provide an additional source of funds not otherwise available.  The continued capital needs for business expansion and modernization, combined with a limited availability of capital funds which are eaten up by government spending and consumer credit, has contributed to leasing’s expanded role in supplying capital for equipment acquisitions.  Due to a lessor’s knowledge of asset values, and access to secondary equipment markets, lessors are generally more willing than conventional lenders to take the value of the leased equipment into consideration when granting approval for a specific transaction.

• Less Restrictive Form of Financing - When lending to a company, a banker typically builds restrictive loan covenants into the loan agreement.  Loan covenants, while attempting to minimize the lender’s risk, oftentimes can be very restrictive.  A company subject to numerous restrictive covenants is greatly reduced in its decision-making autonomy or independence.  Lease agreements on the other hand rarely contain restrictive covenants.  The lessor builds its perceived risk into the pricing of the lease by adjusting the yield, the amount of refundable security deposits, up-front fees or the number of advance rentals.  Leasing can offer greater freedom or flexibility than a loan, as it does not tie up a company’s future financing options through restrictive covenants.

• Economies of Scale in Lessor Purchasing and Servicing - Certain lease companies, due to their large size, can generate savings in the form of quantity discounts received from volume purchasing.  Such savings might be partially passed on to the lessee.  Additional savings from economies of scale might be obtained through the full-service lease, where the cost of maintaining the leased equipment is included as part of each rental payment.  In addition, large leasing companies have greater access to secondary markets in which returned equipment may be resold.  A lessor’s ability to quickly sell returned equipment for a high resale amount allows it to take a higher residual position for lease pricing purposes.

• Lower Cost - At times leasing can be the less expensive method of acquiring the use of equipment.  Typically, financial alternatives such as lease versus a loan are compared on a present value, after-tax basis.  The alternative with the lower cost, adjusted for the impact of taxes and the time value of money, would be selected.  For a variety of reasons, leasing can be the less expensive form of financing in such a comparison, especially when you consider the remarketing and obsolescence factors.

This presentation attempts to stimulate some thought as to why various companies lease instead of buy or finance conventionally.  Solarcom Capital is here to make leasing easy for you.  Remember, your scarcest asset is your time.