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When running a business, companies try to make the most of their money in an attempt to increase their flow of money which increases their investment value. If a firm can reduce the number of assets then their debt ratio decreases from being high to a lower ration freeing up cash resulting in an increase in cash flow. But what allows a firm to relinquish capital and make assets more liquid? The answer is in the process of leasing certain assets versus owning them.
Abstract When running a business, companies try to make the most of their money in an attempt to increase their flow of money which increases their investment value. If a firm can reduce the number of assets then their debt ratio decreases from being high to a lower ration freeing up cash resulting in an increase in cash flow. But what allows a firm to relinquish capital and make assets more liquid? The answer is in the process of leasing certain assets versus owning them.
Leasing Over Buying 1 The Advantages of Leasing Over Buying By Benjamin W. Kratz Professor Swamy Nadig, Ph. D. FINC 5880 Corporate Finance Webster University at Fort Jackson July 30, 2009 Leasing Over Buying 2 Abstract When running a business, companies try to make the most of their money in an attempt to increase their flow of money which increases their investment value. If a firm can reduce the number of assets then their debt ratio decreases from being high to a lower ration freeing up cash resulting in an increase in cash flow. But what allows a firm to relinquish capital and make assets more liquid? The answer is in the process of leasing certain assets versus owning them. Leasing Over Buying 3 Introduction: Many firms are trying to increase their profits during this steep declining economy. They can either decrease their personnel, sell assets, obtains loans, or switch from owning to leasing. What really is leasing and is it really more beneficial than owning the property? Recent business trends over the last fifty years has been one of constantly increasing numbers and values of leases (Beck, 1999). The market is growing, for example, the current level of leasing on small ticket items in the United States is $60 billion, care leasing is popular with one in three cars being leased, and lease owners showing different patterns of behavior, changing and updating the lease equipment more rapidly than those who have many loans purchases (Hendel and Lizzeri, 2002). To understand this there are four primary questions to ask: What risks are acceptable and how will they impact capital budgeting? When deciding on lease versus by, what advantage does computing the present value of outflows provide? What are the advantages of each type of lease? What qualitative factor should be considered? Risks to be considered: Firms must have a working knowledge of their current financial status and what the expected path of the industry will be over the duration of the loan/lease. This is important when choosing a lease since they must know what type of payment terms they are willing to afford. the other aspect is knowing if the asset they are leasing or buying will be technologically out dated by the time the lease is up. Purchasing usually is easier than leasing, and often the advantages of leasing are offset by the time and effort required to establish the lease, particularly if the total purchase price is not oppressive (Roch, 2005). If the firm is needing a big-ticket item that does not show to have a long use life span, then it would be better to lease the item versus buying. This allows the firm to spread out the Leasing Over Buying 4 payments over a longer period of time while allowing them the option of replacing the item if it becomes technologically obsolete before reaching the end of its operational life. Another thing that becomes enticing for leases is if the interest rates for loans are high and less appealing when the interest rates decline. That is why the firm must have a good understanding of the current economic posture of the industry. Another risk to consider is whether to report or not report the asset. When buying the asset the firm takes on additional liability once it owns it and when leasing it is not considered a liability. A capital lease " is one in which the present value of the payment stream equals the acquisition cost of the asset" (Roch, 2005). Advantage of Present Value Computation of Outflow: When the firm decides to purchase an asset it creates a large outflow of funds and one inflow of funds that occurs at a much later time when the asset is sold. Another thing that occurs is several compensating tax inflows from claiming the depreciation of the owned asset. depreciation is not an advantage when deciding to lease the asset. In leasing there are several small payment outflows occurring over the same length of time as a loan. These out flows have a different tax benefit from being able to claim them as expenses. Using the total costs of owners ship with the costs of leasing the firm is now able to compare the value of each outflows. What needs to be computed is the value of committing resources to future outflows along with the future value of the sum of money to be received in the future from selling the asset. Once all values are computed, the firm is able to decide which one has the lesser cost, lease or buy. One area where this is very useful is the IT market. This is due to a higher turnover of equipment due to the advancing technology. In a recent survey of IT managers it was interesting to note that one of the reasons given for an increased interest in leasing was to simplify the Leasing Over Buying 5 financial lifecycle of the equipment as well as to maximize the resources that a limited budget could purchase (PR Newswire, 2002). Lease Types and Advantages: There are five forms of leases and each has a different advantage. The first form is operating lease and the lessor (owner) transfers only the right to use the leased property to the lessee. Once the lease period ends, the lessee returns the property to the lessor. This is advantageous to the lessee since does not assume ownership of the asset which allows the lease to be treated as an operating expense in the income statement. Since the leased item is not reported as and asset, the lease value is also not reported as a liability. This therefore has no effect on the balance sheet resulting in having "little or no impact on a company's ability to borrow, and it could improve key financial measurements such as a company's return on assets or debt-to-equity ratio" (Roch, 2005). Once the lease is over, the firm is allowed to purchase the item at fair market value which could be drastically lower than its original value. That is to say the asset technology has not become outdated. The second form is a capital (financial) lease. In a capital lease, the lessee assumes some of the risk that comes from ownership allowing the lessee to take part in some of the benefits. When both parties sign the lease the asset is considered as both an asset and a liability on the balance sheet. The payments for the lease are considered as a liability. The advantage of this lease occurs from being able to claim a depreciation each year along with deducting the interest of the lease payment when filing taxes. At the end of this lease, the firm can acquire the item for only a nominal amount (perhaps even $100) at the end of the lease, this is worth it if the item has useful life remaining and has been maintained well (Investment, Time and Present Value, n.d.). Leasing Over Buying 6 The third form is Sale-and-leaseback arrangement. In this type of lease an arrangement is created where one party sells a property to a buyer and the buyer immediately leases the property back to the seller. Such and arrangement allows the initial buyer to liquidate the asset without having the capital tied up. Some firms also call this a leaseback since they are selling assets only to have it leased back to them. This is a good solution for firms that have toxic assets since there is no need to value the assets and any losses from the assets would be absorbed by the bank over the long haul. The last two types are combination and synthetic leases. This lease combines some aspects of both operating and financial leases. This means a lessee can use the financial lease containing a cancellation clause that is normally part of an operating lease. Such leases allow firms to pick and choose what they want to use based on their current economic posture. The synthetic lease was first used in the early 1990's by firms to keep debt off their balance sheet. They were called Special Purpose Entity (SPE) where firms obtain financing for 97% of the debt and the other 3% is provided by a third company. When the loan is closed the firm pays off the SPE loan and refinances the loan at current interest while selling the asset to make up the shortfall created by the loan-sale price. Factors to be Considered: One factor is the economic condition and the impact it has on companies. Leases can increase the amount a firm has to spend. If the firm is not willing to cut back on the amount of technology they need then the lease option is better than buying. A survey was taken by firms where they had more than 100 computers and more than 60% of the respondents stated that the economic situation was a factor in planning to lease (PR Newswire, 2002). One thing to note is that when it comes to the IT market the lower costs of leasing is not the only influencing factors. Leasing Over Buying 7 As discussed earlier, the speed in which equipment becomes out dated is another factor. The only issue with purchasing such equipment is the time it takes to dispose of the old so the firm can purchase the newest technology. When using a lease agreement, the company is able to easily adapt to such, and may even include an updating clause to ensure that equipment does not become obsolete (PR Newswire, 2002). With the lease, the firm does not own the equipment and is not responsible for selling it and purchasing the new equipment. Instead, they can cancel the current lease and enter into a new lease. A survey commissioned by the financial serves arm of Compaq, found that for 41% of companies that lease equipment chose to do so to ensure the equipment did not become outdated over the term of the lease (PR Newswire, 2002). Therefore, leasing "provides a hedge against obsolescence, facilitates upgrading, and assists in the disposal of old equipment" (Roch, 2005). Another factor to consider is if the facility needs to be built for a special purpose. If the company operations are unusual and there are few competitors, it is more likely they will own the building versus lease it. If their products are not requiring a special facility then leasing space is an option. However, they might be able to build a facility big enough to lease out a portion of the facility. A final two factors are access to capital markets and control. To own real estate is very capital intensive and a firm will lock down capital that could be used elsewhere. There is a financial cost to owning real estate that is consistent with the cost of obtaining debt and equity capital. The final factor is control of the asset. There may be a financial advantage to owning the real estate like retaining goodwill for a reasonable cost. If they lease the asset then they do not receive the goodwill, the lessor does since their name is associated with the asset. Leasing Over Buying 8 Effect on final statements: Firms decision to lease or buy impacts the financial statements in different ways which can affect the value placed on the business by investors and lenders. Owning the asset shows up as a liability as discussed earlier. However, leases are considered to be "off-balance sheet financing". As seen in Table 1, both firm B and L are identical in every way. Firm B decides to buy new assets where firm L chooses to lease. Since firm L chose to lease there is no change in its debt ratio. However, firm B increases its debt ratio by 25% resulting in a decrease in the operating leverage by increasing its fixed costs and debt in one action. Table 1: Balance Sheet Effects of Leasing (Brigham/Ehrhardt 2008) Conclusion: The trend on leasing over buying will continue to depend on the type of industry and the strength of the economy. There will be some industries that reach their peak of growth in technology like cars and property causing leasing options to drop due to loss of economic benefits over owning. However, industries like IT and agriculture equipment will still increase Leasing Over Buying 9 from the benefits of writing off total payments on accounts, gaining equipment without tying up credit lines, and increases in cash flow. Deciding whether to lease or buy is always an individual firm's decision and is not solely based on only the above discussed factors. The key thing to be considered in all financial decision is which decision provides the better financial benefits. Leasing Over Buying 10 References: Beck Kenneth, (1999, April 21), Office furniture leasing has its advantages. Long Island Business News, i16 p13(1) Brigham, Eugene and Ehrhardt, Michael, (2008). Financial Management: Theory & Practice, 12th Edition. p 720. Hendel Igal; Lizzeri Alessandro (2002, Feb), The role of leasing under adverse selection. Journal of Political Economy, v110 i1 p113(31) Investment, Time and Present Value. (n.d.). CoolEconomics.com. Retrieved November 19, 2006 from http://www.cooleconomics.com/mana/mana-present.pdf. PR Newswire, (no author cited), (2002, Jan 3), Study Shows Information Technology Leasing to Increase in 2002. PR Newswire pDATH02403012002 Roch, William (2005, May 24). Revisiting the lease versus purchase decision. Building an Edge, 6(5). Retrieved November 19, 2006 from http://www- 03.ibm.com/industries/financialservices/doc/content/resource/thought/1596212103.html.
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