Equipment Leasing Nathan J. Muller

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1 Equipment Leasing Nathan J. Muller Payoff Data communications managers today are responsible not only for selecting equipment, but also for recommending purchasing arrangements. Although contract terms have become more flexible in recent years, the fundamental decision still boils down to this: lease or purchase. Introduction Equipment leasing can provide organizations with many financial and nonfinancial benefits. According to the Washington DC-based Computer Leasing and Remarketing Association, $14.7 billion worth of computer and telecommunications equipment was leased in There are a number of financial reasons for considering leasing over purchasing, such as when a company cannot secure credit for an installment loan on the system and has no available line of credit, or cannot make the down payment required for an installment loan. Leasing can improve a company's cash position, since costs are spread over a period of years. Leasing can free up capital for other uses, and even cost-justify technology acquisitions that would otherwise be too expensive. Leasing also makes it possible to procure equipment on short notice that has not been planned or budgeted for. A purchase, on the other hand, increases the debt relative to equity and worsens the company's financial ratios in the eyes of investors, creditors, and potential customers. An operating lease on rental equipment can reduce balance sheet debt, since the lease or rental obligation is not reported as a liability. An operating lease represents an additional source of capital and preserves credit lines. Beyond that, leasing can help companies comply with the covenants in loan agreements that restrict the amount of new debt that can be incurred during the loan period. The purpose of such provisions is to make sure that the company does not jeopardize its ability to pay back the loan. In providing additional capacity for acquiring equipment without violating loan agreements or hurting debt-to-equity ratios, leasing in effect allows companies to have their cake and eat it too. Lower Equipment Costs With major improvements in technology becoming available every 12 to 18 months, leasing can prevent a company from becoming saddled with obsolete equipment. The potential for losses when replacing equipment that has not been fully depreciated can be minimized by leasing rather than purchasing. Furthermore, with rapid advancements in technology and consequently shortened product life cycles, it is becoming more difficult to sell used equipment. Leasing eliminates this problem too, since the leasing company owns the equipment. For organizations concerned with controlling staff size, leasing also minimizes the amount of time and resources spent in cost-justifying capital expenditures, evaluating new equipment and disposing of old equipment, negotiating trade-ins, comparing the capabilities of vendors, performing reference checks on vendors, and reviewing contractual options. There is also no need for additional administrative staff to keep track of configuration details, spare parts, service records, and equipment warranties. Because the

2 leasing firm is usually responsible for installing and servicing the equipment, there is no need to contract for skilled technicians or outside consulting services. Lease agreements may be structured to include ongoing technical support and even a help hotline for end users. Because lessors have a stake in keeping the equipment functioning properly, they usually offer on-site repair and the immediate replacement of defective components and subsystems. In extreme cases, the lessor may even swap the entire system for a properly functioning unit. Although contracts vary, maintenance and repair services that are bundled into the lease can eliminate the hidden costs often associated with an outright purchase. Flexible Contract Terms Leasing usually allows flexibility in customizing contract terms and conditions. There are no set rates and contracts when leasing. Unlike many purchase agreements, each lease is negotiated on an individual case basis. The items typically negotiated in a lease are the equipment specifications, schedule for upgrades, maintenance and repair services, and training. End-of-lease options are also negotiable. This can include signing another lease for the same equipment, signing another lease for more advanced equipment, or buying the equipment. Many lessors will allow customers to end a lease ahead of schedule without penalty if the customer agrees to a new lease on upgraded equipment. Nonfinancial Incentives There are also some very compelling nonfinancial reasons for considering leasing over purchasing. In some cases, leasing can make it easier to try new technologies or the offerings of new vendors. After all, leases always expire or can be canceled (a penalty usually applies), but few vendors are willing to take back purchased equipment. Leasing permits users to take full advantage of the most up-to-date products at the lease risk and often under very attractive financial terms. Leasing is particularly attractive for companies that use technology for competitive advantage because it means that they can continually upgrade by renegotiating the lease, often with little or no penalty for terminating the existing lease early. Similarly, if the company grows faster than anticipated, it can swap the leased equipment for an upgrade. It must be noted, however, that many computer and communications systems are now modular in design, so the fear of early obsolescence may not be as great as it once was. Nevertheless, leasing offers an inducement to try vendor implementations on a limited basis without committing to a particular platform or architecture, and with minimal disruption to mainstream business operations. Getting Rid of Dated Equipment Companies that lease equipment can avoid a problem that invariably affects companies that purchase equipment: how to get rid of outdated equipment. Generally, no used equipment is worth more on a price/performance basis than new equipment, even if it is functionally identical. Also, as new equipment is introduced, it erodes the value of older equipment. These by-products of improved technology make it very difficult for users to unload older, purchased equipment. With equipment that has been leased, the leasing company assumes the responsibility of finding a buyer. Typically, the leasing company is staffed with marketers who know how and where to sell used equipment. They know how to prospect for

3 customers who might consider a secondhand system a step up from the 10-year-old hardware they are currently using. Convenience and Easier Budget Planning There is a convenience factor associated with leasing, since the lessee does not have to maintain detailed depreciation schedules for accounting and tax purposes. Budget planning is also made easier, since the lease involves fixed monthly payments. This locks in pricing over the term of the lease, allowing the company to know in advance what its equipment costs will be over a particular planning period. With leasing, there are also lower overhead costs to contend with. For example, there is no need to stockpile equipment spares, subassemblies, repair parts, and cabling. It is the responsibility of the leasing firm to keep inventories up to date. Their technicians (usually third-party service firms) make on-site visits to swap boards and arrange for overnight shipping of larger components when necessary. Whereas it may take up to eight weeks or longer to obtain equipment purchased from a manufacturer, it may take from one to 10 working days to obtain the same equipment from a leasing firm. Often, the equipment is immediately available from the leasing firm's lease/rental pool. For customers who need equipment that is not readily available, some leasing firms will make a special procurement and have the equipment in a matter of two or three days, provided the lease term is long enough to make the effort worthwhile. Many leasing companies offer a master lease, giving the customer a preassigned credit limit. All of the equipment the customer wants goes on the master lease and is automatically covered by its terms and conditions. In essence, the master lease works like a credit card. Decision Factors In addition to the traditional financial trade-offs, data communications managers must consider such factors as the long- range business plan of the company, the pace of technological change in the industry, and ongoing requirements for equipment maintenance and repair before they can recommend the lease or purchase of equipment. Assuming that internal needs have been properly assessed with input from appropriate departments, the data communications manager must take into account the following business issues. Equipment Title. Equipment purchase results in the transfer of title to the purchaser, but the title remains with the lessor when equipment is leased. A company must have title ownership to be eligible for certain tax considerations, including first-year expensing and depreciation. First-Year Expensing. First-year expensing is an immediate deduction that applies to property purchased for business or professional use. Under current federal tax laws, self-employed individuals and businesses are allowed to immediately deduct up to $17,500 of the cost of business equipment and software placed into service in one year. Any amount over $17,500 must be depreciated over a five-year period. Software can be depreciated over a three- year period. Depreciation. Depreciation is a deduction for the obsolescence of equipment or software due to normal wear and tear, as well as technological advances that render such products out of date. An

4 individual or company can deduct for depreciation. The deduction results in a lowered adjusted net income upon which federal income taxes are computed. The marginal tax rate translates depreciation deductions into actual tax dollars saved. The marginal tax rate is derived from and usually equals an individual's or company's tax bracket. Therefore, a 34% tax bracket has a marginal tax rate of 34% and thus saves $34 in taxes for every $100 of depreciation deductions available per year. Under current tax laws, depreciation is usually fixed according to property type. Computer and communications equipment usually falls into the five-year property class, as do most types of office equipment, including computers, copiers, facsimiles, and telephone systems. Software, as noted, falls into the three-year property class. Taxes. Despite changes in the federal tax laws, which eliminated the investment tax credit, the tax benefits of leasing can still be quite substantial. In addition, the lessee is usually exempt from the state and local taxes applicable to owned equipment, including intangible taxes and property taxes; such taxes are the responsibility of the lessor. The monthly payments of an operating lease are fully deductible, since they represent business expenses and not assets, which must be depreciated over time. Insurance. Depending on the terms of the lease, the lessee may or may not be responsible for insurance, whereas the purchaser is always responsible for insuring purchased equipment. If a loan was used to purchase the equipment, the lender usually requires insurance as a condition of the loan until it is paid in full. Payment Terms. Under most equipment lease arrangements, the lessee is obligated to pay a fixed amount per time period, usually monthly. Upon expiration of the lease, the equipment may be purchased. On the other hand, purchasing equipment requires a large, on-time expenditure unless all or a portion of the purchase cost is financed. Even so, the terms of the loan may require a down payment, which may be quite substantial as much as 25%--depending on the total purchase price. Maintenance. Maintenance is often provided by the lessor and is included in the lease cost. When maintenance is a separate charge, it should be considered an additional lease charge and simply added to the monthly cost of the lease. Price Protection. Under a leasing arrangement, the lessee is protected against the effects of inflation for the duration of the lease. The monthly charge is locked in for the term of the lease and does not fluctuate as current money market rates do. For this reason, it is advisable to have such things as maintenance, disaster recovery, training, and consulting services bundled into the lease. With many purchase contracts, these support costs may rise during periods of inflation because vendors often tie such costs to the government's consumer price index. Discount Potential. Because equipment purchase results in an immediate expenditure of a large amount of money, many vendors provide discounts for purchased equipment or offer some support services at a reduced rate. Although some leasing firms will also negotiate discounts on leased equipment, such discounts usually require an extension on the life of the lease. Replacement.

5 Purchased equipment often represents a large dollar investment; thus, many companies are reluctant to replace such equipment until it has been fully depreciated. Equipment obtained through a leasing arrangement is usually more easily replaced. The lessee simply waits until the lease expires and returns the equipment, or pays an early termination penalty and then returns the equipment. The user can also renegotiate the lean at little or no extra charge, provided that a new lease is signed for upgraded equipment. Payment Alternatives When considering the purchase of equipment, several payment plans are available: Cash. If the company has the financial reserves, it can simply pay cash for the purchase. Installment purchase. Some manufacturers will offer an installment purchase plan, similar to a mortgage, where the system is used as collateral for the loan offered to cover the price. A down payment is normally required, but may be minimal. Credit line. The company may borrow the money for the purchase from a bank, or draw it from an available line of credit. The Cost of Paying Cash The attraction of paying cash is that it costs nothing. No interest is paid, as with a loan or lease, so the cost of the item is the purchase price. However, there are several reasons why cash payment may not be a good idea, aside from the obvious reason that the company may have no cash available. One reason to avoid paying cash for a purchase is that the money may be needed to finance other, more urgent activities. Sometimes a major purchase can be made based on a very low interest rate relative to prevailing commercial rates. To pay cash for equipment when it could be financed at 7%, then to pay 11% interest on a loan six months later, is unsound financing. If financing is at an attractive rate, it is probably better to use that rate and finance the system, unless company cash reserves are so high that future borrowing for any reason will not be required. Another reason for not using reserves to finance a large purchase concerns the issue of credit worthiness. Often a company with little financial history can borrow for a collateralized equipment purchase, but cannot borrow readily for such intangibles as ordinary operating expenses. Other times, an unexpected setback will affect the credit standing of the firm. If all or most of the firm's reserves have been depleted by a major purchase, it may be difficult or impossible to secure quick loans to meet operating expenses, and the company may falter. Deferred Payment Plans For those who elect to purchase equipment, but who cannot or choose not to pay cash, a loan financing arrangement will be required. These arrangements are often difficult to interpret and compare, so users should review the cost of each alternative carefully. If the company is not able or willing to pay cash, the alternative is some form of deferred payment. The purpose of these payments is to stagger costs over a longer period and reduce the cash flow in a given year. But a substantial price to be paid is the interest whether the equipment is leased or installment purchased, interest will be paid.

6 The question of financial priorities must be answered early in the equipment acquisition process. Provided that the interest premium is not unreasonable, a purchase that is financed over a longer period will have a lower net cost per year, taking tax effects of depreciation into consideration. If the company has a critical cash flow situation, longer- term financing and a minimum down payment are the major priorities. The cash flow resulting from an IS purchase will be the annual payments for the system, less the product of the company's marginal tax rate time the annual depreciation. If the system's payments are $5,000 per month on a $200,000 note, and first-year depreciation is 20%, the company will pay $60,000 in the first year and have a tax deduction of $40,000. If the marginal rate is 30%, that deduction will be worth $12,000 so the net cash flow is negative at $48,000. Longer terms will reduce the payments, but not proportionally, due to increased interest. Where cash flow is not a major concern, financing should be undertaken to minimize the interest payment to be made. Interest charges can be reduced by increasing the down payment, reducing the term of the loan, and shopping for the best loan rates. Each of the ways in which a user can finance a system will affect the organization's mobility in these areas. Credit Line Many companies have an open credit line established with one or more banks. When companies need money to finance short-term obligations, they draw from the credit line. Since credit lines for most businesses have a limit, it may not be wise to finance equipment purchases from this source because it may leave less money available for urgent needs that may arise unexpectedly. requesting an extension of the credit line is always an option, but it may tip off the lender that the credit line is not being used wisely and may result in closer scrutiny of the company's finances that may hinder future borrowing. Types of Leases Assuming that the decision has been made to lease rather than purchase equipment, it is important to differentiate between the two main types of leases available, because each is treated differently for tax purposes. One type of lease is the operating lease, in which the leasing company retains ownership of the equipment. At the end of the lease, the lessee may purchase the equipment at its fair market value. The other kind of lease is the capital lease, in which the lessee can retain the equipment for a nominal fee, which can be as low as $1. Operating Leases With the operating lease (also known as a tax-oriented lease), monthly payments are expensed, which means that they are subtracted from the company's pretax earnings. With a capital lease (also know as a non-tax-oriented lease),the amount of the lease is counted as debt and must appear on the balance sheet. In other words the capital lease is treated as just another form of purchase financing and, therefore, only the interest is tax deductible. The Financial Accounting Standards Board (FASB) guidelines help users distinguish an operating lease from a capital lease. A true operating lease must meet the following criteria, some of which effectively limit the maximum term of the lease:

7 The term of the lease must not exceed 80% of the projected useful life of equipment. The equipment's useful life begins on the effective date of the lease agreement. The lease term includes any extensions or renewals at a preset fixed rental. The equipment's estimated residual value in constant dollars(with no consideration for inflation or deflation) at the expiration of the lease must equal a minimum of 20% of its value at the time the lease was signed. Neither the lessee or any related party is allowed to buy the equipment at a price lower than fair market value at the time of purchase. The lessee and related party are also prohibited from paying, or guaranteeing, any part of the price of the leased equipment The lease, therefore, must be 100% financed. The leased equipment must not fall into the category of limited use property; that is, equipment that would be useless to anyone except the lessee and related parties at the end of the lease. With the operating lease, the rate of cash outflow is always balanced to a degree by the rate of tax recovery. With a purchase, the depreciation allowed in a given year may have no connection with the amount of money the buyer actually paid in installment payments. Capital Leases For an agreement to qualify as a capital lease, it must meet one of the following FASB criteria: The lessor transfers ownership to the lessee at the end of the lease term. The lease contains an option to buy the equipment at a price below the residual value. The lease term is equal to 75% or more of the economic life of the property. (This does not apply to used equipment leased at the end of its economic life.) The present value of the minimum lease rental payments is equal to or exceeds 90% of the equipment's fair market value. From these criteria, it becomes clear that capital leases are not set up for tax purposes. Such leases are given the same treatment as installment loans. In the case of an installment loan, only the interest portion of the fixed monthly payment can be deducted as a business expense. However, the lessee may take deductions for depreciation as if the transaction were an outright purchase. For this reason, the monthly payments are usually higher than they would be for a true operating lease. Depending on the amount of the lease rental payments and the financial objectives of the lessee, the cost of the equipment may be amortized faster through tax-deductible rentals than through depreciation and after-tax cash flow. Capital Lease Variations Two common capital lease variations are Lease With Option to Purchase and lease with ownership.under a Lease With Option to Purchase contract, a portion of each monthly payment is applied toward purchasing the equipment. Typically, 50% or less of the rent applies to the capital. Under a lease with ownership agreement, ownership passes to the

8 lessee upon the last lease payment for a nominal amount. The monthly lease cost of these two variations usually exceeds the payments required under the terms of an operating lease agreement. LWOP permits the lessee to decide whether to purchase the equipment while equity builds with each payment. The lessee can also hedge on quantity purchased and later return excess equipment. In addition, lease with option to purchase (LWOP) can be used as a cash-management tool. The lessee continues lease payments until funds are available to pay the purchase price, less the payment accruals for the equipment. A lease with option to purchase (LWOP) can be complicated to implement because only a percentage of each monthly payment is applied toward the purchase of the total equipment, only a certain percentage of the total equipment purchase price can be accrued before equity buildup stops, and additional monthly payments are treated as conventional lease payments. The Downside of Leasing Leasing does have a downside. Although leasing can be used as an alternative source of financing that does not appear on the corporate balance sheet, the cost of a conventional lease arrangement generally exceeds that of outright purchase. Excluding the time value of money and equipment maintenance costs, the simple lease versus purchase break-even point can be determined by a formula: N = P/L where P = the purchase cost L = is the monthly lease cost N = is the number of months needed to break even Thus, if equipment costs $10,000 and the lease costs $250 per month, the break-even point is 40 months. This means that owning equipment is preferable if its use is expected to exceed 40 months. As in any financial transaction, there may be hidden costs associated with the lease. If a lease rate seems very attractive relative to rates offered by other leasing companies, a red flag should go up. Hidden charges may be embedded in the lease agreement. These hidden charges can include shipping and installation costs, higher-than-usual maintenance charges, consulting fees, or even a balloon payment at the end of the lease term. The lessee may even be required to provide special insurance on the equipment. Some lessors even require the lessee to buy maintenance services from a third party to keep the equipment in proper working order over the life of the lease agreement. The lessor may also impose restrictions on where the equipment can be moved, who can service it, and what environmental controls must be in place at the installation site. Role of Data Communications Managers As noted, data communications managers often play a key role in the corporate decision to purchase or lease equipment. In fact, several areas may elude the expertise of financial analysts, so the input of data communications managers is needed. The data communications manager should therefore be prepared to answer the following types of questions:

9 Are there any elements of the new system that have a very short useful life? A special data interface needed for a computer that is to be phased out later might be a candidate for separate rental rather than purchase. Is there a chance that the entire system might have to be traded at a later point? This would affect the depreciation period the accounting organization might set on the system. Are there likely to be additions to the system that might be covered as addendum to the installment loan if the vendor's own financing were selected, but that might require renegotiations if another financial source is selected? Are there any special terms on equipment protection (e.g., right of modification) that might be expensive or difficult to comply with? Conclusion Every data communications manager should understand the fundamentals of equipment leasing. Knowledge of the basics enables the data communications manager to work more effectively with the company's financial and legal departments to choose the best equipment procurement method. Data communications managers should examine the financial condition of their companies, in addition to the speed at which technology changes in their industry, in order to make an informed decision about buying versus leasing. Those managers who are not supported by financial and legal experts may wish to seek out software packages specifically designed to automate the lease-versus-purchase decision process. Author Biographies Nathan J. Muller Nathan J. Muller is an independent consultant in Huntsville AL, specializing in advanced technology marketing and education. During his 20 years in the industry, he has written extensively on many aspects of computers and communications. He has published eight books and hundreds of technical articles, and has held numerous technical and marketing positions with such companies as Control Data Corp., Planning Research Corp., Cable& Wireless Communications, ITT Telecom, and General DataComm Inc. He holds an MA in social and organizational behavior from George Washington University.