There are several misconceptions about leasing that companies use to justify using cash to acquire new equipment. Specifically, and more commonly, the following myths exist:
- Leasing is expensive
- Leasing is complex
- Leasing prohibits ownership
- Lease contracts are non-cancelable
- Leasing reduces tax benefits
- Leasing lowers EBITDA
- Leasing prohibits company’s ability to control assets
The following addresses each of these concerns and shows that leasing can be an effective alternative for acquiring new or used equipment.
Myth: Leasing is Expensive
Companies expecting to use cash to purchase new equipment should consider the following:
- Cash is a component of working capital – why use working capital to purchase assets?
- Working capital is best used for operations – assets are normally best procured using medium-term financing, such as a lease.
- There is an opportunity cost associated with cash – that is, can the cash be put to a more profitable use elsewhere?
- Companies should consider an after-tax net present value analysis to objectively compare the overall costs of lease versus cash (or bank loan) purchase.
The components of an after-tax net present value analysis include monthly lease payments and their associated tax advantages, initial cash outlays (cash purchase or down payment for bank loan), and depreciation and its tax advantages.
Myth: Leasing is Complex
Complex compared to what? Leasing is no more complex than securing bank financing. Usually, to qualify for a lease all a company has to do is complete a simple credit application. Other times the company will be required to provide audited financial statements. The level of
complexity is usually dependant on factors such as the size of the transaction, the type of equipment, the financial health of the company, etc.
Myth: Leasing Prohibits Ownership
Traditionally, companies purchase assets, use those assets to generate revenue, depreciate those assets to recover their cost, and then dispose of them when they no longer can produce profitably. Company management must take into consideration two issues:
- What is the useful life of the asset versus its economic life?
- Where is the value obtained – from using the asset or owning it?
If the answer to the first question is that its useful life is longer than its economic live (time it takes to depreciate the asset to a zero book value), then it is probably advantageous to own the asset. If however, the asset’s useful life is less than or equal to its economic life (take technology for example), then management must consider the answer to the second question. Clearly, the profitable use derived from any equipment comes from using it, not necessarily owning it. Hence, leasing these assets make more business sense.
However, if ownership of an asset is critical to an organization, then leasing can still be used as a vehicle to accomplish this goal. Financial (or capital) leases provide a means for 100% financing for an asset. Title transfers from the lessor to the lessee at the end of the lease term. Operating leases can be structured with purchase options at the end of the lease term allowing the lessee an alternative for ownership.
Myth: Lease Contracts are non-Cancelable
Generally, this is true if the customer decides at some point during the term of the lease that they would simply wish to own the equipment and not incur the monthly lease costs any further. If a lease worked like an amortized bank loan, then the customer could simply pay off the principle owed. However, lessors, including Dynamic Funding, Inc. do not always fund the lease transaction themselves. Many times they obtain funds from a third party. These funds have a specific maturity date and simply paying them off is not feasible or profitable.
In cases where the lessee wishes to upgrade their equipment (mostly for high technology items such as computers or telecommunications equipment), then a lease company will work with the customer (the lessee) to discontinue the lease on the outgoing equipment and create a new lease on the new equipment.
In either case, if a customer decides to purchase leased equipment or upgrade the equipment, then Dynamic Funding, Inc. will negotiate with the customer on how best to discontinue or restructure a lease.
Myth: Leasing Reduces Tax Benefits
Tax benefits depend on the type of lease. Lease payments for an operating lease are tax deductible. For a financial lease, the asset can be capitalized such that depreciation and interest are tax deductible.
More importantly, if the tax depreciable life is longer than the term of the lease and the lease payments are tax deductible (such as an operating lease), then leasing will be more advantageous. If the tax life is short or if the asset qualifies for accelerated tax depreciation, then purchase may be the better alternative.
Myth: Leasing Lowers EBITDA
EBITDA is defined as earnings before interest, taxes, depreciation, and amortization. EBITDA is a measure of a company’s earnings from operations. Operating leases do impact EBITDA (the monthly lease payment is treated as an expense), but these also qualify for off balance sheet financing.
Finance leases do not impact EBITDA because the asset is capitalized. Depreciation and interest are not deducted when determining EBITDA.
Myth: Leasing Prohibits A Company’s Ability to Control its Assets
This is true in the sense that most master lease agreements prohibit a lessee from moving an asset from one location to another without notifying the lessor. However, it is usually just a formality for a company to inform the lessor where an asset is located, and that they intend on moving it to a new location if necessary.