Myths of Leasing
There are several misconceptions about leasing companies may use to improperly justify paying 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
Let’s Clear Things Up
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:
- Defining the Value of Cash – 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.
- Opportunity Cost Associated with Cash – It’s important to consider, could your cash be put to a more profitable use elsewhere?
- Objective Comparison – Companies should consider an after-tax net present value analysis to objectively compare the overall costs of lease versus cash (or bank loan) purchase.
- Analysis – 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 must 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 dependent 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:
1. The Useful Life of the Asset Versus its Economic Life
2. Where the Value is Obtained – By Using the Asset or Owning it
- If the Asset’s Useful Life is Longer than its Economic Life (time it takes to depreciate the asset to a zero-book value) – In this case, it is probably advantageous to own the asset. If, however, the asset’s useful life is less than or equal to its economic life (technology for instance), 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.
- If Ownership of an Asset is Critical to an Organization – 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 with 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.
- 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.
- If a customer decides to purchase leased equipment or upgrade the equipment, 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. For instance:
- Lease payments for an operating lease are tax deductible. For a financial lease, the asset can be capitalized such that all depreciation, accelerated & regular, and interest are tax deductible.
- 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 and capital lease 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 – 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 – 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 generally 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.