Equipment Leasing: Is it Right for Your Foundry?

This article examines equipment leasing and how foundries can take advantage of this option to move forward with capital equipment expansion and modernization plans.

We have seen how the economy has taken a tremendous toll on businesses of all kinds this year. Probably the hardest hit, however, has been the manufacturing sector, making the daily decisions of its managers even more of a tightrope walk. In such uncertain economic times, manufacturers such as foundries can benefit by exploring the pros and cons of equipment leasing, a financing practice that has increased in utilization during the past several decades.

While documents carved on clay tablets as far back as 2000 B.C. show instances of farmers renting tools, the leasing industry did not begin to take shape into the form it is today until the 1960s. After IBM introduced its computer leasing programs, a whole leasing industry was spawned, giving business its first taste of leasing options to come. The 1970s brought leasing to the forefront as an increasingly popular and creative means of financing.

Leasing equipment can help your foundry survive uncertain times and also prepare it for the increase in demand that has been forecast for the years ahead. Leasing helps you to manage your cash flow, guards against obsolescence, increases financial flexibility and, in some cases, may reduce your tax burden. These advantages can apply to most equipment--from the newest model induction furnace or molding line to a new computer system.

Why Lease?

Some of the initial questions to ask yourself when evaluating any financing options include:

* How does the equipment make my business more competitive?

* What's the best use of my cash flow to pay for the equipment?

* How long will it be useful?

* What equipment will I need in the future and when?

* What will it cost?

This last question isn't as easy to answer as it is to ask because a lease looks at the equipment differently than a loan. A lease recognizes that the equipment has value at the end of its term (this is called the "residual"). That lease end will impact the monthly payment--the higher the residual, the lower the payment. Therefore, you don't want to consider rates when comparing loan vs. lease. Rather, take a look at the entire package, down payment, monthly payment and residual payment.

In a survey conducted by the Equipment Leasing Assn., small- and medium-sized businesses were asked to cite the reasons they decided to lease rather than buy equipment. The results (Fig. 1) are described below:

* 35% stated cash flow as the primary factor--This may be especially important in the capital intensive foundry industry;

* 17% cited dollar value--Leasing offers fixed rate financing and payments remain the same throughout the term of the lease, regardless of interest rate fluctuations;

* 13% preferred leasing's convenience and flexibility--A lease can be structured in virtually any possible configuration. For example, because months may pass before your new molding line operates at peak efficiency, a lease may be set so no payments or only smaller payments are due for the first several months. Seasonal businesses also can structure their lease for variable payments;

* 13% claimed taxes were the main attraction--A lease can be structured as an operating lease (see "Options: A Lease for Every Occasion" sidebar) so payments are 100% tax deductible and the lease obligation remains off the balance sheet;

* 13% of the companies preferred maintenance options--Maintenance costs can be included in the lease, therefore reducing maintenance cost variations;

* 9% felt leasing helped them stay abreast of the latest technology--If the equipment is no longer useful to your business at the end of the term, the lessee may elect not to exercise the purchase option.

Several other considerations may be pertinent to the foundry industry. First is expanded credit availability. Leasing normally doesn't impact your bank relationship, preserving your bank's credit availability for short-term needs. Also, if a lease is structured as an operating lease, the lease obligation may not affect leverage ratios in bank loan agreement covenants.

Second, Section 179 of IRS Code allows total annual deductibility of up to $24,000 annually for qualified equipment purchased or leased through a capital lease. The catch is that the company's total equipment expenditures cannot exceed $200,000 for the current tax year.

Third, leasing is an option for some firms to spend despite company policies regarding budget restrictions. Because many leases are often considered expense items, the capital budget review process often is not necessary.

A Case in Paint: ABC Foundry

To illustrate the leasing option, consider the following example, which will be referred to as ABC Foundry. A 50-employee iron casting operation with about $5 million in annual sales, ABC Foundry needed to upgrade its melting equipment to meet the increased demand for truck replacement parts that it projects to come online in the next several years. The cost for the two induction melting furnaces, power supplies and cooling systems, leads and cranes was estimated at $337,423. Management considered funding options such as cash, bank loans and a capital lease, in which the foundry would own the equipment at the end of the lease period.

Lease vs. Cash--Due to the company's leverage situation, cash was not a viable option. Yet even if it had the cash available, paying cash may not have been the right decision due to the opportunity cost of using those dollars in a different way.

According to Dun and Bradstreet, the typical company earns an average of 15% on the money retained within the business. If this holds true in ABC Foundry, Table 1 illustrates that retaining the $337,423 for other purposes would result in $711,011.45 over five years, or a benefit of $261,731.45. If the foundry could only obtain a 10% return on investment for its dollars, it would still be better off leasing, with a net benefit of $105,885.08.

ABC Foundry's managers also understood that paying cash required paying for the equipment well before it was actually productive. A lease or loan would provide a hedge against inflation to keep cash available for the uncertainty of the future.

Lease vs. Loan--After dismissing cash as an option, ABC Foundry's management team evaluated a bank equipment loan vs. the leasing option (Table 2).

The foundry still had $300,000 available on its $500,000 credit line, and the bank offered to restructure the relationship with the foundry to include the equipment loan with a 20% down payment. The bank offered a 5-yr, 9% loan with a down payment of $67,484. Thus, the amount financed would have been $269,934 and the monthly payments would be $5605.

While the terms of the loan were favorable, this arrangement would stretch the foundry's credit line with the bank. This was no small concern, as ABC Foundry wanted to reserve its credit line in the short-term as well as protect its clean financial profile should it want to pursue additional lending options.

After considering the alternatives, management decided to lease, as the opportunity cost of the down payment made leasing more favorable. Leasing allowed the foundry to conserve the cash required for the loan down payment and preserve its bank borrowing capacity to support anticipated growth.

ABC Foundry selected the capital lease (lease-to-own) option because it intended to utilize the melt system well beyond the 5-yr term. Had it selected an operating lease, it would have been eligible for an additional tax benefit.

This is just one example of how leasing is becoming an important element of a company's capital expenditure program. Although leasing isn't always the answer, it is one of the most flexible means of equipment financing.

Types of Finance Companies

After deciding that your company wants to lease equipment, you must next decide whom to lease from. One distinction among leasing companies is the size of the transactions they are willing to finance. For instance, a micro-ticket company only works with leases between $1000-$25,000, a small ticket is between $5000-$250,000, a mid-ticket is $250,OOO-$5 million, and a large ticket is $5 million and more.

Another way the leasing business is segmented is by the company structure. The four general types of leasing firms are listed below:

Bank Affiliated--These firms frequently provide competitive rates. They also are good for relationship building, particularly if it's your company's bank and you have open credit availability. They are not as good, however, if you are maxxing out your conventional credit or if you wish to finance equipment for an operation in another state (and that operation will be making the payments). Some banks may not be able to do business for an out-of-state operation;

Independent--These firms can offer the greatest flexibility, will finance nearly any type of equipment and can offer competitive rates, although not usually as low as the banks or the captive operations;

Brokers--These are generally considered the most expensive form of leasing. They will turn a transaction around and sell it to an independent leasing company or bank-affiliated company. Companies must be approved in order to complete the transaction. While more expensive, brokers provide a valuable service, especially for "bruised" credits;

Captive--This type of leasing company is owned by the equipment manufacturer itself and can provide low rates because of its familiarity with the product and industry. Equipment manufacturers also may use leasing as a "loss lead" to move equipment. Manufacturers typically can only finance their own products and will not lease products from multiple manufacturers. Some independent leasing companies may become a manufacturer's "captive" finance company when the manufacture "buys" down the rate, making it cheaper for the end customer.

As a foundry owner or manager, leasing may be a good alternative when you need to upgrade or expand your foundry's equipment. Leasing has become a way for companies of all sizes to take advantage of the competitive forces in the financial community and to finance equipment in the manner that makes the most sense for management and the shareholders.

In the end, you should seek out and talk to several different sources before deciding on a leasing company. Many companies choose a particular source based on the cheapest rates. Ultimately, rate may not be the most important factor for a foundry. Other considerations are flexibility, ease of working with the leasing company and its willingness to work with you, a casting producer, in your future objectives.

Fig. 1.

This pie chart illustrates
the most commonly cited reasons for
financing equipment through leasing
options. (Source: Equipment Leasing
Assn.)


Ease, Convenience, Flexibility  13%
Cash Flow                       35%
Dollar Value                    17%
Maintenance options Cost        13%
Taxes                           13%
Latest Technology                9%



Note: Table made from pie chart
Table 1.

$1 Buyout vs. Cash--Options for ABC Foundry


Option 1: Cash

Equipment Cost                         $337,423

Option 2: $1 Buyout Lease

Equipment Cost                         $337,423
Monthly Lease Payment                  $7488
Lease Term                             60 Months

Total Monthly Payments                 $449,280

Future Value of Cash Outlay @ 15% [*]
Internal Rate of Return for 60 Months  S711,011.45

Benefit Gained by Leasing
(Net Impact of Future Value Earnings
Minus Total Payments)                  $261,731.45



(*)Calculating the future value of the cash outlay at a 10% internal
rate of return, the benefit gained by leasing would be $105,885.08
Table 2.

$1 Buyout Lease vs. Loan--Options for ABC Foundry


Option 1: Loan

Equipment Cost                          $337,423
Down Payment @ 20%                      $67,484.80
Total Financed                          $269,938.20
Loan Term                               60 Months
Monthly Loan Payment @ 9% Fixed Rate    $5605

Total Cost of Loan + Down Payment       $403,784

Option 2: $1 Buyout Lease

Equipment Cost                          $337,423
Lease Term                              60 Months
Monthly Lease Payment                   $7488
Total Monthly Payments                  $449,280

Future Value of Down Payment @ 15% [*]
Internal Rate of Return for
60 Months                               $142,201.03 [*]

Total Cost of Leasing Equipment         $307,078.97
(Net Impact of Total Payments Minus
Future Value of Down Payment)



(*)Calculating the future value of the down payment at a 10%
internal rate of return, the total cost of leasing equipment would be
$338,247.97

(*)Calculating the future value of the down payment at a 5% internal
rate of return, the total cost of leasing equipment would be
$362,674.00

Options: A Lease for Every Occasion

Leasing comes in all shapes and sizes and can make sense for equipment of all types, as well as small and large investments alike. To help identify the best option, consider factors such as: how long you intend to use the equipment, what your plans are for the equipment at the end of the lease, your company's needs relative to future growth, and the state of your company's tax and cash flow situations.

Here is an overview of types of leases:

[1] Operating Lease-This is the typical "Off Balance Sheet" lease. It is typically a shorter-term lease and frequently is selected on equipment that will likely be jettisoned when the lease ends-such as high-tech equipment, computers and high-usage copiers. IT answer four criteria as established by the Federal Accounting Standards Board:

1. Ownership of the property does not automatically transfer to the lessee at the end of the lease term;

2. The lease does not contain a bargain purchase option;

3. The lease term is less then 75% of the useful life of the equipment;

4. The present value of the lease payment is equal to less then 90% of the cost of the equipment.

Under this scenario, the payments are an expense and no asset or liability is recorded on the balance sheet (this may be changed in the future, however). If your lease meets these current standards, then the payment can be expensed. If your statement are not audited, however, the IRS has a looser definition of what constitutes an operating lease. Typically, the IRS will allow this treatment for any lease with at least a 10% purchase option.

[2] Capital Lease-typically, called a finance lease, this type is an asset-and-liability issue and the lease typically has a bargain purchase option of $1. (Companies who use this type of lease will do so for a variety of reasons, primarily for cash flow management, flexibility, fixed payments and tax deductibility.)

[3] Sale/Leaseback-This type of lease is used in a situation in which a company has already purchased and is using the equipment but later realizes that it could have put the cash to better use. In such an arrangement, the company "sells" the equipment to a leasing company, which in turn charges "rent" for its usage.

[4] 4. Trac Lease-This is for vehicles only. It is a lease whereby the lessee guarantees the lessor that it will not suffer a loss on the residual buyout at the end of the lease. Typically these types of leases are done with semi-tractors and trailers