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Elements of machine-tool leasing.

Elements of machine-tool leasing

In the last decade there has been dramatic growth in leasing. Nearly any asset that can be purchased also can be leased. It is estimated that about $200 billion in leases are currently outstanding. This implies that about 20 percent of all business investment in capital equipment is financed by leasing. Indeed, leasing ranks with bonds and common stock equity as a source of capital, and this puts it ahead of convertible security and preferred stock financing.

Much of the growth of this industry is attributable to the tax treatment of leases and to the many new options built into equipment leases. With so many ways of financing equipment, the economic analysis, evaluation, and comparison of alternative lease arrangements is nontrivial.

Leasing allows a firm to acquire use of equipment without having to purchase it. In a leasing arrangement, the firm receives the right to use the equipment over a specified period in exchange for predetermined rental payments to the owner. The firm is referred to as the "lessee,' while the owner, who holds title to the asset, is referred to as the "lessor.' There are essentially three types of equipment lessors: manufacturers of durable goods, banks, and independent leasing companies.

Manufacturers often establish credit companies to provide outside financing to customers purchasing their parent company's equipment. IBM, for example, leases out about $1.5 billion of its equipment per year. Banks undertake direct leasing as an alternative form of secured loan to individual customers. Independent leasing companies offer to lease items, often with service arrangements, under a myriad of terms.

There are two broad categories of lease arrangements: operating leases and financial leases.

Operating leases

An operating lease is short-term, providing the lessee with the opportunity of cancelling it before maturity. This feature allows returning the equipment when it is no longer needed or becomes obsolete. These leases usually are provided with full service and often are referred to as service leases. The primary reason for using it is to shift the risk of obsolescence to the lessor. As such, these leases are popular for computer and advanced manufacturing technology equipment.

Some operating leases have additional features that possess value for the lessee. A renewable lease, for example, grants the right to extend the maturity date of the lease for a specified number of periods beyond the original, with rental payments usually remaining unchanged.

Some operating leases grant the right to buy the leased asset at maturity for a fixed predetermined price, while others grant the right to purchase at any time. Many leases specify noncancellation periods during which the lessee may not terminate the lease, or they require cancellation notices to be received a certain number of periods before actual return. The possible features of operating leases are endless.

Usually, the options provide benefits to the lessee and induce costs and risks to the lessor. As such, the lease arrangement can be viewed as a financial risk management device that reallocates risk among the parties of the transaction. The greater the risk borne by the lessor, the greater the rental payments.

Financial leases

A financial lease is an arrangement where the lessee maintains use of the item over most of its estimated life. A strict financial lease doesn't provide for maintenance services and isn't cancellable without penalty. The lessee acquires almost all the economic benefits of the equipment, as well as responsibility for all service, insurance, and operating expenses.

In direct leasing, the lessee selects equipment and negotiates payments and delivery terms with the lessor. A closed-end lease requires the lessor to bear the risk of any possible decline in the equipment's economic value. At the end of the lease's term, the lessee usually is given the opportunity to buy the equipment at an "arm's length' fair market value. The lessee, however, has no equity interest and is not bound to purchase. In open-end leases, the lessee bears the risk of any possible decline in the equipment below an agreed upon salvage value.

To fully understand the leasing process, it is useful to establish how lessors set payments and then analyze how lessees establish whether leasing is more economical than purchasing. Once these are understood, the bargaining processes between lessors and lessees can be addressed.

For financial leases with no servicing contracts, establishing a leasing rate is fairly simple. Assuming maintenance, insurance, and other operating costs are incurred by the lessee, the lessor need only be concerned with financing charges. The lease rate is set such that it is competitive, yet still provides a satisfactory return to the lessor. This is accomplished using an analysis that relates the present value of the benefits to the equipment cost.

In arriving at the rental rate, the lessor must specify required rate of return, tax bracket, salvage value, and depreciation method for the tax shield. All things being equal, the benefit of ownership will be higher for firms in high tax brackets that assess salvage value to be high, use accelerated depreciation, and have a low after-tax financing cost.

Lessees evaluate arrangements by analyzing after-tax cash flows and opportunity costs incurred by leasing rather than purchasing. The analysis procedure is referred to as the Net Advantage to Leasing (NAL). The NAL model compares cost of leased equipment, if purchased, with the present value of the lease payments and the foregone opportunity costs associated with ownership.

Since the lessee is responsible for the operating expenses, regardless of whether the item is leased or bought, these costs are ignored in the comparison. NAL essentially compares leasing to an alternate strategy of buying the equipment by borrowing sufficient funds so as to equate the cash flows of the alternatives in each period. As a result, the discount factor that should be used in the calculation is the lessee's after-tax cost of borrowing. Rather than solve the equation for the NAL, it is possible to set the left-hand side equal to zero and find the rate of return that produces indifference between borrowing to buy or leasing. This internal rate of return can then be compared to the firm's after-tax cost of borrowing.

Bargaining issues

By leasing, the firm forfeits ownership benefits. It's in the lessee's interest to recapture some of these benefits by negotiating to reduce the lease payments. To do this effectively, lessees must understand ownership benefits that accrue to the lessor. For lessors in high tax brackets and with low cost of capital, these benefits can be significant.

Owing to the difference in tax brackets and cost of funds between lessors and lessees, as the lease payment is adjusted up or down, the gain to one of the parties is not equal to the loss of the other. As a result of the differential tax rates, through negotiation, both parties can maximize their benefits.

Leasing is preferable to buying: the higher the asset cost, the lower the lease payments, the lower the tax rate, the higher the after-tax cost of equivalent financing, the lower the salvage value, and if straight line depreciation is used. Usually, firms with low effective tax rates or those with huge tax losses will find leasing advantageous.

Many programmable financial calculators and electronic spread-sheet programs on the market offer simple routines that allow evaluating financial leases. In essence, many of these programs simply provide net present value calculations that enable computing the NAL. Using these packages usually requires that the user manually calculate the after-tax cash flows of the lease proposal. Thus, the user must be abreast of the IRS rules for the investment tax credit and depreciation and interest payment tax shields.

These packages typically can't evaluate the complexity of modern lease agreements. Thus, the value of having the option to purchase the item for a given price at a given point in time may be overlooked. Moreover, the actual period through which the lease is in effect may be ignored. For example, a 12-month lease starting in December has significantly different benefits compared to a 12-month lease starting in January.

Lease Analysis Package (LAP) is a microcomputer-based package that allows decision makers to effectively analyze financial and operating leases. Through a series of interactive input menus, the problem is fully specified. Help menus provide the novice with further information to assist in answering questions.

A variety of analyses can be performed. The effect of different depreciation methods and time of project initiation, for example, can be determined. Full sensitivity analyses are provided in tabular and graphical form, so the leasing and purchasing decision can be compared.

Benefits to the lessee and costs to the lessor induced by lowering the lease payments can be assessed. LAP thus can be used to evaluate the advantage that leasing can provide resulting from the different tax brackets and cost of funds between lessee and lessor.

In addition, LAP values the contingent claims, such as value of the right for the lessee to purchase the item at a given price in the future. In fact, all different benefits of the lease are valued and reported separately.

LAP runs on the IBM PC, requiring 128K. If color graphics are available, more features can be exploited.
COPYRIGHT 1985 Nelson Publishing
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Copyright 1985 Gale, Cengage Learning. All rights reserved.

Article Details
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Author:Ritchken, Peter H.; Kane, Luke D.
Publication:Tooling & Production
Date:Jun 1, 1985
Previous Article:Survive 85: industry report - machine tools.
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