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Finance or lease: which is right for the machine tool industry?

Finance or lease: Which is right for the machine tool industry?

Many in the machine-tool industry believe equipment in and of itself has little value; it is use of the equipment and what it produces that is valuable. So, while the decision to finance or lease is important, the key decision is whether to acquire the equipment at all. Taking advantage of leasing or financing is simply a means to this end.

Every company's situation is unique, and once you've decided to acquire equipment, all alternatives for funding new acquisitions should be investigated. Major variables in the equation include the company's tax situation, cash-flow requirements, and future profit potential.

If the decision could be viewed from a cost standpoint alone, after-tax cash flows generated by both leasing and financing could be discounted at a chosen rate of interest and the resulting present values compared. Unfortunately, the decision is not that simple, it involves extensive thought and careful weighing of all variables.

For instance, one financial consideration is the need for off-balance-sheet borrowing. If you want to maintain a lower debt ratio to attract new investors, a lease may be the way to go. No asset is listed, and only the current portion of the liability appears. If, however, the lessee's balance sheet, and the loan as a corresponding liability. An alternative is an off-balance-sheet loan, structured in compliance with the Financial Accounting Standards Board (FASB) regulations governing off-balance-sheet treatment.

Another factor is capital position. It might be a good idea to lease rather than finance, if financing will tie up working capital or lines of credit that may be needed later. Companies who purchase equipment through revolving lines of credit may find that they are taking out a perpetual loan and may by paying for the equipment long after its useful life. A lease can peg this cost directly to minimum useful equipment life.

On the other hand, if a company wants significant variation in the payment schedule, a loan may be the right product. IRS regulations place a limit on how much payments can differ within a lease term, but there are fewer restrictions on loan payments - although they vary from state to state and for different types of loans.

You might also want to consider how quickly the acquisition of the equipment can be approved. In many cases, it is easier to obtain autorization to lease new equipment than to obtain it through other arrangements. This is because many companies don't regard leases as capital expenditures and thus don't require the same level of approval authority.

Other advantages of leases are: They typically require no down payment and no compensating balance; lease payments may be tax deductible; leased equipment can be replaced more easily if it becomes obsolate; and there is flexibility in trading up. Renewal options may offer an opportunity to extend the period of uninterrupted use of the asset without a one-time cash outlay. The major disadvantage is that you own nothing at the end of the lease, equipment at fair market value.

Some companies prefer asset ownership and view accumulation of assets as a long-term goal. They want the ability to control disposition of assets. However, to a certain degree, ownership may produce a psychological stumbling block to replacing equipment when its capabilities have been surpassed by newer, more productive equipment.

The Tax Reform Act of 1986 also changed many of the tax considerations you need to evaluate when making your decision. One of the most powerful incentives of capital spending under the old tax law, the Investment Tax Credit (ITC), no longer exists. Over the years, ITC has been used as a key negotiating point in a lease transaction. Coupled with a depreciation deduction, it offered significant tax savings for those who could use it - including finance companies and even third-party investors seeking to shelter income.

A portion of these savings were passed on to the lessee in the form of lower rates. Without ITC, these tax-sheltered leases have less attractive rates and place more reliance on residual value to offer pricing lower than available for loans.

The 1986 tax legislation also significantly changed the rules for depreciation. Under new rules, depreciation on new assets, while continuing to reduce regular taxable income, also can increase the Alternative Minimum Tax Income (AMTI) created by the law. The new law requires that companies add back to AMTI the difference between the new rate of depreciation - 200 percent declining balance - and the rate of 150 percent.

Depreciation has now become a double-edged sword, cutting taxes one way while possibly raising them in another. If new assets are leased, however, this depreciation issue is not triggered. For existing assets, a company might consider a sale and leaseback to minimize AMT.

AMT is no doubt the most far-reaching business-tax provision of tax reform. It is significant because it is, in effect, a second tax system that is parallel to, but separate from, the regular tax. In fact, for many corporations, AMT will be the predominant tax.

Companies must now maintain a separate set of financial records to calculate AMT. In addition to computing tax liability under the regular system, many companies will also have to calculate their liability under this alternative system. The calculation involves increasing regular taxable income by adjusting certain deductions - for example, depreciation.

Ownership of assets, and the choice of methods by which they are acquired, will significantly affect the amount of AMT a company must pay. As a result, many companies are re-evaluating the value of leasing for both new and existing assets.

What is the net effect of the finance or lease decision for a company? One financial expert calls it a "sharp-pencil operation" involving financing, accounting, and tax considerations. There is no one answer or easy solution. The CIT Group/Industrial Financing cannot advise companies on either the tax or accounting aspects of specific transactions. This advice must be obtained from your attorney and accountant. Long-term investments and commitments require a great deal of analysis to arrive at answers tailored to the needs of different companies.

Madeline Bayliss-Allen Senior VP, National Accounts The CIT Group/Industrial Financing Livingston, NJ
COPYRIGHT 1990 Nelson Publishing
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1990 Gale, Cengage Learning. All rights reserved.

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Author:Bayliss-Allen, Madeline
Publication:Tooling & Production
Date:Jan 1, 1990
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