Leveraged Leasing vs. Buying: Equipment Finance Explained

Introduction: The Lease vs. Buy Decision

Jennifer Schiff (2005), in "Buy vs. Lease: What You Need to Know," argues that answering the question of whether it makes more sense to buy or lease requires consideration of a number of factors, including but not limited to cash flow, cost, depreciation, tax ramifications, and company forecasts. During her research, Schiff explored decisions made by two fast-growing small businesses—one that chose to buy and one that chose to lease. In addition, Schiff interviewed executives at Dell Financial Services and HP Financial Services for their perspectives on the buy vs. lease question. In light of contemporary debates relating to the lease vs. buy argument noted by Schiff and others (Brady & Ingram 2006; Hamill, Sternberg & White 2006), this paper presents a sampling of relevant information, with a particular focus on leveraged leasing.

Two primary points Schiff (2005) asserts from her study include:

1. When a business focuses on cutting-edge technology, buying may make more sense (Schiff 2005).

2. When a business's primary concern is controlling cash flow, and the owner or manager does not have time to invest in equipment-related matters, leasing may prove to be the better option (Schiff 2005).

In "The Lease vs. Buy Dilemma: Which Option Is Best?," Marc Newman (2008), CPA, suggests two rules of thumb for determining which option is best. First, consider that the use of equipment—not its ownership—contributes to operating profits. The leased equipment generates funds for lease payments, a particularly relevant point "when the useful life of the equipment is the same or shorter than the term of the lease" (Newman 2008). Second, although not universally true, "buy what appreciates and lease what depreciates" serves as another traditionally solid guide (Newman 2008).

Types of Leases and Key Considerations

Leases Defined

Leases may be negotiated while simultaneously providing a range of rights applicable to contracting parties. James R. Hamill, Joel Sternberg, and Craig G. White (2006) define a lease essentially as "the purchase of the use of an asset over a specified period of time" (Grenadier, as cited in Hamill, Sternberg & White 2006, p. 43). "These rights provide differing opportunities for flexibility to the lessee and are key to the valuation of the option portion of the contract" (Hamill, Sternberg & White 2006, p. 43).

Buying and Cash Flow Considerations

Ensuring cash will be available during slower months may prove critical for some seasonal operations. Newman (2008) asserts that businesses comparing the options of leasing and buying equipment need to consider: (a) the amount of cash the business can afford to disburse upfront, either from a credit line or the business's liquid assets; (b) whether the business will be able to continue paying its operating expenses and cover unforeseen expenses after expending a lump sum; (c) the percentage of the business's credit line a purchase would consume; (d) the effect of depleting the business's capital by, for example, $24,000 at once versus $245 per month for a preset period; and (e) whether lease options such as skip-payments could benefit the business (Newman 2008).

Operating Lease or Capital Lease

An operating lease constitutes a rental agreement stipulating that equipment may be returned at the end of the lease or purchased for a specific price. A capital lease specifies that the lessee may either purchase the equipment or, at the end of the lease term, pay a nominal amount to own the equipment (Newman 2008). When leasing appears to be the best option, the individual or business must determine which type of lease best fills the need. The following six considerations are relevant to that determination:

1. The anticipated lifespan of the equipment. "For tax purposes, the IRS considers most equipment (other than passenger vehicles) to have a useful life of seven years" (Newman 2008).

2. At the end of the lease term, whether the equipment's residual value constitutes a factor in the purchase option.

3. Whether EPA and/or other community guidelines affect the disposal of old equipment, which may mandate consideration of a purchase option.

4. The business's perception of the equipment's status.

5. The real cost, over time, of leasing the equipment, including finance costs and cost of lost liquidity, "compared to the cost of purchasing the equipment, for example, lost interest or lost liquidity" (Newman 2008).

6. The impact of the decision on the business's financial statements. Contrary to purchased equipment, according to traditionally acknowledged accounting rules, leased equipment and lease debt may not need to be listed on a business's financial statement (Newman 2008).