by Lafe Low

Budget Strategies: A Lesson on Leasing

Dec 01, 20029 mins

The infrastructure needs behind’s operations are a lot like Mother Nature herself?difficult to predict and constantly changing. The online weather forecasting site, which is affiliated with The Weather Channel, gets an average of 10 million page views per day, but when a major weather event is looming, that number can surge to 40 million. Owing to the unpredictability of its traffic volume and the imprecise nature of weather forecasting, relies on 123 IBM servers to accommodate the myriad weather watchers who flood the site in search of continuously updated information.

So how does Vice President of Technology Dan Agronow know his servers are going to be able to keep up with demand spikes and general growth? For starters, he upgrades every two years. Rather than purchase his systems, however, Agronow leases his equipment as a way to facilitate those scheduled upgrades. “By doing a lease, you can refresh your whole environment,” he says. “This is definitely a benefit because you can keep your infrastructure homogeneous.” Agronow adds that short-term lease agreements not only enable him to maintain technological capacity and compatibility but also provide a sufficient ROI.

And Agronow is not alone. Rob Enderle, vice president and research fellow at Cambridge, Mass.-based Giga Information Group, says the IT leasing market has grown steadily in the past few years. Businesses are turning to leasing for several reasons, he says, such as an increased difficulty in obtaining capital for equipment expenditures, flexible balance-sheet reporting and regular equipment replacement cycles. In addition, the market is expected to grow from $10.7 billion in 1999 to $15.9 billion by 2003, according to “Status and Outlook for the U.S. IT Leasing Marketplace,” a study from Arlington, Va.-based Equipment Leasing Association.

Understand the Basics

Making the decision to lease or buy is not for the faint of heart. There are more complicated factors to consider beyond comparing the anticipated return for leased equipment with that of a purchase. Read on to learn some basic tenets.

Initial Capital Outlay If the total cost of equipment exceeds the available operating budget, leasing may be one way to avoid an initial capital expenditure.

Interest Rates Changes in interest rates will affect future payments and the total financial commitment of the lease. For instance, if the lease is renegotiated, the interest rate applied to remaining payments could change, affecting not only the monthly payment but the total amount paid out over the life of the lease.

Depreciation If you are procuring equipment that depreciates rapidly, consider a short-term agreement, and exercise the right to return and replace the equipment at the end of the lease term.

Tax Liability Depreciation can be used to offset income for tax purposes. That can be beneficial with equipment that depreciates so quickly that the dollar value of depreciation can be applied against earnings to limit tax liability.

Fair Market Value Monitor the fair market value, or current resale value, of the equipment when deciding whether to return or purchase it at the end of the lease term. For instance, it may make sense to purchase equipment that maintains a high percentage of its original value.

Length of Lease Set up lease-term lengths that don’t extend too far into the useful life of the equipment. For example, you wouldn’t want to lease 1,000 PCs for three years if they’re likely to depreciate significantly in two years.

The Restrictive Side of Leasing

While leasing provides flexibility in regular upgrades and balance-sheet reporting, it can be restrictive in other aspects. “You are locked into a cycle,” Giga’s Enderle says. “If you want to keep the equipment longer, it’s more difficult to do so.” Likewise, ending a lease before its term is up can result in additional costs from early termination penalties.

Obviously, leasing will help you avoid a large capital outlay required for a purchase, but the cumulative expense over the lease life cycle may be higher. “You are paying a premium to borrow money,” Enderle says. For example, if you made a $5,000 down payment on a two-year lease for $50,000 worth of equipment with an 8 percent interest rate, you’d get a monthly rate of $878. To purchase that equipment with a capital loan, the monthly loan payment at the same interest rate would be $2,035. However, the net cost for the loan is $22,677, whereas the net cost for the lease is $26,997. (The lease is higher because it includes additional charges associated with purchasing the equipment at the end of the lease term.) In this example, an organization concerned with making the lowest possible monthly payments would likely opt for a lease even though the total payout is higher.

Asset management is another challenge. Because leased equipment must be returned in its original condition, keeping track of leased equipment and system upgrades in the interim is critical. “If you don’t do a good job of inventory management, you might find yourself scrambling,” Agronow says. If you’ve added memory to the leased hardware, for example, you’ll have to accurately record that information so that you don’t inadvertently return the additional equipment to the leasing organization.

In addition, Agronow recommends scaling the lease term to match the anticipated return from the equipment investment as well as considering the equipment’s useful life cycle. “Do you do 18 months, 24 months, 36 months?” he asks. “Some of that is [determined] by growth rate and some by the technology you’re leasing. How fast is it going to change, and how much of an effect is that going to have on your environment?”

CIOs considering a lease should also ask the leasing organization whether it will retain ownership of the lease. “The company may get sold or bought, and you could end up with a nasty group of folks,” Enderle says. To that end, a lessee should push for an escape clause that facilitates early termination of the agreement in the event of a sale or transfer should the lessee prefer not to do business with a new lease owner.

Leasing Options Defined

While every lease is customized to each transaction’s particulars, the fundamental choice is between an operating lease or a finance lease. “An operating lease is more desirable by corporate clients because it allows them to treat [payments] as an operating expense,” says Mike Ross, vice president of technology investment at Relational Funding, a technology lessor based in Rolling Meadows, Ill. With a capital or finance lease, businesses have to show payments as a direct expense and account for depreciation on the balance sheet, he says.

Operating Lease With an operating lease, limitations imposed on the length of the lease and the total value of the payments protect the lessee from overpayment, resulting in lower monthly payments. Ultimately, the lessee does not pay the full value of the equipment. Operating leases also offer tax advantages because payments are treated as off-balance-sheet costs. That also improves the return on the leased assets and the earnings reporting. “An operating lease gives the most flexibility with the balance sheet,” says Ross. “It’s not treated as a depreciating hard asset; it’s treated as an operating expense.”

The parameters that define operating leases are collectively known as FASB 13?lease characteristics defined by the Financial Accounting Standards Board to ensure a fair transaction between lessor and lessee. For example, FASB mandates that the length of a lease cannot exceed 75 percent of the useful life of the equipment. Also, the payment stream, or total amount of lease payments, on a present value basis must not exceed 89.9 percent of the cost of the equipment, again as protection against overpayment. Present value refers to the total value of all monthly payments, including all interest paid during the life of the lease. Therefore, the present value can change with adjustments to the interest rate applied to future payments.

An operating lease is often the best way for a company to make the lowest possible payments for the leased equipment, which is why small companies or those operating under intense budget constraints may prefer this type. Operating leases are also suitable for organizations in technology-reliant industries such as financial services or telecommunications needing to upgrade equipment on a regular basis.

Finance Lease A finance lease is a full-payout or nonequity transaction. In other words, the full value of the leased equipment is paid for (plus interest) during the life of the lease agreement. Besides the regular lease payments, the lessee is also responsible for maintenance, tax and insurance charges. A finance lease is similar to an automobile lease, where the lessee pays a certain percentage of the vehicle’s value during the course of the lease, then the remainder (plus interest) at lease expiration.

Finance leases are preferable for businesses looking to achieve the tax advantages of equipment ownership without the capital cost of purchase. Companies can use the cost of equipment depreciation to offset income at tax time. “If you structure the lease to get the tax benefits that limit the amount of corporate income tax you’re going to pay, it can more than offset the total amount of the lease payments,” Ross says. Look at the depreciation expense for the equipment, and determine the extent to which that value can offset the tax liability associated with earnings. A finance lease is also suitable for a company short on operating budget money but with room in the capital budget.

Finance leases are often long term, covering most of the useful life of the equipment. A finance lease may also be called a capital lease, especially when it is accounted for as a purchase by the lessee and as a sale or financing agreement by the lessor.

The option to return or purchase the equipment exists at the end of either lease type. With a finance lease, the lessee purchases the equipment at a predetermined amount agreed upon by the lessee and lessor, as opposed to the flexible fair market value often written into an operating lease.

Financing your IT equipment procurement is a two-stage decision. First, you must carefully evaluate your technology needs and financial situation to determine whether to lease or buy. If you decide on the former, you still have to decide which type is best for your situation. Consider carefully, weigh all the options and be prepared to do so for every technology acquisition. The parameters for each acquisition are unique, so what works in one instance might not work next time.