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Leasing: Types, Benefits, and End-of-Lease Options
Equipment purchases can be one of the largest expenses a company faces. Leasing is a way for a business to obtain the use of new, timesaving, productive equipment with no capital investment, making it an integral part of a company's capital budgeting process, and a way to fund equipment acquisitions. Currently, companies are placing a higher value on their working capital and the need for liquidity. Leasing provides a solution that enables them to get what they want without depleting their cash flow.
For over 40 years, American businesses have increased the use of leasing. Research shows that 80% of companies lease all or some of their equipment. Of the $697 billion spent on productive assets in 2001, $216 billion was acquired by businesses through leasing. That figure was estimated at $204 billion in 2002, and $208 billion in 2003. Companies that choose to lease tend to be growth-oriented, focused on productivity and technology. A very good example is the medical equipment industry where leasing is an attractive option, since technology changes very rapidly. According to an industry research, close to $3 billion worth of medical equipment is leased annually in the United States.
Once a leasing decision is made, there are many types of leases to match business needs and goals. Some lessees need just one piece of equipment that requires a single contract, whereas others may need to recurrently acquire equipment and exercise a master lease. (A master lease is a contract in which the lessee leases currently needed assets and is able to acquire other assets under the same basic terms and conditions without negotiating a new contract.)
The most common types of leases are operating and finance leases. An operating lease is appealing to companies that repeatedly update or replace equipment, want to avoid obsolescence, and do not want equipment ownership. This type of lease usually results in the lowest payment of any financing alternative. An operating lease is typically eligible for off balance-sheet treatment, since it is not considered a long-term debt or liability.
A finance lease is a full pay-out, noncancelable agreement, in which the lessee is responsible for maintenance, taxes and insurance. A finance lease is most appealing in cases where the lessee wants the tax benefits of the ownership or expects a high residual value. This type of lease is constructed as an equipment financing agreement where the lessee purchases equipment at the end of the lease term for a predetermined amount. The term of a finance lease tends to be longer, nearly covering the useful life of the equipment.
Main reasons why companies lease:·
Another benefit leasing provides is flexible end-of-term options. There are several options for disposing of equipment after the lease term ends, which includes returning the equipment, purchasing the equipment or renewing the lease. These options are decided at the origination of the lease and usually have an effect on the periodic payment amount. Typical end-of-lease options are fair market value purchase option, $1 purchase option and 10% purchase option.
A fair market value lease is considered an operating lease for which periodic payments are fully tax-deductible. It is the preferred option for those concerned about technological obsolescence. Also called a true lease, a fair market value lease is a lease for federal income tax purposes whereby the tax incentives, including depreciation, are retained by the lessor and forwarded to the lessee in the form of lower lease payments. Thus, this option tends to yield the lowest monthly payment. At the end of the lease there is the option to purchase the equipment at the then fair market value. Other alternatives are upgrading to new equipment, extending the lease term and returning the equipment.
The $1 purchase option lease is considered a finance lease and is treated as a loan for federal income tax purposes. This lease structure is favored by customers who want to own the equipment at the end of the lease. The $1 purchase option lease contains the benefits of ownership, but tends to yield the highest monthly payments. At the end of the lease term the customer has the option to purchase the equipment for $1.
The 10% purchase option lease is also considered a finance lease. It is a good alternative for those who are uncertain what their needs will be in the future and want a fixed purchase price at the end of the lease. With this lease structure, the monthly payment will be lower than a $1 purchase option lease, but higher than a fair market value lease. At the end of the lease term the lessee may choose to purchase the equipment for 10% of the original cost, upgrade to new equipment or return the equipment.
Capital investment decisions are critical to the financial viability of all organizations. The key is not just what to invest in, but also how to finance the investment. Even for cash-rich companies, leasing provides a wide range of financial benefits from taxation savings and budgetary control to maintaining existing lines of credit and working capital.
