Leverage Leasing Thesis

Pages: 12 (3211 words)  ·  Style: MLA  ·  Bibliography Sources: 7  ·  File: .docx  ·  Level: College Senior  ·  Topic: Economics

Leverage Leasing - Lease v. Buy Argument

The answer to the question: Does it make more sense to buy or lease?

Jennifer Schiff (2005) in "Buy vs. Lease: What You Need to Know," requires consideration of a number of factors, including, but not limited to cash flow, cost, depreciation, tax ramifications, and company forecasts. During her research efforts, Schiff explored decisions regarding buying and leasing of "two fast-growing small businesses, one that made the buy decision...[;] one that decided to lease" (¶ 1). In addition, Schiff interviewed executives at Dell Financial Services and HP Financial Services for perspectives on buying vs. leasing. 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 the researcher particularly focusing on leveraged leasing.

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

When a business focuses on cutting-edge technology, buying may make more sense

Schiff 2005, ¶ 2).

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

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In "The lease vs. buy dilemma: which option is best?," Marc Newman (2008), CPA, suggests the following two "rules of thumb" for determining which option proves to be the best choice. 1. 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, ¶ 2). 2. Although not universally true, "buy what appreciates and lease what depreciates," serves as another traditionally solid guide (Newman 2008, ¶ 2).

Leases

Thesis on Leverage Leasing Assignment

Leases may be negotiated while they simultaneously provide for a range of rights applicable to contracting parties. James R. Hamill (University of New Mexico), Joel Sternberg (Clark University), and Craig G. White (University of New Mexico) (2006) define a lease basically 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

Considerations for Businesses Regarding Leasing and Buying Ensuring cash will be available for slower months may prove critical for some seasonal operations in a number of businesses questions (Newman 2008, How Important Is Controlling Cash Flow? section ¶ 2). Newman asserts businesses comparing options of leasing and buying equipment need to consider: (a) the amount of cash the business can afford to disburse up front, either from a credit line or the business's liquid assets; (b) Whether the business will be able to continue pay its operating expenses, and afford to cover unforeseen expenses if/after it expends a lump sum; - the percentage of the business's credit line a purchase would take; (d) the effect/s of depleting the business's capital by, for example, $24,000 at once, or $245 per month for a preset period; (e) Whether or not lease options such as skip-payments c Sharp ould benefit business (Newman ¶ 2).

Operating Lease or Capital Lease

An operating lease basically constitutes a rental agreement stipulating equipment may be returned at the end of the lease, or purchased for a specific price. A capital lease specifies that the leaser may either purchase the equipment, or at the end of the lease term, pay an ostensible amount to own the equipment (Newman 2008, Two Types of Leases section). When leasing appears to be the best option, the individual or business must determine whether an operating lease or a capital lease best fills the need. The following six considerations, reportedly appropriate for determining whether to secure an operating lease or a capital lease, include:

The anticipated life-span 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, Two Types of Leases section). 2.

At the end of the lease term, whether the equipment's residual value of the equipment constitutes consideration of the purchase option. 3. Whether EPA and/or other community guidelines affect the disposal of old equipment (may mandate consideration for purchase consideration). 4. The business's perception regarding equipment's status. 5. The real cost, over time, to lease equipment. These include finance costs; cost of lost liquidity, etc., "compared to the cost of purchasing the equipment, for example, lost interest or lost liquidity" (Newman 2008, Two Types of Leases section). 6. The impact of decision on business's financial statements. Contrary to purchased equipment, according to traditionally acknowledged accounting rules, leased equipment and/or lease debt may not need to be listed on a business's financial statement. (Newman 2008, Two Types of Leases section)

Concept of Leveraged Leasing

Leveraged Leasing, a Powerful Equipment Finance Tool

Numerous corporations utilize the leveraged lease product to finance capital equipment acquisitions. Deborah Brady and Paul Ingram (2006) explain in "A leveraged lease primer" that:

Commercial aircraft, vessels, railcars and manufacturing lines are assets commonly acquired using this vehicle" (¶ 1). With its optimized structure and inherent tax benefits, leveraged leasing constitutes an attractive financing option. Frequently, during the course of an accountant's work in the financing and/or accounting areas, his/her work will encompass leveraged leasing. To critically and effectively examine such transactions, the accountant will need to ensure he/she understands leveraged leasing.

In "Leveraged leasing," Ashook Roy (1990) explains: "A leveraged lease is a long-term lease in which a major part of the purchase price of the to-be-leased asset is financed by a third party" (¶ 1-2). The lessor combines his/her funds with borrowed money to purchase an asset that requires large capital expenditures. After the purchase is completed, the lessor leases the asset to another party (Roy).

Contrary to an ordinary lease where only two parties, the lessee and the lessor, are involved, three parties participate in a leveraged lease: the lessee, the lessor, and the term lender. Roy (1990) further explains that a leveraged lease is basically a long-term lease where a third party finances primary part of the purchase price of the future to-be-leased asset. The lessor uses a combination of its own funds and borrowed money to purchase the asset (requiring large capital outlays), which is later leased to another party.

Three Parties in Leveraged Leasing the three parties in leveraged leasing, Roy (1990) recounts, include the term lender, the lessor, and the lessee. Genearally, the term lender will be a bank, an insurance company, or a superannuation fund. In return for providing the lessor with "a 'non-recourse' basis 60-85% of the purchase price, the term lender receives debt service from the lessor. The following notes additional information regarding leverage leasing:

The "non-recourse" basis is that the term lender has no legal recourse against the lessor in the event of a failure to meet debt repayments (in other words, the term lender can look only to the security). The security is a chattel mortgage over the lease and an assignment of the lease rentals (generally, no charge is taken over the equipment subject to the lease). The term loan may be in foreign currency named loan funds or on fixed/floating rates. In cases where the asset being financed is very costly, it is usual to have a number of lessors and a consortium of lenders. One of the lessors, in such a case, acts as the packager arranging the leveraged lease.

Basic Leveraged Leasing Components at a minimum, a leveraged lease involves a lessee, a lessor, and a long-term creditor. Generally, an organization with an investment grade credit rating defines the lessee, the end user of the equipment; however, a credit guarantee from a more highly rated organization may support a non-investment grade lessee. Traditional lessees include manufacturers, energy producers, railroads, energy, and airlines (Brady & Ingram 2006, Leveraged Leasing Basics section ¶1). In addition, Brady and Ingram (2006) note:

The lessor, commonly referred to as the equity investor or owner, invests an amount much less than the full cost of the equipment. The amount of the equity investment varies by transaction, but many lessors invest around 20% - 35% of equipment cost. Despite this relatively small investment, the lessor is able to depreciate the full equipment cost for tax purposes. Lessors, be they bank-owned leasing companies, independent leasing companies or captive financing companies, usually have large tax bases to fully utilize these benefits.

The remaining 65%-80% of the cost of the equipment is provided by the long-term creditor. The long-term creditor, often referred to as the third party or non-recourse lender, is the provider of the transaction's leverage. Banks, insurance companies, pension funds, or others seeking long-term returns on a money-over-money basis provide the leverage. More than one lender may participate in a… [END OF PREVIEW] . . . READ MORE

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