LEASING vs. PURCHASING COMPUTER EQUIPMENT?
Leasing and Purchasing Computer Equipment
Scope
Considerations for Lease Option 7-9
Advantages of Financial Leasing 9-12
GE Transportation plans to replace their computer equipment for the Human Resources and recruitment department having roughly 100 employees. This paper is based on researching what is the most economical way for the employer, GE, to outfit its office with computer. In this paper the pros and cons both of buying new equipment for the employees or leasing computers to use are analyzed. As per the results of the research, it was found that it is in the best interest of GE transportation to lease the computer equipment. Purchasing computer equipment will cost U.S. $88,461 and will have limited coverage for repairs. Renting computer equipment will cost 80,793 and will also come with a service contract for $500 annually.
Comparing Leasing vs. Purchasing Computer Equipment?
INTRODUCTION
PURPOSE
In a meeting on March 19th, 2013 Kerry Hamilton of GE Transportation requested Julia Clukey to research the available options for replacing the department’s computer equipment. The two viable options were buying new computer equipment from Lenovo or leasing equipment from a local company.
1.2. SCOPE
Leasing computer equipment is the most economical way to outfit GE’s Human Resource Department with new computers.
1.3. BACKGROUND
In this study, we will evaluate the most feasible method of acquiring IT equipment for GE Transportation. The advantages and disadvantages of leasing or purchasing the equipment are highlighted and evaluated in this paper. And we believe that this paper would be beneficial for every business owner and financial manager.
Leasing has many advantages; the leasing firm has acquired considerable knowledge about the kinds of equipment it leases. Thus, it can provide expert technical advice based on experience with the leased equipment.
Furthermore, another important advantage of leasing is that in the event of bankruptcy, the claims of the lessor to the assets of a firm are more restricted than those of general creditors.
2. DISCUSSION
While the most cost-effective alternative is preferred, non-financial factors such as obsolescence and associated risks also need to be considered as a part of the lease vs. buy decision.
For businesses, capital-leasing property may have significant financial benefits:
1. Leasing is less capital-intensive than purchasing, so if a business has constraints on its capital, it can grow more rapidly by leasing property than it could by purchasing the property outright. A major benefit that is being provided by leasing is that it allows a company to save its capital for investment in various business projects rather than investment in the equipment and infrastructure that is being required to run the business. In addition to that, unlike other methods of financing, leasing does not require any commitment fee or down payment. Leasing can be beneficial in relation to liquidity purposes as it allows the cash of the organization to be invested in liquid assets rather than hard assets. (Alexander, P.)
2. Capital assets may fluctuate in value, therefore, leasing is more beneficial as it shifts risks to the lessor. Through leasing the lessee can transfer the residual value risk to the lessor because the value of their acquisition is less than that of the lessor. In addition to that, the lessor also provides the lessee with an orderly disposal service and due to this service the lessee does not have to consider various unpredictable costs of disposal of the equipment at the end of the lease period. The lessor is responsible for the collection, disposal, discharge or resale of the equipment. All the preceding functions are performed by using the procedures that are in alignment with the laws of environment. These terms can be included in the lease agreement at the beginning of the lease period so that no negotiations are to be performed at the end of the lease period. (Gail Group)
3. Leasing may provide more flexibility to a business which expects to grow or move in a relatively short-term, because a lessee is not usually obliged to renew a lease at the end of its term. Leasing allows the lessee to take full use of the modern technology. Leasing permits the customers to move up on the technology curve as it enables them to use the technology upgrades whenever their business requires. This is an attractive option for the business that project short-term growth. In addition to that, some leases come with an upgrade option that allows the organizations to upgrade their existing technology as per the requirements of the business without even waiting for the lease period to end. (Schwartz, J.)
4. When controlling cash flow is critical and you don’t have time to worry about your equipment, leasing can be a great option. Lease payments are designed in a way that they fit the cash flow and other financial requirements of the lessee. The lessee can design the payments according to his terms and conditions. In our case we can decide to pay less at the start and more at the end of the period. Or we can also make a payment schedule which is in alignment with our seasonal revenues. (Roch, 2005)
5. If the obsolescence risk is high, then the lease will be preferable. In our case the obsolescence risk is very high as the life cycle of technology can be as short as two to three years. Leasing allows the organizations to take full use of the life of the technology as it can be matched with the terms of the lease. Use of new technology improves the performance of the organization and has a positive impact on the price/performance curve of the organization. Organizations cannot remain competitive while waiting for their depreciation cycle to be completed as it is a necessary requirement for the disposal or replacement of the obsolete equipment. Hence in the case of technological equipment leasing is a very attractive option. (Roch, 2005)
6. Lease requires no restriction on a company’s financial operations, while loans often do; a loan usually involves some restrictive conditions and if the borrower does not adhere to these conditions then this may result in default whereas, a lease does not have any such conditions therefore, it does not threaten the decision making authority and independence of the lessee. (“There are some,” )
7. Lease spreads payments over a longer period (which means they’ll be lower) than loans permit; the loans are usually based on floating rates therefore the payment schedule of the loan changes with the change in the market which makes prediction of cash flows very difficult. In addition to that, if the loans are not issued on fixed rate financing, then the payment schedule of loans is usually based on the type of the equipment rather than the use, economic life and obsolescence of the equipment. Lease on the other hand prepares a payment schedule based on the use, economic life and obsolescence of the equipment rather than its type. (“There are some,” )
2.1. CONSIDERATIONS FOR LEASE OPTION
Following considerations should be made while gathering the information about leases:
1. Compensation-related incentives to leases
A manager whose bonus depends on return on invested capital will prefer lease to purchase of, say, office space, unless the lease is capitalized on the balance sheet. As by investing capital in the purchase of hard assets will not be productive for the organization and the organization will not get any return on that investment. Leasing the equipment will enable the organization to invest in more liquid and productive securities and assets. This will increase the organization’s return on investment and will have a positive impact on the compensation of employees. (Rowland, 2001)
2. Specialization in risk-bearing
For unincorporated business leasing reduces the concentration of wealth in one activity, and can facilitate a more efficient allocation of risk bearing. Leasing enables the organizations to invest their money in a pool of assets rather than in the purchase of a single asset. This reduces the liquidity risk as the organization can now invest its capital in a portfolio. For unincorporated organizations this is a very attractive provision as these organizations possess a limited amount of capital for initial investment and they have to hedge the risk carefully. Small businesses that do not have a fixed income can purchase unnecessary equipments through leasing and can use the funds to improve their liquidity. (Rowland, 2001)
3. Sensitivity to use and maintenance decisions
The more sensitive the value of an asset to maintenance and use decisions, the higher the probability that the asset will be purchased. While leasing the equipment, it has been determined that, the requirements to maintain the equipment may be different from that of owning. The decision to purchase or lease the equipment may vary depending on which party is responsible for bearing the unpredictable maintenance costs and depreciation expenses. If the equipment has the tendency to depreciate in a short period of time and it has a high maintenance cost then it is better to purchase the asset. (Rowland, 2001)
2.2. Advantages Of Financial Leasing
1. Operational advantages to the lessee:
Leasing ready-to-use equipment may be more attractive if the asset requires lengthy preparation and set-up. As the setup and preparation costs may be very high and may not fit the firm’s cash flows. In addition to that, if the firm requires the asset for immediate use that it may not have the time that is required to be spent on the setting up and preparation of asset. Therefore, if the asset requires lengthy setup time then it is better to lease it. (Roch, 2005)
Leasing avoids having to own the asset that will be required only seasonally, temporarily or sporadically. It saves the cash of the organization and the firm does not have to spend large amounts of cash on the acquisition of unnecessary assets. (Roch, 2005)
Leasing for short periods provides protection against obsolescence. As discussed above, the life cycle of technology ranges between two to three years. Leasing technological equipment enables the firm to tie it to the lease schedule rather than a depreciation cycle. Therefore, a firm can take full advantage of the life cycle of technological equipment and can easily upgrade it with the advent of new technology through attractive terms under the same lease schedule. (Roch, 2005)
2. Financial advantages to the lessee:
Lease payments can be tailored to suit the lessee’s cash flows (up to 100% financing, instead of the 80% limit by banks). Properly structured leases may be “off-balance sheet,” avoiding Restrictions set by bondholders that prevent firms from taking on additional debt. The payments can be made annually; semiannually, quarterly or monthly with date of payments settled either in advance or on accrued basis. In addition to that, unlike other methods of financing leasing provides the lessee with the facility of ‘stepped payments’ that is the lessee may pay smaller installations at the beginning of the lease periods and larger installations at the end of the lease period. The lessee has the flexibility to adjust the payment schedule according to his revenue generation periods. (NOLO)
Leasing provides tax advantages from accelerated depreciation and interest expense. In case of operating lease the whole amount of the annual lease is deducted from gross profit, as an expense, for the calculation of taxable income hence the organization gets a tax relief. And in case of financial lease the assets are added to the books of the firm. Therefore, for the calculation of the taxable income, depreciation expense and interest expense are deducted from the gross profit and in this case again the organization enjoys a tax relief. (NOLO)
Disadvantages to the lessee:
Leased ready-to-use equipment may be of lower quality than custom built, resulting in lower quality products and lower sales. While purchasing the equipment the organization has the authority to get it customized according to its will whereas, in the case of leasing the organization does not enjoy any such benefit or authority. The leased equipment may be of low quality and it may not fulfill all the requirements of the lessee. (Kishore, 2008)
Seasonal leasing may affect equipment availability and pricing. The prices of equipment in case of seasonal lease may be high and there can be a negative impact on the availability of equipment. (Kishore, 2008)
The premium must be paid for the protection against obsolescence. The lease enables the organization to take the advantage of an equipment to the fullest and then return or upgrade it as per the requirements of the business but for this service the lessee organizations have to pay a premium and this premium increases the overall cost of the equipment. The cost of leasing the equipment, in case of premium is higher than the cost of purchasing the equipment. (Kishore, 2008)
Disadvantages to financial statement users: Off-balance sheet financing hides the true leverage of the firm.
The implications of off balance sheets financing with respect to tax and accounting issues:
It hides the true leverage of the firm. As the purchases made through the lease are not disclosed in the financial statements, therefore, the firm’s total borrowed financing is not represented in the balance sheet. In case of operating lease the purchased asset is never entered into the books of the organization hence the borrowed financing is never mentioned in the balance sheet. This hides the true leverage of the firm from financial statement users. (Kishore, 2008)
There may be an increase in the liability of the firm, which is not disclosed currently. The assets purchased through leasing are a liability for the firms but the firms usually do not add lease obligations in their balance sheets. So an initial increase in the liability of the firm is kept hidden from the balance sheet and the financial statement users. (Kishore, 2008)
It may lead to an artificial increase in profits, which in turn means high taxes. In case of operating lease the purchased asset is not entered into the books and due to this a number of operating expenses, such as depreciation expense, interest expense, maintenance expense etcetera, in relation to that particular asset are not recorded and this lead towards an artificial boost in the profitability and the productivity of the organization and it may misguide the financial statement users. (Kishore, 2008)
Advantages:
It improves the debt equity ratio, which in turn may lead to better corporate reputation. The debt to equity ratio is calculated by dividing the firm’s total liability by the share holder’s equity. As the lease obligations are not recorded in the liability of the firm therefore, leasing enables the firm to have lower debt to equity ratio. Lower debt to equity ratio enhances the standing and reputation of the firms in the market and it also has a positive impact on the overall credit standing of the firm. (Kishore, 2008)
It helps in raising more funds for the organization. Financing the purchase of equipment through loans has certain restrictive conditions and it also have a negative impact on the debt to equity ratio and credit standing of the firm. On the other hand, leasing an equipment does not increase the overall liability of the firm, therefore, the firm can borrow funds from other organizations by issuing bonds and stocks as its debt to equity ratio is not very high. (Kishore, 2008)
3. CONCLUSION
The net present value of the cost of purchasing the computer equipment is $88,461.
The net present value of the cost of leasing the computer is $80,793.
It is evident from the net present values calculated for both the options that leasing is the better option. As the net present value of the purchase option is greater than the net present value of the lease option, mathematically
88,461-80,793= 7,668
Leasing equipment will result in easy management of IT equipment through local company’s extensive knowledge of machines and service plan. Thus the lease option is more compatible for the company.
In addition to that, the lease option costs less and hence it can benefit the company in financial terms.
If the company goes for the purchase option then the company would incur a net cash outflow of $126,965. It is a large outflow and it can have a negative impact on the liquidity position of the company. Moreover, the purchase option will have an unpleasant impact on the cash flow statement of the company as well.
4. RECOMMENDATIONS
It is recommended for Kerry Hamilton at GE to lease computer equipment for her department of 100 employees. As all the calculated data reflect that leasing the equipment will be profitable for the company.
The lease option will also provide the company with a flexible payment structure so it is a preferable option for the organization
As the equipment in hand is a technological equipment therefore, it is recommended that the company should go for the lease option as it will enable the company to take full advantage of the useful life of the equipment.
It is recommended for Kerry Hamilton to include a service plan in the lease agreement for an additional annual fee of $500.
The company can enter the clause for service contract in the lease agreement and can negotiate with the lessor regarding this clause.
It is recommended that the company should add a service contract because the computer equipment require timely maintenance and if incurred separately, the maintenance expense will cost the company more as compared to the service contract.
APPENDICE
Given below are the details regarding the specifications of lease and purchase option. The Net present value was calculated by diving the net cash flow by (1+i) n..
Data for Lease And Purchase Option
The present value factors were as follows:
Year 0
Year 1
Year 2
Year 3
Year 4
Year 5
1
0.909
0.826
0.751
0.683
0.621
Comparison Between Net Present Values of Purchase and Lease Option
It is evident from the net present value of both the options that leasing is the better option. As the net present value of the purchase option is greater than the net present value of the lease option, mathematically
88,461-80,793= 7,668
Bibliography
Alexander, P. (n.d.). business – Should You Lease or Buy Your Tech Equipment? | Entrepreneur.com. Business News & Strategy For Entrepreneurs | Entrepreneur.com. Retrieved March 18, 2013, from http://www.entrepreneur.com/article/80230#
Coastal Leasing, Inc., (n.d.). There are some distinct differences between lease and loan financing! . Retrieved from Coastal Leasing, Inc. website: http://www.coastalleasing.com/MediaZone/Differences Between A Loan & Lease.pdf
Erie, Pennsylvania, Computer, Laptop, Projector, and AV Rentals.(n.d.).Rentech Solutions Computer Rentals, Laptop Rentals, Lcd Projector Rentals. Retrieved March 19, 2013, from http://www.rentechsolutions.com/rentals/pennsylvania/erie/
Gale Group. (n.d.). Computer Rental and Leasing market report | HighBeam Business: Arrive Prepared. Business information, news, and reports | HighBeam Business: Arrive Prepared. Retrieved March 18, 2013, from http://business.highbeam.com/industry-reports/business/computer-rental-leasing
Kishore, R.M. (2008). Financial management. (7th ed., pp. 420-436). Haryana: Tan Publishers.
NOLO.(n.d.).Buying Vs. Leasing Business Equipment – Forbes.com.Information for the World’s Business Leaders – Forbes.com. Retrieved April 1, 2013, from http://www.forbes.com/2007/01/24/smallbusiness-equipmentlease-IRS-ent-fin-cx_nl_0124nolo.html
Roch, W. International Business Machines Corporation (IBM), (2005). Revisiting the lease vs. purchase decision. Retrieved from International Business Machines Corporation (IBM) website: http://www-03.ibm.com/financing/pdf/us/idc_04205_leasevpur.pdf
Rowland, P. Curtin University of Technology, Department of Property Studies. (2001). Lease or buy? how management of the asset upsets the equivalence. Retrieved from Curtin University of Technology website: http://www.prres.net/papers/Rowland_LEASE_OR_BUY_ HOW_Management_OF_THE_ASSET_UPSETS_THE_EQUIVALENCE.pdf
Schwartz, J. (n.d.). Buying Local: How It Boosts the Economy – TIME. Breaking News, Analysis, Politics, Blogs, News Photos, Video, Tech Reviews – TIME.com. Retrieved March 26, 2013, from http://www.time.com/time/business/article/0,8599,1903632,00.html
Sheet1
Lease Option: Purchase Option
Lease term 5 years Cost of Computers 126,965
Time of repayment Beginning of the year Expected life 5 years
Annual MLP 30447 Salvage Value 0.0
Interest Rate 15%
For the purpose of taxation the asset will be written off in a period of 5 years
Effective tax rate 40%
Company’s Required Rate of Return 10%
Lease
Period
0 1-2 3-4 5
Lease Payments 30,447 30,447 30,447 30,447 30,447
Tax Benefit @ 40% on MLP (12,179) (12,179) (12,179) (12,179) (12,179)
Net Cash Flows 30,447 18,268 18,268 18,268 18,268 (12,179)
PV of Cash Flows @ 10% 30,447 16,607 15,098 13,725 12,477 (7,562)
Net PV 80,793
Period
0 1-2 3-4 5
Purchase Cost 126,965
Depreciation 25,393 25,393 25,393 25,393 25,393
Tax Benefit @ 40% on Depreciation (10,157) (10,157) (10,157) (10,157) (10,157)
Net Cash Flows 126,965 (10,157) (10,157) (10,157) (10,157) (10,157)
PV of Cash Flows @ 10% 126,965 (9,234) (8,394) (7,631) (6,938) (6,307)
Net PV 88,461
Sheet1
Lease Option: Purchase Option
Lease term 5 years Cost of Computers 126,965
Time of repayment Beginning of the year Expected life 5 years
Annual MLP 30447 Amount to Borrow from Bank 100%
Interest Rate 15% Annual Interest rate 15%
Time of repayment Beginning of the year
For the purpose of taxation the asset will be written off in a period of 5 years
Effective tax rate 40%
Company’s Required Rate of Return 10%
Period
0.0-1 2-3-4 5
Lease Payments 30,447 30,447 30,447 30,447 30,447
Tax Benefit @ 40% on MLP (12,179) (12,179) (12,179) (12,179) (12,179)
Net Cash Flows 30,447 18,268 18,268 18,268 18,268 (12,179)
PV of Cash Flows @ 10% 30,447 16,607 15,098 13,725 12,477 (7,562)
Net PV 80,793
Lease
Period
0 1-2 3-4 5
Lease Payments 30,447 30,447 30,447 30,447 30,447
Tax Benefit @ 40% on MLP (12,179) (12,179) (12,179) (12,179) (12,179)
Net Cash Flows 30,447 18,268 18,268 18,268 18,268 (12,179)
PV of Cash Flows @ 10% 30,447 16,607 15,098 13,725 12,477 (7,562)
Net PV 80,793
Period
0 1-2 3-4 5
Purchase Cost 126,965
Depreciation 25,393 25,393 25,393 25,393 25,393
Tax Benefit @ 40% on Depreciation (10,157) (10,157) (10,157) (10,157) (10,157)
Net Cash Flows 126,965 (10,157) (10,157) (10,157) (10,157) (10,157)
PV of Cash Flows @ 10% 126,965 (9,234) (8,394) (7,631) (6,938) (6,307)
Net PV 88,461
