There are three methods of paying for equipment and systems: purchasing, leasing, and getting an installment loan. Each has its advantages and disadvantages, depending on the financial objectives of the company.
Purchasing
The attraction of paying cash is that it costs nothing extra; no interest is paid, as with a loan, so the cost of the item from a financial perspective is the purchase price. However, there are several reasons why cash payment may not be a good idea, aside from the obvious reason that the company may have no cash to spare.
The first reason not to pay cash for a purchase is that the money to be taken from cash reserves could probably be used to finance other urgent activities, and the interest rate to be paid when those activities require financing may be higher, if financing can be obtained at all. Sometimes a set of T1 multiplexers, for example, or other major equipment can be purchased based on a very low interest rate relative to prevailing commercial rates. To pay cash for equipment when it could instead be financed at 7 percent, then pay 11 percent for money six months later, is unsound financing. If financing is at an attractive rate, it is probably better to use that rate and finance the system, unless company cash reserves are so high that future borrowing for any reason will not be required.
Another reason not to pay cash is the issue of taxes and cash flow. If a company has accumulated a profit in cash and can use it to pay for a major network upgrade or expansion, for example, the cost cannot be deducted in a single year; it must be depreciated over a period of five or more years. The company will thus be placed in the position of owing tax on its profits, less first-year depreciation (and other operating expenses), and possibly not having enough cash to pay that tax.
A final reason for not using reserves to finance a large purchase concerns the issue of credit worthiness. Often a company with little financial history can borrow for a collateralized purchase such as a network, but it cannot borrow readily for intangibles such as ordinary operating expenses. Other times, an unexpected setback will affect the credit standing of the firm. If all or most of a firm’s reserves have been depleted by a major purchase, it may be impossible to secure quick loans to meet new expenses and the company may falter.
Installment Loan
For organizations that elect to purchase equipment, but cannot or choose not to pay cash, loan financing will be required. These arrangements are often difficult to interpret and compare, so users should review the cost of each alternative carefully.
If a company is not able or willing to pay cash for the system, the alternative is some form of deferred payment. The purpose of these payments is to stagger the purchase effect across a longer period. This improves the cash flow in a given year, but a substantial price to be paid is the interest; whether the equipment is leased or installment purchased, interest must be paid. This may result in a conflict of accounting goals— is cash flow or long-term cost, including interest, the overriding factor?
The question of financial priorities must be answered early in the equipment acquisition process. A purchase financed over a longer period, providing that the interest premium for that longer term is not unreasonable, will have a lower net cost per year, taking tax effects of depreciation into consideration.
If the company is in a critical position with cash flow, longer-term financing and a minimum down payment are the major priorities. The cash flow resulting from a PBX purchase will be the annual payments for the system less the product of the company’s marginal tax rate times the annual depreciation. If the system’s payments are $5,000 per month on a $200,000 note and first-year depreciation is 20 percent, the company will pay $60,000 in the first year and have a tax deduction of $40,000. If the marginal rate is 30 percent, that deduction will be worth $12,000, so the net cash flow is negative at $48,000. Longer terms will reduce the payments, but not proportionally due to increased interest.
Where cash flow is not a major concern, financing should be undertaken to minimize the interest payment to be made. Interest charges can be reduced by increasing the down payment, by reducing the term of the loan, and by shopping for the best loan rates. Each of the ways users can finance a system will affect user mobility in these areas.
Leasing
Assuming the decision has been made to lease rather than purchase equipment, it is important to differentiate between the two types of leases available because each is treated differently for tax purposes. One type of lease is the operating lease, in which the leasing company retains equipment ownership. At the end of the lease, the lessee may purchase the equipment at its fair market value. The other kind of lease is the capital lease, in which the lessee can retain the equipment for a nominal fee, which can be as low as one dollar.
OPERATING LEASE With the operating or tax-oriented lease, monthly payments are expensed, that is, subtracted from the company’s pretax earnings. With a capital or nontax-oriented lease, the amount of the lease is counted as debt and must appear on the balance sheet. In other words, the capital lease is treated as just another form of purchase financing and, therefore, only the interest is tax deductible.
A true operating lease must meet the following criteria, issued by the Financial Accounting Standards Board (FASB), some of which effectively limit the maximum term of the lease:
■ The term of the lease must not exceed 80 percent of the projected useful life of the equipment. The equipment’s “useful life” begins on the effective date of the lease agreement. The lease term includes any extensions or renewals at a preset fixed rental.
■ The equipment’s estimated residual value in constant dollars (with no consideration for inflation or deflation) at the expiration of the lease must equal a minimum of 20 percent of its value at the time the lease was signed.
■ Neither the lessee nor any related party is allowed to buy the equipment at a price lower than fair market value at the time of purchase.
■ The lessee and related party are also prohibited from paying, or guaranteeing, any part of the price of the leased equipment. The lease, therefore, must be 100-percent financed.
■ The leased equipment must not fall into the category of “limited use” property, that is, equipment that would be useless to anyone except the lessee and related parties at the end of the lease.
With the operating lease, the rate of cash outflow is always balanced to a degree by the rate of tax recovery. With a purchase, the depreciation allowed in a given year may have no connection with the amount of money the buyer actually paid out in installment payments.
CAPITAL LEASE For an agreement to qualify as a capital lease, it must meet one of the following FASB criteria:
■ The lessor transfers ownership to the lessee at the end of the lease term.
■ The lease contains an option to buy the equipment at a price below the residual value.
■ The lease term is equal to 75 percent or more of the economic life of the property. (This does not apply to used equipment leased at the end of its economic life.)
■ The present value of the minimum lease rental payments equals or exceeds 90% of the equipment’s fair market value.
From these criteria, it becomes quite clear that capital leases are not set up for tax purposes. Such leases are given the same treatment as installment loans; that is, only the interest portion of the fixed monthly payment can be deducted as a business expense. However, the lessee may take deductions for depreciation as if the transaction were an outright purchase. For this reason, the monthly payments are usually higher than they would be for a true operating lease.
Depending on the amount of the lease rental payments and the financial objectives of the lessee, the cost of the equipment may be amortized faster through tax deductible rentals than through depreciation and after-tax cash flow.
With new technology becoming available every 12 to 18 months, leasing can prevent the user from becoming saddled with obsolete equipment. This means that the potential for losses when replacing equipment that has not been fully depreciated can be minimized by leasing rather than purchasing. With rapid advancements in technology and consequent shortened product life cycles, it is becoming more difficult to sell used equipment. Leasing eliminates such problems.
Leasing can also minimize maintenance and repair costs. Because the lessor has a stake in keeping the equipment functioning properly, it usually offers on-site repair and the immediate replacement of defective components and subsystems. In extreme cases, the lessor may even swap out the entire system for a properly functioning unit. Although contracts vary, maintenance and repair services that are bundled into the lease can eliminate the hidden costs associated with an outright purchase.
Finally, leasing usually allows more flexibility in customizing contract terms and conditions than normal purchasing arrangements. This is simply because there are no set rates and contracts when leasing. Unlike many purchase agreements, each lease is negotiated on an individual basis. The items typically negotiated in a lease are the equipment specifications, schedule for upgrades, maintenance and repair services, and training.
Another negotiable item has to do with the end-of-lease options, which can include signing another lease for the same equipment, signing another lease for more advanced equipment, or buying the equipment. Many lessors will allow customers to end a lease ahead of schedule without penalty if the customer agrees to a new lease on upgraded equipment.
Of course, leasing has its downside. Although leasing can be an alternative source of financing that does not appear on the corporate balance sheet, the cost of a conventional lease arrangement generally exceeds that of outright purchase. Excluding the time value of money and equipment maintenance costs, the simple lease versus purchase break-even point can be determined by the formula: n = p/l, where p is the purchase cost, l is the monthly lease cost, and n is the number of months needed to break even. Thus, if equipment costs $10,000, and the lease costs $250 per month, the break-even point is 40 months. This means that owning equipment is preferable if it is expected to last more than 40 months.
As in any financial transaction, there may be hidden costs associated with the lease. If the lease rate seems very attractive relative to that offered by other leasing companies, a red flag should go up. Hidden charges may be embedded in the lease agreement that would allow the leasing company to recapture lost dollars. These hidden charges can include shipping and installation costs, higher than normal maintenance charges, consulting fees, or even a balloon payment at the end of the lease term.
The lessee may even be required to provide special insurance on the equipment. Some lessors even require the lessee to buy maintenance services from a third party to keep the equipment in proper working order over the life of the lease agreement. The lessor may also impose restrictions, such as where the equipment can be moved, who can service it, and what environmental controls must be in place at the installation site.
Last Word
The choice of procuring technology through purchasing, installment loan, or leasing arrangement depends on the financial condition and financial objectives of the company. Each procurement method has its advantages and disadvantages, which must be weighed in the decision. Often, the choice will be influenced by how frequently the company believes it must upgrade its systems and networks to stay competitive. For some companies, frequent changes might favor a leasing arrangement, whereby the lessor takes responsibility for keeping the system or network up to date with new technology.
