Leases play an essential role in our personal and professional lives. Many of us live in rented apartments, drive leased cars to leased offices, and compile programs on a leased System i! Entire industries are even based on leasing. Commercial airlines lease jets, for example, while construction companies let heavy machinery. Numerous firms also use leasing to satisfy their IT infrastructure needs.

Despite its popularity, leasing is often misunderstood. Without formal training in finance, most people would be hard-pressed to properly value a lease agreement. In this article, I define the major types of leases, examine their pros and cons, and demonstrate how financial modeling can help you make sound lease-versus-buy decisions.

What Is a Lease?

Leases are rental agreements that extend for a year or more and stipulate the conditions by which fixed payments are exchanged for the use of an asset. As formal contracts, leases are fully enforceable by law. Every lease has two parties — a lessor who owns an asset and a lessee who pays to use it.

Leases come in many varieties, but there are two major types. Operating leases are short term, usually lasting one to five years. Under these agreements, lessees use an asset for a fraction of its useful life and do not typically maintain it. They can also return it at lease end. For these reasons, they do not assume the risks of ownership. As a result, operating lease payments are considered expenses. Under a capital lease, lessees not only use an asset for an extended period, but they also typically maintain it as well. Accordingly, they assume at least some risks of ownership. For example, if an airline leases a jet fleet for 20 years, it is committed to that technology and thus exposed to obsolescent risk. Similarly, if it fails to maintain its fleet properly, it is exposed to liability risk. Because capital leases closely resemble ownership, they appear on balance sheets. The distinction between operating and capital leases has important tax- and financial-reporting implications.

Leases are classified further by services the lessor provides. Under a full-service lease, the lessor maintains the asset. Leases are considered net when lessees maintain the assets. For example, airlines sign net capital leases for jets because they maintain and fly them for many, many years. Capital leases tend to be net. In some cases, lessees may sign third-party maintenance agreements. This article focuses on operating leases because they are more germane to IT managers.

The Benefits of Leasing

Technology evolves at a rapid pace. Processors get faster, operating systems progress, and form factors shrink. Leasing equipment is popular because it reduces the risk of obsolescence and forces companies to upgrade at lease end. A friend of mine works at a company that still runs its business on a System/36. The company's owner purchased that computer more than a decade ago and does not want to spend money to replace it. Had that System/36 been leased, the firm would probably have a System i today. Relying on outdated equipment has serious drawbacks. Servicing it is increasingly difficult as replacement parts and knowledgeable technicians become scarce. Even worse, firms are less competitive when they do not take advantage of more productive assets.

Under full-service leases, lessees receive support and maintenance. Given the complexity of hardware, this can be a valuable benefit. Lessors are normally certified to maintain their products, and they gain more experience with each service call. In fact, maintenance is one of their core competencies. Because lessors have numerous accounts, they can afford diagnostic equipment that is beyond many customers' reach. However, the relative value of this benefit depends on the cost and availability of third-party maintenance services.

Because computer equipment contains a potpourri of toxic compounds, many state and municipal governments regulate the disposal of e-waste. When you lease, you don't have to spend time or money to discard assets properly. Instead, you simply return them to the lessor.

Operating leases may also offer greater flexibility than purchasing. Depending on terms, leaseholders may be permitted to terminate agreements early, purchase/upgrade equipment at lease end, or extend a lease's duration. These options cost more, of course. Understanding midterm upgrade options is critical because they usually have above-market costs, which means higher profits for lessors.

Leasing also helps companies preserve capital because down payments, if any, are a fraction of price tags. In addition, it smooths cash flows and facilitates budgeting because expenses are predictable and scheduled. These benefits are valuable if your business is cyclical or if your cash flow is heavily dependent on variable economic forces. It is important to note that a company can also preserve capital through purchases on credit. In either case, the firm's liability is the same. Although beneficial, capital preservation alone is not a valid reason to opt for a lease.

Finally, savvy companies can use operating leases to avoid the alternative minimum tax, or AMT. To help stimulate capital investment, the government lets businesses expense assets using accelerated depreciation. Under accelerated depreciation, a relatively high percentage of an asset's cost is written off during its initial years of operation. This differs from straight-line depreciation, under which the same percentage of an asset's cost is expensed per period. A noncash expenditure, depreciation acts as a tax shield because it reduces taxable income. Tax authorities do not want companies to safeguard too much income, and that's where the AMT comes in. Businesses must compute taxable income a second time with part of the benefit of accelerated depreciation (and other items) added back. If the AMT tax amount is higher, the company has to pay it. Since lease expenses are not included in the AMT calculation, companies can use operating leases to avoid the AMT.

Potential Drawbacks

If leasing had no drawbacks, companies would never purchase equipment. Clearly, that is not the case. Over the long term, leases are invariably more expensive than purchases. After all, lessors must recoup administration, maintenance, and other costs. Many vendors prefer leasing to selling because they can manipulate residuals and renewals in ways that block out competitors and increase profits. In the short term, higher lease payments are usually outweighed by the benefits described earlier. As a rule of thumb, you should buy computer equipment if you plan to use it for four years or more.

Leases can also be problematic if they cannot be cancelled at the lessee's option. Depending on circumstances, you may be obligated to pay for unnecessary hardware. For example, suppose your firm acquires another company that leases its enterprise server. If you migrate its applications to your existing platform, there is no longer a need for the second computer. However, you may still have to pay its lessor for several years. Had your firm purchased the box, it could have been resold.

Higher transaction costs are another downside of leasing. Like most contracts, leases are replete with legal jargon, fine print, and verbose clauses. Companies should use formal legal counsel to properly vet leases. Lessees must also prove their credit worthiness to lessors, and that requires more time. Finally, leasing typically requires more negotiation than purchasing. Because of these headaches, many companies opt to buy when possible.

The Time Value of Money

If someone offered you $100 now or $100 in a year, which would you prefer? I'd opt for the former because it could begin earning interest immediately. This simple case illustrates that a dollar tomorrow is worth less than a dollar today. Let's suppose you could earn 6 percent on a safe investment. According to the formula below, $100 received in one year is worth $94.34 today! In financial terms, we refer to 6 percent as the discount rate.

Present Value = (1 / (1 + .06)) x (100) = $94.34

This example illustrates a central tenant of finance, the "time value" of money. It is important to understand because leases and purchases consist of cash flows over time. To properly value either, you translate their future after-tax cash flows into a lump sum figure expressed in current dollars. This number is known as net present value, or NPV. In a lease-versus-buy situation, you compare the NPVs of various options to determine which is more economical.

Lease-versus-Buy Decisions

Suppose your company wants to invest in a System i that can be purchased for $600,000 or leased for $125,000 per year for four years. Which option makes more sense? The first step is estimating the NPV of each transaction. Regarding the purchase, let's assume your firm spends $600,000 immediately and will recoup $200,000 after four years when it plans to resell the system.

Under straight-line depreciation, each year's asset write-off is $100,000, or the difference between purchase price and resale value divided by years used. If your corporate tax rate is 35 percent, annual depreciation expenses decrease your tax obligation by $35,000. Figure 1 [2] models the purchase's impact on cash flow. Assuming a discount rate of 6 percent, we also determine that the NPV of purchasing this System i is -$320,302.57.35.

You use the same method to compute the lease's NPV, also illustrated in Figure 1. However, there is one important difference. Lease payments are due at the beginning of each period, so the NPV calculation accounts for that difference in timing. (For those of you familiar with annuities, this treatment of lease payments is equivalent to valuing an annuity due.)

Given the results in Figure 1 [3], leasing the System i is clearly more cost effective. Of course, you must temper your numerical analysis with the pros and cons of leasing. (Note: This example is very simple. It does not account for sales tax or maintenance expenses, and the time periods coincide with the calendar year. Real-life analyses have to account for these factors.) Your CFO can also tell you which discount rate is used in your organization.

Putting It Together

To properly compare leases with purchases, you have to consider both qualitative and quantitative factors. Although the qualitative aspect of leasing often varies considerably by industry and company, cash flows can be measured objectively. By looking at both, you improve the odds of making a sound lease-versus-buy decision.

Scott Steinacher has 20 years of managerial and technical experience in application development, e-commerce, business intelligence, and project management. He is a cofounder of TimeTrade Systems, Inc. (timetrade.com), a leading provider of web-based scheduling solutions. Scott has written several dozen articles, as well as Data Warehousing and the AS/400 (29th Street Press). He holds an MBA in corporate finance from NYU’s Stern School of Business and a B.S. in Information Systems from SUNY Albany.