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Financing
Finance
Why Do Eight Out of 10 American Companies Lease Equipment?
Of all the ways to acquire equipment, leasing is the method most frequently used. Today,
eight out of 10 American companies lease some or all of their needed equipment.
Why Should I Lease Equipment Instead of Buy?
Leasing is flexible. Companies have different needs, different cash flow patterns,
different sometime irregular - streams of income. For example, start-up companies typically
are characterized by little cash and limited debt lines. Mature companies might have other
needs: to keep debt lines free, to comply with debt covenants, and to avoid committing
to equipment that may quickly become obsolete. Therefore, your business conditions - cash
flow, specific equipment needs, and tax situation - may help define the terms of your lease.
Moreover, a lease provides the use of
equipment for specific periods of time at fixed rental payments. Therefore, leasing allows
you to be more flexible in the management of your equipment.
Leasing is practical. By leasing,
you transfer the uncertainties and risks of equipment ownership to the lessor, which
allows you to concentrate on using that equipment as a productive part of your business.
Leasing is cost effective. Equipment
is costly and some of the costs are unexpected. When you lease, your risk of getting
caught with obsolete equipment is lower because you can upgrade or add equipment to best
meet your needs.
Further, your equipment needs can change over time due to changes in your company, such
as diversification. Leasing allows you to stay on the cutting edge of technology. Sophisticated
business managers have learned that the primary benefits of higher productivity and profit come
from the use of equipment, not owning it.
Leasing has tax advantages. Rather
than deal with depreciation schedules and Alternative Minimum Tax (AMT) problems, you, the
lessee, simply make the lease payment and deduct it as a business expense.
Leasing helps conserve your operating capital.
Leasing keeps your lines of credit open. You don't tie up your cash in
equity. Also, you avoid costly down payments. With other advantages such as offbalance
sheet financing, leasing helps you better manage your balance sheet.
Who Leases?
Lessees vary widely from small, one-person operations to Fortune 100 corporations.
And the kinds of equipment being leased are just as diverse.
Transactions range from a few thousand
dollars worth of equipment (such as fax machines) to multimillion-dollar cogeneration
facilities, telecommunications systems, medical equipment (including CAT scanners and MRI
imaging), office systems, computers, commercial aircraft, and transportation fleets. There
is no end to the types of equipment companies lease.
What Type of Lease Can I Get?
The type of equipment you want to lease, the term, and whether you want to keep the equipment
at the end of the term will all be factors in choosing a lease.
Lessees may lease one piece of equipment at
a time or many items with a single lease. Companies that continually acquire equipment may
use a master lease (see glossary) to avoid executing a new contract every acquisition.
Two common types of leases are operating leases and finance leases.
With an operating lease, the term is shorter than the expected useful life of the equipment.
Rental payments do not cover the equipment cost for the lessor during the initial lease term.
This type of lease is popular for high-tech equipment, because shorter term leases help equipment users stay
ahead of equipment obsolescence. The lessor uses its equipment remarketing expertise to
subsequently find other users for the returned equipment, something the typical equipment
user does not have time or ability to do.
With a finance lease, the term is longer, more nearly covering the useful life of the equipment.
Rentals tend to be lower because of the longer term and less residual value risk.
From an accounting standpoint, an operating
lease is the simplest type of lease for you to account for because you only expense
rentals; there is no requirement to add the asset to the balance sheet, as long as the
footnotes to the financial statements indicate the amount of your firm's lease rental obligations.
Another lease product you may find
beneficial is the sale-leaseback: You purchase the equipment you need and use it for a
period of time before selling it to a lessor. After selling the equipment, you then lease
the equipment. This is another way to free up your operating capital.
On smaller equipment leases worth thousands
of dollars, leases tend to be more standardized. Above that cost range - several hundred
thousand into the millions - variations appear more frequently. A leveraged lease on a big
ticket acquisition, such as an airplane, may include several customized provisions and
options that would not appear in a typical lease for a smaller amount. Therefore,
flexibility is a product of the size of the lease.
How Do I Determine What Type of Lease is Best For My Company?
As a method of acquiring equipment, you'll find leasing fairly straightforward: It amounts to
a rental agreement that is structured to meet your company's special needs.
As the lessee, you and the lessor consider
the following factors to determine the most effective type of lease for your company.
These factors include: how long you want to use the equipment; what you intend to do with
the equipment at the end of your lease; your tax situation; your cash flow; and your
company's specific needs as they relate to future growth.
Further, your needs will also determine
what happens at the end of the lease. As a lessee, your options include: returning the
equipment to the lessor; purchasing the equipment at fair market value or a nominal fixed
price; or renewing your lease. As the lessee, you should understand what your options are
and discuss them with your lessor.
How Does Leasing Work?
Almost any type of equipment can be leased.
As the lessee, you deal with the lessor concerning the term of the lease and the rate.
Ancillary expenses - such as taxes, service, insurance and maintenance usually are the
responsibility of the lessee and are not deductible from the rental payment.
There are three ways you can acquire equipment through leasing
- You can select and order the equipment and then seek financing through a lessor.
- You can select the equipment by working with a vendor or a manufacturer which offers leasing through its own subsidiary.
- You can obtain the equipment directly through a lessor.
In most cases, the lessee selects and orders the equipment before contacting the lessor.
Unless provided for in the provisions of the lease, lessors don't normally provide equipment
warranties. Equipment warranties are between the lessee and the manufacturer.
By signing the lease, the lessee assigns its purchase rights to the lessor, who already
owns or who then buys the equipment as specified by the lessee.
When the equipment is delivered, the lessee formally accepts it and makes sure it meets
all specifications. The lessor pays for the equipment, and the lease takes effect.
How Can Leasing Help My Financial Picture?
You may ask why should you lease equipment
rather than take a bank loan? For one thing, leasing allows you to keep your bank lines of
credit open. In addition, since leasing companies assume there will be a residual value in
the equipment at the end of the lease, they can offer lower rental payments, equaling a
cash savings to you.
Finally, some types of term debt can
interfere with your company's future financial structure; this does not occur with
leasing. The Financial Accounting Standards Board (FASB) considers lease rental payments
as an expense, not a debt, under many lease agreements.
A key advantage of leasing is that it
permits 100 percent financing, and the term of the lease can be matched with the useful
life of the equipment. Therefore, if cash flow is a problem, leasing can help your company
avoid down payments and keep scheduled payments low by stretching out repayment terms.
Moreover, as your business grows, bank lines of credit and your own cash are still
available to support increases in your company's working capital requirements.
Who are the Lessors?
There are four basic types of leasing companies:
- Banks, or bank-affiliated firms.
- Captive leasing companies - subsidiaries of equipment manufacturers, leasing their parent's products.
- Independent leasing companies, whether small and specialized or large and diversified.
- Others, such as investment bankers, and independent brokers/packagers who bring the parties of a lease together.
Over 850 equipment leasing companies belong
to the Equipment Leasing Association of America (ELA), which was founded in 1961. ELA
members agree to follow the association's Code of Fair Business Practices, which advocates
confidentiality regarding the lessee's financial information as well as proper disclosure
to the lessee of all relevant information regarding the terms and conditions of the lease.
Anyone may obtain a copy of the code from ELA's Arlington, Virginia headquarters.
Equipment Leasing Association of America
1300 North 17th Street, Suite 1010 Arlington, Virginia 22209 Phone 703/527-8655 Fax 703/527-2649
Glossary
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Accelerated Cost Recovery System
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(ACRS) (Modified) The Tax Reform Act of 1986
established the modified ACRS tax appreciation system by prescribing depreciation methods
for each ACRS class in lieu of statutory tables. Equipment is assigned among 3, 5, 7, 10,
15, or 20 year classes depending on ADR lives.
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Alternative Minimum Tax (Amt.)
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An alternative, separate tax calculation
based on the taxpayer's regular taxable income, increased by the taxpayer's preferences
for the year. The resulting amount is called the alternative minimum taxable income
(AMTI). After certain exemptions and offsets, the taxpayer determines its AMT and is
required to pay the larger of the regular tax or alternative minimum tax. Among the
preferences that can increase the taxpayer's AMTI is the accelerated portion of
depreciation, thereby making it more likely that a taxpayer who buys equipment may be
subject to the AMT rather than to regular tax.
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Bargain Purchase Option
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A lease provision allowing the lessee, at its option, to purchase the equipment
for a price predetermined at lease inception, that is substantially lower than
the expected fair market value at the date the option can be exercised.
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Big-Ticket
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A market segment, generally dominated by
leveraged leases, represented by lease financings over $2 million.
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Broker
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A company or person who arranges, for a fee, transactions between lessees and lessors of an asset.
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Capital Lease
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Type of lease classified and accounted for
by a lessee as a purchase and by the lessor as a sale or financing, if it meets any one of
the following criteria: (a) the lessor transfers ownership to the lessee at the end of the
lease term; (b) the lease contains an option to purchase the asset at a bargain price; (c)
the lease term is equal to 75 percent or more of the estimated economic life of the
property (exceptions for used property leased toward the end of its useful life); or (d)
the present value of minimum lease rental payments is equal to 90 percent or more of the
fair market value of the leased asset less related investment tax credits retained by the
lessor. (Also see finance lease.)
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CERTIFICATE OF ACCEPTANCE (Delivery and Acceptance)
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A document whereby the lessee acknowledges
that the equipment to be leased has been delivered, is acceptable, and has been
manufactured or constructed according to specifications.
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Direct Financing Lease (Direct Lease)
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A non-leveraged lease by a lessor (not a
manufacturer or dealer) in which the lease meets any of the definitional criteria of a
capital lease, plus certain additional criteria.
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Economic Life (Useful Life)
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The period of time during which an asset will have economic value and be usable.
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Effective Lease Rate
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The effective rate (to the lessee) of cash flows resulting from a lease transaction.
To compare this rate with a loan interest rate, a company must include in the cash
flows any effect the transactions have on federal tax liabilities.
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Equity Participant
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The owner participant, trustor owner, or grantor owner.
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Equipment Schedule
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A document that describes in detail the equipment being leased. It may also state the
lease term, commencement date, repayment schedule and location of the equipment.
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Fair Market Purchase Option
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An option to purchase leased property at the
end of the lease term at its then fair market value. The lessor does not have the ability
to retain title to the equipment if the lessee chooses to exercise the purchase option.
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Finance Lease (See Single Investor Lease.)
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Typically, a finance lease is a full-payout, noncancellable agreement, in which the
lessee is responsible for maintenance, taxes, and insurance.
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Full Payout Lease
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A lease in which the lessor recovers,
through the lease payments, all costs incurred in the lease plus an acceptable rate of
return, without any reliance upon the leased equipment's future residual value.
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Guideline Lease
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A lease written under criteria established by the IRS to determine the availability of tax benefits to the lessor.
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Hell-or-High-Water Clause
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A clause in a lease that reiterates the unconditional obligation of the lessee to pay
rent for the entire term of the lease, regardless of any event affecting the equipment
or any change in the circumstances of the lessee.
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Indemnity Clause
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A clause in which the lessee indemnifies the lessor from loss of tax benefits.
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Indenture of Trust (Indenture)
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An agreement between the owner trustee and
the indenture trustee: The owner trustee mortgages the equipment and assigns the lease and
rental payments under the lease as security for amounts due to the lenders. Same as a
security agreement or mortgage.
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Lease
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A contract in which one party conveys the
use of an asset to another party for a specific period of time at a predetermined rate.
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Lease Rate (Rental Payment)
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The periodic rental payment to a lessor for the use of assets. Others may define lease
rate as the implicit interest rate in minimum lease payments.
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Lessee
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The user of the equipment being leased.
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Lessor
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The party to a lease agreement who has legal
or tax title to the equipment, grants the lessee the right to use the equipment for the
lease term, and is entitled to the rentals.
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Leveraged Lease
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In this type of lease, the lessor provides
an equity portion (usually 20 to 40 percent) of the equipment cost and lenders provide the
balance on a nonrecourse debt basis. The lessor receives the tax benefits of ownership.
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Master Lease
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A contract where 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.
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Middle Market
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A market segment generally represented by
financings under $2 million and dominated by single investor leases.
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Net Lease
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A lease wherein payments to the lessor do
not include insurance and maintenance, which are paid separately by the lessee.
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Nonrecourse Loan
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In a leveraged lease, the lenders cannot
look to the lessor for repayment. The lender's only recourse is to the lessee and,
therefore, the lessee's credit rating is of prime importance.
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Open-End Lease
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A conditional sale lease in which the lessee
guarantees that the lessor will realize a minimum value from the sale of the asset at the
end of the lease.
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Operating Lease
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Any lease that is not a capital lease. These
are generally used for short term leases of equipment. The lessee can acquire the use of
equipment for just a fraction of the useful life of the asset. Additional services such as
maintenance and insurance may be provided by the lessor.
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Packager
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The leasing company, investment banker, or broker who arranges a leveraged lease.
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Present Value
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The current equivalent of payments or a
stream of payments to be received at various times in the future. The present value will
vary with the discount interest factor applied to future payments.
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Purchase Option
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A provision by which a lessee has the right
to purchase the equipment at the end of the lease. The purchase option may be stated at a
specified amount or at fair market value.
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Put Option
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The requirement to purchase equipment at a
particular time and at a predetermined price. In a lease transaction, this is a lessor's
right to force the lessee (or some third party) to purchase the equipment at the end of
the lease term. IRS guidelines prohibit put options in tax-oriented leases.
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Residual Value
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The value of an asset at the conclusion of a lease.
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Sale-Leaseback
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An arrangement whereby equipment is
purchased by a lessor from the company owning and using it. The lessor then becomes the
owner and leases it back to the original owner, who continues to use the equipment.
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Sales-Type Lease
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A lease by a lessor who is the manufacturer or dealer, in which the lease meets the
definitional criteria of a capital lease or direct financing lease.
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Single Investor Lease (See Full Payout or Finance Lease.)
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A tax-oriented lease whereby the lessor achieves its desired rate of return via a
combination of the rental payments, depreciation, and the fair market value of the
equipment at the end of the original lease term. Because of the value of the tax
benefit, the rental payments will be lower than for a finance lease.
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Small-Ticket Leasing
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Transactions under $100,000, typically using conditional sale leases or single investor true leases.
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Tax Lease
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A lease wherein the lessor recognizes the
tax incentives provided by the tax laws for investment and ownership of equipment.
Generally, the lease rate factor on tax leases is reduced to reflect the lessor's
recognition of this tax incentive.
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Trac Lease
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A tax-oriented lease of motor vehicles or trailers that contains a terminal rental
adjustment clause and otherwise complies with the requirements of the tax laws.
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True Lease
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A type of transaction that qualifies as a lease under the Internal Revenue Code. It
allows the lessor to claim ownership and the lessee to claim rental payments as tax deductions.
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Trustee
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A bank or trust company that holds title to or a security interest in leased property for
the benefit of the lessee, lessor, and/or creditors of the lessor. A leveraged lease often
has two trustees: an owner trustee and an indenture trustee.
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Vendor Leasing
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A working relationship between a financing
source and a vendor to provide financing to stimulate the vendor's sales. The financing
source offers leases or conditional sales contracts to the vendor's customers. The vendor
leasing firm substitutes as the captive finance company of a manufacturer or distributor
through the extension of leasing to customers, provisions of credit checking, and
performance of collections and operational administration. Also known as lease asset
servicing or vendor programs.
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