Leasing vs Purchasing Computer Equipments - Term Paper Example

LEASING Vs. PURCHASING TABLE OF CONTENTS Cover Letter/ Memo …………………………………………………… 3 Executive Summary …………………………………………………. 4 Introduction …………………………………………………………. 5 Research Contexts …………………………………………… 5 Leasing: Overview …………………………………………… 6 Types of Lease ……………………………………………… 7 Leasing or Buying Computer Equipments ………………………… 8 Arguments for Leasing ………………………………………… 8 Arguments for Outright Purchase: …………………………… 10 Analysis ……………………………………………………….. 11 Better option for the Hershey Inc ……………………………… 12 Evaluative Conclusions ……………………………………… 13 Recommendations …………………………………………………… 13 References …………………………………………………………… 14 I was recently prompted to draft for you a report on the leasing and purchasing of the computer equipments based on further investigation and research of relevant literatures. The Hershey Inc is thinking to expand its computer equipments and for that purpose, my senior Account Manager at the company has officially asked me to write a report comparing and contrasting Leasing vs. purchasing options for expanding its computers. I am pleased to prepare and submit this report to my CEO and I would like to inform you that this report is prepared based on reviewing the relevant literatures. The report presents brief discussion of advantages and disadvantages of both purchasing and leasing of computer equipments and provides recommendation based on the discussions. Executive Summary Taking decisions of choosing a financing mode is perhaps one of the major challenges that a business faces. For buying fixed assets, companies often consider various modes of financing like leasing, hire purchasing and mortgage, but taking an appropriate decision is always critical to the business success. The Hershey Inc. is considering Leasing and Purchasing as possible options for expanding its current computer equipments. This report is prepared to submit to the CEO of the Hershey Inc to help them decide on better financing option for expanding its computer requirements. This paper is an attempt to compare and contrast leasing and purchasing options focusing mainly on the financial benefits of both options. Based on the discussions of advantages and disadvantages of leasing vs. purchasing, the report recommends most beneficial action for the Hershey Inc to expand its computer equipments. The question of whether to lease or to purchase is a common dilemma and it is the case with the Hershey Inc too. Even though leasing doesn’t capitalize any fixed assets, it facilitates 100 % financing at fixed rate, protection against obsolescence, tax advantages and flexibility and therefore a suggestion has been made that Leasing equipments will be more advantageous to the company. This report is prepared to help the company find solution for the dilemma of whether leasing or purchasing will be appropriate, effective and financially viable decision for the company’s success. Introduction Leasing has become one of the fastest growing modes of capital investment and has grown tremendously in popularity in recent years. Out of 600 companies that AICPA surveyed in 2004, 575 companies have disclosed Lease data (Kieso, Weygandt and Warfield, 2007, p. 1087). In today’s complex and competitive business contexts, many businesses choose easy and riskless financing methods and thus they would rather lease equipments than buying it. The primary advantage of leasing rather than buying equipments is that a lease generally provides lower effective interest rates and the initial spending are not as large as the down payment required for a conventional loan. The main issue being discussed in this paper is whether leasing or purchasing would be more beneficial for the Hershey Inc for expanding its computer equipments. Rather than taking a decision with no further investigation and research of related factors, the company wants to study the contexts and review the literatures in order to take wise decision regarding buying or leasing of the computer equipments. This paper presents detailed analysis of the factors determining whether leasing computer equipments or buy would be good option for the company. Research Contexts The major theme being discussed in this piece of research paper is whether leasing computer equipments or purchasing it would be beneficial for a company. Main arguments for and against leasing and outright purchasing are detailed in this paper. The paper, based on the discussions and literatures, suggests that leasing is better option than purchasing of the equipments. The research is limited to the current issue that Hershey Inc faces regarding whether leasing or purchasing would be beneficial, and therefore the suggestions made by this piece of research work cannot be considered as general recommendation for other companies with different contexts. The methodology used in this paper is solely explanatory research. Various literatures are included and reviewed in this paper in order to find a suggestion for the current issue of whether leasing or purchasing of computer equipments would be better option. Leasing: Overview Moe equipments are financed today by leasing than other financing methods like bank loan, private placement or any other forms. Any asset that can be purchased can almost be leased as well. According to AAEL (American Association of Equipment Lessors), 80% of American companies depend on leasing each year to acquire the use of $200 billion of capital equipments (Nevitt, Fabozzi and Mathew, 2000, p. 3) Leasing is a form of capital financing which enables the firm to obtain the use of certain fixed assets for which it must make contractual, regular and tax-deductible payments to the lessor. Lessor is the owner of the asset where as Lessee is the receiver of the services of the assets under the lease contract (Gitman, 2006, p. 708). The important feature of leasing is that the use of the equipment is separated from its ownership. Leasing benefits both lessor and lessee that lessor receives periodical money for the assets and the Lessee generates extra income from the use of the assets (Deelen, 2003, P. 3). Leasing is an extensively used financial instrument because, whatever is its form, its relevance transcends tax efficiency and it has a number of universal benefits like preservation of working capital, mitigation asset obsolescence risk, 100 % financing opportunity etc (Boobyer, 2003, p. 2). When it comes to the equipments leasing, especially computer leasing, companies must consider the depreciation of the equipments and evaluate the projected life-span of the technology against the cost of implementing it. Technology is more likely to become obsolete very soon and therefore computer equipment leasing can be chosen only after proper evaluation and analysis of factors related to it. Types of Lease 1- Operating Lease: It is normally a contractual arrangement by which the lessee agrees to make periodic payments to the lessor to obtain an asset’s services. This type of leasing is cancellable because the lessee has an option can cancel this contract at any time on a penalty pay for the cancellation (Gitman, 2006, p. 709). Operating or service lease includes both financing and maintenance services. The lessor may be the manufacturer of the assets or a leasing company that buys from manufacturers only for leasing (Shim and Siegel, 2007, p. 351). The assets generally leased under operating lease arrangement have useful life longer than the period of lease. Computer equipments are prime examples of assets that its efficiency is more likely to diminish and therefore operating lease is a common practice for leasing computer equipments (Gitman, 2006, p. 709). 2- Financial (or Capital) Lease: A financial lease is non-cancellable and comparatively longer-term lease than operating lease. The lessee is obliged to pay for the use of an asset over a pre-determined period. This type of lease is generally used for acquiring land, building and equipments of large price (Gitman, 2006, p. 709). In contrast to the operating lease, financial lease does not provide for the maintenance service (Shim and Siegel, 2007, p. 351). As it is non-cancellable, it is similar to long-term debt and therefore failure to make payments can result in bankruptcy for the lessee. The total payments over the lease period would normally be greater than the lessor’s initial cost of the leased assets (Gitman, 2006, p. 709). 3- Sale and Leaseback: sale and leaseback is an arrangement that a company sells its own assets to another company and then leases it back (Shim and Siegel, 2007, p. 351). 4- Leveraged Lease: It is a leasing arrangement in which the lessor borrows funds for purchasing the assets from a third party, usually a financing institution like bank called lender (Shim and Siegel, 2007, p. 351). Leasing or Buying Computer Equipments To determine whether a lease or an outright purchasing would be more beneficial to a particular company, the arguments for and against buying and leasing options are to be considered. Moreover, the specific requirements and the environment of the company, including whether the company is running taxable or tax-exempt business or whether it wants to own the equipments at the end of the lease period or not, are also highly significant factors that can help determine whether leasing or buying would be beneficial (Reilly, 1993). Arguments for Leasing 1. 100% financing at fixed rates: The companies that need to acquire specific assets like equipments and vehicles can easily enter in to signing of leasing without requiring any money down. It is extremely helpful when the lessee company needs to conserve reserve cash and this is therefore very useful for start-up as well as developing companies (Kieso, Weygandt and Warfield, 2007, p. 1090). Raina and Bakker (2003) found that the 100% financing and no-down payment advantages in turn allow for better and effective cash management of working capital as well. Even though leasing is an extension of credit, it conserves bank credit lines due to its traditional status as renting and it requires payment for only the exact value of the use of the property (p. 73). 2- Protection against Inflation: Kieso, Weygandt and Warfield (2007) emphasized that lease payments, in most cases, remain fixed over the specific period, which in turn protects the lessee against the inflation and economic challenges and increases the cost of money (p. 1090). 3- Protection against Technology Obsolescence: Perhaps, it is the most important and fundamental factor in determining whether to lease or buy fixed capitals, especially computer and other technology equipments for a company. Leasing equipments reduces the risk and loss of obsolescence to the lessee. Another significant factor is that, in many cases, the risk of residual value is passed to the lessor. For instance, the lessee can turn in an old computer for a new one model or for latest technology at any time, by cancelling the old lease agreement and entering in to a new lease (Kieso, Weygandt and Warfield, 2007, 1090). As lessee does not own the properties being leased, he avoids the problem of holding assets that are becoming out of date (Alterowitz and Zonderman, 2006, p. 28). 4- Flexibility: As compared to other debt agreements, lease agreement often contains less restrictive provisions. Most lessors facilitate leasing agreements according to the specific requirements of the lessee (Kieso, Weygandt and Warfield, 2007, 1090) like rent vacation, step-up and step-down payments, pre-lease and interim financing package, early-out and continual upgrade chances and many other creative elements (Raina and Bakker, 2003, p. 73) that are custom-matched to the specific requirements of the lessee. Moyer, McGuigan and Kretlow (2009) emphasized that leasing is more suited to piecemeal financing and therefore companies find it more convenient to lease fixed capital than acquiring them through any other methods (p. 662). 5- Less Costly Financing: Leasing is widely considered as more appropriate for new and developing companies because they find it more cheaper than other forms of financing (Kieso, Weygandt and Warfield, 2007, 1090). 6- Tax Advantages: Leasing allows both lessor and lessee to have better utilization of tax benefits. Tax benefits, like accelerated depreciation for the assets being leased, are same as cash and are necessarily needed to spend on other needs. When companies lease assets, one of the major advantages is that they do not require to report an asset or liability for the lease arrangement and same time for the tax purposes they can capitalize and depreciate the leased assets as well (Kieso, Weygandt and Warfield, 2007, 1091, Raina and Bakker, 2003, p. 73). 6- Off-Balance Sheet Financing: Traditional leases are recorded as regular monthly expenses on company’s income statement rather than showing them as assets and consequent loan liabilities on the balance sheet. This off-balance sheet financing is considered as favorable financial condition for the lenders and investors (Alterowitz and Zonderman, 2006, p. 28). Arguments for Outright Purchase: Below are the main arguments for the outright purchasing of computer equipments in comparison with leasing of the same: 1- Ownership: In contrast to the leasing, outright purchase is characterized by passing ownership of the property immediately to the buyer. Leasing is thus not convenient for acquiring those properties that companies need immediate ownership, rather than renting or leasing them. The lessor retains the control of the leased assets where as outright purchase provides full ownership and control on the assets 2- Leasing means higher cost of borrowing because the lessee will be required to pay for the lessor’s profit objective as well as any lost residual values. The outright purchase option is thus helpful to reduce such costs of borrowing. 3- Payments equal to the actual value of the property: Outright purchasing does not cause spending of more money than the actual initial costs of the purchased assets, whereas in the case of financial leasing, the total payments over the lease period would normally be greater than the lessor’s initial cost of the leased assets (Gitman, 2006, p. 709). Analysis By comparing and contrasting the above detailed advantages and disadvantages of leasing and purchasing options, the following suggestions can be made: 1- Purchasing computer equipments causes large cash outflow whereas Leasing is helpful to overcome this issue and provides better working capital management. No down payment seems to be a major advantage of leasing option. 2- Computer equipments are more likely to become obsolete and therefore outright purchasing of it causes increased risks and losses associated with obsolescence of technology whereas leasing reduces the risks of technology obsolescence. 3- Leasing facilitates flexibility that the lessee can turn in a leased asset at any time for cancellation or for the exchange of the new machines by entering in to contracts where as purchased equipments can never be returned for technology change reason. 4- Outright purchase causes the cash outflow of a large amount that may not be affordable for a start-up or developing company whereas leasing facilitates periodic and fixed payment that in turn saves it from the inflation. 5- An outright purchase of large equipments necessitates that the company should properly be record it in the accounts and no tax benefits, whereas leased assets enjoy tax benefits. Better option for the Hershey Inc Based on the above analysis, it is obvious that Leasing will be the more effective, profitable and financially viable choice for the Hershey Inc for the expansion of computer equipments, because of the following reasons: Computer equipments are very likely to be obsolete and therefore leasing can protect it from the risk of obsolescence Leasing protects the company from inflation Leasing helps better working capital management No-down payment is required Evaluative Conclusions This piece of research paper has highlighted major arguments for leasing computer equipments and purchasing options and based on the final analysis it has suggested that leasing would be more appropriate, convenient and profitable option for the Hershey Inc to expand its computer equipments. If the company goes for purchasing them, it would require a huge spending on those assets that are more likely to become obsolete within the few years to come, especially in today’s fast changing technology environment. The outright purchase will certainly cause a huge initial spending that will affect the company’s financial strength whereas Leasing facilitates periodic payment that helps manage working capital in a better way. Tax benefits and protection from inflation are also considered as major advantages of leasing that help determine that leasing is more suitable option for the company than purchasing the computer equipments. Recommendations This paper has highlighted fundamental factors that determine whether leasing computer equipments or purchasing them will be more beneficial for a particular company. Further investigation will be helpful to find out most beneficial mode of financing out of various financing modes like loan, hire purchase, issue of shares, issue of debentures, leasing, outright purchase and venture capital for acquiring assets that become obsolete within few years like computer equipments. References Alterowitz R and Zonderman J, 2006, Financing your business made easy, Illustrated edition, Entrepreneur Press Boobyer C, 2003, Leasing and asset finance: the comprehensive guide for practitioners, Fourth illustrated edition, Euromoney Books Deelen L, 2003, Leasing for small and micro enterprises: a guide for designing and managing leasing schemes in developing countries, International Labour Organization Gitman L J, 2006, Principles of Managerial Finance, Addison Wesley, Pearson Education, Inc, USA Kieso D E, Weygandt J R and Warfield T D, 2007, Intermediate Accounting, Twelfth Edition, John Wiley and Sons, USA Moyer R C, McGuigan J R and Kretlow W J, 2009, Contemporary Financial Management, Eleventh Edition, Cengage Learning Nevitt P K, Fabozzi F J and Mathew J V, 2000, Equipment leasing, Fourth illustrated edition, John Wiley and Sons Raina L and Bakker M R, 2003, Non-bank financial institutions and capital markets in Turkey, Illustrated edition, World Bank Publications Reilly K F, 1993, Leasing vs. buying: Which is cheaper?, Club Management, St Luis, Finan Publishing Company, Inc, Retrieved from http://proquest.umi.com/pqdweb?did=7561327&sid=1&Fmt=3&clientId=13118&RQT=309&VName=PQD Shim J K and Siegel J G, 2007, Schaum's Outline of Financial Management, Illustrated Third edition, McGraw-Hill Professional Read More