Why Lease?

You hear many suggestions about why companies should lease equipment rather than buy it. Let us look at some sensible reasons and then at four more dubious ones.

1. Sensible Reasons for Leasing

Short-Term Leases Are Convenient Suppose you want the use of a car for a week. You could buy one and sell it seven days later, but that would be silly. Quite apart from the fact that registering ownership is a nuisance, you would spend some time selecting a car, negotiating purchase, and arranging insurance. Then at the end of the week you would negotiate resale and cancel the registration and insurance. You might also have a hard time explaining to sus­picious would-be buyers why you are selling the car so soon. When you need a car only for a short time, it clearly makes sense to rent it. You save the trouble of registering ownership, and you know the effective cost. In the same way, it pays a company to lease equipment that it needs for only a year or two. Of course, this kind of lease is always an operating lease.

Sometimes the cost of short-term rentals may seem prohibitively high, or you may find it difficult to rent at any price. This can happen for equipment that is easily damaged by careless use. The owner knows that short-term users are unlikely to take the same care they would with their own equipment. When the danger of abuse becomes too high, short-term rental markets do not survive. Thus, it is easy enough to buy a Lamborghini Gallardo, provided your pockets are deep enough, but it is much harder to rent one.

Cancellation Options Are Valuable Some leases that appear expensive really are fairly priced once the option to cancel is recognized. We return to this point in the next section.

Maintenance Is Provided Under a full-service lease, the user receives maintenance and other services. Many lessors are well equipped to provide efficient maintenance. However, bear in mind that these benefits will be reflected in higher lease payments.

Standardization Leads to Low Administrative and Transaction Costs Suppose that you operate a leasing company that specializes in financial leases for trucks. You are effectively lending money to a large number of firms (the lessees) that may differ considerably in size and risk. But, because the underlying asset is in each case the same salable item (a truck), you can safely “lend” the money (lease the truck) without conducting a detailed analysis of each firm’s business. You can also use a simple, standard lease contract. This standardization makes it possible to “lend” small sums of money without incurring large investigative, admin­istrative, or legal costs.

For these reasons leasing is often a relatively cheap source of cash for the small company with few tangible assets to support a debt issue.^[2] It offers secure financing on a flexible, piecemeal basis, with lower transaction costs than in a bond or stock issue.

Tax Shields Can Be Used The lessor owns the leased asset and deducts its depreciation from taxable income. If the depreciation tax shields are more valuable to the lessor than to the asset’s user, it may make sense for the lessor to own the equipment and pass on some of the tax benefits to the lessee in the form of low lease payments.

Lessors May Fare Better Than Lenders in Bankruptcy Lessors in financial leases are in many ways similar to secured lenders, but lessors may fare better in bankruptcy. If a lessee defaults on a lease payment, you might think that the lessor could pick up the leased asset and take it home. But if the bankruptcy court decides that the asset is “essential” to the lessee’s business, it affirms the lease. Then the bankrupt firm can continue to use the asset. It must still make the lease payments, however. This can be good news for the lessor, who is paid while other creditors cool their heels. Even secured creditors are not paid until the bankruptcy process works itself out.

If the lease is not affirmed but rejected, the lessor can recover the leased asset. If it is worth less than the present value of the remaining lease payments, the lessor can try to recoup this loss. But in this case the lessor must get in line with unsecured creditors.

Unfortunately for lessors, there is a third possibility. A lessee in financial distress may be able to renegotiate the lease, forcing the lessor to accept lower lease payments. For example, in 2001 American Airlines (AA) acquired most of the assets of Trans World Airlines (TWA). TWA was bankrupt, and AA’s purchase contract was structured so that AA could decide whether to affirm or reject TWA’s aircraft leases. AA contacted the lessors and threatened to reject. The lessors realized that rejection would put about 100 leased aircraft back in their laps to sell or re-lease, probably at fire-sale prices. (The market for used aircraft was not strong at the time.) The lessors ended up accepting renegotiated lease rates that were about half what TWA had been paying.^[3]

Lessees May Sidestep the Limitation on Debt Interest The 2017 Tax Cuts and Jobs Act lim­ited the tax deductibility of interest payments to 30% of earnings before interest and deprecia­tion. Companies that are up against this limit may find it convenient to lease new equipment rather than to borrow in order to buy it. The rental payments on the lease are fixed obligations like debt interest, but there is no restriction on the company’s ability to deduct them when calculating its tax liability.

2. Some Dubious Reasons for Leasing

Leasing Avoids Capital Expenditure Controls In many companies, lease proposals are scru­tinized as carefully as capital expenditure proposals, but in others, leasing may enable an operating manager to avoid the approval procedures needed to buy an asset. Although this is a questionable reason for leasing, it may be influential, particularly in the public sector. For example, city hospitals have sometimes found it politically more convenient to lease their medical equipment than to ask the city government to provide funds for purchase.

Leasing Preserves Capital Leasing companies provide “100% financing”; they advance the full cost of the leased asset. Consequently, they often claim that leasing preserves capital, allowing the firm to save its cash for other things.

But the firm can also “preserve capital” by borrowing money. If Greymare Bus Lines leases a $100,000 bus rather than buying it, it does conserve $100,000 cash. It could also (1) buy the bus for cash and (2) borrow $100,000, using the bus as security. Its bank balance ends up the same whether it leases or buys and borrows. It has the bus in either case, and it incurs a $100,000 liability in either case. What’s so special about leasing?

Leases May Be Off-Balance-Sheet Financing In the United States, the Financial Account­ing Standards Board (FASB) distinguishes between financial leases and operating leases. It defines financial leases as leases that meet any one of the following requirements:

1. The lease agreement transfers ownership to the lessee by the time that the lease expires.
2. The lessee can purchase the asset for a bargain price when the lease expires.
3. The lease lasts for at least 75% of the asset’s estimated economic life.
4. The present value of the lease payments is at least 90% of the asset’s value.

For many years, only financial leases needed to be shown on the balance sheet. Therefore, if a firm could structure a lease so that it was classified as an operating lease, it could understate the true degree of financial leverage. As a result, more than a trillion dollars in lease obliga­tions were not recorded on company balance sheets. In 2016, the FASB moved to plug this gap by introducing new rules that require all leases with terms of more than a year to be shown on the balance sheet. From 2019, when the new rules start to come into effect, the opportunities for companies to use leasing as a way to hide their leverage will largely disappear.⁵

Source:  Brealey Richard A., Myers Stewart C., Allen Franklin (2020), Principles of Corporate Finance, McGraw-Hill Education; 13th edition.