Southern Lending Solutions

To continue the argument of Use v Ownership and why Leasing benefits the small business owner, I have gotten down to some raw numbers based on our last week’s example. We have a 50k piece of equipment financed through a loan v leased for 36 months. The other assumptions are use of MACRS accelerated depreciation and a sales tax of 7%. This tells the story better than I can but please feel free to email me @ Stu@southernlendingsolutions.com with any questions or for the more detailed chart outlining this study.

Stu Lustman

Southern Lending Solutions

I often get asked ‘Why should I lease equipment that I need in the course of my business’?

Here is an example I often use to explain to people why:

Imagine yourself as a business owner that makes and sells widgets. This year the big widget making machine is the Widget Pro 1000 and it costs $50,000. You need this machine (or one like it) to make the widgets that you will then sell. You have 2 options:

A) You buy the equipment either with your own cash or through a loan with a bank
B) You lease the equipment instead over 3 years with a 10% Purchase Option at the end of the period

Each has advantages and disadvantages. With Option A, the overall cost is less over that same 3 year period and you get to depreciate the 50k cost over 5 yrs with one of the 3 depreciation methods previously discussed. Those are the advantages.

With Option B, you are paying a little more than a loan and thats the big disadvantage. The advantages? One advantage is every dollar of every lease payment is tax deductible, so we are not limited to the 50k purchase price. Let’s see the biggest advantage though:

2 Years From Now, the Widget Pro 2000 comes out and provides 15% more output for the same cost or saves 15% for the same level of production, a significant technological upgrade. What can we do about it?

Human nature dictates that when we pay for something and own it, we want to get maximum use out of it so since there is likely 5-6 years use in the WP 1000, it means we are likely to keep it another 3 yrs even though we know better is out there? Why? Because we feel like we are throwing our $$ away if we don’t. The biggest hidden disadvantage of ownership is right here, feeling like we are locked into outdated, obsolete equipment because we bought it. If you think you would make the smarter business choice of the immediate upgrade, then think about how many break/fix computer guys there are to help extend the life of computers and you know its just not true.

With a lease, we are locked into one more yr, use the purchase option to RETURN the equipment that is now outdated, and upgrade to the WP 2000 right away so we can increase output, lower our costs, or both.

So which way is really cheaper in the end?

Stu Lustman

Southern Lending Solutions

Lease rates are often determined by two things that most people are not aware of. Those two things are 3 and 5 Year Treasury Rates and 3 and 5 Year Treasury Interest Rate Swaps.

3 and 5 year Treasuries are something many people are aware of. They are bonds issued by the Federal Government with a 3 or 5 year period until maturity, when the repayment of principal occurs. Interest payments are made in the interim on a quarterly or annual basis. They are the basis for some lease rates because the average lease period is 3-5 years.

Interest Rate Swaps
An Interest Rate Swap is An exchange of interest payments on a specific principal amount. This is a counterparty agreement, and so can be standardized to the requirements of the parties involved.  Counterparty agreements within finance usually mean the 2 parties holding the agreements are financial firms, professional firms or even law firms or other legal entities like an offshore investment fund.

An interest rate swap usually involves just two parties, but occasionally involves more. Often, an interest rate swap involves exchanging a fixed amount per payment period for a payment that is not fixed (the floating side of the swap would usually be linked to another interest rate, often the LIBOR, London’s version of The Prime Rate). In an interest rate swap, the principal amount is never exchanged, it is just a notional principal amount so it is just used to determine the amount and terms of payment streams being swapped. Also, on a payment date, it is normally the case that only the difference between the two payment amounts is turned over to the party that is entitled to it, as opposed to exchanging the full interest amounts. Thus, an interest rate swap usually involves very little cash outlay.  Current rates are 1.00% for 3 Year and 1.95% for 5 Year Treasuries.

Why do firms engage in swaps? Primarily to either match payments with their expenses at that given time OR because they believe it reduces some of their portfolio risk in their loan and lease portfolios.

The next factor is the risk related to that specific deal.  A lower risk transaction might only be priced at 50 or 100 basis points (0.50% or 1.00%) ABOVE the current Treasury rates.  Higher risk transactions will be priced higher of course like 200 or 300 basis points above Treasury rates.

So to get an idea of how rates are going in the marketplace, its wise to check on the trend in Treasuries Rates to get an idea of what you could be paying, although equipment types, terms and leasing structure will affect the overall lease payment as well.

Stu Lustman

Southern Lending Solutions