Key Takeaways:
- Leasing can help preserve cash and make financial planning more predictable.
- Moving the depreciation benefits to a lessor can reduce the cost of financing.
- Leasing equipment can be a hedge against obsolescence.
- Leveraging equipment leasing could allow companies to gain a competitive edge and adapt more readily to market changes and technology innovations.
While companies can acquire equipment through many means, some methods might prove better than others in an unpredictable rate environment. Current volatility in rates could tilt the balance in favor of leasing, which offers a pathway to preserve capital.
Leasing equipment can provide flexibility, mitigate some of the risks associated with capital expenditures, and allow for quicker adaptation to market changes and advancements. This approach is particularly relevant to investments where the pace of innovation necessitates agility.
Let’s look at the strategic advantages of leasing against buying, considering the complexities of today’s economic environment and the pressing need for companies to maintain financial stability while seeking growth opportunities.
Economic landscape and corporate financing impact
Though the Fed has signaled rate cuts later in 2024, and the market outlook suggests the same, rate forecasts frequently miss targets. Long-term rates are up year-to-date as the expected date of the first short-term Fed Funds rate cut keeps being pushed further out and estimates of the ultimate size of the cuts continue getting smaller. For example, the 10-year treasury yield was 3.866% back on January 1st and is up to 4.196% as of March 27th. On January 2nd, the market believed the Fed would cut short-term rates by March, with only a 21% change of rates staying unchanged† – which is ultimately what occurred. At the March Fed meeting, the Federal Reserve Open Market Committee (FOMC) held steady on their benchmark rate for the fifth consecutive meeting.
This uncertainty has prompted some companies to delay or scale down investments that necessitate significant upfront capital to preserve cash. A National Association of Manufacturers (NAM) Q4 2023 outlook survey found respondents expect capital spending to rise 0.6% over the next 12 months, the slowest prediction since Q2 2020 – or Q2 2016, if we exclude the COVID-19 pandemic‡.
Concerns about ongoing inflation, elevated rates, and global conflicts all factor into a hesitancy to purchase equipment outright, leading companies to seek alternative options. The growing preference in acquiring equipment through some form of financing supports this sentiment: The Equipment Leasing and Finance Association (ELFA) forecasts 54% of equipment acquisitions in 2024 will be financed through leases, secured loans, or lines of credit§.
On the other hand, desire to support growth through capital expenditures is high.
In the battle between growing operations and preserving cash flow, leasing emerges as a strategic solution.
Capital preservation
Leasing allows companies to access the equipment they need without the substantial initial cash expenditure required for purchasing.
There are five ways in which companies can preserve cash through leasing:
- Fixed-payment leases offer protection from rate fluctuations that could impact loan repayments.
- Avoiding a significant upfront investment means cash can be put toward working capital and growth.
- Freight, taxes, fees, rigging, and set-up charges may be included in the equipment cost and amortized over the lease term.
- Though leasing does carry interest or financing charges embedded into these lease payments, those expenses are generally more predictable and can be lower than those associated with a loan.
- Leasing enables companies to strategically balance equipment expenses with revenue. For example, if a company requires certain equipment for a project, they can match their equipment usage and expenses with the revenue generated during the project to maximize cash flow.
Payment predictability could aid in financial planning and budgeting, which might be more attractive when the future of rates is uncertain. Furthermore, leasing does not tie up a company’s credit line to the same extent that loans do, preserving a company’s borrowing capacity for other uses.
Equipment depreciation bonus considerations
The bonus associated with an equipment purchase is an incentive for many companies to choose a loan over a lease. However, market fluctuations and regulatory changes can decrease this incentive, which in turn reduces the immediate tax savings associated with it. There are also limits on the amount of depreciation a business can claim each year.
Some types of leases, such as a capital lease, allow companies to keep the equipment on their balance sheet and afford them tax benefits. But if that is not desired – like the reasons above – there are other beneficial options.
Leasing equipment through a true lease offers numerous advantages in these situations:
- Lease payments are typically deductible as business expenses, providing a tax benefit even if companies cannot claim more depreciation.
- The lower cost of financing can offset the absence of depreciation deductions.
- Shifting the depreciation benefit to a financial institution can reduce the lessee’s financing cost by lowering the payments and overall cost associated with leasing the equipment.
To illustrate these advantages, below is an example comparing the after-tax economics of a lease versus loan finance structure of a $5 million equipment transaction.
Example of a Lease vs. Loan Financing Structure of an Equipment Deal
| Loan | Lease | |
|---|---|---|
| Transaction Cost | $5,000,000.00 | $5,000,000.00 |
| Term/Month | 60 | 60 |
| Balloon Payment | 20% | 20% |
| Billing | Arrears | Arrears |
| Monthly Payment | $83,938.18 | $80,739.12 |
| Net Present Value (NPV) | $5,036,290.01 | $4,844,341.19 |
| NPV Savings | N/A | $191,948.82 |
| Implicit interest Rate | 6.55% | 5.55% |
Companies whose goal is to enter a lease for flexibility or off-balance-sheet financing purposes should work closely with their accounting teams and tax advisors to review these considerations and understand the tax implications of their lease agreement(s).
Risk mitigation advantages
Companies opt for leasing for risk management as well, as it can offer a buffer against the risks associated with fixed capital investments in IT, medical technology, machinery, energy equipment, and other areas that experience rapid depreciation.
By leasing the equipment as opposed to purchasing it, the lessee can avoid obsolescence. Leasing offers the flexibility to purchase, renew, or return the equipment when the lease expires.
Leasing can also act as a hedge against market volatility and interest rate fluctuations. Fixed lease payments enable businesses to forecast and manage their cash flow more effectively, avoiding the uncertainty of variable-rate loans.
Leveraging leasing for a competitive edge
With the fast pace of technological and digital innovations, strategic leasing structures could offer a competitive advantage.
Leasing allows companies to stay technologically advanced without the financial burden of purchasing equipment outright or the weight of outdated assets on their balance sheet.
Research forecasts the global machinery and industrial automation market size to reach a value of $407 billion by 2032, up from $185 billion in 2022≠.
This rise is due in part to the rapid advancements in robotics, AI, and IoT, which is being increasingly adopted to improve efficiency and scale operations.
Choosing to lease equipment in these areas could allow companies to adapt to market changes and technological innovation more readily. Partnering with a financial institution and staying informed about market trends and interest rate forecasts can help companies plan their strategies effectively.
Benefits of leasing amidst rate uncertainty
Economic uncertainty poses undeniable challenges for businesses aiming to expand or update their capabilities. By enabling capital flow preservation, offering flexibility, mitigating risks, and providing a competitive edge, leasing emerges as a compelling choice for businesses.
Many factors impact how your organization acquires equipment in any economic environment. Huntington’s Equipment Finance Group can help you determine which option might be right for you. Reach out to start the conversation.
