Often you hear one or both of the following statements when CIOs and IT pros discuss leasing computer hardware:
- Leasing eliminates the risk of technology obsolescence.
- Leasing saves money.
If executed properly, leasing provides flexibility and shifts technology risk to the lessor. Lessors are compensated for taking risk, and the specific terms and end-of-lease details for each leasing transaction ultimately determine the cost of that flexibility.
When tech leaders say they’re leasing because “it saves money,” it’s usually shorthand for one of the following reasons:
- Leasing reduces short-term cash outflow.
- Leasing exerts a smaller impact on the annual budget.
- Leasing presents the best economic option, because it limits cash outflow, has a smaller impact on my budget, and is the only viable choice.
Weighing the benefits to the company and the business unit
Since leasing allows enterprises to stretch the payment for the use of the computer hardware over a multiyear term, the first two reasons hold true. The first reason is often the cash-constrained company’s primary basis for leasing. If the company’s cash and credit position is constrained, leasing is more favorable than purchasing.
The second reason for leasing comes into play when corporate managers try to squeeze the maximum resources out of a limited budget. Leasing is typically an individual business unit management decision—the business unit either doesn’t have the budget to support a purchase or the business leaders want to sidestep a formal purchase approval process, so they lease. If an individual manager’s budget situation is constrained, leasing is more favorable than purchasing for that manager. Whether leasing is more economically favorable for the company is another question.
The best approach to making that decision is with an economic analysis. The evaluation usually consists of a discounted cash flow analysis of the projected cash flows associated with the lease and purchase scenarios. Discounted cash flow analysis considers the time-value of money. Consider this example: You can either purchase hardware today for $12,000 or lease it over three years at an annual net cash outflow of $4,000. In both cases, the total cash outflow is the same, but the values of those cash outflows in today's dollars differ. While the value for the purchase option is $12,000, the value of the lease option would be less than $12,000 because you could earn an investment return on cash you retained over those three years.
The cash flow projections rely on assumptions regarding several factors, such as hardware requirements, expected market life, and the term of lease needed. It is those assumptions that will determine whether leasing is the right decision to make.
The assumptions regarding those factors drive the projected cash flows.
To make an educated decision, a technical manager should understand each of the following factors and provide related assumptions for any lease analysis.
- Useful life of the hardware within the organization
- Useful life of the hardware in the marketplace
- Expected end of lease action (e.g., return, renew, purchase)
- Possible pre-end of lease actions (e.g., termination, upgrade)
- Organization’s asset management capabilities
The useful life within an organization determines the most appropriate lease term. The useful life of the hardware in the marketplace is key because its relationship to the useful life in your organization determines whether lessors might provide an economically attractive lease.
The third and fourth factors are critical because the final actions will ultimately determine whether the lease made economic sense. Considering these factors and reviewing actual past experience will also help IT executives identify specific terms (e.g., early termination schedule, renewal rates, purchase rates, substitution rights) to include in the lease.
The final factor is important when dealing with distributed assets like PCs. Leasing does not magically eliminate the need for effective asset management. Consequently, if you don’t effectively manage distributed assets, you must consider the potential impact of those poor practices on the economics of a leasing decision.
The best approach may be a mixed approach
Because computer hardware leasing decisions are typically made by individual business units within an enterprise, the most common scenario is that companies have a mixed leased/owned equipment landscape in house.
Figure A provides some general guidelines on what characteristics define hardware lease candidates vs. purchase candidates. Although these guidelines aren’t a substitute for an economic analysis that considers the factors previously discussed, they provide a quick check.
There’s always going to be a lively and unique discussion among IT leaders and business chiefs when the leasing vs. purchase issue is suggested within a business unit due to the various factors at play—such as budget constraints and a technology’s life expectancy. Forecasting the actual consequences of the leasing decision is critical to making the right decisions for the enterprise.