What you need to know
about financing
“What you need to know about financing” is a list of
questions and answers designed to help you and the brand
sales team understand the basic concepts and benefits of
financing. They are introductory in nature and designed to
be used as a springboard to understanding IGF and how
financing can help you reach your sales goals.
The subjects discussed on the following pages are:
What are the advantages of leasing versus buying?
What are non-financial reasons customers lease?
What is the difference between a lease and a loan?
What is the time value of money and how does it impact a decision to acquire an asset?
What is residual value and why is it important?
How is residual value estimated?
What is the pricing yield and how does it differ from the customer’s Internal Rate of
Return (IRR)?
What are the differences between a full payout lease and a fair market value lease?
What is the difference between capital leases and operating leases?
What is the 7D Test and why is it important?
What is the Incremental Borrowing Rate (IBR) and when is it used?
What is weighted average cost of capital (WACC) and what does it include?
What are the tax benefits of leasing to customers?
What is Alternative Minimum Tax? How can leasing help?
1
March 2003
What you need to know about financing
What are the advantages of leasing versus buying?
There are many good reasons to lease rather than purchase IT equipment. Some of the
most common are: free cash for other uses; lower monthly payments; budget planning; flexible
payment options; simplify budget management; and cash management.
Free cash
Most leases do not require down payments. The customer only uses cash required for the
monthly payments, conserving the balance of the purchase cash for other investments.
Lower monthly payments
All other things being equal, a fair market value lease will always result in lower monthly
cash outflows when compared to loan. With a lease, the customer only pays for the portion of
the equipment that will be used. This portion is the difference between the original purchase
cost and the residual value at lease end.
Budget Planning
Leases and loans are fixed payment agreements and IT managers can easily plan for future
expenditures. This removes some of the uncertainty of the budget planning process.
Flexible Payment Options
The pattern of lease payments may be modified from a fixed monthly cost to a variable cost
to meet specific budget requirements. Most often lease payments are the same over the entire
term. However, a lease may be structured with deferred or low payments in the beginning of
the term which increase over time. In some cases lease payments can be higher in the
beginning and reduced over time. These structures require special handling but are available
to meet your customers’ needs. Typically banks will not structure such flexible loan
payments.
Simplify Budget Management
Lease billing can be designed to meet customers’ budget management requirements. For
example, equipment may be grouped together by department, user area or project. Quarterly
and semiannual billing are also available, subject to credit restrictions.
Cash Management
Leasing provides three key benefits to cash management; lower monthly payments through
leasing for FMV leases, 100% financing and fixed rate financing. Lower monthly payments
enable a customer to acquire more equipment for each budget dollar. One hundred percent
financing enables a company to conserve working capital and provides an alternate source of
funds. Finally, fixed rate financing aids in the budgeting process and locks in cost of
financing for the duration of the project.
2
March 2003
What you need to know about financing
What are non-financial reasons customers lease?
There are many non-financial reasons to lease including: asset management, equipment disposal,
technology hedging, and shifting risks of ownership to the lessor.
Asset Management
IBM Global Financing finances all IBM Equipment, some non-IBM Equipment, all IBM
one-time-charge software and almost all IBM services. IGF also guarantees, subject to credit
approval, funds will be available for follow-on financing of upgrades and additions to the
lease. All of the customer's IT financing may be done through a single source, eliminating
the problems associated with managing relationships with multiple funding sources.
Equipment Disposal
Eventually equipment is no longer useful and must be discarded. Customers who have access
to the used equipment markets may be able to sell the obsolete equipment. This ready access
is unlikely. The process of disposing of computer equipment, particularly monitors and
processors is tightly regulated by EPA and can be expensive. In addition, customers may
have stranded assets on their accounting books. This means the book value exceeds the
market value. The company will be forced to retain the equipment beyond its usefulness or
write down the value of the equipment. Either alternative is sub-optimal to customers.
Leasing eliminates all of these problems. At the end of the lease, the customer can simply
return the equipment to IBM Global Financing.
Technology hedge
Historically, computer technology has changed rapidly and this is a continuing trend. In ideal
circumstances an IT manager exactly matches computer hardware to application
requirements. Leasing provides customers the flexibility needed to upgrade and change
equipment in a timely and cost effective manner. This facilitates orderly application growth
and development and helps control costs.
Ownership Risks shifted to the lessor
There are myriad risks associated with equipment ownership such as physical tracking of
assets, configuration management, property tax reporting, equipment disposal, insurance
reporting, and accounting considerations. As the owner of the leased equipment, IGF
assumes many of these risks.
For example, all personal property tax filing is done by IGF, not the customer. While
customers must report upon equipment location, they need not file tax returns in what may be
multiple locations with different reporting dates and modalities. IGF leases may also include
casualty insurance and help manage end of lease options to minimize the efforts associated
with equipment disposal. Finally, IGF offers services to help customers track and manage
their installed computer assets.
3
March 2003
What you need to know about financing
What is the difference between a lease and a loan?
While both are legal agreements between financier and user, leasing separates the concepts
of usage and ownership. With a loan, the user owns the equipment and the financier lends the
customer funds to pay off the financial obligation associated with the equipment acquisition.
With a lease, the user of the equipment is the lessee and the owner is the financier or lessor.
What is the time value of money and how does it impact a decision to acquire an asset?
During normal inflationary economic conditions, a currency value, say one dollar, has more
purchasing power today than one dollar received some time in the future. When a company
acquires an asset, it assumes financial benefits will flow over time from use of the asset. The
company must calculate the benefits of using the assets over time as the purchasing power of
its currency weakens. The company anticipates the estimated cash outflows associated with
making the investment and running the business, and the cash inflows generated by the
investment. Time value of money concepts are used to analyze these outflows and inflows in
terms of today’s currency value and ensure that the investment will add value to the
company.
What is residual value and why is it important?
Residual value is the actual or anticipated value of leased equipment at the end of the lease
term. It is a key component in pricing a lease because it is included when analyzing the yield
of the cash flows of a lease. The higher the anticipated residual value at lease end, the lower
the lease payment.
How is residual value estimated?
Residual Values are estimated by IBM Global Financing’s pricing methodology organization.
Valuations are based upon many factors including; product life cycle, product availability and
roll out, competition, and historical RV’s. As a captive lessor, IGF has visibility to the IBM
product plan. .
What is the pricing yield and how does it differ from the customer’s Internal Rate of
Return (IRR)?
The lessor’s pricing yield is equal to the interest rate used to calculate payments charged in a
lease. It must recover cost of debt and expense, as well as compensate the business for credit
risk, and make profit. The customer’s IRR is the rate which equates the present value of the
lease payments to the purchase price financed. With a fair market value lease, if the customer
does not buy the asset at the end of the transaction, the IRR will be lower than the lessor’s
pricing yield. With a Full Payout Lease, it is possible for the customer’s IRR to be the same
as the pricing yield. IGF does not disclose its pricing yields to customers.
4
March 2003
What you need to know about financing
What are the differences between a full payout lease and a fair market value lease?
A full-payout lease is priced without a residual value assumption, so the lessor recovers all
costs associated with the transaction in the lease payments. A fair market value lease is
priced with a residual value assumption since the anticipated value of the equipment is
expected to be recovered at lease end. Therefore, the payments for a fair market value lease
are lower than the payments of a similarly structured full payout lease.
What is the difference between capital leases and operating leases?
These are accounting terms which are generally used throughout the world. Leases specify a
predetermined period of time the lessee will use the equipment as well as the amount and
frequency of payment, and end of lease options. The lessor and lessee will determine
independently of one another, the lease classification. With an operating lease, the lessor
assumes the lessee will return the equipment at the end of the contract and, at that time, the
equipment will have some residual value.
With a capital lease, the lessor assumes the customer will keep the equipment at the end of
the contract. This transaction will be structured like an installment payment agreement or
loan.
With both capital and operating leases, the lessor assumes the risks of ownership, such as
property tax reporting and equipment disposal at lease end. All other pricing variables being
equal, capital lease payments will be higher than operating lease payments.
From a customer’s perspective, a capital lease will appear on the balance sheet as an asset
and on the income statement in the depreciation and interest expense lines (like a loan). An
operating lease, or off balance sheet financing, will only appear in the footnotes of the
financial statements and as a lease expense in the income statement. Each party to the lease
will perform a separate analysis of the transaction to determine whether it is a capital or
operating lease.
What is the 7D Test and why is it important?
The Financial Accounting Standards Board (FASB) is the governing body of the accounting
profession in the United States. FASB Rule 13 outlines four tests to determine if a lease
should receive capital treatment. The tests are performed by both the lessor and the lessee
independently of one another at the inception of the lease. The fourth test, the 7D test, states
that if the present value of the lease payments at the beginning of the lease, (excluding costs
such as insurance, maintenance and taxes), is greater than or equal to ninety percent of the
purchase price financed, then the transaction is a capital lease. (paraphrased) The payments
are discounted at the customer’s incremental borrowing rate.
Usually the lessee wants the transaction to fail the 7D test so the lease may be classified as
operating. Operating leases are off balance sheet. This means the leased assets do not show
on the balance sheet, which may improve financial measurements such as return on assets
and debt to equity ratios.
5
March 2003
What you need to know about financing
Although FASB 13 is a US accounting rule, it is applied by IBM Global Financing
throughout the world. Of course, local accounting practices are followed for each country on
its local accounting books. Each country has two sets of accounting books, local and
consolidated. Customers may use FASB 13 or a more loosely defined standards such as
those defined by the International Accounting Standards Board (IASB) or their own
country’s accounting standards. However, if a company wishes to trade on one of the US
stock exchanges, it will use FASB 13 for lease classification on the financial statements it
reports to the United States Securities and Exchange Commission.
What is the Incremental Borrowing Rate (IBR) and when is it used?
The Incremental Borrowing Rate is stipulated by the FASB as the discount rate to be used to
determine whether a lease is operating or capital. It is defined as the incremental, pretax,
coterminous, secured, installment borrowing rate, without a compensating balance, that would be
used to purchase an asset if it were not leased. Therefore, it is potentially different for each
analysis. Further, it should be readily available and verifiable. Normally the IBR is higher than
the average debt cost but lower than the weighted average cost of capital. The discount rate used
to calculate the FASB 13, 7D test cannot exceed the IBR. The higher the discount rate, the lower
the present value of the payments and the more likely the lease will be operating.
What is weighted average cost of capital (WACC) and what does it include?
When a company invests in a new asset it can either borrow money to fund the purchase or use
stockholders’ investments (equity) in the company. The blend of all these debt costs and the
investors’ equity is the company’s weighted average cost of capital. WACC may be used as a
discount rate in the capital budgeting process and other financial analyses.
.What are the tax benefits of leasing to customers?
Tax classification of a lease is separate from accounting classification. If a lease is classified as a
tax lease then the lessor retains the risks of ownership and is entitled to the depreciation tax
benefits in the United States. The lessee, in this case, treats all lease payments as tax deductible
expenses. In a nontax lease, the risk of ownership is with the lessee who takes the tax benefits of
depreciation. The lessee would also be able to take a tax deduction on the interest portion of the
lease payments. Other countries may have similar tax benefits associated with depreciation, but
the laws regarding depreciation are unique to each country.
What is Alternative Minimum Tax (AMT)? How can leasing help?
AMT is a separate tax calculation the US taxpayer must perform. The corporate AMT rate,
although lower than the regular tax rate, is applied to a different, typically higher, taxable income
than for regular taxes. The taxpayer must pay the HIGHER of the two calculations.
If a customer must pay AMT, leases where the lessee has use of the equipment but the lessor is
the equipment owner (tax leases), help companies avoid or minimize the higher taxes associated
with AMT.
6
March 2003