The Lease you can do

The Lease you can do

Giving finance the lowdown on IS leasing can save the company moneySuppose a company, let's call it Moore Power Tuya, needs to boost its data centre's computing power with a new million-dollar mainframe. Because the company has more money available in its operating budget than in its capital budget, it decides to lease a system rather than buy one. So the IS department solicits proposals from lessors - among them equipment vendors, manufacturers and leasing companies - and passes them on to the finance department. Finance considers each potential lessor's financial stability, reputation and cost of proposal, then decides which lessor to enlist. Despite finance's best efforts, IS feels like Moore Power ended up making the wrong choice.Sound like a familiar pattern? When business functions are compartmentalised, companies risk making less-than-optimal decisions. The hand-off from IS to finance is no exception. But if IS properly defines from the beginning how a system will be used and how the lease will be affected, and clearly explains that information to finance, then finance will make the right decision when choosing a lessor - even in the eyes of IS.

Business as usual

This is the process Moore Power follows in shopping for a mainframe to lease: the IS department solicits proposals and selects three serious contenders. Each bid is based on a 36-month lease with monthly payments in advance and no interim rents. IS submits the three leases to the finance group, which looks for the bid that will produce the lowest discounted present value of lease payments. (The discounted rate is what the company would have paid if it had borrowed money to buy the mainframe and repaid the loan over a term equal to the lease term.) Finance decides to go with Low Rentals Ltd, the bidder that seems to be the least expensive.

Has finance used a valid analysis method? Yes. Has finance made the right decision? No.

So what is the problem? Finance usually analyses information for the base case, a 36-month unaltered deal. But if such a scenario is not likely to unfold, then finance has found the right answer to the wrong question. In fact, it is very possible that the lease deal will not run unchanged for 36 months with the equipment being returned to the lessor at the end of the term, even though that was precisely the scenario finance used to make its choice.

High-tech deals frequently are altered before they expire for a number of reasons. For example, IS may need to terminate the lease early and migrate to newer technology or decide to modify or sublease the system during the lease term. IS also may want to purchase the equipment at the end of the lease term or try to extend the lease while waiting for a specific new technology to become available. As a result, the true lowest-cost lessor may well be different from the lowest base-case bidder. That is often the case if the bidders offer their own contracts rather than negotiate based on contracts prepared by the company signing the lease. If Low Rentals believed the lowest-rent bidder would win the Moore Power contract, it may simply have lowered the rent it offered Moore Power and increased the cost options mentioned elsewhere in the agreement to make up the difference. Its goal was to guess how Moore Power would make its decision; by correctly assuming that finance would go for the low-rent option, Low Rentals got the contract.

Setting the scenarios

Moore Power's IS department couldn't have expected finance to anticipate the current and future business purposes of the mainframe to be leased. But IS could have improved the chances for getting a good deal by identifying the most likely scenarios for the 36-month base-case deal (such as early termination or possible renewal), negotiating for various options with lessors and then providing finance with the cost of each scenario before finance made its final decision. And IS could have calculated the total cost of each proposal according to 18-, 24- and 30-month terms as well as a 36-month term. That approach would have forced both IS and finance personnel to analyse more than one scenario. And besides, scenarios not accompanied by cost data are too easy for finance to ignore as unquantifiable.

Identifying a system's specific needs from the start also makes rights and options a higher negotiation priority to begin with and thus inspires rival lessors to offer more favourable terms on key issues. To figure out the importance of various lease flexibility options, IS should examine its company's own operating history. For example, when a major bank recently reviewed its mainframe financing history, paying particular attention to departures from contractual lease terms, it discovered that it had never gone full-term on a mainframe lease. The bank had always terminated early or upgraded, and those can be expensive habits: if a company cuts out of a lease early but doesn't have pre negotiated terms for doing so, the company probably will wind up paying the lessor the balance of the contract. So the next time the bank decides to lease high-tech equipment, it will require bidders to include a termination schedule in their lease proposals.

Now what if Moore Power has a history of modifying or upgrading its mainframe equipment? That can be one of the most challenging scenarios. Adding to an existing unit is relatively easy; migrating from one system to another during a lease term is much more difficult - and expensive. Com-panies that upgrade can use only their best efforts to forecast the cost of doing so. Negotiating with potential lessors up front to get well-defined rights can help. Ideally, the lessee should be allowed to upgrade with any equipment vendor or lessor without the permission of the incumbent lessor and without granting the incumbent lessor the right to match other upgrade offers.

The company also should have the right to sublease without getting permission from the lessor (though the lessor must be notified), even if it's for the same rent the original lessor is charging. If the cost of terminating the lease - the "termination value" - seems relatively steep, substituting sublease rights may be a less expensive solution. So if history shows that Moore Power is likely to exercise that option (even if it's only within the company itself), IS should try to figure out when that might happen and what the sublease rent will be. If the right to sublease is not in a lessor's contract or requires the lessor's permission, Moore Power might save money by substituting a termination value.

Another factor IS should have considered in determining appropriate scenarios to evaluate is whether Moore Power usually buys its mainframe equipment when a lease expires. The cost of purchasing equipment at that point varies from lessor to lessor. Some will resist giving any price other than the fair market value determined when the lease is up, while others can be persuaded to give an up front fixed-price purchase option based on a forecast of the mainframe's value when the lease expires. And some may agree to sell the equipment for whichever ends up being the lower price of the two.

If Moore Power had a record of extending leases for the type of mainframe it wants for six to 12 months beyond the initial term, IS could have negotiated fixed renewal rates as part of the original deal. If renewal rates are not pre negotiated, they likely will be equal to or greater than the base term rent. In either case, IS should give the fixed or forecast renewal rate to finance along with an assessment of the probability that the option will be exercised. (That assessment can be explained in terms as simple as "high," "low" or "medium".)When IS communicates critical information about high-tech leasing options to finance, the two groups can make more economical decisions for the company without necessarily having to learn more about each other's function. So the next time Moore Power decides to lease mainframe equipment, the IS department should analyse the possible leasing scenarios and clearly present those options to finance, thus steering them away from the Low Rentals of the world. And by using the scenario approach, IS will earn the rare opportunity to reverse roles and finally tell finance how to save a dollar or two.

(James M Johnson is a finance professor in the Graduate School of Business at Northern Illinois University)

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