To lease, or not to lease? Excerpted from a research paper by Dennis J. Gilstad, founder and CEO of FCM Rail, Ltd., and Gary M. Andrew. Both have extensive academic as well as practical experience in the economics of leasing

Railway Age, Dec, 2004 by Dennis J. Gilstad, Gary M. Andrew

At a time when all railroads are pressed for investment capital, it may well bc time to take a new look at the lease vs. purchase equation. Leasing, which offers flexible options, may help railroads decrease total equipment costs, reduce the risks of obsolescence, and increase profitability and return on equity.

Asset management is not just a finance department question. Operating departments are concerned with overall equipment costs and the problems associated with older, less efficient assets requiring ongoing, high maintenance. Further, budgeting constraints can limit the capital an operating department has avail able for needed equipment.

Leasing can provide capital equipment on an as-needed basis without maintaining a large inventory, of costly assets--hence, better utilization. Operating leases are often negotiated with clauses that permit cancellation on short notice, reducing costs when the equipment is not required. With metered leasing, the cost of using equipment can be simplified using a cost system that will provide one dollar of performance per one dollar of equipment cost. For example, instead of purchasing a $200,000 spiker, a railroad or contractor may find better value by paying on a per-spike basis with a metered lease.

Aging equipment owned by a railroad presents long-term maintenance problems leading to large, expensive parts inventories that often become obsolete. The high costs of maintaining and operating shops can make the rebuilding of aging equipment uneconomical. New technology often produces more efficient equipment. The fact that equipment is owned often creates a mindset in accounting and financial planning: "If it works, use it." This forces operating departments to continue to use equipment beyond its useful life, with attendant high maintenance costs and disruptive down time, delaying introduction of new technology.

Leasing can provide more efficient new and/or rebuilt equipment, and contract terms can be customized. For example, a short line using 15-year-old m/w equipment wanted to improve productivity. Faced with the inability to allocate $1.2 million to purchase new equipment, the railroad came to FCM Rail, Ltd. to explore leasing options. This railroad needed a payment schedule to match its six-month work season and revenue cash flows. Certain new equipment was not available from the manufacturers within the time constraints, so some used equipment from FCM's pool was leased in the first year of the equipment plan. A lease was structured to allow for payments from May through November. Lease-end options included purchase (less a 50% rental credit on all lease payments), a lease renewal for additional usage (including on-property storage in the off season to avoid shipping charges), or return of the equipment with no further obligation. A renewal could include adding new equipment or replacing individual used pieces with new ones, if available.

After reviewing more than 170 research papers and the leasing chapters from many current textbooks, we found numerous cases of bias against leasing. Academic researchers have predicted that users of equipment specialized to an industry will own the asset, not lease; textbooks continue to repeat this prediction. Time has proven both wrong. There are now specialized companies that lease MRI scanners, plastic injection molding equipment, and railway m/w equipment, to name a few.

Most textbooks ignore the value of options contained in lease contracts. Options can include the right to purchase the asset at the end of the lease, renew a lease, and/or cancel a lease. Each of these options has value to the lessee; ignoring them can create a bias against leasing.

RELATED ARTICLE: Lease vs. purchase analysis.

Lease/BuyNet software was developed by FCM to enable the potential lessee to set all the input parameters to the specifics of its capital structure, current financial markets, and the unique characteristics of a lease. This capability, plus the opportunity to examine every step of the computations, can provide unbiased guidance for asset acquisition. A research paper that formed the basis of this article, and the Lease/ BuyNet software CD-ROM, are available by request from LeaseBuy@FCMRail.com or by writing FCM Rail, Ltd., 15173 North Road, Fenton, MI 48430.

Dennis I. Gilstad (denny@fcmrail.com), CEO of FCM Rail, Ltd., Fenton, Mich., has 30 years experience in the leasing business, both as a lessee and lessor. Prior to founding FCM, he worked for Grand Trunk Western and Union Pacific. Gary M. Andrew (drgandrew@aol.com) served on the faculties of the Graduate Schools of Business at the University of Minnesota and the University of Colorado at Boulder, was Vice Chancellor for Administration at UCB, and has consulted with railroads, industry, and government for the past 40 years. He holds a Ph.D. in Operations Research from Case Institute of Technology.