Lease versus Buy – Why You Need a Strategy
Today’s large cloud-based technology corporations that reside in the digital realm — think Facebook, eBay and Google — use billions of dollars’ worth of equipment and assets in building the infrastructure and data centers that are necessary to serve their customers. Given this, it’s surprising how little strategic planning sometimes goes into how these corporations acquire their equipment and assets.
To make the right decisions about how to acquire equipment and assets, you need to understand the concept of weighted average cost of capital, or WACC as it’s sometimes referred to. This is a calculation of a company’s cost of capital in which each category of capital is weighted proportionately. Businesses create value for shareholders by earning a return on invested capital that is higher than the cost of capital. WACC is an expression of the cost of capital that can be used to determine whether or not certain uses of capital are worthwhile from a shareholder return perspective.
Asset Acquisition Strategies
There are two main ways that cloud-based technology businesses (or any business, for that matter) can acquire assets: They can purchase them or lease them. Purchasing assets outright (or cap ex, as it’s sometimes referred to) is fairly simple; companies buy the assets out of the retained earnings of the business.
On the leasing side, cloud-based technology companies can choose from two different kinds of leases: a capital lease or an operating lease. A capital lease is similar to a term loan, with interest and principal payments. After the completion of the lease term, ownership rights of the asset are transferred from the lessor to the lessee.
With an operating lease, also sometimes referred to as a true lease or a fair market value lease, the lessee has the option of purchasing the asset at the end of the lease term or simply returning it to the lessor. The lease payments are considered to be operating expenses so they are kept off of the balance sheet.
So which option is usually better for cloud-based technology companies when it comes to acquiring the high-tech assets and equipment needed to build their infrastructure and data centers? To answer this question, you must determine whether or not the company’s finite capital would be better used to buy equipment and assets outright or preserved for other uses, such as acquiring other businesses and technologies or hiring more staff. In other words, you must determine the WACC for each option.
Three Things to Remember
There are three things to keep in mind with regard to WACC and today’s cloud-based technology corporations. First, these businesses must spend millions of dollars on the high-tech equipment and assets that make up their infrastructure and data centers before they realize one penny of revenue from these investments. Second, this technology must be updated (or refreshed) on a regular basis to avoid obsolescence. And third, investors and Wall Street value these businesses based primarily on their free cash flow.