Asset Based Finance Citibank

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Asset-Based Finance - Draft January 1996

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ASSET BASED FINANCE

Warning This workbook is the product of, and copy-righted by, Citibank N.A. It is solely for the internal use of Citibank, N.A., and may not be used for any other purpose. It is unlawful to reproduce the contents of these materials, in whole or in part, by any method, printed, electronic, or otherwise; or to disseminate or sell the same without the prior written consent of the Global Corporate & Investment Bank Training and Development (GCIB T&D) — Latin America, Asia / Pacific and CEEMEA.

Please sign your name in the space below.

TABLE OF CONTENTS

Unit 1: Understanding the Leasing Industry Introduction............................................................................................... 1-1 Unit Objectives ......................................................................................... 1-1 What Is a Lease? ..................................................................................... 1-2 Definition of a Lease..................................................................... 1-2 Industry Viewpoint ........................................................................ 1-2 History of the Leasing Industry................................................................. 1-3 Early History................................................................................. 1-3 Development of the United States Leasing Industry.................... 1-4 Equipment Leasing Today ....................................................................... 1-5 Market Segments ......................................................................... 1-5 Small Ticket Market.......................................................... 1-6 Large Ticket Market.......................................................... 1-6 Middle Market.................................................................... 1-6 Today's Lessors........................................................................... 1-6 Independent Leasing Companies .................................... 1-7 Captive Finance Organizations........................................ 1-8 Lease Brokers or Packagers ........................................... 1-8 Summary.................................................................................................. 1-9 Progress Check 1.1 ............................................................................... 1-11 Reasons Lessees Lease Equipment .................................................... 1-15 Hedge Against Technological Obsolescence............................ 1-15 Financial Reporting .................................................................... 1-16 Off Balance Sheet Financing ................................................................. 1-16 Reported Earnings ......................................................... 1-17 Return on Assets ........................................................... 1-17 Spending Authority ......................................................... 1-17 Cash Management..................................................................... 1-17 Lower Down Payments.................................................. 1-18 Lower Monthly Payments ............................................... 1-18 v01/11/96 p12/3/99

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TABLE OF CONTENTS

Unit 1: Understanding the Leasing Industry (Continued) Improved Cash Forecasting........................................... 1-18 Capital Budget Constraints ............................................ 1-18 Cost Constraints ............................................................ 1-19 Income Tax................................................................................. 1-19 Reciprocity of Tax Benefits ............................................ 1-19 Deductible Lease Payments .......................................... 1-19 U.S. Tax Law Penalties .................................................. 1-20 Ownership Considerations ........................................................ 1-20 Stranded Assets............................................................. 1-20 Potential for Ownership.................................................. 1-21 Flexibility and Convenience........................................................ 1-21 Economic Reasons ................................................................... 1-22 Diversification of Financing Sources ............................. 1-22 Future Financing Options............................................... 1-23 Lower Expenses ............................................................ 1-23 Summary................................................................................................ 1-24 Progress Check 1.2 ............................................................................... 1-25 Reasons Lessors Provide Leasing Services ........................................ 1-27 General Lessor Benefits ............................................................ 1-27 Profitability ...................................................................... 1-27 Income Tax Benefits ...................................................... 1-28 Financial Leverage ......................................................... 1-28 Residual Value ........................................................................... 1-30 International Leasing .................................................................. 1-31 Benefits of Vendor Leasing ........................................................ 1-31 Convenience for Customers.......................................... 1-32 Market Control ................................................................ 1-32 Profit Potential ................................................................ 1-32 Integration Opportunities ................................................ 1-33 Vertical Integration.......................................................... 1-33 Horizontal Integration...................................................... 1-33 Conglomerate Integration............................................... 1-34

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Unit 1: Understanding the Leasing Industry (Continued) Trends in the Leasing Industry............................................................... 1-34 Changing Lessor Base .............................................................. 1-34 Lessee Perspective ................................................................... 1-35 Changes in Products ................................................................. 1-35 Profitability .................................................................................. 1-36 Tax and Accounting.................................................................... 1-36 International Markets .................................................................. 1-36 Economic Factors...................................................................... 1-37 Summary................................................................................................ 1-37 Progress Check 1.3 ............................................................................... 1-39

Unit 2: Financial Reporting and Tax Classifications Introduction............................................................................................... 2-3 Unit Objectives ......................................................................................... 2-4 Financial Reporting Classifications.......................................................... 2-4 Operating and Capital Leases ..................................................... 2-4 Classification Criteria ................................................................... 2-4 Implications for Financial Reporting......................................................... 2-7 Lessor and Lessee Accounting ................................................... 2-7 Lessor Accounting for a Capital Lease............................ 2-8 Lessor Accounting for an Operating Lease..................... 2-8 Lessee Accounting for a Capital Lease........................... 2-9 Lessee Accounting for an Operating Lease .................... 2-9 Operating Lease Accounting Benefits - Lessee ........................ 2-12 Financial Statement Comparison .................................. 2-12 Summary................................................................................................ 2-13 Progress Check 2.1 ............................................................................... 2-15 Tax Classifications ................................................................................. 2-19 Tax and Nontax Leases ............................................................. 2-19 Sources of Classification Criteria .............................................. 2-19 Revenue Ruling 55-540.................................................. 2-20

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TABLE OF CONTENTS

Unit 2: Financial Reporting and Tax Classifications (Continued) Revenue Procedure 75-21............................................. 2-21 Tax Court Decisions ...................................................... 2-22 Implications of Tax Classifications......................................................... 2-22 Tax Consequences .................................................................... 2-23 Terminology................................................................................ 2-23 Tax Returns................................................................................ 2-24 Lessor - Tax Lease........................................................ 2-24 Lessor - Nontax Lease................................................... 2-24 Lessee - Tax Lease ....................................................... 2-25 Lessee - Nontax Lease.................................................. 2-25 Modified Accelerated Cost Recovery System (MACRS)........... 2-25 Midquarter Convention ............................................................... 2-27 Effect of the Midquarter Convention............................... 2-28 Value of Depreciation ................................................................. 2-29 Corporate Alternative Minimum Tax (AMT) ............................... 2-32 How AMT Works ............................................................ 2-32 Marketing Approach........................................................ 2-33 Lessor Perspective ........................................................ 2-34 Lease Products .......................................................................... 2-34 Tax Lease Products ....................................................... 2-34 Nontax Lease Products.................................................. 2-35 Summary................................................................................................ 2-37 Progress Check 2.2 ............................................................................... 2-38

Unit 3: Legal Classification and Lease Documentation Introduction............................................................................................... 3-1 Unit Objectives ......................................................................................... 3-1 Legal Classifications ................................................................................ 3-1 The Uniform Commercial Code (UCC) ....................................... 3-2 Article 9............................................................................. 3-2 Article 2............................................................................. 3-3 Article 2A-Leases ......................................................................... 3-3 DRAFT

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Unit 3: Legal Classification and Lease Documentation (Continued) Scope of Coverage .......................................................... 3-3 Definition of a Lease......................................................... 3-3 The Finance Lease .......................................................... 3-4 Remedies and Damages ................................................. 3-4 Case Law Perspective................................................................. 3-4 Legal Implications..................................................................................... 3-5 UCC Filings .................................................................................. 3-5 Bankruptcy Issues for Lessors .................................................... 3-6 Summary.................................................................................................. 3-6 Progress Check 3.1 ................................................................................. 3-7 Lease Documentation.............................................................................. 3-9 Factors Affecting Documentation ................................................ 3-9 Lease Documentation.................................................................. 3-9 Protecting the Lessor................................................................. 3-10 Lease/Credit Application ................................................ 3-10 Master Lease.................................................................. 3-10 Equipment Schedule...................................................... 3-13 Fair Market Value Purchase Option Rider ..................... 3-13 Fair Rental Value Renewal Option Rider ....................... 3-13 Certificate of Acceptance............................................... 3-14 Casualty Value Schedule ............................................... 3-14 Officer's Certificate or Corporate Resolution................. 3-14 Certificate of Insurance.................................................. 3-14 Precautionary Form UCC-1 ........................................... 3-15 Remedies Upon Lessee Default................................................ 3-15 Default Provisions .......................................................... 3-15 Remedies ....................................................................... 3-16 Summary................................................................................................ 3-17 Progress Check 3.2 ............................................................................... 3-19

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TABLE OF CONTENTS

Unit 4: Credit Analysis and Risk Assessment Introduction............................................................................................... 4-1 Unit Objectives ......................................................................................... 4-1 Risk Assessment..................................................................................... 4-2 Lessee Credit Risk Assessment ................................................. 4-2 Confirmation..................................................................... 4-3 Corroboration ................................................................... 4-4 Catastrophe...................................................................... 4-5 Concatenation .................................................................. 4-5 Classification.................................................................... 4-5 Consideration ................................................................... 4-5 Computation..................................................................... 4-5 Compilation ...................................................................... 4-6 Characteristics of Lessees .......................................................... 4-7 Character ......................................................................... 4-7 Capital .............................................................................. 4-7 Capacity ........................................................................... 4-9 Credit.............................................................................. 4-10 Cash Flow ...................................................................... 4-10 Chronological Age .......................................................... 4-11 CAPM-Beta Coefficient .................................................. 4-11 Capability........................................................................ 4-13 Competence................................................................... 4-13 Control............................................................................ 4-13 Course............................................................................ 4-14 Constraints ..................................................................... 4-14 Lease Environment Risk Factors .............................................. 4-15 Collateral ........................................................................ 4-15 Complexity...................................................................... 4-16 Currency......................................................................... 4-18 Category......................................................................... 4-18 Cross-border.................................................................. 4-18 Competition .................................................................... 4-19

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Unit 4: Credit Analysis and Risk Assessment (Continued) Cyclical and Countercyclical.......................................... 4-19 Copartner ....................................................................... 4-19 Concealed Value ............................................................ 4-20 Circumstances............................................................... 4-20 Summary................................................................................................ 4-21 Progress Check 4.1 ............................................................................... 4-23 Financial Statement Analysis ................................................................. 4-27 Income Statement Analysis ....................................................... 4-27 Balance Sheet Analysis ............................................................. 4-28 Cash Flow Analysis.................................................................... 4-28 Standard Ratio Analysis ............................................................. 4-28 Profitability and Earnings Growth Ratios ....................... 4-32 Liquidity and Working Capital Ratios ............................. 4-36 Investment Utilization (Activity) Ratios ........................... 4-38 Financial Leverage Ratios.............................................. 4-41 Solvency and Risk Ratio ................................................ 4-43 Owners' Equity Ratios ................................................... 4-43 Cash Flow Analysis................................................................................ 4-45 Statement of Cash Flows .......................................................... 4-45 Advantages of Cash Flow Worksheet ........................... 4-48 Calculating Disposable Cash Flow ................................ 4-49 Nondiscretionary Cash Requirements........................... 4-49 Cash Flow Ratios....................................................................... 4-49 Income Statement to Cash Flow Ratios ........................ 4-50 Cash Flow to Cash Flow Ratios .................................... 4-51 Cash Flow to Balance Sheet Ratios .............................. 4-52 Summary................................................................................................ 4-53 Progress Check 4.2 ............................................................................... 4-55

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TABLE OF CONTENTS

Unit 5: Financial Concepts and Calculations (Continued) Introduction............................................................................................... 5-1 Unit Objectives ......................................................................................... 5-1 Present Value........................................................................................... 5-2 Calculating Present Value............................................................ 5-3 Present Value of a Single Cash Flow .............................. 5-5 Present Value of an Ordinary Annuity (Annuity in Arrears).................................................... 5-6 Present Value of an Annuity Due (Annuity in Advance).................................................. 5-8 Present Value of an Annuity with Multiple Advance Payments ....................................................................... 5-10 Present Value of Multiple, Uneven Cash Flows ............. 5-12 Internal Rates Of Return (IRR) .............................................................. 5-13 IRR – Even Cash Flows............................................................. 5-14 IRR – Multiple, Uneven Cash Flows........................................... 5-15 Unit Summary ........................................................................................ 5-18 Progress Check 5 .................................................................................. 5-19

Unit 6: Introduction to the Lease vs. Buy Analysis Introduction............................................................................................... 6-1 Unit Objectives ......................................................................................... 6-1 Information Needed for a Lease / Buy Decision ...................................... 6-2 Lease vs. Buy Example ........................................................................... 6-3 Gather Information........................................................................ 6-3 Calculate After-tax Cash Flows for Each Alternative................... 6-4 Calculate the Present Value of the Cash Flows .......................... 6-7 Sensitivity Analysis (Break-even Point).................................................... 6-9 Discount Rate .............................................................................. 6-9 Salvage Value............................................................................. 6-11 Factors that Affect the Lease vs. Buy Analysis ..................................... 6-12 Discount Rate ............................................................................ 6-13 Salvage Value............................................................................. 6-14

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Unit 6: Introduction to the Lease vs. Buy Analysis (Continued) Unit Summary ........................................................................................ 6-14 Progress Check 6 .................................................................................. 6-17

Unit 7: Lease Structuring Introduction............................................................................................... 7-1 Unit Objectives ......................................................................................... 7-1 Elements of Lease Pricing....................................................................... 7-2 Pricing (Structuring) to a Given Pretax Yield............................................ 7-3 Introduction to Advanced Structuring ....................................................... 7-6 Structuring Unusual Payment Streams ....................................... 7-6 Skipped Payments ........................................................... 7-7 Step-up Lease.................................................................. 7-7 Step-down Lease............................................................. 7-8 Known Initial Payments .................................................... 7-8 Early Terminations of Leases ...................................................... 7-9 Evaluating the Competition .................................................................... 7-10 Reasons for Pricing Differences................................................ 7-10 Financial ......................................................................... 7-10 Operational..................................................................... 7-11 Restrictive ...................................................................... 7-11 Termination .................................................................... 7-11 Liability and Warranty..................................................... 7-11 Analyzing Competing Proposals ................................................ 7-12 Payment Differences ..................................................... 7-12 Total Cash Over Term ................................................... 7-13 Lease Rate Factor ......................................................... 7-13 Lessee's Implicit Cost.................................................... 7-13 Net Present Value (NPV)................................................ 7-14 Lease Proposal Evaluation Matrix.............................................. 7-15 Unit Summary ........................................................................................ 7-16 Progress Check 7 .................................................................................. 7-17

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TABLE OF CONTENTS

Unit 8: Vendor Lease Programs Introduction............................................................................................... 8-1 Unit Objectives ......................................................................................... 8-1 Benefits of Vendor Leasing Programs..................................................... 8-2 Market Control .............................................................................. 8-2 Market Enhancement ................................................................... 8-3 Additional Income Sources .......................................................... 8-4 Tax Benefits ................................................................................. 8-4 Financial Leverage ....................................................................... 8-5 Reasons Vendors Outsource Leasing Programs ................................... 8-6 Reasons Vendors Lack Customer Financing Programs ............ 8-6 Third-party Participants ................................................................ 8-7 Ways to Meet Vendor Needs ................................................................... 8-7 Third-party Services ..................................................................... 8-8 Sales-aid / Training .......................................................... 8-8 Lease Structuring / Documentation ................................. 8-8 Credit Review ................................................................... 8-8 Outplacement / Investment Syndication .......................... 8-9 Funding............................................................................. 8-9 Administrative Services.................................................. 8-10 Remarketing / Asset Management................................. 8-10 Unit Summary ........................................................................................ 8-10 Progress Check 8 .................................................................................. 8-11

Glossary Appendix...................................................................................................G-1

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Unit 1

UNIT 1: UNDERSTANDING THE LEASING INDUSTRY INTRODUCTION Worldwide, leasing is used more and more to finance equipment and property. In the United States alone, businesses acquire 33 percent of all equipment through leasing. Companies, federal and municipal governments, and nonprofit organizations choose leasing to finance equipment because it offers many benefits. From an equipment provider’s standpoint, leasing is a venture in which substantial profits may be made. This unit will introduce you to the leasing industry. You will learn what a lease is, how leasing evolved, what the leasing industry is like today, and why leasing is so appealing.

UNIT OBJECTIVES When you complete this unit, you will be able to:

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n

Define a lease

n

Recognize the factors that help divide the leasing market into segments

n

Distinguish among the three major types of lessors

n

Understand the benefits of leasing

n

Define residual value

n

Recognize the major trends in today’s leasing industry

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UNDERSTANDING THE LEASING INDUSTRY

WHAT IS A LEASE?

Definition of a Lease Agreement for use of property

A lease is an agreement between the owner of an asset (the lessor) and the user of the asset (the lessee). In a lease transaction, the lessor transfers use, but not ownership, of the property to the lessee for a certain period. In exchange for use of the property, the lessee makes payments to the lessor. At the end of the lease period, the lessee may return the property to the lessor.

Written contracts

Lease agreements are generally written contracts that contain the terms and conditions of the lease transaction. These terms and conditions include the number of periods the equipment is to be used, the amount and timing of the lease payments, a description of the equipment leased, and any end-of-term conditions.

Industry Viewpoint Transaction labelled a lease

From an industry standpoint, a lease is a contract that has been labeled a lease. However, many transactions that are labeled as leases are not true usage agreements. They are more like an installment or conditional sale rather than a pure usage agreement.

Lease treatment

The differences between a true usage agreement and an installment or conditional sale agreement determine how the lease is treated for accounting, tax, and legal purposes. In Units Two and Three, you will learn about the ways various regulatory bodies classify leases and how these classifications affect the way the lease is treated. For now, keep in mind that a capital lease is really a purchase agreement and an operating lease is an agreement for use of property owned by another party.

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HISTORY OF THE LEASING INDUSTRY The practice of letting property be used in exchange for payment has existed for thousands of years. To understand the lease process of today, it helps to understand how leasing evolved.

Early History First records

No one knows the exact date of the first leasing transaction, but we do know that the earliest records of leasing were written before 2000 B.C. in the ancient Sumerian city of Ur. Sumerian lease documents, which were produced in damp clay, recorded lease transactions for agricultural tools, land and water rights, and oxen and other animals. Early legal systems often included leasing laws. The famous Babylonian king, Hammurabi, who reigned in about 1700 B.C., mentioned leasing in his collection of laws. Near Babylon, in approximately 400 to 450 B.C., businesses leased land, oxen, farm equipment, and seed to local farmers. Other ancient civilizations, including the Greeks, Romans, and Egyptians, also used leasing to finance equipment, land, and livestock. The ancient Phoenicians chartered ships and crews. These ship charters resembled a pure form of an equipment lease. In medieval times, most leases were for horses and farming implements. However, unique opportunities sometimes occurred. For example, many knights of old leased their armor!

Industrial Revolution

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In the early 1800s, the amount and types of leased equipment in the United Kingdom (U.K.) increased greatly. The development of the agricultural, manufacturing, and transportation industries during the Industrial Revolution brought about new types of equipment, many of which were suitable for lease financing.

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Railroad expansion


The growth and expansion of the railroads also brought about major advances in the development and use of leasing. Most early railroad companies were able to supply only the track, and charged tolls for the use of their lines. Many entrepreneurs began providing the railroad companies and independent shippers with locomotives and rail cars.

Development of the United States Leasing Industry Need for leasing

While the demand for lease financing was growing in the U.K., the populace of the United States (U.S.) also was experiencing a need for lease financing. The first recorded leases of personal property in the U.S. were written in the 1700s. These early transactions provided for the leasing of horses, buggies, and wagons by livery men. The use and development of leasing increased as new types of equipment were developed and needs for equipment increased. It was the expansion of the railroad industry in the 1800s, however, that stimulated real growth in the U.S. leasing industry. Leasing provided the means to finance locomotives and rail cars when conventional financing was not available or affordable.

Vendor leasing begins

In the early 1900s, a developing economy and the desire of manufacturers to provide financing for their products increased the demand for leasing. Manufacturers or vendors thought they would be able to sell more of their products if they were able to offer an affordable payment plan. This idea led to the beginning of lease financing provided by vendors, which is still a significant force in the equipment leasing industry today.

Third-party leasing companies form

Eventually, independent or third-party leasing companies were formed to provide specific product financing for manufacturers and dealers. In the early 1950s, many independent leasing companies also began providing leasing services directly to the lessee for other, unrelated equipment.

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Banks enter the leasing industry

1-5

In 1963, the U.S. Comptroller of the Currency issued a ruling that permitted national banks to own and lease personal property. In 1970, an amendment to the Bank Holding Company Act further legitimized the involvement of banks in equipment leasing. This amendment allowed banks to form holding companies. Under a holding company, banks could engage in a number of nontraditional financing activities, such as equipment leasing. It also is important to note that, especially in recent times, significant tax and accounting regulations in the U.S. have affected the evolution of the leasing industry. These are covered in later units.

EQUIPMENT LEASING TODAY The equipment leasing industry continues to grow. Worldwide, leasing volume has reached the $350 billion plateau as market penetration continues to increase. Leasing remains a widely used method of external finance.

Market Segments Today, virtually all types of equipment are leased. Leased products include automobiles, aircraft, computers, furniture, laboratory equipment, copiers, satellites, and ships. Factors that determine segment

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The differing types of equipment, the price ranges of the equipment, and the key decision factors that influence lessees help divide the leasing industry into three core segments: the small ticket market, the large ticket market, and the middle market.

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Small Ticket Market The small ticket market concentrates on leasing lower-priced equipment, such as copiers, personal computers, and word processors. The high end of the transaction range for the small ticket market is from $25,000 to $100,000. (The cut-off point depends upon individual firms' interpretations.) The lessee in this market is more concerned with the convenience of acquisition, maintenance, and disposal than with cost. Large Ticket Market The large ticket market focuses on higher-priced equipment, such as aircraft, mainframe computers, ships, and telecommunications equipment. The large ticket market is typically defined as equipment having a cost of $1,000,000 or more. Because of the transaction size, the market is very price-sensitive and competition is intense. Documentation tends to be more involved than in the small ticket market because of the size and complexity of each individual transaction. Middle Market The middle market fills the wide gap in size and complexity between the small ticket and large ticket markets. This market is influenced by a number of factors which sometimes conflict. Both price and convenience are common issues in the negotiation process.

Today's Lessors Classification

Leasing companies may be classified into three groups: n

Independent leasing companies

n

Captive finance organizations

n

Lease brokers, or packagers

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There are few accurate statistics to substantiate the proportion of the leasing industry represented by any individual lessor group, although the majority of lessors are considered independents. Independent Leasing Companies Three parties

Independent leasing companies represent a large part of the leasing industry. These companies are independent of any one manufacturer. They purchase equipment from various manufacturers, and then lease the equipment to the end-user or lessee. Independent leasing companies are often referred to as third-party lessors. The three parties are the lessor, the unrelated manufacturer, and the lessee. Financial institutions such as banks, thrift institutions, and insurance companies that lease property also are considered independent lessors.

Manufacturer Equipment Purchase

Payment Independent Lessor

Equipment Lease

Lease Payments

Lessee

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Figure 1.1: Independent leasing company

Captive Finance Organizations Set up by manufacturer or dealer

The second type of lessor is a captive finance organization (lessor). A captive lessor is a leasing company that a manufacturer or equipment dealer sets up to finance its own products. The captive lessor is also referred to as a two-party lessor. One party consists of the parent company and its captive leasing subsidiary, and the other party is the lessee (or actual user) of the equipment.

Parent/ Manufacturer

Payment Subsidiary/ Lessor Equipment Lease

Equipment Lease

Lease Payments

Lessee

Figure 1.2: Captive lessor

Lease Brokers or Packagers Middle-man services

The final type of leasing company is the lease broker, or packager. The lease broker is essentially a middle-man who provides one or more various services. The lease broker may do the following: n

Find the interested lessee

n

Arrange for the equipment with the manufacturer

n

Secure debt financing for the lessor to use in purchasing the leased equipment

n

Find the ultimate lessor in the lease transaction DRAFT

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The lease broker typically does not own the equipment or retain the lease transaction for its own account.

Lessee

Equipment

Lease Broker

Ultimate Lessor

Funding

Figure 1.3: Lease broker / packager

SUMMARY The concept of leasing as an equipment financing tool has survived 4,000 years of history. The need for equipment leasing continues to grow. The benefits of leasing, such as affordable payments and off balance sheet financing, have contributed to its popularity. Today's leasing market includes virtually every type of equipment. In the U.S., market transactions range from less than $25,000 to more than $1,000,000. Three major classifications of lessors have evolved to handle the varying needs of the industry: independent leasing companies, captive finance organizations, and lease brokers (or packagers). These classifications are based on the leasing company's relationship to the equipment manufacturer and the types of services they provide.

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In the next section, you will find out about the benefits of leasing and the forces that shape today’s leasing industry. Before you continue to that section, check your understanding of the concepts you have just learned by completing the Progress Check that follows. If you answer any question incorrectly, please return to the text and read the section again.

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1-11

þ PROGRESS CHECK 1.1 Directions: Determine the correct answer to each question. Check your answers with the Answer Key on the next page. Question 1: A lease is a(n): ____ a) method of borrowing in which the lessor is fully at-risk for any borrowed funds. ____ b) contract that involves the transfer of ownership of equipment. ____ c) agreement in which the owner of property gives use of the property to another party for a predetermined period in exchange for compensation. ____ d) arrangement that calls for a lessee to make payments for equipment directly to the lender. Question 2: During the last 200 years, the demand for leasing has increased primarily as a result of: ____ a) the desire of manufacturers to provide financing for their products. ____ b) the development of new types of equipment and the need for affordable financing. ____ c) the expansion of the railroad industry. ____ d) tax and accounting regulations that favor lease financing. Question 3: The middle market is more price-sensitive and competitive than the small ticket and large ticket markets. ____ a) True ____ b) False Question 4: A captive lessor is a leasing company that: ____ a) a manufacturer or equipment dealer sets up to finance its own products. ____ b) does not own the equipment or retain the lease transaction for its own account. ____ c) is independent of any one manufacturer.

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ANSWER KEY

Question 1: A lease is a(n): c) agreement in which the owner of property gives use of the property to another party for a predetermined period in exchange for compensation.

Question 2: During the last 200 years, the demand for leasing has increased primarily as a result of: b) the development of new types of equipment and the need for affordable financing.

Question 3: The middle market is more price-sensitive and competitive than the small ticket and large ticket markets. b) False

Question 4: A captive lessor is a leasing company that: a) a manufacturer or equipment dealer sets up to finance its own products.

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1-13

PROGRESS CHECK 1.1 (Continued)

Question 5: In the 1800s, which of the following had the greatest effect on the growth of leasing in the United States? ____ a) The growth and expansion of the railroads ____ b) The formation of third-party leasing companies ____ c) The need for horses, buggies, and wagons by livery men ____ d) The development of the leveraged lease

Question 6: The involvement of banks in equipment leasing was advanced in 1970 through an amendment to the: ____ a) constitution. ____ b) tax laws. ____ c) third-party leasing agreements. ____ d) Bank Holding Company Act. Question 7: The classification of a leasing market segment as small ticket, large ticket, or middle market is based on: ____ a) the types of equipment leased, the price ranges of the equipment, and the key decision factors that influence lessees. ____ b) the size of the transactions only. ____ c) how the leases are funded. ____ d) the type of lessor involved.

Question 8: A lessor that purchases equipment from various manufacturers, and then leases the equipment to the end-user or lessee is referred to as a(n): ____ a) lease broker or packager. ____ b) captive or two-party lessor. ____ c) independent or third-party leasing company. ____ d) nonrecourse lessor.

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ANSWER KEY

Question 5: In the 1800s, which of the following had the greatest effect on the growth of leasing in the United States? a) The growth and expansion of the railroads

Question 6: The involvement of banks in equipment leasing was advanced in 1970 through an amendment to the: d) Bank Holding Company Act.

Question 7: The classification of a leasing market segment as small ticket, large ticket, or middle market is based on: a) the types of equipment leased, the price ranges of the equipment, and the key decision factors that influence lessees.

Question 8: A lessor that purchases equipment from various manufacturers, and then leases the equipment to the end-user or lessee is referred to as a(n): c) independent or third-party leasing company.

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REASONS LESSEES LEASE EQUIPMENT Leasing offers many advantages, benefits, and flexible options to lessees. Some may lease for only one reason, others for a variety of reasons. Lessors who understand the motivations of lessees are better able to offer products that attract lessees. Most reasons lessees choose to lease fall into the following categories: n

Hedge against technological obsolescence

n

Financial reporting

n

Cash management

n

Income tax

n

Ownership considerations

n

Flexibility and convenience

n

Economics

Let’s examine each of these categories from the lessee’s viewpoint. In turn, the lessor will see how these advantages strengthen the sales process. Hedge Against Technological Obsolescence Risk of ownership

One of the strongest reasons for acquiring the use of equipment through leasing is that leasing helps lessees avoid many of the risks of owning equipment. Much of today’s equipment is based upon rapidly changing technology. Equipment soon becomes technologically obsolete. A company’s risk in buying and owning technologically sensitive equipment is that it may become economically useless much earlier than expected. Sometimes the equipment becomes useless before the owner has paid off a loan used to buy the equipment!

Example

For example, a computer that is expected to be worth 20 percent of its original value at the end of five years could easily be worthless in three years because of new advances in technology.

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Transfer of risk to lessor


Leasing helps lessees avoid the risk of owning obsolete equipment by transferring that risk to a lessor. In other words, lessees let the leasing company worry about the equipment becoming obsolete.

Lessor

Lessee Risk of Obsolescence

Financial Reporting Financial reporting, or accounting presentation, comprises an important part of the decision to lease or buy equipment. Leasing results in a very different accounting presentation than that of buying a piece of equipment. Loans from banks and capital raised from stockholders often depend upon the reported financial health of a company. For this reason, leasing is of great importance to many lessees. Here we discuss four aspects of financial reporting. Off Balance Sheet Financing No asset or liability entry

If a lease is a true usage agreement (an operating lease) for financial reporting purposes, the lessee’s balance sheet does not show the equipment as an asset or a liability. The only expense on the lessee’s income statement for the lease is the lease rental expense. This reporting practice is called off balance sheet financing.

Improved financial ratios

Off balance sheet financing helps make a firm’s financial statements look better. It improves many of the firm’s financial ratios and measurements (at least for the first few years). Because there is no debt or liability for the lease on the balance sheet, the firm appears to be less in debt and more profitable. Lenders may be more willing to lend more funds to such a company.

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Reported Earnings Positive effect on income statement

In the early years of a lease, an operating lease has a more positive effect on a lessee’s income statement than a capital lease. Initially, the operating lease expense (rental payments) is less than the combined depreciation and interest expense for the capital lease. Therefore, an operating lease raises the lessee’s overall reported earnings. Return on Assets

Increased return on assets

Because the use of an operating lease lowers the asset base and increases reported earnings, a lessee may report a higher return on assets (ROA). Many managers are sensitive to the level of the reported ROA, because bonus and profitability goals sometimes are tied to the ROA that the division or company attains. Spending Authority

Payments within spending guidelines

Managers who do not have the authority to spend funds necessary to purchase equipment find leasing to be a convenient alternative. The amount of the monthly lease payment often falls within their spending authority guidelines. Cash Management

Affordability

Since leasing equipment is often more affordable than purchasing equipment, many companies choose this option as new and more advanced (and more expensive) equipment becomes available in the marketplace. Let’s examine some of the cash management benefits. Lower Down Payments

Up-front costs

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Generally, leasing companies require lower down payments than financial institutions. Also, the leasing company may include other incidental costs of acquiring the equipment, such as sales tax and installation charges, as part of the lease payment. If the company buys equipment, it must pay these costs up front.

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Lower Monthly Payments Affordable payments

A lease may be more affordable to a company than a conventional loan because the monthly lease payment is lower than the monthly loan payment. Improved Cash Forecasting

Future cost

Because the amount of the lease payments is fixed, the lessee knows the future cost of the equipment. This enables the company’s planning personnel to prepare more accurate cash forecasts and plans. Capital Budget Constraints

Operating budget

If a department or division has already used its allowance for capital expenditures, the department or division manager may lease the necessary equipment. Lease payments are paid out of the operating budget instead of the capital budget. The operating budget contains the amount of noncapital goods and services a firm is authorized to spend during the operating period.

Expenditure approvals

Similarly, some state and local governments must have either special capital appropriations made by the decision-making bodies or voter approval before they can buy equipment. This process may take a long time. Since lease payments can be paid out of the operating budget, and approvals for operating expenses generally require much less time than approvals for capital expenditures, government bodies often obtain equipment faster through the leasing process. Cost Constraints

Affordable payments

In certain cases, the only realistic means of acquiring use of equipment is through leasing. For example, a company may need partial use of a satellite to transmit data to regional offices in other parts of the world. Unfortunately, the satellite may cost more than the firm can possibly afford. Through leasing, the company can obtain the use of a portion of the satellite’s power in exchange for affordable, periodic rental payments.

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Income Tax Because leasing provides several income tax benefits to the lessor as well as the lessee, the lessor must understand them well. Reciprocity of Tax Benefits Lower lease rates

When lessors receive tax benefits because they are considered the tax owners of the equipment, they may fully or partially pass these benefits on to lessees as lower lease rates. This allows the lessees to indirectly share in the tax benefits. This reciprocity, or exchange of tax benefits for a lower lease rate, is particularly important for a lessee that is currently in a nontax paying position. This is because the lessee cannot directly use the tax benefits of ownership. Deductible Lease Payments

Income tax benefit

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When the lessor is deemed the owner of the equipment for tax purposes, the lessee may fully deduct the lease payments for federal income tax purposes. Although the lessee does not receive the depreciation benefits of ownership, the fact that payments are deductible is a clear tax benefit.

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U.S. Tax Law Penalties Negative impact of additional purchases

Current U.S. tax law may result in penalties for purchasing additional equipment. A company that purchases new equipment may have to pay more taxes because of the loss or reduction of certain tax benefits. For companies facing these situations, it makes more sense to lease equipment.

Lessor n

Tax benefits

Equipment Lease

Lower Lease Payments

Lessee n

Deductible lease payment

Ownership Considerations Leasing can help lessees avoid the risk of owning equipment. Two major reasons are discussed here. Stranded Assets Estimated economic life

For financial reporting purposes, owners depreciate equipment over the equipment’s estimated economic life. If equipment becomes technologically obsolete before the end of its depreciable life, the company owns a worthless piece of equipment that is not fully depreciated on its books. If the company sells the obsolete equipment, it will be at a loss. This lowers the company’s reported earnings. If the company retains the worthless equipment until it is fully depreciated, the equipment is considered a stranded asset. The lessee can avoid stranded assets by selecting a short-term lease that specifies reasonable renewal terms for additional periods of use.

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Potential for Ownership Purchase options

Another reason for leasing’s growing popularity is the lessee’s ability to purchase the equipment at the end of the lease term. Some purchase options fix the purchase amount; others base the purchase price on the equipment’s fair market value at the end of the lease term. Fixed purchase options can be risky. However, having the option to purchase equipment at fair market value is acceptable to those lessees seeking flexibility in equipment use and financing. Flexibility and Convenience Another benefit of leasing is that it offers many convenience advantages over other forms of financing. These are summarized below. n

Acquiring the use of an asset through a lease can involve less red tape and time than bank financing. Also, the leasing company may be able to obtain speedier delivery of equipment because of its relationship with the manufacturer.

One-stop shopping

n

A lessor can provide product variety and knowledge, the product itself, financing, and many flexible options, all under one roof. In addition, a lessor may bundle other products or services, such as maintenance and insurance, with the lease to offer a full-service package. A full-service package may be less expensive than if the lessee separately purchases the same services.

Reporting convenience

n

Operating leases require much less bookkeeping than outright purchases because the entire payment is shown as rental expense. Also, because most leases have fixed equal periodic payments, cash flow projections are easier.

n

In most companies, the budgeting analysis is not as involved for leasing a piece of equipment as it is for purchasing equipment.

n

Leasing makes the planned replacement of existing equipment with new technology easier because company management must review equipment needs at the end of the lease term.

Timing factors

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Flexible options

Control

Lower risks


n

Lessors can structure lease payments and equipment use options to meet the needs of lessees.

n

Within legal limits, the lessee may have more control over the leasing company of a manufacturer in the event of warranty disputes.

n

The lessee can return the equipment to the lessor upon termination of the lease without further obligation. The lessor bears the burden and risk of disposing of the equipment for an adequate price.

Economic Reasons A crucial selling point for the lessor is that leasing can make good economic sense for the lessee. The lessor should be familiar with these aspects. Diversification of Financing Sources Financing availability

National economies always experience swings in the availability of financing. Depending solely upon one source of equipment financing can be dangerous. Using a variety of financing sources makes good business sense whether credit is in short supply or not. Also, banks commonly have, by regulatory law, built-in limits on the amount of funds they may loan to any single customer.

Additional source of financing

Over the last 30 years, many economic factors have led to shortages in capital through conventional capital financing sources. To sell their products, many manufacturing companies turned to leasing to make financing available to those customers who otherwise could not afford the equipment. Even when bank financing is generally available, some businesses may not be able to obtain credit. Fortunately, leasing provides an additional source of financing for companies that cannot borrow needed funds.

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Future Financing Options When lending to a company, a banker typically builds restrictive loan covenants or agreements into the loan agreement. These covenants restrict a company’s future financing options. Their purpose is to help lessen any potential default on the loan by the borrower. If the borrower violates any of the covenants and puts the loan at risk of default, the lender has the option to demand repayment of the loan.

Loan restrictions

A company subject to many restrictive covenants has much less freedom to make financing decisions. Lease agreements, on the other hand, rarely contain restrictive covenants. Therefore, leasing can offer greater freedom or flexibility than a loan. Lower Expenses Economies of scale

Due to their large size, certain leasing companies can save money by buying equipment in volume and receiving quantity discounts. The leasing companies may pass on some of these savings to the lessee in the form of lower lease payments.

Lower cost

Leasing can be less expensive than buying equipment. Typically, potential lessees compare the costs of financial alternatives (such as a lease versus a loan) after they adjust the alternatives for the effect of taxes and the time value of money. For a variety of reasons, in such a comparison, leasing can be the less expensive form of financing. To effectively determine whether a lease will cost less than an outright purchase of equipment, one should perform a formal analysis. You will learn about the lease versus buy analysis in Unit Five.

SUMMARY In this section, you learned that there are many important reasons lessees choose to lease equipment. These include the following: n

Guarding against technological obsolescence

n

Financial reporting

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n

Cash management

n

Income tax motivations

n

Ownership considerations

n

Flexibility and convenience

n

Economics

Some of the reasons can be a single source of motivation for a company to lease. In other cases, it is the combined benefits of leasing that influence a company to lease. Lessors who understand the motivations of lessees are better able to develop lease products that attract lessees.

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þ PROGRESS CHECK 1.2 Directions: Select the correct answer to each question. Check your answers with the Answer Key on the next page. Question 1: A major risk of owning equipment is that: ____ a) ownership offers no tax advantages. ____ b) loans used to finance the equipment usually contain restrictive covenants. ____ c) the equipment may become technologically obsolete. ____ d) the equipment may not be fully depreciable on a company’s financial statements.

Question 2: Operating leases provide off balance sheet financing for the: ____ a) lessor. ____ b) lessee. ____ c) both the lessor and lessee.

Question 3: In the early years of the lease, an operating lease has a more positive effect on a lessee’s income statement than a capital lease. ____ a) True ____ b) False

Question 4: Leasing is often a more affordable financing option than purchasing because: ____ a) leasing companies require lower up-front costs and monthly payments. ____ b) leasing expenses can be paid from a company’s capital budget. ____ c) it offers the lessee direct tax benefits such as depreciation. ____ d) a lease is not reported as an asset on a firm’s balance sheet.

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ANSWER KEY

Question 1: A major risk of owning equipment is that: c) the equipment may become technologically obsolete.

Question 2: Operating leases provide off balance sheet financing for the: b) lessee.

Question 3: In the early years of the lease, an operating lease has a more positive effect on a lessee’s income statement than a capital lease. a) True

Question 4: Leasing is often a more affordable financing option than purchasing because: a) leasing companies require lower up-front costs and monthly payments.

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REASONS LESSORS PROVIDE LEASING SERVICES In the previous section, we looked at leasing primarily from the lessee’s point of view. Although there are many advantages to the lessee, the lessor benefits as well. In this section we will see that there are many reasons for lessors to be in the leasing business. Understanding these reasons is beneficial for all parties to the lease transaction. Some benefits apply to all lessors, and some are specific to vendor leasing. General Lessor Benefits There are several opportunities associated with leasing that make the business attractive to lessors. They include profitability, income tax benefits, financial leverage, residual value of the leased equipment, and the expanding international leasing market. Profitability Reasonable profits

Simply stated, a lessor’s main objective is to obtain reasonable profits from each of its lease transactions. Because of the complexities involved, the lessor must have an in-depth understanding of all aspects of the lease transaction.

Minimizing risks

A lease requires few, if any, up-front payments and typically requires lower payments throughout the lease term and, therefore, a lessor’s earnings and profitability may be at risk. To minimize the risk, a lessor can structure leases that are based on a number of considerations, including equipment cost, payment stream, tax benefits, residual value of the equipment, operating cost, and debt cost.

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Income Tax Benefits Benefits of ownership

When the lessor is considered the tax owner of the leased equipment according to the Internal Revenue Service criteria, the lessor is entitled to the many tax benefits of ownership. The primary benefits are (1) depreciation; (2) gross profit tax deferral (when the lessor also is the manufacturer of the equipment); and (3) tax-exempt interest for qualifying municipal leases. Financial Leverage

Return on equity

One of the more important economic aspects of leasing is financial leverage. A lessor typically borrows most of the funds needed to buy a piece of equipment and pays for only a fraction of the cost of the equipment from its own funds, or equity. Because the debt costs less than the interest rate charged in the lease, the lessor can earn substantial returns on its equity. Use of significant amounts of financial leverage is commonplace in leasing. Lessors can fund their leased equipment in a number of ways. The type of funding used is one of the ways in which different types of leases are identified. How a lease is funded determines whether it is a singleinvestor lease or a leveraged lease.

Recourse borrowing

In a single-investor lease, the cash the lessor pays for the equipment is made up of the lessor's own equity as well as pooled funds that the lessor has borrowed from a variety of sources on a recourse basis. In recourse borrowing, the lessor is fully at-risk for any borrowed funds. This means that if the lessee defaults on the lease, the lessor is still responsible for its debt with the lender. The lender does not know or care who the lessee is, or what the credit position of the lessee is. The lender has loaned money to the lessor based on the credit of the lessor (see Figure 1.4).

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Lessor

n n

Lessor

Equity Pooled funds

Payment

Equipment

Lessee

Figure 1.4: Single-investor lease

Nonrecourse borrowing

In a leveraged lease, the lessor borrows a significant amount of money on a nonrecourse basis. In nonrecourse borrowing, the borrower is not at-risk for the borrowed funds. The lender expects repayment from the lessee. Often the lessor assigns or discounts the lease payment series to the lender in return for up-front cash. This cash amount represents the amount of the loan. In other cases, the lessor borrows a fixed amount of nonrecourse debt.

Lessor n

Equity Loan Amount

Equipment Lease

Lessee Lease Payment

Figure 1.5: Leveraged lease

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Assigned lease payments

In nonrecourse borrowing, the lender considers the creditworthiness of the lessee and the value of the leased equipment, not the credit-worthiness of the lessor. Because the lease payments in a leveraged lease are assigned to the lender, the lessee generally makes lease payments directly to the lender. The lending institution seeks recovery of any losses from the lessee or from the salvage of the leased equipment (collateral).

Benefits

In a leveraged lease, the lessee gets the use of the equipment for a lower cost. The lessor receives tax benefits and a return on its equity investment through the value of the equipment at the end of the lease.

Residual Value Residual value is the actual or expected value of leased equipment at the end or termination of the lease. The residual value of leased equipment is an important cash inflow to the lessor and may be a significant part of the overall return in the lease. Effect on lease rates

If the lessee returns the leased equipment to the lessor at the end of the lease term, the lessor attempts to re-lease or sell the equipment for the highest possible amount. To offer competitive lease pricing, the lessor must factor some of this expected future value into the lease rates. For example, if the lessor is confident the equipment will be worth at least 10 percent of its original value at lease end, the lessor can price the lease payments to recover 90 percent of the equipment cost. The lessor hopes to realize the remaining 10 percent once the equipment is returned and subsequently salvaged or re-leased.

Risk in residual value

Generally, the amount of the residual used in the lessor’s pricing is not the exact amount the lessor expects to receive at the end of the term. Rather, it is the amount the lessor is willing to be at-risk for in the lease. The lessor must receive the at-risk residual amount in order to recover all costs and earn the return it wants. The risk is that the residual value will be less than the amount assumed when the lease was priced.

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International Leasing Expanding opportunities

Overseas leasing is expected to expand significantly in order to serve large multinational companies as well as foreign companies who are seeking new forms of asset financing. Although equipment leasing abroad by U.S. companies started only 20 years ago, the amount of equipment on lease in Western Europe and other parts of the world has grown significantly. One reason for the growing popularity of leasing abroad is that many foreign banks offer loans for about three years. This means equipment buyers must negotiate two or three loans during the life of a particular piece of equipment.

Types of equipment leased abroad

As in the United States, all types of equipment are being leased abroad: tankers, railroad cars, computers, machine tools, printing presses, aircraft, restaurant equipment, mining equipment, and drilling rigs.

Limitations

Since foreign tax laws differ from U.S. tax laws, many international leases do not offer the same benefits of depreciation or the possibility of residual value gains. Also, restrictive foreign government regulations concerning percentage of local ownership requirements, varying tax laws, foreign exchange fluctuations, and export laws affect the profitability of international leasing. However, many equipment leasing companies are still interested in the expanding leasing markets abroad. Many U.S. based multinationals use leasing to promote foreign sales. In addition, there are numerous tax, import, and investment tax credit benefits available to the experienced international lessor. In essence, the same reasons that led to an expansion of leasing in this country have also stimulated leasing abroad.

Benefits of Vendor Leasing Leasing is advantageous to manufacturers in various ways. Here, we will look at four important considerations: customer convenience, control of the market, profit potential, and integration opportunities.

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Convenience for Customers Product distinction

Providing lease financing is a successful way for manufacturers to distinguish their product from their competitors’ products. Providing the equipment, as well as the financing, may entice a potential customer to choose a certain manufacturer’s product due to the convenience offered. Market Control

Locking out the competition

By locking in the sale with financing so it will not be lost to a competitor as the customer searches for financing, the manufacturer exerts a considerable amount of market control. Also, the manufacturer knows when its customer, the lessee, is in need of a new piece of equipment (i.e., at the termination of the existing lease term). This allows the manufacturer to market a new piece of equipment to its current leasing customer long before a competitor is aware a potential transaction exists. Profit Potential

Increased sales

Vendor lessors may benefit from increased sales because leasing can make equipment acquisition affordable for customers who cannot purchase the equipment outright. Along the same lines, customers may be able and willing to lease more expensive models or additional accessories now that the cash flow advantages of leasing have put these extras within their reach.

Full-service contracts

Captive lessors can benefit from the combined marketing approach and profitability of providing bundled services in a full-service contract. These services typically include maintenance, insurance, film, reagents, software, and property taxes for the lessee. The captive lessor may be able to provide these services for less cost than that which the lessee can separately procure and, as a result, profit from these additional revenues. Also, the convenience of one-stop shopping may entice a lessee to choose a captive lessor’s product.

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Integration Opportunities Types of integration

Integration refers to ways in which a company can expand operations. Vertical integration refers to control over the means of providing a product, through production and transportation, to the final wholesale and retail outlets. Horizontal integration refers to expansion into the sales and production of related products (like wax production for an oil company). Conglomerate integration is where a company enters into a wholly unrelated business venture. Let’s see how integration activities provide opportunities for vendor leasing. Vertical Integration

Control over residuals

Establishing a vendor leasing program to further promote sales is an important step in vertically integrating a company. Extensive knowledge of the product permits the lessor to predict residual values with greater accuracy. This enhanced knowledge of residual values may enable the vendor leasing company to fine tune the lease payment amount it charges. Control over residuals also allows the vendor lessor to sell equipment at the termination of the lease to a somewhat captive clientele. Horizontal Integration

Unrelated product leasing

Some vendor lease companies find leasing so profitable that they begin leasing equipment other than that manufactured by the parent company. This expansion into new, unrelated product leasing is a form of horizontal integration that is becoming popular among manufacturer-lessors. A bank acquiring a leasing company would be a form of horizontal integration since the leasing service is closely related to the bank’s loan service.

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Conglomerate Integration New business opportunities

Some other companies enter into the leasing business as a totally unrelated business opportunity in relation to their normal operations. New business ventures involved with leasing would represent a form of conglomerate integration. A utility acquiring a leasing company would be an example of conglomerate integration. Now that you understand the opportunities that leasing offers to both parties, let’s look at some of the trends that are developing in the leasing industry.

TRENDS IN THE LEASING INDUSTRY Many important trends are developing in the leasing industry. Some of these trends are ongoing; others are subtle shifts in prior trends. Many of the trends result directly from the many recent changes that have occurred in the world economies.

Changing Lessor Base Business goals

Mergers and acquisitions continue within the leasing industry for many reasons. The goal of some companies is to increase market share or enter into a specific market niche. For others, the goal may be to achieve economies of scale, experience growth without the associated sales costs, or unload an unprofitable finance subsidiary. The ups and downs of the economy also lead to an increase in mergers and acquisitions as companies struggle to adapt to the changes.

Tax laws

In the U.S., the changes to the tax laws brought about by the Tax Reform Act of 1986 continue to affect the way leasing companies do business. The alternative minimum tax (AMT) has had the greatest effect. Companies in an AMT position often have difficulty remaining competitive. For some, the problem is severe enough to cause them to sell their portfolio and get out of the leasing business.

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Lessee Perspective Increased knowledge

The level of lessees’ sophistication about leasing continues to increase. More lessees are using leasing to avoid the risk of obsolescence. At the same time, they are seeking more assurance as to end-of-term consequences, and selecting lessors more cautiously. Also, a wide array of inexpensive analytical software is available to help lessees make their financing decisions.

Lessee motivations

Lessees continue to lease for a variety of reasons. Recently, the impact of tax reform has made tax motivations one of the more important reasons for leasing. The problems with the U.S. economy, along with a scarcity of available debt from traditional sources, have also led to more business for lessors.

Changes in Products Changing needs

Lessors continue to develop new products to meet the changing needs of lessees. They are creating new structures to meet lessee demands for off balance sheet accounting. In response to lessees’ concerns about the end-of-term consequences of leases, lessors are offering more fixed or capped purchases and renewals. The number of full service leases continues to grow. Lessors are also responding to requests for more bundled services.

Leveraged leasing continues

Leveraged leasing continues to attract investors; however, the competitiveness of this market requires more and more sophistication, expertise, and creativity. This market has experienced major concerns over aircraft residuals and concentrations, but has seen an increase in both railcars and satellites.

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Profitability New emphasis on residuals and asset management

Companies have not been able to maintain the profitability levels of the late 1980s. Competition remains high. Fewer, yet larger, companies strive to increase market share. Companies must rely increasingly on residual and end-of-term options for profits. This reliance increases the need for asset management. In most lease companies, the role of the remarketer is expanding every day. Even so, opportunities for residual profits continue to narrow.

Lessors seek other sources of profits

Many lessors have shifted part of their business into other financial service products such as real estate or insurance to improve profitability. Lessors have also looked to internal sources of additional profit. These include closely monitoring expenses, using improved software and systems, and outsourcing some services.

Tax and Accounting Changes in tax laws

Changes in the U.S. corporate tax structure are highly probable. Congress continues to use tax laws to promote and achieve a variety of social and economic goals. Key among these goals is a national healthcare program. The provisions of the program may indirectly affect the willingness of companies to invest in new equipment. The likelihood of an increase in the tax burden is quite high.

Accounting standards evolve

An emphasis on accounting for lease economics will continue. Also, lease accounting standards will continue to evolve. The Financial Accounting Standards Board (FASB) continues to address issues that indirectly relate to leasing in specific situations such as specialpurpose corporations and financial instruments.

International Markets Worldwide economic growth

International

Worldwide, leasing is increasing as countries develop their infrastructure from an accounting, tax, and economic perspective. From South America to Africa to the Far East, the leasing industry is growing — sometimes at double-digit rates.

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At the same time, many foreign leasing companies are active in the U.S. The spread of economic unions such as the European Economic Community (EEC) and the union created by the NAFTA agreement signed by the U.S., Mexico, and Canada have helped expand foreign leasing opportunities.

Economic Factors Used equipment leases

Used equipment is increasingly being leased as lessees are less set on having the latest technology. Often, they find that an older model performs adequately, especially when they consider the cost of acquiring the latest technology.

Product requests

More lessees are asking for unique lease structures to aid in their cash flow requirements. Lessees are also requesting more bundled leases and facilities management contracts in order to decrease overhead costs.

SUMMARY There are many motivations for lessors to be in the leasing business. The primary objective of a lessor is to make a reasonable profit from the lease transaction. The reasons lessors are in the leasing business fall into the following categories: n

Profitability

n

Income tax benefits

n

Financial leverage

n

Residual value

n

Vendor leasing issues such as market control, product distinction, and increased sales through bundled services

n

Expansion (integration) opportunities

n

International opportunities

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mergers and acquisitions. Changes in the U.S. economy and tax laws are forcing lessors to seek other ways to make profits. Lessees are seeking more full service packages and are leasing more used equipment. Lessors are changing their leasing products to better meet lessees’ needs and wants. Also, leasing is becoming more global in scope. U.S. lessors are becoming more active abroad — and foreign leasing companies are doing business in the U.S. You have just completed Unit 1: Understanding the Leasing Industry. Please complete the following Progress Check before you continue to Unit 2: Lease Classifications — Financial Reporting and Tax Classification. If you answer any question incorrectly, you should return to the text and read that section again.

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þ PROGRESS CHECK 1.3 Directions: Select the correct answer to each question. Check your answers with the Answer Key on the next page. Question 1: A full service lease is one in which: ____ a) the lessee must provide all its own services such as maintenance and insurance. ____ b) a lessor provides additional services to the lessee such as equipment, maintenance, and insurance. ____ c) a third party receives the lessee payments and remits the proper amounts for services to the maintenance and insurance providers. ____ d) a lessee has more control over the manufacturer in the event of a warranty dispute.

Question 2: A major difference between a single-investor lease and a leveraged lease is that in a: _____ a) leveraged lease, the borrower is not at-risk for the borrowed funds; but in a single-investor lease, the lessor is fully at-risk for any borrowed funds. _____ b) single-investor lease, the lender owns the property; while in a leveraged lease, the lessor owns the property. _____ c) single-investor lease, the lender is concerned with the credit-worthiness of the lessee; while in a leveraged lease, the lender is concerned with the credit-worthiness of the lessor. _____ d) single-investor lease, the lessor assigns or discounts the lease payments to the lender in return for up-front cash; while in a leveraged lease, the lessee usually makes payments directly to the lessor.

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ANSWER KEY

Question 1: A full service lease is one in which: b) a lessor provides additional services to the lessee such as equipment, maintenance, and insurance.

Question 2: A major difference between a single-investor lease and a leveraged lease is that in a: a) leveraged lease, the borrower is not at-risk for the borrowed funds; but in a single-investor lease, the lessor is fully at-risk for any borrowed funds.

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Question 3: In financial leverage, a lessor: _____ a) borrows funds on a nonrecourse basis. _____ b) assigns or discounts the lease payment series to the lender, in return for up-front cash. _____ c) earns substantial returns on its equity because it pays only a fraction of the cost of equipment with its own funds. _____ d) is fully at-risk for any borrowed funds.

Question 4: Residual value is the actual or expected value of leased equipment at the end or termination of the lease. _____ a) True _____ b) False

Question 5: Most of the current trends in the leasing industry result from: _____ a) tax and accounting reforms. _____ b) economic factors. _____ c) advances in technology. _____ d) growing competition among lessors.

Question 6: Today’s lessors are offering more bundled services, off balance sheet structures, and capped renewals because: _____ a) the Tax Reform Act of 1986 favors these lease products. _____ b) these products are more profitable. _____ c) they wish to achieve economies of scale. _____ d) knowledgeable lessees request these products.

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ANSWER KEY

Question 3: In financial leverage, a lessor: c) earns substantial returns on its equity because it pays only a fraction of the cost of equipment with its own funds.

Question 4: Residual value is the actual or expected value of leased equipment at the end or termination of the lease a) True

Question 5: Most of the current trends in the leasing industry result from: b) economic factors.

Question 6: Today’s lessors are offering more bundled services, off balance sheet structures, and capped renewals because: d) knowledgeable lessees request these products.

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Unit 2

UNIT 2: FINANCIAL REPORTING AND TAX CLASSIFICATIONS

INTRODUCTION

As you learned in Unit One, lease agreements are written contracts that contain the terms and conditions of the lease transaction. These terms and conditions have certain accounting, tax, and legal characteristics. The characteristics help the various regulatory bodies determine how the lease is to be treated for financial reporting, tax, and legal purposes. Each regulatory body has its own criteria for classifying leases. However, all regulatory groups consider the substance of the transaction rather than the form to determine classification. This means that even though a transaction is labeled a lease (its form), the substance of the agreement (the meaning of the content) may indicate that the transaction is not a true lease. In Units Two and Three, you will learn how the characteristics of a lease affect how it is classified for various purposes and how each classification dictates the way the lease is treated. Specifically, in Unit Two, you will see how the accounting (financial reporting) classification affects how the lessor and lessee report the lease on their financial reports. Then you will learn how tax considerations affect the after-tax cash flows (and, therefore, the entire pricing structure) of a lessor. In Unit Three, you will see how legal classifications are determined, why they are important considerations for the lessor (as well as the lessee), and why provisions of the lease must be carefully documented.

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FINANCIAL REPORTING AND TAX CLASSIFICATIONS

UNIT OBJECTIVES

When you complete this unit, you will be able to: n

Distinguish between operating leases and capital leases

n

Recognize how lessors and lessees account for operating and capital leases

n

Understand the tax implications of tax and nontax leases

FINANCIAL REPORTING CLASSIFICATIONS

Operating and Capital Leases Definitions

For financial reporting purposes, leases are classified as either operating leases or capital leases. An operating lease is a “true” usage agreement in which the lessor is considered the owner of the equipment. A capital lease is really an installment or conditional sale agreement. In a capital lease, the lessee is considered the owner of the equipment.

Classification Criteria FASB

The Financial Accounting Standards Board (FASB) sets the criteria for classifying leases and the rules for reporting leases in a firm’s financial statements. FASB Statement 13 - Accounting for Leases (FASB 13) contains the accounting rules for lease transactions. The main goal of the criteria is to establish who, in substance, owns the equipment.

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The lessee and the lessor apply the criteria independently. This means that each party may classify the same lease differently. They make their decisions at the inception of the lease and cannot change the classification later. Four criteria

There are four classification criteria that determine whether a lease transaction resembles a purchase agreement (capital lease) or a usage agreement (operating lease). If a transaction meets any one of the four criteria, it is classified as capital. The criteria are as follows:

Transfer of ownership

1. The lease automatically transfers ownership of the property to the lessee by the end of the lease term. If the title will automatically pass to the lessee, then the transaction is not a usage agreement, but an ownership agreement.

Bargain purchase option

2. The lease contains an option that allows the lessee to purchase the leased property at a bargain price. If the lease contains a purchase option that is so low that the lessee is likely to exercise it, the lessee is viewed as the owner of the equipment.

Dollar-out and fair market value options

Most lease companies offer two general categories of products: dollar-out leases and fair market value (FMV) leases. In a dollarout lease, the lessee may purchase the equipment for one dollar at the end of the lease term. This is clearly a bargain purchase option. In an FMV lease, the lessee can purchase the equipment at the end of the lease term for its fair market value. This is clearly not a bargain purchase option. Sometimes the answer is not as clear. In these cases, the transaction classifier must decide if the lessee is likely to become the owner.

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Economic life of equipment


3. The lease term is equal to or greater than 75% of the estimated economic life of the leased property. FASB 13 defines economic life as the useful life in the hands of multiple users, given normal repairs and maintenance. If the lessee will use the equipment for a major portion of the equipment’s economic life, the lease should be classified as a capital lease. The theory is that assets effectively produce income for a limited time. If the lessee uses the equipment for more than 75 percent of that time, the lessee is, in effect, the owner. In addition to the asset’s economic life and the lease term, the classifier must take into account any lease provisions that could extend the lease term. For example, if all periods in the lease are covered by bargain renewal options or nonrenewal penalties, the classifier should classify the lease as a capital lease.

Effective ownership

4. The present value of the minimum lease payments is equal to, or greater than, 90% of the fair value of the leased property less any investment tax credit retained by the lessor. This is the most complex of the four criteria, and is used to determine effective ownership of the equipment. The present value of the minimum lease payments is compared to 90 percent of the equipment’s fair market value. If the result is greater than or equal to 90% of the fair value, the transaction is a capital lease. The minimum lease payments are all the required payments according to the lease agreement. Fair market value is the value of a piece of equipment if it were to be sold at arm’s length under terms and conditions similar to those in the lease. Present value is the discounted value of a future payment stream. It represents a series of future cash flows expressed in today’s dollars. A present value calculation (see page 5-__) removes the time value of money (interest). The remaining value is the portion of the equipment cost that will be recovered from the lease payments.

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If the calculation indicates that the lessor is recovering more than 90 percent of the equipment cost from the minimum lease payments, then the lessee is, in effect, paying for the equipment over time. The lease must be classified as capital. FASB 13 requires that lessors and lessees use specific discount rates in the analysis. In some situations, the rates may differ between lessors and lessees. The fact that definitions for terms such as economic life, lease term, and minimum lease payments may vary between lessor and lessee adds to the complexity of this classification process. These differences in the definition of minimum lease payments, as in those of the discount rate, may lead lessors and lessees to classify the same lease differently.

IMPLICATIONS FOR FINANCIAL REPORTING

Now that you know how leases are classified, you are ready to look at how these classifications affect the way lessors and lessees account for leases in their financial records.

Lessor and Lessee Accounting Accounting regulations

In addition to setting the criteria for classifying a transaction, FASB 13 provides the rules lessors and lessees use to account for lease transactions. The goal of the FASB 13 regulations is to have the balance sheet and income statement reflect the substance of the transaction (ownership or not). The accounts in the balance sheet and income statement that lessors and lessees use for leases is summarized in Figure 2.1. An explanation of each quadrant follows.

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Figure 2.1: Lessor/lessee lease account summary

Lessor Accounting for a Capital Lease Lessor as financier

Quadrant 1 shows the accounting for a lessor capital lease where the lessor is not (in substance) the owner of the equipment. Instead, the lessor is financing the lessee’s acquisition of the equipment. The accounting is similar to accounting for a loan. On the balance sheet, the lessor records a net investment in lease receivables, which is similar to a note receivable account that a bank sets up to record a loan. The income statement reflects interest income earned on the outstanding lease receivable, just as a bank earns interest income on the outstanding principal in a loan. Lessor Accounting for an Operating Lease

Lessor as owner

Quadrant 2 shows lessor accounting for an operating lease. The lessor accounts for the transaction as if it owns the equipment and is allowing the lessee to use the equipment. The equipment cost is recorded as an asset on the balance sheet and depreciated over the lease term. Rents received from the lessee for use of the equipment are recorded as income on the income statement.

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Lease term income

2-7

It is important to note that the classification of the lease does not affect the total amount of income recognized by the lessor. Over the life of the lease, the interest income recognized in a capital lease will equal the difference between rental income and depreciation expense in an operating lease. The following equation represents income for the two types of leases over the entire lease term: Interest Income = Rental Income – Depreciation

Lessee Accounting for a Capital Lease Lessee as owner

Lessee accounting for a capital lease is shown in Quadrant 3. If the lease is classified as a capital lease, the lessee is considered to be the owner of the equipment. The accounting for a capital lease is similar to the accounting for a loan used to purchase the equipment. On the balance sheet, the lessee records an asset for the equipment and a liability for the lease payable. The lessee’s income statement shows depreciation expense on the asset and interest expense on the lease payable. Lessee Accounting for an Operating Lease

Lessee as user of equipment

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Quadrant 4 shows the lessee’s operating lease accounting. In an operating lease, the lessee is the user of the equipment, not the owner. The lessee records nothing on the balance sheet, which is why operating leases are often referred to as off balance sheet leases. On the income statement, the lessee records rent expense for the payments made to the lessor. It is important to note that FASB 13 requires the lessee to disclose this liability in the footnotes (set of notes) accompanying the financial statements. Footnotes are used to explain how numbers on the financial statements were derived and to document obligations that do not appear on the statements themselves.

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Just as in lessor accounting, the classification of the lease does not affect the total expense recognized by the lessee. Over the life of the lease, the depreciation expense plus interest expense of a capital lease will equal the total rent expense of an operating lease. The following equation represents total expense over the entire lease term:

Rent Expense = Depreciation + Interest Expense

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ABC COMPANY BALANCE SHEET (End of first year) ASSETS Operating Lease

Capital Lease

Difference

Current Assets Cash in bank Accounts receivable Inventory Total current assets

$13,684 12,000 8,000 $33,684

$13,684

0 96,000 0 (30,000) $99,684

$ 1,070

($1,070)

96,000 100,000 (50,000) $180,754

(100,000) 20,000 ($81,070)

12,000 8,000 $33,684

Fixed Assets Deferred tax charge Property, plant, equipment Capital leased equipment Less: accum. depreciation Total assets

$

LIABILITIES Current Liabilities Accounts payable Lease payable Total current liabilities

$6,000 0 $6,000

$6,000 18,350 $24,350

(18,350) ($18,350)

Long-term Liabilities Notes payable Lease payable Total liabilities

$30,000 0 $36,000

$30,000 64,706 $119,056

($64,706) ($83,056)

STOCKHOLDERS’ EQUITY Common stock Retained earnings (prior) Current portion Total equity Total liabilities and equity

$14,000 $20,000 29,684

$14,000 $20,000 27,698

$1,986

$63,684

$61,698 $180,754

$1,986 ($81,070)

$99,684

Figure 2.5: Operating / capital lease balance sheet comparison

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Operating Lease Accounting Benefits - Lessee Financial reporting benefits

To help you understand the financial reporting differences for the lessee, let’s look at a balance sheet and an income statement for the same lease, accounted for as both a capital lease and an operating lease. From this example you will see why, from an accounting perspective, lessees prefer operating leases. Financial Statement Comparison

A balance sheet comparison of the lease, accounted for as both operating and capital is shown in Figure 2.5. The balance sheet is presented as of the end of the first year. As you examine the income statement comparison for the first year (Figure 2.6), notice that earnings and net income are higher if this lease is classified as an operating lease. In the later years of the lease the operating lease expense will be higher, since the total expense over the life is the same for both lease types. ABC COMPANY INCOME STATEMENT (End of first year) ASSETS Operating Lease Revenue Sales Cost of goods sold Gross profit Operating Expenses Selling General and administrative Lease expense Depreciation expense Operating income

Capital Lease

Difference

$300,000 (160,000) $140,000

$300,000 160,000 $140,000

($4,000) (44,000) (24,332) (10,000) $57,668

($4,000) (44,000) 0 (30,000) $62,000

($24,332) 20,000 ($4,332)

($12,000) $45,668 (15,984) $29,684

$19,388 42,612 (14,914) $27,698

$7,388 $3,056 (1,070) $1,986

Other Income and Expenses Interest expense Income before taxes Income taxes @ 35% Net Income

Figure 2.6: Operating / capital lease income statement comparison

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SUMMARY

Understanding the accounting for leases for both lessors and lessees is made easier by remembering that the accounting reflects the substance of the transaction. The substance of the lease transaction is established by the four criteria of FASB 13. In an operating lease, the accounting reflects ownership of the equipment in the hands of the lessor. In a capital lease, the lessee is considered the owner of the equipment. One of the major reasons lessees lease is off balance sheet financing. The example in this section showed both the enhancement of earnings that operating leases provide and the improvement of perceived financial health. In the next section, you will learn about the tax classification of leases. Before you continue to the next section, check your understanding of the concepts you have just learned by completing the Progress Check that follows. If you answer any question incorrectly, please return to the text and read the section again.

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PROGRESS CHECK 2.1

Directions: Determine the correct answer to each question. Check your answers with the Answer Key on the next page. Question 1: A lease that transfers substantially all the benefits and risks of ownership to the lessee should be accounted for as a(n): ____ a) operating lease. ____ b) capital lease.

Question 2: If the lessee effectively purchases the asset by the end of the lease term, it would classify the lease as a(n): ____ a) capital lease. ____ b) operating lease.

Question 3: In accounting for an operating lease, the lessor shows the rental income and depreciation expense on its income statement. ____ a) True ____ b) False

Question 4: The lessee prefers operating lease financial statement presentation. ____ a) True ____ b) False

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ANSWER KEY

Question 1: A lease that transfers substantially all the benefits and risks of ownership to the lessee should be accounted for as a(n): b) capital lease.

Question 2: If the lessee effectively purchases the asset by the end of the lease term, it would classify the lease as a(n): a) capital lease.

Question 3: In accounting for an operating lease, the lessor shows the rental income and depreciation expense on its income statement. a) True

Question 4: The lessee prefers operating lease financial statement presentation. a) True

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Question 5: For the lessee, capital lease accounting is: ____ a) less complex than accounting for an operating lease. ____ b) similar to accounting for a loan. ____ c) the same as for lessor capital lease accounting.

Question 6: A lease that provides off balance sheet financing to a lessee is called a(n): ____ a) operating lease. ____ b) capital lease.

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ANSWER KEY

Question 5: For the lessee, capital lease accounting is: b) similar to accounting for a loan.

Question 6: A lease that provides off balance sheet financing to a lessee is called a(n): a) operating lease.

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TAX CLASSIFICATIONS

As discussed earlier, each regulatory body has its own criteria for classifying leases. In the previous section, you learned that the FASB classification (operating or capital) determines how the lease is accounted for on financial statements. In this section, we will discuss how the U.S. IRS classifies leases and what this means to taxpayers.

Tax and Nontax Leases Ownership and tax benefits

According to U.S. tax law, as interpreted by the Internal Revenue Service (IRS), leases must be classified from a tax viewpoint as either tax leases or nontax leases. In a tax lease, the lessor bears the risks of ownership and is entitled to the tax benefits of ownership (i.e., depreciation and tax credits). In a nontax lease, the lessee is, or will become, the owner of the leased equipment. As owner or potential owner, the lessee is entitled to the tax benefits of ownership. A nontax lease is actually an installment sale contract in the form of a lease. Congress has never enacted legislation specifically addressing the classification of a lease. Taxpayers are unable to refer to a particular code section in the Internal Revenue Code for guidance as to whether or not the transaction is a true lease (tax lease) for tax purposes or a nontax lease.

Sources of Classification Criteria Internal Revenue Service statements

To help taxpayers, the IRS has issued several statements to outline the criteria the IRS uses to classify lease transactions. You will see that the criteria used to determine the tax classification of a lease are similar to, but different from, those used for accounting purposes. The most important criteria come from Revenue Ruling 55-540 and Revenue Procedure 75-21. Also providing guidance to taxpayers are the various tax court rulings that have been rendered over the years.

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Revenue Ruling 55-540

Ruling 55-540 provides the elements of a nontax lease. The more important items (according to the IRS) are quoted below. If any of these provisions are included in a lease, the lease must be considered a nontax lease. As we stated above, in a nontax lease, the lessee is, or will become, the owner of the leased equipment. Tax status criteria

1. Portions of the periodic payments (rentals) are made specifically applicable to an equity interest to be acquired by the lessee. 2. The lessee will acquire title upon the payment of a stated number of rentals which under the contract he is required to make. This situation occurs two ways: a. Paying a stated number of rentals after which title transfers. b. Title transfers automatically at the end of the lease without a purchase option or guaranteed residual. 3. The total amount which the lessee is required to pay for a relatively short period of use constitutes an inordinately large proportion of the total sum required to be paid to secure the transfer of title. 4. A bargain purchase option exists in which the option cost is less than the expected fair market value of the leased asset or is small in comparison to the total lease payments to be made. 5. Some portion of the periodic payments is specifically designated as interest or is otherwise readily recognizable as the equivalent of interest.

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Revenue Procedure 75-21 Guidance for large leveraged lease structures

In 1975, the IRS issued Revenue Procedure 75-21 (Rev. Proc. 75-21) to provide guidance for structuring large leveraged leases. Because an equity investor (the lessor) and a nonrecourse lender finance the equipment in a leveraged lease, the parties were often uncertain as to whether the lessor was at risk. As you will recall, the party that bears the risk of ownership is the one that receives the tax benefits. Both the IRS and the leasing industry use the guidelines of Rev. Proc. 75-21 to help classify the transaction. The more important guidelines for tax lease consideration are as follows:

Classification criteria

n

Minimum unconditional at-risk investment - 20 percent minimum investment - Equipment must have a remaining life beyond the lease term of the longer of one year or 20 percent of the originally estimated depreciable life

n

Purchases and sale rights - No bargain purchase options allowed

n

No investment by the lessee

n

No lessee loans or guarantees

n

Profit requirement (complex IRS formula)

n

Positive cash flow (complex IRS formula)

Tax Court Decisions

In addition to the IRS statements we’ve just described, tax court rulings have influenced the tax classification of a lease transaction. The tax courts have focused on three important variables in reaching their decisions: risk, intent of the parties, and economic merit.

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Risk of ownership

According to the tax courts, the party that bears the risk of ownership in the transaction should receive the tax benefits of ownership. The courts often refer to Revenue Ruling 55-540 and Rev. Proc. 75-21 to help identify and allocate risk. They also examine the transaction for credit risk and for the risk associated with the unrecovered cost of the equipment, or the residual risk. The risk of ownership must be clear. For instance, a tax lease should not contain a bargain purchase option or specify a lessee guaranteed residual value. Either of these two events removes the residual risk from the lessor.

Intent

The courts also try to establish the true intent of the parties. Did the lessee believe it was just using the property in a rental agreement, or did it perceive the transaction as an installment sale? To establish the intent of the parties, the courts examine the transaction as well as previous cases.

Economic merit

Economic merit means that the transaction must have been entered into for other than tax-motivated purposes. The courts look for positive cash flow and profits from sources other than tax benefits.

IMPLICATIONS OF TAX CLASSIFICATIONS

The tax classification of a lease transaction is important because it determines which party (the lessor or lessee) is entitled to the tax benefits of ownership. In this section, we will examine the tax considerations of tax and nontax leases, describe how tax benefits affect lease pricing, and discuss a few tax and nontax lease products.

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Tax Consequences Cash flows

Tax consequences represent either positive or negative cash flows to a company. The sooner companies receive cash, the more it is worth to them. This concept is referred to as the time value of money. Understanding this concept is critical to understanding the importance of tax benefits in the pricing of a lease. Tax benefits are cash inflows to the lessor. They affect the after-tax cash flows. For this reason, they influence the entire pricing structure of a lessor. The lessor can use them to enhance its yield or to lower the lessee’s payment.

Lease vs. purchase decision

Tax considerations also affect the lessee’s decision to lease or to purchase equipment. The lessee must weigh the tax benefits of ownership against the benefits of leasing we discussed in Unit One.

Terminology To understand the tax implications of leasing, you must be familiar with the following terms. Asset Class Life (ADR Class Life) — IRS-approved depreciable lives for all types of property. Depreciation Basis — The amount of the original cost of the property that has not been depreciated. Depreciation basis is represented by the following formula: Basis = Original Cost – Accumulated Depreciation

Modified Accelerated Cost Recovery System (MACRS) — The current regular tax depreciation methodology. This is the current form of tax depreciation corporations use to depreciate their tax assets for federal income tax purposes.

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Tax Returns Earlier, you learned that tax ownership of equipment determines whether a lease is a tax lease or a nontax lease. In a tax lease, the lessor, as owner of the property, is entitled to the tax benefits. If the transaction is a nontax lease, the lessee is deemed the property owner, and is entitled to the tax benefits. A summary of the tax return implications for lessors and lessees is presented in Figure 2.7.

Figure 2.7: Lessor/lessee tax implications

Lessor - Tax Lease Ownership benefits

Quadrant 1 shows the benefits of ownership for a lessor in a tax lease: tax depreciation and any credits available. In addition, the lessor records as income the rents received from the lessee. Lessor - Nontax Lease

Taxed on interest

Quadrant 2 shows the tax implications to the lessor in a nontax lease. Since the lessee is deemed to be the owner of the equipment in a nontax lease, the lessor is taxed on interest income.

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Timing of taxable income

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It is important to note that the tax status of a lease does not affect the total amount of taxable income recognized; it affects only when that income is taxable. Over the life of the lease, the rental income less depreciation expense recognized in a tax lease will equal the interest income recognized if the lease is classified as a nontax lease. Lessee - Tax Lease

Rent expense

Quadrant 3 illustrates the tax implications for the lessee if the lease is a tax lease. The lessee is the user of the equipment and ownership is in the hands of the lessor in a tax lease. The lessee is entitled to a deduction on its tax return for the rent expense paid to the lessor. Lessee - Nontax Lease

Ownership benefits

In a nontax lease, the lessee is considered the owner of the equipment, as detailed in quadrant 4. The lessee receives a deduction for depreciation and also a deduction for interest expense.

Modified Accelerated Cost Recovery System (MACRS) Accelerated tax depreciation is one of the tax law provisions that the U.S. federal government uses to encourage investment in assets. MACRS is the current form of tax depreciation corporations use to depreciate their tax assets for federal income tax purposes. General provisions

The three general rules are as follows: 1. MACRS generally applies to property placed in service after December 31, 1986. 2. There are six classes of property dealing with personal property, which is all property other than land and buildings. 3. The MACRS depreciable life is based on the asset class life, which is the IRS-designated economic life of an asset.

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Half-year convention


MACRS is an accelerated form of tax depreciation because depreciation deductions are calculated using a half-year convention for the year the equipment is acquired and the year of disposition. The convention assumes that all property is placed in service in the middle of the taxpayer's tax year. For a calendar-year taxpayer, all property is assumed to have been placed in service on July 1. This means that these taxpayers can take a half-year depreciation deduction even if they placed the property in service on December 31. For the year of disposition, taxpayers assume the asset is disposed of in the middle of the year, regardless of the actual date of disposition. MACRS depreciation rates are based on the asset class life and the recovery year. The MACRS table is shown in Figure 2.8. Taxpayers refer to this table for the applicable percentages for any year to calculate their depreciation deductions.

Example

For this example, assume an original equipment cost of $100,000 and 5-year MACRS property that is in its third year of depreciation. You calculate the deduction taken on the tax return as follows: Equipment cost

$100,000

MACRS % (third year)

x 19.2%

Tax return deduction $ 19,200

MACRS TABLE DRAFT

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If the recovery year is:

and the recovery period is:

3 Years

5 Years

33.33% 44.45 14.81 7.41

20.00% 32.00 19.20 11.52 11.52 5.76

7 Years

10 Years

15 Years

20 Years

the depreciation rate is: 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21

14.29% 24.49 17.49 12.49 8.93 8.92 8.93 4.46

10.00% 18.00 14.40 11.52 9.22 7.37 6.55 6.55 6.56 6.55 3.28

5.00% 9.50 8.55 7.70 6.93 6.23 5.90 5.90 5.91 5.90 5.91 5.90 5.91 5.90 5.91 2.95

3.750% 7.219 6.677 6.177 5.713 5.285 4.888 4.522 4.462 4.461 4.462 4.461 4.462 4.461 4.462 4.461 4.462 4.461 4.462 4.461 2.231

Figure 2.8: Modified Accelerated Cost Recovery System table

Positive cash flow

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As a tax benefit, MACRS represents a positive cash flow to the taxpayer because the benefits and cash flows are received more quickly. Remember that the sooner cash flows are received, the more they are worth on a present value basis.

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Midquarter Convention TRA 86

The midquarter convention is a provision in the Tax Reform Act of 1986 (TRA 86). Congress enacted the midquarter convention rule to prevent taxpayers from over-utilizing the half-year convention benefit. This rule sets a limit on the amount of equipment a company can place in service in the fourth quarter of a tax year and still receive the benefit of the half-year convention.

The 40% penalty

The midquarter convention is sometimes referred to as the 40 percent penalty. Under this penalty, if more than 40 percent of all personal property placed into service during the tax year is placed into service in the last three months of the taxable year, the taxpayer must use the midquarter convention instead of the half-year convention. The concept of the midquarter convention is illustrated in Figure 2.9.

Figure 2.9: Triggering midquarter penalty

Effect of the Midquarter Convention Slowed cash inflow

The midquarter convention causes the tax benefits from depreciation deductions to be realized at a slower pace. Again, if the realization of the tax benefits is slowed, the cash flow benefit is slowed. Because of the time value of money, the tax benefit is not worth as much as it was under the half-year convention.

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Because lease companies often complete many transaction in the fourth quarter, they are prime candidates to be affected by the midquarter convention. If a lessor is in a midquarter position, the slowing cash flows realized from tax benefits will lower the yield in the lease. Looked at another way, if the lessor desires the same yield in the lease as would be expected under the half-year convention, then the lessor must increase cash flows from the monthly payments, fees, or from residual realization. The slower depreciation rate of the midquarter convention is highlighted in Figure 2.10. MIDQUARTER / HALF-YEAR COMPARISON Midquarter Convention Year

Amount

1 2 3 4 5 6

5,000 38,000 22,800 13,680 10,944 9,576

Cumulative

Half-Year Convention Amount

5,000 43,000 65,800 79,480 90,424 100,000

20,000 32,000 19,200 11,520 11,520 5,760

Cumulative 20,000 52,000 71,200 82,720 94,240 100,000

Difference Amount

Cumulative

(15,000) 6,000 3,600 2,160 (576) 3,816

(15,000) (9,000) (5,400) (3,240) (3,816) -0-

Figure 2.10: Midquarter convention effects on depreciation deductions

Value of Depreciation In this section we quantify the value of the depreciation tax benefit and show how tax benefits affect lessor pricing. This will help you understand why depreciation is a source of profit for lessors and why lease rate factors are generally lower in the fourth quarter. Assumptions

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We use the following assumptions to illustrate the value of depreciation: n

$100,000 equipment cost

n

5-year MACRS benefits versus principal repayment

n

Pretax equivalent loan rate of 10.50 percent

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Tax lease income


n

Cost of capital is 7.15 percent

n

Payments are $2,149.39 per month, in arrears

n

Lease inception date is December 31

In Figure 2.11, we can see the income recognized if the transaction is a tax lease. Notice that the total income recognized is the same under both rental income and MACRS over the 60-month term. Only the nature and the timing of the income vary. TAX LEASE INCOME Tax Year 1 2 3 4 5 6

(2,149.39 x 12) “ “ “ “

Rental Income

MACRS

0 25,793 25,792 25,793 25,792 25,793 128,963

20,000 32,000 19,200 11,520 11,520 5,760 100,000

Total Income (20,000) (6,207) 6,592 14,273 14,272 20,033 28,963

Figure 2.11: Income from tax lease transaction

Comparison

Lessors realize more of a time value of money benefit from leasing than they do from lending. A year-by-year loan/lease income comparison is displayed in Figure 2.12.

Timing of cash flows

The difference column of Figure 2.12 shows the differences in taxable income. The timing of the deductions and taxable income affects the timing of the resultant cash flows. Therefore, the lessor realizes a time value of money benefit if the end-user of the equipment leases the equipment. The amount of this time value of money benefit is determined by computing the present value of the difference column times the tax rate. This amount represents the value of depreciation in this transaction.

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Worth of lease alternative

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In this transaction, the lease alternative is worth an additional $2,892 to the lessor. This represents the amount, on a present value basis, of the tax savings from the accelerated depreciation deductions compared to the principal reductions in the loan. The additional cash flow, realized purely from timing differences in income recognition, either increases the lessor's yield or allows the lessor to offer a lower payment to the lessee.

INCOME COMPARISON Year 1 2 3 4 5 6

Loan Income 0 9,742 7,973 6,010 3,829 1,409 28,963

Lease Income (20,000) (6,207) 6,592 14,273 14,272 20,033 28,963

Difference 20,000 15,949 1,381 (8,263) (10,443) (18,624) 0

Figure 2.12: Loan / lease income comparison

Effect of inception date

In the above example we used an inception date of December 31. Because of the half-year convention, this date results in the maximum timing differences of the two alternatives. If the inception date were January 1, the depreciation value would be lower. Although still beneficial, the effect of depreciation is greatly lowered for tax transactions completed early in the year. The lessor's pricing reflects this.

Fourth quarter

As you can see, a lease that starts in the fourth quarter is more sensitive to the value of depreciation. By realizing more of the yield in the lease from tax benefits, the lessor may rely less on the periodic payment. Hence, the lessee's payment is typically lower if structured in the fourth quarter.

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Corporate Alternative Minimum Tax (AMT) Limits on MACRS depreciation

Although corporations are allowed to reduce taxable income with MACRS depreciation, Congress has placed limits on the amount of these deductions. If these limits are exceeded, an additional tax is imposed. This tax is referred to as the AMT. The AMT attempts to ensure that all corporations pay a minimum tax. It requires corporations to compute both the regular tax and the AMT, and then pay the higher of the two calculations. How AMT Works

Examine Figure 2.13 to see how the AMT works. BASIC AMT CALCULATION Regular Tax

AMT

Income before taxes – Adjustments

Income before taxes – Adjustments__

Taxable income x 35%

Taxable income + Preferences

Taxes payable

a

AMT income x 20%

a

AMT payable

Figure 2.13: Calculation of Corporate Alternative Minimum Tax (AMT)

Adjustments

The adjustments referred to in the illustration are various Internal Revenue Code (IRC) adjustments firms make to income before taxes in order to arrive at taxable income. These adjustments (such as MACRS) decrease or increase the income before taxes. Tax departments in corporations identify and use the IRC-allowed adjustments to lower the firm’s taxes. More negative adjustments result in lower taxable income, which means the corporation will pay fewer taxes to the IRS.

Preference

Under the AMT, for some adjustments taken to arrive at taxable DRAFT

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income, a portion of the adjustment or deduction is added back to regular taxable income. These are preference items. The preference item with the greatest impact on the leasing industry is accelerated depreciation on personal property. This preference item is the difference between depreciation used for the regular tax calculation (generally MACRS) and depreciation calculated using the prescribed AMT method. Marketing Approach

Once a lessor understands the complexities of AMT, it can use its knowledge of the AMT to identify lessees in a potential AMT position and convince the lessee to lease the equipment to avoid AMT. Potential customers

Avoid preferences

Characteristics of companies in AMT include: n

Companies experiencing low taxable income and high AMT preferences

n

Companies that heavily invest in machinery and equipment

n

Companies that purchase equipment that falls at the high end (long ADR life) of the MACRS classification

n

Young companies that have rapidly growing asset bases and that cannot benefit substantially from the turn-around of older assets, which would lessen the preference burden

In marketing tax leases to a potential lessee, the goal is to show the client how to minimize the risk of paying AMT through leasing. Because preferences cause AMT situations, a number one priority is to help the lessee to avoid those preferences that may trigger AMT. The preference for accelerated depreciation can be avoided by tax leasing because the preference applies only if the lessee owns and depreciates equipment. Purchasing creates a depreciation preference, whereas tax leasing does not.

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Lessor Perspective AMT risk

As the tax owner of the equipment in a tax lease, lessors are prime candidates to be in AMT. Industrywide, about 50 percent of leases are tax leases and are, therefore, creating preferences for lessors. If a lessor is in AMT, strategies must be adopted that will minimize its impact. For example, different nontax lease products can be developed. In some situations, however, lessors will be unable to avoid the AMT.

Lease Products Within each of the two broad categories — tax leases and nontax leases — are several types of lease products lessors have developed to meet the needs of various customers. In this section, we will discuss tax and nontax lease products. Tax Lease Products

Two tax lease products worthy of mention are the TRAC lease and the tax-exempt user lease. Target industry

The TRAC lease is a tax lease specifically designed for the commercial vehicle leasing industry. TRAC stands for Terminal Rental Adjustment Clause.

Lessee assumes residual risk

In the TRAC lease, the lessee assures the lessor receipt of a specified residual, or salvage, value of vehicle. The lease payments in a TRAC lease are lower because the lessor relies on the lessee assurances regarding the residual value of the equipment.

Qualifying vehicles

Examples of specialized vehicles that qualify for TRAC leases include dealer service trucks, dealer haul trucks, contractor haul trucks, equipment trailers, and busses.

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End-of-term adjustment

A TRAC is a provision in a lease agreement that requires a rental adjustment at the end of the lease term. This adjustment amount is determined by the comparison of the current fair market value (FMV) of the equipment versus the lessee-assured residual value upon which the lease payments are based.

Shifts risk to lessee

If the realized actual value is less than the assured value, the lessee is required to pay the deficit to the lessor as the final rental. If the actual value is greater than the assured value, the lessor may pay to the lessee the surplus, which essentially reduces the amount of the lease payments paid by the lessee. Even though risk is being shifted to the lessee, the lessee standing behind the residual will not cause tax lease treatment to be disallowed by the IRS, due to a special provision in the IRC.

Full payment taxable

Lessors enter into a tax-exempt user lease with tax-exempt or nonprofit organizations such as hospitals or federal government agencies. The IRS requirements for a tax lease must be met. This lease is considered a tax lease even though the user does not pay federal income taxes. The lessor records the full payment as taxable income. In most circumstances, depreciation is received at a slower rate than the standard MACRS class life schedule. Nontax Lease Products

Lessee ownership

Recall that when a lease fails to meet the IRS criteria for a tax lease, the transaction is classified as a nontax lease. In a nontax lease, the lessor is treated as a provider of financing. Let’s look at a few nontax lease products.

Similarity to a loan

Sometimes the substance of the lease transaction resembles a sale. In a conditional sales contract, the seller sells the asset and transfers possession to the purchaser, but retains title to the asset until the purchaser has fully paid for it. A conditional sale is a form of financing, much like a loan. A dollar-out lease, in which the lessee may purchase the equipment for one dollar at the end of the lease term, is an example of a conditional sales contract.

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Ownership options

A money-over-money lease is a conditional sales contract. The substance of the lease is that the lessee is, or will become, the owner of the leased equipment by the end of the lease term. This could occur if the lessee has the option to acquire title to the equipment at the end of the lease for no additional consideration, or for a fixed-price purchase option that is substantially less than fair market value.

Interest rate differences

In a money-over-money lease, the lessor's profit in the lease is the difference between the interest rate at which the lessor borrowed the money to purchase the equipment and the interest rate it charges the lessee. The lessor is making money over money, or a spread. For example, if the lessor borrowed the money from the lender at 10 percent and is charging the lessee 13 percent, the spread is 3 percent. Municipalities can enter into a special lease called a municipal lease. A municipal lease is a nontax lease or a conditional sales contract and has the characteristics of tax exempt debt.

Tax-exempt interest earnings

An interest rate is stated in the contract. The municipality becomes the owner of the equipment at lease termination. The key characteristic of a municipal lease is that the interest earnings to the lessor are taxexempt. The lessor can pass part of this tax saving on to the municipal lessee by charging a lower payment than it would normally need to charge a taxable organization.

SUMMARY

Leases are classified as either tax leases or nontax leases. In a tax lease, the lessor bears the risks of ownership and is entitled to the tax benefits associated with the equipment. In a nontax lease, the lessee is deemed owner of the equipment and is entitled to the tax benefits. The criteria used to classify leases for tax purposes comes from Revenue Ruling 55-540, Revenue Procedure 75-21, and various tax court rulings.

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The classification of a lease has important tax consequences for both lessors and lessees. In a tax lease, tax benefits such as accelerated depreciation represent cash inflows to a lessor. For this reason, tax consequences influence a leasing company’s pricing structure and the way it does business. A lease that starts in the fourth quarter is more sensitive to the value of depreciation. The lessor is able to realize more of the yield in the lease from tax benefits, thereby relying less on the periodic payment. Hence, the lessee's payment is typically lower if structured in the fourth quarter. Tax consequences do not always have a positive effect on lease transactions. Tax limitations such as the midquarter convention and AMT can adversely affect the lessor’s yield in a lease. Within each of the two broad categories — tax leases and nontax leases — are several types of lease products structured to meet the needs of various customers. You have completed Unit Two: Financial Reporting and Tax Classifications. In the next unit, you will learn how leases are classified for legal purposes. Before you continue to the next section, check your understanding of the concepts you have just learned by completing the progress check that follows. If you answer any question incorrectly, please return to the text and read the section again.

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PROGRESS CHECK 2.2

Directions: Determine the correct answer to each question. Check your answers with the Answer Key on the next page. Question 1: Which of the following will probably not lead to a nontax classification of a lease agreement? ____ a) Bargain purchase option ____ b) A lessee guaranteed residual value ____ c) Acceptance of residual risk by lessor

Question 2: The purpose of Revenue Procedure 75-21 was to: ____ a) clarify the tax responsibilities in a tax lease. ____ b) establish the true intent of the parties to the lease agreement. ____ c) define asset class life. ____ d) provide guidance for structuring large leveraged leases.

Question 3: In a nontax lease, the lessee is entitled to which of the following? ____ a) Full rental payment deductions ____ b) Half of the normal depreciation allowance ____ c) Interest and depreciation deductions ____ d) Expense deductions for depreciation and rental amounts

Question 4: In a tax lease, the lessor records: ____ a) rental income less depreciation expense. ____ b) depreciation expense plus interest income. ____ c) rent expense. ____ d) interest income.

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ANSWER KEY

Question 1: Which of the following will probably lead to a nontax classification of a lease agreement? c) Acceptance of residual risk by lessor

Question 2: The purpose of Revenue Procedure 75-21 was to: d) provide guidance for structuring large leveraged leases.

Question 3: In a nontax lease, the lessee is entitled to which of the following? c) Interest and depreciation deductions

Question 4: In a tax lease, the lessor records: a) rental income less depreciation expense.

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Question 5: Which one of the following statements is true? ____ a) The half-year convention discourages investment in assets. ____ b) MACRS represents a negative cash flow to the taxpayer. ____ c) The midquarter convention slows the pace of tax benefits from depreciation deductions. ____ d) The midquarter convention primarily affects lessees in tax leases.

Question 6: Asset class life is: ____ a) the depreciable economic life of an asset. ____ b) the current tax depreciation methodology. ____ c) equal to the recovery year in the MACRS table.

Question 7: The impact of depreciation is greatly enhanced for tax transactions completed early in the year. ____ a) True ____ b) False

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ANSWER KEY

Question 5: Which one of the following statements is true? c) The midquarter convention slows the pace of tax benefits from depreciation deductions.

Question 6: Asset class life is: a) the depreciable economic life of an asset.

Question 7: The impact of depreciation is greatly enhanced for tax transactions completed early in the year. b) False

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Unit 3

UNIT 3: LEGAL CLASSIFICATION AND LEASE DOCUMENTATION

INTRODUCTION

The financial reporting (or accounting), tax, and legal considerations of leasing are very important to a complete understanding of the leasing product. Financial reporting and tax classifications were described in Unit Two. In this unit, you will learn that, from a legal viewpoint, lease transactions are classified as either true leases or secured transactions. These distinctions are particularly important in the event that the lessee defaults on the lease or one of the parties files for bankruptcy. The documentation of a lease is an important consideration also, as provisions in the lease influence the way courts view the lease.

UNIT OBJECTIVES

When you complete this unit, you will be able to: n

Understand the criteria used by the legal system to distinguish a true lease from a secured transaction

n

Recognize how lease documentation provisions protect lessors

LEGAL CLASSIFICATIONS

Because true leases are treated differently from sales and loans in commercial law, a lease must be separately classified from a legal viewpoint.

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Sources of criteria

Focus on ownership

LEGAL CLASSIFICATION AND LEASE DOCUMENTATION

The classification criteria the U.S. legal system uses today are based on three sources: n

The Uniform Commercial Code (UCC), which is a set of laws governing a variety of business transactions

n

Article 2A, which is a recent addition to the UCC

n

Various court cases

Conceptually, the criteria from these sources are similar to the criteria used for accounting and tax purposes. Once again, the focus is on ownership of the equipment. If the lessor is deemed to be the owner of the equipment, and the lessee the user, the lease is a true lease. If, in substance, the lessee is deemed to be the owner, the lease is referred to as a secured transaction.

The Uniform Commercial Code (UCC) Technically, true leases are not covered by the UCC at the present time. However, provisions from the UCC have been applied regularly to lease transactions. Secured transactions are covered by Article 9. Sales transactions are covered by Article 2. Article 9

Article 9 of the code discusses secured transactions — specifically the rights of a borrower and the rights of a lender. Secured interest

A secured transaction is created when a debtor (lessee) gives a creditor (lessor) a security interest in certain property. From a legal standpoint, a secured transaction is not a true lease. Therefore, Article 9 is used to distinguish between true leases and secured leases.

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Article 2 Implied warranties

Article 2 deals with sales and the rights of buyers and sellers. The article has been applied to transactions in which a lessor buys goods from a supplier. Although the article does not technically apply to the lessor-lessee relationship in a true lease transaction, the courts have applied some of its provisions either directly or by analogy. Most notable has been the application of the implied warranties provision. This provision requires that the property is saleable and is fit for its usual purpose.

Article 2A-Leases Proposed article

Article 2A is a recent addition to the UCC that specifically covers true leases. It has been adopted by 49 states. In this section, we cover some of the article's more important points. Scope of Coverage

True leases

The article applies to any transaction, regardless of form, that creates a true lease. It does not apply to conditional sales or loans that may appear documented as a lease. It covers all leasing transactions, whether business or consumer, daily rental, or multimillion dollar leveraged lease transactions. There are no exemptions or exceptions from coverage of the article. Definition of a Lease

Article 2A provides a definition of a lease: “Lease” means a transfer to the right to possession and use of goods for a term in return for consideration; but a sale, including a sale on approval or a sale or return, or retention or creation of a security interest is not a lease. Unless the context clearly indicates otherwise, the term includes a sublease agreement.

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The Finance Lease

The Article also recognizes that a modern finance lease is different from a traditional rental. It provides a definition of a finance lease. "Finance lease" means a lease in which (i) the lessor does not select, manufacture or supply the goods, (ii) the lessor acquires the goods in connection with the lease, and (iii) either the lessee receives a copy of the contract evidencing the lessor's purchase of the goods on or before signing the lease contract, or the lessee's approval of the contract evidencing the lessor's purchase of the goods is a condition to effectiveness of the lease contract. Remedies and Damages Computation formula

The Article provides a complex remedies and damages scheme for those parties who have not specified damages by contract, or whose contract provisions are unenforceable or otherwise fail. The basic underlying principle of damage computation is that the lessee's original rent will be compared to fair market rent.

Case Law Perspective Case law criteria

Some of the factors courts have considered in deciding whether a transaction is a true lease or secured transaction are below. n

The mere existence of a purchase option by a lessee

n

The existence of a “nominal purchase option”

n

The transfer of title at the end of the lease for no additional consideration

n

The creation of an equity in the equipment in favor of the lessee

n

Total lease payments by the lessee “substantially equal to or greater than the purchase price” of the equipment

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n

Periodic lease payments that do not reflect “reasonable rental value”

n

How the lessor conducts its business

n

How other lessees have dealt with the lessor, e.g., how many lessees exercised their purchase option, how many returned the equipment, etc.

n

The filing of a financing statement by the lessor

n

How the lessor treats the transaction on its books

n

What the parties understood the transaction to be

n

Whether the lessee was responsible for paying the taxes and insurance on the equipment and keeping it maintained and repaired

n

Who bears the risk of depreciation in estimated residual value

LEGAL IMPLICATIONS

The legal classification of a lease is important because commercial law treats lease transactions and secured transactions differently. In this section, we discuss the two ways lessors protect their interests in leased equipment: UCC filings and action upon notice of lessee bankruptcy.

UCC Filings Protecting interest

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By definition, a true lease is not a secured transaction and is not subject to any filing requirement. However, much legal action has occurred over the issue of security interest. A careful lessor will always make a UCC filing to protect its interests in case the courts decide that the transaction was a secured transaction. The filing fee is cheap insurance against an expensive legal battle that could cost the lessor all its remaining value in the leased property.

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Bankruptcy Issues for Lessors Lessee default

One of the most important situations in which a transaction must be classified as a true lease or a secured transaction must be answered in the event that the lessee defaults on the lease. The consequences for both lessor and lessee vary significantly depending on the rulings of the court. A lessor receiving notice of a bankruptcy petition filing by one of its lessees should quickly determine a course of action to protect its interests and retrieve the equipment. Otherwise, the lessor faces the possibility of waiting a year or more to regain possession of equipment that has, in the meantime, lost some of its value.

SUMMARY

For legal purposes, transactions that are labeled leases are classified as either true leases or secured transactions. If the lessor is deemed to be the owner of the equipment, the lease is a true lease. If the lessee is deemed to be the owner, the lease is referred to as a secured transaction. The legal classification criteria are based on three sources: the UCC, Article 2A, and court decisions. Whether the lease is considered by the courts to be a true lease or a secured transaction has important consequences in the event a lessee files for bankruptcy. A lessor receiving notice of a bankruptcy petition filing by one of its lessees should quickly determine a course of action to protect its interests. Please complete the following Progress Check before continuing too the final section of this unit, “Lease Documentation.”

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PROGRESS CHECK 3.1

Directions: Determine the correct answer to each question. Check your answers with the Answer Key on the next page. Question 1: The tax, legal, and accounting definitions of a lease are: ____ a) dependent criteria. ____ b) independent criteria. ____ c) determined by FASB 13.

Question 2: Article 2A of the Uniform Commercial Code: ____ a) applies only to lease transactions deemed to be true leases. ____ b) replaces Article 2 of the Uniform Commercial Code. ____ c) is a federally mandated code.

Question 3: Which factor will most likely cause a transaction to be considered a secured transaction? ____ a) Net terms ____ b) A lessee option to terminate the lease before full payment has been made ____ c) An obligation by the lessee to pay the initial value of the equipment ____ d) The transfer of the title at the end of the lease for no additional consideration

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ANSWER KEY

Question 1: The tax, legal, and accounting definitions of a lease are: b) independent criteria.

Question 2: Article 2A of the Uniform Commercial Code: a) applies only to lease transactions deemed to be true leases.

Question 3: Which factor will most likely cause a transaction to be considered a secured transaction? d) The transfer of the title at the end of the lease for no additional consideration

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LEASE DOCUMENTATION

In the previous section, you learned that the courts treat true leases and secured transactions differently. In this section, we will discuss the types of documents generally included in lease transactions and point out document provisions that help protect the lessor’s interests in legal situations. Factors Affecting Documentation Variable requirements

There are many ways to structure a lease transaction, whether it be a leveraged lease, single investor lease, consumer lease, municipal lease, or otherwise. The documentation for each different type of lease transaction can vary greatly. Even the dollar volume of the equipment influences the complexity of the documentation. In this section you will learn about the documentation usually required for a lease transaction. The document provisions generally apply to most lease transactions. Lease Documentation

Checklist

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The lease documentation could include the following: n

Lease/Credit Application

n

Master Lease

n

Equipment Schedule

n

Fair Market Value Purchase Option Rider

n

Fair Rental Value Renewal Option Rider

n

Certificate of Acceptance

n

Casualty Value Schedule

n

Officer's Certificate or Corporate Resolution

n

Certificate of Insurance

n

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Protecting the Lessor Some of the documents we listed above protect the lessee, but most are drafted to protect the lessor's interest. Below, we outline the various documents involved in a leveraged lease transaction and show how the document provisions protect the lessor. Lease/Credit Application Assess credit risk

The Lease/Credit Application is typically used in equipment leasing transactions involving smaller ticket items of $150,000 or less. It is a fill-in-the-blank type of document lessors use to gather necessary information about the prospective lessee and the equipment to be leased. The lessor uses this information to assess the creditworthiness of the prospective lessee and the worth of the proposed lease transaction. Master Lease

Common terms and conditions

A Master Lease is often used in a lease transaction involving large ticket equipment or involving one lease transaction of many to come. The Master Lease sets forth all major terms and conditions that will be common to all lease transactions that follow. The variable terms and conditions of each lease transaction (i.e., description of equipment, lease term, and payment amount and terms) are set forth in each succeeding Equipment Schedule. The major terms and conditions of a Master Lease that protect the lessor include the following: n

Limitation of liability, disclaimer of warranty This provision protects a lessor from liability that could result from express or implied warranties recognized by the UCC.

n

Obligation to pay rent DRAFT

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This provision details the lessee's obligation to make the rental payments. n

Assignment The purpose of this provision is to protect the lessor's interest in the equipment and in the rentals flowing from it. It reads that the lessee may not assign, transfer, or dispose of the lease or the equipment.

n

Risk of loss and damage Under this provision, the lessee bears the risk of damage or destruction of the equipment, as well as the risk of a theft or governmental taking of the equipment.

n

Insurance This provides for insurance. The purpose of this provision is (1) to protect the lessor's investment in the equipment and (2) to protect the lessor, the lessor's assignee, and the lessee from liability to a third party for injury to persons or property.

n

Indemnity This provision protects the lessor against any claims related to the purchase, use, and ownership of the equipment.

n

Liens and taxes This provision sets forth the lessee's obligation to pay all license and registration fees and all taxes related to the equipment under a net lease.

n

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Personal property, location of equipment

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The basic test of whether the equipment is personal property or a fixture is the intent of the parties. This provision sets the intent of the parties — that the equipment is, and shall remain, personal property. Also, this provision bars the lessee from relocating the equipment without the lessor's prior written consent. n

Designation of ownership The wording of this provision confirms that the lessor is the owner of the equipment for tax and UCC purposes.

n

Use This provision requires the lessee to use the equipment in a careful and proper manner. It protects the lessor from liability in the event that the lessee’s misuse of the equipment causes injury to a third party or damages the equipment.

n

Surrender of equipment This provision documents the lessor's status as the owner of the equipment for tax and UCC purposes. It also requires the lessee to bear the expense of returning the equipment to the lessor. In addition, it protects the lessor from excessive wear and tear or depreciation of the equipment caused by the lessee.

n

Suspension of obligations of lessor This provision protects the lessor from liability. It waives liability in the event the lessor cannot deliver the equipment or perform its responsibilities under the lease due to acts of God, strikes, or failure of the supplier or manufacturer.

n

Lessee's failure to perform Under this provision, if the lessee fails to perform an obligation under the lease, the lessor may carry out the obligation and then charge the lessee for all expenses incurred, plus interest.

n

Events of default

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This provision defines the events that constitute a default (a deviation from the terms of the lease). n

Remedies This provision defines the actions the lessor may take in the event the lessee defaults on the lease agreement.

Equipment Schedule Variable lease information

An Equipment Schedule sets forth all the variable fill-in-the-blank information for a particular lease transaction, including a description of the equipment. The most critical information contained in an Equipment Schedule is the amount of the lease payment, the commencement date, and the lease term. Fair Market Value Purchase Option Rider

End-of-term purchase option

This rider provides lessees with the option to purchase the equipment at the end of the lease term at the equipment’s fair market value. Fair Rental Value Renewal Option Rider

Re-lease option

The Fair Rental Renewal Option gives lessees the option to re-lease the equipment for its then-current fair rental value. Certificate of Acceptance

Representations upon delivery

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This document requires, upon delivery of the equipment, (1) confirmation that the lessee received, inspected, and accepted the equipment, (2) re-confirmation of Master Lease representations, and (3) proof that the lessee has insured the equipment in accordance with the terms of the lease. It also requires the lessee to confirm the location of the equipment. Most important, the document sets forth the acceptance date for the Equipment Schedule. This date has tax and UCC consequences.

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Casualty Value Schedule Compute compensation for loss

The objective of the Casualty Value Schedule is to establish the value (to the lessor) of the lease and the equipment at various times over the term of the lease. It is used to compute lessee payments for the loss, destruction, or condemnation of the equipment. Officer's Certificate or Corporate Resolution

Authorization

This resolution ensures that (1) the lease has been accepted by each corporation's Board of Directors and (2) the agent signing the lease documents is authorized and empowered to do so on behalf of the corporation. Certificate of Insurance

Insurance obligation

The purpose of the Certificate of Insurance is to assure the lessor that the lessee has obtained the appropriate insurance coverage. Precautionary Form UCC-1

Priority claim

The purpose of a Form UCC-1 is to provide notice to third parties that the lessor has an interest in the equipment. The form insures that the lessor will have a priority claim in the equipment regardless of the bankruptcy court’s classification as either a lease or a secured transaction.

Remedies Upon Lessee Default The lessor’s position is strengthened if default actions and the lessor’s options (remedies) are included in the lease. Let’s examine them more closely.

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Default Provisions

Default provisions are probably the most important clauses in the lease agreement. No UCC definitions

Notice to lessee

A breach or default of an agreement results when one of the parties fails to perform one or more of its promises. The UCC does not define what events constitute a default. Thus, it is important to carefully define the actions of the lessee that constitute a default in the lease agreement. These actions generally include the following: n

False representations

n

Failure to pay rent within the specified days of the due date

n

Failure to perform or observe any other term or condition of the Master Lease and Equipment Schedule

n

Any affirmative act of insolvency such as filing for bankruptcy

n

Levy, seizure, assignment, or sale of the lessee’s property or the equipment for, or by, any creditor or governmental agency

These definitions put the lessee on notice that any failure to adhere to the terms of the lease may result in the lessor pursuing one or more of the remedies specified in the lease. Remedies

Lessor control

There is no assurance that the lessor’s options for remedy will be upheld in a court of law. However, including them in the lease agreement enhances that possibility. It also serves to notify the lessee of the options the lessor may take. By specifying the available remedies, the lessor again maintains a degree of control and flexibility. Typical remedies specified in a lease agreement include the following: n

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The lessor may take back the equipment and re-lease it, sell it or keep it. DRAFT

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n

If the lessee fails to perform an obligation such as paying for insurance or taxes, the lessor may carry out the obligation and then charge the lessee for all expenses incurred, plus interest. The lessor may opt for this remedy when the lessee has permitted a judgment or execution to be rendered against the equipment.

n

If the lessee loses or destroys the equipment, the lessor may collect liquidated damages in the amount of the casualty value of the equipment.

SUMMARY

The documentation for each type of lease transaction can vary greatly. However, certain provisions apply to most lease transactions. Most of these provisions serve to protect the lessor in the event the lessee defaults on the terms and conditions of the agreement. Lessee actions considered to be default actions should be defined in the lease agreement. Including remedies or actions in the lease that the lessor may take in the event of lessee default helps strengthen the lessor’s position. You have just completed Unit Three: Legal Classification and Lease Documentation. Please complete the following Progress Check before you continue to Unit Four: Credit Analysis and Risk Assessment. If you answer any question incorrectly, you should return to the text and read that section again.

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]

PROGRESS CHECK 3.2

Directions: Determine the correct answer to each question. Check your answers with the Answer Key on the next page. Question 1: Most lease documents protect the lessee. ____ a) True ____ b) False

Question 2: A Master Lease usually contains: ____ a) the amount of the lease payment, the commencement date, and the lease term. ____ b) a Casualty Value Schedule. ____ c) the common terms and conditions that apply to all subsequent transactions. ____ d) renewal and purchase options.

Question 3: Which of the following definitions applies to remedies in lease documentation? ____ a) Actions a lender may take if the lessor fails to make its payments ____ b) Actions that constitute a default under the agreement ____ c) Actions the courts may take to define a secured agreement ____ d) Actions that a lessor may take in the event the lessee defaults on the agreement

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ANSWER KEY

Question 1: Most lease documents protect the lessee. b) False

Question 2: A Master Lease usually contains: c) the common terms and conditions that apply to all subsequent transactions.

Question 3: Which of the following definitions applies to remedies in lease documentation? d) Actions that a lessor may take in the event the lessee defaults on the agreement

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Unit 4

UNIT 4: CREDIT ANALYSIS AND RISK ASSESSMENT

INTRODUCTION

Like other creditors, lessors use credit analysis to assess the credit-worthiness of a company. The goal is to avoid, or at least manage, bad debt losses. To evaluate creditworthiness, lessors have aggressively borrowed financial analysis techniques used by other creditors, including financial statement analysis and cash flow analysis. In addition, lessors must assess and evaluate risk factors that are unique to the leasing industry. In this unit, we describe the credit analysis process, the factors lessors consider in their evaluations, and some of the tools they use to assess a potential lessee’s creditworthiness. Methods lessors can use to minimize specific leasing risks are discussed throughout the unit.

UNIT OBJECTIVES

When you complete this unit, you will be able to:

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n

Recognize the risks inherent in leasing

n

Identify ways a lessor can minimize risks

n

Understand how financial ratios are used to reveal the financial health of a potential lessee

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CREDIT ANALYSIS AND RISK ASSESSMENT

RISK ASSESSMENT Focus is lessor concerns

It is important for lessors to understand the risks inherent in leasing so they can structure leases to minimize these risks. In this section, we focus on the lessor’s main concerns: the process of assessing and evaluating risks and the risk factors.

30 variables of lease credit

There are 30 variables of lease credit, each of which begins with the letter “C.” These variables fall into three categories: n

Lessee credit risk assessment

n

Characteristics of lessees

n

Lease environment risk factors

Lessor credit assessment includes the basic analytical functions that credit analysts perform in the lease assessment process. The second and third categories identify the various risk factors credit analysts must consider. Let’s begin by looking at how credit analysts assess and evaluate a lessee’s credit.

Lessee Credit Risk Assessment Analytical functions

There are eight steps in the credit evaluation and assessment process. The eight Cs of Lessee Credit Risk Assessment are: n

Confirmation

n

Classification

n

Corroboration

n

Consideration

n

Catastrophe

n

Computation

n

Concatenation

n

Compilation

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Confirmation Obtaining information

Confirmation is the process of obtaining the information the lessor needs to perform a quantitative and/or qualitative risk evaluation. The primary sources of confirmation for the lessor are as follows: n

Starting point

Audited financial statements are prepared according to generally accepted accounting principles (GAAP). These statements provide an excellent starting point in risk assessment. Later in this section, you will learn how lessors use this source of information. n

Warning of extended risk

Limited availability

Review or limited review of financial statements These are periodic or special reviews such as those produced when a bank or factory requires periodic reviews on receivables or inventories. Availability is limited.

n

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A compilation or disclaimer If an accounting firm has compiled the financial statements, but has not audited them, it is likely to include a disclaimer statement declaring that they have not audited the statements. The lessor should view a disclaimer as a warning sign of extended lessor risk.

n

Different from financial statements

Audit report from an auditing firm

Tax returns Tax returns are an excellent source of information to use for evaluating lessor risk. The lessor must keep in mind that tax returns are prepared according to tax legislation rather than GAAP; therefore, differences between financial statements and tax statements will occur.

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n

SEC and industryspecific reports

Other special reports Other reports that can help the lessor evaluate risk include periodic reports filed with the Securities and Exchange Commission (SEC) and special reports required in specialized industries, such as the airline and broadcast industries.

Corroboration Validation

In corroboration, the lessor validates the credit information supplied by the prospective lessee. This means the lessor must obtain bank references and credit disclosures from the lessee’s creditors. n

Bank references Bank documentation would include the following: Name and location of the bank Loans outstanding Loan amounts Collateralization Payment history Length of the credit relationship Highest amount of debt extended Contingent debt Leases with that bank

n

Not always reliable

Prior leasing commitments with other lessors Many banks and lessors avoid disclosing information that may subject them to litigation. Therefore, a lessor cannot rely on this source of information. You will find alternative corroborative sources under the subsection entitled Credit.

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Catastrophe Worst-case exposure

The lessor should identify the worst down-side possibility and then evaluate the probability and amount of exposure this catastrophe could cause. Once the analysis is completed, the lessor should decide how to protect against down-side risk. Concatenation

Select credit variables

Concatenation means that the lessor must determine which credit variables are important in the credit decision. Classification

Rank credit variables

In classification, the lessor ranks the credit variables identified in concatenation and assigns a weighted value to each variable. The rankings start with the most important variables and end with the least important ones. The weighted values add up to one. Consideration

Score credit variables

Consideration is the degree to which a credit standard is met. After ranking the credit variables, the lessor subjectively scores each variable on a predetermined scale. For example, on a 0 - 10 scale, an important credit variables is assigned a value of 8 to 10. An unimportant variable is assigned a value of 0 to 3. Variables of average importance are assigned values of 4 to 7. Computation

Compute

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In computation, the lessor multiplies the classification weighted value by the consideration score. Figure 4.1 is an example of a computation worksheet. The lessor adds all the computed products to derive the lessee credit rating.

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Compilation Result used to make decision

Based on where the credit rating falls on the scale, the credit may be accepted or rejected. Figure 4.1 shows the compilation process and scale.

Attaining consistency through matrix development

You may view Figure 4.1 as a completed credit matrix. It is important to realize that each analyst may assign different classification values and consideration scores to a risk factor causing variation in computation from analyst to analyst. To attain consistency within a credit evaluation team, credit managers can develop credit matrices based on their existing leases. By analyzing the good, average, and bad leases in its portfolio to derive classification values and consideration weightings, a lessor can develop matrices that help the team achieve uniform evaluations. COMPUTATION WORKSHEET a

CONCATENATION

CLASSIFICATION

CONSIDERATION

(Weighting)

COMPUTATION

0 -10 a

Future potential

.30

x

7

=

2.10

Independent verification

.20

x

6

=

1.20

Past experience

.15

x

8

=

1.20

Additional risk factors

.15

x

1

=

.15

Product and diversification risk

.10

x

4

=

.40

Mitigating considerations

.10

x

3

=

.30

1.00

5.35 - Credit rating COMPILATION

Reject

0-4

Accept (charge premium rate)

4.1 - 5

Accept

5 .1 - 7

Accept (give preferential rate)

7.1 -10

Figure 4.1: Computation worksheet

You can see that the weighted value of this credit is 5.35. Based on the compilation table, this credit would probably be accepted.

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Characteristics of Lessees Now that you are familiar with the steps in the credit risk evaluation process, we will look at the 12 C characteristics of the lessee that the lessor investigates and evaluates. As you learned in the previous section, lessors select, rank, score, and compute risk factors on a credit matrix. Each of the variables discussed in this section represents a risk factor that the lessor credit analyst may include in a credit matrix. Character Integrity, honesty, commitment

Character refers to the lessee’s potential integrity, honesty, and commitment to honor its financial obligations. Previous experience with the lessee is an excellent indicator, but if the lessor has no previous experience, other indicators may be used. The lessor may assess the lessee’s character from a personal interview or through checking with other leasing companies, bankers, and creditors with whom the lessee has done business. Another indicator of character is whether or not the potential lessee has properly disclosed any off balance sheet financing arrangements — proper disclosure the lowers lessor’s risk. Capital

Three definitions

Capital has several meanings. We will use three meanings of the term here. 1. In its broadest sense, capital refers to the total resources available for a firm's usage including all assets and balance sheet resources. Nonbalance sheet resources such as people, experience, and other factors normally not quantified as resources also have been included. 2. A narrower definition of capital is the definition of capital assets, which is generally regarded as property, plant, and equipment. 3. An even narrower definition regards capital as cash.

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Lessee’s capital position


For risk assessment purposes, a creditor usually looks for strong net worth and limited financial leverage. A strong capital position means the lessee has assets available to satisfy a judgment in the event of default. The following accounting formula conveys this concept: Assets = Liabilities + Equity

The left-hand side of the equation represents all quantified asset values and the right-hand side indicates the source of financing for those assets. There are only two methods of funding assets. n

Borrowing money to purchase assets

n

Investing equity funds to purchase assets

The lessor can analyze the balance sheet equation to determine both the degree of the lessee’s net worth and the extent of financial leverage. The lessor should also determine the degree to which assets may be encumbered (tied up as collateral). It is possible for a company to have a high net worth but have an excessive amount of assets placed as collateral with other creditors. This could mean that there is not enough protection for a new lease. If the asset has a questionable residual value or is rapidly losing value, a wise lessor will obtain additional unencumbered capital protection. With smaller companies, the lessor may request additional collateral from the lessee and/or personal guarantees. In the case of personal guarantees, the lessor should also evaluate the lease guarantor’s capital position. In larger lease transactions and in most public companies, personal guarantees cannot or will not be given; the net worth of the lessee stands alone. Later in this unit you will learn about ratios that can be used to analyze capital.

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Capacity Lessee’s ability to pay

Capacity refers to the lessee's ability to pay. Typically, credit analysts examine the lessee’s income statement to determine that the net income is adequate. Lessors should trend historical net income figures to determine the pattern of growth. If net income is growing, but at a declining rate, the risk that the lessee will not be able to pay its obligations in the future increases. On the other hand, steady growth of net income or growth at an increasing rate would indicate a decreased risk. The lessee’s source of income also affects capacity. If the lessee realizes a sizable portion of net income through a limited number of customers, the lessor may verify the probability of continued sales by obtaining written or verbal confirmations from the customers.

Liquidity assessment

Recall that a broad interpretation of capacity includes not only the current ability of a lessee to earn, but also the lessee’s ability to maintain adequate liquidity, cash flow, and to sustain solvency. Credit analysts typically assess liquidity by examining the current assets and the current liabilities. If a lessee's cash flow position deteriorates or is threatened, liquidity may become inadequate, which increases the lessor’s risk. To assess this risk, a lessor should determine whether the lessee’s cash budget (forecast) demonstrates adequate cash for at least onehalf of the lease term. We will cover this in more detail later in this unit. Finally, the lessor must determine whether net income will grow at a rate sufficient to sustain and strengthen solvency.

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Credit Size of capital and payment trends

The lessor should investigate credit experience to determine the lessee’s past trading policies and practices. Dunn & Bradstreet is a common source; it reports size of capital and payment trends (how big a company is and how fast it pays). Typically, the assumption is that the bigger a company is and the faster it pays, the better the risk. Conversely, a smaller company that pays slowly would normally be assessed as less creditworthy. Some firms choose not to provide Dunn & Bradstreet with the financial information requested to determine the rating. In these circumstances, Dunn & Bradstreet either estimates the information or comments in the rating that the company does not choose to be rated. View this as a warning sign.

Officer credit checks

Lessors also may obtain credit checks on selected officers, owners and principals of a lessee seeking credit. This may be particularly important if the lessee is a closely-held company or is a relatively new company. The lessor will feel more comfortable about extending credit if the principals have superior individual credit records.

Sources of credit information

Trade associations are a frequent source of credit information. These associations tend to be a close-knit club credit information is informally shared with those who have privileged membership. Additionally, formal rating agencies, such as Moody's and Standard and Poor's, have research arms that formally rate most large and some small companies. TRW and National Credit Information Services (NACIS) are two other players in the independent credit verification business. Cash Flow

An analysis of a company’s cash flows should indicate that the lessee can pay for the lease without threatening liquidity. Because of the importance of cash flow to risk assessment, we will discuss cash flow analysis in a separate section later in this unit.

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Chronological Age History affects extent of risk

A company with a relatively short history presents increased risk to the lessor. In the case of start-up companies, the lessor may look to the past successes and failures of the principals to assess risk. For established firms, the lessor should trend relevant income and other financial data to provide a basis for evaluating forecasted data. CAPM-Beta Coefficient

Capital asset and risk evaluation

The capital asset pricing model (CAPM), with its attendant beta coefficient, is a way to measure the risk in capital budgeting. Because leasing is basically a capital expenditure consideration, it makes sense for lessors to understand this conceptual approach to capital asset and risk evaluation.

Two components of risk

You should understand that interest rates that lessors receive usually varies according to the risks they bear. Interest may be separated into two components; risk-free rate and risk premium. Lessors consider the return on U.S. government securities to be the risk-free rate. For the second interest rate component, the lessor assigns a risk premium to each lessee. Risky lessees dictate higher risk premiums; low-risk lessees dictate lower risk premiums; and leases, such as those to the federal government, would have no risk premium.

Example

To illustrate this concept, let’s assume that a lessor has determined that the risk-free rate is 7%. Furthermore, because the lessee is considered an average risk, the lessor assigns an additional risk premium of 5%. Thus, the total expected return on the lease investment would be 12% (7% + 5%) to compensate for both types of risk.

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Beta coefficient


This is where the concept of the beta coefficient comes into our example. The beta coefficient is the educated assessment of the financial risk premium of individual companies compared to their industry averages. Merrill Lynch, Standard and Poor's, and many other financial organizations publish "beta books" in which the industry average for risk premium is assigned a value of one. Individual companies with a beta coefficient of less than one (lower than the industry average) appear more stable and those with a beta in excess of one (higher than the industry average) are perceived as less stable. To complete the example, let’s assume the beta coefficient is one, as illustrated below: 7% + (1)(5%) = 12%

However, if one of the financial reporting services determines the beta coefficient in the capital model has increased to 1.8, our formula is revised to yield a rate of 16% [7% + (1.8)(5%)].

Beta books

Lessors servicing listed corporations should subscribe to a beta book in order to obtain the beta coefficients of all large public companies. Lessors who want to calculate a beta coefficient for unlisted lessees should refer to the relevant chapters in a graduate-level finance text. A substantial change in a company’s beta coefficient indicates a change in the risk level of the company, and the lessor should adjust the lease terms accordingly.

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Capability Management expertise

Capability is the lessee's level of management expertise — new management frequently has a lower level of capability than experienced management. Lessors should assess a managerial staff to determine that they possess requisite skills, training, and experience. Numerous studies have indicated that this is one of the most important factors in predicting corporate success. Competence

Productivity

Competence refers to the productivity of the lessee. The lessor seeks to determine how well the lessee’s management has done with the capital and labor resources entrusted to it. Control

Feedback and budget systems

Control refers to the feedback systems (such as standard cost accounting systems, budget variance systems, and zero base budgeting systems) that companies use to correct or confirm past actions. The lessor should pay attention to the type of cost system (such as a job lot cost accounting or a process costing system) that is in place as well as the lessee’s budgeting process. The budgeting process should include a strategic plan, a capital plan, and an operating plan. The strategic plan shows the company’s planned growth. In the capital plan (balance sheet), the company decides what assets it must gather and how these assets are to be financed. The operating plan is the budget or income statement plan. The concern for the lessor is the kind of budgetary or feedback tools the company has in place. If the lessee does not have a budget or feedback tools, credit risk is high — lessor beware!

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Course Compare historical trends to historical plans

Course refers to the financial direction of the lessee. It also relates to the financial history of the company. The lessor should first determine that a proper trend analysis is available for cash flow, financial ratios, and capacity indicators. The lessor can compare this analysis to the strategic plan of a company to see if historical trends have substantiated historical plans. Next, the lessor should compare the company’s forecasts of future positioning in the market with historical trends to see if they correlate. For example, if historical trending indicates a lease applicant has traditionally experienced a ROA of 11% or 12%, but the financial forecasts indicate an expected ROA of 20%, the company must show changes in the strategic plan, the capital plan, and the operating plan that will create this growth. Constraints

Success factors

Constraints are those unique business, governmental, and social requirements that impede or promote a potential lessee's success. The credit analyst must determine the unique characteristics of the potential lessee that strengthen or weaken its ability to perform on a lease contract. For example, the best product idea may be doomed to failure if it is not marketed correctly. Thus, the lessor must take into account the lessee’s marketing experience as well as the product potential before extending credit.

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4-15

Lease Environment Risk Factors In the previous section, you learned about the characteristics of the lessee that the lessor investigates and evaluates to assess risk. However, these are not the only risks lessors must evaluate. There are also credit risks inherent in the lease environment itself! These are factors that are external to the lessee and may affect the lessor’s decision to extend lease credit. They include: n

Collateral

n

Competition

n

Complexity

n

Cyclical and Countercyclical

n

Currency

n

Copartner

n

Category

n

Concealed Value

n

Cross-border

n

Circumstances

Collateral Value of equipment over time

Collateral is important because the lessor must look to the value of the equipment if the lessee defaults. Equipment that maintains value over time is obviously a better risk than equipment that does not maintain resale value. For example, commercial airplanes and jets frequently are worth as much after being leased seven years as they were at the inception of the lease. In contrast, computers may lose a significant amount of their value even between the time they are ordered and the time they are delivered to the lessee.

Tool for assessing increased risk

Because the question of collateral is so important in many leases, the lessor should assess its risks carefully. One assessment method used compares an actuarial investment recovery curve for the equipment to the economic obsolescence curve. The shaded area between the curves in Figure 4.3 represents the area of increased risk to the lessor.

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Figure 4.3: Collateral risk

Structuring lease to minimize risk

Lessors can minimize collateral risk through lease structuring. For example, the lessor can require a guaranteed residual. (Unfortunately, a guaranteed residual may also cause the lessor to lose tax benefits.) Similarly, the lessor can enforce strict preventative maintenance clauses and excess-use penalties to lessen the effect of impaired collateral value caused by excessive wear and tear.

Other collateral guarantees

Another way to minimize collateral risk is to obtain a collateral guarantee from a vendor or an insurance company. Increasingly, lessors can get the vendor manufacturer to make partial or full guarantees of the residual value. It is important to note that, under FASB 13, a lease with this type of guarantee can still qualify as an operating lease from the lessee's viewpoint but not from the viewpoint of the lessor. Similarly, an insurance company guarantee reduces the risk of exposure but is an additional expense that reduces the lessor’s profit.

Remarketing agreements

Lessors may also consider remarketing agreements to reduce collateral risk. These are agreements in which the vendor does not guarantee the residual equipment value, but does agree to assist in the remarketing of the equipment. Complexity

Complexity refers to risk due to inherent or designed intricacy of the equipment, the lease agreement, the tax law, or any bundling of services.

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Equipment sophistication

Equipment sophistication has increased. If the lessee finds that the leased equipment is operationally inappropriate, it is unlikely that the revenue the equipment generates will cover the lease payments. Therefore, the lease would have to be paid from other operating revenues. To lessen the risk, the lessor can (1) check for a proper engineering study with specifications and (2) have the lessee sign an equipment indemnification agreement stipulating that the equipment received is as ordered and that the order was based upon adequate studies and specifications. This does not eliminate the risk, but it causes the lessee to carefully rethink and review the lease agreement.

Lease agreement details

Another source of complexity is the lease itself. To protect its interests, the lessor should specify in the agreement all details of its security interests, require an insurance binder, and include details of any contingent lease agreements that exist.

Provision for tax law changes

The lessor should also consider provisions for covering the effect of tax legislation on its cash flow. One approach may be to specify that the lessor's after-tax cash flow return on investment will remain constant if a tax law change occurs.

AMT

An additional area of complexity in the field of leasing is that of alternative minimum tax, which we discussed in Unit Two. Because AMT has changed the after-tax cost of leasing so dramatically for lessees, the lessor should discuss it with all prospective lessees.

Bundled services

Bundling of services is also a source of complexity. Lessees find it more difficult to determine the true cost of the lease. The lessor must calculate carefully the profitability of the various portions of the bundled lease to determine that the overall package provides adequate financial reward for the inherent complexity.

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Currency Monetary unit risks

Currency rates, restrictions, fluctuations, and translations all increase risk to the lessor. The primary risk in currency is the monetary unit itself. Traditionally, contracts, including leases, have been denominated in U.S. dollars. If a lease is denominated in a foreign currency that is subsequently translated into a balance sheet and income statement, a translation gain or loss may also occur. Lessors must understand these risks. Category

Asset-specific risks

Risk assessment is affected by the type of equipment in several ways. Certain categories of equipment involve additional risk because they cannot be easily moved such as elevators, air conditioning systems, and even wallpaper. Other types of assets are subject to a high degree of abuse, such as certain rental cars, construction equipment, and carpeting. If the equipment is substantially abused, the lessor must make considerable financial outlays to restore the asset to re-lease or sale condition. Thus, lessors must quantify this credit risk and work it into the lease proposal. Cross-border

Political and economic risks

Cross-border leasing is the leasing of equipment in one geographical jurisdiction for utilization in another. In cross-border leasing, the major risk is changing economic and political conditions. For example, during the 1970s as political and economic situations in Mexico were stabilizing, cross-border leasing increased. When the economic conditions changed in the early 1980s, many American lessors were faced with enormous risks they had not anticipated. Another cross-border risk is the constant state of flux associated with property and income taxes. Sudden changes in local tax policies can force lessors to rethink their cross-border policies or even withdraw from the market. Political and religious conditions may also alter the degree of risk inherent in cross-border leasing. When a cross-border lease goes bad, it is frequently not possible to recover the asset.

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Competition Lessee’s growth potential

Competition involves the lessee's markets, market shares, and trends. The lessor should determine if the lessee has a growing, stable, or declining share of a growing, stable, or declining market.

International lessor competition

The lessor must also consider the foreign competition the lessee faces. The growing internationalization of the business community has introduced many new competitive players. These competitors are using their respective strengths (such as lower interest rates) to gain a strong foothold. This suggests a dramatic change in international competition in the future. Cyclical and Countercyclical

Lessee’s reaction to economic swings

Cyclical and countercyclical risk refers to the type of economic reaction the company has to general economic conditions. For example, if interest rates rise dramatically, the housing industry typically experiences difficulty; if interest rates drop to abnormally low levels, car sales increase dramatically. Other companies react in a countercyclical nature. For example, when the economic climate deteriorates, grocery store sales do better than ever (people are forced to do more of their own cooking). Lessors should determine what type of cyclical or countercyclical risk to expect. Copartner

Relationship with another investing party

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Copartner refers to reducing risks by sharing them through a relationship with a second investing party. Typically, a genuine partnership dilutes the profitability of the lease. However, other types of copartnership arrangements are available that reduce risk without diluting earnings — for example, vendor guarantees and joint ventures. Many cross border leases use joint ventures to avoid partnership liability and to gain additional expertise. Within certain political jurisdictions, however, joint ventures are regarded as partnerships and will not reduce the lessor’s risk.

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Concealed Value Book value vs. fair market value

Concealed value refers to the difference between the book value and the fair market value of a fixed asset. Because balance sheets are prepared according to GAAP, fixed assets reflect historical cost less accumulated depreciation (book value). However, many pieces of equipment retain a high market value which varies considerably from the lower amount shown on the balance sheet. A good example of this is large aircraft. An aircraft may be fully depreciated on the balance sheet after 10 years, yet the fair market value may be a significant portion of its original cost. For this reason, the credit analysis should include sufficient fair market values on fixed assets.

Intangible assets

Intangible assets are another source of valuation risk for lessors. Many lease applicants may have unreported goodwill, patents, copyrights, and trademarks that add to the value of a company. Lessors should attempt to uncover intangible, undervalued, and unreported hidden assets and consider them in the credit analysis. At the same time, lessors must be wary of lessees who report intangible assets of questionable value. Circumstances

Subjective view

Even though a potential lessee's creditworthiness appears suspect based on the other considerations, circumstances may justify extending credit. For example, the equipment to be leased or used may be part of a profitable, self-liquidating project that is not dependent upon other less profitable operations of the business. Another circumstance may be a start-up company that is just entering a period of normal profit after having incurred losses during the development stage. Consideration of circumstances is a last subjective view of a company to determine whether any conditions exist that might justify extending credit when most other credit indicators suggest credit refusal.

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SUMMARY

In this section, we discussed the 30 Cs of lease credit analysis. We categorized these as steps credit analysts perform in the analysis process, risk factors involving the lessee, and risk factors involving the lease environment. Included in these categories are some methods for minimizing risks associated with particular risk factors. Examples of these are guaranteed residuals, co-partnership arrangements such as joint ventures, and lease provisions such as preventative maintenance clauses. Please check your understanding of the 30 Cs of lease credit analysis by completing Progress Check 4.1, then continue to the next section, Financial Statement Analysis. If you answer any questions incorrectly, review the appropriate text.

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PROGRESS CHECK 4.1

Directions: Determine the correct answer to each question. Check your answers with the Answer Key on the next page. Question 1: Audit reports, tax returns, and SEC reports are all sources of ___________________ for the lessor credit analyst.

Question 2: The end purpose of concatenation, classification, consideration, computation, and compilation is to: ____ a) identify the worst down-side possibility. ____ b) rank credit variables from most important to least important. ____ c) use the result to reach a credit decision. ____ d) determine the degree to which a credit standard is met.

Question 3: Whether a potential lessee has disclosed any off balance sheet financing arrangements is an indication of the lessee’s: ____ a) character. ____ b) competence. ____ c) credit. ____ d) capability.

Question 4: The purpose of analyzing fixed payment coverage (times interest earned) is to: ____ a) calculate a break-even point. ____ b) determine the lessee’s pattern of income growth. ____ c) track historical trends of gross operating margin. ____ d) detect limitations in the lessee’s ability to pay.

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ANSWER KEY

Question 1: Audit reports, tax returns, and SEC reports are all sources of confirmation for the lessor credit analyst.

Question 2: The end purpose of concatenation, classification, consideration, computation, and compilation is to: c) use the result to reach a credit decision.

Question 3: Whether a potential lessee has disclosed any off balance sheet financing arrangements is an indication of the lessee’s: a) character.

Question 4: The purpose of analyzing fixed payment coverage (times interest earned) is to: d) detect limitations in the lessee’s ability to pay.

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Question 5: The CAPM-Beta coefficient is used to measure: ____ a) nonbalance sheet resources such as people and experience. ____ b) the risk of a company. ____ c) cash flow. ____ d) the productivity of the lessee.

Question 6: The larger the lessee’s net income, the better able the lessee is to fund a new lease transaction. ____ a) True ____ b) False

Question 7: Guaranteed residuals, remarketing agreements, and excess-use penalties are all ways the lessor can minimize risks associated with: ____ a) complexity. ____ b) collateral. ____ c) credit. ____ d) control.

Question 8: The introduction of a partner into a lease agreement reduces liability: ____ a) in a cross-border arrangement. ____ b) and increases profitability. ____ c) but may also reduce profitability.

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ANSWER KEY

Question 5: The CAPM-Beta coefficient is used to measure: b) the risk of a company.

Question 6: The larger the lessee’s net income, the better able the lessee is to fund a new lease transaction. b) False It is possible for a company to have a positive net income, but a negative cash flow. An example is a growth company that invests large amounts in assets.

Question 7: Guaranteed residuals, remarketing agreements, and excess-use penalties are all ways the lessor can minimize risks associated with: b) collateral.

Question 8: The introduction of a partner into a lease agreement reduces liability: c) but may also reduce profitability.

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FINANCIAL STATEMENT ANALYSIS

Up to now, our discussion has focused on the methods lease credit analysts use and the risk factors they assess. Financial statement analysis traditionally has been a major part of the credit analysis process. Financial statements provide important information about a company. n

The income statement communicates profitability for a given period of time.

n

The balance sheet illustrates balances or economic residuals at the end of such a period.

n

The cash flow statement, which is required by Financial Accounting Standards Board statement No. 95 (FASB 95), provides information about the uses and sources of cash.

In this section, we will discuss the use of each financial statement for lease credit analysis.

Income Statement Analysis Vertical analysis

An income statement may be analyzed in different ways. Its components may be broken down either vertically or horizontally. In vertical analysis, the first figure, sales, is equated to 100%. Each successive income and expense line item is expressed as a percentage of sales.

Horizontal analysis

A horizontal analysis, however, assumes a totally different strategy: that of trending. Each line item in Year 1 is defined as the base year and equated to 100%. For each successive year, the line items of the income statement are expressed as a function of the base year. Horizontal analysis reveals the dynamic nature of the income.

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Balance Sheet Analysis Economic snapshot

The balance sheet is an economic snapshot of the company at a particular time. Like the income statement, the balance sheet may be analyzed horizontally or vertically. Horizontal analysis provides trending information, whereas vertical analysis results in a comparison of one classified line item to another.

Cash Flow Analysis Accrual accounting vs. cash flow

Earlier in this unit, we mentioned the importance of analyzing cash flow to evaluate the lessee’s ability to pay. To appreciate why cash flow gives a lessor a better view of a potential lessee’s capacity, you need to understand that income statements and balance sheets are prepared on an accrual basis, according to GAAP. Accrual financial statements reflect sales as revenue before payment is received. Also, expenses may be recorded before they are paid. The problem with accrual accounting is that salaries, invoices and dividends are not paid with accrual net income; they are paid with cash. A credit analyst must manipulate the accrual statements to determine how much cash is flowing into and out of the company. The FASB agrees with the importance of cash flow analysis, which is why it has issued FASB 95. FASB 95 requires a statement of cash flows in the financial statements. Because cash flow analysis is so important, we will discuss it in detail as a separate topic later in this unit.

Standard Ratio Analysis From a credit analyst’s point of view, the main purpose of financial statement analysis is to determine a company’s current and future financial health. We have just seen how the income statement reports a company’s operations over a period of time, how a company’s balance sheet reports the company’s position at a point in time, and how the cash flow analysis reports a company’s sources and uses of cash over a given period.

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Relationships between financial statement accounts

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Another tool credit analysts use to assess a company’s financial wellbeing is a financial ratio analysis. Financial ratios are useful because they reveal relationships between financial statement accounts. Credit analysts use ratios for comparative analysis, interrelationship studies, and input to forecasting models. Figure 4.4 shows how ratios are used and the effect they have on the decision process. RATIOS AND THE DECISION PROCESS

How Ratios are Used

Effect on the Decision Process COMPARISONS

1) Currently established ratios are compared with the same ratios of prior periods for the same firm.

1) Trends are established by looking at a series of ratios over time.

2) Industry ratios are compared with similar companies within an industry.

2) Relative standing is established within an industry. Relative standing could highlight strengths or weaknesses.

INTERRELATIONSHIPS 1) In-depth analysis finds logical relationships among various items on the balance sheet and income statement.

1) Pinpointing the causes of weaknesses is facilitated by the use of ratios casually related to a problem.

2) Ratios are categorized according to common objectives of financial management.

2) Common financial objectives that must be met to maximize profit, insure growth in share price, and maintain liquidity are highlighted, along with serious weaknesses in one category that could ultimately lead to a weakening of another major category. MODELS

1) Simulation models developed from interrelated ratios to show the simultaneous effects of changes in these ratios.

1) The overall effect of component variables can be observed from the use of simulation models.

2) Forecasting models are developed by using regression analysis techniques on particular ratios.

2) Planning is facilitated by the use of forecasting models. Budgets can be established as the result of a particular forecast of certain ratios.

Figure 4.4: Ratios and the decision process

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Categories of noncash ratios


Standard ratios can be grouped into six broad categories, each of which depicts a particular aspect of the financial condition of the company: n

Profitability and earnings growth

n

Liquidity and working capital

n

Investment utilization and activity

n

Financial leverage

n

Solvency and risk

n

Owner's equity

Ratios within each category give the credit analyst an indication of whether the company is meeting the goal of the particular category. Information used for examples

We will use the year-end financial information for ABC Company in Figures 4.5 and 4.6 to illustrate how the ratios in each category are computed and how they are used in the decision process. We will assume that the average price per share for ABC Company stock during 1993 is $35 and that dividends in the amount of $28,000 were paid.

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ABC Company BALANCE SHEET

ASSETS Cash Accounts receivable Inventories Plant and equipment (net) Patents Other intangible assets Total assets LIABILITIES AND EQUITY Accounts payable Federal income tax payable Miscellaneous accrued payables and dividends payable Bonds payable (4%, due 1996) Preferred stock ($100 par, 7% cumulative, non-participating and callable at $110) Common stock (no par, 20,000 shares authorized, issued and outstanding) Retained earnings Treasury stock - 800 shares of preferred Total liabilities and equity

1993

1992

$ 106,000 566,000 320,000 740,000 26,000 14,000

$ 192,000 483,000 250,000 716,000 26,000

$ 1,772,000

12,000 $ 1,679,000

$ 170,000 32,000

$ 126,000 13 ,000

38,000 300,000

45,000 300,000

200,000

200,000

400,000 720,000 (88,000) $ 1,772,000

400,000 683,000 (88,000) $ 1,679,000

Figure 4.5: Balance sheet

ABC Company INCOME STATEMENT 1993 Net sales Cost of goods sold

1992

$1,500,000 900,000

$ 1,100,000 710,000

Gross margin on sales Operating expenses (including interest)

$ 600,000 498,000

$ 390,000 355,000

Income before federal income taxes Income tax expense

$ 102,000 37,000

$ 35,000 13,000

$ 65,000

$ 22,000

Net income Figure 4.6: Income statement

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Profitability and Earnings Growth Ratios Dual objectives

If we assume that the goal of management is to maximize shareholders' value, then the company must (l) maximize profits so continual dividends will be paid and (2) maintain steady growth in earnings so the investor's stock price will grow (capital gains). These two objectives are interrelated. A company that pays proportionately high dividends compared to amounts retained each year from net income will find it difficult to grow as fast as another company that retains more earnings.

Profitability model

Seven ratios have been developed into a model (Figure 4.7) that describes a company's profitability and also describes the effect of dividend payout on potential growth rate in earnings.

PROFITABILITY MODEL x = x = x =

1. 2. 3. 4. 5. 6. 7.

Net profit to net sales (net profit margin) Net sales to total assets (asset turnover) Return on investment or assets Financial leverage advantage (assets to equity ratio) Net income to owners' equity (return on equity) Retention ratio (l - dividend to net income ratio) Potential growth rate in earnings.

Figure 4.7: Profitability model

Note that each factor in the model can stand alone and still have significance. However, the model does show the effect of a change in any one factor on both return on equity (ROE) and potential growth rate — two objectives that management should be especially concerned about in the planning process. The following examples of profitability and earnings growth ratios are based on the information in Figures 4.5 and 4.6.

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1. NET PROFIT TO NET SALES (NET PROFIT M ARGIN)

The formula for computing this ratio is: Net income (after taxes) $65,000 = = 4.33% Net sales (after returns and allowances) $1,500,000

Net income as percentage of sales

Net profit margin calculates net income as a percentage of sales. Stable or growing net profit margins are favorable indicators so long as asset turnover has not been overly reduced. 2. NET SALES TO T OTAL ASSETS (ASSET T URNOVER)

The formula for computing this ratio is: Net sales $1,500,000 = = 89.34% Total assets (beginning of year) $1,679,000

Sales that investments in assets can generate

Asset turnover indicates the amount of sales that each dollar invested in assets can generate. Thus, in this example, each dollar of assets is able to generate $.8934 of sales revenue. Increases in asset turnover are considered favorable so long as profit margins are not unduly sacrificed to generate volume increases. Remember, it is net profit margin times asset turnover that really indicates profitability (return on investment or assets).

Using as part of profitability model

Notice that when we calculate asset turnover as part of the profitability growth model, we use: beginning of the year assets rather than an average and total assets rather than net fixed assets, which are more commonly used for asset turnover computations. 3. RETURN ON ASSETS (RETURN ON INVESTMENT)

The formula for computing this ratio is: Net Profit Margin x Total Asset Turnover or

Net income $65,000 = = 3.87% Total assets $1,679,000

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ROA indicators


Return on assets (ROA) demonstrates the after-tax interest equivalent return on assets invested. Thus, assets are earning 3.87% after-tax. Steady or growing ROA percentages are important indices of financial health in a potential lessee. 4. FINANCIAL LEVERAGE ADVANTAGE (ASSETS TO EQUITY RATIO)

The formula for computing this ratio is: Total assets (beginning of year) $1,679,000 = = 1.405 Owners' equity (beginning of year) $1,195,000

Effect of financial leverage

This ratio is not one that indicates profitability directly; rather, it indicates the effect of financial leverage on profit. When a company earns more than enough on its assets to pay interest on debt, the balance goes to equity. This ratio, when multiplied times ROA, shows the effect on equity when leverage is used. Assets are 1.405 times equity and the ROA, when converted to return on equity (ROE), will be 140.5% higher, as the next ratio demonstrates. 5. NET INCOME TO OWNERS ' EQUITY (RETURN ON EQUITY)

The formula for computing this ratio is as follows: ROA x Financial leverage advantage = Return on equity 3.87% x 1.405 = 5.44% or Net income (after taxes) $65,000 = = 5.44% Net worth (beginning of year) $1,195,000

Steady or growing ROE

A company's ROE should be steady or growing and be relatively close to other industry competitors. However, increased ROEs that stem from increased financial leverage, rather than from a growing ROA, should not be considered a favorable indicator of creditworthiness.

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6. RETENTION RATIO

The formula for computing this ratio is: 1-

Dividends Net income

Declines indicate profit crisis

= 1-

$28,000 $65,000

= 56.92%

This ratio indicates the percentage of net income that remains after dividend payment. Sudden or systematic declines in the retention ratio could indicate an impending profitability crisis. 7. POTENTIAL GROWTH RATE

The formula for computing this ratio is: ROE × Retention ratio = 5.44% × 56.92% = 3.10%

Growth factors

A company’s growth rate cannot exceed the product of its retention ratio times its ROE. To grow faster, either ROE has to be increased or dividend payout reduced. Therefore, if leases are to be paid out of anticipated future earnings derived from increased growth, that growth should be justified. Additional profitability and earnings growth ratios help the analyst anticipate possible future problems. They include: price/earnings ratio, gross margin, and dividend yield. Remember, the figures in the examples are taken from the financial information for ABC Company (page 4-31). PRICE EARNINGS RATIO

The formula for computing this ratio is: Market price per share (average may be used) Net income per share (Previous 4 quarters)

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=

$35 = $10.769 per share  $65,000     20,000 

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Decreases relative to S & P 500


Sudden decreases in the price / earnings ratio relative to the price/earnings ratios of the Standard and Poors 500 could indicate an impending profitability problem. GROSS M ARGIN

The formula for computing this ratio is: Gross profit on sales $600,000 = = 40% Total sales revenue $1,500,000

Percentage of sales as gross profit

Gross profit margin indicates what percentage of sales is gross profit. Steady or increasing gross profit margins are favorable if asset turnover is not being reduced too fast or general and administrative expenses are not increasing too rapidly. DIVIDEND YIELD

The formula for computing this ratio is as follows:  $28,000     20,000  Dividend p er share = = 4% Average price per share 35

Reductions indicate problems

Dividend yields usually remain constant within a narrow range of 2% to 4%. Ratios above 4%, or sudden reductions in a ratio when the general stock market is constant, could indicate upcoming profitability problems. Liquidity and Working Capital Ratios

Ability to meet obligations

In addition to profitability, another vital concern of the financial analyst is liquidity, or the ability of the firm to meet its maturing obligations (current liabilities). Four ratios that indicate liquidity and the composition of working capital in terms of inventory and accounts receivable are: current ratio, acid-test ratio, inventory-to-net working capital, and accounts receivable-to-net working capital.

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CURRENT RATIO

The formula for computing this ratio is: Current assets $992,000 = = 4.13 times Current liabilities $240,000

Compares assets to liabilities

Current assets are 4.13 times as large as current liabilities. Keep in mind, however, that a significant portion of current assets may not be liquid enough to pay liabilities when due. ACID-T EST RATIO (QUICK RATIO)

The formula for computing this ratio is: Quick assets (cash, securities, accounts receivable) $672,000 = = 2.8 times Current liabilities $240,000

A better index of liquidity

Quick (readily convertible to cash) assets are 2.8 times current liabilities, which is a more realistic index of liquidity than current ratio. INVENTORY-TO-NET WORKING CAPITAL

The formula for computing this ratio is: Inventory (end of period or average) $285,000 = = 37.90% Net working capital $992,000 - $240,000

Inventory as percentage of working capital

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Note that net working capital is current assets minus current liabilities. This ratio indicates what percentage of working capital is comprised of inventory, its most nonliquid component. An increasing inventory-to-net working capital ratio indicates movement towards a nonliquid position.

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ACCOUNTS RECEIVABLE-TO-NET WORKING CAPITAL

The formula for computing this ratio is: Accounts receivable (end of period or average) $525,000 = = 69.81% Net working capital $752,000

Accounts receivable as percentage of net working capital

A growing accounts receivable to net working capital ratio is favorable because it indicates a more liquid working capital than if inventory were the predominant component.

Investment Utilization (Activity) Ratios Effective use of resources

Investment utilization or activity ratios measure how effectively the firm employs its resources. One method to measure investment utilization is to review the total operating cycle, which is an analysis of the time required to convert cash into merchandise, then into accounts receivable, and ultimately back into cash again. There are several common ratios that aid in an analysis of investment utilization: 1. Days’ receivables 2. Days’ inventories 3. Total operating cycle 4. Days’ payables, and accounts payable turnover 5. Net sale to owner’s equity 6. Net sales to working capital

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DAYS' RECEIVABLES (COLLECTION PERIOD)

The formula for computing this ratio is: 365 Accounts receivable turnover

=

365   Credit sales  Average accounts receivable 

365     $1,500,000     $566,000 + $483,000      2 

Growing time period signals liquidity problems

= 127.628 days

If credit sales are not available, total sales may be used, and year-end accounts receivable may be used in place of average accounts receivable. This ratio indicates it takes an average of 128 days to collect ABC Company's receivables. If this time period is growing, a red flag is raised indicating liquidity problems such as bad debts, ineffective collection policy, etc. DAYS' INVENTORIES (SALES PERIOD)

The formula for computing this ratio is: 365 Inventory turnover

 Cost of goods sold   Average in ventory

365 = 115.583 days     $900,000     $320,000 + $250,000     2  

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Growing ratio warrants investigation


If cost of goods sold is not available, total sales may be used. Ending inventory may be used instead of average inventory. This ratio indicates the time required to convert inventory into a sale. A growing ratio may indicate sales slowdown, manufacturing inefficiencies, or a new product mix — all of which should be investigated and understood. T OTAL OPERATING CYCLE

The formula for computing this ratio is: Days' receivables + days' inventories = 127.628 + 115.583 = 243.2 days

Growth indicates poor resource utilization

This ratio represents the total time to convert inventory into a sale, then into a receivable, and back into cash. Growth of this conversion time period may indicate poorer overall utilization of resources. DAYS' PAYABLES AND ACCOUNTS PAYABLE T URNOVER

The formula for computing this ratio is: 365 Payable turnover

 Cost of goods sold   Average payable

365 = 60.022 days     $900,000     $170,000 + $126,000     2  

Growth in result indicates liquidity, profitability problems

This ratio represents the average time taken to pay trade payables. The time period should be less than both days’ receivables or days’ inventories. Growth in the days’ payable may indicate forthcoming liquidity and profitability problems since trade creditors are being forced to increase their waiting period for payment.

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NET SALES TO OWNERS ' EQUITY

The formula for computing this ratio is: Net sales $1,500,000 = = 1.26 times Owners' equity (average) $1,195,000

Dependency of sales on owner’s equity

This ratio indicates how dependent sales are on owners' equity (assuming constant financial leverage). If this ratio has held constant, increased sales may require additional equity — without equity infusions expansion might be limited. Increases in the ratio may indicate improvement in operational efficiencies. NET SALES TO WORKING CAPITAL

The formula for computing this ratio is: Net sales $1,500,000 = = 2.01 times Average net working capital $747,000

Dependency of sales on working capital

The net sales to average net working capital ratio indicates the degree to which sales are dependent upon working capital. If this ratio increases, working capital inefficiencies are occurring or a new product with slower turnover is being sold. Financial Leverage Ratios

Lessee’s debt burden

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A lessor granting credit should always be concerned with the debt burden a potential lessee is carrying, for if the lessee is too highly leveraged it may not be able to pay the lease payment. We will present four financial leverage ratios aid the analyst in determining the risk associated with debt: n

Total liabilities-to-total assets (Debt ratio)

n

Current liabilities-to-owner’s equity

n

Interest-to-net income before interest

n

Total liabilities-to-owner’s equity DRAFT

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T OTAL LIABILITIES -TO-T OTAL ASSETS (DEBT RATIO)

The formula for computing this ratio is: Total liabilities (or long - term liabilities) $540,000 = = 30.47% Total assets $1,772,000

Growing ratio may signal inefficiencies

This ratio describes what percentage of the total capital structure is debt. If a company's ROE is relatively constant while this ratio is growing, inefficiencies may be occurring. CURRENT LIABILITIES -TO-OWNERS ' EQUITY

The formula for computing this ratio is: Current liabilities $240,000 = = 19.48% Owners' equity $1,232,000

Growing ratio signals liquidity needs

This ratio indicates relative commitment to the company: trade creditors (current liabilities) versus owners' equity. A growing ratio may indicate forthcoming liquidity needs. INTEREST-TO-NET INCOME BEFORE INTEREST

The formula for computing this ratio is: Interest Interest + Net income

Growing ratio compared to ROE increases

or

Interest (1 - t) Interest (1 - t) + Net income

=

$120,000 $185,000

= 64.86%

Whereas total liabilities to total assets indicate total leverage, this ratio indicates both total leverage and the cost of the leverage relative to net income. A growing ratio without corresponding increases in ROE may indicate a profitability problem and a possible forthcoming credit shortage.

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T OTAL LIABILITIES -TO-OWNERS ' EQUITY

The formula for computing this ratio is: Total liabilities Owners' equity

Growing percentage: Liquidity problems

=

$540,000 $1,232,000

= 43.83%

This ratio indicates the liabilities relative to the investment commitment of the company; all creditors (trade and long-term) versus owners' equity. A growing percentage may indicate forthcoming liquidity problems. Solvency and Risk Ratio

The ability of a lessee to meet the carrying costs on its existing debt provides a good idea of its potential ability to make the lease payment. This ratio measures that capability. T IMES INTEREST EARNED

The formula for computing this ratio is: Net income + taxes + interest Interest

=

$222,000 $120,000

= 1.85 times

Interest could have been paid 1.85 times before income is used up. Owners' Equity Ratios

The amount of equity the owners are retaining in the business is another important measure of financial stability. The following three ratios are used:

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n

Net fixed assts to owner’s equity

n

Book value per common share

n

Return on common equity

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NET FIXED ASSETS TO OWNERS ' EQUITY

The formula for computing this ratio is: Fixed assets (net of depreciation) Owner's equity

Reliance of property, plant, and equipment on equity

=

$740,000 $1,232,000

= 60.06%

This ratio indicates the reliance of property, plant and equipment on equity. Increases in this percent indicate permanent capital requirements as opposed to short- and intermediate-term funding. Too rapid an increase could indicate a forthcoming liquidity problem as well a cutback on property, plant, and equipment expansion. BOOK VALUE PER COMMON SHARE

The formula for computing this ratio is: Total book value of common stock Shares outstanding

Owners’ equity less liquidation values

=

$1,012,000 $20,000

= $50.60

The liquidation value of callable preferred stock, cumulative preferred dividends in arrears and treasury stock is deducted from the total owners' equity in order to obtain the total book value of common stock. RETURN ON COMMON EQUITY

The formula for computing this ratio is: Net income - preferred dividends currently due Total book value of common stock

Decreases warrant inquiry

=

$65,000 - $14,000 $1,012,000

= 5.04%

So long as financial leverage is held constant, increases in ROE are the ultimate measure of profitability. Decreases in this percent indicate problems worthy of further inquiry.

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Evolution from accrual accounting

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Traditionally, credit analysts have used standard financial ratios in their analyses. However, traditional ratio analyses evolved from accrual accounting, and standard ratios present some limitations for cash accounting. Therefore, many credit analysts use nontraditional cash flow ratios in addition to standard cash flow ratios. We will discuss cash flow ratios in the next section.

CASH FLOW ANALYSIS Tool to assess lessee’s creditworthiness

We mentioned the importance of cash flow analysis previously in this unit. Many credit analysts consider cash flow analysis to be the best tool to assess a potential lessee's creditworthiness, because available cash represents the resource the lessee will use to pay the lease payments. In this section, we demonstrate why cash flow analysis is a useful tool for lessors.

Statement of Cash Flows Cash flow worksheet

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Figure 4.8 shows the cash flow statement required by FASB 95. In Figure 4.9, we present a worksheet for cash flow analysis that is useful in credit analysis. The numbers in Figure 4.9 represent the same cash flow information as in Figure 4.8 restated in a form that is appropriate to credit analysis. Later in this unit, we will explain each element of the worksheet and show how it helps an analyst make a good lease credit decision.

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Statement of Cash Flows CASH FLOWS FROM OPERATING ACTIVITIES Cash received from customers $ 13,850 Cash paid to suppliers and employees (12,000) Dividend received from affiliate 20 Interest received 55 Interest paid (net of amount capitalized) (220) Income taxes paid (325) Insurance proceeds received 15 Cash paid to settle lawsuit for patent infringement (30) Net cash provided by operating activities $ 1,365 CASH FLOWS FROM INVESTING ACTIVITIES Proceeds from sale of facility $ 600 Payment received on note for sale of plant 150 Capital expenditures (1,000) Payment for purchase of Company S, net of cash acquired (925) Net cash used in investing activities (1,175) CASH FLOWS FROM FINANCING ACTIVITIES Net borrowings under line-of-credit agreement $ 300 Principal payments under capital lease obligation (125) Proceeds from issuance of long-term debt 400 Proceeds from issuance of common stock 500 Dividends paid (200) Net cash provided by financing activities 875 NET INCREASE IN CASH AND CASH EQUIVALENTS $ 1,065 Cash and cash equivalents at the beginning of the year 600 Cash and cash equivalents at the end of the year $ 1,665 RECONCILIATION OF NET INCOME TO NET CASH PROVIDED BY OPERATING ACTIVITIES Net income $ 760 Depreciation and amortization $ 445 Provision for losses on accounts receivable 200 Gain on sale of facility (80) Undistributed earnings of affiliate (25) Payment received on installment note receivable for sale of inventory 100 Change in assets and liabilities net of effects from purchase of Company S: Increase in accounts receivable (215) Decrease in inventory 205 Increase in prepaid expenses (25) Decrease in accounts payable and accrued expenses (250) Increase in interest and income taxes payable 50 Increase in deferred taxes 150 Increase in other liabilities 50 Total adjustments 605 Net cash provided by operating activities $ 1,365 SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES The Company purchased all of the capital stock of Company S for $950. In conjunction with the acquisition, liabilities were assumed as follows: Fair value of assets acquired $ I,580 Cash paid for the capital stock (950) Liabilities assumed $ 630 A capital lease obligation of $850 was incurred when the Company entered into a lease for new equipment. Additional common stock was issued upon the conversion of $500 of long-term debt. DISCLOSURE OF ACCOUNTING POLICY For purposes of the statement of cash flows, the Company considers all highly liquid debt instruments purchased with a maturity of three months or less to be cash equivalents.

Figure 4.8: Statement of cash flows DRAFT

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4-47

CASH FLOW ANALYSIS WORKSHEET NET OPERATING CASH GENERATION Gross operating cash generation Add: Net income Depreciation Other noncash amortizations Increase in deferred tax credits Payment received on installment note Bad debt expense (allowance method) Subsidiary dividends (equity method) Gross operating sources Deduct: Gains on the sale of fixed assets Decrease in deferred tax credits Subsidiary income (equity method) Miscellaneous Gross operating uses Gross operating cash generation Working capital cash generation (usage) Add: Increase in accounts payable Increase in accrued expenses Increase in taxes payable Decrease in inventory Decrease in accounts receivable Decrease in prepaid expenses Working capital sources Deduct: Decrease in accounts payable Decrease in accrued expenses Decrease in taxes payable Increase in inventory Increase in accounts receivable Increase in prepaid expenses Working capital uses Working capital cash generation

$

150 100 200 $

50 50 205

$ 305 ($ 250) ( ) ( ) ( ) ( 215) ( 25) ($ 490) ($ 185) $

NONDISCRETIONARY CASH REQUIREMENTS Dividends Replacement property, plant and equipment Inflationary property, plant and equipment Short-term debt repayment Long-term debt repayment Principal payments on capital lease Total nondiscretionary requirements

($ ( ( ( ( ( ($ $

Figure 4.9: Cash flow analysis worksheet

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DRAFT

1,655

($ 80) ( ) ( 25) ( ) ($ 105) $ 1,550

NET OPERATING CASH GENERATED

DISPOSABLE NET OPERATING CASH FLOW

760 445

1,365

200) 445)3 151)3 ) ) 125) 921) 444

4-48


CASH FLOW ANALYSIS WORKSHEET (CONTINUED) DISCRETIONARY CASH NEEDS Additional property, plant, and equipment Other investments (subsidiaries) Reduction of permanent debt (bonds, etc.) Reduction of equity Total discretionary needs

($ 404)3 ($ 925) ( ) ( ) ($ 1,329)

NET CASH NEEDS

($

885)

NON-OPERATING CASH SOURCES Short-term debt increase Long-term debt increase Permanent debt increase (bonds) Sale of equity Sale of fixed assets proceeds Sale leaseback proceeds Payment on note receivable sale of plant Non-operating cash sources

150 1,950

NET INCREASE (DECREASE) IN CASH

1,065

300 400 500 600

Figure 4.9: Cash flow analysis worksheet

Advantages of Cash Flow Worksheet Separate gross operating and working capital sources

The advantage of this worksheet presentation is that operating sources of cash flow are separated into gross operating sources and working capital sources. This allows the analyst to determine the degree to which net operating cash generation is dependent upon working capital as opposed to actual operations. In the long run, only operational cash flow is important since there is a limit to which working capital can generate cash flow through increasing trade payables, accrued expenses, and other sources.

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Calculating Disposable Cash Flow Source of cash for future leases

Any future leases or loans would be repaid from disposable cash flow. Therefore, the computation of disposable cash flow is the whole purpose of the cash flow analysis worksheet. If a company cannot demonstrate that it will have enough disposable cash flow, the lessor probably should not extend credit. In our example, we subtracted total nondiscretionary requirements of $921 from net operating cash generation of $1,365 to arrive at disposable net operating cash flow ($444 from Figure 4.9). Nondiscretionary Cash Requirements

Cash flows as a function of discretion

In Figure 4.9, the non-operating cash sources on the cash flow worksheet disclose the sources of cash that provided for the $885 cash needs, plus the $1,065 increase in cash. Again, the advantage of the preceding cash flow analysis worksheet is to source cash inflows and outflows as a function of management discretion and nondiscretion since only disposable cash flow will be available to pay off future debt or lease obligations.

Cash Flow Ratios Comparison to standard ratio analysis

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Earlier in this unit, you saw how standard ratio analysis relates income statement data to balance sheet data, income statement to income statement, and balance sheet to balance sheet. In this section, we relate cash flow data to income statement, balance sheet, and other cash flow information. We will use the data in Figure 4.9 to illustrate cash flow ratios.

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Income Statement to Cash Flow Ratios

There are four cash flow ratios used to identify trends in relationships between the income statement and cash flow. 1. Net income

=

Gross operating cash flow

Gross operating cash flow as a percentage of net income

$760

= 49.03%

$1,550

This ratio demonstrates the proportion of gross operating cash flow derived from net income. If this percentage increases, less cash flow is being generated for each dollar of net income. If such a trend continues, liquidity problems might arise. 2. Net income Net operating cash flow

Impact of working capital sources

=

$760 $1,365

= 55.68%

This ratio is similar to the first ratio, however, the impact of working capital sources and uses is factored in. If this ratio is growing or exceeds ratio 1, it may indicate that working capital requirements are consuming gross operating cash flow. A continuation of this trend may indicate a forthcoming liquidity problem. However, a decline in this percentage indicates favorable cash flow generation. 3. Net operating cash flow Interest and lease rentals

Unadjusted cash flow

=

$1,365 $220 + $0

= 6.2045%

This ratio is similar to times interest earned except that the cash flow has not been adjusted for tax expenses or interest. The ratio is important because it shows that interest expense was covered 6.2 times by net operating cash flow. 4. Disposable net operating cash flow Interest and lease r entals

DRAFT

=

$444 $220

= 2.018%

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Feasibility of new expense

4-51

This cash flow ratio is similar to times interest earned also; however, this key ratio deals with disposable cash that is available to pay existing or future interest expense. Without a ratio greater than one, any proposed interest expense or rental expense would not appear feasible, due to a lack of disposable cash. Cash Flow to Cash Flow Ratios

There are three cash flow ratios to identify trends in relationships between different cash flows. 1. Net operating cash generation Disposable net operating cash flow

Impact of nondiscretionary cash needs

=

$1,365 $444

= 3.074%

This ratio demonstrates the impact of nondiscretionary cash needs. If needs are few, the ratio would be closer to one. High or growing ratios indicate greater cash flow commitments, which reduce cash available to pay off future loan or lease payments. 2. Gross operating cash flow Disposable net operating cash flow

Cash flow commitments

=

$1,550 $444

= 3.491%

This is the same as ratio 1 except the impact of working capital cash use or generation has been removed. Increases in this ratio indicate greater cash flow commitments trending towards less cash available to pay future loans or leases. 3. Discretionary cash flow Net operating cash flow

Discretionary spending

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=

$885 $1,365

= .648%

This ratio indicates the percent of net operating cash flow that is being spent on discretionary requirements. Increases in the percentage or a high percentage could indicate excess or runaway growth, which is hampering the creation of disposable cash flow.

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Cash Flow to Balance Sheet Ratios

There are three cash flow ratios used to identify trends in relationships between the balance sheet and cash flow. For purposes of these ratios, assume the following information: Assets: $5,000 Equity: $2,300 Net working capital: $500 1. Net Operating cash flow Assets

Profitability indicator

=

$1,365 $5,000

= 27.3%

This ratio is the same as the standard ROA except it represents the total cash flow ROA. Decreases in this ratio indicate a decrease in the company's profitability. 2. Net workin g capital Net operating cash flow

Working capital management

=

$500 $1,365

= 36.63%

The percentage that net working capital is of net operating cash flow should remain steady. Increases could indicate inefficiencies in working capital management. 3. Net operating cash flow Equity

Net operating cash flow as a percentage of equity

=

$1,365 $2,300

= 59.35%

This ratio is the same as the standard ROE except this represents the total cash flow ROE. This percentage should remain relatively constant, however, increases in the percentage would be considered favorable if financial leverage remains constant.

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SUMMARY

Credit analysis is the process of examining financial statements to determine the current and future financial health of a company. There are two basic approaches to analyzing financial statements: horizontal analysis and vertical analysis. Each method results in a different view of the information contained in the statement. For example, the timespanning nature of the income statement is most apparent in a horizontal decomposition. Another tool credit analysts use to assess a company’s financial well-being is ratio analysis. There are two major types of ratio analysis: standard ratio analysis, which has its roots in accrual accounting, and cash flow analysis, which focuses a company’s cash inflows and outflows. Cash flow is considered to be the better tool to assess creditworthiness because cash represents the resource the company will use to pay lease or loan payments. You have completed Unit Four: Credit Analysis and Risk Assessment. In Unit Five: Financial Concepts and Calculations, you will learn some of the key concepts of financial transaction analysis and discover how they apply to cash flow and the other concepts coverd in this unit. Before you continue to the next unit, please check your understanding of the credit analysis section by completing the Progress Check 4.2. If you answer any of the questions incorrectly, please return to the text and read the section again.

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(This Page Is Intentionally Blank)

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]

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PROGRESS CHECK 4.2

Directions: Determine the correct answer to each question. Check your answers with the Answer Key on the next page. Question 1: Horizontal decomposition of an income statement reveals the: ____ a) relationship between profitability and earnings growth. ____ b) relationship of one line item to another. ____ c) relationship of line items to sales. ____ d) time relationships of line items. Question 2: From a credit analyst’s viewpoint, the problem with preparing financial statements on an accrual basis is that accrual accounting does not show: ____ a) cash inflow and outflow. ____ b) income and expenses within the time frame they were incurred. ____ c) intangible assets. Question 3: In standard ratio analysis, a profitability model: ____ a) describes a company’s cash flow. ____ b) shows the effect of a change in any one factor on each of the other factors. ____ c) describes only the effect of dividend payout on potential growth rate in earnings. ____ d) uses net fixed assets in the asset turnover computation. Question 4: In liquidity ratios, inventory is the most nonliquid component of working capital. ____ a) True ____ b) False

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ANSWER KEY

Question 1: Horizontal decomposition of an income statement reveals the: d) time relationships of line items.

Question 2: From a credit analyst’s viewpoint, the problem with preparing financial statements on an accrual basis is that accrual accounting does not show: a) cash inflow and outflow.

Question 3: In standard ratio analysis, a profitability model: b) shows the effect of a change in any one factor on each of the other factors.

Question 4: In liquidity ratios, inventory is the most nonliquid component of working capital. a) True

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Question 5: Financial leverage ratios help a credit analyst determine the risk associated with: ____ a) profitability. ____ b) debt. ____ c) solvency. ____ d) liquidity.

Question 6: Cash flow is considered the best tool to assess creditworthiness because it: ____ a) reveals the lessees ability to pay the lease payments. ____ b) is less cumbersome than using accrual ratios. ____ c) shows the degree to which net operating cash generation is dependent upon actual operations. ____ d) combines discretionary and nondiscretionary cash needs.

Question 7: A high or growing cash flow to cash flow ratio indicates a potential lessee will have the cash to pay off future leases. ____ a) True ____ b) False

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ANSWER KEY

Question 5: Financial leverage ratios help a credit analyst determine the risk associated with: b) debt.

Question 6: Cash flow is considered the best tool to assess creditworthiness because it: a) reveal s the lessees ability to pay the lease payments.

Question 7: A high or growing cash flow to cash flow ratio indicates a potential lessee will have the cash to pay off future leases. b) False

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Unit 5

UNIT 5: FINANCIAL CONCEPTS AND CALCULATIONS

INTRODUCTION

Leasing involves a series of cash flows, with some occurring today and some in the future. As you know, a dollar received today is worth more than a dollar received tomorrow because of the effect of interest. Due to this time value of money, we cannot make a valid comparison of the face value of cash flows. To compare investment and funding alternatives, we use present value analysis to convert future cash flows to today’s dollars. In the leasing industry, present value calculations are used to make lease versus buy decisions and to structure (price) leases, so it is important that you understand them. Internal rate of return, or IRR, is another analytical tool used to compare funding alternatives. IRR is used to compute yields (interest). Whereas present value deals primarily with principal, IRR concerns the interest in a financial transaction. In this unit, you will be introduced to present value and IRR computations. We will show you how to calculate the present value of future cash flows and IRR with the HP12C financial calculator. Through these examples, you will see how these concepts are applied in the leasing industry. In Unit Six: Introduction to the Lease versus Buy Analysis and Unit Seven: Lease Pricing, we present more detailed examples of using present value and IRR calculations in leasing.

UNIT OBJECTIVES

When you complete this unit, you will be able to: +

Perform present value calculations

+

Compute IRRs on a stream of cash flows

+

Recognize the applications of present value and internal rate of return to leasing

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5-2

FINANCIAL CONCEPTS AND CALCULATIONS

PRESENT VALUE Removing time value of money

The concept of present value involves taking a known future value amount and stripping out the time value of money factor (discount rate). Removing the effects of interest from a cash flow stream tells us what those future cash flows are worth today (present value).

Example

Assume that someone owes you $10,000 at the end of 36 months and has signed a note payable to that effect. If someone were to offer to buy that note payable from you today, for $6,500, would you sell the note? To decide, you must weigh the value of $10,000 to be received 36 months in the future against receiving $6,500 today. Since the values are not comparable, you must convert the $10,000 into today’s dollars by removing the effects of interest. If your investment yield is 12 percent, you would use this discount rate to strip out the time value of money from the $10,000 and arrive at its present value. Let’s see how to calculate the present value on the HP12C calculator.

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5-3

Calculating Present Value Information needed for present value calculation

In the remainder of this section, we will discuss five applications of present value computations: +

Present value of one cash flow

+

Present value of an ordinary annuity (annuity in arrears)

+

Present value of an annuity due (annuity in advance)

+

Present value of an annuity with multiple advance payments

+

Present value of multiple, uneven cash flows

To calculate present value amounts, we must know the following information:

Calculator keys

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+

The number of future cash flows

+

The amount of each future cash flow

+

The number of periods over which the cash flow(s) will be discounted

+

The discount rate to be used in the present value calculation

In our examples, we will show how to enter this information with the following keys on the HP12C calculator: n

The term or number of compounding periods over which the cash flow is to be discounted

FV

The amount of the future cash flow (inflow or outflow)

i

The interest (discount rate) being used over the compounding periods

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5-4


PMT

The periodic payment amount.

PV

The present value of a future cash flow or series of cash flows

In addition, we show the following keys: CLX

Clears the display

CHS

Changes a number from positive to negative or vice-versa

BEG

Changes payment mode to advance

END

Changes payment mode to arrears

f

Indicates a gold key function

g

Indicates a blue key function

Present Value of a Single Cash Flow Single cash flow

A single cash flow could represent a purchase option or a balloon payment, expected to be received at the end of a financing term, or a large, nonrecurring cash flow, such as a maintenance expense to occur in the 30th month of a 48-month lease transaction. Let’s look at an example:

Example

A $15,000 balloon payment is due at the end of a 48-month term loan. The discount rate to be used in the analysis is 13.25% per annum (p.a.). What is the present value of the $15,000 payment?

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5-5

KEYSTROKES

15,000

DISPLAY

EXPLANATIONS

f

CLX

0.00

Clears all data from registers

f

2

0.00

Rounds answers to two decimal places

g

BEG

0.00

Indicates payment mode

CHS

FV

48

n

13.25

g

-15,000.00 48.00

12 ÷

PV

1.10 8,854.76

Enters balloon payment as a negative amount (outflow) Enters number of discount periods Enters monthly discount rate Calculates present value of balloon payment

The present value of the $15,000 payment due at the end of a 48month term loan is $8,854.76. Present Value of an Ordinary Annuity (Annuity in Arrears) End-of-period payment stream

Now that you have seen how to calculate present value on a single cash flow, we will show you how to calculate present value on a series of future cash flows. An annuity in arrears refers to a stream of future cash flows, such as monthly lease payments, due at the end of each period. The first payment, or cash flow, is received at the end of the first period, and each subsequent payment occurs at the end of each succeeding period. The following timeline illustrates this cash flow. Assume one-year payment periods in a lease with a five-year term.

0

5 years

First payment due at end of first period

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DRAFT

Subsequent payments due at the end of each succeeding period

5-6


When you calculate an annuity in arrears, you must start by changing the payment mode in the calculator to indicate that the cash flows will be received at the end of each period. Here is how to do this on the 12C: KEYSTROKES g

DISPLAY

END

0.00

EXPLANATIONS Changes payment mode to arrears

Now you can enter the values. Here are two examples. Please note that the examples in this section demonstrate even cash flows (the same payment amount each period). Example

A 48-month lease has monthly lease payments, in arrears, of $640 each. What is the present value of the stream of even (equal) payments when the annual discount rate is 18% (1.5% monthly)? KEYSTROKES

DISPLAY

EXPLANATIONS

f

CLX

0.00


g

END

0.00


CHS

PMT

-640.00

18

g

12 ÷

1.50

Enters monthly discount rate

48

n

48.00

Enters number of cash flows

640

PV

21,787.23

Enters amount of each payment

Solves for present value

The present value of the stream of cash flows is $21,787.23.

DRAFT

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Example

5-7

A potential lessee wishes to determine the present value of 60 lease payments of $2,000 due at the end of each period (no advance payments). A rate of 14% will be used as the appropriate discount rate. What is the present value? KEYSTROKES

DISPLAY

EXPLANATIONS

f

CLX

0.00


g

END

0.00


CHS

PMT

-2,000.00

14

g

12 ÷

1.17


60

n

60.00


2,000

PV

85,954.03



The present value of 60 even monthly payments of $2,000, received in arrears, discounted at 14%, is $85,954.03. Present Value of an Annuity Due (Annuity in Advance) Payments received at beginning of period

An annuity due is similar to an ordinary annuity except that we assume payments are received at the beginning of each period (the first one being due at time “0”). Annuities due are common in all types of finance transactions, including leasing.

0

5 years

First payment due at inception of the contract

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Subsequent payments due at beginning of each subsequent period

5-8


Before you enter the information for an annuity due calculation, you must change the payment mode to advance to indicate cash flows are received at the beginning of each period. To do this: KEYSTROKES g

DISPLAY

BEG

0.00

EXPLANATIONS Changes payment mode to advance

Now you can enter the values. Here are two examples. Example

Calculate the present value of 48 monthly lease payments of $250 each, with the first payment due in advance. Use a discount rate of 14% per annum. KEYSTROKES

DISPLAY

EXPLANATIONS

f

CLX

0.00


g

BEG

0.00


CHS

PMT

-250.00

14

g

12 ÷

1.17


48

n

48.00


250

PV

9,255.37



The present value of a stream of 48 equal monthly lease payments due at the beginning of each period is $9,255.37. Example

To make a lease versus buy decision, a prospective lessee wishes to determine the present value of 60 lease payments of $2,000, with one payment in advance. Use the lessee’s borrowing rate of 14% to discount the lease payments.

KEYSTROKES

DISPLAY

DRAFT

EXPLANATIONS

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5-9

f

CLX

0.00


g

BEG

0.00


CHS

PMT

-2,000.00

14

g

12 ÷

1.17


60

n

60.00


2,000

PV

86,956.83



If the cash price is less than $86,956.83, the customer may prefer to purchase the equipment. If the cash price is greater than the present value amount, the customer may prefer to lease. Present Value of an Annuity with Multiple Advance Payments Uneven cash flow stream

Some leases require that the lessee make more than one payment in advance. More than one payment in advance creates a multiple, uneven cash flow situation.

Cash flow keys

For uneven cash flows, you do not have to select a payment mode because you will enter each cash flow and the number of times it occurs. In our illustrations, we will use the following keys: g CFo

Initial cash flows

g CFj

Subsequent cash flows

g Nj

Number of times cash flow occurs

For example: V01/11/96 P12/06/99

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5-10


KEYSTROKES 1,000

g

CFo

300

g

CFj

3

g

Nj

400

g

CFj

2

g

Nj

DISPLAY 1,000.00 300.00 3.00 400.00 2.00

EXPLANATIONS Cash flow at time 0 Amount of first cash flow Number of times first cash flow occurs Amount of second cash flow Number of times second cash flow occurs

Note that if the cash flow you are working with occurs only once, you need only press g CFj and then enter the amount of the next cash flow. Now let’s look at an example. Example

A lease requires 48 payments of $250 per month, with three advance payments due at the inception of the transaction. What is the present value of the lease payments discounted at 14%?

Timeline view

To gain perspective as to when the cash flows in this transaction take place, use a timeline:

0

46

3 advance payments received at inception

48 months

Final payment in 46th month

End of term

In this example, payment numbers 1, 47 and 48 ($750) are made at the inception of the lease and the final payment is made at the beginning of the 46th month.

Keystrokes

The keystrokes for entering this uneven cash flow stream are as follows:

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KEYSTROKES

5-11

DISPLAY

EXPLANATIONS

f

CLX

0.00


750

g

CFo

750.00

Enters three advance payments

250

g

CFj

250.00

Enters the next cash flow

45

g

Nj

14

g f

45.00

Enters number of times cash flow occurs

12 ÷

1.17

Enters monthly discount rate since these are monthly cash flows

NPV

9,463.80

Computes present value

The present value of 48 payments of $250 per month with three advance payments due at the inception of the lease is $9,463.80, assuming a discount rate of 14%. Present Value of Multiple, Uneven Cash Flows Other types of multiple, uneven cash flows

In the previous section, you learned that advance payment transactions are a form of multiple, uneven cash flow transactions. In this section we will look at another transaction — a step-down lease -- that creates multiple, uneven cash flows. In a step-down transaction, payments decrease over the lease term. Just as in working with multiple advance payments, you must enter each cash flow and the number of times it occurs to solve for the present value of multiple, uneven cash flows. Let’s look at an example.

Example

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What is the present value of a 48-month lease with one advance payment? The lease is a step-down transaction — the first 36 payments are $12,000 each, and the remaining 12 payments are $3,000 each. At the end of the term, a purchase option amount of $7,500 is due. Discount the cash flows at the monthly equivalent of a 14% annual rate.

DRAFT

5-12


To help visualize the pattern of cash flows for this transaction, study the timeline shown below.

0

36

6

$12,000 35 payments

48 $3,000

$12,000

12 payments $7,500

Now let’s see how to solve for present value in this step-down transaction: KEYSTROKES

Solution

DISPLAY

EXPLANATIONS

12,000

g

CFo

12,000.00

Enters initial advance payment

12,000

g

CFj

12,000.00

Enters next cash flow

35

g

Nj

3,000

g

CFj

12

g

Nj

7,500

g

CFj

14

g

12 ÷

1.17

f

NPV

381,764.75

35.00 3,000.00 12.00 7,500.00

Enters number of times cash flow occurs Enters next cash flow Enters number of times cash flow occurs Enters final cash flow Enters monthly discount rate since these are monthly cash flows Computes present value

The present value of a 48-month step-down lease with a $7,500 purchase option, discounted at 14%, is $381,764.75.

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5-13

INTERNAL RATES OF RETURN (IRR)

In the previous section, we demonstrated how to take a known future value amount and strip out the time value of money (interest) factor. Internal rates of return (IRR) measures that time value of money factor. Lessors use IRRs to determine whether a given lease is sufficiently profitable to justify an investment. In this section we will show you how to compute IRRs on the HP12C calculator. You will find many similarities between solving for IRRs and solving for present value. Definition

An IRR is the unique discount rate that equates the present value of a series of cash inflows to the present value of the cash outflows. In a leasing context, the cash inflows usually represent payments and residual value. The cash outflow consists of equipment (investment) cost. The IRR is sometimes referred to as the yield or interest rate inherent in the lease. It is analogous to the interest rate that a bank would quote a borrower on a loan.

IRR applications

You may apply IRR analysis to a stream of cash flows throughout a period as well as to single amounts due. You can compute IRRs on transactions that have either even or multiple, uneven cash flow streams. In this section we focus on IRRs for transactions with even cash flows (annuities in arrears or advance) and IRRs for transactions with multiple, uneven cash flows, including transactions with multiple advance payments.

IRR – Even Cash Flows Common IRRs include lease yields, interest costs, interest rates and earnings rates.

Required information

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To calculate IRRs, you must know the time-zero (present value) cash flows, the number and amount(s) of the future cash flows and the number of periods over which the cash flows are being measured. We will use the same calculator keys we used to calculate present value.

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5-14


Recall these keys: n

The number of compounding periods over which the cash flows are being measured

FV

The amount of any end of term cash flows (inflows or outflows)

PV

The amount of any present value, or time zero, cash flows (inflows or outflows)

PMT

The amount of any periodic cash flows (inflows or outflows)

i

The interest or yield being used over the compounding periods

Outflows and inflows

When you compute financial yields, think of investments as cash outflows (negative) and repayments as cash inflows (positive). Now let’s look at an example.

Example

A lease agreement with a 10-year term requires monthly payments in arrears of $199.93, based on an original investment, or equipment cost, of $10,000. What is the IRR in this lease investment? Before you begin, remember to clear the register and set the mode to END. KEYSTROKES 120

DISPLAY

EXPLANATIONS

n

120.00

Enters number of payments

199.93

PMT

199.93

Enters amount of payments

10,000

CHS PV

-10,000.00

i 12 x

Enters original investment

1.75

Monthly IRR

21.00

Annual IRR

The yield in this lease is 21%.

IRR -- Multiple, Uneven Cash Flows Separate

Earlier in this unit you learned that multiple advance payments and DRAFT

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entries

5-15

step-down transactions are forms of multiple, uneven cash flows. To compute the IRR for uneven cash flows, you must enter each cash flow followed by the number of times it occurs. As in our present value calculations, we illustrate entry of the amount of each cash flow with the g CFj keys, and the number of times each cash flow occurs with the g Nj keys. CFo

Amount of initial cash flow

CFj

Subsequent cash flow

Nj


Here are some sample keystrokes. KEYSTROKES 1,000 300 3 400 2

g CFo g CFj g Nj g CFj g Nj

DISPLAY 1,000.00 300.00 3.00 400.00 2.00

EXPLANATIONS Cash flow at time zero Amount of next cash flow Number of times next cash flow occurs Amount of second cash flow Number of times second cash flow occurs

Remember that if the cash flows you are working with occur only once, simply enter the amount of the next cash flow in the g CFj register. Now let’s look at an example.

Example

A lease agreement with an inception date of February 1 offers payments that are in proportion to the lessee’s expected revenue curve. High payments are to be made in the summer, with no payments due during the winter months. Spring and fall payments are normal. The lease payments are in advance (due at the beginning of each period) and are based on a principal amount of $220,000. Let’s

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compute the IRR of this transaction, assuming the following payment schedule repeats for two years. March

$10,000

September

$10,000

April

$10,000

October

$10,000

May

$10,000

November

$10,000

June

$20,000

December

-0-

July

$20,000

January

-0-

August

$20,000

February

-0-

Here are the keystrokes: KEYSTROKES 220,000 10,000 3 20,000 3 10,000

DISPLAY

CHS g CFo

-220,000.00

g CFj

10,000.00

g Nj

3.00

g CFj

20,000.00

g Nj

3.00

g CFj

10,000.00

EXPLANATIONS Enters initial cash flow Enters next cash flow Number of times the cash flow occurs Enters next cash flow Number of times cash flow occurs Enters next cash flow amount

3

g Nj

3.00


0

g CFj

0.00

Enters next cash flow amount

3

g Nj

3.00


10,000

3 20,000 3 10,000 3

g CFj

10,000.00

g Nj

3.00

g CFj

20,000.00

g Nj

3.00

g CFj

10,000.00

g Nj

3.00

DRAFT

Enters next cash flow amount

Number of times cash flow occurs Enters next cash flow amount Number of times cash flow occurs Enters the final cash flow amount Number of times cash flow occurs V01/11/96 P12/06/99


f 12

5-17

IRR

0.81

Solves for monthly IRR

x

9.68

Converts to annual IRR

The interest rate inherent in this lease is 9.68%. A lessor may view this rate as an indicator of the profitability of the transaction.

UNIT SUMMARY

A present value analysis is used to convert future cash flows to today’s dollars so that investment alternatives may be compared. In a present value calculation, the time value of money is removed from a future value amount. In this unit, we discussed five forms of present value calculations: + Present value of one cash flow + Present value of an ordinary annuity (annuity in arrears) + Present value of an annuity due (annuity in advance) + Present value of an annuity with multiple advance payments + Present value of multiple, uneven cash flows

To calculate present value amounts, you must know the number of future cash flow(s), the amount(s) of the future cash flow(s), the number of periods over which the cash flows(s) will be discounted, and the discount rate to be used in the present value calculation. The internal rate of return or IRR is a measurement of the time value of money. The IRR is also called the yield or interest rate. Like present value analysis, IRR analysis is a tool used to compare investment alternatives. We discussed two forms of IRR calculations: + Even cash flows + Multiple, uneven cash flows

In IRR calculations, investments are considered cash outflows and repayments as cash inflows. To compute IRRs, you must know the time-zero, or present value cash flows, the V01/11/96 P12/06/99

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number and amount(s) of the future cash flows, and the number of periods over which the cash flows are being measured. You have completed Unit Five: Financial Concepts and Calculations. Please check your understanding of this unit by completing the exercises in Progress Check 5, then continue to Unit Six: Introduction to the Lease Vs. Buy Analysis. If you answer any questions incorrectly, please review the appropriate examples in the text.

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]

5-19

PROGRESS CHECK 5

Directions: Determine the correct answer to each question. Check your answers with the Answer Key on the next page. Question 1: In five years, you have a balloon payment due on your home mortgage in the amount of $25,000. You have recently received an inheritance and would like to immediately put adequate funds into a safe investment to assure that you have the balloon payment amount when it falls due. You have found an investment that will safely earn 10.5% per year, compounded monthly. What is the present value equivalent of $25,000 that you must set aside today?

$____________________

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ANSWER KEY

Question 1: In five years, you have a balloon payment due on your home mortgage in the amount of $25,000. You have recently received an inheritance and would like to immediately put adequate funds into a safe investment to assure that you have the balloon payment amount when it falls due. You have found an investment that will safely earn 10.5% per year, compounded monthly. What is the present value equivalent of $25,000 (five years hence) that you must set aside today? $14,822.69 KEYSTROKES

25,000

DISPLAY

EXPLANATIONS

f

CLX

0.00


f

2

0.00

Rounds answers to two decimal places

g

BEG

0.00

Indicates payment mode

CHS FV

60

n

10.5

g PV

-25,000.00 60.00 12 ÷

0.88 14,822.69

DRAFT

Enters balloon payment cost as a negative amount Enters number of discount periods Enters monthly discount rate Calculates present value of balloon payment

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5-21

PROGRESS CHECK 5 (Continued)

Question 2: What is the present value of 60 monthly lease payments of $2,000, discounted at 15%, with two payments in advance?

$____________________

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ANSWER KEY

Question 2: What is the present value of 60 monthly lease payments of $2,000, with two payments in advance, discounted at 15%. $86,159.05 KEYSTROKES

DISPLAY

EXPLANATIONS

4,000

g

CFo

4,000.00

Enters initial cash flow of two advance payments

2,000

g

CFj

2,000.00


58

g

Nj

15

g

f

58.00


12 ÷

1.25

Enters monthly discount rate since these are monthly cash flows

NPV

86,159.05

DRAFT

Computes present value

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5-23


Question 3: A lease contract requires 36 payments of $2,000 followed by 24 payments of $3,000. Three payments (3 x $2,000) are due in advance, and the lease contains a purchase option of $20,000. Find the present value of the lease payments and purchase option using a 16% annual discount rate. You may want to draw the timeline on a piece of paper to visualize this cash flow series.

$____________________

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ANSWER KEY

Question 3: A lease contract requires 36 payments of $2,000 followed by 24 payments of $3,000. Three payments (3 x $2,000) are due in advance, and the lease contains a purchase option of $20,000. Find the present value of the lease payments and purchase option using a 16% annual discount rate. You may want to draw the timeline on a piece of paper to visualize this cash flow series. $107,722.87 KEYSTROKES

DISPLAY

EXPLANATIONS

6,000

g

CFo

6,000.00

Enters the initial cash flow of three advance payments

2,000

g

CFj

2,000.00


33

g

Nj

3,000

g

CFj

24

g

Nj

0

g

CFj

0.00


2

g

Nj

2.00


20,000

g

CFj

16

g

12 ÷

1.33

f

NPV

107,722.87

33.00 3,000.00 24.00

20,000.00

DRAFT

Enters number of times cash flow occurs Enters next cash flow Enters number of times cash flow occurs

Enters final cash flow Enters monthly discount rate Solves for present value

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5-25


Question 4: A lessor invests $800,000 in a new piece of equipment that will generate net cash returns of $85,000 at the end of each quarter for three years (12 quarters). What is the annual IRR of this investment?

$____________________

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ANSWER KEY

Question 4: A lessor invests $800,000 in a new piece of equipment that will generate net cash returns of $85,000 at the end of each quarter for three years (12 quarters). What is the annual IRR of this investment? 15.80% KEYSTROKES

DISPLAY

g END

0.00

800,000

CHS PV

12

n

85,000

PMT

-800,000.00

EXPLANATIONS Changes payment mode to arrears Enters original investment

12.00

Enters number of payments

85,000.00

Enters amount of payments

i

3.95

4x

15.80

DRAFT

Quarterly IRR Annual IRR

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5-27


Question 5: A lease is generating net, after-tax annual cash flows, in arrears, as follows: Year

Amount

1

56,464

2

67,504

3

60,144

4

46,440

Compute the annual IRR of this lease based on an original net investment of 170,956.

$____________________

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ANSWER KEY

Question 5: A lease is generating net, after-tax annual cash flows, in arrears, as follows: Year

Amount

1

56,464

2

67,504

3

60,144

4

46,440

Compute the annual IRR of this lease based on an original net investment of 170,956. 13.59% KEYSTROKES 170,956

CHS

DISPLAY

g CFo

-170,956.00

EXPLANATIONS Enters initial cash flow

56,464

g CFj

56,464.00


67,504

g CFj

67,504.00


60,144

g CFj

60,144.00


46,440

g CFj

46,440.00


f

IRR

13.59

Solves for IRR

The annual IRR of this investment is based on the assumption that the four net cash flows are received exactly at the end of each of the four respective periods.

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Unit 6

UNIT 6: INTRODUCTION TO THE LEASE VS. BUY ANALYSIS

INTRODUCTION

In Unit Five, we discussed using present value analysis to convert the value of future cash flows to today’s dollars. In this unit, we focus on the application of present value to the lease vs. buy analysis. Lease vs. buy analysis refers to the comparison of the present value, after-tax costs of two financing alternatives: present value to remove the time value of money and after-tax to consider the tax consequences of owning or leasing equipment. For the lessee, the analysis identifies the most cost-effective means of acquiring equipment. From a lessor’s perspective, the analysis helps quantify the benefits of the lease product to the customer. In this unit, we discuss the information needed to make a lease vs. buy decision, illustrate a lease vs. buy analysis, and describe the effects of changing the salvage value or using a different discount rate.

UNIT OBJECTIVES


Understand the steps in a lease vs. buy analysis

+

Recognize how the discount rate affects the results of the lease vs. buy analysis

+

Recognize the purpose of a sensitivity analysis

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6-2

INTRODUCTION TO THE LEASE VS. BUY ANALYSIS

INFORMATION NEEDED FOR A LEASE / BUY DECISION Details of financing alternatives

A good lease vs. purchase decision depends on accurate, valid, and relevant information. In this section, we discuss some of the more important items of information required to make an informed lease vs. buy decision. Please note that some items are facts, and others are assumptions. +

Applicable corporate tax rate. Because the process is aftertax, we need to estimate the entity’s tax rate for the period of financing.

+

Details of the lease quote: − Lease term − Payment amount − End-of-term options

+

Details of the purchase choice: − Mode of purchase (cash or loan) − Terms of financing: the number of periods, the interest rate and the payment amount

+

Salvage value. This is the amount for which the company expects to sell the purchased equipment at the end of the period of use.

+

Tax depreciation schedule for the purchase choice

+

Differential costs. These are installation, insurance, taxes, and operating costs that differ with the mode of acquisition. For instance, if the cost of maintaining purchased equipment is $100 per month, but is only $75 per month for leased equipment, maintenance is a differential cost.

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+

6-3

Discount rate. This is one of the most critical variables in the analysis, as the ultimate decision to lease or purchase can be altered by the discount rate used. Later in this unit, we discuss choosing an appropriate discount rate.

LEASE VS. BUY EXAMPLE Three-step process

There are three main steps in the lease vs. buy analysis process: 1. Gather detailed information for all alternatives 2. Calculate after-tax cash flows for each alternative 3. Calculate the present value of the cash flows

Example

To illustrate the process, we will compare the choice of leasing a $15,000 piece of equipment with purchasing the equipment. We start by gathering information.

Gather Information Let’s begin by looking at the information used in this example: General Assumptions:

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Equipment cost:

$15,000

Company’s tax rate:

35%, and its tax-year end is December 31

After-tax cost of capital (opportunity cost):

15.25%

After-tax cost of debt:

8.42% (12.75% times 1-tax rate)

Lease/purchase date:

January 1

Differential costs:

None

DRAFT

6-4


Lease Assumptions Payments:

$4,015 annually in arrears, for five years

End-of-term option:

Equipment will be returned to the lessor

Purchase Assumptions Financing:

Five-year loan at 12.75% per annum; five annual payments in arrears of $3,391; a down payment of 20%

Depreciation:

Five-year declining balance tax depreciation

Salvage value:

$1,500 at the end of year five

Calculate After-tax Cash Flows for Each Alternative Now that we have the information we need, we can calculate the aftertax cash flows for the lease (Figure 6.1). For simplicity, we will assume annual cash flows.

0 Lease payments

$

Tax savings @ 35% Net after-tax cost

$

1

2

3

4

5

0

$4,015

$4,015

$4,015

$4,015

$4,015

0

(1,405)

(1,405)

(1,405)

(1,405)

(1,405)

0

$2,610

$2,610

$2,610

$2,610

$2,610

Figure 6.1: Lease after-tax cash flows

Notice that because the lease payment is fully tax deductible, the net cost to the lessee is only $2,610 per year ($4,015 x [1-.35]).

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6-5

The next step is to calculate the after-tax cash flows for an installment loan used to purchase the equipment (Figure 6.2).

0

1

2

3

4

5

Down payment

$3,000

$0

$0

$0

$0

$0

Loan payments

0

3,391

3,391

3,391

3,391

3,391

Interest tax benefit

0

(536)

(452)

(359)

(253)

(134)

Depreciation tax benefit

0

(1,050)

(1,680)

(1,008)

(605)

(302)

Salvage value

0

0

0

0

0

(1,580)

$3,000

$1,805

$1,259

$2,024

$2,533

$1,375

Net after-tax cost

Figure 6.2: Loan after-tax cash flows

Cash inflows

Notice that the interest tax benefit and the depreciation tax benefit represent cash inflows to the company, and are shown in parentheses. The interest tax benefit was derived by multiplying the interest from the loan amortization schedule (Figure 6.3) by the tax rate (Figure 6.4).

Year

Interest

Principal

1

1,530.00

1,861.00

10,139.00

2

1,292.72

2,098.28

8,040.72

3

1.025.19

2,365.81

5,674.91

4

723.55

2,667.45

3,007.46

5

383.45

3,007.55

0

Figure 6.3: Amortization schedule

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Balance

6-6


Year

Interest

Tax Rate

Tax Benefit

1

1,530.00

X .35

$535.50

2

1,292.72

X .35

452.45

3

1,025.19

X .35

358.82

4

723.55

X .35

253.24

5

383.45

X .35

134.21

Figure 6.4: Tax benefits

The tax benefit from depreciation was calculated similarly. In Figure 6.5 we show the calculations.

Year

Equipment Cost

1

$15,000 X

Declining Balance Percentage

Annual Deduction

Tax Rate

Tax Benefit

.2000

=

$3,000

X

.35

1,050.00

2

$15,000

X

.3200

=

4,800

X

.35

1,680.00

3

$15,000

X

.1920

=

2,880

X

.35

1,008.00

4

$15,000

X

.1152

=

1,728

X

.35

604.80

5

$15,000

X

.0576

=

864

X

.35

302.40

$13,272 Figure 6.5: Tax benefit from depreciation

Salvage value cash flow

At this point, the only remaining cash flow we need to identify is the after-tax cash flow resulting from the disposal of the equipment (salvage value). We show the calculations for this cash flow in Figure 6.6.

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6-7

Pretax salvage value

$1,500

Less remaining tax basis: Original cost Less depreciation taken

$15,000 – 13,272

Tax basis

(1,728)

Loss on disposition

($ 228)

X Tax rate

.35

Tax benefit from loss deduction

$ 80

Salvage value

1,500

After-tax salvage value

1,580

Figure 6.6: After-tax salvage value

Calculate the Present Value of the Cash Flows Choosing discount rate

Once the after-tax cash flows for each alternative have been calculated, the present value of the cash flows must be computed. Recall from Unit Five that we use a discount rate to calculate present value. In this example, we use a discount rate of 8.42 percent, which is the after-tax cost of debt. Note that we could use the opportunity cost of 15.25 percent if the lessee’s goal is to maximize cash flow.

Using the calculator

Let’s look at the HP12C keystrokes required to calculate the present value of the lease cash flows. The cash flow amount is from Figure 6.1.

KEYSTROKES f 8.42 2,610 5

CHS

DISPLAY REG

0.00

Clears all registers

i

8.42

Enters the discount rate

2,610.00

Enters net after-tax cost

PMT n PV

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EXPLANATIONS

DRAFT

5.00 10,306.63

Enters number of discount periods Solves for present value

6-8


Now let’s calculate the present value of the purchase cash flows and compare the difference (Figure 6.7). KEYSTROKES f 8.42

DISPLAY

EXPLANATIONS

REG

0.00


i

0.00


3,000

g

CFo

3,000.00

Enters the initial cash flow

1,805

g

CFj

1,805.00


1,259

g

CFj

1,259.00


2,024

g

CFj

2,024.00


2,533

g

CFj

2,533.00


1,375

g

CFj

1,375.00


f

NPV

10,074.95


Present value at 8.42% Lease

$10,307

Purchase

$10,075

Difference

($232)

Figure 6.7: Present value summary

As you can see, the company should purchase the equipment when the after-tax cost of debt is used as the discount rate. In the next section, we will discuss how to isolate individual variables of the analysis and assess the impact of changing any one or more of them.

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6-9

SENSITIVITY ANALYSIS (BREAK-EVEN POINT)

In the previous example, we saw that there are several variables in the lease vs. buy analysis that influence the result. Two critical variables are the discount rate and the salvage value. To assess the effect of changing the discount rate or the salvage value, we use a sensitivity analysis. Break-even investment rate

A sensitivity analysis gives us the break-even (indifference) point of a variable. For example, if a company can reinvest funds at the same rate inherent in the lease, the company is indifferent between leasing and purchasing. However, if the company can reinvest at a rate greater than the break-even rate, leasing makes more sense.

Use as a marketing tool

From a lessor point of view, the break-even rate provides a floor above which leasing will be preferred over purchasing. This technique can be used to market leases. The lessor’s job is to convince a company that its opportunity cost is greater than the break-even rate. Now let’s see how to calculate the break-even discount rate.

Discount Rate IRR of differential cash flows

The break-even discount rate is equal to the internal rate of return of the differential cash flows between two financing alternatives. In other words, it is the IRR at which the present value is the same for both alternatives. To help you understand this concept, we will refer to our example in the previous section. First, let’s look at the difference in the cash flows for each period (Figure 6.8).

0 Lease cash flows Purchase cash flows Difference

$

1

2

4

5

0

$2,610

$2,610

$2,610

$2,610

$2,610

($3,000)

($1,805)

($1,259)

($2,024)

($2,533)

($1,375)

(3,000)

805

1,351

586

77

1,235

Figure 6.8: Cash flow differential

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DRAFT

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Using the calculator


Now let’s calculate the internal rate of return for the differential cash flows.

KEYSTROKES

DISPLAY

f

REG

0.00

g

CFo

3,000.00

805

g

CFj

805.00


1,351

g

CFj

1,351.00


586

CFj

586.00


77

CFj

77.00


1,235

CFj

1,235.00


3,000

CHS

f

Present value at break-even IRR

EXPLANATIONS

IRR

11.4698

Clears all registers Enters the first cash flow

Solves for IRR

The break-even rate is 11.4698. If we solve for present value using 11.4698 as the discount rate, the present value will be the same for both the lease and the loan. Let’s prove this concept. LEASE KEYSTROKES f 11.4698 2,610 5

DISPLAY

REG i

CHS

PMT n

0.00

DRAFT


11.4698


2,610.00

Enters net after-tax cost

5.00

PV

EXPLANATIONS

9,533.37

Enters number of discount periods Solves for present value

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6-11

PURCHASE KEYSTROKES f 11.4698

DISPLAY

EXPLANATIONS

REG

0.00


i

0.00


3,000

g

CFo

3,000.00

Enters the initial cash flow

1,805

g

CFj

1,805.00


1,259

g

CFj

1,259.00


2,024

g

CFj

2,024.00


2,533

g

CFj

2,533.00


1,375

g

CFj

1,375.00


f

NPV

9,533.37


As you can see, the present value cost of both alternatives is $9,533.37 when this discount rate is used. Any discount rate higher than 11.4698 will favor leasing; any discount rate lower than this value will favor purchasing.

Salvage Value Subjective value

Sensitivity analysis also can be used to find the break-even point of salvage value. Because salvage value is judgmental, it makes sense to solve for the salvage value that will equate leasing to purchasing. Recall that in our lease vs. buy example we used a $1,500 salvage value, resulting in a present value difference between leasing and purchasing of $232 (Figure 6.7). At what salvage value would the present value be the same for leasing and purchasing? To find out, we must first convert the $232 difference to a pretax future value number, as it is an after-tax present value number and the new salvage value is a pretax future value.

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6-12

Convert to pretax future value


We use a two-step process to convert the $232 to its pretax future value of $535. Step 1 − Calculate future value of the difference at 8.42 percent. KEYSTROKES f 8.42 232 5

CHS

DISPLAY

EXPLANATIONS

REG

0.00


i

8.42


PV

232.00

n FV

5.00 347.56

Enters present value difference Enters number of discount periods Solves for future value

Step 2 − Convert the after-tax value to a pretax value. 347.56 / (1 - tax rate) = 534.71

Indifference value

The difference between the original salvage value and the pretax future value we calculated above is the indifference value: $1,500 - $535 = $965

Therefore, if the company expects a salvage value greater than $965, it should purchase. If it expects to receive less than $965, it should lease.

FACTORS THAT AFFECT THE LEASE VS. BUY ANALYSIS

So far, we’ve discussed the lease vs. buy process and a related process, the sensitivity analysis. We found that variables such as the discount rate and the salvage value have a great impact on the result of the lease vs. buy analysis. In this section, we discuss these variables in greater detail to emphasize their importance. DRAFT

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6-13

Discount Rate Effect of discount rate

As mentioned in the previous section, the choice of a discount rate is very important to the lease vs. buy analysis. Generally, when a lower discount rate (after-tax cost of debt) is selected, the analysis favors purchasing. When a higher discount rate (after-tax cost of capital) is selected, the analysis favors leasing. Of course, the objective is not to favor one alternative over the other, but to arrive at an unbiased conclusion.

Company goals

Selection of a proper discount rate will depend on each company’s situation. A large company usually views leasing as debt. Because of its need to maintain constant leverage ratios, the additional cash flow generated by the lease is not meaningful to a large company. These companies should use the after-tax cost of debt as the base discount rate for the analysis. On the other hand, a small, entrepreneurial company seeks to maximize cash flow, so that the savings can be reinvested back into the business at a high rate of return. If this is the case, either the cost of capital or the opportunity cost will be the appropriate discount rate.

Salvage value and risk

The type of transaction being entered into also affects the choice of the discount rate. If the lessor takes a small residual position (as in a finance lease), there is little asset risk in the transaction. However, if the lessor assumes a substantial residual risk (as in an operating lease), the large salvage value in the lease/buy decision increases the risk in the transaction. The greater the risk, the higher the discount rate that should be used.

Consistency

Finally, you should remember that it is important to use the same discount rate to analyze all financing alternatives. Otherwise, they are not comparable!

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Salvage Value Factors to consider

The salvage value has the greatest effect on the result of the lease vs. buy analysis. Therefore, it is important to arrive at a realistic salvage value, incorporating anticipated use and deinstallation and disposal costs. Expert opinions may be used, if necessary. A faulty salvage value assumption could alter the lease vs. buy decision.

Using indifference value

In our discussion of the discount rate, we suggested that the uncertainty associated with a large salvage value increases the risk inherent in a transaction. Therefore, the discount rate used in high residual risk situations should be higher than the rate normally used. An alternative would be to adjust the salvage value to its indifference equivalent and use the base discount rate.

UNIT SUMMARY

Once a company has decided to acquire equipment, it must determine whether to buy the equipment with cash, finance the equipment with a loan, or enter into a tax lease with a lessor for the use of the equipment. For the lessee, a lease vs. buy analysis quantifies a financing decision: it compares a tax lease to one of the other financing alternatives. Adequate information about each alternative is necessary to make a valid comparison. The analysis consists of converting all cash flows to after-tax cash flow values and then calculating the present value at the appropriate discount rate. The choice of a discount rate depends on the company’s circumstances. If the company wishes to minimize its interest cost, it uses the after-tax cost of debt as the appropriate discount rate. If the company desires to maximize cash flow, then the appropriate discount rate will be the after-tax cost of capital. The company should choose the financing option with the lowest present-value cost. Using the after-tax cost of debt as the discount rate will generally favor the purchase alternative; using the after-tax cost of capital tends to favor the lease alternative. A sensitivity analysis on either the discount rate or the salvage value should be a part of every lease vs. buy decision, as it provides both the lessor and the lessee with additional perspective. A lessor may use the break-even discount rate to persuade the potential lessee to lease. DRAFT

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6-15

You have completed Unit Six: Introduction to the Lease Vs. Buy Analysis. Please check your understanding of this unit by completing the exercises in Progress Check 6, then continue to Unit Seven: Lease Structuring. If you answer any questions incorrectly, please review the appropriate sections in the text.

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DRAFT

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]

6-17

PROGRESS CHECK 6

Directions: Determine the correct answer to each question. Check your answers with the Answer Key on the next page. Question 1: A valid lease vs. buy decision depends on ___________________.

Question 2: The reason a lease vs. buy analysis is performed on an after-tax basis is to: ____ a) equate the future cash flows. ____ b) arrive at an appropriate discount rate. ____ c) consider the tax consequences of the alternatives. ____ d) determine the effect of the after-tax cost of debt.

Question 3: Why is present value analysis used in lease vs. buy calculations? ____ a) Leasing and purchasing generate different future cash flows. ____ b) The investment rates for leasing and purchasing usually differ. ____ c) It is important to use the same discount rate for both alternatives.

Question 4: For the lessor, a sensitivity analysis on the discount rate: ____ a) helps determine whether the potential lessee has reached the indifference point. ____ b) may be used as a marketing tool. ____ c) is less important than a sensitivity analysis on the salvage value. ____ d) may be used to lower the lessee’s lease payments.

Question 5: When a break-even discount rate is used, the future cash flows are the same for both financing options. ____ a) True ____ b) False

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ANSWER KEY

Question 1: A valid lease vs. buy decision depends on accurate, valid, relevant information. Any one or more of these answers is correct.

Question 2: The reason a lease vs. buy analysis is performed on an after-tax basis is to: c) consider the tax consequences of the alternatives.

Question 3: Why is present value analysis used in lease vs. buy calculations? a) Leasing and purchasing generate different future cash flows.

Question 4: For the lessor, a sensitivity analysis on the discount rate: b) may be used as a marketing tool.

Question 5: When a break-even discount rate is used, the future cash flows are the same for both financing options. b) False The present value of the future cash flows is the same for both financing options.

DRAFT

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6-19


Question 6: The purpose of performing a sensitivity analysis on the salvage value of equipment is to: ____ a) calculate the expected sale value that will equate purchasing with leasing. ____ b) convert the difference between the present values of leasing and purchasing to a pretax future value. ____ c) arrive at a realistic salvage value.

Question 7: Generally, selecting the after-tax cost of capital as the discount rate tends to favor: ____ a) large corporations. ____ b) purchasing equipment. ____ c) leasing equipment. ____ d) installment loans.

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ANSWER KEY

Question 6: The purpose of performing a sensitivity analysis on the salvage value of equipment is to: a) calculate the expected sale value that will equate purchasing with leasing.

Question 7: Generally, selecting the after-tax cost of capital as the discount rate tends to favor: c) leasing equipment.

DRAFT

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Unit 7

UNIT 7: LEASE STRUCTURING

INTRODUCTION

In lease structuring, a lessor pulls together the many components of a lease to create a single lease transaction. Structuring includes lease pricing, end-of-term options, documentation issues, indemnification clauses, funding, and residual valuations. In this unit, we will focus on one of the most important components − pricing. Pricing is the process of determining the pattern of payments to be made by a lessee. For lessors, the goal of pricing is to satisfy a customer’s financing desires while ensuring that a profit will be earned. Lessees seek a payment stream that will suit their cash flow patterns and allow them to successfully use the equipment to earn a profit. The transaction must be viewed as a win for both sides. Without proper pricing, the lease may be unacceptable in the marketplace, or the transaction may not meet the lessor’s and lessee’s profit requirements. In this unit, we will introduce you to lease pricing concepts and work through some examples. You will see how the present value analysis concepts you learned in Unit Five apply to lease pricing. We will also provide you with methods for evaluating competitors’ leases.

UNIT OBJECTIVES


Understand the basic steps in the pricing process for a pretax yield

+

Understand the methods lessors use to evaluate competitors’ proposals

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7-2

LEASE STRUCTURING

ELEMENTS OF LEASE PRICING Return of investment and return on investment

In pricing, the lessor solves for a monthly payment amount that will recover its investment in the equipment and earn the targeted yield. The lessor’s targeted profit must be received from the payments and residual value. Pricing is based on cash flow. Every cash flow is separated into a return of investment (recovery of cash outlay) and a return on investment (profit). This breakout is done on a present value basis. In the pricing calculations, the lessor uses its desired pretax as the discount rate to strip out the time value of money (lessor’s profit). The present value amount remaining represents the recovery of the lessor’s investment in the lease transaction.

Pricing factors

Lessors consider several factors when they price a lease: +

Number of rental payments

+

Number of lease payments in advance

+

Pretax yield required by the lessor

+

Initial direct costs incurred by the lessor

+

Equipment cost

+

Closing or lease documentation fees

+

Refundable security deposit

+

Residual value

To illustrate some of these factors, we will present examples of pricing a transaction to determine a payment that will earn a lessor a given targeted yield on a pretax basis. Structuring to a pretax yield is an acceptable, though less accurate, method of pricing for lessors who pay taxes. A more accurate method is to price on an after-tax basis. This is a more complicated structuring process that will not be covered in this basic course.

DRAFT

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7-3

PRICING (STRUCTURING) TO A GIVEN PRETAX YIELD Four-step process

In this section, we discuss the four basic steps that are necessary to structure a lease to a given pretax yield. These steps apply whether the lease has even (level) payments or uneven payment streams. The four basic steps are: 1. Compute the present value of all the known cash flows 2. Calculate the net outflow of costs at time zero 3. Compute the present value of the unknown lease payment, letting each payment equal one dollar 4. Calculate the monthly lease payment by dividing the results of step two by the results of step three

Example

To help you understand these steps, let’s work through an example. Assumptions: Equipment cost $100,000 Refundable security deposit 3,000 Residual value 15,000 Initial direct costs 2,507 Closing fee 1,000 60 payments in advance 10 percent pretax gross yield required 1. Compute the present value of all the known cash flows

Net cash outflow at time zero plus target yield

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The monthly payment we are solving for is affected by all cash flows in the lease. For example, the higher the residual, the lower the monthly payment. To solve for the monthly payment that will recover the lessor’s investment and earn the targeted yield (10 percent), we must first calculate the present value of all future cash flows. The payment must recover the net cash outflow at time zero (the beginning of the lease) and earn at the 10 percent targeted yield.

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7-4

Residual value adjustment

LEASE STRUCTURING

In this example, the only future cash flow is the residual value, adjusted for the return of the security deposit (15,000 - 3,000 = 12,000). Let’s calculate the present value on the HP12C: KEYSTROKES

10

f

REG

0.00

g

12 ÷

.83

60 12,000

DISPLAY

n CHS

60.00

FV

12,000.00

PV

7,293.46

The present value of the adjusted residual value is $7,293.46. 2. Calculate the net outflow of costs at time zero Total net outflow components

We can now add the present value of the net residual to the other components of the net cash outflow at time zero. Let’s look at a time line of the cash flows to see the total net outflow (Figure 7.1).

0

60

(100,000.00) 3,000.00 (2,507.00) 7,293.46 1,000.00 91,213.54

15,000.00 (3,000.00) 12,000.00

Figure 7.1: Net cash outflow at time zero

The payment must recover a net outflow (investment) of $91,213.54, plus earn the targeted yield of 10 percent.

DRAFT

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LEASE STRUCTURING

7-5

3. Compute the present value of the unknown lease payment, letting each payment equal one dollar In this step, we solve for a factor (the investment recovery unit or IRU) that represents the amount of principal a one-dollar payment over the lease term would recover and still earn a 10 percent yield. The keystrokes for this calculation are: KEYSTROKES

1

f

REG

0.00

g

BEG

0.00

CHS

PMT

-1.00

(One-dollar payment)

n

60.00

(60 payments)

60 10

g

12 ÷ PV

Principal of one-dollar payment

DISPLAY

.83

(Enters pretax yield)

47.4576

From this calculation, we see that if the payment were only one dollar, then 60 payments in advance would recover principal (investment) of $47.46. Recall that the required payment must recover principal of $91,213.54 (step two). 4. Calculate the monthly lease payment: (divide step two by step three)

Step 2

91,213.54

Step 3

47.4576

=

1,922

As you can see, a monthly payment of $1,922 will recover the lessor’s investment in the lease and earn a 10 percent pretax yield.

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LEASE STRUCTURING

INTRODUCTION TO ADVANCED STRUCTURING

In the previous section, we discussed solving for a payment that would give the lessor a given before-tax return on its investment. You learned that the monthly payment is based on all cash flows in the lease as well as the targeted yield. In this section, we will examine some special situations that affect lease pricing. Keep in mind that the pricing is still based upon the structuring principles you learned about in the previous section. The situations we will look at are: +

Unusual payment streams

+

Early terminations of leases

Structuring Unusual Payment Streams Conform to lessee’s cash flow

Frequently, a lessor will structure a lease with a varied or unusual payment pattern to accommodate a lessee's cash flow requirements. Examples of leases with unusual payment streams include skipped, step-up, and step-down payment streams. In a skipped payment stream, the lessee skips the payments during the season when revenue is not being generated. Step-up lease payments start low and are increased once cash flow is expected to increase. In a step-down lease, the lease begins with higher payments and then “steps down” to lower ones.

Steps modified for effect of varied payments

The same structuring steps we described in the previous section are followed in structuring unusual payment stream leases, except some of the steps are slightly modified to include the effect of the unusual payment stream. For example, the assumed one-dollar lease payments must be altered for the periods with the skipped, increased, or decreased payments. To see how unusual payment streams affect structuring, let’s look at the structuring approach for several common uneven payment streams. We will assume that the pretax structuring steps apply.

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7-7

Skipped Payments Skipped payments = zero

To structure skipped payment leases, let each regular payment equal one dollar and the skipped payments equal zero when finding the present value of the one-dollar payments. KEYSTROKES 8.343

i

(Discount rate)

5

g

CFo

(Base one-dollar payments, first year)

9

g

CFj

(Base one-dollar payments, subsequent years)

3

g

Nj

(Three skipped payments)

4

g

CFj

(Base one-dollar payments, year five)

f

NPV

30.954135

f

x

10.524406

x

10.183415

.34 .9676

Step-up Lease Increased payment as a percentage of base rental

In a step-up lease, express the stepped-up payment as a percentage of the base one-dollar payment. For example, in a lease term consisting of 24 monthly base payments, in arrears, followed by 24 payments that are 12 percent higher than the base payments, the stepped-up payments are set equal to 1.12, which is 12 percent higher than the base rental of one dollar: KEYSTROKES .67

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i

(Discount rate) (Base one-dollar payments)

1

g

CFj

24

g

Nj

1.12

g

CFj

24

g

Nj

f

NPV

DRAFT

(Stepped-up payments at 112% of the one dollar base)

43.189882

7-8

LEASE STRUCTURING

Step-down Lease Reduced payments as a percentage of base payment

Structuring a step-down lease is similar to structuring a step-up lease. For example, assume the lessee desires 36 base payments, one in advance, followed by 12 reduced payments that are 87 percent of the base payment. In step two, we let each regular payment equal one dollar and the stepped-down payments equal 87 percent of the onedollar base rental. KEYSTROKES .67

i

(After-tax IRR) (One advance payment)

1

g

CFo

1

g

CFj

35

g

Nj

.87

g

CFj

12

g

Nj

f

NPV

(Stepped-down payments at 87% of the one-dollar base)

40.021926

Known Initial Payments

The structuring methodology changes when the lessee can pay only a limited amount of rent during the early months of a lease. Price of remaining payments

Assume the lessee can pay only $1,800 per month in arrears for the first 12 months of a 48-month lease. We must determine the price of the 36 remaining payments that will produce the required yield. The first adjustment requires including the known cash flows of $1,800 per month as part of step one, where all known cash flows are identified and present valued.

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7-9

KEYSTROKES .67

i

1,800

g

CFj

12

g

Nj

f

NPV

(Known lease payments)

20,688.01

In step two, we let each regular payment equal one dollar and use zero, in place of the twelve $1,800 payments already considered in step one, to solve for the present value of the remaining payment stream: KEYSTROKES .67

i

0

g

CFj

12

g

Nj

1

g

CFj

36

g

Nj

f

NPV

(12 payments already considered)

29.437088

Early Terminations of Leases Making the lessor “whole”

Leases are sometimes terminated prior to the end of their noncancellable terms. For example, the lessee may want to purchase the equipment or return the equipment to the lessor. Regardless of the reason, the lessor must compute the amount the lessee owes at the termination date in order to make the lessor “whole” (as defined in the lease agreement or by the lessor). In computing early terminations, lessors attempt to achieve one of four basic objectives:

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+

Maintain the pretax yield in the lease

+

Maintain the after-tax yield in the lease

+

Maintain the accounting yield (avoid book loss)

+

Penalize the lessee

DRAFT

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LEASE STRUCTURING

The basic procedure used to determine lease payoffs is to compute the present value of all costs and benefits that were incurred or received up to the date of the lease termination. Since all benefits will have been received at this point, there will be a net unrecouped present value investment cost still remaining. The lease payoff will be the pretax equivalent of the future value of this unrecouped net investment.

EVALUATING THE COMPETITION

To market leases effectively, lessors should be able to identify the possible reasons for pricing differences in competing proposals. In this section, we will discuss the factors that a lessor should look for when evaluating a competitor’s proposal and methods used to analyze competing proposals.

Reasons for Pricing Differences Quantitative and qualitative factors

There are many different factors that lessors should consider when evaluating proposals from other lessors. Some of these factors are quantitative, such as monthly payment or internal rate of return. Others are qualitative, such as insurance requirements or the existence of restrictive covenants. Here, we list five categories of factors that a lessor should examine when evaluating the difference between lease products. Financial +

Lease term

+

Up-front origination, closing, documentation fees

+

Payment stream (even, skipped payments, step-ups, stepdowns)

+

Contingent payments such as an excessive use penalty

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7-11

Operational +

Accounting classification (capital versus operating lease status)

+

Appraisal techniques used to determine the fair market value at the end of the lease term

+

Inspection rights and fees

+

Installation, deinstallation, maintenance, repair, and insurance provisions

Restrictive +

Restrictive covenants such as limits on debt-to-equity ratios

+

Sublease rights

+

Lessor right of assignment

+

Definition of what constitutes default

Termination +

Purchase option consequences and charges

+

Physical condition of equipment provisions

+

Early-out and payoff amounts

+

Automatic extension policy and terms

Liability and Warranty

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+

Insurance amount and type

+

Maintenance requirements

+

Tax indemnification provisions

+

Stipulated loss value table

DRAFT

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LEASE STRUCTURING

Analyzing Competing Proposals There are several methods of analyzing competing proposals. Some methods are simply a matter of analyzing cash flow. Others use more financially sophisticated methods such as IRR and NPV (net present value). Five methods

In this section, we will discuss and illustrate five methods of analyzing two competing proposals: payment differences, total cash over term, lease rate factor, lessee’s implicit cost, and NPV. Assumptions: 48 months 50,000 cost 11% pretax yield

COMPANY A

COMPANY B

1 in advance

In arrears

$300 broker fee

No broker fee

Payment $1,205.58

Payment, $1,212.22

$5,000 residual

$4,800 residual

Payment Differences Ignores payment mode

A simplistic, yet commonly used, method of analyzing leases is to compare the monthly payment amounts. This method ignores the fact that although Company A's payment is lower, payments are made in advance, while Company B's are made in arrears.

COMPANY B

$1,212.22

COMPANY A

1,205.58 $

DRAFT

6.64

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7-13

Total Cash Over Term Terms must be equal

Since the term for both proposals is the same, total cash over the term will again favor Company A. However, terms will not necessarily always be the same, and unequal terms cannot be compared. COMPANY B

$58,186.56

COMPANY A

57,867.84 $

318.72

Lease Rate Factor Payment ÷ equipment cost

The lease rate factor is calculated by dividing the payment by the equipment cost. Because the cost of the equipment is the same for both proposals, this method again favors Company A.

COMPANY B

.024244

COMPANY A

.024112 .000132

Lessee's Implicit Cost Impact of payment mode

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A more sophisticated method of comparing proposals is to examine the lessee's implicit cost. Here, the effect of advance payments versus payments in arrears is factored into the analysis. This is accomplished by calculating the IRR inherent in the lessee's cash flows. As shown on the next page, this IRR calculation favors Company B.

DRAFT

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LEASE STRUCTURING

COMPANY A KEYSTROKES 48,794.42

CHS

g

CFo

1,205.58

g

CFj

47

g

Nj

f

IRR

.6405

12 x

7.6865

COMPANY B KEYSTROKES g 50,000

CHS

END PV

1,212.22

PMT

48

n

Nj

i 12 x

.6367 7.6402

Differences COMPANY A

7.6865

COMPANY B

7.6402 .0463

Net Present Value (NPV) Assume discount rate

The last method we will examine requires the evaluator to assume a discount rate and calculate the net present value of the two alternatives. While dependent on the discount rate selected. The NPV method favors Company B in this example.

DRAFT

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7-15

Assume a 9.75 percent borrowing rate. COMPANY A KEYSTROKES

9.75 1,205.58

g

BEG

g

12 ÷

CHS

PMT

48

n PV

48,148

COMPANY B KEYSTROKES

9.75 1,212.22

g

END

g

12 ÷

CHS

PMT

48

n PV

48,023

Differences COMPANY A

48,148

COMPANY B

48,023 125

Lease Proposal Evaluation Matrix The following matrix can be a useful tool for evaluating competing proposals. It is used to weight the importance of each evaluation method. While the IRR and NPV methods are financially more accurate, lessors should be aware that, for many lessees, the method given the greatest weight is monthly payment.

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LEASE STRUCTURING

Value Amount METHOD OF COMPARISON

Co. A

Co. B

Co. C

Co. D

Monthly payment Total cash outlay Lease rate factor Implicit/interest cost Net present value

UNIT SUMMARY

The purpose of lease structuring (pricing) is to determine a monthly payment that will recover the lessor’s investment and earn the desired profit (return on investment). There are two basic methods of structuring leases: pricing to a pretax yield and structuring to an aftertax yield. In this unit, we discussed pricing to a pretax yield. Cash flows are separated into recovery of investment and return on investment. In calculating the present value of the cash flows, the targeted yield (return on investment) is used as the discount rate. Lessors often structure leases with varied or unusual payment streams to accommodate lessees’ cash flow requirements. Skipped payment, step-up, step-down, and known initial payments are common structures. The same basic approach is used to price such leases. Some of the steps are modified to account for the effect of the varied payments. When faced with an early lease termination, a lessor calculates a payoff amount. The lease payoff is the pretax equivalent of the future value of the unrecouped net investment. In marketing leases, lessors often evaluate competitors’ proposals. In this unit, we listed financial, operational, restrictive, termination, and liability factors that may be compared. We also presented five methods of analyzing competing proposals: payment differences, total cash over term, lease rate factor, lessee’s implicit cost, and net present value. You have completed Unit 7: Lease Structuring. Please check your understanding of this unit by completing the exercises in Progress Check 7, then continue to Unit Eight: Vendor Programs. If you answer any questions incorrectly, please review the appropriate portions in the text. DRAFT

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]

PROGRESS CHECK 7

Directions: Determine the correct answer to each question. Check your answers with the Answer Key on the next page. Question 1: The present value amount that remains after the lessor’s desired yield is removed from cash flows is the: ____ a) net cash outflow at time zero. ____ b) required monthly payment amount. ____ c) recovery of the lessor’s investment. ____ d) intraperiod present value factor.

Question 2: Structuring to a pretax yield is more accurate than structuring to an after-tax yield. ____ a) True ____ b) False

Question 3: The reason for letting each payment equal one dollar when computing the present value of the unknown lease payment is to: ____ a) solve for a factor that can be applied to the net investment at time zero. ____ b) account for the adjusted residual value. ____ c) make it easier to compute the effects of tax benefits.

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LEASE STRUCTURING

ANSWER KEY

Question 1: The present value amount that remains after the lessor’s desired yield is removed from cash flows is the: c) rate of recovery of the lessor’s investment.

Question 2: Structuring to a pretax yield is more accurate than structuring to an after-tax yield. b) False

Question 3: The reason for letting each payment equal one dollar when computing the present value of the unknown lease payment is to: a) solve for a factor that can be applied to the net investment at time zero.

DRAFT

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Question 4: Skipped payment, step-ups, and step-downs are example of: ____ a) varied payment streams that meet a lessee’s cash flow needs. ____ b) unusual payment streams that must be estimated rather than calculated. ____ c) known initial payment streams. ____ d) structuring approaches for early lease terminations.

Question 5: The secret to structuring a skipped payment lease is to: ____ a) express the skipped payment as a percentage of the base one-dollar payment. ____ b) ignore the tax liability on the skipped payments. ____ c) let each regular payment equal one dollar and the skipped payments equal zero when computing present value. ____ d) maintain the after-tax yield in the lease.

Question 6: One of the ways lessors may be made “whole” in an early payoff situation is to maintain the yield upon which the payments were based. ____ a) True ____ b) False

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LEASE STRUCTURING

ANSWER KEY

Question 4: Skipped payment, step-ups, and step-downs are example of: a) varied payment streams that meet a lessee’s cash flow needs.

Question 5: The secret to structuring a skipped payment lease is to: c) let each regular payment equal one dollar and the skipped payments equal zero when computing present value.

Question 6: One of the ways lessors may be made “whole” in an early payoff situation is to maintain the yield upon which the payments were based. a) True

DRAFT

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7-21


Question 7: In evaluating competing proposals, a lessor should compare: ____ a) only the lease term, payment amount, and up-front fees. ____ b) both quantitative factors such as monthly payment and qualitative factors such as limits on debt-to-equity ratio. ____ c) financial factors such as the lease term and operational factors such as accounting classification.

Question 8: Using payment differences as a way to analyze a competing lease: ____ a) is a more complex approach than other analytical methods. ____ b) compares total cash flow over the term of the lease. ____ c) does not take into account the payment mode (advance or arrears). ____ d) requires use of a discount rate.

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LEASE STRUCTURING

ANSWER KEY

Question 7: In evaluating competing proposals, a lessor should compare: b) both quantitative factors such as monthly payment and qualitative factors such as limits on debt-to-equity ratio.

Question 8: Using payment differences as a way to analyze a competing lease: c) does not take into account the payment mode (advance or arrears).

DRAFT

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Unit 8

UNIT 8: VENDOR LEASE PROGRAMS

INTRODUCTION

In Unit One, you learned that manufacturing companies, distributors, or equipment merchandising dealers who use leasing programs to help sell their products are known as vendor lessors. Often, a manufacturer or dealer will establish a wholly owned subsidiary to perform the leasing function, creating a captive leasing company. In this unit, we use the term “vendor leasing” to refer to any program, including captives, in which a manufacturer, distributor, or dealer uses leasing as a way to sell its product. Sometimes vendor lessors outsource all or part of their customer financing activity. Financial organizations such as Citibank may assume all aspects of the vendor’s customer financing, from program development through billing and collections, or play a partial role in the program, such as handling billing, collection, and credit checking. Citibank can act as finance program advisor and developer, providing servicing programs and education, training, and marketing support, or play the role of equity investor or purchaser of vendors’ portfolios of leases. Vendor leasing is rapidly increasing in importance today. In this unit, we will discuss the reasons vendors establish leasing programs and why they use third-party organizations to develop or support these programs. We will also examine some of the ways third parties, such as Citibank, work with vendor lessors.

UNIT OBJECTIVES


Identify the benefits of vendor leasing programs

+

Recognize the various ways third parties participate in vendor leasing programs

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VENDOR LEASE PROGRAMS

BENEFITS OF VENDOR LEASING PROGRAMS Third-party benefits

For financial organizations such as Citibank, assisting vendors with leasing programs offers several benefits. Such programs broaden client relationships by setting up an additional link to the client’s sales and marketing force, and produce new net revenue and annuity revenue.

Five reasons

To market vendor leasing programs effectively, it is important to understand the many benefits vendor leasing programs offer vendors. In this section, we will discuss five reasons vendors establish vendor leasing programs. As you read about these benefits, think about how they could be used as selling points. The benefits we will discuss are: +

Market control

+

Market enhancement

+

Ancillary income

+

Tax benefits

+

Financial leverage

Market Control Critical periods

Most vendor leasing programs are established for marketing reasons. Vendor programs give vendors control during critical periods over the useful life of equipment, including: +

Control at inception, to prevent loss of a sale during the time the customer needs to locate funding. On-the-spot financing can help close a deal.

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+

Control during the noncancellable lease term to provide for upgrades, maintenance, parts, supplies, and any other service or product. Monthly contact through billing gives the lessor an advantage in winning sales of additional services or products.

+

Control over disposition of the equipment, so that at lease termination, the vendor lessor is able to steer the lessee toward acquiring the lessor's new equipment

+

Control over the resale prices of used equipment repossessed, returned, or traded-in to support lease yields, operating lease programs, and avoid price competition problems with new products

+

Control over package (blanket) leasing to insure that the lessor's product is part of the multiple product package

Market Enhancement In addition to market control, both the size and quality of a manufacturer's sales market can be improved through leasing. Market enhancement results from:

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+

Reduction or elimination of discounts off list price by directing the customer’s attention from purchase price to the financial considerations of a lease

+

Improvement of sales volume through product differentiation obtained by the unique combination of product attributes, financial services, and other bundled services

+

Increased sales volume through the offering of operating lease and rental programs that meet certain lessee needs not met by other financing alternatives

+

Speed of asset turnover through takeout-rollover programs that remove a competitor's equipment before the end of the equipment's lease term and replace it with the lessor’s equipment

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+

Expansion of market penetration for new products through rental programs that allow a customer to try out equipment and lease subsidies that provide low rate financing

+

Improvement of dealer sales through vendor guarantee programs that attract third-party lessors who can offer attractive financing for customers

Additional Income Sources Increased sale of the vendor’s product is not the only source of profit in vendor leasing programs. Here, we look at several additional sources: +

The interest spread (difference) between interest income and interest expense, brokerage fees, and service fees when the lessor continues to service the lease

+

Incremental sales generated from bundled services and products in a full-service lease

+

Residual profit to the degree returned equipment can be sold for more than its remaining book value at the end of a lease

Tax Benefits In Unit Two, we discussed the various tax benefits of leasing. Recall that in the U.S., the primary tax benefits for leasing are MACRS and gross profit deferral. The value of MACRS increases the later in the tax year the lease is structured. The value of gross profit tax deferral depends upon the size of the gross profit, the discount rate applied, and the MACRS classlife of the leased equipment. A comparison of third-party and two-party leasing tax benefits appears in Figure 8.1. (All values are expressed as a percentage of retail sales price, based on an after-tax present value computation.)

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Ability to use tax benefits

8-5

The value of tax benefits to a vendor program can be significant. If the vendor lessor cannot use the tax benefits, it should consider joint venturing with a partner who can use the benefits. Selling (brokering) tax leases can generate fees that help compensate for unusable tax benefits.

Third-party Lessor

Two-party Lessor

MACRS

4.263%

4.263%

Gross profit tax deferral

0.000

2.425

Total

4.263%

6.688%

Assumptions: (1) 40% gross margin (2) 12% parent discount rate (Values would be lower if a typical captive discount rate of 6 to 8% were used in the present value analysis) (3) December 15 structuring date (4) 5-year MACRS classlife (5) 35% corporate tax rate

Figure 8.1: Third-party versus two-party lessor tax benefits

Financial Leverage Interest rate and cost of debt

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Recall that in a leveraged lease, the lessor borrows much of the equipment cost and assigns the future lease payment stream to the lender in return for the funds borrowed. The use of financial leverage increases a company's return on equity because the interest rate implicit in the lease is greater than the cost of the debt used to leverage the lease. To receive as much cash as possible, captive lessors use large amounts of debt to fund their leasing portfolios. Leveraging also lowers the investment risk since the lessor uses a minimal amount of its own equity funds.

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Off balance sheet funding


In addition to enhancing return on equity, financial leveraging may offer a vendor lessor certain accounting benefits. In the U.S., a partially owned subsidiary (≤ 50 percent) is not consolidated for accounting purposes, so the debt does not appear on the balance sheet of the parent company.

REASONS VENDORS OUTSOURCE LEASING PROGRAMS

In the previous section, we discussed the many benefits vendor leasing programs offer manufacturers and equipment dealers. We saw that vendor leasing programs help vendors sell their products, increase revenues, and accelerate cash flow. With so many benefits to gain, why don’t all manufacturers and equipment distributors have customer financing programs? In this section, we will examine the reasons and see how using third-party lessors such as Citibank can help.

Reasons Vendors Lack Customer Financing Programs Although there are many reasons vendors do not establish financing programs, most pertain to lack of resources and leasing expertise, concerns about the risks in leasing, and the inability to compete with large leasing specialists. Expertise and capital issues

The lack of in-house leasing expertise is one of the most important reasons vendors do not have leasing programs. Leasing is a specialized field. Most companies do not have the time or the resources to develop the needed expertise or to hire leasing experts. Also, many companies do not wish to divert capital away from their primary business to fund and support a leasing portfolio. They also fear that their cost of capital may be too high to compete with the lease rates of third-party finance companies.

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Concerns over risks

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Even for companies with the resources to set up a leasing program, concerns about the many risks in leasing (residual risk, credit risk, interest rate risk) or an excess tax benefit position may keep them from doing so. As we shall see in the following sections, most of these concerns can be addressed through outsourcing customer financing programs to third-party participants.

Third-party Participants Variety of participants and services

There are a large number of third-party participants in the vendor leasing market, including lease brokers, financial institutions such as Citibank, and independent leasing companies. The level of services varies. Some participants function solely as lenders to captives. Others provide special services, such as remarketing, to the vendors. Another class of participants provides funding and a limited range of support services. Finally, some offer full-service leasing and provide the vendors with a wide variety of services, from lease origination through equipment disposition. We will discuss these roles in more detail in the next section.

Joint ventures

In addition to the roles just mentioned, the third-party lessor also can serve as a joint venture/equity partner. Under such an arrangement, the third party invests directly in the leasing subsidiary. More commonly, the vendor and an outside party jointly establish a separate company to lease the vendor’s products to customers. Vendors who want to retain a portion of the financing profit and tax benefits in-house, but do not want to bear all the risks of a full captive, often choose to enter a joint venture.

WAYS TO MEET VENDOR NEEDS

There are many ways a third party can service vendor lessors. Generally, it is the noncaptive vendor lessors who have the greatest need for services (although more and more captive lessors are outsourcing some functions). V01/11/96 P12/06/99

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Third-party Services The services third parties offer vendors can be grouped into seven categories: sales-aid/training, lease structuring/documentation, credit review, outplacement/investment syndication, funding, administrative services, and remarketing/asset management. Let’s review each category. Sales-aid / Training Education, joint marketing, support

Sales-related services provided by a third-party lessor range from helping the vendor establish an effective leasing program by educating the vendor’s sales force to on-going sales support services, such as customizing deals. Services can include sales force training, joint customer calls, customized lease documentation and marketing materials, jointly sponsored advertising, and pricing support. Lease Structuring / Documentation

Third-party lessor’s expertise

This is an area where third-party lessors offer a great deal of added value. The third-party company works with a vendor to customize a transaction to a particular lessee’s needs. The vendor benefits from the third-party’s expertise in structuring lease products. The vendor can also rely on the third-party lessor for help in processing and tracking the lease documentation prior to closing the transaction. Credit Review

Customer’s creditworthiness

Vendors often rely on a third party’s expertise in assessing a customer’s creditworthiness. The credit review process usually involves researching the customer’s credit history, analyzing financial statements, and checking references.

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Outplacement / Investment Syndication Lack of capital

A lack of capital often causes vendors to seek an equity partner or have a lease broker sell off its equity investment in leases. Sometimes the investor buys the entire lease (assumes the credit and residual risks); other times the vendor sells only the rental stream or the residual. Funding

Direct and indirect funding

There are many ways to fund a vendor leasing program or captive. The method chosen depends on the vendor’s desired tax and accounting consequences. There are two basic types of funding − direct and indirect. Indirect funding involves loans to the captive or vendor, who then uses the borrowed funds to lease the equipment directly to the customer. Under direct funding methods, the third party is the lessor and provides the financing directly to the vendor’s customer. The third-party lessor may buy the asset from the vendor and lease it directly to the customer, or purchase existing leases from the vendor.

Accounting issues

Whether the vendor, the third-party lessor, or the customer retains the residual and tax rights to the asset depends on how the initial sale and lease of the equipment is structured, and on the type of lease (capital or operating). As you learned in Unit Two, the type of borrowing − recourse or nonrecourse − has important accounting considerations. In a recourse arrangement, the vendor agrees to stand behind the customer’s lease payments. Alternatively, the vendor can sell its interest in the residual only, retaining the lease payment stream and associated credit risk.

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Administrative Services Handling paperwork

Vendors may find it more cost-effective to purchase services from an equipment leasing specialist, whose size and leasing concentration enable it to achieve certain economies of scale. The administrative services a third-party lessor might provide include booking the transaction; billing and collecting the monthly lease payments; processing customer service complaints; filing, collecting and remitting sales, use and property taxes; and preparing financial statements and tax returns. Remarketing / Asset Management

Control over asset

Vendors often seek outside help in remarketing the asset at the end of the lease term or in the event of a customer default. Also, a vendor may choose to use the asset tracking systems offered by many leasing companies. These systems alert the lessor as to which assets are coming off lease, report on the status of any off-lease equipment, and process any subsequent sales or re-leases of any returned equipment.

UNIT SUMMARY

There are many reasons vendors create captive leasing companies and vendor programs: market control, market enhancement, ancillary income, tax benefits, and financial leverage. Outsourcing some or all of the leasing function helps vendors minimize the risks associated with leasing, fund their leasing programs, and benefit from third-party expertise. Third parties meet vendor leasing program needs in a variety of ways. Many provide funding only, while others provide both funding and a limited range of support services such as billing, collecting, and credit review. Some third party companies provide special services, such as remarketing, to vendors. Others offer full-service leasing, from lease origination through equipment disposition. Congratulations! You have completed the Basics of Asset Based Financing Course. Please complete Progress Check 8 to check your understanding of vendor leasing programs. If you answer any questions incorrectly, please review the appropriate portions of the text.

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]

PROGRESS CHECK 8

Directions: Determine the correct answer to each question. Check your answers with the Answer Key on the next page. Question 1: The primary reason manufacturing companies, distributors, or equipment merchandising dealers use customer financing programs is to: ____ a) control resale prices of used equipment. ____ b) gain tax benefits. ____ c) reduce risks. ____ d) help sell their products. Question 2: The reason vendors wish to exercise control at the time of sale is to: ____ a) increase sales by providing the customer with supplies and other services. ____ b) prevent loss of a sale while the customer seeks financing. ____ c) make sure its product is part of a product package. ____ d) influence the resale value of the equipment. Question 3: One of the ways vendors can increase profits through leasing programs is to purchase noncompeting equipment at wholesale prices and package it with their own equipment. ____ a) True ____ b) False Question 4: Financial leverage helps increase a lessor’s return on equity because: ____ a) it generates incremental sales from bundled services and products. ____ b) sales volume is increased by reducing reliance on discounts off list price. ____ c) it generates income from syndication fees. ____ d) the rate of return from the lease generally exceeds the cost of borrowing to leverage the lease.

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ANSWER KEY

Question 1: The primary reason manufacturing companies, distributors, or equipment merchandising dealers use customer financing programs is to: d) help sell their products.

Question 2: The reason vendors wish to exercise control at the time of sale is to: b) prevent loss of a sale while the customer seeks financing.

Question 3: One of the ways vendors can increase profits through leasing programs is to purchase noncompeting equipment at wholesale prices and package it with their own equipment. a) True

Question 4: Financial leverage helps increase a lessor’s return on equity because: d) the rate of return from the lease generally exceeds the cost of borrowing to leverage the lease.

DRAFT

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Question 5: An important reason vendors use third-party lessors is to: ____ a) improve sales. ____ b) avoid the risks inherent in leasing. ____ c) gain tax advantages. ____ d) earn a greater return on equity.

Question 6: Vendors who wish to retain a portion of the financing profit and tax benefits without bearing all the risks of leasing should consider: ____ a) a captive subsidiary. ____ b) lease brokering. ____ c) a joint venture. ____ d) an asset tracking system.

Question 7: A vendor often finds it beneficial to outsource its lease administration activity to a leasing specialist because: ____ a) the third party’s knowledge of leasing and size enables it to administer leases more efficiently. ____ b) outsourcing helps increase the value of depreciation. ____ c) it retains full tax benefits without the risks. ____ d) leasing specialists know how to remarket equipment.

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ANSWER KEY

Question 5: An important reason vendors use third-party lessors is to: b) avoid the risks inherent in leasing.

Question 6: Vendors who wish to retain a portion of the financing profit and tax benefits without bearing all the risks of leasing should consider: c) a joint venture.

Question 7: A vendor often finds it beneficial to outsource its lease administration activity to a leasing specialist because: a) the third party’s knowledge of leasing and size enables it to administer leases more efficiently.

DRAFT

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Unit 9

UNIT 9: VENDOR PROGRAMS

INTRODUCTION

In Units Two through Eight, we discussed leasing, a key ABF product, in detail. In that context, we introduced the concept of vendors using leasing programs to help sell their products and accelerate cash flow from sales. In this unit, we expand our discussion of that topic to include all vendor finance programs (loans and leases). Specifically, we will examine the reasons vendors establish programs to finance their customers’ product purchases, why they use third-party organizations such as Citibank to develop or support these programs, and how Citibank uses vendor programs to accelerate ABF activity. We will also look at several marketing and structuring aspects of vendor programs — vendor selection criteria, program structuring, and risk-sharing mechanisms.

UNIT OBJECTIVES


Identify the benefits of vendor financing programs

+

Recognize the various ways third parties participate in vendor financing programs

+

Identify criteria Citibank uses to select vendors

+

Understand the major types of risk sharing mechanisms in vendor programs

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VENDOR PROGRAMS

BENEFITS OF VENDOR FINANCE PROGRAMS Finance sales of products

In Unit Two, you learned that manufacturing companies, distributors, or equipment merchandising dealers who use financing programs to help sell their products are known as vendor lessors. Recall that some manufacturers or dealers establish a wholly owned subsidiary to finance the purchase of their products, creating a captive (two-party) financing company. In other instances, vendors outsource all or part of their customer financing activity to a financial organization such as Citibank. In this unit, we use the term vendor financing to refer to any program, including captives, in which a manufacturer, distributor, or dealer finances the sale of its products to end users. In this section we will look at the benefits of vendor financing from two perspectives — that of Citibank and that of the vendor. Understanding the benefits from both viewpoints will help you market and structure successful vendor programs. Let’s begin with the benefits to Citibank.

Citibank Benefits Access to equipment users

Why does Citibank use vendor programs as part of its asset based financing activity? The main reason is that vendor programs help speed the bank’s access to equipment users. Established vendors have a customer base in place and a marketing program to acquire new customers. Through vendor financing, Citibank establishes relationships with equipment users that may lead to direct finance arrangements in the future. To help you understand the role Citibank plays in vendor financing, in Figure 9.1, we show the equipment financing flow when Citibank finances the sale of the product to the end user. Note that Citibank is providing equipment financing through the vendor for the equipment user, not the manufacturer, dealer, or distributor.

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VENDOR PROGRAMS

9-3

Sale

Distributor

Manufacturer

Sale Equipment User

or Dealer

Citibank Financing • Vendor • Direct Figure 9.1: Financing equipment purchases

Additional advantages

In addition to providing access to equipment customers, participating in vendor financing programs offers Citibank several other advantages. +

Broadens client relationships by setting up an additional link to the client’s sales and marketing force

+

Produces new revenues

+

Establishes credibility and prestige in the equipment market

+

Speeds deal flow by enhancing the sales and marketing force

+

Reduces credit risk through risk sharing arrangements, access to the vendor’s knowledge of the equipment and the customer base, and access to larger secondary markets

+

Provides economies of scale to justify equipment and industry specialization

As you can see, there are many reasons for Citibank to be involved with vendor finance arrangements. Likewise, vendor programs are beneficial to manufacturers, dealers, and distributors. Let’s continue our discussion by looking at the benefits from the vendor’s view.

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VENDOR PROGRAMS

Vendor Benefits Benefit categories

To effectively market vendor financing programs, it is important that you understand the many benefits vendor financing programs offer vendors. In this section, we discuss five reasons vendors establish financing programs. As you read about these benefits, think about how they could be used as selling points. The benefits we will discuss are: +

Market control

+

Market enhancement

+

Ancillary income

+

Tax benefits

+

Financial leverage

Market Control Critical periods

Most vendor financing programs are established for marketing reasons. Vendor programs give vendors command over the equipment and control during critical periods over the useful life of the equipment, including control: +

At inception, to prevent loss of a sale during the time the customer needs to locate funding. On-the-spot financing can help close a deal.

+

During the funding term to provide for upgrades, maintenance, parts, supplies, and any other service or product. Monthly contact through billing gives the vendor an advantage in winning sales of additional services or products.

+

Over disposition of the equipment, so that at lease termination, the vendor is able to steer the user toward acquiring the vendor’s new equipment

+

Over the resale prices of used equipment repossessed, returned, or traded-in to support lease yields, operating lease programs, and avoid price competition problems with new products DRAFT

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VENDOR PROGRAMS

9-5

+

Over package (blanket) financing to ensure that the vendor’s product is part of the multiple product package

Market Enhancement Market size and quality

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In addition to market control, both the size and quality of a manufacturer's sales market can be improved through financing. Market enhancement results from: +

Reduction or elimination of discounts off list price by directing the customer’s attention from the purchase price to the financial considerations of a lease or loan

+

Improvement of sales volume through product differentiation obtained by the unique combination of product attributes, financial services, and other bundled services

+

Increased sales volume through the offering of operating lease and rental programs that meet certain equipment user needs not met by other financing alternatives

+

Speed of asset turnover through takeout-rollover programs that remove a competitor's equipment before the end of the equipment's lease term and replace it with the vendor’s equipment

+

Expansion of market penetration for new products through rental programs that allow a customer to try out equipment and lease and loan subsidies that provide low rate financing

+

Improvement of dealer sales through vendor guarantee programs that attract third-party creditors who can offer attractive financing for customers

DRAFT

9-6

VENDOR PROGRAMS

Additional Income Sources Interest, incremental sales, residual profits

Increased sale of the vendor’s product is not the only source of profit in vendor financing programs. Here are three additional sources: +

The interest spread (difference) between interest income and interest expense, brokerage fees, and service fees when the lessor continues to service the lease

+

Incremental sales generated from bundled services and products in a full-service lease

+

Residual profit to the degree returned equipment can be sold for more than its remaining book value at the end of a lease

Tax Benefits MACRS and gross profit deferral

In Unit Three, we discussed the various tax benefits of leasing. Recall that in the U.S., the primary tax benefits for leasing are MACRS and gross profit deferral. Let’s review two important points from that discussion: +

The value of MACRS increases the later in the tax year the lease is structured.

+

The value of gross profit tax deferral depends upon the size of the gross profit, the discount rate applied, and the MACRS classlife of the leased equipment.

Keeping these points in mind, look at the comparison of third-party and two-party leasing tax benefits in Figure 9.2. (All values are expressed as a percentage of retail sales price, based on an after-tax present value computation.) Ability to use tax benefits

As you can see, the value of tax benefits in a vendor program can be significant. If the vendor lessor cannot use the tax benefits, it should consider joint venturing with a partner who can use the benefits. Selling (brokering) tax leases can generate fees that help compensate for unusable tax benefits.

DRAFT

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VENDOR PROGRAMS

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Third-party Lessor

Two-party Lessor

MACRS

4.263%

4.263%

Gross profit tax deferral

0.000

2.425

Total

4.263%

6.688%

Assumptions: (1) 40% gross margin (2) 12% parent discount rate (Values would be lower if a typical captive discount rate of 6 to 8% were used in the present value analysis) (3) December 15 structuring date (4) 5-year MACRS classlife (5) 35% corporate tax rate

Figure 9.2: Third-party versus two-party lessor tax benefits

Financial Leverage Interest rate and cost of debt

Recall that in a leveraged lease, the lessor borrows much of the equipment cost and assigns the future lease payment stream to the lender in return for the funds borrowed. The use of financial leverage increases a company's return on equity because the interest rate implicit in the lease is greater than the cost of the debt used to leverage the lease. To receive as much cash as possible, captive lessors use large amounts of debt to fund their leasing portfolios. Leveraging also lowers the investment risk since the lessor uses a minimal amount of its own equity funds.

Off balance sheet funding

In addition to enhancing return on equity, financial leveraging may offer a vendor lessor certain accounting benefits. In the U.S., a partially owned subsidiary (less than or equal to 50 percent) is not consolidated for accounting purposes, so the debt does not appear on the balance sheet of the parent company.

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VENDOR PROGRAMS

THIRD PARTY VENDOR PROGRAMS

In the previous section, we discussed the many benefits vendor financing programs offer manufacturers and equipment dealers. We saw that vendor financing programs help vendors sell their products, increase revenues, and accelerate cash flow. With so many benefits to gain, why don’t all manufacturers and equipment distributors have customer financing programs? In this section, we will examine the reasons and see how using third-party creditors such as Citibank can help overcome the constraints vendors confront.

Reasons Vendors Lack Customer Financing Programs Although there are many reasons vendors do not establish captive financing programs, most pertain to lack of resources and financing expertise, concerns about the risks in leasing and lending, and the inability to compete with large leasing specialists. Let’s examine each of these reasons more closely. Expertise and Capital Issues Lack of specialized resources

The lack of in-house financing expertise is one of the most important reasons vendors do not have financing programs. Leasing, in particular, is a specialized field. Most companies do not have the time or the resources to develop the needed expertise or to hire leasing experts. Also, many companies do not wish to divert capital away from their primary business to fund and support a financing portfolio. Another problem is that internal credit processes may lack integrity because of ties to marketing, and borrowers may not take a supplier’s credit seriously.

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Risk Issues Financing risks and tax position

Even for companies with the resources to set up a financing program, concerns about the many risks in financing equipment or an excess tax benefit position may keep them from doing so. Residual, credit, interest rate, and country risks are some of the risks captive finance companies face. Inability to Compete

Cost of capital and administration

Few vendors have the administrative and collection infrastructure necessary to conduct a financing program. Vendors also fear that their cost of capital may be too high to compete with the rates of thirdparty finance companies. As we shall see in the following section, most of these concerns can be addressed through outsourcing customer financing programs to third-party participants.

Ways Third-parties Meet Vendor Needs Variety of participants and services

There are a large number of third-party participants in the vendor financing market, including lease brokers, financial institutions such as Citibank, and independent leasing companies. Third parties service vendors in a variety of ways, at a variety of levels. It is important for you to understand the types of services offered so that you can help a vendor compare the program you are offering to those of competitors. Some participants function solely as lenders to captives. Others provide special services, such as remarketing. Another class of participants provides funding and a limited range of support services, while others offer full-service financing, from lease/loan origination through billing, collections, and equipment disposition.

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Joint ventures

VENDOR PROGRAMS

In addition to the roles just mentioned, the third-party creditor also can serve as a joint venture/equity partner. Under such an arrangement, the third party invests directly in the financing subsidiary. More commonly, the vendor and an outside party jointly establish a separate company to lease the vendor’s products to customers. Vendors who want to retain a portion of the financing profit and tax benefits in-house, but do not want to bear all the risks of a full captive, often choose to enter a joint venture. The various ways creditors service vendors are shown in Figure 9.3.

Loans (Indirect funding)

Captive

Equity (Contract purchases) Specialized Services Administrative Services

Joint Venture

VENDOR

Equity (as a partner) Specialized Services Administrative Services

FullService

Direct Financing All Services Program development through billing and collections

Figure 9.3: Roles of third-party organizations

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VENDOR PROGRAMS

Citibank roles

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Citibank may assume all aspects of the vendor’s customer financing (full-service program), from program development through billing and collections, or play a partial role in the program, such as handling billing, collection, and credit checking. Citibank can act as finance program advisor and developer, providing servicing programs and education, training, and marketing support, or play the role of equity investor or purchaser of vendors’ portfolios of leases or loans. The services Citibank and other full-service financial organizations offer vendors may be grouped into seven categories: +

Sales-assistance and training

+

Lease and loan structuring and documentation

+

Credit review

+

Outplacement/investment syndication

+

Funding

+

Administrative services

+

Remarketing/asset management

Let’s examine each category. Sales-assistance and Training Education, joint marketing, support

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Sales-related services provided by a third-party creditor range from helping the vendor establish an effective financing program by educating the vendor’s sales force to on-going sales support services, such as customizing deals. Services can include sales force training, joint customer calls, customized lease documentation and marketing materials, jointly sponsored advertising, and pricing support.

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VENDOR PROGRAMS

Lease and Loan Structuring and Documentation Third-party lessor’s expertise

This is an area where third-party creditors offer a great deal of added value. The third-party company works with a vendor to develop financial products and customize individual transactions to the needs of a particular lessee or borrower. The vendor benefits from the thirdparty’s expertise in structuring lease and loan products. The vendor can also rely on the third-party creditor for help in preparing, processing, and tracking the documentation prior to closing the transaction. Credit Review

Customer’s creditworthiness

Vendors often rely on a third party’s expertise in assessing a customer’s creditworthiness. Third party creditors can develop and maintain a credit approval process with integrity because it is independent of the vendor’s marketing function. The credit review process usually involves researching the customer’s credit history, analyzing financial statements, and checking references. Outplacement and Investment Syndication

Lack of capital

A lack of capital often causes vendors to seek an equity partner or have a lease broker sell off its equity investment in leases. Sometimes the investor buys the entire lease (assumes the credit and residual risks); other times the vendor sells only the rental stream or the residual. Funding

Direct and indirect funding

There are many ways to fund a vendor financing program or captive organization. The method chosen depends on the vendor’s desired tax and accounting consequences.

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There are two basic types of funding − direct and indirect. Indirect funding involves loans to the captive or vendor, who then uses the borrowed funds to lease the equipment directly to the customer. Under direct funding methods, the third party is the lessor or lender and provides the financing directly to the vendor’s customer. The third-party lessor may buy the asset from the vendor and lease it directly to the customer, or purchase existing leases from the vendor. Accounting issues

Whether the vendor, the third-party creditor, or the customer retains the residual and tax rights to the asset depends on how the initial sale and lease of the equipment are structured, and on the type of lease (capital or operating). As you learned in Unit Three, the type of borrowing — recourse or nonrecourse — has important accounting considerations. In a recourse arrangement, the vendor agrees to stand behind the customer’s lease payments. Alternatively, the vendor can sell its interest in the residual only, retaining the lease payment stream and associated credit risk. Administrative Services

Handling paperwork

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Vendors may find it more cost-effective to purchase services from an equipment leasing specialist, whose size and leasing concentration enable it to achieve certain economies of scale. The administrative services a third-party creditor might provide include booking the transaction; billing and collecting the monthly lease payments; processing customer service complaints; filing, collecting and remitting sales, use and property taxes; and preparing financial statements and tax returns.

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Remarketing / Asset and Remedial Management Control over asset

Vendors often seek outside help in remarketing the asset at the end of the lease term or in the event of a customer default. Also, a vendor may choose to use the asset tracking systems offered by many financing companies. These systems alert the lessor as to which assets are coming off lease, report on the status of any off-lease equipment, and process any subsequent sales or re-leases of any returned equipment. Vendors may also need assistance in remedial management to know when a transaction is in trouble and how to work out a solution. It is important to note that each of the services listed in this section has a cost to the provider of the service, whether the provider be the vendor or a third party. The cost of services is an important point in marketing vendor programs, the topic of the next section.

SUMMARY

There are many reasons vendors create captive financing companies and vendor programs — market control, market enhancement, ancillary income, tax benefits, and financial leverage. Outsourcing some or all of the financing function helps vendors minimize the risks associated with financing, fund their financing programs, and benefit from third-party expertise. For Citibank, vendor programs accelerate access to equipment users, expand client relationships, produce new revenues, establish credibility and prestige, speed deal flow, and reduce credit risk. Third parties meet vendor financing program needs in a variety of ways. Many provide funding only, while others provide both funding and a limited range of support services. Some third party companies provide special services, such as remarketing, to vendors. Others offer full-service financing, from lease/loan origination through equipment disposition. You have completed the first part of Unit Nine, Vendor Programs. Please complete Progress Check 9.1 to check your understanding. If you answer any questions incorrectly, please review the appropriate portions of the text before continuing to the next section, “Marketing and Structuring Vendor Programs.”

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PROGRESS CHECK 9.1

Directions: Determine the correct answer to each question. Check your answers with the Answer Key on the next page. Question 1: Access to the vendor’s equipment knowledge and secondary market are ways for Citibank to: ____ a) justify risk sharing arrangements. ____ b) gain prestige in the equipment market. ____ c) speed financing transactions. ____ d) reduce credit risk. Question 2: The primary reason manufacturing companies, distributors, or equipment merchandising dealers use customer financing programs is to: ____ a) control resale prices of used equipment. ____ b) gain tax benefits. ____ c) reduce risks. ____ d) help sell their products. Question 3: The reason vendors wish to exercise control at the time of sale is to: ____ a) increase sales by providing the customer with supplies and other services. ____ b) prevent loss of a sale while the customer seeks financing. ____ c) make sure its product is part of a product package. ____ d) influence the resale value of the equipment. Question 4: One of the ways vendors can increase profits through financing programs is to purchase noncompeting equipment at wholesale prices and package it with their own equipment. ____ a) True ____ b) False

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ANSWER KEY

Question 1: Access to the vendor’s equipment knowledge and secondary market are ways for Citibank to: d) reduce credit risk.

Question 2: The primary reason manufacturing companies, distributors, or equipment merchandising dealers use customer financing programs is to: d) help sell their products.

Question 3: The reason vendors wish to exercise control at the time of sale is to: b) prevent loss of a sale while the customer seeks financing.

Question 4: One of the ways vendors can increase profits through financing programs is to purchase noncompeting equipment at wholesale prices and package it with their own equipment. a) True

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Question 5: Financial leverage helps increase a lessor’s return on equity because: ____ a) it generates incremental sales from bundled services and products. ____ b) sales volume is increased by reducing reliance on discounts off list price. ____ c) it generates income from syndication fees. ____ d) the rate of return from the lease generally exceeds the cost of borrowing to leverage the lease. Question 6: An important reason vendors use third-party lessors is to: ____ a) improve sales. ____ b) avoid the risks inherent in leasing. ____ c) gain tax advantages. ____ d) earn a greater return on equity. Question 7: Vendors who wish to retain a portion of the financing profit and tax benefits without bearing all the risks of leasing should consider: ____ a) a captive subsidiary. ____ b) lease brokering. ____ c) a joint venture. ____ d) an asset tracking system. Question 8: A vendor often finds it beneficial to outsource its lease administration activity to a leasing specialist because: ____ a) the third party’s knowledge of leasing and size enables it to administer leases more efficiently. ____ b) outsourcing helps increase the value of depreciation. ____ c) it retains full tax benefits without the risks. ____ d) leasing specialists know how to remarket equipment.

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ANSWER KEY

Question 5: Financial leverage helps increase a lessor’s return on equity because: d) the rate of return from the lease generally exceeds the cost of borrowing to leverage the lease.

Question 6: An important reason vendors use third-party lessors is to: b) avoid the risks inherent in leasing.

Question 7: Vendors who wish to retain a portion of the financing profit and tax benefits without bearing all the risks of leasing should consider: c) a joint venture.

Question 8: A vendor often finds it beneficial to outsource its lease administration activity to a leasing specialist because: a) the third party’s knowledge of leasing and size enables it to administer leases more efficiently.

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MARKETING AND STRUCTURING VENDOR PROGRAMS

So far, we have focused on the benefits of vendor finance programs and the ways third party creditors can help vendors achieve their goals. With this foundation in mind, we will now discuss marketing and structuring vendor programs. First, we describe the common types of vendor financing programs and various risk sharing structures; next, we discuss marketing and structuring successful programs.

Program Types There are several ways for a financial institution to provide financing to a vendor’s customers. Here, we describe three basic types of programs — referral, full recourse, and risk sharing. Referral Creditor has control and bears risks

In a referral program, the vendor directs or refers its customers to the creditor for their financing needs, but does not provide support or recourse. The creditor may be the only institution the vendor refers its customers to (exclusive basis) or one of several creditors (nonexclusive basis). The creditor has complete control over credit extension and bears all the credit risks. Each transaction received is judged on its own merits according to the creditor’s risk acceptance criteria. Full Recourse (100% Guarantee)

Vendor assumes all credit risk

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Full recourse refers to an arrangement in which the vendor assumes 100% of the credit risk by providing a demand guarantee for 100% of the amount of the transaction. In the event of default, the vendor buys back the contract for the full amount and is responsible for all follow-up actions related to the contract.

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The vendor controls the credit approval process, but the creditor retains veto rights, which are exercised only for non-credit reasons. This type of guarantee is suitable for smaller programs and small ticket programs. Risk Sharing Split credit or collateral value risks

In a risk sharing (partial recourse) program, Citibank and the vendor agree to share credit and/or collateral value risks. For example, Citibank and the vendor may enter a co-lending agreement in which each funds 50% of the transaction. Risk sharing is usually necessary until Citibank earns enough of a specific market to make nonrecourse programs feasible. Vendor support may be reduced as the vendor and creditor develop greater experience and historical data in markets. There are several possible risk sharing arrangements. Because this is Citibank’s preferred approach, we discuss risk sharing in detail separately in the following section.

Forms of Risk Sharing Balance with benefits

Citibank requires some form of risk sharing for major programs in Latin America, so it is important for you to know about the various types. Of course, most vendors do not want to assume any risk; therefore, the challenge is to design programs that are better than the other financing arrangements available in the market place. Remember, the vendor’s goal is to sell more products! The marketing benefits that justify a risk sharing arrangement must be clear to the vendor. The types of risk sharing we will discuss here are: +

First loss deficiency guarantee

+

Asset value guarantee

+

Co-lending (Pari Passu)

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Before we describe these mechanisms, let’s look at the objectives of risk sharing from a creditor’s view so that you will understand the importance of these arrangements. +

Permit risk acceptance criteria under which 80-90% of eligible transactions will be approved quickly. When risks are shared, more transactions may be approved.

+

Retain sufficient reasonable business risks so that vendors will encourage their customers to finance equipment through the program. Vendors who bear all the risks are unlikely to support the creditor, whereas shared risk promotes cooperation.

+

Have sufficient business risk to justify target yields. The vendor must see that the benefits the creditor offers offset the creditor’s required margins.

Think about how these objectives may be achieved as you read about the three types of risk sharing mechanisms. First Loss Deficiency Guarantee (FLDG) Percentage of financing

In this risk sharing arrangement, the vendor guarantees an amount equal to a percentage of the amount that the creditor financed. This percentage, referred to as the FLDG liability, is calculated annually.

Example

Assume a 25% first loss deficiency program. If Citibank booked US$10 million in transactions, the vendor’s liability under the program would be US$2.5 million (.25 X $10 million).

Loss applied against liability

If a borrower defaults on a contract, the vendor repurchases the contract for its full face value from Citibank. The vendor then repossesses the equipment and attempts to sell it. The sale may create a chargeable loss, which is the difference between the purchase price of the defaulted loan and the net sales proceeds. This loss is applied against the vendor’s FLDG liability.

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Motivation to resolve defaults

When the vendor repurchases the defaulted contract, it assumes the responsibilities and risks of repossessing and remarketing the equipment. For this reason, FLDG arrangements motivate the vendor or dealer to resolve default situations. If the vendor restructures the transaction instead of creating a loss, the amount of the FLDG liability is not reduced. If the vendor cannot repossess and resell the equipment for any reason, the amount of the FLDG liability is not reduced.

Example

Look at the example in Figure 9.4. Notice that the vendor guarantee for the first year is $13,000. Assume that two borrowers in Country B default on their contracts for a total of $10,000. The vendor repurchases the contracts and sells the equipment for $4,000, realizing a $6,000 loss. In this example, the vendor FLDG is reduced to $7,000 (13,000 6,000 = 7,000).

Figure 9.4: FLDG schedule of loss positions

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Asset Value Guarantee (AVG) Collateral value guaranteed

In an asset value guarantee (buy back), the vendor guarantees a collateral value for each transaction. The AVG agreement contains a schedule of values over time at which the vendor agrees to repurchase any equipment the creditor repossesses. Thus, the vendor acts as an assured and secondary market. It is important for you to know that the program loss rate (including remedial management, loan work-out, and repossession costs and risks) for an AVG typically is higher than under an FLDG program. Co-lending (Pari Passu)

Split credit risk

In co-lending, a vendor assumes 50 percent of the credit risk of each transaction on a transaction-by-transaction basis (either directly extending 50 percent of the funding or providing a demand guarantee for 50 percent). Citibank and the vendor separately approve or veto each transaction. This type of risk sharing is most suitable for programs with larger transactions where the vendor has sound transaction screening practices and a credit process with integrity. Comparison

Each of the program types and risk sharing mechanisms described in this section affect turn around time, approval ratios, the cost of the delivery system, and the degree of risk shifting differently. To help you visualize these differences, we’ve summarize them in Figure 9.5

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Referral 0% Guarantee

Full Recourse 100% Guarantee

First Loss Deficiency Guarantee

Co-lending 50% Guarantee

Asset Value Guarantee

TurnAround Time

Medium

Fast

Fast

Slow

Fast

Control of Credit Criteria

Citibank

Vendor

Vendor

Citibank and vendor, independently

Citibank

Approval Ratio

Low. Only upper tier customers are likely to qualify.

High. All customer classes included.

High. Small high-risk borrowers could be included.

Low. Small high-risk and medium-size borrowers would be excluded.

Medium. Small, highrisk borrowers would be excluded.

Cost of Delivery System

High

Low

Low

High

Low

Risk Shifting to Citibank

Vendor shifts all program risks to Citibank

No program risks shifted to Citibank

Risk shifting to Citibank limited

Risk shifting to Citibank is explicit and against all risk categories with vendor retaining all risk types

Risk shifting to Citibank is significant. Vendor retains risk type (collateral and resale values)

Figure 9.5: Program comparison

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Structuring Vendor Programs Success criteria

As you might assume, each of the program types we just discussed — referral, risk sharing, and full recourse — requires a different structuring approach. The officer’s goal should be to develop a regional or country-specific vendor financing partnership that will build on the strengths of each party, keeping in mind how the program structure will motivate the vendor to support the creditor, especially in default situations. In a successful program, the vendor sells more equipment, Citibank transacts more loans and leases, and defaults are controlled. To build a successful program, the officer must: +

Select vendors carefully

+

Effectively market the services

+

Design a program that will meet the vendor’s sales goals and provide Citibank with the margins it needs

The following discussions will help you understand these points. Vendor Selection Criteria

Vendor selection is the first step in building a successful vendor program. In this section, we identify the vendor selection criteria Citibank has developed. The criteria will help you recognize vendors that make good candidates for vendor finance programs. Existing relationship

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The ideal vendor has an existing relationship with Citibank and serves one of the target asset based financing industries. Strong candidates believe that customer financing plays a key role in its sales and marketing efforts. Other criteria are: +

Creditworthy (public debt rating of “A” or better)

+

Has multicountry, multiproduct capabilities

+

Holds dominant market position in key markets

+

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+

Good potential financing volume in region or country (for example, US$100 million)

+

Average cost of equipment is greater than US$75,000

+

Equipment is moveable and has stable collateral values

+

Customers have limited access to external capital, especially unsecured capital

Now let’s discuss how to market to selected vendors. Marketing Assess need

Once you have determined that a vendor meets the selection criteria, you should: +

Find out what the vendor is doing now

+

Find out what is not working now

+

Find out what the vendor has tried before

As you go through this exercise, think about how the services Citibank offers might solve the vendor’s problem. Recall the seven categories of services — help with sales and training, transaction structuring and documentation, credit review, capital for equity, funding, administrative services, and remarketing/asset management. Collect basic information

Next, gather the basic information required to develop a preliminary program structure. See Figure 9.6 for a list of key questions.

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What is the revenue potential? What are the key risks? What data is available on historical loss and delinquency performance for the vendor’s equipment? What is the existing break down of the target market? How might the vendor financing program change the target market? What are the limitations on legal repossession and sales of assets? What are the tax and accounting objectives of the customers? How big is the secondary market for the equipment and what are the distribution channels? If novel or complicated financing products are to be offered, what level of financial education and marketing is required? Figure 9.6: Information needed to structure a vendor program

Program Outline Contents

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Once you have the answers you need, develop a preliminary program outline. The contents of a program outline should: +

Identify common interests

+

Provide for a highly consistent regional program with the ability to tailor financing for individual markets

+

Describe how local delivery systems (vendor marketing and Citibank financing units) will work together

+

Balance rates with service quality and value-added services, such as marketing support

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+

Provide for balanced, limited risk sharing and initial support that allows Citibank a high transaction approval rate and quick turn-around time. The approval ratio and turn-around time are extremely important to vendors and their customers.

+

Address critical issues such as default provisions, the definition of loss, who will deal with loss, and who will handle repossessions

+

Provide for on-going program monitoring and adjusting

+

Contain incentives and flexibility

+

Specify the margin Citibank requires

Remember, vendors want nonrecourse programs. You must build a risk reward package to justify Citibank’s margins to customer!

SUMMARY

In this section, we discussed three basic types of vendor programs — referral, full recourse (100% guarantee), and risk sharing. The most common forms of risk sharing arrangements are: +

First loss deficiency guarantee

+

Asset value guarantee

+

Co-lending

The type of program affects the average length of time it takes to process a transaction, the transaction approval rate, and the cost of the delivery system. It is important for vendors to understand how the type of program affects the goal they wish to achieve. Balanced and limited risk sharing arrangements allow for higher approval rates, whereas referral program approval rates are typically low.

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To build a successful vendor program, the officer should evaluate vendors against Citibank’s selection criteria, identify vendors that would benefit from a financing program, and structure a program that helps the vendor increase sales and provides Citibank with the required margin. In structuring a program, the officer should always anticipate the way a structure might motivate the behavior of the vendor.

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]

PROGRESS CHECK 9.2

Directions: Determine the correct answer to each question. Check your answers with the Answer Key on the next page. Question 1: In a full recourse arrangement, the creditor’s credit risk is: ____ a) 100 percent. ____ b) 50 percent. ____ c) 0 (zero) percent. Question 2: Requiring the vendor to share credit and/or collateral risks is not necessary when the vendor’s credit rating is “A” or better. ____ a) True ____ b) False Question 3: In a first loss deficiency guarantee, the amount of the vendor’s liability is reduced by: ____ a) the amount of the vendor’s loss when it is unable to repossess and resell equipment. ____ b) the difference between the amount of the original transaction and the restructured transaction. ____ c) the difference between the purchase price of the equipment and the resale proceeds. ____ d) the percentage specified in the FLDG agreement (for example, 20 percent). Question 4: In an asset value guarantee (buy back), the vendor: ____ a) reimburses the creditor if the collateral resale value is below market price. ____ b) purchases defaulted contracts from the creditor. ____ c) agrees to repossess and resell the equipment. ____ d) is a certain, secondary market.

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ANSWER KEY

Question 1: In a full recourse arrangement, the creditor’s credit risk is: c) 0 (zero) percent. The vendor assumes all the credit risk.

Question 2: Requiring the vendor to share credit and/or collateral risks is not necessary when the vendor’s credit rating is “A” or better. b) False The reason we ask vendors to share risks is to create a financing arrangement that will be attractive enough to motivate the vendor’s customers to buy while permitting Citibank to attain its target margin. The credit rating of the vendor is not a factor.

Question 3: In a first loss deficiency guarantee, the amount of the vendor’s liability is reduced by: c) the difference between the purchase price of the equipment and the resale proceeds. Question 4: In an asset value guarantee (buy back), the vendor: d) is a certain, secondary market. In an asset value guarantee, the vendor agrees to buy back collateral that the creditor repossesses at the price specified in the AVG schedule; thus, the vendor is a guaranteed secondary market.

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Question 5: Turn-around time in a co-lending arrangement is typically: ____ a) slow. ____ b) fast. ____ c) medium.

Question 6: Select the two risk sharing mechanisms that may best benefit the creditor when the secondary market is questionable. ____ a) Full recourse ____ b) Asset value guarantee ____ c) Co-lending ____ d) First loss deficiency

Question 7: Select two signs that may indicate that company is a good candidate for a vendor program. ____ a) The vendor’s customers have limited access to capital. ____ b) Equipment resale values are stable. ____ c) The equipment manufacturer’s market share is low and they need to sell more equipment. ____ d) The vendor’s products are permanent fixtures that are unlikely to “disappear.”

Question 8: A vendor program should be structured to allow a high transaction approval rate and quick turn-around time. ____ a) True ____ b) False

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ANSWER KEY

Question 5: Turn-around time in a co-lending arrangement is typically: a) slow. Both the vendor and the creditor must approve each transaction separately, which tends to take more time.

Question 6: Select the two risk sharing mechanisms that may best benefit the creditor when the secondary market is questionable. a) Full recourse b) Asset value guarantee

Question 7: Select two signs that may indicate that company is a good candidate for a vendor program. a) The vendor’s customers have limited access to capital. b) Equipment resale values are stable. The vendor should hold the dominant position in key markets, and the collateral should be moveable so that repossession is easier.

Question 8: A vendor program should be structured to allow a high transaction approval rate and quick turn-around time. a) True The vendor will sell more equipment under these conditions.

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Unit 10

UNIT 10: FRANCHISE FINANCING

INTRODUCTION

In Unit Nine, you learned about vendor finance, one of the programs Citibank uses to advance its asset based financing activity. In this unit, we discuss another such program − franchise financing. The purpose of this unit is to help you understand the nature of this industry and the factors that affect franchise lending decisions. You will see that a banker’s approach to franchise financing is somewhat different from the approach to leasing.

UNIT OBJECTIVES

When you complete this unit, you will be able to: + Recognize common terminology associated with franchise financing + Understand the franchise financing markets + Identify the key considerations in franchise credit analysis + Understand the legal considerations of franchise finance

WHAT IS A FRANCHISE?

In this section, we explain what a franchise is and define common terms used in this industry. We also look at the types of franchise stores and ownership options. This overview will prepare you for the concepts presented in the remainder of the unit.

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Franchise Industry Terms Definitions of key terms

A franchise is a license offered by a company that grants the right to others to sell its products and operate under the same business name. For example, the Taco Bell restaurant system sells franchise licenses to owner/operators so that they can open Taco Bell restaurants and sell the same food products as other Taco Bell outlets. The company that sells licenses to operate under its business name is called a franchisor. The owner/operator who purchases the license is called the franchisee.

Agreements

The license is governed by a franchise agreement for which the franchisor requires an up-front franchise fee, ongoing royalties, and advertising fees. The franchise agreement spells out the responsibilities of the franchisor and franchisee, defines remedies for agreement violations, and specifies the renewal options and the period covered by the agreement. A key component is the right of the franchisor to terminate the franchise agreement if the franchisee fails to perform and remedy any default. Later in this unit, we describe how these provisions affect lenders such as Citibank. Typically, in addition to the franchise agreement, a franchisee signs an agreement for the right to develop stores in a given territory. This development agreement specifies the number of stores to be opened in the territory and the number of years in the development period.

Advantages

In addition to the right to sell under a recognized name, a franchise agreement provides a franchisee a system for doing business and many other valuable services that give a franchise business strength and value. Franchises are popular for this reason.

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Franchisor screening

10-3

It is important to note that franchisors receive many applications for franchise licenses, but grant the right to own and operate a franchise to few. Franchisors carefully screen applicants for successful business experience and financial strength. Franchisors also require successful completion of in-store training and textbook courses. What this means to Citibank is that those who are granted franchises may tend to be better risks. Also, the franchisor may serve as an important source of information about the prospect.

Franchise Sales Outlets Outlet types

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The types of stores a franchisee may open depend on the types the franchisor offers. It is important for you to understand the types of outlets because different store types have different collateral values. The basic types of outlets you are likely to encounter are these: Free-standing

Store is free-standing and not attached to any other building

In-line

Store is one of many businesses in a given building, which is usually a strip center with several vendors or tenants. Customers access each business from outdoors.

In-mall

This is an outlet that is inside an enclosed shopping area called a mall. Customers access the outlet from inside the mall. The store may have its own seating or may share seating with other food outlets in what is called a food court.

Kiosk

This is a small unit that sells a cooked product prepared at a different location. The cooked product is brought to the kiosk during the peak hours; the menu offerings are limited. Kiosks are prefabricated and require assembly, making them somewhat portable.

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DELCO

This is a term used by Pizza Hut, and is an acronym for “delivery and carry-out.” This type of outlet does not have seating.

Express unit

This is another term used by Pizza Hut. It refers to restaurants that sell only small personal pizza (for one person) and pizza by the slice.

Ownership Options Companies that sell franchises to owner/operators may also own and operate their own stores and enter partnership agreements to own and operate stores. Citibank does not finance company-owned stores; the stores must be 100% franchised. Categories

Of course, even though a restaurant is 100% franchised, the franchisee still has various options for owning the land, building, furniture, fixtures, and equipment. Let’s look at the three categories of ownership: Fee Simple

The franchisee owns the land, building, furniture, fixtures, and equipment (LBFF&E). Ground Lease

The franchisee leases the land from a third party and constructs the building. Here, the franchisee owns the building, furniture, fixtures, and equipment (BFF&E).

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Land and Building Lease (Leasehold)

The franchisee finds an investor who owns the land and is willing to construct the building and lease the property to the franchisee for a specific period. The franchisee owns only the furniture, fixtures, and equipment (FF&E). Each of the options described above has product, legal, and credit implications for Citibank. Later in this unit, we will see how Citibank’s franchise finance products and credit practices address the franchisee’s financing needs. First, let’s examine the franchise industry markets.

FRANCHISE INDUSTRY MARKETS

So far, you have been introduced to common franchise industry terms, various types of franchise stores, and ownership options available to the franchisee. Keep this background in mind as we discuss franchise industry markets.

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Fast-food restaurants

FRANCHISE FINANCING

The franchise industry consists mainly of fast-food restaurant systems such as Burger King, Kentucky Fried Chicken (KFC) , McDonalds, Pizza Hut, and Taco Bell. We often refer to a restaurant system as a concept. Citibank Bankers Leasing - Franchise Finance (CBL-FF), located in Irvine, California, is a national lender to major fast-food concepts in the U.S. Included in its loan portfolio are franchisees of the restaurant concepts listed above, which are considered Tier I business. Citibank defines Tier I business as the top two franchise concepts in total sales in each primary food group. For example, in the U.S., McDonalds and Burger King are the Tier I hamburger concepts. We will have more to say about Tier I concepts in the next section. Tier II businesses are national or regional chains with strong market share or concentration in a given area. Citibank does finance some Tier II restaurant concepts, as well as gas station franchises, but is selective about lending to these businesses. Also, Citibank may consider other types of franchised businesses. (Some retail stores and dry cleaning companies offer franchises.) Tier I Franchise Restaurant Systems

Strengths

A major reason that Citibank focuses on Tier I concepts is that they provide many important services and benefits that improve the franchisees’ chances of success. Among these are: +

Good initial and ongoing training

+

A proven system for developing uniform and consistent products

+

Advertising and marketing expertise

+

Good restaurant site selection criteria and support

+

Supplier arrangements

+

Brand name recognition

Let’s examine three of these services and see how they contribute to the success of the business.

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Franchisor Operations and Control Systems Forced compliance with standards

Tier I franchisees are expected to follow prescribed operating and food preparation procedures and standards that promote consistent quality, service, and cleanliness throughout the restaurant system. Franchisors monitor and audit franchises throughout the year and expect those who fail to meet standards to remedy the problem within a given time, often with the frachisor’s help. From a loan officer’s view, the expected consistency and regular monitoring help maintain the value of the business. Site Selection Expertise

Site studies

One of the many benefits to Tier I franchisees is the site selection expertise the franchisor provides. Tier I franchisors develop site selection studies to identify preferred or ideal sites and make the criteria available to franchisees. The study and criteria do not guarantee success, but have proven to be a very good tool for identifying good restaurant sites. As a safeguard, the franchisee is not permitted to begin construction until the franchisor has approved the site, the store plan, and the architecture.

Sales projections

Franchisees use the information gathered during the site study to project sales and cash flows on the proposed site and review these projections with the franchisor to determine how reasonable they are. Later, we will see how Citibank uses these projections in credit analysis. The point you should remember is that from a lender’s standpoint, careful site selection and realistic projections tend to lessen the risk of default.

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FRANCHISE FINANCING

Supplier Arrangements Approved products and equipment

Tier I franchisors work with franchisees to identify suppliers of equipment and inventory to make the product for a restaurant. A supplier may be the franchisor, a local company, or a foreign supplier. In any case, franchisors work to ensure that suppliers distribute approved products and equipment to the franchisee. Like the other services we’ve discussed in this section, supplier arrangements help increase the franchisee’s chances of success. As you can see, there are many advantages in lending to Tier I concepts. Next, we will look at the status of the fast-food industry in the U.S. and see how business there has influenced interest in other markets such as Latin America.

The U.S. Franchise Industry Slow growth

In the U.S., the fast-food business is a maturing industry that continues to grow at a slow pace. In 1992 and 1993, the growth rate was 3%, with the same rate forecasted for 1994. There is an over supply of fast-food restaurants competing for market share, making the market highly competitive.

Foreign Markets Expanding opportunities

Because growth opportunities are limited in the U.S., companies that franchise fast-food restaurants are expanding in Asia, Europe, Latin America, and the Caribbean. In Latin America and the Caribbean alone, fast-food companies will require an average of US$241MM in capital investment from their franchisees per year. This investment represents 237 new stores per year that require financing! As you can see, the significant expansion planned by these companies presents a huge opportunity for Citibank, which is positioning itself to take a large portion of this business.

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Agreements with franchisors

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One way that Citibank is helping increase its market share is through cooperative agreements with franchisors. An example is the letter of understanding with the PepsiCo Group, which includes KFC, Pizza Hut, and Taco Bell restaurant companies. This agreement states that the PepsiCo Group and Citibank will work together and share information to increase finance capability in Latin America and the Caribbean (CARIBLA). Of major benefit to Citibank is the support and assistance PepsiCo provides to resolve loan default situations that may arise. For example, if a franchisee defaults on a Citibank loan or lease, a member of the PepsiCo group assists Citibank in: +

Locating another franchisee capable of assuming operation of the business

+

Reviewing the franchisee’s business to determine if it is a viable operation

+

The sale of the franchisee’s business

CBL-FF is discussing similar arrangements with other franchisors. It is important to remember that Citibank’s relationship with a franchisor is a key factor in building a successful franchise portfolio.

FRANCHISE FINANCE PRODUCTS AND PROSPECTS

The preceding discussion of franchise industry markets revealed that the franchise market is expanding in Latin America and the Caribbean. Next, we will examine Citibank’s franchise finance products and explore ways to identify and take advantage of these growing franchise finance opportunities.

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FRANCHISE FINANCING

Franchise Products Asset types and tenors

In both Latin America and the U.S., Citibank provides financing for real estate and furniture, fixtures, and equipment to licensed franchisees. In this unit, we focus on loans, but you should note that Citibank will consider leasing equipment to franchisees in Latin American markets as well. Loan tenors offered depend on the asset to be financed. In the U.S., funds are offered for tenors of five, seven, and ten years, with up to fifteen years amortization on land and building loans. Most franchise loan products fall into three main categories: secured term loans, secured nonrevolving lines of credit, and fee simple real estate loans. All loan products are secured by a pledge of collateral. Let’s examine each category. Secured Term Loans

Old and new obligations

These loans are issued for financing existing and new stores, refinancing and consolidating existing debt, market acquisitions (one operator buys existing stores from another franchisee), and financing personal obligations such as stock repurchases. Secured Nonrevolving Lines of Credit

Project financing

Financing of new stores is often done with a line of credit that converts to term financing upon the completion and opening of the new store (a form of project financing). Lines are generally available for a one- or two-year period. Citibank does not provide working capital. Fee Simple Real Estate

Longer terms

Longer term financing (up to 10-year tenors with 15-year amortization) is provided when there is real estate collateral. Typically, a rate review is scheduled about midway through the loan term.

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You can see that Citibank provides products to meet all a franchisee’s capital and real estate needs, from furniture and fixtures to building and land. With this knowledge, you are better prepared to search for franchise financing opportunities.

Franchise Financing Opportunities Identify opportunities

Franchise financing opportunities come in many forms. Look for remodeling projects, expansion projects, and system upgrades. Also be alert for the introduction of new products. New products often mean the franchisee must acquire new equipment to produce the product!

Quantify opportunity

Once you’ve identified an opportunity, find out whether the opportunity is large enough to justify Citibank’s involvement. How many outlets are franchisee operated, and how many are company operated? What is the dollar size of the financing project? How many outlets are affected? What is the timing? What type of operator needs the financing (average, good, poor)? Who are the existing lenders?

Assess collateral

Next, consider the collateral. Who controls the location? What assets are owned by the operator? (Generally, the more control over the property Citibank has, the more attractive the deal.) What franchisor support is available?

Evaluate agreements

Finally, examine the franchise and lease agreements. What is the length of the agreements? What are the renewal options? What are the responsibilities and obligations of each party? What remedies are available to the franchisor for noncompliance? What is the operator turnover history? Are there exclusive rights to a territory? What are the fees and costs? Are there restrictions on operating other types of businesses? As you begin to work on franchise deals, we suggest that you periodically review this process to make sure you have complete information for an assessment of the opportunity.

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FRANCHISE FINANCING

SUMMARY

A franchise is a license offered by a company (franchisor) that permits an owner/operator (franchisee) to sell the franchisor’s products and operate under the same business name. The license is governed by a franchise agreement that details the rights and remedies of each party to the agreement. Franchises are attractive because they offer name recognition, leverage with suppliers, business expertise, training, and a system of operations and controls. The franchise industry market consists mainly of fast-food restaurant systems. Such restaurant systems are referred to as concepts. Citibank targets Tier I concepts, which are the top two franchise concepts in total sales in each food product group. The reason for this focus is that Tier I concepts provide many important services to their franchisees that tend to increase the franchisee’s ability to succeed. There are several types of fast-food franchise outlets, each with a different collateral value. Collateral value is also determined by the type of ownership option the franchisee chooses (fee simple, ground lease, leasehold). Citibank finances land, buildings, furniture, fixtures, and equipment with secured term loans, secured nonrevolving lines of credit, and real estate loans. Once a franchise financing opportunity has been identified, it is important to quantify the opportunity, assess the collateral, and evaluate the terms in the franchise agreements to adequately judge its value to Citibank. You have completed the first part of Franchise Financing. Please complete the Progress Check and then continue with the section on “Credit Analysis.” If you answer any questions incorrectly, please review the appropriate text.

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]

PROGRESS CHECK 10.1

Directions: Determine the correct answer to each question. Check your answers with the Answer Key on the next page. Question 1: A license offered by a company that allows an owner/operator to open and operate an outlet under the company’s business name is called a(n) __________________________.

Question 2: Match each ownership option with a description of the option. Write the letter of the description next to the name of the option. Ownership Option

Description

______

Leasehold a) The franchisee leases the land and owns the building, furniture, fixtures, and equipment.

______ Lease

Ground

b) The franchisee owns the land, building, furniture, fixtures, and equipment.

______ Simple

Fee

c) The franchisee leases the land and building and owns the furniture, fixtures, and equipment.

Question 3: The franchise industry consists solely of fast-food restaurant systems such as KFC, McDonalds, and Pizza Hut. ____ a) True ____ b) False

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ANSWER KEY

Question 1: A license offered by a company that allows an owner/operator to open and operate an outlet under the company’s business name is called a franchise agreement.

Question 2: Match each ownership option with a description of the option. Write the letter of the description next to the name of the option. Ownership Option c

Leasehold a) The franchisee leases the land and owns the building, furniture, fixtures, and equipment.

a

Ground

b) The franchisee owns the land, building, furniture, fixtures, and equipment.

b

Fee

c) The franchisee leases the land and building and owns the furniture, fixtures, and equipment.

Lease

Simple

Description

Question 3: The franchise industry consists solely of fast-food restaurant systems such as Kentucky Fried Chicken (KFC), McDonalds, and Pizza Hut. b) False Gas stations, laundry and dry cleaning companies, retail stores, and other companies offer franchises.

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Question 4: Select two basic characteristics of Tier I markets that influence the value of their franchise outlets: ____ a) Promote consistent standards of quality and service ____ b) Help resolve loan default situations ____ c) Provide good initial and ongoing training ____ d) Guarantee the franchisee’s debts Question 5: The purpose of a site study is to: ____ a) obtain site approval from the franchisor. ____ b) ensure that product and equipment suppliers are available in the area. ____ c) identify good locations for outlets. ____ d) determine the value of the land collateral. Question 6: Select the franchise loan product offered for refinancing, consolidating existing debt, and purchasing existing stores from another franchisee. ____ a) Secured term loan ____ b) Secured non-revolving line of credit ____ c) Fee simple real estate Question 7: Select the two best franchise financing opportunities: ____ a) A Taco Bell franchisee plans to expand ten outlets. ____ b) A new restaurant chain begins to offer franchises in your country. ____ c) A Pizza Hut franchisee needs to replace two ovens. ____ d) KFC introduces a new chicken product that requires different cooking equipment.

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FRANCHISE FINANCING

ANSWER KEY

Question 4: Select two basic characteristics of Tier 1 markets that influence the value of their franchise outlets. a) Promote consistent standards of quality and service c) Provide good initial and ongoing training Franchisors do not normally help resolve loan default situations unless they have a prior agreement with the lender to do so.

Question 5: The purpose of a site study is to: c) identify good locations for outlets.

Question 6: Select the franchise loan product offered for refinancing, consolidating existing debt, and purchasing existing stores from another franchisee. a) Secured term loan

Question 7: Select the two best franchise financing opportunities. a) A Taco Bell franchisee plans to expand ten outlets. d) KFC introduces a new chicken product that requires nonstandard cooking equipment. The opportunities that involve a number of outlets are most likely to result in transactions that are large enough to justify Citibank’s effort.

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CREDIT ANALYSIS

So far, we’ve seen that franchise financing, particularly of Tier I concepts, can be an attractive market for lenders because of the many benefits they offer franchisees, and that the value of a transaction is affected by the size of the deal and the type of collateral that secures the loan. In this section, we will see how these ideas are applied in franchise credit analysis. Four aspects

As you may have concluded from our earlier discussions, the credit analysis process for franchise financing is somewhat different than the process for other types of asset based financing because of the nature of the industry. In the following sections, we discuss three aspects of franchise credit analysis: +

Industry risks and offsets

+

Ways out

+

Information requested from the borrower

We begin with the types of industry risks in franchise financing.

Industry Risks and Offsets Portfolio level

There are several credit risks inherent in the franchise industry that are important for you to know. We label these risks industry or program risks because they are usually addressed in the broader context of the franchise portfolio rather than in individual credit memos. In this section, we discuss five such risks. This discussion will increase your understanding of the franchise industry and the strategies lenders use to minimize franchise industry risks. Market Share

Competition risk

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The franchise fast-food industry is a maturing market where competition is intense. The battle for market share increases the level of risk within this industry.

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Offset strategies

FRANCHISE FINANCING

To minimize this risk, lenders such as Citibank may use these strategies: +

Target franchises with strong market share and strong financial strength (relative to the industry) that maintain strong name recognition through effective marketing campaigns.

+

Avoid overexposure to any one market segment.

+

Lend only a portion (for example, 80%) of the estimated collateral value to maintain an adequate collateral cushion, and use financial ratio covenants (agreement clauses in the loan contract) to identify financial deterioration early on.

Fraudulent Conveyance Transfer of security interests

For tax or other ownership reasons, it is common for fast-food franchisees to establish several companies under which they operate their restaurants. These business owners may use properties they own from one company to back a loan for one of their other companies. Sometimes, prior to bankruptcy, an owner may transfer ownership of an asset from one company to another to avoid debt or to hinder creditors. This is called fraudulent conveyance. In addition to fraudulent conveyance, the concern to an asset based lender is that other creditors may legally void transfers of security interests under certain circumstances, even when there has been no intent to defraud. Here are some approaches for offsetting this risk: +

Investigate the borrower’s viability during the due diligence process and document the rationale for doing the deal.

+

Avoid structuring deals with cross-stream (subsidiary guarantees another subsidiary) and upstream (subsidiary guarantees parent company) guarantees whenever possible.

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+

Include solvency provisions drafted from the region’s applicable fraudulent conveyance statutes along with financial projections as an exhibit to the loan agreement. Obtain written acknowledgments of the lender’s security interest (lien) from major suppliers and from the company’s officers.

Commodity and Labor Price Increases Effect on cash flow

Commodity prices are relatively stable, but unpredictable. Labor costs may increase because of labor shortages, minimum wage legislation, and requirements for minimum health benefits. Increases in these costs could adversely affect the borrower’s cash flow.

Business solutions

Franchisors and franchisees have some control over these risks. Franchisees can pass on some or all of a cost increase to their customers by increasing menu prices. To offset commodity cost increases, franchisors can change their product mix, offering a lowercost item to offset the more costly commodity. The major franchisors address the cost of labor by automating their food preparation processes to limit the amount of workers needed.

Coverage ratios

One way lenders mitigate these risks is by requiring the borrowers to maintain cash flow coverages greater than 1:1 (the point at which the cash flow available to cover debt is exactly same as the debt service requirement of the business). The coverage ratio is set to provide a cushion so that cash flow will still cover costs if they should increase. No Security Interest in the Franchise Licenses

Right to sell as going concern

Franchise licenses generally prohibit lenders from taking a security interest in the franchise rights. This means a lender such as Citibank can’t sell or take over the operation of stores it has financed. Here are two ways this type of risk may be mitigated:

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FRANCHISE FINANCING

+

Execute a letter of understanding with the franchisor to gain the franchisor’s assistance in evaluating the location in the event of a default and in locating a new franchisee to buy the store.

+

Secure a first perfected interest in the furniture, fixtures, and equipment of the restaurant, real property/leasehold rights, and a pledge of stock (if possible). This is a legal approach that helps Citibank keep the restaurant open until a buyer is located and bars the franchisor or third party from taking security interest or obtaining clear title to the site before Citibank.

Lender Liability Under Environmental Law Cleanup costs

Many countries have laws to regulate the emission, discharge, and handling of hazardous waste. If these laws make owners of contaminated properties liable for cleanup costs and consider a secured lender an owner, a lender may be responsible for the costs of cleaning the site. The risk is usually in the restaurant site’s previous use. If the site was contaminated by a previous user and the site was not cleaned or was not cleaned properly, the lender could be liable. It is important for your unit to understand the laws in your region and take steps to mitigate the risks.

U.S. mitigation strategies

In the U.S., Citibank manages environmental liability risks by not exercising undue control over the property and by not foreclosing on properties that could be contaminated. Also, CBL-FF’s practice of lending to multi-unit operators helps spreads the risk over several properties. Citibank’s risk is further mitigated by its standard loan provisions and documentation, which require the borrower to indemnify Citibank of all potential liabilities relating to a hazardous waste cleanup and allow Citibank to perform environmental audits on any site at the borrower’s expense. Of course, even if Citibank isn’t held liable, a real risk is the loss of revenue caused by the interruption of the business during a cleanup period. In the U.S., this risk is mitigated by the business interruption insurance that many of our borrowers carry.

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As you can see, a creditor has a number of risks and mitigants to consider in the credit analysis process. In the next section, we discuss another set of considerations − ways out.

Ways Out Two ways out

Earlier in this course, we stated that in asset based financing there is a greater need to analyze “ways out” than in other types of financing. Recall that “ways out” refers to the ways an obligation is satisfied. In this section, we look at three ways franchise debt is satisfied. As you read about these, keep in mind that the ways out of a particular transaction depend on the transaction’s structure, the nature of the assets involved, and the specific markets involved. Cash Flow from Operations

Covers debt service

The first “out” a lender relies on is that cash flow from operations (either historical or projected) covers debt service by a specific margin. In franchise financing, there is more reliance on cash flow than collateral. The goal here is to structure transactions that do not require the sale of assets or stores to repay debt. Sale of Stores

Value as a going concern

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If cash flow fails, debt may be satisfied through the sale of a store, group of stores, or the entire company. Since the franchise credit philosophy is based on the value of the restaurants as going concerns, the borrower is encouraged to sell the store as a going concern (with the assistance and approval of the franchisor). This option is possible because of the strong secondary market that exists in most countries for the restaurants of certain concepts, particularly Tier I concepts.

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FRANCHISE FINANCING

Sale Leaseback Proceeds from sale to pay debt

For franchisees who own the real estate under their restaurants, sale leasebacks are an option to satisfy obligations. In a sale leaseback, the franchisee sells the property and then leases it back. The proceeds of the sale may be used to pay down debt while the franchisee continues to operate the restaurant. Credit Analysis Information

Items requested from borrower

Now that we’ve seen the industry (program) risks in franchise financing and some of the ways lenders address these risks, we’ll shift our focus to individual transactions. In this section, we present a list of items the officer requests from the borrower to assess credit capacity.

Proposal and commitment letter

Before we begin the list, let’s review two types of documents we issue the potential borrower − the proposal and the commitment letter. The proposal outlines the terms and conditions under which Citibank is willing to consider a credit application and recommend approval to a Citibank credit officer. It includes the loan to value ratio (the ratio of the loan amount to the value of the collateral), interest rates, and covenants. A commitment letter is an acknowledgment of credit approval and availability, and includes all terms and conditions. The items described below represent information the officer gathers before issuing a proposal and commitment letter. Ideally, the officer obtains and analyzes all the items. Of course, it may not be possible to obtain every item for every transaction! We recommend that you view this list as a set of guidelines and ask for direction from CBL-FF when you are unable to obtain an item. Business Financial Statements

Balance sheet and income statements

Accountant-prepared financial statements and internally prepared financial statements should include the following:

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+

Balance sheets, income statements, changes in financial position, and sources and uses of funds for − Each of the last three year-end periods − The most current year-to-date period and for the comparable prior year-to-date period

+

On both an annual basis and on a per-month basis, individual and consolidated store sales history for the last three-year period and, if available, through the current year-to-date period.

Projections Individual store and group figures

Recall that franchisees generate projections from information gathered during the site study. You should request these sales projections for each individual store and for the group of stores the franchisee owns. Projections for new stores should be for the first 12 months of operations. Request that the franchisee prepare the projections in the same format as the internally prepared profit and loss statements, as this will simplify the analysis. Ownership Structure

Identify management structure

Request a list of all affiliated and interrelated companies and the owners of each company. With regard to multiple owners or shareholders, identify the percent of ownership of each owner/shareholder. Also ask for an organization chart. Personal Financial Statements

Owners’ financial position

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Request a personal financial statement for each major owner or shareholder that lists all assets, liabilities, and net worth.

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FRANCHISE FINANCING

Store Information

Ask for a list of all the stores the franchisee operates, and the following information on each store: +

Restaurant type (free-standing, mall, in-line, etc.)

+

Owned or leased

+

Opening date

+

Monthly rent payment and lease expiration date

Existing Lease and Loan Information Current debt

For each lease and loan, request the debt amount (original balance and current balance, payment amount and frequency of payment), annual interest rate, collateral for the loan (type and location), maturity date of financing, and owner/shareholder personal guarantees. Capital Investments/Financing Needs

Capital needs

This includes detail of the capital investment requirement by location and by use (such as land, building, equipment, furniture and fixtures, initial inventory, working capital). Also find out the projected opening date for each store. Documentation

Before issuing a commitment letter, the officer should obtain and review copies of the following: +

Franchise and development agreements Franchise agreements usually change with time and differ among franchisors; therefore, an officer should always review the agreement carefully to understand terms, conditions, rights, and remedies of both parties.

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+

Applicable deeds of trust when Citibank finances properties in which the land and building is owned by the franchisee

+

Applicable leases on the subject store properties when Citibank finances leasehold properties

+

Applicable articles of incorporation. These are documents filed with a government body authorizing a business to act as a legal entity. This document describes ownership, shareholders, board of directors, and type of business.

+

Site/demographic studies for proposed sites

As you can see, the type of information the officer gathers for franchise financing credit analysis is similar to the information gathered for leasing and vendor credit analysis. In the next section, we will see how this information is used in the credit analysis process.

SUMMARY

In this section, we discussed three aspects of credit analysis for franchise financing: industry risks and offsets, ways out of a franchise obligation, and credit analysis information requested from the borrower. We saw that there are several risks inherent in the franchise industry: +

The battle for market share

+

Fraudulent conveyance

+

Commodity and labor price increases

+

Lack of security interest in the franchise license

+

Lender liability under environmental law

Industry considerations are generally addressed at the portfolio level. Another set of considerations − the ways out of a franchise obligation − include cash flow from operations, sale of stores, and the sale/ leaseback.

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FRANCHISE FINANCING

To assess creditworthiness, the officer requests several types of credit information from potential franchise borrowers: financial history and sales projections, the ownership structure and personal financial statements, existing lease and loan information, financing needs, and documentation (franchise agreements, deeds of trust, lease agreements, articles of incorporation, and site studies). You have completed the first part of the section on “Credit Analysis.” Please complete the Progress Check and then continue with the section “Credit Analysis Process.” If you answer any questions incorrectly, please review the appropriate text.

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]

PROGRESS CHECK 10.2

Directions: Determine the correct answer to each question. Check your answers with the Answer Key on the next page. Question 1: When franchisees transfer the security interests in property of one company to another company they own, the lender may be at risk for __________________________.

Question 2: To reduce the risks of commodity and labor price increases, lenders can: ____ a) require the borrower to maintain a cash flow ratio greater than 1:1. ____ b) execute a letter of understanding with suppliers to limit price increases. ____ c) encourage the franchisee to automate food preparation. ____ d) require covenant ratios for capital expenditures and minimum equity. Question 3: Lenders to franchised businesses prefer that franchisees satisfy debts through ____________________.

Question 4: Compared to leasing and vendor credit, the type of credit information a lender requests from a franchise prospect is: ____ a) usually more trustworthy. ____ b) more detailed. ____ c) very much the same. ____ d) more sales-oriented.

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ANSWER KEY

Question 1: When franchisees transfer the security interests in property of one company to another company they own, the lender may be at risk for fraudulent conveyance.

Question 2: To reduce the risks of commodity and labor price increases, lenders can: a) require the borrower to maintain a cash flow ratio greater than 1:1. Lenders usually have no say over supplier prices or food preparation methods, and capital expenditures and equity do not affect commodity and labor prices.

Question 3: Lenders to franchised businesses prefer that franchisees satisfy debts through cash flow.

Question 4: Compared to leasing and vendor credit, the type of credit information a lender requests from a franchise prospect is: c) very much the same.

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Credit Analysis Process The type of information the officer gathers from a prospect was discussed in the previous section. The next step is to analyze the information. In this section, we focus on several aspects of the franchise financing credit analysis process. You will see some similarities to the process used in equipment leasing, but you will also see several differences. What are the reasons for the differences? Comparison to equipment financing

Like equipment leasing, franchise financing is secured by one or more assets (the land, building, and the furniture, fixtures, and equipment). The difference between equipment financing and franchise financing is that franchised stores do not have the same remarketing characteristics as equipment; they are less liquid and more difficult to remarket. For this reason, lenders rely more on the ability of the business to produce cash flow to repay debt rather than on the value of the collateral. Once installed, the equipment financed is worth very little. Risks are mitigated through the analysis of the business value of the store. The goal is to structure transactions that do not require the sale of assets or stores to repay debt. Keep this concept in mind as you read about the components of the credit analysis. Consolidated Historical Profit and Loss Spreads

If the franchisee already owns and operates one or more outlets, we develop a consolidated profit and loss spread for analysis. In Figure 10.1, we show the recommended format for the spread. Notice the type of items we spread to calculate earnings before depreciation, interest expense, and income taxes (EBDIT). These items (food and paper, store labor, etc.) are typical expenses in the fast-food industry. Also note that we look at both post-compensation and precompensation figures in computing cash flow. This is because officers’ salaries are usually discretionary.

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Expense, cash flow comparison

FRANCHISE FINANCING

The consolidated profit and loss spread provides a basis for comparing the performance of the franchisee to another operator of the same concept or to the average operator of the concept in your portfolio. The spread reveals whether the prospect has high or low food and paper, labor, and rent expenses, and how good of a cash flow generator the business is compared to others. This spread is also used to: +

Determine trends

+

Analyze the consistency of sales and cash flow

+

Calculate debt service capacity

In the next section, we discuss one of these purposes − debt service capacity − in detail.

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Debt Service Capacity Formula

Recall that debt service capacity is a measure of a prospect’s ability to repay debt. To calculate debt service capacity, we divide cash flow (cash available to repay principal and interest on current and future debts) by debt service (sum of the principal and interest on all loans and capital leases). Here we see this concept expressed as a formula:

Net Income + N o n C a s h Charges + Interest Expense + Excessive O w n e r s ' C o m p e n s a tion Current Portion of L ong Term Debt and Capital Leases + Interest Expense

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Cash flow less capital expenditures

When computing debt service capacity for franchise financing, it is important to consider the franchisee’s ongoing capital expenditures (CAPEX). CAPEX may include painting, parking lot resurfacing, uniforms, and replacement of kitchen cooking utensils. If capital expenditures are not expensed and included in the profit and loss statement, we subtract them from the cash flow available to service debt.

Ability to generate cash flow

Once we have calculated the debt service capacity of the prospect, we can compare it to the debt service coverage ratio on the Risk Asset Acceptance Criteria (RAAC). The RAAC used in the U.S. is shown in Figure 10.2. Under part II, note the minimum debt service coverage ratios required for the subject concepts. Under what conditions should a higher ratio be required? Generally, the greater the inconsistency of sales and cash flows, the larger the number of new stores being financed, or the more leveraged the borrower, the higher the debt service coverage should be. Because a franchise is a cash flow business, lenders to this industry measure a borrower’s ability to repay debt more conservatively compared to measuring debt coverage in traditional middle market banking.

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Individual Store Profit and Loss Statements Compare individual stores

There are two reasons for reviewing each individual store’s sales history and financial statements. The first is to identify any bad locations. If the franchisee plans to open a new store in an unprofitable area, you should question the reasons.

Projection assessment

A second purpose for reviewing these statements is to analyze changes in annual sales. This trend and history data help us determine whether the franchisee’s projections, which we discuss in the next section, are reasonable, conservative, or aggressive. Profit and Loss Projections

Line item comparison

For a valid analysis, it is important that all items on the historical profit and loss statements appear in the profit and loss projection supplied by the prospective borrower. This means that you need to review each line item on the historical statements to make sure that each has been accounted for on the projection.

Projection categories

It is easier to compare figures when we spread projections in the same format as the historical consolidated profit and loss statements, but with data divided into three category columns. The three categories are:

Example

+

Projections for existing stores only

+

Projections for new stores only

+

Consolidated projections for existing and new stores

In Figure 10.3 we show an abbreviated example of projection spreads. Note that the example includes columns for year-end and year-to-date historical figures. This is so we can compare projected numbers to historical profit and loss figures.

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We need to caution you on a few important points. It is important for you to understand the franchisor’s site selection process to adequately assess the projections presented by a franchisee. Also, you should always verify with the franchisor the integrity of the information the franchisee provides and confirm that store sales, cash flows, and the cost to build the store are reasonable. Prior to funding a loan, you should obtain verbal or written confirmation from the franchisor that the store plan and architecture has been approved.

SUMMARY

So far, we’ve looked at several aspects of the credit analysis process: +

Consolidated historical profit and loss spreads

+

Debt service capacity

+

Individual store profit and loss statements

+

Profit and loss projections

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The consolidated profit and loss spread is used to compare the performance of a franchisee who owns more than one outlet to other franchisees. The items compared include food and paper, labor, and rent expenses. The spread also reveals the business’ success in generating cash flow. Other areas of particular interest are trends, sales consistency, and debt service capacity. Debt service capacity is a measure of the franchisee’s ability to repay debt. To calculate debt service capacity, we divide cash flow by the sum of the principal and interest on all debt. We compare the ratio derived from this calculation to the target debt service coverage ratio on the Risk Asset Acceptance Criteria (RAAC). Other considerations, such as inconsistency of sales and cash flows, the number of stores being financed, and the prospect’s leverage, also influence the acceptability of the prospect’s debt service capacity. We review the sales history and financial statements for each store to identify bad locations and to compare trend and sales history to the franchisee’s projections. This comparison reveals how reasonable the projections are. For a valid comparison, all item s on the historical profit and loss statements must be included in the projections. You have completed the first part of “Credit Analysis Process.” Before you continue with this discussion, please complete the Progress Check. If you answer any questions incorrectly, please review the appropriate text.

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PROGRESS CHECK 10.3

Directions: Determine the correct answer to each question. Check your answers with the Answer Key on the next page. Question 1: A consolidated profit and loss spread is used to compare the franchisee’s performance with that of other operators. ____ a) True ____ b) False Question 2: Select two factors that affect the required debt service coverage: ____ a) fluctuations in sales and cash flows. ____ b) low liquidity. ____ c) number of stores financed. ____ d) capital expenditures. Question 3: We use the results of the trend and sales history analysis of individual profit and loss statements to: ____ a) determine whether the consolidated historical statements are valid. ____ b) compare labor, food and paper, and rent expenses. ____ c) calculate debt service capacity. ____ d) help determine whether the projections are reasonable. Question 4: Understanding the franchisor’s site selection process: ____ a) helps the officer identify questionable locations. ____ b) is necessary to adequately assess new store sales projections. ____ c) prepares the officer to compare rent expenses. ____ d) assures the officer that the franchisor has approved the store plan and architecture.

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ANSWER KEY

Question 1: A consolidated profit and loss spread is used to compare the franchisee’s performance with that of other operators. a) True

Question 2: Select two factors that affect the required debt service coverage: a) fluctuations in sales and cash flows. c) number of stores financed.

Question 3: We use the results of the trend and sales history analysis of individual profit and loss statements to: d) help determine whether the projections are reasonable.

Question 4: Understanding the franchisor’s site selection process: b) is necessary to adequately assess new store sales projections.

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Sensitivity Analysis Margin for error and break-even point

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Recall that a sensitivity analysis is a way to determine what happens when the value of certain variables used in a credit assessment changes. The sensitivity analysis includes determining the break-even point of the business. (Remember, the break-even point is the point at which the cash flow available to cover debt is exactly same as the debt service requirement of the business, thus covering the debt on a oneto-one basis.) In franchise credit analysis, we perform a sensitivity analysis on the projection spread to determine what happens to a borrower's ability to repay the proposed debt when we assume certain deviations from the projected figures. Items that we perform a sensitivity analysis on include sales growth, margins, interest rates, and currency devaluation. In Figure 10.4, we show a sample sensitivity analysis of sales decline and expense increases.

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Business and Collateral Value Value factors

The value of a franchise business is influenced by store type, the assets owned, and the attractiveness of the business as a going concern to another potential franchisee or to the franchisor. Usually, a franchise business commands a higher price when it is sold or traded as a going concern. This is a key idea in franchise financing.

Example

For example, a Pizza Hut business sold as a Pizza Hut sells for more than if the business were sold as an independent pizza restaurant. A Pizza Hut that is sold to be converted to a hamburger food concept is usually sold for a much lower price. To place a value on the collateral, we first determine the types of stores being used as collateral and the type of ownership in these stores. Lets review the three types of ownership: +

Land, building, furniture, fixtures and equipment (LBFF&E) are all owned by the operator (called fee simple)

+

Operator has a ground lease, but owns BFF&E

+

Land and building are leased by the operator (also called a leasehold property), and only FF&E are owned by the franchisee.

In the U.S., to determine total value of a going concern, credit analysts usually separate business value from real estate value. We calculate business value to determine the loan to value, which is the ratio of the loan amount to the value of the collateral. Let’s see how this idea is applied.

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Multiple of adjusted earnings

To determine business value, we assume that the property (land and building) is rented. Because this is the case with leasehold properties, we may calculate business value without adjusting for the real estate. Normally, we calculate business value as a multiple of earnings before depreciation, interest expense, and income taxes (EBDIT). In the U.S., the multiple is usually a factor between 4 and 5. These are benchmark factors developed from Citibank’s knowledge and experience, and may vary in other locales.

Example

Let’s assume an EBDIT of US$100M. This value multiplied by 5 yields a business value of US$500M. Therefore, the business value of the store on rented premises is US$500M.

Adjustment for ownership of real estate

When the franchisee owns the premises (fee simple ownership), we must make an adjustment to EBDIT to calculate business value. (Remember, the calculation for business value assumes that the land and building are leased and not owned.) To calculate the business value for a property that is not rented, we must reduce EBDIT by a fair market rent on the premises before we multiply EBDIT by the business value factor.

Example

For instance, let’s assume the EBDIT from a fee simple restaurant is US$200M per year. Now, let’s assume that a fair market monthly rent for this location is US$6,000 per month, or US$72M per year. The business value is determined as follows: Business Value = (EBDIT minus Fair Market Rent) X a factor of 5

Fair market rent

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BV

= (US$200M - US$72M) X 5

BV

= US$128M X 5

BV

= US$640M

You may be wondering how to estimate fair market rent. One way is to look at the rental charge on the profit and loss statements of similar stores the franchisee rents rather than owns. Another way is to see what rents other franchisees in your portfolio are paying for similar properties.

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Calculating Real Estate Value Appraisals

Once we have calculated the business value, we can determine the value of the real estate (land and building) collateral. We can have a qualified certified appraiser do an assessment on the property, but appraisals can sometimes be expensive, and the prospective borrower may not want to incur such an expense. Is there is a way to estimate the value?

Percentage of land and building cost

In the U.S., the value of real estate is sometimes estimated by using a rental factor. Rents tend to be based on a percentage (the rental factor) of the total cost for land and building to a real estate investor. This factor is a function of the rate of return required by a real estate investor and market and supply in a specific area.

Example

For example, assume the rental factor for a given area is 12% per annum. If the monthly rent for the subject property is estimated at US$6M, per month, then the annual rent is US$72M. Divide the US$72M by the 12% rental factor to estimate the fair market value of the land and building ($72M ÷ .12 = $600M). Looking at it in a different way, a property that cost US$600M with a rental factor of 12% will rent for US$72M per year (600M X .12). Balance Sheet Analysis

Franchise attributes

Traditional analysis of a fast-food franchisee's balance sheet typically reveals low liquidity and net worth, and sometimes high leverage. This is because inventories usually turn quicker than trade payables (food and paper is sold faster than it is paid for), and large investment in fixed assets such as furniture, fixtures, and equipment are rapidly depreciated, making book value low. Does this mean the franchise business is a poor risk? The answer lies in remembering that the value of a franchise business is in its worth as a going concern rather than in its assets. For this reason, we approach balance sheet analysis for this industry a little differently. In the next two sections, we see how two credit indicators, leverage and liquidity, are handled in franchise credit analysis.

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Leverage Book equity

Recall that in standard ratio analysis, we compare total liabilities to the book value of total assets to determine leverage. In franchised businesses, however, book value is not a good indicator of the value of the business. Because the value of a franchise business is in its worth as a going concern, comparing liabilities to actual market value is a more accurate measure of leverage. Therefore, in franchise credit analysis, we measure leverage by replacing book equity with fair market value (FMV), which is the sum of business value and real estate value (true value). The formula for calculating fair market leverage is: Total Liabilities (Cash + Inventory + Business FMV), less Total Liabilities

Remember, business FMV is the sum of business value and real estate value. Total liabilities excludes stockholder debt that can be paid only after the bank’s loan debt is paid. Acceptable ratios

In the U.S., the combined operations of a franchisee cannot have a market value leverage exceeding 4:1 (assuming an acceptable debt service coverage ratio). Furthermore, the bank's overall advance rate cannot exceed 80% of the collateral business FMV. Liquidity

Acceptable ratio

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A standard way to measure liquidity is to compare current assets to liabilities. Because of the cash flow nature of the franchise business, we view liquidity more liberally than in other businesses. We adjust current assets to exclude intercompany and/or stockholder and affiliate receivables, and adjust current liabilities to exclude current portion of long term debt (CPLTD) and current portion of capitalized leases. CBL-FF officers consider a minimum adjusted current ratio of greater than or equal to .50:1 acceptable for this business.

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Regional Risks

As with all lending, the officer must identify various risks and mitigants for the franchise financing transaction. Earlier in this unit, we identified franchise industry risks. Recall that these included commodity price increases, fraudulent conveyance, labor cost increases, and lack of security interest in the franchise licenses. Weak secondary market

In the Latin American and Caribbean markets, we face an additional risk because fast-food is an emerging industry in these regions. A mature secondary market does not exist. Therefore, the officer must carefully consider and assess the desirability or attractiveness of the market to both the franchisor and other potential franchisees.

Cultural acceptance

Another risk in Latin America and the Caribbean is that of cultural tastes and differences. Pizzas, fried chicken, and hamburgers may not be easily accepted in smaller towns or rural areas where people are not as open to different products, and such products may not be affordable for routine consumption. Therefore, you should carefully analyze financing of a concept’s first entry to the smaller and more rural areas. Credit Ratings

Ratings from franchisors

As you probably know, the credit analysis process includes obtaining credit ratings from suppliers and creditors. In franchise financing, we have another source of credit information − the franchisor. For existing franchisees, the franchisor can provide a character reference, indicate how good an operator the franchisee is, and tell us how he or she compares to other franchisees. The franchisor can also provide a rating on the operations and disclose if the franchisee is in default of the franchise or development agreement. A franchisor can also rate how punctual a franchisee is with paying franchise fees, monthly royalties, and equipment payments. This is a source of credit information you must not overlook!

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RAAC Applicability

In Figure 10.2, we presented the RAAC used in the U.S. for franchise business. If your unit has not developed a RAAC for franchise business in your country, use the U.S. RAAC as a starting tool for screening and identifying creditworthy customers. Keep in mind that the requirements and quantitative variables in this RAAC need to be tested for applicability in each country and modified appropriately. Covenant Ratios

Periodic review of financial status

Recall that covenant ratios are financial ratios agreed to in a loan or lease contract. Requiring a borrower to maintain certain covenant ratios is a way to monitor a borrower’s finances so that problems can be identified and dealt with early on. Depending on the complexity and strength of the credit, financial information can be requested monthly, quarterly, or annually. Standard covenant ratios for franchise business are debt service coverage, liquidity, and leverage. Citibank may include covenants for capital expenditures and minimum equity requirements.

SUMMARY

In our review of the credit analysis process, we saw that lenders to franchise businesses rely more on the ability of the business to produce cash flow to repay debt rather than on the value of the collateral, that risks are mitigated through the analysis of the business value of the store, and that the credit emphasis is on the value of the franchise business as a going concern. You have completed the “Credit Analysis” section. Please complete the progress check and then continue with the section on “Legal Considerations.” If you answer any questions incorrectly, please review the appropriate text.

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PROGRESS CHECK 10.4

Directions: Determine the correct answer to each question. Check your answers with the Answer Key on the next page. Question 1: Franchise credit philosophy places emphasis on: ____ a) analyzing the ways out of a franchise transaction. ____ b) maintaining an adequate collateral cushion. ____ c) perfecting a security interest in the property financed. ____ d) the value of the business as a going concern. Question 2: Identify two items usually included in a franchise financing sensitivity analysis. ____ a) Currency devaluation ____ b) Administrative expenses ____ c) Decline in sales ____ d) Depreciation Question 3: The purpose of separating business value from real estate value in franchise credit analysis is to: ____ a) account for differences in fee simple, ground lease, and leasehold ownership. ____ b) recognize the value of the business as an ongoing concern. ____ c) remove the fair market rent from the total value. ____ d) estimate the value of land and building collateral.

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ANSWER KEY

Question 1: Franchise credit philosophy places emphasis on: d) the value of the business as a going concern.

Question 2: Identify two items usually included in a franchise financing sensitivity analysis. a) Currency devaluation c) Decline in sales

Question 3: The purpose of separating business value from real estate value in franchise credit analysis is to: b) recognize the value of the business as an ongoing concern.

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Question 4: When measuring leverage in franchise financing, we replace book equity with __________________.

Question 5: Typically, analysis of a fast-food franchisee’s balance sheet indicates: ____ a) high leverage, high liquidity, and low investment utilization. ____ b) low equity, low leverage, low solvency. ____ c) low net worth, low liquidity, and high leverage. ____ d) low net worth, high equity, low liquidity. Question 6: Financing a fast-food franchise’s first entry in a rural region may be risky because: ____ a) it will be difficult to find experienced labor. ____ b) there may not be enough people in the area to support the restaurant. ____ c) the franchisor has not developed site studies for the region. ____ d) unfamiliar food products may not be accepted.

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ANSWER KEY

Question 4: When measuring leverage in franchise financing, we replace book equity with fair market value.

Question 5: Typically, analysis of a fast-food franchisee’s balance sheet indicates: c) low net worth, low liquidity, and high leverage.

Question 6: Financing a fast-food franchise’s first entry in a rural region may be risky because: d) unfamiliar food products may not be accepted.

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LEGAL CONSIDERATIONS

Our discussion of the credit analysis process disclosed a number of items lenders must consider before extending credit. In this section, we discuss two important categories of legal considerations that lenders to franchise businesses confront. The first concerns the protection of the lender’s interests, and the second deals with lender’s interest in the franchisee’s relationship with other parties as well as its own relationship with the franchisee.

Security of Lender’s Interests Collateral to pay debt

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As in any lending or leasing transaction, the structuring and documentation of a franchise transaction should provide Citibank the greatest possible protection of its interests in collateral. Even though we’ve emphasized the reliance on cash flow rather than collateral in this unit, the collateral is still the final source of satisfying a franchise debt. Here are several guidelines that will help you protect Citibank’s interest in franchise collateral. +

Determine the extent to which collateral for the loan is encumbered. Require release of existing liens before funding the loan.

+

Understand the applicable laws in your region for securing Citibank’s interest in the equipment, furniture, fixtures, and real estate financed. Take the action necessary to ensure that Citibank can take the collateral to satisfy its debt as prescribed by law. This could mean filing documents with a regulatory body or including provisions in the loan agreement.

+

Obtain the greatest possible protection from competing real estate claimants and other secured parties. Again, the action you take depends on the laws and practices in your region.

+

Require the borrower to obtain and pay for lender’s title insurance or use other means to secure Citibank’s interest in the real estate property.

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These guidelines illustrate the importance of understanding security interest laws in your region and documenting the transaction properly. In addition, you need to consider the legal relationships among the parties involved in a franchise. We discuss these in the following section.

Legal Relationships Between Franchise Parties Here we examine three relationships that affect Citibank’s interests in the franchise − that of the franchisee and franchisor, that of the franchisee and the landlord (if any), and that of the franchisee and Citibank. Let’s begin with the relationship between the franchisee and the franchisor. Franchisee and Franchisor Review of franchise agreement

Recall that the obligations, responsibilities, and rights of the franchisor and franchisee are spelled out in the franchise agreement. To help you understand franchise agreements, we’ve provided a sample agreement (between Pizza Hut and a franchisee) in Appendix ??. It is important for you to remember that franchisors often revise and improve these agreements. Therefore, you and your counsel should always read the subject agreement and become familiar with the rights and remedies of each party. Key components you should focus on are: +

Length and expiration dates of the franchise agreement and renewal options. The expiration dates of the franchise agreement affect the loan tenor Citibank can offer.

+

Events viewed as failure to perform or defaults. Default situations normally include loan default and filing of insolvency by a franchisee. Examples of failure to perform include chronically failing to meet the minimum standards for quality, service, and cleanliness, or failure to correct a loan default.

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Effect on lender

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+

Provisions for transfers of ownership. The agreement may grant the franchisor the right to monitor and restrict such transfers. The franchisor’s control over the capability of the owners of the business benefits Citibank.

+

Courses of action and remedies available to the franchisor in event of default. Franchisors usually give a franchisee an opportunity to comply with the agreement and often offer to help resolve the situation. Because a business is usually worth more under the franchised name, an operator will often work with the franchisor to sell the business to another franchisee when asked to do so. However, a franchisor cannot force a franchisee to sell the business. If a solution cannot be reached, the franchisor can disenfranchise the business.

When a business is disenfranchised, the franchisee must de-image the restaurant (take down all signs and logos) and stop producing and selling the franchisor’s product. This presents a problem for lenders because the value of the business drops. To complicate matters, the agreement often prohibits, for a specified time, the franchisee from operating a business that sells a similar product. Franchisee and the Landlord (Owner) of the Site

Citibank viewpoint

Often, a franchisee will lease the ground and/or building of a franchised store. Since the franchise business is more valuable under the franchise name, a good relationship between the landlord and the lessee (our borrower) is very important to Citibank. If the lessee becomes delinquent with the lease payment and faces eviction, it is in Citibank’s interest to avert the eviction. The value of the business can decrease significantly if the business is permanently or temporarily closed.

Agreement with landlord

One way Citibank can protect its interests is to secure an agreement with the landlord, called a Landlord Consent and Waiver, that enables the bank and the landlord to work together and resolve lease defaults. The Landlord Consent and Waiver normally contains five key provisions:

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+

The bank will finance and lien (and sometimes mortgage) the franchisee’s furniture, fixtures, and equipment at the subject location.

+

If the franchisee defaults on the lease payment, the landlord will notify the bank in writing within a specified number of days.

+

The bank has the right, but not the obligation, to make the lease payment and bring the lease current.

+

The bank has the right to assume the lease and the right to reassign that lease to another franchisee.

+

The bank has the right to enter the premises and remove its collateral.

These provisions illustrate the significance of the Landlord Consent and Waiver. You can see why this document is so important to Citibank! Citibank and the Franchisee Default remedies

Our discussion of the bank’s relationship with the franchisee will focus on the bank’s options in the event the franchisee defaults on the loan agreement. We categorize the options according to the type of asset financed. Furniture, fixtures, and equipment +

Try to establish a working arrangement

+

Take possession of the collateral

Property +

Foreclose (sell the property to satisfy the debt)

+

Have the borrower transfer the deed to the property to Citibank

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+

Request the appointment of a receiver to take possession of the property

Many of the remedies listed here are considered “last-resort” attempts to recover debt. Remember, the resale value of franchise collateral is usually low. The preferred solution is to work out a friendly resolution.

SUMMARY

Lenders to the franchise industry must take steps to protect their interests in the collateral. The specific legal actions used to insure Citibank’s right to repossess its collateral, gain protection form competing claimants, and secure its interest in real estate vary according to country. In its legal relationship with the franchisee, Citibank retains the right to take possession of the collateral or render the collateral unusable if the franchisee defaults on the loan. With real estate, Citibank reserves the option to foreclose, request that a receiver take possession of the property, or require the borrower to transfer the deed to Citibank. In addition to its own relationship with the franchisee, Citibank is concerned with the relationship between the franchisee and the franchisor, and between the franchisee and the landlord. These relationships are important because the franchisor’s and landlord’s remedies for default can affect the value of the business. The officer should review the franchise agreement carefully and secure a Landlord Consent and Waiver to protect Citibank’s interests. You have completed Unit 10: Franchise Financing. Before you continue to the next unit, check your understanding of the concepts you have just learned by completing the progress check that follows. If you answer any question incorrectly, please return to the text and read the section again.

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PROGRESS CHECK 10.5

Directions: Determine the correct answer to each question. Check your answers with the Answer Key on the next page. Question 1: Select two ways for a lender to protect its interest in franchise collateral. ____ a) File documents with appropriate regulatory agencies to perfect a security interest. ____ b) Immediately repossess the collateral if the franchisee defaults on lease payments to the landlord. ____ c) Require the release of existing liens on the collateral before funding a loan. ____ d) Restrict the franchisee’s right to transfer ownership of the business. Question 2: Citibank works to help the franchisee avoid being disenfranchised because: ____ a) the value of the collateral drops when the business is closed permanently or temporarily. ____ b) the bank will be barred from entering the premises to collect its collateral if the business is disenfranchised. ____ c) the business will not be worth as much if it is not part of a known restaurant system. ____ d) the borrower will not have enough cash flow to pay its debt. Question 3: Select two components of a franchise agreement that greatly concern a lender. ____ a) The amount of the franchise fee ____ b) Actions the franchisor may take for noncompliance ____ c) Restrictions on transfer of ownership ____ d) Company indemnification provisions

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ANSWER KEY

Question 1: Select two ways for a lender to protect its interest in franchise collateral. a) File documents with appropriate regulatory agencies to perfect a security interest. c) Require the release of existing liens on the collateral before funding a loan.

Question 2: Citibank works to help the franchisee avoid being disenfranchised because: c) the business wi ll not be worth as much if it is not part of a known restaurant system.

Question 3: Select two components of a franchise agreement that greatly concern a lender. b) Actions the franchisor may take for noncompliance c) Restrictions on transfer of ownership

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Question 4: A Landlord Consent and Waiver agreement helps Citibank protect its interests in the franchise business by having a measure of control over the: ____ a) franchisee’s right to transfer ownership of the business. ____ b) franchisee’s continued occupancy of the premises. ____ c) landlord’s right to seize the bank’s collateral for lease default. ____ d) landlord’s obligation to pay for environmental cleanup.

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ANSWER KEY

Question 4: A Landlord Consent and Waiver agreement helps Citibank protect its interests in the franchise business by having a measure of control over the: b) franchisee’s continued occupancy of the premises.

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Unit 11

UNIT 11: RISK MANAGEMENT

INTRODUCTION

In Unit One, you learned that asset based financing is a risk-management rather than a riskavoidance business. Throughout this course, you have been introduced to some of the riskmanagement mechanisms used in this type of financing. We focused on credit review, cash flow analysis, transaction structure, and documentation. In this unit, we review these mechanisms and introduce you to additional ABF risk management mechanisms. The purpose of this discussion is to broaden your understanding and appreciation of ABF risk management.

UNIT OBJECTIVES


Understand the ABF risk management process

+

Identify methods used to manage ABF risks

+

Define common terms used in risk management

INTRODUCTION

In this course, you’ve learned how creditors balance the various types of risk to structure sound ABF transactions. Recall that the primary way we balance risks is to rely on the value of the collateral. Because asset based financing requires that we consider and weigh several types of risk, risk management is a critical part of the business.

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ABF risks

ABF life cycle

RISK MANAGEMENT

Let’s take a moment to review the core ABF risks that we must deal with in Latin American transactions. This review will prepare you for the risk management concepts presented in this unit. Credit

The risk in extending credit is the capacity of the borrower or lessee to repay debt now and in the future, and its commitment to honor its debts. Central to evaluating credit risk are the applicant’s cash flow and character.

Collateral

The value of the collateral over time is a key consideration in ABF because the collateral secures repayment of the debt. If the borrower or lessee defaults, the creditor ultimately relies on the value of the collateral to satisfy the obligation.

Documentation

The various documents involved in a credit transaction determine how the transaction is treated for legal, tax, and accounting purposes. The risk lies in proper document preparation and execution. The emphasis is on including provisions and remedies that protect the creditor’s interests.

Country

The country’s political, economic, and currency restrictions and fluctuations all increase the creditor’s risk of monetary loss.

Cross Border

The risk in financing equipment in one geographical jurisdiction with equipment use in another rests in political and economic conditions and in fluctuating property and income taxes.

Because we consider each of these risks plus the composition of the portfolio to reach a credit decision, our risk-management practices must address each risk throughout the ABF life cycle. To help you understand the process, we divide risk management into six phases.

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Credit initiation

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Risk administration

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Collateral management

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Portfolio management

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Problem recognition

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Remedial management

In the remainder of this unit, we discuss risk management in terms of these phases. You should keep in mind that these are arbitrary divisions, and that the risk management practices we describe sometimes overlap phases or extend throughout the ABF life cycle.

CREDIT INITIATION Definition

Credit initiation refers to the evaluation, analysis, and approval of individual credit transactions. It includes information gathering, financial analysis, structuring, and other processes leading up to the decision to extend or deny credit. Both new credits and ongoing risk decisions, such as additions, increases, restructures, new extensions, and line renewals, are part of credit initiation. It is important that you understand the risk management techniques used in this phase because what you do here affects what may happen later.

Two types of processes

In this section, we discuss two types of risk management processes commonly associated with credit initiation:

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Standards

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Risk Analysis

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Standards Key areas

Credit initiation standards vary according to the business segment, product, market, and location. Typically, the unit of the bank in which you work will have its own format standards and instructions for handling ABF credit approvals, usually by program and target market. However, all standards focus on five key areas of risk management:

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Target market compliance — addresses target market risks

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Program RAAC compliance — addresses industry and program risks

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Transaction and recourse structure — addresses collateral, country, cross border, and credit risks, with emphasis on protecting the bank against other creditors

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Documentation — covers the types of documents required for each form of transaction and the required filings, with emphasis on protecting the bank from a legal standpoint

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Concentration limits — deals with the risks associated with the composition of the portfolio

Risk Analysis Like the standards we’ve just described, credit initiation processes are also used to manage risks. Let’s review the five key elements of risk analysis practiced during credit initiation to see how each contributes to risk management. Financial Statement Analysis Credit risks

Here, the emphasis is on identifying financial risks. The officer examines the applicant’s income statements, balance sheets, and other financial data, focusing on:

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Risk mitigation

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Historical and forecasted performance

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Repayment alternatives or ways out

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Sensitivity of repayment schedule to risk factors (economic, regulatory, competitive, industry cycle)

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Business practices

As the credit analyst identifies the risks, he or she may begin to formulate a plan to manage or mitigate the risks. For example, the analyst may consider adjusting the repayment schedule to accommodate the borrower’s business operating cycle. For an ongoing transaction involving a temporary overdraft, the analyst may establish a plan to monitor the transaction. Cash Flow Analysis

Capacity to repay debt

Recall that we use cash flow analysis to determine the applicant’s capacity to repay debt. In the analysis, we look at the applicant’s disposable income. Because cash flow is a major way out, it is a key element of risk management. Management Analysis

Character of key personnel

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In a management analysis, we assess the customer’s potential integrity, honesty, and commitment to honor its financial obligations. The emphasis is on the character of the company’s key individuals, their financial capacity, and their ability to manage change. Understanding these aspects of management helps us limit the risk we are willing to assume.

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Collateral Evaluation Value over time

Managing collateral risk is extremely important because the creditor must ultimately look to the value of the equipment if the customer does not meet the obligation. As you’ve learned, equipment that maintains value over time is a better risk than equipment that does not maintain resale value. To manage the risks associated with collateral, we use structures such as vendor guarantees and support, insurance, and maintenance requirements to protect the value we expect to receive from the equipment. Documentation

Forms and procedures

In Unit Four, Lease Classification and Legal Documentation, you learned how the proper preparation and execution of documentation helps creditors manage legal risks. Documentation risk strategies include using: +

Standard forms approved by local legal counsel

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A checklist of required documents for each transaction

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Proper execution (signatures, registration, stamp duties)

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Appropriate covenants that mitigate political, commercial, and repossession risks and provide sufficient time to permit remedial action in the event of difficulty

RISK ADMINISTRATION

In the previous section, we saw how credit initiation standards and risk analysis processes are used to manage risks. In this section, we discuss another phase of the ABF risk management life cycle — risk administration.

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Management systems

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Risk administration refers to the ongoing “housekeeping” tasks associated with managing risks; that is, the credit support, control systems, and other practices necessary to manage the outstanding risk assets and to properly monitor business risks. Let’s look at four important aspects of risk administration: +

Maintenance of credit files

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Review procedures

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Overdraft procedures

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Tracking past-due obligations

Credit Files History of credit decision

The credit file should contain all the information necessary to reconstruct the decision to extend credit. It serves as an important risk management tool for two major events: +

To review the basis on which credit was extended and any limitations when the borrower seeks additional credit

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To identify any deficiencies in the process if the borrower defaults

Review Procedures Early problem detection

The timely reviews of credit, collateral, documentation, industry, and support structures is a critical part of risk management. Regular reviews help the officer spot potential problems early on, when more options exist to avoid or correct the problem.

Overdraft or Line Excess Procedures Approval procedures

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No line excesses or overdrafts should occur without proper credit approval. To manage this risk, approval procedures must be in place and followed closely.

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Past-Due Obligation Tracking Tracking system

To manage the risk of past due principal or interest, a system for tracking amortization schedules is appropriate. As you can see, risk administration practices are important from the beginning through the end of the ABF life cycle. Similarly, the next topic we will discuss, collateral management, is significant throughout the entire ABF life cycle.

COLLATERAL MANAGEMENT

Understanding the management of collateral is critical to your understanding of asset based financing. Collateral (equipment) risk management is a broad concept that includes: +

Collateral analysis

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Equipment value

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Residual risk

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Asset management

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Structuring

Let’s examine each of these aspects.

Collateral Analysis Determine value over time

We know that equipment that maintains value over time is a better risk than equipment that does not maintain resale value. To assess the value over time, a collateral analysis must be performed. The analysis helps us manage risk by revealing the factors that affect the equipment’s value now and in the future. Once we know these factors, we can structure the transaction to protect the value we expect to receive from the equipment.

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Key factors to consider

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The collateral analysis is a complex process involving several considerations. It is important for you to know the items collateral analysts evaluate so that you can do a better job of gathering information. Here we discuss three key considerations: +

Equipment

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Investment

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Remarketing

Equipment Considerations Traits

To assess value, the analyst first looks at the characteristics of the equipment itself. • Equipment’s manufacturer, model, year, features, options, and acceptance to the market • Use (special or general purpose), industry of usage, adaptability for other use • Cost and discounts • Product life cycle, useful economic life, risk of obsolescence Investment Considerations

Profit potential

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The items focused on here help the analyst determine whether the equipment is a good investment. +

Acquisition price, fair market value, and distress values; probability of buyout or renewal

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Upgrade/add-on potential

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Environmental issues, geographic area of use

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Necessity and severity of use DRAFT

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Remarketing Considerations Secondary market

We must be able to resell or re-lease the equipment to derive the expected value. Accordingly, the analyst assesses the chances of successfully remarketing the equipment by analyzing the following: +

Diversity of users and market depth, including equipment’s adaptability for other usage

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Cost to refurbish and remarket; parts and service availability

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Time to remarket and the cost of carrying

These considerations give the analyst an idea of what the equipment is worth and will be worth in the future. However, equipment worth may be defined in more than one way. In the next section, we discuss the various definitions.

Equipment Value Factors that affect definition

Use in risk management

We know that the creditor must look to the value of the equipment if the customer defaults or if the equipment is resold at the end of a lease term. However, in asset based financing, we use several different definitions of value. The definition is affected by: +

The economic and legal needs of the seller and buyer

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The cost of doing business

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The continuation or break in the use of the equipment

Value definitions should always be included in documentation as a risk management tool. Understanding the differences among the various definitions will help you structure and document appropriately. Here, we look at five definitions. +

Fair market value

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Orderly liquidation value (OLV)

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Distress value DRAFT

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Scrap value

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Value in use

As you read these definitions, note that net values exclude the costs of doing business (repossession costs, refurbishing, maintenance, storage, remarketing, shipping, insurance, advertising, brokerage fees, shipping). Fair Market Value (FMV) Price at normal conditions

The fair market value is the gross price that a willing and informed buyer would pay to a willing and informed seller when neither is under pressure to conclude a transaction. The time it takes to sell the equipment is dependent on the industry, but is usually nine months to a year, assuming a normal market. Orderly Liquidation Value (OLV)

Net of FMV

Orderly liquidation value is defined as the net price that a willing and informed buyer would pay to a willing and informed seller when neither is under pressure to conclude a transaction. The time it takes to sell the equipment is dependent on the industry and the needs of the buyer or seller, but is usually three to six months, assuming a normal market. Distress Value

Net price under duress

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Distress value is the net price that would be paid under duress (forced liquidation) for equipment either in a legally distressed situation or when the asset is in a distressed situation. The equipment is always sold “as is, where is.” The time it takes to conclude a transaction depends on economic conditions and legal factors. From one to two months is common.

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Scrap Value Junk value

Scrap value is the amount that could be realized from the property if it were sold to a junk dealer. Value-In-Use

Value as ongoing concern

The retail, fair market value of equipment sold as part of an on-going operation or concern is referred to as value-in-use. This value assumes equipment to be fully installed and operational. To put these values in perspective, in Figure 11.1, we present an example of the relationships among the values and the lessee payments for the ABC company.

Figure 11.1: Relationship between value definitions and payments

As you may be able to conclude, each of the various definitions described in this section serves an important purpose in risk management. Let’s look at an example. DRAFT

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Example

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Assume that the vendor of a piece of industrial equipment has agreed to support the value of the collateral through a remarketing agreement that does not define collateral values. The creditor has assumed, and based its pricing on, equipment resale at fair market value. One year before the end of the lease term, the lessee goes bankrupt and stops making payments. The vendor repossesses the equipment and sells it quickly for below fair market value, creating a loss for the creditor. Consider that the result would probably have been very different if collateral value requirements had been clearly defined in the agreement!

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RISK MANAGEMENT

As you can see, the definitions of value we described in this section have a significant effect on risk. However, our discussion of equipment value is not complete! Residual value, which you were introduced to earlier in this course, is covered in the next section.

Residual Risk In Unit Two, Understanding the Leasing Industry, we defined the residual value of a piece of equipment as the projected market value remaining at the end of the contract. We excluded from our definition guaranteed residuals in which purchase at contract end is reasonably assured. Use in pricing

Recall that lessors take the expected residual value of the equipment into consideration in the pricing of leases that do not have a fixed purchase option. The higher the residual value, the less the lessor needs to recover from the lease payment. In simplistic terms, if a lessor assumes a 10 percent residual, it needs to recover only 90 percent of the original equipment cost through the lease payments. Therefore, the higher the residual value, the lower the periodic payments. Because residual value plays such an important role in the lessor’s return on investment, it is important that we manage residual risks carefully. Poorly informed or unmanaged residual risk-taking can result in substantial loss. Let’s examine four categories of ways to manage residual risk: +

Risk assessment

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Pricing

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Administration

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Portfolio management

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Risk Assessment Three factors

To assess residual risk, we look at three primary factors: +

Equipment characteristics − Standard, specialized, or customized? − Susceptible to technological change? − Long or short life cycle? − Is use essential?

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Transaction structure and documentation − Maintenance provisions asset-specific or general? − Return provisions costly or cheap for lessee? − Notification provisions well in advance of term end, near

term end, or at term end? − End-of-lease options well defined or loosely defined? − Controlled by lessee or lessor? − Long or short term? +

Remarketing capability − Secondary market broad and deep or narrow and shallow? − Third-party sale direct to end user or dealer/speculator? − Difference in retail/wholesale value small or large? − Any refurbish and maintenance capabilities?

Residual risk vs. “at risk”

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When we consider all these factors, we see that the size of the residual risk, which is expressed as a percentage of acquisition cost, does not always reflect our true “at risk” position. We may be more vulnerable booking a 5 percent residual on high-tech, short-lived equipment than a 40 percent residual on low-tech, long-lived assets! DRAFT

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RISK MANAGEMENT

In general, the more certain we are of the equipment value, the less of a safety margin we need. The final decision as to how much risk is appropriate must be based on a careful evaluation of each relevant factor. Pricing Higher return

Usually, creditors require a higher return on residual risk than on the related payment risk. The reason for this is that residual risk has no contractual payment obligation to support it, and remarketing costs and cost of carry must be covered in addition to the booked residual. Note that pricing residuals to “meet the competition” is rarely appropriate. Creditors who do so probably have not differentiated themselves properly, are in the wrong target market, have high operating costs, or face uninformed competition. Administration

Use of special resources and tools

To manage residual risk, we sometimes use special resources to inspect, appraise, refurbish, and remarket the asset. We view these resources as administrative risk management tools. It is also important that we recognize early on any deteriorating market conditions and non-compliance with maintenance requirements. Annual reviews, classification of deteriorating credits (discussed in a later section), and remedial management of residual exposures are some of the other administrative tools we use to manage deteriorating residual risk. Portfolio Administration

Sell off unwanted exposures

The ability to sell off unwanted exposures is important to managing equipment risk. Changing market or tax circumstances, and the need to manage equipment concentrations and remarketing workloads, are among the factors that affect a decision to sell certain transactions. We will have more to say about portfolio management later in this unit.

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Asset Management So far, we have seen how using collateral analysis, equipment value definitions, and residual risk management techniques help creditors control collateral risk. The methods we discussed may be considered part of asset management, which refers to managing the asset throughout the asset cycle. Continuous asset control

Asset management includes: +

Identifying niche markets and becoming industry specialists

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Conducting a complete analysis of the collateral value

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Structuring transactions from a collateral perspective (with guarantees and other provisions that assure the value of the collateral)

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Performing regular equipment inspections and evaluations

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Performing periodic trend analyses of collateral and markets

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Being alert to new and emerging industries that may affect the value of current collateral

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Selling or re-leasing assets at the end of the lease term

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Managing defaulted assets for maximum value as opposed to liquidation

As you can see, asset management is really a set of processes that reflect a continuous cycle of valuating and assuring the collateral value.

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Structuring Costs vs. value over time

In structuring, we define the most appropriate financing alternative that addresses the applicant’s financial considerations and provides the best protection of our collateral. To protect the collateral, we must give close attention to the perfection of security interest and the creditor rights with respect to bankruptcy and repossession. A creditor’s ability to act quickly to secure its collateral under default situations is very important to success, because the creditor’s defaultrelated costs increase over time, while the collateral (almost without exception) decreases in value over time. Recall that there are several ways for creditors to minimize collateral risk through transaction structuring. Let’s review five key methods: +

Require a guaranteed residual

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Use and enforce strict preventative maintenance clauses, inspection rights, and excess-use penalties to lessen the effect of impaired collateral value caused by excessive wear and tear

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Obtain a collateral guarantee from a vendor or an insurance company

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Obtain a remarketing agreement. Recall that these are agreements in which the vendor does not guarantee the residual equipment value, but does agree to assist in the remarketing of the equipment.

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Use end-of-lease options and return provisions that protect the value of the collateral

If you have any questions about these structuring techniques, we suggest that you read Units Two through Four again.

SUMMARY

In this section, we discussed three categories of risk management — credit initiation, risk administration, and collateral management. In our discussion of credit initiation, we saw how risk analysis processes and standards are used to manage a variety of risks (target DRAFT

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market, program, industry, country, and cross border). In contrast, risk administration is concerned mainly with managing credit risk through tracking, procedural, and control systems. To manage collateral risk, creditors use a broad range of tools. These include conducting a collateral analysis, clearly defining equipment value, using administrative systems and controls, pricing, and structuring. Managing the collateral throughout the asset life cycle is a key concept in collateral risk. You have completed the first part of Unit Eleven, Risk Management. Please complete Progress Check 11.1 to check your understanding of the concepts in this section. If you answer any questions incorrectly, please review the appropriate portions of the text before continuing to the next section, “Portfolio Management.”

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PROGRESS CHECK 11.1

Directions: Determine the correct answe r to each question. Check your answers with the Answer Key on the next page. Question 1: Which risk management method is used to address target market and program compliance? ____ a) Portfolio review ____ b) Credit initiation standards ____ c) Financial statement analysis ____ d) Trend analysis Question 2: Overdraft procedures, control systems, and file maintenance are considered: ____ a) Problem recognition strategies ____ b) Portfolio administration tasks ____ c) Asset management tasks ____ d) Risk administration tools Question 3: Select two key considerations in collateral analysis. ____ a) Distress value ____ b) Characteristics of the equipment ____ c) Remarketing potential ____ d) Industry of use Question 4: The net price that a willing and informed buyer would pay to a willing and informed seller when neither is under pressure to conclude the transaction is referred to as the: ____ a) Value-in-use ____ b) Orderly liquidation value ____ c) Fair market value d) ___ Residual value V01/11/96 P12/06/99

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ANSWER KEY Question 1: What is the risk management method commonly used to address target market and program compliance? b) Credit initiation standards Question 2: Overdraft procedures, control systems, and file maintenance are considered: d) Risk administration tools Question 3: Select two key considerations in collateral analysis. b) Characteristics of the equipment c) Remarketing potential The industry of use is considered an equipment characteristic, and distress value is one of several investment considerations. Question 4: The net price that a willing and informed buyer would pay to a willing and informed seller when neither is under pressure to conclude the transaction is referred to as the: b) Orderly liquidation value Value-in-use is the retail, fair market value of equipment sold as part of an ongoing operation. Fair market value is the gross price that a willing and informed buyer would pay to a willing and informed seller when neither is under pressure to conclude the transaction. Residual value is the projected market value remaining at the end of a contract.

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Question 5: The net price that would be paid during a forced liquidation is called the ___________________________.

Question 6: Charging a higher return for residual risk than for the payment risk is appropriate because: ____ a) the size of the residual risk does not always reflect our true “at risk” position. ____ b) we may not be able to sell off unwanted exposures. ____ c) pricing must cover the costs of storing and remarketing the equipment. ____ d) we need a larger safety margin when we are unsure of the equipment value. Question 7: Performing regular equipment inspections and conducting periodic trend analyses of equipment markets are ways to: ____ a) monitor maintenance compliance. ____ b) manage assets throughout the asset life cycle. ____ c) identify deficiencies in the equipment valuation process. ____ d) track the cost to refurbish and remarket equipment. Question 8: Using and enforcing an excess-use penalty is a way to protect the value of collateral through: ____ a) inspection rights. ____ b) defining “value” in the documentation. ____ c) transaction structuring. ____ d) asset management.

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ANSWER KEY

Question 5: The net price that would be paid during a forced liquidation is called the distress value.

Question 6: Charging a higher return for residual risk than for the payment risk is appropriate because: c) pricing must cover the costs of storing and remarketing the equipment. a) and d) are true, but are not valid reasons for charging a higher return than the payment risk. A valid reason that was not included here is that residual risk does not have a contractual payment obligation to support it. Question 7: Performing regular equipment inspections and conducting periodic trend analyses of equipment markets are ways to: b) manage assets throughout the asset life cycle. Question 8: Using and enforcing an excess-use penalty is a way to protect the value of collateral through: c) transaction structuring.

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PORTFOLIO MANAGEMENT Definition

A collection of transactions is referred to as a portfolio. In our discussion of residual risk in the previous section, we said that the ability to sell off unwanted exposures in a portfolio is an important aspect of risk management. You may have wondered how creditors identify unwanted exposures. The main way is to conduct periodic portfolio reviews. In this section, we discuss the two primary types of reviews: +

Individual transactions

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Portfolio composition

Understanding the types of reviews will prepare you for conducting or assisting with reviews in your unit.

Individual Transactions Transaction’s effect on portfolio

The quality of a portfolio depends upon the quality of the individual transactions in the portfolio. Periodic reviews of individual transactions help us see how each transaction affects the risk and return of the entire portfolio. The items that the analyst should focus on are: +

How collectible the principal and interest are in each transaction

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Transaction weaknesses, trends, and risks

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Adequacy of present safeguards (collateral, covenants, alternative repayment sources)

The results of the review allow the analyst to recommend selling off certain transactions and bolstering others.

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Portfolio Composition Focus on total portfolio

Although assessing the weaknesses and strengths of individual transactions is important in portfolio management, it is equally important to examine the health of the portfolio as a whole. In a portfolio composition review, we look at the portfolio from several perspectives to reveal risk categories. The viewpoint categories are: +

Concentrations

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Risk and asset liquidity

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Environmental context

Let’s examine the way each of these categories affects the quality of the portfolio. Concentrations Common trait

Mix less risky

A concentration is a group of transactions that share a common characteristic. There are a number of possible concentrations in a portfolio. A few of the most important are: +

Industry, sub-industry, or type of borrower

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Currency used to fund transaction

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Transaction maturity patterns

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Type of collateral or loan/lease product

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Geographic location

Too much exposure in any one concentration is viewed as risky. Generally, diversification, which is the strategy of maintaining a mix of concentrations, is less risky because adverse results in a single concentration have less effect on the portfolio as a whole.

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Risk in overexposure

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Determining the concentrations in a portfolio helps reveal overexposure. For example, a review may reveal that 40 percent of the portfolio transactions are for a single industry. An unexpected downturn in this industry could mean disaster for the creditor! The creditor may want to sell of some of this exposure and acquire transactions for other industries to balance the mix. Risk Asset Liquidity

Ability to collect on credits

When we talk about liquidity in a portfolio, we are referring to the creditor’s ability to collect on credits. Liquidity is a function of the collection options available to the lender. In many markets, liquidity is a major concern for the bank. Factors which have an adverse effect on asset liquidity include concentrations in: +

One-way-out loans

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Non-amortizing loans

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Foreign currency exposure to foreign-exchange-poor countries or to borrowers with questionable access to foreign exchange

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Borrowers or industries dependent upon government support

Environmental Context Factors to monitor

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As you know, both external and internal factors can greatly affect a borrower or lessee’s ability to repay debt. Therefore, monitoring the environment is an important element of managing portfolio risk. Factors that bear watching are: +

Industry — Technology, raw material, markets, competition, supply/demand characteristics, government priorities

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Economic and business climate — Impact of business cycle, balance of payment, management/labor conditions and practices, capital/money markets, commercial practices and business ethics, legal framework, auditing and accounting, banking system

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Political and regulatory conditions — Role of regulation in the economy and the financial industry, private vs. public sector dominance, political interference, government stability, country sovereign risk management process

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Market position and strategy — Market share in terms of size, earning, loan losses, tier position with target market names, business and vehicles in the market, customer and government attitudes, unit’s overall risk management and marketing strategy

It should be clear to you that portfolio reviews help creditors spot problems in their early stages. In the next section, we discuss more ways to recognize current and potential credit problems.

PROBLEM RECOGNITION Early detection

Problem recognition refers to the process of anticipating, detecting, recognizing the significance of, and reporting potential problems as early as possible. In the previous section, we discussed the use of periodic portfolio reviews to identify potential problems. In this section, we look at three additional ways risks are managed through a problem recognition process: +

Credit monitoring

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Credit classification

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A watchlist

In the discussion of these topics, we present a number of specific signals you may watch for to recognize and evaluate the significance of credit problems.

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Credit Monitoring Early identification

The goal of credit monitoring is to identify threats early on and take steps to reinforce credits while adequate alternatives for action exist. To effectively manage risk, it is essential for the officer to monitor each transaction regularly. For other than customer payment default, monthly credit reviews plus semiannual and annual credit/ business reviews are usually adequate. Your unit may have its own timing standards. What should the officer look for during a credit review? Let’s look at three categories of items that may be cause for concern: +

Management changes

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Leverage and financial factors

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Economics and external factors

Management Changes Changes justify concern

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Changes in management or management practices may indicate trouble ahead. A shift in any of the following may call for closer inquiry. +

Key executives or directors

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Ownership

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The effectiveness of the board of directors

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The nature of the business, the business objectives, or the business practices

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Attitudes or skill levels

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Availability of internal financial information

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Maintenance practices

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Employee morale

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Leverage and Financial Factors Warning signs

Leveraged situations are usually the most vulnerable to financial trouble. The wise officer watches for rising leverage, diminishing margins of profitability, and for signs that subsidiaries or other business segments could be a financial burden. Economics and External Factors

Business and economic cycles

The business cycle has a continuing effect on a credit obligation, and should be watched closely. Other external factors also play an important role. Energy cost increases can diminish purchasing power, alter cost factors, and render existing equipment obsolete. Likewise, economic cycles may affect the ability of a debtor to meet credit obligations.

Anticipating risks

The astute officer will anticipate the risks likely to arise when economic signals change. For example, a recession is typically marked by a downswing in consumer spending, with a resulting adjustment in inventories throughout the system of distribution and production, and a reduction in the total volume of capital spending. Therefore, when a business economy is in the maturing stage, officers should keep abreast of their customers’ affairs and reinforce credits where appropriate. Signals to watch for include: +

Inventory build-up

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Adverse industry or regulatory information

+

Adverse stock market reports and international developments

+

Changing technology

+

Competition from subsidized or capitalized industries

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Diagnosis and action plan

11-31

Critical to the concept of credit monitoring is proper diagnosis to understand the nature of the customer’s problem. Is it temporary or permanent? What are the causes? Does the customer have a viable plan to resolve the problem? The next step is to review the creditor’s options, which may be to help the customer resolve the problem, restructure the transaction, or hold firm to the existing deal (which could mean repossessing and remarketing the equipment).

Credit Classification Definition

Once a potential or actual credit problem has been identified, the creditor may use a classification system to track the credit. Classification is the process of assigning to a transaction a class that represents the level of loss risk. In Figure 11.2, we show a sample classification system. Classification systems serve several purposes: +

Highlight problem credits for attention and remedial action

+

Categorize problem credits according to severity of actual and potential risk of loss

+

Apply a common language to problem credit identification and management

Timely classification and reporting of favorable or adverse changes in the status of a transaction is an important risk management tool. In the next section, we examine a related tool, the watchlist.

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1 - Normal

No identified problems

1A - OAEM

Other Assets Especially Mentioned: (1) The credit review has revealed evidence of weakness in the borrower’s financial condition or creditworthiness, (2) the repayment program is unrealistic, or (3) we lack adequate collateral, credit information, or documentation. Early attention, including substantive discussions with borrowers, is required to correct deficiencies.

II - Substandard

The normal repayment of principal and interest may be, or has been, jeopardized by adverse trends, weaknesses in collateral, or by financial, managerial, economic, or political developments. Prompt corrective action is required to strengthen the bank’s position as a lender to reduce its exposure and to assure that the borrower takes adequate remedial measures.

III - Doubtful

Full repayment of credit appears questionable, but the amount and timing of the eventual loss has not yet been determined. Vigorous action is required to avert or minimize losses.

IV - Loss

Payment is not collectible.

Figure 11.2: Classification system

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Watchlist Definition

Watchlist maintenance

A watchlist is a list of transactions that do not warrant classification, but do require watching. The basis for including a transaction on a watchlist is usually a current or anticipated change in: +

Industry patterns or structures

+

Management, composition, or succession

+

National or international political and economic trends that may affect the credit

+

Nature of the lender/borrower relationship

+

Borrower performance vs. budget or forecast

+

Nature of joint-venture arrangements or relationships

To be an effective risk management tool, the list should be updated regularly (at least quarterly). Deteriorating transactions may be classified according to the classification system in use. Clearly, the problem recognition methods we’ve discussed in this section can be important risk management tools. Of course, it is not enough to simply identify a potential problem! Steps must be taken to eliminate or at least reduce the identified risks. This is the topic of the next section, “Remedial Management.”

REMEDIAL MANAGEMENT

In the previous section, you learned how creditors use credit monitoring, credit classification, and the watchlist to recognize and track credit problems. The next step in the risk management process is remedial management.

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Definition

RISK MANAGEMENT

Remedial management refers to the actions we take to avert or minimize the credit problems we’ve identified. It means taking opportunities to get concessions or additional collateral, and forcing decisions at a time when the company still has viability. Remedial management is results-oriented. The goals are to reduce classifications and write-offs while increasing recoveries. To help you understand how these goals are met, we divide the process into two parts: +

Documentation review

+

Action plan

Documentation Review Purpose

One of the first actions that should be taken after a credit has been classified is to review its documentation. The purpose of the review is to: +

Identify possible causes of instability

+

Identify any weaknesses in the documentation that could put the creditor’s interest in the collateral in jeopardy

+

Review the creditor’s options in the event of default

Action Plan Alternate strategies

After the documentation has been reviewed, the creditor must develop a strategy to resolve the credit problem. To reach the best decision, its a good idea to consider and document several alternate strategies along with their attendant risks. Appropriate strategies may include: +

Restructuring the loan/lease to encourage the customer to seek other sources of financing

+

Restructuring the loan/lease to retain some degree of return on the transaction

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+

Encouraging the customer to sell assets to meet its obligations

+

Requiring additional collateral

Many more strategies are possible. The remedial approach the creditor takes must be based on the individual characteristics of the transaction and the relationship with the customer.

SUMMARY

Portfolio management, problem recognition, and remedial management were the three risk management categories discussed in the second part of this unit. Under portfolio management, we described the two types of portfolio reviews — individual transaction and portfolio composition. Each type of review helps manage portfolio risks from a different perspective. In our discussion of problem recognition, we stressed that the goal of problem recognition is to identify problem credits early on, while more options to resolve the problem exist. We described three risk management tools associated with problem recognition: credit monitoring, credit classification, and use of a watchlist. A classification system is used to highlight credits that require immediate or ongoing attention. A watchlist is a related tool used to track potential problem credits. Remedial management is a results-oriented approach to managing problem credits. The process consists of two parts — the documentation review and the action plan. The ultimate goal of remedial management is to avert or minimize losses. Congratulations! You have completed the Basics of Asset Based Financing Course. Please complete Progress Check 11.2 to check your understanding of risk management. If you answer any questions incorrectly, please review the appropriate portions of the text.

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]

PROGRESS CHECK 11.2

Directions: Determine the correct answer to each question. Check your answers with the Answer Key on the next page. Question 1: A portfolio concentration refers to: ____ a) the effect of political and economic regulations on the portfolio. ____ b) the strategy of maintaining a mix of industries and products. ____ c) a transaction that has an adverse effect on rest of the portfolio. ____ d) a group of transactions that have something in common. Question 2: In a portfolio, liquidity is the creditor’s ability to collect on debts. ____ a) True ____ b) False Question 3: Diversification in a portfolio tends to be lessen risk because: ____ a) the exposure in any one risk category is limited. ____ b) covenants and other present safeguards are adequate. ____ c) it lessens the adverse effects of environmental factors. ____ d) the creditor has more collection options available. Question 4: When a customer’s leverage increases, the creditor may monitor the credit less frequently. ____ a) True ____ b) False

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ANSWER KEY

Question 1: A portfolio concentration refers to: d) a group of transactions that have something in common. Question 2: In a portfolio, liquidity is the creditor’s ability to collect on debts. a) True Question 3: Diversification in a portfolio tends to be lessen risk because: a) the exposure in any one risk category is limited. Diversification is the strategy of maintaining a mix of industries and products so that adverse results in any one concentration does not jeopardize the entire portfolio. Question 4: When a customer’s leverage increases, the creditor may monitor the credit less frequently. b) False Highly leveraged situations are more susceptible to financial problems and warrant more frequent monitoring.

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Question 5: One way that creditors manage risk when an economic downturn is likely is to: ____ a) classify the credits. ____ b) deny requests for line renewals or extensions. ____ c) restructure vulnerable transactions. ____ d) use special resources to appraise and remarket the equipment. Question 6: To tag problem credits that required additional analysis and monitoring, creditors use a _____________________________.

Question 7: To monitor an anticipated change in a customer’s management, industry cycles, or relationships with partners, creditors may use a _____________________.

Question 8: The main purpose of remedial management is to: ____ a) identify weaknesses in the documentation. ____ b) develop a strategy for handling a credit problem. ____ c) reduce the number of classified credits and losses. ____ d) identify the reasons for a credit problem.

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ANSWER KEY

Question 5: One way that creditors manage risk when an economic downturn is likely is to: c) restructure vulnerable transactions. Credits are not classified unless they become problems. The customer may need more credit to implement a viable plan to ride out a recession; denying all requests for more credit may place the customer in greater jeopardy. Using specialists to remarket equipment is premature because credit problems are only possible. Question 6: To tag problem credits that require additional analysis and monitoring, creditors use a classification system.

Question 7: To monitor an anticipated change in a customer’s management, industry cycles, or relationships with partners, creditors may use a watchlist.

Question 8: The main purpose of remedial management is to: c) reduce the number of classified credits and losses. Identifying the reasons for the credit problem, identifying documentation weaknesses, and developing a strategy are all methods for attaining the primary goal of reducing classified credits and losses.

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Appendix

APPENDIX

GLOSSARY Accelerated Cost Recovery System (ACRS)

The tax depreciation, or cost recovery, method for Internal Revenue Service (IRS) purposes which was effective for all depreciable property placed into service after December 31, 1980 and before January 1, 1987

Accelerated Depreciation

Any depreciation method that allows for greater deductions or charges in the earlier years of an asset’s depreciable life, with charges becoming progressively smaller in each successive period

Accumulated Depreciation

A financial reporting term for a contra-asset balance sheet account that shows the total depreciation charges for an asset since acquisition

Actuarial Interest

A constant interest charge (or return) based upon a declining principal balance

Adjusted (or Remaining) Basis

The undepreciated amount of an asset’s original basis that is used, for tax purposes, to calculate the gain or loss on disposition of an asset

ADR System

A tax depreciation system that establishes the minimum, midpoint, and maximum number of years, by asset category, over which an asset can be depreciated

Advance Payments

One or more lease payments required to be paid to the lessor at the beginning of the lease term

Advance Rent

A general term used to describe any rent that precedes the base lease term and base lease rent

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GLOSSARY

Alterations

Modifications to leased equipment, generally subject to restoration at the conclusion of the lease

Alternative Minimum Tax (AMT)

A penalty tax, of sorts, in which a taxpayer must pay the higher of its regular tax or AMT liability

Annuity

A stream of even (equal) cash flows occurring at regular intervals, such as even monthly lease payments

Arrears

A payment stream in which each lease payment is due at the end of each period during the lease

Asset Class Life

The IRS-designated economic life of an asset, used as the recovery period for alternative tax depreciation computations

Asset Depreciation Range (ADR)

A tax depreciation system that establishes the minimum, midpoint, and maximum number of years, by asset category, over which an asset can be depreciated; the midpoint life has become synonymous with the term “ADR class life”

Assign

To transfer or exchange future rights

At Risk Rules

Federal tax laws that prohibit individuals (and some corporations) from deducting tax losses from equipment leases in excess of the amount they have at risk

Bargain Purchase Option

A lease provision allowing the lessee, at its option, to purchase the leased property at the end of the lease term for a price that is so much lower than the expected fair market value of the property that the lessee is reasonably sure to exercise it

Bargain Renewal Option

A lease provision allowing the lessee, at its option, to extend the lease for an additional term in exchange for periodic rental payments that are so much less than fair value rentals for the property that the lessee is reasonably sure to exercise it

Base Term

The minimum time period during which the lessee will have the use and custody of the equipment

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GLOSSARY

G-3

Basis

The original cost of an asset plus other capitalized acquisition costs such as installation charges and sales tax; basis reflects the amount upon which depreciation charges are computed

Basis Point

One one-hundredth of a percent (.01%)

Broker

A company or person who arranges lease transactions between lessees and lessors for a fee; see “Lease Broker”

Bundled Lease

A lease that includes many additional services such as maintenance, insurance, and property taxes that are paid for by the lessor, the cost of which is built into the lease payments

Call Option

Any option in a lease, such as a purchase or a renewal option, that is exercised at the discretion of the lessee, not the lessor

Capital Lease

A lease that has the characteristics of a purchase agreement, and also meets certain criteria established by Financial Accounting Standards Board Statement No. 13 (FASB 13)

Capitalize

To record an expenditure that may benefit future periods as an asset rather than as an expense to be charged off in the period of its occurrence

Capitalized Cost

The amount of an asset to be shown on the balance sheet, from a financial reporting perspective; the total capitalized cost (or basis) also is the amount upon which tax benefits are based, and may include asset cost plus other amounts such as sales tax

Captive Lessor

A leasing company that has been set up by a manufacturer or dealer of equipment to finance the sale or lease of its own products to endusers or lessees

Casualty Value (see also Stipulated Loss Value Table)

A schedule included in a lease that states the agreed value of equipment at various times during the term of the lease, and establishes the liability of the lessee to the lessor in the event the leased equipment is lost or rendered unusable during the lease term due to casualty loss

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GLOSSARY

Certificate of Delivery and Acceptance

A document that is signed by the lessee to acknowledge that the equipment to be leased has been delivered and is acceptable

Closed-end Lease

A lease that does not contain a purchase or renewal option, thereby requiring the lessee to return the equipment to the lessor at the end of the initial lease term

Commitment Fee

A fee required by the lessor, at the time a proposal or commitment is accepted by the lessee, to lock in a specific lease rate or other lease terms

Commitment Letter

A document prepared by the lessor that sets forth its commitment, including the lease rate and term, to provide lease financing to the lessee

Compensating Balance

The amount of funds that a bank requires a borrower to keep on deposit during the term of a loan

Conditional Sales Contract

An agreement for the purchase of an asset in which the lessee is treated as the owner of the asset for federal income tax purposes (thereby being entitled to the tax benefits of ownership, such as depreciation), but does not become the legal owner of the asset until all terms and conditions of the agreement have been satisfied

Construction Contract Assignment

See Purchase Agreement Assignment

Contingent Rentals

Rentals in which the payment of rents are dependent upon some factor other than passage of time

Cost of Capital

The weighted-average cost of funds that a firm secures, from both debt and equity sources, in order to fund its assets

Cost of Debt

The costs incurred by a firm to fund the acquisition of assets through the use of borrowings

Cost of Equity

The return on investment required by the equity holders of a firm

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GLOSSARY

G-5

Debt Optimization

A method of borrowing funds in a leveraged lease where the equity participants borrow and repay the obligation in such a manner as to maximize their return on equity, maintain a constant return while offering a lower lease payment, maximize cash flow, etc., or to maximize a combination of factors

Debt Participant

A long-term lender in a leveraged lease transaction

Declining Balance Depreciation

A type of accelerated depreciation in which a constant percentage of an asset’s declining remaining basis is depreciated each year

Depreciation

A means for a firm to recover the cost of a purchased asset, over time, through periodic deductions or offsets to income

Direct Financing Lease

A lessor capital lease (per FASB 13) that does not give rise to manufacturer’s or dealer’s profit (or loss) to the lessor

Discount Rate

A certain interest rate that is used to bring a series of future cash flows to their present value in order to state them in current (today’s) dollars

Discounted Lease

A lease in which the lease payments are assigned to a funding source in exchange for up-front cash to the lessor

Dry Lease

A net lease; a term traditionally used in aircraft and marine leasing to describe a lease agreement that provides financing only

Early Termination

A situation that occurs when the lessee returns leased equipment to the lessor prior to the end of the lease term as permitted by the original lease contract or subsequent agreement

Economic Life of Leased Property

The estimated period during which the property is expected to be economically usable by one or more users, with normal repairs and maintenance, for the purpose for which it was intended at the inception of the lease

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GLOSSARY

Economic Recovery Tax Act of 1981 (ERTA ‘81)

The federal tax act that introduced ACRS, among other provisions

End-of-term Options

Options stated in the lease agreement that give the lessee flexibility in its treatment of the leased equipment at the end of the lease term

Equipment Schedule

A document, incorporated by reference into the lease agreement, that describes in detail the equipment being leased, the lease term, commencement date, and repayment schedule

Equipment Specifications

A specific description of a piece of equipment that is to be acquired, including equipment make, model, configuration, and capacity requirements

Equity Investor or Participant

An entity that provides equity funding in a leveraged lease transaction and, thereby, becomes the owner and ultimate lessor of the leased equipment

Executory Costs

Recurring costs in a lease, such as insurance, maintenance, and taxes for the leased property, whether paid by the lessor or the lessee

External Rate of Return (ERR)

A method of yield calculation; ERR is a modified internal rate of return (IRR) that allows for the incorporation of specific reinvestment, borrowing, and sinking-fund assumptions

Fair Market Value

The value of a piece of equipment if the equipment were to be sold in a transaction determined at arm’s length, between a willing buyer and a willing seller, for equivalent property and under similar terms and conditions

FASB 13

Financial Accounting Standards Board Statement No. 13, ‘Accounting for Leases’ that specifies the proper classification, accounting, and reporting of leases by lessors and lessees

Finance Lease

An expression often used in the industry to refer to a capital lease or a nontax lease; also a type of tax-oriented lease

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GLOSSARY

G-7

Financial Accounting Standards Board (FASB)

The rule-making body that establishes financial reporting guidelines

Financial Institution Lessor

A type of independent leasing company that is owned by, or a part of, a financial institution such as a commercial bank, thrift institution, insurance company, industrial loan company, or credit union

Financing Statement

A notice of a security interest filed under the Uniform Commercial Code (UCC); also known as UCC-1

Floating Rental Rate

Rental that is subject to upward or downward adjustments during the lease term

Full Payout Lease

A lease in which the lessor recovers, through the lease payments, all costs incurred in the lease plus an acceptable rate of return without any reliance upon the leased equipment’s future residual value

Full-Service Lease

A lease that includes many additional services such as maintenance, insurance, and property taxes that are paid for by the lessor, the cost of which is built into the lease payments

Funding Source

An entity, such as a lessor or a bank, that provides any part of the funds used to pay for the cost of the leased equipment

Guaranteed Residual Value

A situation in which the lessee or an unrelated third party (e.g., equipment manufacturer, insurance company) guarantees to the lessor that the leased equipment will be worth a certain fixed amount at the end of the lease term; the guarantor agrees to reimburse the lessor for any deficiency realized if the leased equipment is subsequently salvaged at an amount below the guaranteed residual value

Guideline Lease

A tax lease that meets or follows the IRS guidelines as established by Revenue Ruling 75-21, for a leveraged lease

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GLOSSARY

Half-year Convention

A tax depreciation convention that assumes all equipment is purchased or sold at the midpoint of a taxpayer’s tax year; allows an equipment owner to claim a half-year of depreciation deductions in the year of acquisition, as well as in the year of disposition, regardless of the actual date within the year that the equipment was placed in service or disposed of

Implicit Rate

The discount rate that, when applied to the minimum lease payments (excluding executory costs) together with any unguaranteed residual, causes the aggregate present value at the inception of the lease to be equal to the fair market value (reduced by any lessor retained Investment Tax Credits) of the leased property

Inception of a Lease

The date of the lease agreement (or commitment, if earlier)

Incremental Borrowing Rate

The interest rate that a person would expect to pay for an additional borrowing at interest rates prevailing at the time

Indemnity Clauses

Indemnity provisions in a lease such as general indemnity, the general tax indemnity, and the special tax indemnity

Independent Lessor

A type of leasing company that is independent of any one manufacturer and purchases equipment from various unrelated manufacturers

Initial Direct Costs

Costs incurred by the lessor that are directly associated with negotiating and consummating a lease (for example, commissions, legal fees, costs of credit investigations, and the cost of preparing and processing documents for new leases acquired)

Interest Rate Implicit in a Lease (as used in FASB 13)

The discount rate which, when applied to minimum lease payments (excluding executory costs paid by the lessor) and unguaranteed residual value, causes the aggregate present value at the beginning of the lease term to be equal to the fair market value of the leased property at the inception of the lease, minus any investment tax credit retained by the lessor and expected to be realized by it

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GLOSSARY

G-9

Interim Rent

A charge for the use of a piece of equipment from either its in-service date or delivery date until the date on which the base term of the lease commences

Internal Rate of Return (IRR)

The unique discount rate that equates the present value of a series of cash inflows (lease payments, purchase option) to the present value of the cash outflows (equipment or investment cost)

Investment Tax Credit (ITC)

A credit that a taxpayer is permitted to claim on the federal tax return (a direct offset to tax liability) as a result of ownership of qualified equipment

Lease Acquisition

The process whereby a leasing company purchases or acquires a lease from a lease originator such as a lease broker or leasing company

Lease Agreement

The contractual agreement between the lessor and the lessee that sets forth all the terms and conditions of the lease

Lease Broker

An entity that provides one or more services in the lease transaction, but that does not retain the lease transaction for its own portfolio

Lease Origination

The process of uncovering (through a sales force), developing, and consummating lease transactions

Lease Term

The fixed, noncancellable term of the lease

Lessee

The user of the equipment being leased

Lessee’s Incremental Borrowing Rate

The interest rate which the lessee would have incurred (at the inception of the lease) to borrow, over a similar term, the funds necessary to purchase the leased assets

Lessor

The owner of the equipment that is being leased to a lessee or user

Leverage

An amount borrowed

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GLOSSARY

Leveraged Lease

A specific form of lease involving at least three parties: a lessor, lessee, and funding source — the lessor borrows a significant portion of the equipment cost on a nonrecourse basis by assigning the future lease payment stream to the lender in return for up-front funds (the borrowing); the lessor puts up a minimal amount of its own equity funds (the difference between the equipment cost and the present value of the assigned lease payments) and is generally entitled to the full tax benefits of equipment ownership

MACRS Class Life

The specific tax cost recovery (depreciation) period for a class of assets as defined by MACRS

Maintenance Contract

An agreement in which the lessee contracts with another party to maintain and repair the leased property during the lease term in exchange for a payment or stream of payments

Master Lease Agreement

A lease line of credit that allows a lessee to obtain additional leased equipment under the same basic lease terms and conditions as originally agreed to, without having to renegotiate and execute a new lease contract with the lessor

Match Funded Debt

Debt, incurred by the lessor, to fund a specific piece of leased equipment, the terms and repayment of which are structured to correspond to the repayment of the lease obligation by the lessee

Midquarter Convention

A depreciation convention (replacing half-year convention for certain taxpayers in certain years) that assumes all equipment is placed in service halfway through the quarter in which it was actually placed in service

Minimum Lease Payments

From the lessee perspective, all payments that are required to be made to the lessor per the lease agreement; minimum lease payments for the lessor include all payments to be received from the lessee, as well as the amount of any residual guarantees by unrelated third-party guarantors

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GLOSSARY

G-11

Modified Accelerated Cost Recovery System (MACRS)

The current tax depreciation system as introduced by the Tax Reform Act of 1986, generally effective for all equipment placed in service after December 31, 1986

Money-overmoney Lease

A nontax lease in which the lessee is, or will become, the owner of the leased equipment by the end of the lease term

Multiple Investment Sinking Fund (MISF)

A method of income allocation used to report earnings on a leveraged lease that assumes a zero earnings rate during periods of disinvestment (a sinking-fund rate equal to 0)

Municipal Lease

A conditional sales contract disguised in the form of a lease available only to municipalities in which the interest earnings are tax-exempt to the lessor

Net Lease

A lease in which all costs in connection with the use of the equipment, such as maintenance, insurance, and property taxes, are paid for separately by the lessee and are not included in the lease rental paid to the lessor

Net Present Value

The total discounted value of all cash inflows and outflows from a project or investment

Nonrecourse

A type of borrowing in which the borrower (a lessor in the process of funding a lease transaction) is not at-risk for the borrowed funds; the lender expects repayment from the lessee and/or the value of the leased equipment

Nontax Lease

A type of lease in which the lessee is, or will become, the owner of the leased equipment, and is entitled to all the risks and benefits (including tax benefits) of equipment ownership

Off Balance Sheet Financing

Any form of financing, such as an operating lease, that, for financial reporting purposes, is not required to be reported on a firm’s balance sheet

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GLOSSARY

Open-end Lease

A lease in which the lessee guarantees the amount of the future residual value to be realized by the lessor at the end of the lease; if the equipment is sold for less than the guaranteed value, the lessee must pay the amount of any deficiency to the lessor

Operating Budget

A budget that lists the amount of noncapital goods and services a firm is authorized by management to expend during the operating period

Operating Lease

From a financial reporting perspective, a lease that has the characteristics of a usage agreement and also meets certain criteria established by the FASB; leases in which the lessor has taken a significant residual position in the lease pricing and, therefore, must salvage the equipment for a certain value at the end of the lease term in order to earn its rate of return

Packager

A name used to describe the leasing company, investment banker, or broker who arranges a leveraged lease

Payments in Advance

A payment stream in which each lease payment is due at the beginning of each period during the lease

Payments in Arrears

A payment stream in which each lease payment is due at the end of each period during the lease

Payoff

A situation that occurs when the lessee purchases the leased asset from the lessor prior to the end of the lease term

Placed in Service

A phrase used to indicate that equipment was delivered and available for use, although the equipment may still be subject to final installation and/or assembly

Point

One percent, or one percentage point (1.00%); also represents 100 basis points

Pooled Funds

A funding technique, used by lessors, in which several forms of borrowing are pooled, or grouped, for use in funding leases and are not specifically tied to the purchase of one piece of leased equipment

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Present Value

The discounted value of a payment or stream of payments to be received in the future, taking into consideration a specific interest or discount rate; present value represents a series of future cash flows expressed in today’s dollars

Pricing

The process of arriving at the periodic rental amount to charge a lessee

Private Ruling

A ruling by the IRS that was requested by parties to a lease transaction and is applicable to the assumed facts stated in the opinion

Purchase Agreement Assignment

An agreement where the lessee has entered into a contract to purchase the equipment to be leased prior to the arranging of the financing; under the agreement, the lessee normally assigns some or all of its rights under the purchase agreement (always including the right to take title to the equipment) to the owner trustee prior to the delivery of the property

Purchase Option

An option in the lease agreement that allows the lessee to purchase the leased equipment at the end of the lease term for either a fixed amount or at the future fair market value of the leased equipment

Put Option

An option in a lease (for example, for equipment purchase or lease renewal) in which the exercise of the option is at the lessor’s, not the lessee’s, discretion

Recourse

A type of borrowing in which the borrower (a lessor funding a lease) is fully at-risk to the lender for repayment of the obligation; the recourse borrower (lessor) is required to make payments to the lender whether or not the lessee fulfills its obligation under the lease agreement

Refundable Security Deposit

An amount paid by the lessee to the lessor as security for fulfillment of all obligations outlined in the lease agreement that is subsequently refunded to the lessee once all obligations have been satisfied

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GLOSSARY

Remarketing

The process of selling or leasing the leased equipment to another party upon termination of the original lease term

Renewal Option

An option in the lease agreement that allows the lessee to extend the lease term for an additional period of time beyond the expiration of the initial lease term in exchange for lease renewal payments

Rent Holiday

A period of time in which the lessee is not required to pay rents; typically, the rents are capitalized into the remaining lease payments

Residual Value

The value, either actual or expected, of leased equipment at the end, or termination, of the lease

Retained Transaction

A lease transaction or investment kept for one’s own portfolio; a retained transaction is not sold to another lessor or investor

Return on Assets (ROA)

A common measure of profitability based upon the amount of assets invested; ROA is equal to the ratio of either net income to total assets or net income available to common stockholders to total assets

Return on Equity (ROE)

A measure of profitability related to the amount of invested equity; ROE is equal to the ratio of either net income to owners’ equity or net income available to common stockholders to common equity

Revenue Procedures

The IRS Revenue Procedures 75-21, 75-28, and 76-30, which set forth requirements for obtaining a favorable federal income tax ruling that a particular leveraged lease transaction is a true lease

Revenue Ruling

A written opinion of the Internal Revenue Service requested by parties to a lease transaction which is applicable to assumed facts stated in the opinion

Rollover

A change in the lease term or lease payment resulting from a change in equipment, such as in a takeout or upgrade

Rule of 78

An accelerated method of allocating periodic earnings in a lease (or a loan) based upon the sum-of-the-years method

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GLOSSARY

G-15

Running Rate

The rate of return to the lessor (or cost to the lessee) in a lease, based solely upon the initial equipment cost and the periodic lease payments, without any reliance on residual value, tax benefit, deposits, or fees

Sales-leaseback

A transaction that involves the sale of equipment to a leasing company and a subsequent lease of the same equipment back to the original owner who continues to use the equipment

Sales-type Lease

A capital lease from the lessor’s perspective (per FASB 13) that gives rise to manufacturer’s or dealer’s profit to the lessor

Salvage Value

The expected or realized value from selling a piece of equipment

Saw Tooth Rents

Rents which vary throughout the term of the lease, usually to match debt payments and tax payments in a leveraged lease so as to lessen the need for a sinking fund

Schedule

Listing of equipment to become subject to a lease that describes the equipment, the lease term, the commencement date, and the location of the equipment

Single Investor Lease

A lease in which the lessor is fully at-risk for all funds (both equity and pooled funds) used to purchase the leased equipment

Sinking Fund

A reserve set aside for the future payment of taxes (generally applicable only in leveraged leases) or for the purpose of payment of any liability anticipated to become due at a future date

Sinking Fund Rate

The earnings allocated to a sinking fund

Skipped-payment Lease

A lease that contains a payment stream requiring the lessee to make payments only during certain periods of the year

Spread

The difference between two values generally used to describe the difference between the lease interest rate and the interest rate on the debt

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DRAFT

G-16

GLOSSARY

Step-payment Lease

A lease that contains a payment stream requiring the lessee to make payments that either increase (step-up) or decrease (step-down) in amount over the term of the lease

Stipulated Loss Value Table

A schedule included in the lease agreement, generally used for purposes of minimum insurance coverage, that sets forth the agreedupon value of the leased equipment at various points throughout the lease term

Straight-line Depreciation

A method of depreciation (for financial reporting and tax purposes) where the owner of the equipment claims an equal amount of depreciation in each year of the equipment’s recovery period

Structuring

The process of pulling together the many components of a lease to arrive at a single lease transaction; structuring includes, but is not limited to, lease pricing, end-of-term options, documentation issues, indemnification clauses, funding, and residual valuations

Subchapter S Corporation

A firm legally organized as a corporation but taxed as a partnership

Takeout

A flexible lease option in which the lessor replaces existing leased equipment with either different equipment or newer equipment of the same make

Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA ‘82)

Tax law enacted in 1982 that, among other things, modified the Accelerated Cost Recovery System (ACRS) and Investment Tax Credit (ITC) rules, as well as introduced the finance lease (which has since been repealed)

Tax Lease

A generic term for a lease in which the lessor takes on the risks of ownership (as determined by various IRS pronouncements) and, as the owner, is entitled to the benefits of ownership, including tax benefits

Tax Reform Act of 1984 (TRA ‘84)

U.S. tax law enacted in 1984 that included changes to the general effective date for finance leases (renamed transitional finance leases), defined limited use property, set forth the luxury automobile rules, and placed restrictions on equipment leases to tax-exempt users

DRAFT

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GLOSSARY

G-17

Tax Reform Act of 1986 (TRA ‘86)

U.S. tax law that effected a major overhaul of the U.S. tax system by lowering tax rates, modifying the Accelerated Cost Recovery System (now MACRS), repealing the Investment Tax Credit (ITC), and repealing the transitional finance lease

Tax-exempt User Lease

A type of tax lease available to tax-exempt or nonprofit entities in which the lessor receives only limited tax benefits

Terminal Rental Adjustment Clause (TRAC)

A lessee-guaranteed residual value for vehicle leases (automobiles, trucks, or trailers), the inclusion of which will not disqualify the tax lease status of a tax-oriented vehicle lease

Termination Value

A value of leased equipment, representing the lessee’s liability, if the agreement is terminated because the leased equipment becomes obsolete or surplus

Third-party Lessor

An independent leasing company (or lessor) that writes leases involving three parties: 1) the unrelated manufacturer, 2) the independent lessor, and 3) the lessee

Ticket Size

A term that refers to the cost of equipment being leased; the leasing market place is roughly segmented into the small, middle, and large ticket markets

True Lease

A tax lease where, for IRS purposes, the lessor qualifies for the tax benefits of ownership and the lessee is allowed to claim the entire amount of the lease rental as a tax deduction

Two-party Lessor

A captive leasing company (or lessor) that writes leases involving two parties: 1) the consolidated parent and captive leasing subsidiary and 2) the lessee or end-user of the equipment

UCC Financing Statement (UCC-1)

A document, under the UCC, filed with the county (and sometimes the Secretary of State) to provide public notice of a security interest in personal property

Unguaranteed Residual Value

The portion of residual value for which the lessor is at-risk

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DRAFT

G-18

GLOSSARY

Uniform Commercial Code (UCC)

The Uniform Commercial Code that governs commercial transactions

Upgrade

An option that allows the lessee to add equipment to an existing piece of leased equipment in order to increase its capacity or improve its efficiency

Useful Life

A period of time during which an asset will have economic value and be usable

Vendor Leasing

Lease financing offered to an equipment end-user in conjunction with the sale of equipment

Wet Lease

A lease in which the lessor provides bundled services, such as the payment of property taxes, insurance, maintenance costs, fuel, or provisions, and may even provide persons to operate the leased equipment

Wrap Lease

A lease in which the lessor leases equipment at a rental rate that amortizes the investment over a longer period than the term of the initial lease

Yield

The rate of return to the lessor in a lease investment

DRAFT

V01/11/96 P12/06/99

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