Documente Academic
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Finance - Draft
January 1996
Warning
This workbook is the product of, and copy-righted by,
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N.A., and may not be used for any other purpose. It is
unlawful to reproduce the contents of these materials, in
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Investment Bank Training and Development (GCIB
T&D) — Latin America, Asia / Pacific and CEEMEA.
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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
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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1-2 UNDERSTANDING THE LEASING INDUSTRY
WHAT IS A LEASE?
Definition of a Lease
Written Lease agreements are generally written contracts that contain the
contracts 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 From an industry standpoint, a lease is a contract that has been labeled
labelled a lease 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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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.
Industrial In the early 1800s, the amount and types of leased equipment in the
Revolution 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 The growth and expansion of the railroads also brought about major
expansion 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.
Need for While the demand for lease financing was growing in the U.K., the
leasing 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.
Vendor leasing In the early 1900s, a developing economy and the desire of
begins 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.
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UNDERSTANDING THE LEASING INDUSTRY 1-5
Banks enter the In 1963, the U.S. Comptroller of the Currency issued a ruling that
leasing industry 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.
Market Segments
Factors that The differing types of equipment, the price ranges of the equipment,
determine and the key decision factors that influence lessees help divide the
segment leasing industry into three core segments: the small ticket market, the
large ticket market, and the middle market.
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1-6 UNDERSTANDING THE LEASING INDUSTRY
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
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UNDERSTANDING THE LEASING INDUSTRY 1-7
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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1-8 UNDERSTANDING THE LEASING INDUSTRY
Parent/ Payment
Subsidiary/
Manu-
Lessor
facturer
Equipment Lease
Equipment Lease
Lease Payments
Lessee
Middle-man The final type of leasing company is the lease broker, or packager.
services The lease broker is essentially a middle-man who provides one or
more various services. The lease broker may do the following:
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UNDERSTANDING THE LEASING INDUSTRY 1-9
The lease broker typically does not own the equipment or retain the
lease transaction for its own account.
Lessee
Lease Ultimate
Equipment
Broker Lessor
Funding
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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UNDERSTANDING THE LEASING INDUSTRY 1-11
____ 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:
Question 3: The middle market is more price-sensitive and competitive than the small
ticket and large ticket markets.
____ a) True
____ b) False
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ANSWER KEY
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
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Question 5: In the 1800s, which of the following had the greatest effect on the growth of
leasing in the United States?
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):
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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?
Question 6: The involvement of banks in equipment leasing was advanced in 1970 through
an amendment to the:
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):
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Risk of One of the strongest reasons for acquiring the use of equipment
ownership 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!
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1-16 UNDERSTANDING THE LEASING INDUSTRY
Transfer of risk Leasing helps lessees avoid the risk of owning obsolete equipment by
to lessor transferring that risk to a lessor. In other words, lessees let the leasing
company worry about the equipment becoming obsolete.
Lessee Lessor
Risk of Obsolescence
Financial Reporting
No asset or If a lease is a true usage agreement (an operating lease) for financial
liability entry 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 Off balance sheet financing helps make a firm’s financial statements
financial ratios 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 In the early years of a lease, an operating lease has a more positive
on income effect on a lessee’s income statement than a capital lease. Initially, the
statement 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 Because the use of an operating lease lowers the asset base and
return on assets 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 Managers who do not have the authority to spend funds necessary to
spending purchase equipment find leasing to be a convenient alternative. The
guidelines amount of the monthly lease payment often falls within their spending
authority guidelines.
Cash Management
Up-front costs 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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1-18 UNDERSTANDING THE LEASING INDUSTRY
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.
Operating If a department or division has already used its allowance for capital
budget 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 Similarly, some state and local governments must have either special
approvals 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
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Income Tax
Lower lease When lessors receive tax benefits because they are considered the tax
rates 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.
Income tax When the lessor is deemed the owner of the equipment for tax
benefit 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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1-20 UNDERSTANDING THE LEASING INDUSTRY
Negative impact Current U.S. tax law may result in penalties for purchasing additional
of additional equipment. A company that purchases new equipment may have to pay
purchases 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 Lower
Lease 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 For financial reporting purposes, owners depreciate equipment over the
economic life 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.
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Purchase Another reason for leasing’s growing popularity is the lessee’s ability
options 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.
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1-22 UNDERSTANDING THE LEASING INDUSTRY
Flexible options 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
Control
the leasing company of a manufacturer in the event of
warranty disputes.
n The lessee can return the equipment to the lessor upon
Lower risks 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.
Additional Over the last 30 years, many economic factors have led to shortages in
source of capital through conventional capital financing sources. To sell their
financing products, many manufacturing companies turned to leasing to make
financing available to those customers who otherwise could not afford
the equipment.
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Lower Expenses
Economies Due to their large size, certain leasing companies can save money by
of scale 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 Financial reporting
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1-24 UNDERSTANDING THE LEASING INDUSTRY
n Cash management
n Ownership considerations
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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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 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:
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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
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Benefits of When the lessor is considered the tax owner of the leased equipment
ownership 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
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 single-
investor lease or a leveraged lease.
Recourse In a single-investor lease, the cash the lessor pays for the equipment
borrowing 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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UNDERSTANDING THE LEASING INDUSTRY 1-29
Lessor Lessor
n Equity
n Pooled funds
Equipment Payment
Lessee
Lessor
n Equity
Non-
Lessee recourse
Lease Lender
Payment
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1-30 UNDERSTANDING THE LEASING INDUSTRY
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
Effect on lease If the lessee returns the leased equipment to the lessor at the end of
rates 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.
Risk in residual Generally, the amount of the residual used in the lessor’s pricing is
value 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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UNDERSTANDING THE LEASING INDUSTRY 1-31
International Leasing
Types of As in the United States, all types of equipment are being leased
equipment abroad: tankers, railroad cars, computers, machine tools, printing
leased abroad 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.
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Market Control
Locking out the By locking in the sale with financing so it will not be lost to a
competition 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 Captive lessors can benefit from the combined marketing approach
contracts 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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UNDERSTANDING THE LEASING INDUSTRY 1-33
Integration Opportunities
Vertical Integration
Horizontal Integration
Unrelated Some vendor lease companies find leasing so profitable that they
product leasing 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.
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Conglomerate Integration
New business Some other companies enter into the leasing business as a totally
opportunities 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.
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
Changes in Products
Changing Lessors continue to develop new products to meet the changing needs
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.
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Profitability
New emphasis Companies have not been able to maintain the profitability levels
on residuals of the late 1980s. Competition remains high. Fewer, yet larger,
and asset companies strive to increase market share. Companies must rely
management 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 Many lessors have shifted part of their business into other financial
other sources of service products such as real estate or insurance to improve
profits 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.
Changes in tax Changes in the U.S. corporate tax structure are highly probable.
laws 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.
International Markets
International
Many U.S. lessors are going overseas to tap into these fertile markets.
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agreements 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 Used equipment is increasingly being leased as lessees are less set on
leases 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 More lessees are asking for unique lease structures to aid in their cash
requests 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
Another key concept presented in this unit is that economic changes in the U.S. and abroad
are having a strong effect on leasing trends. Economic ups and downs have led to more
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1-38 UNDERSTANDING THE LEASING INDUSTRY
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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UNDERSTANDING THE LEASING INDUSTRY 1-39
____ 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.
_____ 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
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 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:
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 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:
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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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UNIT OBJECTIVES
n Recognize how lessors and lessees account for operating and capital leases
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.
Transfer of
1. The lease automatically transfers ownership of the property
ownership to the lessee by the end of the lease term.
Dollar-out and Most lease companies offer two general categories of products:
fair market dollar-out leases and fair market value (FMV) leases. In a dollar-
value options out 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 3. The lease term is equal to or greater than 75% of the
of equipment estimated economic life of the leased property.
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 4. The present value of the minimum lease payments is equal to,
ownership or greater than, 90% of the fair value of the leased property
less any investment tax credit retained by the lessor.
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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.
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.
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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2-6 FINANCIAL REPORTING AND TAX CLASSIFICATIONS
Lessor as Quadrant 1 shows the accounting for a lessor capital lease where the
financier 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 as Quadrant 2 shows lessor accounting for an operating lease. The lessor
owner 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 It is important to note that the classification of the lease does not
income 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:
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ABC COMPANY
BALANCE SHEET
(End of first year)
ASSETS
Operating Capital
Lease Lease Difference
Current Assets
Cash in bank $13,684 $13,684
Accounts receivable 12,000 12,000
Inventory 8,000 8,000
Total current assets $33,684 $33,684
Fixed Assets
Deferred tax charge $ 0 $ 1,070 ($1,070)
Property, plant, equipment 96,000 96,000
Capital leased equipment 0 100,000 (100,000)
Less: accum. depreciation (30,000) (50,000) 20,000
Total assets $99,684 $180,754 ($81,070)
LIABILITIES
Current Liabilities
Accounts payable $6,000 $6,000
Lease payable 0 18,350 (18,350)
Total current liabilities $6,000 $24,350 ($18,350)
Long-term Liabilities
Notes payable $30,000 $30,000
Lease payable 0 64,706 ($64,706)
Total liabilities $36,000 $119,056 ($83,056)
STOCKHOLDERS’ EQUITY
Common stock $14,000 $14,000
Retained earnings (prior) $20,000 $20,000
Current portion 29,684 27,698 $1,986
Total equity $63,684 $61,698 $1,986
Total liabilities and equity $99,684 $180,754 ($81,070)
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2-10 FINANCIAL REPORTING AND TAX CLASSIFICATIONS
Financial To help you understand the financial reporting differences for the
reporting lessee, let’s look at a balance sheet and an income statement for the
benefits 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.
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 Capital
Lease Lease Difference
Revenue
Sales $300,000 $300,000
Cost of goods sold (160,000) 160,000
Gross profit $140,000 $140,000
Operating Expenses
Selling ($4,000) ($4,000)
General and administrative (44,000) (44,000)
Lease expense (24,332) 0 ($24,332)
Depreciation expense (10,000) (30,000) 20,000
Operating income $57,668 $62,000 ($4,332)
Other Income and Expenses
Interest expense ($12,000) $19,388 $7,388
Income before taxes $45,668 42,612 $3,056
Income taxes @ 35% (15,984) (14,914) (1,070)
Net Income $29,684 $27,698 $1,986
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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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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):
Question 2: If the lessee effectively purchases the asset by the end of the lease term, it
would classify the lease as a(n):
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
____ a) True
____ b) False
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2-14 FINANCIAL REPORTING AND TAX CLASSIFICATIONS
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
a) True
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Question 6: A lease that provides off balance sheet financing to a lessee is called a(n):
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2-16 FINANCIAL REPORTING AND TAX CLASSIFICATIONS
ANSWER KEY
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.
Internal To help taxpayers, the IRS has issued several statements to outline the
Revenue criteria the IRS uses to classify lease transactions. You will see that
Service the criteria used to determine the tax classification of a lease are
statements
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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Tax status 1. Portions of the periodic payments (rentals) are made specifically
criteria 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:
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Guidance for In 1975, the IRS issued Revenue Procedure 75-21 (Rev. Proc. 75-21)
large to provide guidance for structuring large leveraged leases. Because an
leveraged equity investor (the lessor) and a nonrecourse lender finance the
lease
equipment in a leveraged lease, the parties were often uncertain as to
structures
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:
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2-20 FINANCIAL REPORTING AND TAX CLASSIFICATIONS
Risk of According to the tax courts, the party that bears the risk of ownership
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 Economic merit means that the transaction must have been entered
merit into for other than tax-motivated purposes. The courts look for
positive cash flow and profits from sources other than tax benefits.
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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. Tax considerations also affect the lessee’s decision to lease or to
purchase purchase equipment. The lessee must weigh the tax benefits of
decision ownership against the benefits of leasing we discussed in Unit One.
Terminology
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2-22 FINANCIAL REPORTING AND TAX CLASSIFICATIONS
Tax Returns
Ownership Quadrant 1 shows the benefits of ownership for a lessor in a tax lease:
benefits tax depreciation and any credits available. In addition, the lessor
records as income the rents received from the lessee.
Taxed on Quadrant 2 shows the tax implications to the lessor in a nontax lease.
interest 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 It is important to note that the tax status of a lease does not affect the
taxable total amount of taxable income recognized; it affects only when that
income 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.
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.
Ownership In a nontax lease, the lessee is considered the owner of the equipment,
benefits as detailed in quadrant 4. The lessee receives a deduction for
depreciation and also a deduction for interest expense.
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.
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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2-24 FINANCIAL REPORTING AND TAX CLASSIFICATIONS
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:
MACRS TABLE
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If the
recovery
year is: and the recovery period is:
Positive cash As a tax benefit, MACRS represents a positive cash flow to the
flow 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
Slowed cash The midquarter convention causes the tax benefits from depreciation
inflow 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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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.
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Tax lease In Figure 2.11, we can see the income recognized if the transaction is
income 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.
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.
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Worth of lease In this transaction, the lease alternative is worth an additional $2,892
alternative 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
Loan Lease
Year Income Income Difference
1 0 (20,000) 20,000
2 9,742 (6,207) 15,949
3 7,973 6,592 1,381
4 6,010 14,273 (8,263)
5 3,829 14,272 (10,443)
6 1,409 20,033 (18,624)
28,963 28,963 0
Fourth As you can see, a lease that starts in the fourth quarter is more
quarter 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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Preference Under the AMT, for some adjustments taken to arrive at taxable
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Marketing Approach
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
Avoid In marketing tax leases to a potential lessee, the goal is to show the
preferences 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.
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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.
Two tax lease products worthy of mention are the TRAC lease and the
tax-exempt user lease.
Target The TRAC lease is a tax lease specifically designed for the
industry commercial vehicle leasing industry. TRAC stands for Terminal
Rental Adjustment Clause.
Lessee In the TRAC lease, the lessee assures the lessor receipt of a specified
assumes residual, or salvage, value of vehicle. The lease payments in a TRAC
residual risk lease are lower because the lessor relies on the lessee assurances
regarding the residual value of the equipment.
Qualifying Examples of specialized vehicles that qualify for TRAC leases include
vehicles dealer service trucks, dealer haul trucks, contractor haul trucks,
equipment trailers, and busses.
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Shifts risk to If the realized actual value is less than the assured value, the lessee
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 Lessors enter into a tax-exempt user lease with tax-exempt or
taxable 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.
Lessee Recall that when a lease fails to meet the IRS criteria for a tax lease,
ownership 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.
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Interest rate In a money-over-money lease, the lessor's profit in the lease is the
differences 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.
Tax-exempt An interest rate is stated in the contract. The municipality becomes the
interest owner of the equipment at lease termination. The key characteristic of
earnings a municipal lease is that the interest earnings to the lessor are tax-
exempt. 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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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?
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ANSWER KEY
Question 1: Which of the following will probably lead to a nontax classification of a lease
agreement?
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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 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
n Understand the criteria used by the legal system to distinguish a true lease
from a secured transaction
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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3-2 LEGAL CLASSIFICATION AND LEASE DOCUMENTATION
Sources of The classification criteria the U.S. legal system uses today are based
criteria on three sources:
Focus on Conceptually, the criteria from these sources are similar to the
ownership criteria used for accounting and tax purposes. Once again, the focus is
on ownership of the equipment.
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
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Article 2
Implied Article 2 deals with sales and the rights of buyers and sellers. The
warranties 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 2A is a recent addition to the UCC that specifically covers true
article 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
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Computation The Article provides a complex remedies and damages scheme for
formula 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 Some of the factors courts have considered in deciding whether a
criteria transaction is a true lease or secured transaction are below.
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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 Whether the lessee was responsible for paying the taxes and
insurance on the equipment and keeping it maintained and
repaired
LEGAL IMPLICATIONS
UCC Filings
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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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Directions: Determine the correct answer to each question. Check your answers with
the Answer Key on the next page.
Question 3: Which factor will most likely cause a transaction to be considered a secured
transaction?
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3-8 LEGAL CLASSIFICATION AND LEASE DOCUMENTATION
ANSWER KEY
b) independent criteria.
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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LEGAL CLASSIFICATION AND LEASE DOCUMENTATION 3-9
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.
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
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 Precautionary Form UCC-1
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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
Master Lease
The major terms and conditions of a Master Lease that protect the
lessor include the following:
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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 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.
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3-12 LEGAL CLASSIFICATION AND LEASE DOCUMENTATION
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 Events of default
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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 An Equipment Schedule sets forth all the variable fill-in-the-blank
information 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.
End-of-term This rider provides lessees with the option to purchase the equipment
purchase at the end of the lease term at the equipment’s fair market value.
option
Re-lease The Fair Rental Renewal Option gives lessees the option to re-lease
option the equipment for its then-current fair rental value.
Certificate of Acceptance
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3-14 LEGAL CLASSIFICATION AND LEASE DOCUMENTATION
Compute The objective of the Casualty Value Schedule is to establish the value
compensation (to the lessor) of the lease and the equipment at various times over the
for loss term of the lease. It is used to compute lessee payments for the loss,
destruction, or condemnation of the equipment.
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 The purpose of the Certificate of Insurance is to assure the lessor that
obligation the lessee has obtained the appropriate insurance coverage.
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.
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Default Provisions
n False representations
n Failure to pay rent within the specified days of the due date
Notice to These definitions put the lessee on notice that any failure to adhere to
lessee 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.
n The lessor may take back the equipment and re-lease it, sell it
or keep it.
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3-16 LEGAL CLASSIFICATION AND LEASE DOCUMENTATION
The lessor may opt for this remedy when the lessee has
permitted a judgment or execution to be rendered against 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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Directions: Determine the correct answer to each question. Check your answers with
the Answer Key on the next page.
____ a) True
____ b) False
____ 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.
____ 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
b) False
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 credit-
worthiness. Methods lessors can use to minimize specific leasing risks are discussed
throughout the unit.
UNIT OBJECTIVES
n Understand how financial ratios are used to reveal the financial health
of a potential lessee
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RISK ASSESSMENT
30 variables of There are 30 variables of lease credit, each of which begins with
lease credit the letter “C.” These variables fall into three categories:
n Characteristics of lessees
Analytical There are eight steps in the credit evaluation and assessment process.
functions 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
n A compilation or disclaimer
Warning of If an accounting firm has compiled the financial statements, but
extended risk 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 Tax returns
Different from Tax returns are an excellent source of information to use for
financial evaluating lessor risk. The lessor must keep in mind that tax
statements returns are prepared according to tax legislation rather than
GAAP; therefore, differences between financial statements and
tax statements will occur.
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Corroboration
n Bank references
Bank documentation would include the following:
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Catastrophe
Worst-case The lessor should identify the worst down-side possibility and then
exposure 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 Concatenation means that the lessor must determine which credit
variables variables are important in the credit decision.
Classification
Rank credit In classification, the lessor ranks the credit variables identified in
variables 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 Consideration is the degree to which a credit standard is met. After
variables 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
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Compilation
Result used to Based on where the credit rating falls on the scale, the credit may
make decision be accepted or rejected. Figure 4.1 shows the compilation process and
scale.
Attaining You may view Figure 4.1 as a completed credit matrix. It is important
consistency to realize that each analyst may assign different classification values
through matrix and consideration scores to a risk factor
development
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 COMPUTATION
(Weighting) 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
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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CREDIT ANALYSIS AND RISK ASSESSMENT 4-7
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
Capital
Three Capital has several meanings. We will use three meanings of the term
definitions here.
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Lessee’s For risk assessment purposes, a creditor usually looks for strong net
capital worth and limited financial leverage. A strong capital position means
position the lessee has assets available to satisfy a judgment in the event of
default. The following accounting formula conveys this concept:
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.
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Capacity
Lessee’s Capacity refers to the lessee's ability to pay. Typically, credit analysts
ability to pay 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.
Liquidity Recall that a broad interpretation of capacity includes not only the
assessment 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.
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Credit
Size of capital The lessor should investigate credit experience to determine the
and payment lessee’s past trading policies and practices. Dunn & Bradstreet is a
trends 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 Lessors also may obtain credit checks on selected officers, owners
checks 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.
Cash Flow
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Chronological Age
History affects A company with a relatively short history presents increased risk to
extent of risk 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 The capital asset pricing model (CAPM), with its attendant beta
and risk coefficient, is a way to measure the risk in capital budgeting. Because
evaluation leasing is basically a capital expenditure consideration, it makes sense
for lessors to understand this conceptual approach to capital asset and
risk evaluation.
Two You should understand that interest rates that lessors receive usually
components varies according to the risks they bear. Interest may be separated into
of risk 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 This is where the concept of the beta coefficient comes into our
coefficient 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.
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.
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Capability
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 Control refers to the feedback systems (such as standard cost
budget accounting systems, budget variance systems, and zero base budgeting
systems 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 Course refers to the financial direction of the lessee. It also relates
historical to the financial history of the company. The lessor should first
trends to determine that a proper trend analysis is available for cash flow,
historical
financial ratios, and capacity indicators. The lessor can compare this
plans
analysis to the strategic plan of a company to see if historical trends
have substantiated historical plans.
Constraints
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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 Collateral is important because the lessor must look to the value of
equipment the equipment if the lessee defaults. Equipment that maintains value
over time 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 Because the question of collateral is so important in many leases, the
assessing lessor should assess its risks carefully. One assessment method used
increased risk 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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Complexity
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Equipment Equipment sophistication has increased. If the lessee finds that the
sophistication 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.
Provision for The lessor should also consider provisions for covering the effect of
tax law tax legislation on its cash flow. One approach may be to specify that
changes the lessor's after-tax cash flow return on investment will remain
constant if a tax law change occurs.
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Currency
Monetary unit Currency rates, restrictions, fluctuations, and translations all increase
risks 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
Cross-border
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Competition
Lessee’s Competition involves the lessee's markets, market shares, and trends.
growth The lessor should determine if the lessee has a growing, stable, or
potential declining share of a growing, stable, or declining market.
International The lessor must also consider the foreign competition the lessee
lessor faces. The growing internationalization of the business community has
competition 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.
Copartner
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Concealed Value
Book value Concealed value refers to the difference between the book value and
vs. fair market the fair market value of a fixed asset. Because balance sheets are
value 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 Intangible assets are another source of valuation risk for lessors.
assets 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
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SUMMARY
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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 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:
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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 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:
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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
____ a) complexity.
____ b) collateral.
____ c) credit.
____ d) control.
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ANSWER KEY
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.
b) collateral.
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CREDIT ANALYSIS AND RISK ASSESSMENT 4-27
In this section, we will discuss the use of each financial statement for
lease credit analysis.
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Relationships Another tool credit analysts use to assess a company’s financial well-
between being is a financial ratio analysis. Financial ratios are useful because
financial they reveal relationships between financial statement accounts. Credit
statement
analysts use ratios for comparative analysis, interrelationship studies,
accounts
and input to forecasting models. Figure 4.4 shows how ratios are used
and the effect they have on the decision process.
COMPARISONS
2) Industry ratios are compared with similar 2) Relative standing is established within an
companies within an industry. industry. Relative standing could highlight
strengths or weaknesses.
INTERRELATIONSHIPS
MODELS
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Categories of Standard ratios can be grouped into six broad categories, each of
noncash which depicts a particular aspect of the financial condition of the
ratios company:
Information We will use the year-end financial information for ABC Company
used for in Figures 4.5 and 4.6 to illustrate how the ratios in each category
examples 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
1993 1992
ASSETS
Cash $ 106,000 $ 192,000
Accounts receivable 566,000 483,000
Inventories 320,000 250,000
Plant and equipment (net) 740,000 716,000
Patents 26,000 26,000
Other intangible assets 14,000
12,000
Total assets $ 1,772,000 $ 1,679,000
ABC Company
INCOME STATEMENT
1993 1992
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Profitability Seven ratios have been developed into a model (Figure 4.7) that
model describes a company's profitability and also describes the effect of
dividend payout on potential growth rate in earnings.
PROFITABILITY MODEL
1. Net profit to net sales (net profit margin)
x 2. Net sales to total assets (asset turnover)
= 3. Return on investment or assets
x 4. Financial leverage advantage (assets to equity ratio)
= 5. Net income to owners' equity (return on equity)
x 6. Retention ratio (l - dividend to net income ratio)
= 7. Potential growth rate in earnings.
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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Net income as Net profit margin calculates net income as a percentage of sales.
percentage of Stable or growing net profit margins are favorable indicators so long
sales as asset turnover has not been overly reduced.
Sales that Asset turnover indicates the amount of sales that each dollar invested
investments in assets can generate. Thus, in this example, each dollar of assets is
in assets can able to generate $.8934 of sales revenue. Increases in asset turnover
generate
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 Notice that when we calculate asset turnover as part of the
of profitability profitability growth model, we use: beginning of the year assets rather
model than an average and total assets rather than net fixed assets, which are
more commonly used for asset turnover computations.
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Effect of This ratio is not one that indicates profitability directly; rather, it
financial indicates the effect of financial leverage on profit. When a company
leverage 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.
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6. RETENTION RATIO
Dividends $28,000
1- = 1- = 56.92%
Net income $65,000
Declines This ratio indicates the percentage of net income that remains after
indicate profit dividend payment. Sudden or systematic declines in the retention ratio
crisis could indicate an impending profitability crisis.
Growth A company’s growth rate cannot exceed the product of its retention
factors 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.
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GROSS M ARGIN
Percentage of Gross profit margin indicates what percentage of sales is gross profit.
sales as gross Steady or increasing gross profit margins are favorable if asset
profit turnover is not being reduced too fast or general and administrative
expenses are not increasing too rapidly.
DIVIDEND YIELD
$28,000
Dividend p er share 20,000
= = 4%
Average price per share 35
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CURRENT RATIO
Compares Current assets are 4.13 times as large as current liabilities. Keep in
assets to mind, however, that a significant portion of current assets may not be
liabilities liquid enough to pay liabilities when due.
A better index Quick (readily convertible to cash) assets are 2.8 times current
of liquidity liabilities, which is a more realistic index of liquidity than current ratio.
Inventory as Note that net working capital is current assets minus current
percentage of liabilities. This ratio indicates what percentage of working capital is
working comprised of inventory, its most nonliquid component. An increasing
capital
inventory-to-net working capital ratio indicates movement towards a
nonliquid position.
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Effective use Investment utilization or activity ratios measure how effectively the
of resources 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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365 365
=
Accounts receivable turnover Credit sales
Average accounts receivable
365
= 127.628 days
$1,500,000
$566,000 + $483,000
2
Growing time If credit sales are not available, total sales may be used, and year-end
period signals accounts receivable may be used in place of average accounts
liquidity receivable. This ratio indicates it takes an average of 128 days to
problems
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.
365
= 115.583 days
$900,000
$320,000 + $250,000
2
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Growing ratio If cost of goods sold is not available, total sales may be used.
warrants Ending inventory may be used instead of average inventory. This ratio
investigation 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.
Growth This ratio represents the total time to convert inventory into a sale,
indicates poor then into a receivable, and back into cash. Growth of this conversion
resource time period may indicate poorer overall utilization of resources.
utilization
365
= 60.022 days
$900,000
$170,000 + $126,000
2
Growth in This ratio represents the average time taken to pay trade payables. The
result time period should be less than both days’ receivables or days’
indicates inventories. Growth in the days’ payable may indicate forthcoming
liquidity,
liquidity and profitability problems since trade creditors are being
profitability
problems
forced to increase their waiting period for payment.
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Dependency This ratio indicates how dependent sales are on owners' equity
of sales on (assuming constant financial leverage). If this ratio has held constant,
owner’s equity increased sales may require additional equity — without equity
infusions expansion might be limited. Increases in the ratio may
indicate improvement in operational efficiencies.
Dependency The net sales to average net working capital ratio indicates the degree
of sales on to which sales are dependent upon working capital. If this ratio
working increases, working capital inefficiencies are occurring or a new
capital
product with slower turnover is being sold.
Lessee’s debt A lessor granting credit should always be concerned with the debt
burden 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:
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Growing ratio This ratio describes what percentage of the total capital structure is
may signal debt. If a company's ROE is relatively constant while this ratio is
inefficiencies growing, inefficiencies may be occurring.
Growing ratio This ratio indicates relative commitment to the company: trade
signals creditors (current liabilities) versus owners' equity. A growing ratio
liquidity needs may indicate forthcoming liquidity needs.
Growing ratio Whereas total liabilities to total assets indicate total leverage, this
compared to ratio indicates both total leverage and the cost of the leverage relative
ROE to net income. A growing ratio without corresponding increases in
increases
ROE may indicate a profitability problem and a possible forthcoming
credit shortage.
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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.
Interest could have been paid 1.85 times before income is used up.
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Reliance of This ratio indicates the reliance of property, plant and equipment on
property, equity. Increases in this percent indicate permanent capital
plant, and requirements as opposed to short- and intermediate-term funding.
equipment on
Too rapid an increase could indicate a forthcoming liquidity problem
equity
as well a cutback on property, plant, and equipment expansion.
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Tool to assess We mentioned the importance of cash flow analysis previously in this
lessee’s unit. Many credit analysts consider cash flow analysis to be the best
credit- tool to assess a potential lessee's creditworthiness, because available
worthiness
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.
Cash flow Figure 4.8 shows the cash flow statement required by FASB 95. In
worksheet 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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Source of Any future leases or loans would be repaid from disposable cash flow.
cash for Therefore, the computation of disposable cash flow is the whole
future leases 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).
Cash flows as In Figure 4.9, the non-operating cash sources on the cash flow
a function of worksheet disclose the sources of cash that provided for the $885
discretion 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 non-
discretion since only disposable cash flow will be available to pay off
future debt or lease obligations.
Comparison to Earlier in this unit, you saw how standard ratio analysis relates income
standard ratio statement data to balance sheet data, income statement to income
analysis 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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There are four cash flow ratios used to identify trends in relationships
between the income statement and cash flow.
1.
Net income $760
= = 49.03%
Gross operating cash flow $1,550
Gross This ratio demonstrates the proportion of gross operating cash flow
operating derived from net income. If this percentage increases, less cash flow
cash flow as a is being generated for each dollar of net income. If such a trend
percentage of
continues, liquidity problems might arise.
net income
2.
Net income $760
= = 55.68%
Net operating cash flow $1,365
Impact of This ratio is similar to the first ratio, however, the impact of working
working capital sources and uses is factored in. If this ratio is growing or
capital exceeds ratio 1, it may indicate that working capital requirements are
sources
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 $1,365
= = 6.2045%
Interest and lease rentals $220 + $0
Unadjusted This ratio is similar to times interest earned except that the cash flow
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 $444
= = 2.018%
Interest and lease r entals $220
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Feasibility of This cash flow ratio is similar to times interest earned also; however,
new expense 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.
1.
Net operating cash generation $1,365
= = 3.074%
Disposable net operating cash flow $444
Impact of non- This ratio demonstrates the impact of nondiscretionary cash needs.
discretionary If needs are few, the ratio would be closer to one. High or growing
cash needs ratios indicate greater cash flow commitments, which reduce cash
available to pay off future loan or lease payments.
2.
Gross operating cash flow $1,550
= = 3.491%
Disposable net operating cash flow $444
Cash flow This is the same as ratio 1 except the impact of working capital cash
commitments 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 $885
= = .648%
Net operating cash flow $1,365
Discretionary This ratio indicates the percent of net operating cash flow that is being
spending 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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Assets: $5,000
Equity: $2,300
Net working capital: $500
1.
Net Operating cash flow $1,365
= = 27.3%
Assets $5,000
Profitability This ratio is the same as the standard ROA except it represents the
indicator total cash flow ROA. Decreases in this ratio indicate a decrease in the
company's profitability.
2.
Net workin g capital $500
= = 36.63%
Net operating cash flow $1,365
Working The percentage that net working capital is of net operating cash flow
capital should remain steady. Increases could indicate inefficiencies in
management working capital management.
3.
Net operating cash flow $1,365
= = 59.35%
Equity $2,300
Net operating This ratio is the same as the standard ROE except this represents the
cash flow as a total cash flow ROE. This percentage should remain relatively
percentage of constant, however, increases in the percentage would be considered
equity
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 time-
spanning 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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Directions: Determine the correct answer to each question. Check your answers with
the Answer Key on the next page.
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) True
____ b) False
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ANSWER KEY
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:
b) shows the effect of a change in any one factor on each of the other
factors.
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:
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:
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
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5-2 FINANCIAL CONCEPTS AND CALCULATIONS
PRESENT VALUE
Removing The concept of present value involves taking a known future value
time value of amount and stripping out the time value of money factor (discount
money 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?
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Calculator In our examples, we will show how to enter this information with the
keys following keys on the HP12C calculator:
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Single cash A single cash flow could represent a purchase option or a balloon
flow 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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FINANCIAL CONCEPTS AND CALCULATIONS 5-5
The present value of the $15,000 payment due at the end of a 48-
month term loan is $8,854.76.
End-of-period Now that you have seen how to calculate present value on a single cash
payment flow, we will show you how to calculate present value on a series of
stream 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
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5-6 FINANCIAL CONCEPTS AND CALCULATIONS
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).
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0 5 years
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5-8 FINANCIAL CONCEPTS AND CALCULATIONS
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:
Now you can enter the values. Here are two examples.
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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.
Uneven cash Some leases require that the lessee make more than one payment in
flow stream advance. More than one payment in advance creates a multiple, uneven
cash flow situation.
Cash flow For uneven cash flows, you do not have to select a payment mode
keys because you will enter each cash flow and the number of times it
occurs. In our illustrations, we will use the following keys:
For example:
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5-10 FINANCIAL CONCEPTS AND CALCULATIONS
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 48 months
Keystrokes The keystrokes for entering this uneven cash flow stream are as
follows:
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FINANCIAL CONCEPTS AND CALCULATIONS 5-11
Other types In the previous section, you learned that advance payment transactions
of multiple, are a form of multiple, uneven cash flow transactions.
uneven cash In this section we will look at another transaction — a step-down
flows
lease -- that creates multiple, uneven cash flows. In a step-down
transaction, payments decrease over the lease term.
Example 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.
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5-12 FINANCIAL CONCEPTS AND CALCULATIONS
To help visualize the pattern of cash flows for this transaction, study
the timeline shown below.
0 36
$12,000 6
48
35 payments
$3,000
$12,000 12 payments
$7,500
Now let’s see how to solve for present value in this step-down
transaction:
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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 You may apply IRR analysis to a stream of cash flows throughout
applications 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.
Common IRRs include lease yields, interest costs, interest rates and
earnings rates.
Required To calculate IRRs, you must know the time-zero (present value) cash
information 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 FINANCIAL CONCEPTS AND CALCULATIONS
Outflows and When you compute financial yields, think of investments as cash
inflows outflows (negative) and repayments as cash inflows (positive). Now
let’s look at an example.
Before you begin, remember to clear the register and set the mode
to END.
Separate Earlier in this unit you learned that multiple advance payments and
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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.
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5-16 FINANCIAL CONCEPTS AND CALCULATIONS
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FINANCIAL CONCEPTS AND CALCULATIONS 5-17
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:
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:
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
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5-18 FINANCIAL CONCEPTS AND CALCULATIONS
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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] 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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5-20 FINANCIAL CONCEPTS AND CALCULATIONS
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
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PROGRESS CHECK 5
(Continued)
$____________________
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5-22 FINANCIAL CONCEPTS AND CALCULATIONS
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
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FINANCIAL CONCEPTS AND CALCULATIONS 5-23
PROGRESS CHECK 5
(Continued)
$____________________
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5-24 FINANCIAL CONCEPTS AND CALCULATIONS
ANSWER KEY
$107,722.87
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FINANCIAL CONCEPTS AND CALCULATIONS 5-25
PROGRESS CHECK 5
(Continued)
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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5-26 FINANCIAL CONCEPTS AND CALCULATIONS
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%
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FINANCIAL CONCEPTS AND CALCULATIONS 5-27
PROGRESS CHECK 5
(Continued)
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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5-28 FINANCIAL CONCEPTS AND CALCULATIONS
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%
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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
+ Recognize how the discount rate affects the results of the lease vs. buy
analysis
1
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6-2 INTRODUCTION TO THE LEASE VS. BUY ANALYSIS
Details of A good lease vs. purchase decision depends on accurate, valid, and
financing relevant information. In this section, we discuss some of the more
alternatives important items of information required to make an informed lease vs.
buy decision. Please note that some items are facts, and others are
assumptions.
− Lease term
− Payment amount
− End-of-term options
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INTRODUCTION TO THE LEASE VS. BUY ANALYSIS 6-3
Three-step There are three main steps in the lease vs. buy analysis process:
process
1. Gather detailed information for all alternatives
Gather Information
General Assumptions:
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6-4 INTRODUCTION TO THE LEASE VS. BUY ANALYSIS
Lease Assumptions
Purchase Assumptions
Now that we have the information we need, we can calculate the after-
tax cash flows for the lease (Figure 6.1). For simplicity, we will
assume annual cash flows.
0 1 2 3 4 5
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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INTRODUCTION TO THE LEASE VS. BUY ANALYSIS 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
Cash inflows Notice that the interest tax benefit and the depreciation tax benefit
represent cash inflows to the company, and are shown in parentheses.
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6-6 INTRODUCTION TO THE LEASE VS. BUY ANALYSIS
Declining
Balance Annual
Year Equipment Cost Percentage Deduction Tax Rate Tax Benefit
Salvage value At this point, the only remaining cash flow we need to identify is
cash flow 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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INTRODUCTION TO THE LEASE VS. BUY ANALYSIS 6-7
Choosing Once the after-tax cash flows for each alternative have been
discount rate 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 Let’s look at the HP12C keystrokes required to calculate the
calculator present value of the lease cash flows. The cash flow amount is from
Figure 6.1.
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6-8 INTRODUCTION TO THE LEASE VS. BUY ANALYSIS
Now let’s calculate the present value of the purchase cash flows and
compare the difference (Figure 6.7).
As you can see, the company should purchase the equipment when the
after-tax cost of debt is used as the discount rate.
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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.
Use as a From a lessor point of view, the break-even rate provides a floor above
marketing tool 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.
Discount Rate
IRR of The break-even discount rate is equal to the internal rate of return
differential of the differential cash flows between two financing alternatives. In
cash flows other words, it is the IRR at which the present value is the same for
both alternatives.
0 1 2 3 4 5
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6-10 INTRODUCTION TO THE LEASE VS. BUY ANALYSIS
Using the Now let’s calculate the internal rate of return for the differential cash
calculator flows.
Present value The break-even rate is 11.4698. If we solve for present value using
at break-even 11.4698 as the discount rate, the present value will be the same for
IRR both the lease and the loan. Let’s prove this concept.
LEASE
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INTRODUCTION TO THE LEASE VS. BUY ANALYSIS 6-11
PURCHASE
Salvage Value
Subjective Sensitivity analysis also can be used to find the break-even point of
value 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 INTRODUCTION TO THE LEASE VS. BUY ANALYSIS
Convert to We use a two-step process to convert the $232 to its pretax future
pretax future value of $535.
value
Indifference The difference between the original salvage value and the pretax future
value value we calculated above is the indifference value:
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.
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INTRODUCTION TO THE LEASE VS. BUY ANALYSIS 6-13
Discount Rate
Salvage value The type of transaction being entered into also affects the choice of
and risk 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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6-14 INTRODUCTION TO THE LEASE VS. BUY ANALYSIS
Salvage Value
Factors to The salvage value has the greatest effect on the result of the lease vs.
consider 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.
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.
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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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] PROGRESS CHECK 6
Directions: Determine the correct answer to each question. Check your answers with
the Answer Key on the next page.
Question 2: The reason a lease vs. buy analysis is performed on an after-tax basis is to:
Question 3: Why is present value analysis used in lease vs. buy calculations?
____ 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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6-18 INTRODUCTION TO THE LEASE VS. BUY ANALYSIS
ANSWER KEY
Question 1: A valid lease vs. buy decision depends on accurate, valid, relevant
information.
Question 2: The reason a lease vs. buy analysis is performed on an after-tax basis is to:
Question 3: Why is present value analysis used in lease vs. buy calculations?
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.
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PROGRESS CHECK 6
(Continued)
____ 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:
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6-20 INTRODUCTION TO THE LEASE VS. BUY ANALYSIS
ANSWER KEY
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.
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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.
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
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7-2 LEASE STRUCTURING
Return of In pricing, the lessor solves for a monthly payment amount that will
investment recover its investment in the equipment and earn the targeted yield.
and return on The lessor’s targeted profit must be received from the payments and
investment
residual value.
Pricing factors Lessors consider several factors when they price a lease:
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LEASE STRUCTURING 7-3
Four-step In this section, we discuss the four basic steps that are necessary to
process 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:
Example To help you understand these steps, let’s work through an example.
Assumptions:
Net cash The monthly payment we are solving for is affected by all cash
outflow at time flows in the lease. For example, the higher the residual, the lower
zero plus the monthly payment. To solve for the monthly payment that will
target yield
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 LEASE STRUCTURING
Residual value In this example, the only future cash flow is the residual value,
adjustment adjusted for the return of the security deposit (15,000 - 3,000 =
12,000). Let’s calculate the present value on the HP12C:
KEYSTROKES DISPLAY
f REG 0.00
10 g 12 ÷ .83
60 n 60.00
12,000 CHS FV 12,000.00
PV 7,293.46
Total net We can now add the present value of the net residual to the
outflow other components of the net cash outflow at time zero. Let’s look
components at a time line of the cash flows to see the total net outflow (Figure
7.1).
0 60
(100,000.00) 15,000.00
3,000.00 (3,000.00)
(2,507.00)
7,293.46 12,000.00
1,000.00
91,213.54
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LEASE STRUCTURING 7-5
KEYSTROKES DISPLAY
f REG 0.00
g BEG 0.00
1 CHS PMT -1.00 (One-dollar payment)
60 n 60.00 (60 payments)
10 g 12 ÷ .83 (Enters pretax yield)
PV 47.4576
Principal of From this calculation, we see that if the payment were only one
one-dollar dollar, then 60 payments in advance would recover principal
payment (investment) of $47.46. Recall that the required payment must
recover principal of $91,213.54 (step two).
Step 2 91,213.54
= 1,922
Step 3 47.4576
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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7-6 LEASE STRUCTURING
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Skipped Payments
Skipped To structure skipped payment leases, let each regular payment equal
payments = one dollar and the skipped payments equal zero when finding the
zero present value of the one-dollar payments.
KEYSTROKES
Step-up Lease
KEYSTROKES
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7-8 LEASE STRUCTURING
Step-down Lease
KEYSTROKES
The structuring methodology changes when the lessee can pay only a
limited amount of rent during the early months of a lease.
Price of Assume the lessee can pay only $1,800 per month in arrears for the
remaining first 12 months of a 48-month lease. We must determine the price of
payments the 36 remaining payments that will produce the required yield.
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KEYSTROKES
.67 i
1,800 g CFj (Known lease payments)
12 g Nj
f NPV 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 payments already
considered)
12 g Nj
1 g CFj
36 g Nj
f NPV 29.437088
Making the Leases are sometimes terminated prior to the end of their
lessor noncancellable terms. For example, the lessee may want to purchase
“whole” 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).
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Quantitative There are many different factors that lessors should consider when
and evaluating proposals from other lessors. Some of these factors are
qualitative quantitative, such as monthly payment or internal rate of return. Others
factors
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, step-
downs)
+ Contingent payments such as an excessive use penalty
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Operational
Restrictive
Termination
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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
COMPANY B $1,212.22
COMPANY A 1,205.58
$ 6.64
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Terms must Since the term for both proposals is the same, total cash over the term
be equal 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
Payment ÷ The lease rate factor is calculated by dividing the payment by the
equipment equipment cost. Because the cost of the equipment is the same for
cost both proposals, this method again favors Company A.
COMPANY B .024244
COMPANY A .024112
.000132
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7-14 LEASE STRUCTURING
COMPANY A
KEYSTROKES
f IRR .6405
12 x 7.6865
COMPANY B
KEYSTROKES
g END
50,000 CHS PV
1,212.22 PMT
48 n Nj
i .6367
12 x 7.6402
Differences
COMPANY A 7.6865
COMPANY B 7.6402
.0463
Assume The last method we will examine requires the evaluator to assume
discount rate 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.
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COMPANY A
KEYSTROKES
g BEG
9.75 g 12 ÷
1,205.58 CHS PMT
48 n
PV 48,148
COMPANY B
KEYSTROKES
g END
9.75 g 12 ÷
1,212.22 CHS PMT
48 n
PV 48,023
Differences
COMPANY A 48,148
COMPANY B 48,023
125
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7-16 LEASE STRUCTURING
Value Amount
METHOD OF COMPARISON Co. Co. Co. Co.
A B C D
Monthly payment
Implicit/interest cost
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 after-
tax 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.
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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) 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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ANSWER KEY
Question 1: The present value amount that remains after the lessor’s desired yield is
removed from cash flows is the:
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.
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PROGRESS CHECK 7
(Continued)
____ 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 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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ANSWER KEY
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
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PROGRESS CHECK 7
(Continued)
____ 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.
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ANSWER KEY
c) does not take into account the payment mode (advance or arrears).
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Unit 8
UNIT 8: VENDOR LEASE PROGRAMS
INTRODUCTION
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
+ Recognize the various ways third parties participate in vendor leasing programs
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8-2 VENDOR LEASE PROGRAMS
+ Market control
+ Market enhancement
+ Ancillary income
+ Tax benefits
+ Financial leverage
Market Control
Critical Most vendor leasing programs are established for marketing reasons.
periods Vendor programs give vendors control during critical periods over the
useful life of equipment, including:
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Market Enhancement
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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:
Tax Benefits
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Ability to use The value of tax benefits to a vendor program can be significant. If the
tax benefits 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 Two-party
Lessor Lessor
Gross
profit tax 0.000 2.425
deferral
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
Financial Leverage
Interest rate Recall that in a leveraged lease, the lessor borrows much of the
and cost of equipment cost and assigns the future lease payment stream to the
debt 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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Expertise and The lack of in-house leasing expertise is one of the most important
capital issues 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 Even for companies with the resources to set up a leasing program,
over risks 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.
Third-party Participants
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.
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).
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8-8 VENDOR LEASE PROGRAMS
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
Third-party This is an area where third-party lessors offer a great deal of added
lessor’s value. The third-party company works with a vendor to customize a
expertise 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
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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 There are many ways to fund a vendor leasing program or captive. The
indirect method chosen depends on the vendor’s desired tax and accounting
funding 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 Whether the vendor, the third-party lessor, or the customer retains the
issues 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
Control over Vendors often seek outside help in remarketing the asset at the end of
asset 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 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
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ANSWER KEY
Question 2: The reason vendors wish to exercise control at the time of sale is to:
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
d) the rate of return from the lease generally exceeds the cost of
borrowing to leverage the lease.
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PROGRESS CHECK 8
(Continued)
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) 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 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.
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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
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9-2 VENDOR PROGRAMS
Finance sales In Unit Two, you learned that manufacturing companies, distributors,
of products 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.
Citibank Benefits
Access to Why does Citibank use vendor programs as part of its asset based
equipment financing activity? The main reason is that vendor programs help speed
users 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.
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Dealer
Citibank Financing
• Vendor
• Direct
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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9-4 VENDOR PROGRAMS
Vendor Benefits
+ Market control
+ Market enhancement
+ Ancillary income
+ Tax benefits
+ Financial leverage
Market Control
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Market Enhancement
Market size In addition to market control, both the size and quality of a
and quality manufacturer's sales market can be improved through financing.
Market enhancement results from:
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9-6 VENDOR PROGRAMS
Interest, Increased sale of the vendor’s product is not the only source of profit
incremental in vendor financing programs. Here are three additional sources:
sales, residual
profits
+ The interest spread (difference) between interest income and
interest expense, brokerage fees, and service fees when the
lessor continues to service the lease
Tax Benefits
MACRS and In Unit Three, we discussed the various tax benefits of leasing. Recall
gross profit that in the U.S., the primary tax benefits for leasing are MACRS and
deferral 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.
Ability to use As you can see, the value of tax benefits in a vendor program can be
tax benefits 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.
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Third-party Two-party
Lessor Lessor
Gross
profit tax 0.000 2.425
deferral
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
Financial Leverage
Interest rate Recall that in a leveraged lease, the lessor borrows much of the
and cost of equipment cost and assigns the future lease payment stream to the
debt 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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Lack of The lack of in-house financing expertise is one of the most important
specialized reasons vendors do not have financing programs. Leasing, in
resources 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 Even for companies with the resources to set up a financing program,
risks and tax concerns about the many risks in financing equipment or an excess tax
position 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 Few vendors have the administrative and collection infrastructure
and necessary to conduct a financing program. Vendors also fear that their
administration cost of capital may be too high to compete with the rates of third-
party finance companies.
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9-10 VENDOR PROGRAMS
Joint ventures 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.
Direct Financing
Full-
Service All Services
Program development
through billing and collections
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Citibank roles 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.
+ Credit review
+ Outplacement/investment syndication
+ Funding
+ Administrative services
+ Remarketing/asset management
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Third-party This is an area where third-party creditors offer a great deal of added
lessor’s value. The third-party company works with a vendor to develop
expertise financial products and customize individual transactions to the needs
of a particular lessee or borrower. The vendor benefits from the third-
party’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
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 There are many ways to fund a vendor financing program or captive
indirect organization. The method chosen depends on the vendor’s desired tax
funding 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 Whether the vendor, the third-party creditor, or the customer retains
issues 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
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9-14 VENDOR PROGRAMS
Control over Vendors often seek outside help in remarketing the asset at the end of
asset 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.
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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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:
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:
Question 3: The reason vendors wish to exercise control at the time of sale is to:
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 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) 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
d) the rate of return from the lease generally exceeds the cost of
borrowing to leverage the lease.
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.
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Program Types
Referral
Creditor has In a referral program, the vendor directs or refers its customers to the
control and creditor for their financing needs, but does not provide support or
bears risks recourse. The creditor may be the only institution the vendor refers its
customers to (exclusive basis) or one of several creditors (non-
exclusive 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.
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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 In a risk sharing (partial recourse) program, Citibank and the vendor
collateral agree to share credit and/or collateral value risks. For example, Citibank
value risks 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.
Balance with Citibank requires some form of risk sharing for major programs in Latin
benefits 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.
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Think about how these objectives may be achieved as you read about
the three types of risk sharing mechanisms.
Percentage of In this risk sharing arrangement, the vendor guarantees an amount equal
financing 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 If a borrower defaults on a contract, the vendor repurchases the contract
against for its full face value from Citibank. The vendor then repossesses the
liability 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 When the vendor repurchases the defaulted contract, it assumes the
resolve responsibilities and risks of repossessing and remarketing the
defaults 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).
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Collateral In an asset value guarantee (buy back), the vendor guarantees a collateral
value value for each transaction. The AVG agreement contains a schedule of
guaranteed 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.
Split credit In co-lending, a vendor assumes 50 percent of the credit risk of each
risk 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
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Success As you might assume, each of the program types we just discussed —
criteria 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.
+ Design a program that will meet the vendor’s sales goals and
provide Citibank with the margins it needs
Existing The ideal vendor has an existing relationship with Citibank and serves
relationship 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:
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Marketing
Assess need Once you have determined that a vendor meets the selection criteria,
you should:
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 Next, gather the basic information required to develop a preliminary
information program structure. See Figure 9.6 for a list of key questions.
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What is the existing break down of the target market? How might the
vendor financing program change the target market?
How big is the secondary market for the equipment and what are the
distribution channels?
Program Outline
Contents Once you have the answers you need, develop a preliminary program
outline. The contents of a program outline should:
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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:
+ 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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Directions: Determine the correct answer to each question. Check your answers with
the Answer Key on the next page.
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).
____ 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
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.
b) False
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.
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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____ 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.
Question 7: Select two signs that may indicate that company is a good candidate for
a vendor program.
____ a) True
____ b) False
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ANSWER KEY
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.
The vendor should hold the dominant position in key markets, and the
collateral should be moveable so that repossession is easier.
a) True
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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
WHAT IS A FRANCHISE?
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Outlet types 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:
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Ownership Options
Fee Simple
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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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.
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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:
+ Supplier arrangements
Let’s examine three of these services and see how they contribute to
the success of the business.
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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 Franchisees use the information gathered during the site study to
projections 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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Supplier Arrangements
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 Because growth opportunities are limited in the U.S., companies that
opportunities 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 One way that Citibank is helping increase its market share is through
with cooperative agreements with franchisors. An example is the letter of
franchisors 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).
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Franchise Products
Asset types In both Latin America and the U.S., Citibank provides financing for
and tenors 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.
Old and new These loans are issued for financing existing and new stores,
obligations refinancing and consolidating existing debt, market acquisitions (one
operator buys existing stores from another franchisee), and financing
personal obligations such as stock repurchases.
Project Financing of new stores is often done with a line of credit that
financing 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.
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.
Assess Next, consider the collateral. Who controls the location? What assets
collateral 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 Finally, examine the franchise and lease agreements. What is the
agreements 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?
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SUMMARY
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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Directions: Determine the correct answer to each question. Check your answers with
the Answer Key on the next page.
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.
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 2: Match each ownership option with a description of the option. Write the
letter of the description next to the name of the option.
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:
Question 6: Select the franchise loan product offered for refinancing, consolidating
existing debt, and purchasing existing stores from another franchisee.
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ANSWER KEY
Question 4: Select two basic characteristics of Tier 1 markets that influence the value of
their franchise outlets.
Franchisors do not normally help resolve loan default situations unless they
have a prior agreement with the lender to do so.
Question 6: Select the franchise loan product offered for refinancing, consolidating
existing debt, and purchasing existing stores from another franchisee.
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
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:
+ Ways out
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
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Offset To minimize this risk, lenders such as Citibank may use these
strategies strategies:
Fraudulent Conveyance
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Effect on cash Commodity prices are relatively stable, but unpredictable. Labor costs
flow 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 Franchisors and franchisees have some control over these risks.
solutions 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 lower-
cost 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 One way lenders mitigate these risks is by requiring the borrowers to
ratios 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.
Right to sell Franchise licenses generally prohibit lenders from taking a security
as going interest in the franchise rights. This means a lender such as Citibank
concern can’t sell or take over the operation of stores it has financed.
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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 In the U.S., Citibank manages environmental liability risks by not
strategies 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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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.
Covers debt The first “out” a lender relies on is that cash flow from operations
service (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 If cash flow fails, debt may be satisfied through the sale of a store,
going concern 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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Sale Leaseback
Proceeds For franchisees who own the real estate under their restaurants, sale
from sale to leasebacks are an option to satisfy obligations. In a sale leaseback, the
pay debt 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.
Items Now that we’ve seen the industry (program) risks in franchise
requested financing and some of the ways lenders address these risks, we’ll shift
from borrower 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 Before we begin the list, let’s review two types of documents we issue
commitment the potential borrower − the proposal and the commitment letter. The
letter 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.
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Projections
Ownership Structure
Identify Request a list of all affiliated and interrelated companies and the
management owners of each company. With regard to multiple owners or
structure shareholders, identify the percent of ownership of each
owner/shareholder. Also ask for an organization chart.
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Store Information
Ask for a list of all the stores the franchisee operates, and the
following information on each store:
+ Owned or leased
+ Opening date
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 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
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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:
+ Fraudulent conveyance
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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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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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:
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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:
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Expense, The consolidated profit and loss spread provides a basis for comparing
cash flow the performance of the franchisee to another operator of the same
comparison 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.
+ Determine trends
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Cash flow less When computing debt service capacity for franchise financing, it is
capital important to consider the franchisee’s ongoing capital expenditures
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 Once we have calculated the debt service capacity of the prospect, we
generate cash can compare it to the debt service coverage ratio on the Risk Asset
flow 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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Compare There are two reasons for reviewing each individual store’s sales
individual history and financial statements. The first is to identify any bad
stores locations. If the franchisee plans to open a new store in an
unprofitable area, you should question the reasons.
Line item For a valid analysis, it is important that all items on the historical
comparison 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.
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SUMMARY
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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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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:
Question 3: We use the results of the trend and sales history analysis of individual profit
and loss statements to:
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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:
Question 3: We use the results of the trend and sales history analysis of individual profit
and loss statements to:
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Sensitivity Analysis
Margin for Recall that a sensitivity analysis is a way to determine what happens
error and when the value of certain variables used in a credit assessment
break-even changes. The sensitivity analysis includes determining the break-even
point
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 one-
to-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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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.
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Adjustment for When the franchisee owns the premises (fee simple ownership), we
ownership of must make an adjustment to EBDIT to calculate business value.
real estate (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:
BV = (US$200M - US$72M) X 5
BV = US$128M X 5
BV = US$640M
Fair market You may be wondering how to estimate fair market rent. One way is to
rent 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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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 In the U.S., the value of real estate is sometimes estimated by using a
land and rental factor. Rents tend to be based on a percentage (the rental
building cost 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).
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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).
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.
Liquidity
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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.
Cultural Another risk in Latin America and the Caribbean is that of cultural
acceptance 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 As you probably know, the credit analysis process includes obtaining
franchisors credit ratings from suppliers and creditors. In franchise financing, we
have another source of credit information − the franchisor.
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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 Recall that covenant ratios are financial ratios agreed to in a loan or
review of lease contract. Requiring a borrower to maintain certain covenant
financial ratios is a way to monitor a borrower’s finances so that problems can
status
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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Directions: Determine the correct answer to each question. Check your answers with
the Answer Key on the next page.
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
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:
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Question 4: When measuring leverage in franchise financing, we replace book equity with
__________________.
Question 6: Financing a fast-food franchise’s first entry in a rural region may be risky
because:
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ANSWER KEY
Question 4: When measuring leverage in franchise financing, we replace book equity with
fair market value.
Question 6: Financing a fast-food franchise’s first entry in a rural region may be risky
because:
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LEGAL CONSIDERATIONS
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Agreement One way Citibank can protect its interests is to secure an agreement
with landlord 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.
+ 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.
Default Our discussion of the bank’s relationship with the franchisee will
remedies 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.
Property
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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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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.
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.
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ANSWER KEY
Question 1: Select two ways for a lender to protect its interest in franchise collateral.
Question 2: Citibank works to help the franchisee avoid being disenfranchised because:
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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:
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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:
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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 risk-
avoidance business. Throughout this course, you have been introduced to some of the risk-
management 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
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 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.
ABF life cycle 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
+ Risk administration
+ Collateral management
+ Portfolio management
+ Problem recognition
+ Remedial management
CREDIT INITIATION
Two types of In this section, we discuss two types of risk management processes
processes commonly associated with credit initiation:
+ Standards
+ 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:
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.
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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+ Business practices
Risk As the credit analyst identifies the risks, he or she may begin to
mitigation 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.
Capacity to Recall that we use cash flow analysis to determine the applicant’s
repay debt 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
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Collateral Evaluation
Value over Managing collateral risk is extremely important because the creditor
time 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 In Unit Four, Lease Classification and Legal Documentation, you
procedures learned how the proper preparation and execution of documentation
helps creditors manage legal risks. Documentation risk strategies
include using:
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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+ Review procedures
+ Overdraft procedures
Credit Files
History of The credit file should contain all the information necessary to
credit reconstruct the decision to extend credit. It serves as an important risk
decision management tool for two major events:
Review Procedures
Early problem The timely reviews of credit, collateral, documentation, industry, and
detection 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.
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Tracking To manage the risk of past due principal or interest, a system for
system 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
+ Collateral analysis
+ Equipment value
+ Residual risk
+ Asset management
+ Structuring
Collateral Analysis
Determine We know that equipment that maintains value over time is a better risk
value over than equipment that does not maintain resale value. To assess the value
time 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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+ Equipment
+ Investment
+ Remarketing
Equipment Considerations
Traits To assess value, the analyst first looks at the characteristics of the
equipment itself.
Investment Considerations
Profit The items focused on here help the analyst determine whether the
potential equipment is a good investment.
+ Upgrade/add-on potential
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Remarketing Considerations
Equipment Value
Factors that We know that the creditor must look to the value of the equipment if
affect the customer defaults or if the equipment is resold at the end of a
definition lease term. However, in asset based financing, we use several different
definitions of value. The definition is affected by:
+ Distress value
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+ Scrap value
+ 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).
Price at The fair market value is the gross price that a willing and informed
normal buyer would pay to a willing and informed seller when neither is under
conditions 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.
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 Distress value is the net price that would be paid under duress
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 on- The retail, fair market value of equipment sold as part of an on-going
going concern operation or concern is referred to as value-in-use. This value
assumes equipment to be fully installed and operational.
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Example 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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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
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.
+ Risk assessment
+ Pricing
+ Administration
+ Portfolio management
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Risk Assessment
+ Equipment characteristics
− Is use essential?
+ Remarketing capability
Residual risk When we consider all these factors, we see that the size of the
vs. “at risk” 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!
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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
Portfolio Administration
Sell off The ability to sell off unwanted exposures is important to managing
unwanted equipment risk. Changing market or tax circumstances, and the need to
exposures 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
+ Being alert to new and emerging industries that may affect the
value of current collateral
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Structuring
Recall that there are several ways for creditors to minimize collateral
risk through transaction structuring. Let’s review five key methods:
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
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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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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?
Question 2: Overdraft procedures, control systems, and file maintenance are considered:
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
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ANSWER KEY
Question 1: What is the risk management method commonly used to address target
market and program compliance?
Question 2: Overdraft procedures, control systems, and file maintenance are considered:
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:
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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 8: Using and enforcing an excess-use penalty is a way to protect the value of
collateral through:
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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:
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 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
+ Individual transactions
+ Portfolio composition
Individual Transactions
Transaction’s The quality of a portfolio depends upon the quality of the individual
effect on transactions in the portfolio. Periodic reviews of individual
portfolio transactions help us see how each transaction affects the risk and
return of the entire portfolio.
The results of the review allow the analyst to recommend selling off
certain transactions and bolstering others.
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Portfolio Composition
+ Concentrations
+ Environmental context
Let’s examine the way each of these categories affects the quality of
the portfolio.
Concentrations
+ Geographic location
Mix less risky 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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+ One-way-out loans
+ Non-amortizing loans
Environmental Context
Factors to As you know, both external and internal factors can greatly affect a
monitor 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:
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PROBLEM RECOGNITION
+ Credit monitoring
+ Credit classification
+ A watchlist
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Credit Monitoring
Early The goal of credit monitoring is to identify threats early on and take
identification 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
Management Changes
+ Ownership
+ Maintenance practices
+ Employee morale
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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.
Business and The business cycle has a continuing effect on a credit obligation, and
economic should be watched closely. Other external factors also play an
cycles 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 The astute officer will anticipate the risks likely to arise when
risks 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.
+ Inventory build-up
+ Changing technology
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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.
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Watchlist
REMEDIAL MANAGEMENT
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+ 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:
Action Plan
Alternate After the documentation has been reviewed, the creditor must develop
strategies 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:
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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.
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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Directions: Determine the correct answer to each question. Check your answers with
the Answer Key on the next page.
____ a) True
____ b) False
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
a) True
Question 4: When a customer’s leverage increases, the creditor may monitor the credit
less frequently.
b) False
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Question 5: One way that creditors manage risk when an economic downturn is likely is
to:
Question 6: To tag problem credits that required additional analysis and monitoring,
creditors use a _____________________________.
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ANSWER KEY
Question 5: One way that creditors manage risk when an economic downturn is likely is
to:
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.
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Appendix
APPENDIX
GLOSSARY
Accelerated Cost The tax depreciation, or cost recovery, method for Internal Revenue
Recovery System Service (IRS) purposes which was effective for all depreciable
(ACRS) property placed into service after December 31, 1980 and before
January 1, 1987
Accelerated Any depreciation method that allows for greater deductions or charges
Depreciation in the earlier years of an asset’s depreciable life, with charges
becoming progressively smaller in each successive period
Actuarial Interest A constant interest charge (or return) based upon a declining principal
balance
Adjusted (or The undepreciated amount of an asset’s original basis that is used, for
Remaining) Basis 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 One or more lease payments required to be paid to the lessor at the
Payments 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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G-2 GLOSSARY
Alternative A penalty tax, of sorts, in which a taxpayer must pay the higher of its
Minimum Tax regular tax or AMT liability
(AMT)
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 A tax depreciation system that establishes the minimum, midpoint, and
Depreciation maximum number of years, by asset category, over which an asset can
Range (ADR) be depreciated; the midpoint life has become synonymous with the
term “ADR class life”
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 A lease provision allowing the lessee, at its option, to purchase the
Purchase Option 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 A lease provision allowing the lessee, at its option, to extend the lease
Option 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
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)
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 end-
users or lessees
Casualty Value A schedule included in a lease that states the agreed value of
(see also equipment at various times during the term of the lease, and
Stipulated Loss establishes the liability of the lessee to the lessor in the event the
Value Table)
leased equipment is lost or rendered unusable during the lease term
due to casualty loss
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G-4 GLOSSARY
Closed-end A lease that does not contain a purchase or renewal option, thereby
Lease 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 A document prepared by the lessor that sets forth its commitment,
Letter including the lease rate and term, to provide lease financing to the
lessee
Conditional Sales An agreement for the purchase of an asset in which the lessee is
Contract 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
Contingent Rentals in which the payment of rents are dependent upon some factor
Rentals 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
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 A lessor capital lease (per FASB 13) that does not give rise to
Lease 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 A lease in which the lease payments are assigned to a funding source
Lease 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 The estimated period during which the property is expected to be
Leased Property 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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G-6 GLOSSARY
Economic The federal tax act that introduced ACRS, among other provisions
Recovery Tax Act
of 1981 (ERTA ‘81)
End-of-term Options stated in the lease agreement that give the lessee flexibility in
Options its treatment of the leased equipment at the end of the lease term
Equity Investor An entity that provides equity funding in a leveraged lease transaction
or Participant 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
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
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 A type of independent leasing company that is owned by, or a part of, a
Institution Lessor financial institution such as a commercial bank, thrift institution,
insurance company, industrial loan company, or credit union
Floating Rental Rental that is subject to upward or downward adjustments during the
Rate 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
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
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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G-8 GLOSSARY
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
Incremental The interest rate that a person would expect to pay for an additional
Borrowing Rate borrowing at interest rates prevailing at the time
Initial Direct Costs incurred by the lessor that are directly associated with
Costs 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 The discount rate which, when applied to minimum lease payments
Implicit in a (excluding executory costs paid by the lessor) and unguaranteed
Lease (as used residual value, causes the aggregate present value at the beginning of
in FASB 13)
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 The unique discount rate that equates the present value of a series of
Return (IRR) cash inflows (lease payments, purchase option) to the present value of
the cash outflows (equipment or investment cost)
Investment Tax A credit that a taxpayer is permitted to claim on the federal tax return
Credit (ITC) (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
Lessee’s The interest rate which the lessee would have incurred (at the
Incremental inception of the lease) to borrow, over a similar term, the funds
Borrowing Rate necessary to purchase the leased assets
Lessor The owner of the equipment that is being leased to a lessee or user
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G-10 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 The specific tax cost recovery (depreciation) period for a class of
Life assets as defined by MACRS
Master Lease A lease line of credit that allows a lessee to obtain additional leased
Agreement 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, incurred by the lessor, to fund a specific piece of leased
Debt equipment, the terms and repayment of which are structured to
correspond to the repayment of the lease obligation by the lessee
Minimum Lease From the lessee perspective, all payments that are required to be made
Payments 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 The current tax depreciation system as introduced by the Tax Reform
Accelerated Cost Act of 1986, generally effective for all equipment placed in service
Recovery System after December 31, 1986
(MACRS)
Money-over- A nontax lease in which the lessee is, or will become, the owner of the
money Lease leased equipment by the end of the lease term
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 The total discounted value of all cash inflows and outflows from a
Value project or investment
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 Any form of financing, such as an operating lease, that, for financial
Sheet Financing reporting purposes, is not required to be reported on a firm’s balance
sheet
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G-12 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 A budget that lists the amount of noncapital goods and services a firm
Budget 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
Payments in A payment stream in which each lease payment is due at the beginning
Advance of each period during the lease
Payments in A payment stream in which each lease payment is due at the end of
Arrears 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
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GLOSSARY G-13
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 An agreement where the lessee has entered into a contract to purchase
Agreement the equipment to be leased prior to the arranging of the financing;
Assignment 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
Refundable An amount paid by the lessee to the lessor as security for fulfillment
Security Deposit 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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G-14 GLOSSARY
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
Return on Assets A common measure of profitability based upon the amount of assets
(ROA) invested; ROA is equal to the ratio of either net income to total assets
or net income available to common stockholders to total assets
Revenue The IRS Revenue Procedures 75-21, 75-28, and 76-30, which set
Procedures 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
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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-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
Single Investor A lease in which the lessor is fully at-risk for all funds (both equity
Lease 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
Skipped-payment A lease that contains a payment stream requiring the lessee to make
Lease 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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G-16 GLOSSARY
Step-payment A lease that contains a payment stream requiring the lessee to make
Lease payments that either increase (step-up) or decrease (step-down) in
amount over the term of the lease
Stipulated Loss A schedule included in the lease agreement, generally used for
Value Table purposes of minimum insurance coverage, that sets forth the agreed-
upon value of the leased equipment at various points throughout the
lease term
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 Tax law enacted in 1982 that, among other things, modified the
Fiscal Accelerated Cost Recovery System (ACRS) and Investment Tax Credit
Responsibility (ITC) rules, as well as introduced the finance lease (which has since
Act of 1982
been repealed)
(TEFRA ‘82)
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 U.S. tax law enacted in 1984 that included changes to the general
of 1984 (TRA ‘84) 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
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GLOSSARY G-17
Tax Reform Act U.S. tax law that effected a major overhaul of the U.S. tax system by
of 1986 (TRA ‘86) lowering tax rates, modifying the Accelerated Cost Recovery System
(now MACRS), repealing the Investment Tax Credit (ITC), and
repealing the transitional finance lease
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 A document, under the UCC, filed with the county (and sometimes the
Statement Secretary of State) to provide public notice of a security interest in
(UCC-1) personal property
Unguaranteed The portion of residual value for which the lessor is at-risk
Residual Value
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G-18 GLOSSARY
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
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
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