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Asset-BasedFinance - Draft January 1996

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ASSET BASED FINANCE

Warning

This workbook is the product of, and copy-righted by,

Citibank N.A. It is solely for the internal use of Citibank,

N.A., and may not be used for any other purpose. It is

unlawful to reproduce the contents of these materials, in

whole or in part, by any method, printed, electronic, or

otherwise; or to disseminate or sell the same without the

prior written consent of the Global Corporate &

Investment Bank Training and Development (GCIB

T&D) — Latin America, Asia / Pacific and CEEMEA.

Please sign your name in the space below.



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TABLE OF CONTENTS

Unit 1: Understanding the Leasing Industry

Introduction............................................................................................... 1-1

Unit Objectives ......................................................................................... 1-1

What Is a Lease? ..................................................................................... 1-2

Definition of a Lease..................................................................... 1-2

Industry Viewpoint ........................................................................ 1-2

History of the Leasing Industry................................................................. 1-3

Early History................................................................................. 1-3

Development of the United States Leasing Industry.................... 1-4Equipment Leasing Today ....................................................................... 1-5

Market Segments ......................................................................... 1-5

Small Ticket Market.......................................................... 1-6

Large Ticket Market.......................................................... 1-6

Middle Market.................................................................... 1-6

Today's Lessors........................................................................... 1-6

Independent Leasing Companies .................................... 1-7

Captive Finance Organizations........................................ 1-8Lease Brokers or Packagers........................................... 1-8

Summary.................................................................................................. 1-9

Progress Check 1.1 ............................................................................... 1-11

Reasons Lessees Lease Equipment .................................................... 1-15

Hedge Against Technological Obsolescence............................ 1-15

Financial Reporting .................................................................... 1-16

Off Balance Sheet Financing ................................................................. 1-16

Reported Earnings ......................................................... 1-17

Return on Assets ........................................................... 1-17

Spending Authority ......................................................... 1-17

Cash Management..................................................................... 1-17

Lower Down Payments.................................................. 1-18

Lower Monthly Payments............................................... 1-18



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Unit 1: Understanding the Leasing Industry (Continued)

Improved Cash Forecasting........................................... 1-18

Capital Budget Constraints ............................................ 1-18

Cost Constraints ............................................................ 1-19Income Tax................................................................................. 1-19

Reciprocity of Tax Benefits ............................................ 1-19

Deductible Lease Payments .......................................... 1-19

U.S. Tax Law Penalties.................................................. 1-20

Ownership Considerations ........................................................ 1-20

Stranded Assets............................................................. 1-20

Potential for Ownership.................................................. 1-21

Flexibility and Convenience........................................................ 1-21

Economic Reasons ...................................................................1-22

Diversification of Financing Sources ............................. 1-22

Future Financing Options............................................... 1-23

Lower Expenses ............................................................ 1-23

Summary................................................................................................ 1-24

Progress Check 1.2 ............................................................................... 1-25

Reasons Lessors Provide Leasing Services ........................................ 1-27

General Lessor Benefits ............................................................ 1-27

Profitability...................................................................... 1-27

Income Tax Benefits ......................................................1-28

Financial Leverage......................................................... 1-28

Residual Value ........................................................................... 1-30

International Leasing .................................................................. 1-31

Benefits of Vendor Leasing........................................................ 1-31

Convenience for Customers..........................................1-32

Market Control................................................................ 1-32

Profit Potential ................................................................ 1-32

Integration Opportunities ................................................ 1-33

Vertical Integration.......................................................... 1-33

Horizontal Integration...................................................... 1-33

Conglomerate Integration............................................... 1-34



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Unit 1: Understanding the Leasing Industry (Continued)

Trends in the Leasing Industry............................................................... 1-34

Changing Lessor Base.............................................................. 1-34

Lessee Perspective ...................................................................1-35Changes in Products ................................................................. 1-35

Profitability.................................................................................. 1-36

Tax and Accounting.................................................................... 1-36

International Markets .................................................................. 1-36

Economic Factors...................................................................... 1-37

Summary................................................................................................ 1-37

Progress Check 1.3 ............................................................................... 1-39

Unit 2: Financial Reporting and Tax Classifications

Introduction............................................................................................... 2-3

Unit Objectives ......................................................................................... 2-4

Financial Reporting Classifications.......................................................... 2-4

Operating and Capital Leases ..................................................... 2-4

Classification Criteria ................................................................... 2-4

Implications for Financial Reporting......................................................... 2-7

Lessor and Lessee Accounting ................................................... 2-7Lessor Accounting for a Capital Lease............................ 2-8

Lessor Accounting for an Operating Lease..................... 2-8

Lessee Accounting for a Capital Lease........................... 2-9

Lessee Accounting for an Operating Lease.................... 2-9

Operating Lease Accounting Benefits - Lessee ........................ 2-12

Financial Statement Comparison ..................................2-12

Summary................................................................................................ 2-13

Progress Check 2.1 ............................................................................... 2-15Tax Classifications ................................................................................. 2-19

Tax and Nontax Leases ............................................................. 2-19

Sources of Classification Criteria .............................................. 2-19

Revenue Ruling 55-540.................................................. 2-20



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Unit 2: Financial Reporting and Tax Classifications (Continued)

Revenue Procedure 75-21............................................. 2-21

Tax Court Decisions ......................................................2-22

Implications of Tax Classifications......................................................... 2-22Tax Consequences.................................................................... 2-23

Terminology................................................................................ 2-23

Tax Returns................................................................................ 2-24

Lessor - Tax Lease........................................................ 2-24

Lessor - Nontax Lease................................................... 2-24

Lessee - Tax Lease....................................................... 2-25

Lessee - Nontax Lease.................................................. 2-25

Modified Accelerated Cost Recovery System (MACRS)........... 2-25

Midquarter Convention ............................................................... 2-27

Effect of the Midquarter Convention............................... 2-28

Value of Depreciation................................................................. 2-29

Corporate Alternative Minimum Tax (AMT)............................... 2-32

How AMT Works ............................................................ 2-32

Marketing Approach........................................................ 2-33

Lessor Perspective........................................................ 2-34

Lease Products .......................................................................... 2-34

Tax Lease Products ....................................................... 2-34

Nontax Lease Products.................................................. 2-35

Summary................................................................................................ 2-37

Progress Check 2.2 ............................................................................... 2-38

Unit 3: Legal Classification and Lease Documentation

Introduction............................................................................................... 3-1

Unit Objectives ......................................................................................... 3-1

Legal Classifications ................................................................................ 3-1

The Uniform Commercial Code (UCC) ....................................... 3-2

Article 9............................................................................. 3-2

Article 2............................................................................. 3-3

Article 2A-Leases ......................................................................... 3-3



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Unit 3: Legal Classification and Lease Documentation (Continued )

Scope of Coverage .......................................................... 3-3

Definition of a Lease......................................................... 3-3

The Finance Lease.......................................................... 3-4Remedies and Damages................................................. 3-4

Case Law Perspective................................................................. 3-4

Legal Implications..................................................................................... 3-5

UCC Filings .................................................................................. 3-5

Bankruptcy Issues for Lessors.................................................... 3-6

Summary.................................................................................................. 3-6

Progress Check 3.1 ................................................................................. 3-7

Lease Documentation.............................................................................. 3-9

Factors Affecting Documentation ................................................ 3-9

Lease Documentation.................................................................. 3-9

Protecting the Lessor................................................................. 3-10

Lease/Credit Application ................................................ 3-10

Master Lease.................................................................. 3-10

Equipment Schedule...................................................... 3-13

Fair Market Value Purchase Option Rider ..................... 3-13

Fair Rental Value Renewal Option Rider ....................... 3-13

Certificate of Acceptance............................................... 3-14

Casualty Value Schedule............................................... 3-14

Officer's Certificate or Corporate Resolution................. 3-14

Certificate of Insurance.................................................. 3-14

Precautionary Form UCC-1........................................... 3-15

Remedies Upon Lessee Default................................................ 3-15

Default Provisions .......................................................... 3-15

Remedies ....................................................................... 3-16

Summary................................................................................................ 3-17

Progress Check 3.2 ............................................................................... 3-19



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Unit 4: Credit Analysis and Risk Assessment

Introduction............................................................................................... 4-1

Unit Objectives ......................................................................................... 4-1

Risk Assessment..................................................................................... 4-2Lessee Credit Risk Assessment ................................................. 4-2

Confirmation..................................................................... 4-3

Corroboration ................................................................... 4-4

Catastrophe...................................................................... 4-5

Concatenation .................................................................. 4-5

Classification.................................................................... 4-5

Consideration ................................................................... 4-5

Computation..................................................................... 4-5

Compilation ...................................................................... 4-6

Characteristics of Lessees .......................................................... 4-7

Character ......................................................................... 4-7

Capital .............................................................................. 4-7

Capacity ........................................................................... 4-9

Credit.............................................................................. 4-10

Cash Flow ...................................................................... 4-10

Chronological Age.......................................................... 4-11

CAPM-Beta Coefficient .................................................. 4-11

Capability........................................................................ 4-13

Competence................................................................... 4-13

Control............................................................................ 4-13

Course............................................................................ 4-14

Constraints ..................................................................... 4-14

Lease Environment Risk Factors .............................................. 4-15

Collateral ........................................................................ 4-15

Complexity...................................................................... 4-16

Currency......................................................................... 4-18

Category......................................................................... 4-18

Cross-border.................................................................. 4-18

Competition .................................................................... 4-19



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Unit 4: Credit Analysis and Risk Assessment (Continued)

Cyclical and Countercyclical.......................................... 4-19

Copartner ....................................................................... 4-19

Concealed Value............................................................ 4-20Circumstances............................................................... 4-20

Summary................................................................................................ 4-21

Progress Check 4.1 ............................................................................... 4-23

Financial Statement Analysis ................................................................. 4-27

Income Statement Analysis ....................................................... 4-27

Balance Sheet Analysis ............................................................. 4-28

Cash Flow Analysis.................................................................... 4-28

Standard Ratio Analysis............................................................. 4-28

Profitability and Earnings Growth Ratios ....................... 4-32

Liquidity and Working Capital Ratios ............................. 4-36

Investment Utilization (Activity) Ratios ........................... 4-38

Financial Leverage Ratios.............................................. 4-41

Solvency and Risk Ratio ................................................ 4-43

Owners' Equity Ratios ................................................... 4-43

Cash Flow Analysis................................................................................ 4-45

Statement of Cash Flows .......................................................... 4-45

Advantages of Cash Flow Worksheet ...........................4-48

Calculating Disposable Cash Flow................................ 4-49

Nondiscretionary Cash Requirements........................... 4-49

Cash Flow Ratios....................................................................... 4-49

Income Statement to Cash Flow Ratios........................ 4-50

Cash Flow to Cash Flow Ratios .................................... 4-51

Cash Flow to Balance Sheet Ratios.............................. 4-52

Summary................................................................................................ 4-53

Progress Check 4.2 ............................................................................... 4-55



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Unit 5: Financial Concepts and Calculations (Continued)

Introduction............................................................................................... 5-1

Unit Objectives ......................................................................................... 5-1

Present Value........................................................................................... 5-2Calculating Present Value............................................................ 5-3

Present Value of a Single Cash Flow .............................. 5-5

Present Value of an Ordinary Annuity(Annuity in Arrears).................................................... 5-6

Present Value of an Annuity Due(Annuity in Advance).................................................. 5-8

Present Value of an Annuity with Multiple AdvancePayments ....................................................................... 5-10

Present Value of Multiple, Uneven Cash Flows............. 5-12

Internal Rates Of Return (IRR) .............................................................. 5-13

IRR – Even Cash Flows............................................................. 5-14

IRR – Multiple, Uneven Cash Flows........................................... 5-15

Unit Summary ........................................................................................ 5-18

Progress Check 5 .................................................................................. 5-19

Unit 6: Introduction to the Lease vs. Buy Analysis

Introduction............................................................................................... 6-1Unit Objectives ......................................................................................... 6-1

Information Needed for a Lease / Buy Decision ...................................... 6-2

Lease vs. Buy Example ........................................................................... 6-3

Gather Information........................................................................ 6-3

Calculate After-tax Cash Flows for Each Alternative................... 6-4

Calculate the Present Value of the Cash Flows.......................... 6-7

Sensitivity Analysis (Break-even Point).................................................... 6-9

Discount Rate .............................................................................. 6-9Salvage Value............................................................................. 6-11

Factors that Affect the Lease vs. Buy Analysis ..................................... 6-12

Discount Rate ............................................................................ 6-13

Salvage Value............................................................................. 6-14



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Unit 6: Introduction to the Lease vs. Buy Analysis (Continued)

Unit Summary ........................................................................................ 6-14

Progress Check 6 .................................................................................. 6-17

Unit 7: Lease Structuring

Introduction............................................................................................... 7-1

Unit Objectives ......................................................................................... 7-1

Elements of Lease Pricing....................................................................... 7-2

Pricing (Structuring) to a Given Pretax Yield............................................ 7-3

Introduction to Advanced Structuring....................................................... 7-6

Structuring Unusual Payment Streams....................................... 7-6

Skipped Payments ........................................................... 7-7

Step-up Lease.................................................................. 7-7

Step-down Lease............................................................. 7-8

Known Initial Payments.................................................... 7-8

Early Terminations of Leases ...................................................... 7-9

Evaluating the Competition .................................................................... 7-10

Reasons for Pricing Differences................................................ 7-10

Financial ......................................................................... 7-10

Operational..................................................................... 7-11Restrictive ...................................................................... 7-11

Termination .................................................................... 7-11

Liability and Warranty..................................................... 7-11

Analyzing Competing Proposals ................................................ 7-12

Payment Differences ..................................................... 7-12

Total Cash Over Term................................................... 7-13

Lease Rate Factor ......................................................... 7-13

Lessee's Implicit Cost.................................................... 7-13Net Present Value (NPV)................................................ 7-14

Lease Proposal Evaluation Matrix.............................................. 7-15

Unit Summary ........................................................................................ 7-16

Progress Check 7 .................................................................................. 7-17



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Unit 8: Vendor Lease Programs

Introduction............................................................................................... 8-1

Unit Objectives ......................................................................................... 8-1

Benefits of Vendor Leasing Programs..................................................... 8-2Market Control.............................................................................. 8-2

Market Enhancement................................................................... 8-3

Additional Income Sources .......................................................... 8-4

Tax Benefits ................................................................................. 8-4

Financial Leverage....................................................................... 8-5

Reasons Vendors Outsource Leasing Programs ................................... 8-6

Reasons Vendors Lack Customer Financing Programs ............ 8-6

Third-party Participants ................................................................ 8-7

Ways to Meet Vendor Needs ................................................................... 8-7

Third-party Services ..................................................................... 8-8

Sales-aid / Training .......................................................... 8-8

Lease Structuring / Documentation................................. 8-8

Credit Review................................................................... 8-8

Outplacement / Investment Syndication.......................... 8-9

Funding............................................................................. 8-9

Administrative Services.................................................. 8-10

Remarketing / Asset Management................................. 8-10

Unit Summary ........................................................................................ 8-10

Progress Check 8 .................................................................................. 8-11

Glossary

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



Unit 1



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UNIT 1: UNDERSTANDING THE LEASING INDUSTRY

INTRODUCTION

Worldwide, leasing is used more and more to finance equipment and property. In the UnitedStates alone, businesses acquire 33 percent of all equipment through leasing. Companies,federal and municipal governments, and nonprofit organizations choose leasing to financeequipment 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, howleasing evolved, what the leasing industry is like today, and why leasing is so appealing.

UNIT OBJECTIVES

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

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



1-2 UNDERSTANDING THE LEASING INDUSTRY

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WHAT IS A LEASE?

Definition of a Lease

Agreement

for use of

property

A lease is an agreement between the owner of an asset (the lessor)and the user of the asset (the lessee). In a lease transaction, the lessortransfers use, but not ownership, of the property to the lessee for acertain period. In exchange for use of the property, the lessee makespayments to the lessor. At the end of the lease period, the lessee mayreturn the property to the lessor.

Written

contracts

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

Industry Viewpoint

Transaction

labelled a lease

From an industry standpoint, a lease is a contract that has been labeleda lease. However, many transactions that are labeled as leases are not

true usage agreements. They are more like an installment orconditional sale rather than a pure usage agreement.

Lease treatment The differences between a true usage agreement and an installment orconditional sale agreement determine how the lease is treated foraccounting, tax, and legal purposes. In Units Two and Three, you willlearn about the ways various regulatory bodies classify leases and howthese classifications affect the way the lease is treated. For now, keepin mind that a capital lease is really a purchase agreement and anoperating lease is an agreement for use of property owned by

another party.



UNDERSTANDING THE LEASING INDUSTRY 1-3

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HISTORY OF THE LEASING INDUSTRY

The practice of letting property be used in exchange for payment hasexisted for thousands of years. To understand the lease process of

today, it helps to understand how leasing evolved.

Early History

First records No one knows the exact date of the first leasing transaction, but we doknow that the earliest records of leasing were written before 2000B.C. in the ancient Sumerian city of Ur. Sumerian lease documents,which were produced in damp clay, recorded lease transactions foragricultural tools, land and water rights, and oxen and other animals.

Early legal systems often included leasing laws. The famousBabylonian king, Hammurabi, who reigned in about 1700 B.C.,mentioned leasing in his collection of laws.

Near Babylon, in approximately 400 to 450 B.C., businesses leasedland, oxen, farm equipment, and seed to local farmers. Other ancientcivilizations, including the Greeks, Romans, and Egyptians, also usedleasing to finance equipment, land, and livestock. The ancientPhoenicians chartered ships and crews. These ship charters resembled

a pure form of an equipment lease.

In medieval times, most leases were for horses and farmingimplements. However, unique opportunities sometimes occurred. Forexample, many knights of old leased their armor!

Industrial

Revolution

In the early 1800s, the amount and types of leased equipment in theUnited Kingdom (U.K.) increased greatly. The development of theagricultural, manufacturing, and transportation industries during theIndustrial Revolution brought about new types of equipment, many of

which were suitable for lease financing.




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Railroad

expansion

The growth and expansion of the railroads also brought about majoradvances in the development and use of leasing. Most early railroadcompanies were able to supply only the track, and charged tolls for theuse of their lines. Many entrepreneurs began providing the railroad

companies and independent shippers with locomotives and rail cars.

Development of the United States Leasing Industry

Need for

leasing

While the demand for lease financing was growing in the U.K., thepopulace of the United States (U.S.) also was experiencing a need forlease financing. The first recorded leases of personal property in theU.S. were written in the 1700s. These early transactions provided forthe leasing of horses, buggies, and wagons by livery men.

The use and development of leasing increased as new types of equipment were developed and needs for equipment increased. Itwas the expansion of the railroad industry in the 1800s, however, thatstimulated real growth in the U.S. leasing industry. Leasing providedthe means to finance locomotives and rail cars when conventionalfinancing was not available or affordable.

Vendor leasing

begins

In the early 1900s, a developing economy and the desire of manufacturers to provide financing for their products increased the

demand for leasing. Manufacturers or vendors thought they would beable to sell more of their products if they were able to offer anaffordable payment plan. This idea led to the beginning of leasefinancing provided by vendors, which is still a significant force in theequipment leasing industry today.

Third-party

leasing

companies form

Eventually, independent or third-party leasing companies were formedto provide specific product financing for manufacturers and dealers. Inthe early 1950s, many independent leasing companies also beganproviding leasing services directly to the lessee for other, unrelated

equipment.




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Banks enter the

leasing industry

In 1963, the U.S. Comptroller of the Currency issued a ruling thatpermitted national banks to own and lease personal property. In 1970,an amendment to the Bank Holding Company Act further legitimizedthe involvement of banks in equipment leasing. This amendment

allowed banks to form holding companies. Under a holding company,banks could engage in a number of nontraditional financing activities,such as equipment leasing.

It also is important to note that, especially in recent times, significanttax and accounting regulations in the U.S. have affected the evolutionof the leasing industry. These are covered in later units.

EQUIPMENT LEASING TODAY

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

Market Segments

Today, virtually all types of equipment are leased. Leased productsinclude automobiles, aircraft, computers, furniture, laboratoryequipment, copiers, satellites, and ships.

Factors that

determine

segment

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




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S m a l l T i ck e t M a r k e t

The small ticket market concentrates on leasing lower-pricedequipment, such as copiers, personal computers, and word processors.

The high end of the transaction range for the small ticket market isfrom $25,000 to $100,000. (The cut-off point depends uponindividual firms' interpretations.) The lessee in this market is moreconcerned with the convenience of acquisition, maintenance, anddisposal than with cost.

L a r g e T i c k e t Ma r k e t

The large ticket market focuses on higher-priced equipment, such

as aircraft, mainframe computers, ships, and telecommunicationsequipment. The large ticket market is typically defined as equipmenthaving a cost of $1,000,000 or more. Because of the transaction size,the market is very price-sensitive and competition is intense.Documentation tends to be more involved than in the small ticketmarket because of the size and complexity of each individualtransaction.

Midd le Mar k e t

The middle market fills the wide gap in size and complexity betweenthe small ticket and large ticket markets. This market is influenced bya number of factors which sometimes conflict. Both price andconvenience are common issues in the negotiation process.

Today's Lessors

Classification Leasing companies may be classified into three groups:

n Independent leasing companies

n Captive finance organizations

n Lease brokers, or packagers




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There are few accurate statistics to substantiate the proportion of theleasing industry represented by any individual lessor group, althoughthe majority of lessors are considered independents.

I n d e p en d e n t L e a s i n g Co m p a n i es

Three parties Independent leasing companies represent a large part of the leasingindustry. These companies are independent of any one manufacturer.They purchase equipment from various manufacturers, and thenlease the equipment to the end-user or lessee. Independent leasingcompanies are often referred to as third-party lessors. The three partiesare 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

EquipmentPurchase

Pa ment

IndependentLessor

EquipmentLease

LeasePayments

Lessee




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Figure 1.1: Independent leasing company

C a p t i v e Fi n a n c e O r g a n i z a t i o n s

Set up by manufacturer

or dealer

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

Pa ment

E ui ment Lease

Parent/Manu-

facturer

Subsidiary/Lessor

EquipmentLease

Lessee

LeasePayments

Figure 1.2: Captive lessor

Lease Brok er s or Pa ck agers

Middle-man

services

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

n Find the interested lessee

n Arrange for the equipment with the manufacturer

n Secure debt financing for the lessor to use in purchasing theleased equipment

n Find the ultimate lessor in the lease transaction




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

Lessee

EquipmentLeaseBroker

UltimateLessor

Funding

Figure 1.3: Lease broker / packager

SUMMARY

The concept of leasing as an equipment financing tool has survived 4,000 years of history.The need for equipment leasing continues to grow. The benefits of leasing, such asaffordable 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., markettransactions 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 theindustry: independent leasing companies, captive finance organizations, and lease brokers(or packagers). These classifications are based on the leasing company's relationship to theequipment 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 shapetoday’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 youanswer any question incorrectly, please return to the text and read the section again.




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þ PROGRESS CHECK 1.1

Directions: Determine the correct answer to each question. Check your answers withthe Answer Key on the next page.

Question 1: A lease is a(n):

____ a) method of borrowing in which the lessor is fully at-risk for any borrowedfunds.

____ b) contract that involves the transfer of ownership of equipment.

____ c) agreement in which the owner of property gives use of the property toanother 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 aresult of:

____ a) the desire of manufacturers to provide financing for their products.

____ b) the development of new types of equipment and the need for affordablefinancing.

____ c) the expansion of the railroad industry.

____ d) tax and accounting regulations that favor lease financing.

Question 3: The middle market is more price-sensitive and competitive than the smallticket and large ticket markets.

____ a) True

____ b) False

Question 4: A captive lessor is a leasing company that:

____ a) a manufacturer or equipment dealer sets up to finance its own products.

____ b) does not own the equipment or retain the lease transaction for its ownaccount.

____ c) is independent of any one manufacturer.




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ANSWER KEY

Question 1: A lease is a(n):

c) agreement in which the owner of property gives use of the property toanother party for a predetermined period in exchange for compensation.

Question 2: During the last 200 years, the demand for leasing has increased primarily as aresult 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 smallticket and large ticket markets.

b) False

Question 4: A captive lessor is a leasing company that:

a) a manufacturer or equipment dealer sets up to finance its own products.




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PROGRESS CHECK 1.1(Continued)

Question 5: In the 1800s, which of the following had the greatest effect on the growth of

leasing in the United States?

____ a) The growth and expansion of the railroads

____ b) The formation of third-party leasing companies

____ c) The need for horses, buggies, and wagons by livery men

____ d) The development of the leveraged lease

Question 6: The involvement of banks in equipment leasing was advanced in 1970 through

an amendment to the:

____ a) constitution.

____ b) tax laws.

____ c) third-party leasing agreements.

____ d) Bank Holding Company Act.

Question 7: The classification of a leasing market segment as small ticket, large ticket, ormiddle market is based on:

____ a) the types of equipment leased, the price ranges of the equipment, and thekey decision factors that influence lessees.

____ b) the size of the transactions only.

____ c) how the leases are funded.

____ d) the type of lessor involved.

Question 8: A lessor that purchases equipment from various manufacturers, and then

leases the equipment to the end-user or lessee is referred to as a(n):____ a) lease broker or packager.

____ b) captive or two-party lessor.

____ c) independent or third-party leasing company.

____ d) nonrecourse lessor.




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ANSWER KEY

Question 5: In the 1800s, which of the following had the greatest effect on the growth of leasing in the United States?

a) The growth and expansion of the railroads

Question 6: The involvement of banks in equipment leasing was advanced in 1970 throughan amendment to the:

d) Bank Holding Company Act.

Question 7: The classification of a leasing market segment as small ticket, large ticket, ormiddle market is based on:

a) the types of equipment leased, the price ranges of the equipment, and thekey decision factors that influence lessees.

Question 8: A lessor that purchases equipment from various manufacturers, and thenleases the equipment to the end-user or lessee is referred to as a(n):

c) independent or third-party leasing company.




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REASONS LESSEES LEASE EQUIPMENT

Leasing offers many advantages, benefits, and flexible options tolessees. Some may lease for only one reason, others for a variety of

reasons. Lessors who understand the motivations of lessees are betterable to offer products that attract lessees.

Most reasons lessees choose to lease fall into the followingcategories:

n Hedge against technological obsolescence

n Financial reporting

n Cash management

n Income taxn Ownership considerations

n Flexibility and convenience

n Economics

Let’s examine each of these categories from the lessee’s viewpoint. Inturn, the lessor will see how these advantages strengthen the salesprocess.

Hedge Against Technological Obsolescence

Risk of

ownership

One of the strongest reasons for acquiring the use of equipmentthrough leasing is that leasing helps lessees avoid many of the risks of owning equipment. Much of today’s equipment is based upon rapidlychanging technology. Equipment soon becomes technologicallyobsolete. A company’s risk in buying and owning technologicallysensitive equipment is that it may become economically useless muchearlier than expected. Sometimes the equipment becomes useless

before the owner has paid off a loan used to buy the equipment!

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




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Transfer of risk

to lessor

Leasing helps lessees avoid the risk of owning obsolete equipment bytransferring that risk to a lessor. In other words, lessees let the leasingcompany worry about the equipment becoming obsolete.

Financial Reporting

Financial reporting, or accounting presentation, comprises animportant part of the decision to lease or buy equipment. Leasingresults in a very different accounting presentation than that of buying a

piece of equipment. Loans from banks and capital raised fromstockholders often depend upon the reported financial health of acompany. For this reason, leasing is of great importance to manylessees. Here we discuss four aspects of financial reporting.

O f f B a l a n c e S h e et Fi n a n c i n g

No asset or

liability entry

If a lease is a true usage agreement (an operating lease) for financialreporting purposes, the lessee’s balance sheet does not show the

equipment as an asset or a liability. The only expense on the lessee’sincome statement for the lease is the lease rental expense. Thisreporting practice is called off balance sheet financing.

Improved

financial ratios

Off balance sheet financing helps make a firm’s financial statementslook better. It improves many of the firm’s financial ratios andmeasurements (at least for the first few years). Because there is nodebt or liability for the lease on the balance sheet, the firm appears tobe less in debt and more profitable. Lenders may be more willing tolend more funds to such a company.

Lessee Lessor

Risk of Obsolescence




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R e p o r t e d E a r n i n g s

Positive effect

on income

statement

In the early years of a lease, an operating lease has a more positiveeffect on a lessee’s income statement than a capital lease. Initially, the

operating lease expense (rental payments) is less than the combineddepreciation and interest expense for the capital lease. Therefore, anoperating lease raises the lessee’s overall reported earnings.

R e t u r n o n A s s e t s

Increased

return on assets

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

S p e n d i n g A u t h o r i ty

Payments within

spending

guidelines

Managers who do not have the authority to spend funds necessary topurchase equipment find leasing to be a convenient alternative. Theamount of the monthly lease payment often falls within their spendingauthority guidelines.

Cash Management

Affordability Since leasing equipment is often more affordable than purchasingequipment, many companies choose this option as new and moreadvanced (and more expensive) equipment becomes available in themarketplace. Let’s examine some of the cash management benefits.

L o w e r D ow n P a y m e n t s

Up-front costs Generally, leasing companies require lower down payments thanfinancial institutions. Also, the leasing company may include otherincidental costs of acquiring the equipment, such as sales tax andinstallation charges, as part of the lease payment. If the company buysequipment, it must pay these costs up front.




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L o w e r Mon t h l y P a y m e n t s

Affordable

payments

A lease may be more affordable to a company than a conventional loanbecause the monthly lease payment is lower than the monthly loan

payment.

Im proved Cash Forecas t in g

Future cost Because the amount of the lease payments is fixed, the lessee knowsthe future cost of the equipment. This enables the company’s planningpersonnel to prepare more accurate cash forecasts and plans.

C a p i t a l B u d g e t Co n s tr a i n t s

Operating

budget

If a department or division has already used its allowance for capitalexpenditures, the department or division manager may lease thenecessary equipment. Lease payments are paid out of the operatingbudget instead of the capital budget. The operating budget containsthe amount of noncapital goods and services a firm is authorized tospend during the operating period.

Expenditure

approvals

Similarly, some state and local governments must have either specialcapital appropriations made by the decision-making bodies or voter

approval before they can buy equipment. This process may take a longtime. Since lease payments can be paid out of the operating budget,and approvals for operating expenses generally require much less timethan approvals for capital expenditures, government bodies oftenobtain equipment faster through the leasing process.

C os t C on s t r a i n t s

Affordable

payments

In certain cases, the only realistic means of acquiring use of

equipment is through leasing. For example, a company may needpartial use of a satellite to transmit data to regional offices in otherparts of the world. Unfortunately, the satellite may cost more than thefirm can possibly afford. Through leasing, the company can obtain theuse of a portion of the satellite’s power in exchange for affordable,periodic rental payments.




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Income Tax

Because leasing provides several income tax benefits to the lessor aswell as the lessee, the lessor must understand them well.

R ecipr oc i t y o f Ta x Ben e f i t s

Lower lease

rates

When lessors receive tax benefits because they are considered the taxowners of the equipment, they may fully or partially pass thesebenefits on to lessees as lower lease rates. This allows the lessees toindirectly share in the tax benefits. This reciprocity, or exchange of tax benefits for a lower lease rate, is particularly important for alessee that is currently in a nontax paying position. This is because thelessee cannot directly use the tax benefits of ownership.

Dedu c t ib le Lease Paym ents

Income tax

benefit

When the lessor is deemed the owner of the equipment for taxpurposes, the lessee may fully deduct the lease payments for federalincome tax purposes. Although the lessee does not receive thedepreciation benefits of ownership, the fact that payments aredeductible is a clear tax benefit.




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U .S . T a x L a w P e n a l t i e s

Negative impact

of additional

purchases

Current U.S. tax law may result in penalties for purchasing additionalequipment. A company that purchases new equipment may have to pay

more taxes because of the loss or reduction of certain tax benefits.For companies facing these situations, it makes more sense to leaseequipment.

n Tax benefits

n Deductible lease payment

Lessor

EquipmentLease

Lessee

LowerLease

Pa ments

Ownership Considerations

Leasing can help lessees avoid the risk of owning equipment. Twomajor reasons are discussed here.

S t r a n d e d A ss et s

Estimated

economic life

For financial reporting purposes, owners depreciate equipment over theequipment’s estimated economic life. If equipment becomestechnologically obsolete before the end of its depreciable life, thecompany owns a worthless piece of equipment that is not fullydepreciated on its books. If the company sells the obsolete equipment,

it will be at a loss. This lowers the company’s reported earnings.

If the company retains the worthless equipment until it is fullydepreciated, the equipment is considered a stranded asset . The lesseecan avoid stranded assets by selecting a short-term lease that specifiesreasonable renewal terms for additional periods of use.




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P o t en t i a l f o r O w n e r sh i p

Purchase

options

Another reason for leasing’s growing popularity is the lessee’s abilityto purchase the equipment at the end of the lease term. Some purchase

options fix the purchase amount; others base the purchase price on theequipment’s fair market value at the end of the lease term. Fixedpurchase options can be risky. However, having the option to purchaseequipment at fair market value is acceptable to those lessees seekingflexibility in equipment use and financing.

Flexibility and Convenience

Timing factors

Another benefit of leasing is that it offers many convenienceadvantages over other forms of financing. These are summarized below.

n Acquiring the use of an asset through a lease can involveless red tape and time than bank financing. Also, the leasingcompany may be able to obtain speedier deliveryof equipment because of its relationship with themanufacturer.

One-stop

shopping

n A lessor can provide product variety and knowledge, theproduct itself, financing, and many flexible options, allunder one roof. In addition, a lessor may bundle other

products or services, such as maintenance and insurance,with the lease to offer a full-service package. A full-servicepackage may be less expensive than if the lessee separatelypurchases the same services.

Reporting

convenience

n Operating leases require much less bookkeeping thanoutright purchases because the entire payment is shown asrental expense. Also, because most leases have fixed equalperiodic payments, cash flow projections are easier.

n In most companies, the budgeting analysis is not as involved

for leasing a piece of equipment as it is for purchasingequipment.

n Leasing makes the planned replacement of existingequipment with new technology easier because companymanagement must review equipment needs at the end of thelease term.




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Flexible options

Control

Lower risks

n Lessors can structure lease payments and equipment useoptions to meet the needs of lessees.

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

n The lessee can return the equipment to the lessor upontermination of the lease without further obligation. Thelessor bears the burden and risk of disposing of theequipment 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 withthese aspects.

D i v er s i f i ca t i on o f F i n a n c i n g S o u r c e s

Financing

availability

National economies always experience swings in the availability of financing. Depending solely upon one source of equipment financingcan be dangerous. Using a variety of financing sources makes goodbusiness sense whether credit is in short supply or not. Also, banks

commonly have, by regulatory law, built-in limits on the amount of funds they may loan to any single customer.

Additional

source of

financing

Over the last 30 years, many economic factors have led to shortages incapital through conventional capital financing sources. To sell theirproducts, many manufacturing companies turned to leasing to makefinancing available to those customers who otherwise could not affordthe equipment.

Even when bank financing is generally available, some businesses may

not be able to obtain credit. Fortunately, leasing provides an additionalsource of financing for companies that cannot borrow needed funds.




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F u t u r e F i n a n c i n g O p t i on s

Loan

restrictions

When lending to a company, a banker typically builds restrictive loancovenants or agreements into the loan agreement. These covenants

restrict a company’s future financing options. Their purpose is to helplessen any potential default on the loan by the borrower. If theborrower violates any of the covenants and puts the loan at risk of default, the lender has the option to demand repayment of the loan.

A company subject to many restrictive covenants has much lessfreedom to make financing decisions. Lease agreements, on the otherhand, rarely contain restrictive covenants. Therefore, leasing can offergreater freedom or flexibility than a loan.

Lower Exp enses

Economies

of scale

Due to their large size, certain leasing companies can save money bybuying equipment in volume and receiving quantity discounts. Theleasing companies may pass on some of these savings to the lessee inthe 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 acomparison, leasing can be the less expensive form of financing. Toeffectively determine whether a lease will cost less than an outrightpurchase of equipment, one should perform a formal analysis. You willlearn about the lease versus buy analysis in Unit Five.

SUMMARY

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

n Guarding against technological obsolescence

n Financial reporting




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n Cash management

n Income tax motivations

n Ownership considerations

n Flexibility and convenience

n Economics

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




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Directions: Select the correct answer to each question. Check your answers with

the Answer Key on the next page.

Question 1: A major risk of owning equipment is that:

____ a) ownership offers no tax advantages.

____ b) loans used to finance the equipment usually contain restrictive covenants.

____ c) the equipment may become technologically obsolete.

____ d) the equipment may not be fully depreciable on a company’s financialstatements.

Question 2: Operating leases provide off balance sheet financing for the:

____ a) lessor.

____ b) lessee.

____ c) both the lessor and lessee.

Question 3: In the early years of the lease, an operating lease has a more positive effect

on a lessee’s income statement than a capital lease.

____ a) True

____ b) False

Question 4: Leasing is often a more affordable financing option than purchasing because:

____ a) leasing companies require lower up-front costs and monthly payments.

____ b) leasing expenses can be paid from a company’s capital budget.

____ c) it offers the lessee direct tax benefits such as depreciation.

____ d) a lease is not reported as an asset on a firm’s balance sheet.




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ANSWER KEY

Question 1: A major risk of owning equipment is that:

c) the equipment may become technologically obsolete.

Question 2: Operating leases provide off balance sheet financing for the:

b) lessee.

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

a) True

Question 4: Leasing is often a more affordable financing option than purchasing because:

a) leasing companies require lower up-front costs and monthly payments.




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REASONS LESSORS PROVIDE LEASING SERVICES

In the previous section, we looked at leasing primarily from thelessee’s point of view. Although there are many advantages to the

lessee, the lessor benefits as well. In this section we will see thatthere are many reasons for lessors to be in the leasing business.Understanding these reasons is beneficial for all parties to the leasetransaction. Some benefits apply to all lessors, and some are specificto vendor leasing.

General Lessor Benefits

There are several opportunities associated with leasing that make the

business attractive to lessors. They include profitability, income taxbenefits, financial leverage, residual value of the leased equipment,and the expanding international leasing market.

P r o f i t a b i l i t y

Reasonable

profits

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

of the lease transaction.

Minimizing

risks

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




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I n c o m e T a x B e n e f it s

Benefits of

ownership

When the lessor is considered the tax owner of the leased equipmentaccording to the Internal Revenue Service criteria, the lessor is

entitled to the many tax benefits of ownership. The primary benefitsare (1) depreciation; (2) gross profit tax deferral (when the lessor alsois the manufacturer of the equipment); and (3) tax-exempt interest forqualifying municipal leases.

F in a n c ia l L e v er a g e

Return on

equity

One of the more important economic aspects of leasing is financialleverage. A lessor typically borrows most of the funds needed to buy a

piece of equipment and pays for only a fraction of the cost of theequipment from its own funds, or equity. Because the debt costs lessthan the interest rate charged in the lease, the lessor can earnsubstantial returns on its equity. Use of significant amounts of financial leverage is commonplace in leasing.

Lessors can fund their leased equipment in a number of ways. The typeof funding used is one of the ways in which different types of leasesare identified. How a lease is funded determines whether it is a single-investor lease or a leveraged lease.

Recourse

borrowing

In a single-investor lease, the cash the lessor pays for the equipmentis made up of the lessor's own equity as well as pooled funds that thelessor has borrowed from a variety of sources on a recourse basis.In recourse borrowing, the lessor is fully at-risk for any borrowedfunds. This means that if the lessee defaults on the lease, the lessoris still responsible for its debt with the lender. The lender does notknow or care who the lessee is, or what the credit position of thelessee is. The lender has loaned money to the lessor based on thecredit of the lessor (see Figure 1.4).




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Lessor Lessor

n Equityn Pooled funds

E ui ment Payment

Lessee

Figure 1.4: Single-investor lease

Nonrecourse

borrowing

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

EquipmentLease

n Equity

Lessor

LeasePayment

Loan Amount

Non-recourseLender

Lessee

Figure 1.5: Leveraged lease




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Assigned lease

payments

In nonrecourse borrowing, the lender considers the credit-worthiness of the lessee and the value of the leased equipment, not thecredit-worthiness of the lessor. Because the lease payments in aleveraged lease are assigned to the lender, the lessee generally makes

lease payments directly to the lender. The lending institution seeksrecovery of any losses from the lessee or from the salvage of theleased equipment (collateral).

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

Residual Value

Residual value is the actual or expected value of leased equipment atthe end or termination of the lease. The residual value of leasedequipment is an important cash inflow to the lessor and may be asignificant part of the overall return in the lease.

Effect on lease

rates

If the lessee returns the leased equipment to the lessor at the end of the lease term, the lessor attempts to re-lease or sell the equipmentfor the highest possible amount. To offer competitive lease pricing,the lessor must factor some of this expected future value into the

lease rates.

For example, if the lessor is confident the equipment will be worth atleast 10 percent of its original value at lease end, the lessor can pricethe lease payments to recover 90 percent of the equipment cost. Thelessor hopes to realize the remaining 10 percent once the equipmentis returned and subsequently salvaged or re-leased.

Risk in residual

value

Generally, the amount of the residual used in the lessor’s pricing isnot 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 inthe lease. The lessor must receive the at-risk residual amount in orderto recover all costs and earn the return it wants. The risk is that theresidual value will be less than the amount assumed when the lease waspriced.




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International Leasing

Expanding

opportunities

Overseas leasing is expected to expand significantly in order to servelarge multinational companies as well as foreign companies who are

seeking new forms of asset financing. Although equipment leasingabroad by U.S. companies started only 20 years ago, the amount of equipment on lease in Western Europe and other parts of the worldhas grown significantly. One reason for the growing popularity of leasing abroad is that many foreign banks offer loans for about threeyears. This means equipment buyers must negotiate two or three loansduring the life of a particular piece of equipment.

Types of

equipment

leased abroad

As in the United States, all types of equipment are being leasedabroad: tankers, railroad cars, computers, machine tools, printing

presses, aircraft, restaurant equipment, mining equipment, and drillingrigs.

Limitations Since foreign tax laws differ from U.S. tax laws, many internationalleases do not offer the same benefits of depreciation or the possibilityof residual value gains. Also, restrictive foreign governmentregulations concerning percentage of local ownership requirements,varying tax laws, foreign exchange fluctuations, and export laws affectthe profitability of international leasing.

However, many equipment leasing companies are still interested in theexpanding leasing markets abroad. Many U.S. based multinationals useleasing to promote foreign sales. In addition, there are numerous tax,import, and investment tax credit benefits available to the experiencedinternational lessor. In essence, the same reasons that led to anexpansion of leasing in this country have also stimulated leasingabroad.

Benefits of Vendor Leasing

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




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C on v e n i e n c e f or C u s t om e r s

Product

distinction

Providing lease financing is a successful way for manufacturers todistinguish their product from their competitors’ products. Providing

the equipment, as well as the financing, may entice a potentialcustomer to choose a certain manufacturer’s product due to theconvenience offered.

Ma rk e t Con tro l

Locking out the

competition

By locking in the sale with financing so it will not be lost to acompetitor as the customer searches for financing, the manufacturerexerts a considerable amount of market control. Also, the

manufacturer knows when its customer, the lessee, is in need of a newpiece of equipment (i.e., at the termination of the existing lease term).This allows the manufacturer to market a new piece of equipment toits current leasing customer long before a competitoris aware a potential transaction exists.

P r o f i t P ot e n t i a l

Increased sales Vendor lessors may benefit from increased sales because leasing canmake equipment acquisition affordable for customers who cannot

purchase the equipment outright. Along the same lines, customers maybe able and willing to lease more expensive models or additionalaccessories now that the cash flow advantages of leasing have putthese extras within their reach.

Full-service

contracts

Captive lessors can benefit from the combined marketing approachand profitability of providing bundled services in a full-servicecontract. These services typically include maintenance, insurance,film, reagents, software, and property taxes for the lessee. The captivelessor may be able to provide these services for less cost than that

which the lessee can separately procure and, as a result, profit fromthese additional revenues. Also, the convenience of one-stop shoppingmay entice a lessee to choose a captive lessor’s product.




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I n t e gr a t i on O p p o r t u n i t i es

Types of

integration

Integration refers to ways in which a company can expand operations.Vertical integration refers to control over the means of providing a

product, through production and transportation, to the final wholesaleand retail outlets. Horizontal integration refers to expansion into thesales and production of related products (like wax production for anoil company). Conglomerate integration is where a company entersinto a wholly unrelated business venture. Let’s see how integrationactivities provide opportunities for vendor leasing.

V e r t i ca l I n t e gr a t i o n

Control over residuals

Establishing a vendor leasing program to further promote sales isan important step in vertically integrating a company. Extensiveknowledge of the product permits the lessor to predict residual valueswith greater accuracy. This enhanced knowledge of residual valuesmay enable the vendor leasing company to fine tune the lease paymentamount it charges. Control over residuals also allows the vendorlessor to sell equipment at the termination of the lease to a somewhatcaptive clientele.

H o r i z on t a l I n t e gr a t i o n

Unrelated

product leasing

Some vendor lease companies find leasing so profitable that theybegin leasing equipment other than that manufactured by the parentcompany. This expansion into new, unrelated product leasing is a formof horizontal integration that is becoming popular amongmanufacturer-lessors.

A bank acquiring a leasing company would be a form of horizontal

integration since the leasing service is closely related to the bank’s

loan service.




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C on g l om e r a t e In t e g r a t i on

New business

opportunities

Some other companies enter into the leasing business as a totallyunrelated business opportunity in relation to their normal operations.

New business ventures involved with leasing would represent a formof conglomerate integration. A utility acquiring a leasing companywould be an example of conglomerate integration.

Now that you understand the opportunities that leasing offers to bothparties, let’s look at some of the trends that are developing in theleasing industry.

TRENDS IN THE LEASING INDUSTRY

Many important trends are developing in the leasing industry. Someof these trends are ongoing; others are subtle shifts in prior trends.Many of the trends result directly from the many recent changes thathave occurred in the world economies.

Changing Lessor Base

Business goals Mergers and acquisitions continue within the leasing industry formany reasons. The goal of some companies is to increase market shareor enter into a specific market niche. For others, the goal may be toachieve economies of scale, experience growth without the associatedsales costs, or unload an unprofitable finance subsidiary. The ups anddowns of the economy also lead to an increase in mergers andacquisitions as companies struggle to adapt to the changes.

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




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Lessee Perspective

Increased

knowledge

The level of lessees’ sophistication about leasing continues toincrease. More lessees are using leasing to avoid the risk of

obsolescence. At the same time, they are seeking more assurance asto end-of-term consequences, and selecting lessors more cautiously.Also, a wide array of inexpensive analytical software is available tohelp lessees make their financing decisions.

Lessee

motivations

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

Changes in Products

Changing

needs

Lessors continue to develop new products to meet the changing needsof lessees. They are creating new structures to meet lessee demandsfor off balance sheet accounting. In response to lessees’ concernsabout the end-of-term consequences of leases, lessors are offeringmore fixed or capped purchases and renewals. The number of fullservice leases continues to grow. Lessors are also responding torequests for more bundled services.

Leveraged

leasing

continues

Leveraged leasing continues to attract investors; however, thecompetitiveness of this market requires more and moresophistication, expertise, and creativity. This market has experiencedmajor concerns over aircraft residuals and concentrations, but hasseen an increase in both railcars and satellites.




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Profitability

New emphasis

on residuals

and asset

management

Companies have not been able to maintain the profitability levelsof the late 1980s. Competition remains high. Fewer, yet larger,

companies strive to increase market share. Companies must relyincreasingly on residual and end-of-term options for profits. Thisreliance increases the need for asset management. In most leasecompanies, the role of the remarketer is expanding every day. Even so,opportunities for residual profits continue to narrow.

Lessors seek

other sources of

profits

Many lessors have shifted part of their business into other financialservice products such as real estate or insurance to improveprofitability. Lessors have also looked to internal sources of additional profit. These include closely monitoring expenses, using

improved software and systems, and outsourcing some services.

Tax and Accounting

Changes in tax

laws

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

Accounting

standards

evolve

An emphasis on accounting for lease economics will continue. Also,lease accounting standards will continue to evolve. The FinancialAccounting Standards Board (FASB) continues to address issues thatindirectly relate to leasing in specific situations such as special-purpose corporations and financial instruments.

International Markets

Worldwideeconomic

growth

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

International Many U.S. lessors are going overseas to tap into these fertile markets.




v01/11/96 DRAFTp12/3/99

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

leasing opportunities.

Economic Factors

Used equipment

leases

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

Product requests More lessees are asking for unique lease structures to aid in their cashflow requirements. Lessees are also requesting more bundled leasesand facilities management contracts in order to decrease overheadcosts.

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 lessorsare 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 abroadare having a strong effect on leasing trends. Economic ups and downs have led to more




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mergers and acquisitions. Changes in the U.S. economy and tax laws are forcing lessors toseek other ways to make profits. Lessees are seeking more full service packages and areleasing more used equipment. Lessors are changing their leasing products to better meetlessees’ 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 theU.S.

You have just completed Unit 1: Understanding the Leasing Industry. Please completethe following Progress Check before you continue to Unit 2: Lease Classifications —

Financial Reporting and Tax Classification. If you answer any question incorrectly, youshould return to the text and read that section again.




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Directions: Select the correct answer to each question. Check your answers with


Question 1: A full service lease is one in which:

____ a) the lessee must provide all its own services such as maintenance andinsurance.

____ 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 amountsfor services to the maintenance and insurance providers.

____ d) a lessee has more control over the manufacturer in the event of a warrantydispute.

Question 2: A major difference between a single-investor lease and a leveraged lease isthat in a:

_____ a) leveraged lease, the borrower is not at-risk for the borrowed funds; but ina 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 leveragedlease, the lessor owns the property.

_____ c) single-investor lease, the lender is concerned with the credit-worthinessof the lessee; while in a leveraged lease, the lender is concerned with thecredit-worthiness of the lessor.

_____ d) single-investor lease, the lessor assigns or discounts the lease paymentsto the lender in return for up-front cash; while in a leveraged lease, thelessee usually makes payments directly to the lessor.




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ANSWER KEY

Question 1: A full service lease is one in which:

b) a lessor provides additional services to the lessee such as equipment,maintenance, and insurance.

Question 2: A major difference between a single-investor lease and a leveraged lease isthat in a:

a) leveraged lease, the borrower is not at-risk for the borrowed funds; but ina single-investor lease, the lessor is fully at-risk for any borrowed funds.




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Question 3: In financial leverage, a lessor:

_____ a) borrows funds on a nonrecourse basis.

_____ b) assigns or discounts the lease payment series to the lender, in return forup-front cash.

_____ c) earns substantial returns on its equity because it pays only a fraction of the cost of equipment with its own funds.

_____ d) is fully at-risk for any borrowed funds.

Question 4: Residual value is the actual or expected value of leased equipment at the endor termination of the lease.

_____ a) True

_____ b) False

Question 5: Most of the current trends in the leasing industry result from:

_____ a) tax and accounting reforms.

_____ b) economic factors.

_____ c) advances in technology.

_____ d) growing competition among lessors.

Question 6: Today’s lessors are offering more bundled services, off balance sheetstructures, and capped renewals because:

_____ a) the Tax Reform Act of 1986 favors these lease products.

_____ b) these products are more profitable.

_____ c) they wish to achieve economies of scale.

_____ d) knowledgeable lessees request these products.




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ANSWER KEY

Question 3: In financial leverage, a lessor:

c) earns substantial returns on its equity because it pays only a fraction of the cost of equipment with its own funds.

Question 4: Residual value is the actual or expected value of leased equipment at the endor termination of the lease

a) True

Question 5: Most of the current trends in the leasing industry result from:

b) economic factors.

Question 6: Today’s lessors are offering more bundled services, off balance sheet

structures, and capped renewals because:

d) knowledgeable lessees request these products.



Unit 2



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UNIT 2: FINANCIAL REPORTING

AND TAX CLASSIFICATIONS

INTRODUCTION

As you learned in Unit One, lease agreements are written contracts that contain the termsand conditions of the lease transaction. These terms and conditions have certain accounting,tax, and legal characteristics. The characteristics help the various regulatory bodiesdetermine 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 regulatorygroups consider the substance of the transaction rather than the form to determineclassification. This means that even though a transaction is labeled a lease (its form), thesubstance of the agreement (the meaning of the content) may indicate that the transaction isnot a true lease.

In Units Two and Three, you will learn how the characteristics of a lease affect how it isclassified for various purposes and how each classification dictates the way the lease istreated. 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 legalclassifications are determined, why they are important considerations for the lessor (aswell as the lessee), and why provisions of the lease must be carefully documented.



2-2 FINANCIAL REPORTING AND TAX CLASSIFICATIONS

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UNIT OBJECTIVES


n Distinguish between operating leases and capital leases

n Recognize how lessors and lessees account for operating and capital leases

n Understand the tax implications of tax and nontax leases

FINANCIAL REPORTING CLASSIFICATIONS

Operating and Capital Leases

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

agreement. In a capital lease, the lessee is considered the owner of theequipment.

Classification Criteria

FASB The Financial Accounting Standards Board (FASB) sets the criteria forclassifying leases and the rules for reporting leases in a firm’sfinancial 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 theequipment.



FINANCIAL REPORTING AND TAX CLASSIFICATIONS 2-3

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The lessee and the lessor apply the criteria independently. This meansthat each party may classify the same lease differently. They maketheir decisions at the inception of the lease and cannot change theclassification later.

Four criteria There are four classification criteria that determine whether a leasetransaction resembles a purchase agreement (capital lease) or a usageagreement (operating lease). If a transaction meets any one of the

four criteria, it is classified as capital.

Transfer ofownership

The criteria are as follows:

1. The lease automatically transfers ownership of the propertyto the lessee by the end of the lease term.

If the title will automatically pass to the lessee, then thetransaction is not a usage agreement, but an ownership agreement.

Bargainpurchaseoption

2. The lease contains an option that allows the lessee topurchase the leased property at a bargain price.

If the lease contains a purchase option that is so low that the lesseeis likely to exercise it, the lessee is viewed as the ownerof the equipment.

Dollar-out andfair marketvalue options

Most lease companies offer two general categories of products:dollar-out leases and fair market value (FMV) leases. In a dollar-out lease, the lessee may purchase the equipment for one dollarat the end of the lease term. This is clearly a bargain purchaseoption.

In an FMV lease, the lessee can purchase the equipment at the endof the lease term for its fair market value. This is clearly not abargain purchase option. Sometimes the answer is not as clear. In

these cases, the transaction classifier must decide if the lessee islikely to become the owner.




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Economic lifeof equipment

3. The lease term is equal to or greater than 75% of theestimated economic life of the leased property.

FASB 13 defines economic life as the useful life in the hands

of multiple users, given normal repairs and maintenance. If the lessee will use the equipment for a major portion of theequipment’s economic life, the lease should be classified as acapital lease. The theory is that assets effectively produce incomefor a limited time. If the lessee uses the equipment for more than75 percent of that time, the lessee is, in effect, the owner.

In addition to the asset’s economic life and the lease term, theclassifier must take into account any lease provisions that couldextend the lease term. For example, if all periods in the lease are

covered by bargain renewal options or nonrenewal penalties, theclassifier should classify the lease as a capital lease.

Effectiveownership

4. The present value of the minimum lease payments is equal to,or greater than, 90% of the fair value of the leased propertyless any investment tax credit retained by the lessor.

This is the most complex of the four criteria, and is used todetermine effective ownership of the equipment. The present valueof the minimum lease payments is compared to 90 percent of theequipment’s fair market value. If the result is greater than or equalto 90% of the fair value, the transaction is a capital lease.

The minimum lease payments are all the required paymentsaccording to the lease agreement. Fair market value is the value of apiece of equipment if it were to be sold at arm’s length under termsand conditions similar to those in the lease.

Present value is the discounted value of a future payment stream.It represents a series of future cash flows expressed in today’s dollars.

A present value calculation (see page 5-__) removes the time value of money (interest). The remaining value is the portion of the equipmentcost that will be recovered from the lease payments.




V01/11/96 DRAFTP12/03/99

If the calculation indicates that the lessor is recovering more than 90percent of the equipment cost from the minimum lease payments, thenthe lessee is, in effect, paying for the equipment over time. The leasemust be classified as capital.

FASB 13 requires that lessors and lessees use specific discount ratesin the analysis. In some situations, the rates may differ betweenlessors and lessees. The fact that definitions for terms such aseconomic life, lease term, and minimum lease payments may varybetween lessor and lessee adds to the complexity of this classificationprocess.

These differences in the definition of minimum lease payments, as inthose of the discount rate, may lead lessors and lessees to classify the

same lease differently.

IMPLICATIONS FOR FINANCIAL REPORTING

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

Lessor and Lessee Accounting

Accountingregulations

In addition to setting the criteria for classifying a transaction, FASB 13provides the rules lessors and lessees use to account for leasetransactions. The goal of the FASB 13 regulations is to have the balancesheet and income statement reflect the substance of the transaction(ownership or not).

The accounts in the balance sheet and income statement that lessors and

lessees use for leases is summarized in Figure 2.1. An explanation of each quadrant follows.




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Figure 2.1: Lessor/lessee lease account summary

Les sor Accoun t i ng f or a Cap i t a l Lease

Lessor asfinancier

Quadrant 1 shows the accounting for a lessor capital lease where thelessor is not (in substance) the owner of the equipment. Instead, thelessor is financing the lessee’s acquisition of the equipment. Theaccounting is similar to accounting for a loan. On the balance sheet,the lessor records a net investment in lease receivables, which issimilar to a note receivable account that a bank sets up to record a

loan. The income statement reflects interest income earned on theoutstanding lease receivable, just as a bank earns interest income onthe outstanding principal in a loan.

Les sor Accoun t i ng f o r a n O pera t i ng Lease

Lessor asowner

Quadrant 2 shows lessor accounting for an operating lease. The lessoraccounts for the transaction as if it owns the equipment and isallowing the lessee to use the equipment. The equipment cost is

recorded as an asset on the balance sheet and depreciated over thelease term. Rents received from the lessee for use of the equipmentare recorded as income on the income statement.




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Lease termincome

It is important to note that the classification of the lease does notaffect the total amount of income recognized by the lessor. Over thelife of the lease, the interest income recognized in a capital lease willequal the difference between rental income and depreciation expense

in an operating lease. The following equation represents income forthe two types of leases over the entire lease term:

Interest Income = Rental Income – Depreciation

Lessee Accoun t in g for a Capi ta l Lease

Lessee asowner

Lessee accounting for a capital lease is shown in Quadrant 3. If thelease is classified as a capital lease, the lessee is considered to be theowner of the equipment. The accounting for a capital lease is similarto the accounting for a loan used to purchase the equipment. On thebalance sheet, the lessee records an asset for the equipment and aliability for the lease payable. The lessee’s income statement showsdepreciation expense on the asset and interest expense on the leasepayable.

Lessee Accoun t in g for an Operat in g Lease

Lessee asuser ofequipment

Quadrant 4 shows the lessee’s operating lease accounting. In anoperating lease, the lessee is the user of the equipment, not theowner. The lessee records nothing on the balance sheet, which is whyoperating leases are often referred to as off balance sheet leases. On theincome statement, the lessee records rent expense for the paymentsmade to the lessor. It is important to note that FASB 13 requiresthe lessee to disclose this liability in the footnotes (set of notes)accompanying the financial statements. Footnotes are used to explainhow numbers on the financial statements were derived and to documentobligations that do not appear on the statements themselves.




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Just as in lessor accounting, the classification of the lease does notaffect the total expense recognized by the lessee. Over the life of thelease, the depreciation expense plus interest expense of a capital lease

will equal the total rent expense of an operating lease. The followingequation represents total expense over the entire lease term:

Rent Expense = Depreciation + Interest Expense




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ABC COMPANYBALANCE SHEET

(End of first year)ASSETS

OperatingLease

CapitalLease Difference

Current Assets

Cash in bank

Accounts receivable

Inventory

Total current assets

$13,684

12,000

8,000

$33,684

$13,684

12,000

8,000

$33,684

Fixed Assets

Deferred tax charge

Property, plant, equipment

Capital leased equipment

Less: accum. depreciation

Total assets

$ 0

96,000

0

(30,000)

$99,684

$ 1,070

96,000

100,000

(50,000)

$180,754

($1,070)

(100,000)

20,000

($81,070)

LIABILITIES

Current Liabilities

Accounts payable

Lease payable

Total current liabilities

$6,000

0

$6,000

$6,000

18,350

$24,350

(18,350)

($18,350)

Long-term Liabilities

Notes payable

Lease payable

Total liabilities

$30,000

0

$36,000

$30,000

64,706

$119,056

($64,706)

($83,056)

STOCKHOLDERS’ EQUITY

Common stock

Retained earnings (prior)

Current portion

$14,000

$20,000

29,684

$14,000

$20,000

27,698 $1,986

Total equity

Total liabilities and equity

$63,684

$99,684

$61,698

$180,754

$1,986

($81,070)

Figure 2.5: Operating / capital lease balance sheet comparison




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Operating Lease Accounting Benefits - Lessee

Financialreportingbenefits

To help you understand the financial reporting differences for thelessee, let’s look at a balance sheet and an income statement for the

same lease, accounted for as both a capital lease and an operatinglease. From this example you will see why, from an accountingperspective, lessees prefer operating leases.

F in a n c i a l S t a t e m e n t C om p a r i s on

A balance sheet comparison of the lease, accounted for as bothoperating and capital is shown in Figure 2.5. The balance sheet ispresented as of the end of the first year.

As you examine the income statement comparison for the first year(Figure 2.6), notice that earnings and net income are higher if thislease is classified as an operating lease. In the later years of the leasethe operating lease expense will be higher, since the total expenseover the life is the same for both lease types.

ABC COMPANYINCOME STATEMENT

(End of first year)

ASSETS

OperatingLease

CapitalLease Difference

Revenue

Sales

Cost of goods sold

Gross profit

$300,000

(160,000)

$140,000

$300,000160,000

$140,000

Operating Expenses

Selling

General and administrative

Lease expense

Depreciation expense

Operating income

($4,000)

(44,000)

(24,332)

(10,000)

$57,668

($4,000)(44,000)

0

(30,000)

$62,000

($24,332)

20,000

($4,332)

Other Income and ExpensesInterest expense

Income before taxes

Income taxes @ 35%

Net Income

($12,000)

$45,668

(15,984)

$29,684

$19,388

42,612(14,914)

$27,698

$7,388

$3,056

(1,070)

$1,986

Figure 2.6: Operating / capital lease income statement comparison




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SUMMARY

Understanding the accounting for leases for both lessors and lessees is made easier byremembering 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 capitallease, the lessee is considered the owner of the equipment.

One of the major reasons lessees lease is off balance sheet financing. The example in thissection showed both the enhancement of earnings that operating leases provide and theimprovement of perceived financial health.

In the next section, you will learn about the tax classification of leases. Before youcontinue to the next section, check your understanding of the concepts you have justlearned by completing the Progress Check that follows. If you answer any questionincorrectly, please return to the text and read the section again.




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V01/11/96 DRAFTP12/03/99

] PROGRESS CHECK 2.1


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

____ a) operating lease.

____ b) capital lease.

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

____ a) capital lease.

____ b) operating lease.

Question 3: In accounting for an operating lease, the lessor shows the rental income anddepreciation expense on its income statement.

____ a) True

____ b) False

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

____ a) True

____ b) False




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ANSWER KEY

Question 1: A lease that transfers substantially all the benefits and risks of ownership tothe 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, itwould classify the lease as a(n):

a) capital lease.

Question 3: In accounting for an operating lease, the lessor shows the rental income anddepreciation expense on its income statement.

a) True

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

a) True




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Question 5: For the lessee, capital lease accounting is:

____ a) less complex than accounting for an operating lease.

____ b) similar to accounting for a loan.

____ c) the same as for lessor capital lease accounting.

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

____ a) operating lease.

____ b) capital lease.




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ANSWER KEY

Question 5: For the lessee, capital lease accounting is:

b) similar to accounting for a loan.

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

a) operating lease.




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TAX CLASSIFICATIONS

As discussed earlier, each regulatory body has its own criteria forclassifying leases. In the previous section, you learned that the FASB

classification (operating or capital) determines how the lease isaccounted for on financial statements. In this section, we will discusshow the U.S. IRS classifies leases and what this means to taxpayers.

Tax and Nontax Leases

Ownershipand taxbenefits

According to U.S. tax law, as interpreted by the Internal RevenueService (IRS), leases must be classified from a tax viewpoint as eithertax leases or nontax leases. In a tax lease, the lessor bears the risks

of ownership and is entitled to the tax benefits of ownership (i.e.,depreciation and tax credits). In a nontax lease, the lessee is,or will become, the owner of the leased equipment. As owner orpotential owner, the lessee is entitled to the tax benefits of ownership.A nontax lease is actually an installment sale contractin the form of a lease.

Congress has never enacted legislation specifically addressing theclassification of a lease. Taxpayers are unable to refer to a particularcode section in the Internal Revenue Code for guidance as to whether

or not the transaction is a true lease (tax lease) for tax purposes or anontax lease.

Sources of Classification Criteria

InternalRevenueServicestatements

To help taxpayers, the IRS has issued several statements to outline thecriteria the IRS uses to classify lease transactions. You will see thatthe criteria used to determine the tax classification of a lease aresimilar to, but different from, those used for accounting purposes.

The most important criteria come from Revenue Ruling 55-540 andRevenue Procedure 75-21. Also providing guidance to taxpayers arethe various tax court rulings that have been rendered over the years.




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R evenu e R u l in g 55-540

Ruling 55-540 provides the elements of a nontax lease. The moreimportant items (according to the IRS) are quoted below. If any of

these provisions are included in a lease, the lease must beconsidered a nontax lease. As we stated above, in a nontax lease, thelessee is, or will become, the owner of the leased equipment.

Tax statuscriteria

1. Portions of the periodic payments (rentals) are made specificallyapplicable to an equity interest to be acquired by the lessee.

2. The lessee will acquire title upon the payment of a stated numberof rentals which under the contract he is required to make. Thissituation occurs two ways:

a. Paying a stated number of rentals after which title transfers.

b. Title transfers automatically at the end of the lease without apurchase option or guaranteed residual.

3. The total amount which the lessee is required to pay for arelatively short period of use constitutes an inordinately largeproportion of the total sum required to be paid to secure thetransfer of title.

4. A bargain purchase option exists in which the option cost is lessthan the expected fair market value of the leased asset or is smallin comparison to the total lease payments to be made.

5. Some portion of the periodic payments is specifically designatedas interest or is otherwise readily recognizable as the equivalent of interest.




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R evenu e Procedu re 75-21

Guidance forlarge

leveragedleasestructures

In 1975, the IRS issued Revenue Procedure 75-21 (Rev. Proc. 75-21)to provide guidance for structuring large leveraged leases. Because an

equity investor (the lessor) and a nonrecourse lender finance theequipment in a leveraged lease, the parties were often uncertain as towhether the lessor was at risk. As you will recall, the party that bearsthe 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 guidelinesfor tax lease consideration are as follows:

Classification

criteria

n Minimum unconditional at-risk investment

- 20 percent minimum investment

- Equipment must have a remaining life beyond the leaseterm of the longer of one year or 20 percent of theoriginally estimated depreciable life

n Purchases and sale rights

- No bargain purchase options allowed

n No investment by the lessee

n No lessee loans or guarantees

n Profit requirement (complex IRS formula)

n Positive cash flow (complex IRS formula)

Ta x Cour t D ec i si ons

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




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Tax Returns

Earlier, you learned that tax ownership of equipment determineswhether a lease is a tax lease or a nontax lease. In a tax lease, the

lessor, as owner of the property, is entitled to the tax benefits. If thetransaction is a nontax lease, the lessee is deemed the property owner,and is entitled to the tax benefits.

A summary of the tax return implications for lessors and lessees ispresented in Figure 2.7.

Figure 2.7: Lessor/lessee tax implications

Lessor - Ta x L ease

Ownershipbenefits

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

Lessor - Non tax Lease

Taxed oninterest

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




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Timing oftaxableincome

It is important to note that the tax status of a lease does not affect thetotal amount of taxable income recognized; it affects only when thatincome is taxable. Over the life of the lease, the rental income lessdepreciation expense recognized in a tax lease will equal the interest

income recognized if the lease is classified as a nontax lease.

Lessee - Ta x L ease

Rent expense Quadrant 3 illustrates the tax implications for the lessee if the lease isa tax lease. The lessee is the user of the equipment and ownership is inthe hands of the lessor in a tax lease. The lessee is entitled to adeduction on its tax return for the rent expense paid to the lessor.

Lessee - N ont a x Lea se

Ownershipbenefits

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

Modified Accelerated Cost Recovery System (MACRS)

Accelerated tax depreciation is one of the tax law provisions that theU.S. federal government uses to encourage investment in assets.MACRS is the current form of tax depreciation corporations use todepreciate their tax assets for federal income tax purposes.

Generalprovisions

The three general rules are as follows:

1. MACRS generally applies to property placed in service afterDecember 31, 1986.

2. There are six classes of property dealing with personal property,which is all property other than land and buildings.

3. The MACRS depreciable life is based on the asset class life, whichis the IRS-designated economic life of an asset.




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Half-yearconvention

MACRS is an accelerated form of tax depreciation becausedepreciation deductions are calculated using a half-year conventionfor the year the equipment is acquired and the year of disposition. The

convention assumes that all property is placed in service in the middleof the taxpayer's tax year. For a calendar-year taxpayer, all property isassumed to have been placed in service on July 1. This means thatthese taxpayers can take a half-year depreciation deduction even if they placed the property in service on December 31. For the year of disposition, taxpayers assume the asset is disposed of in the middle of the year, regardless of the actual date of disposition.

MACRS depreciation rates are based on the asset class life and therecovery year. The MACRS table is shown in Figure 2.8. Taxpayers

refer to this table for the applicable percentages for any year tocalculate their depreciation deductions.

Example For this example, assume an original equipment cost of $100,000 and5-year MACRS property that is in its third year of depreciation. Youcalculate the deduction taken on the tax return as follows:

Equipment cost $100,000

MACRS % (third year) x 19.2%

Tax return deduction $ 19,200

MACRS TABLE




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If the

recovery

year is: and the recovery period is:

3 Years 5 Years 7 Years 10 Years 15 Years 20 Years

the depreciation rate is:

123

4567891011121314151617181920

21

33.33%44.4514.81

7.41

20.00%32.0019.20

11.5211.52

5.76

14.29%24.4917.4912.49

8.938.928.934.46

10.00%18.0014.4011.52

9.227.376.556.556.566.553.28

5.00%9.508.557.706.936.235.905.905.915.905.915.905.915.905.912.95

3.750%7.2196.6776.1775.7135.2854.8884.5224.4624.4614.4624.4614.4624.4614.4624.4614.4624.4614.4624.461

2.231

Figure 2.8: Modified Accelerated Cost Recovery System table

Positive cashflow

As a tax benefit, MACRS represents a positive cash flow to thetaxpayer because the benefits and cash flows are received morequickly. Remember that the sooner cash flows are received, the morethey are worth on a present value basis.




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Midquarter Convention

TRA 86 The midquarter convention is a provision in the Tax Reform Act of 1986 (TRA 86). Congress enacted the midquarter convention rule to

prevent taxpayers from over-utilizing the half-year convention benefit.This rule sets a limit on the amount of equipment a company can placein service in the fourth quarter of a tax year and still receive thebenefit of the half-year convention.

The 40%penalty

The midquarter convention is sometimes referred to as the 40 percentpenalty. Under this penalty, if more than 40 percent of all personalproperty placed into service during the tax year is placed into servicein the last three months of the taxable year, the taxpayer must use themidquarter convention instead of the half-year convention.

The concept of the midquarter convention is illustrated in Figure 2.9.

Figure 2.9: Triggering midquarter penalty

E f f ec t of the Midq u ar ter Con vent ion

Slowed cashinflow

The midquarter convention causes the tax benefits from depreciationdeductions 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 wasunder the half-year convention.




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Because lease companies often complete many transaction in thefourth quarter, they are prime candidates to be affected by themidquarter convention. If a lessor is in a midquarter position, theslowing cash flows realized from tax benefits will lower the yield in

the lease. Looked at another way, if the lessor desires the same yieldin the lease as would be expected under the half-year convention, thenthe lessor must increase cash flows from the monthly payments, fees,or from residual realization.

The slower depreciation rate of the midquarter convention ishighlighted in Figure 2.10.

MIDQUARTER / HALF-YEAR COMPARISON

Midquarter Half-YearConvention Convention Difference

Year Amount Cumulative Amount Cumulative Amount Cumulative

123456

5,00038,00022,80013,68010,9449,576

5,00043,00065,80079,48090,424

100,000

20,00032,00019,20011,52011,5205,760

20,00052,00071,20082,72094,240

100,000

(15,000)6,0003,6002,160(576)3,816

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

-0-

Figure 2.10: Midquarter convention effects on depreciation deductions

Value of Depreciation

In this section we quantify the value of the depreciation tax benefit andshow how tax benefits affect lessor pricing. This will help youunderstand why depreciation is a source of profit for lessors and whylease rate factors are generally lower in the fourth quarter.

Assumptions We use the following assumptions to illustrate the value of

depreciation:

n $100,000 equipment cost

n 5-year MACRS benefits versus principal repayment

n Pretax equivalent loan rate of 10.50 percent




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n Cost of capital is 7.15 percent

n Payments are $2,149.39 per month, in arrears

n Lease inception date is December 31

Tax leaseincome

In Figure 2.11, we can see the income recognized if the transaction isa tax lease. Notice that the total income recognized is the same underboth rental income and MACRS over the 60-month term. Only thenature and the timing of the income vary.

TAX LEASE INCOME

TaxYear

RentalIncome MACRS

TotalIncome

123456

(2,149.39 x 12)““““

025,79325,79225,79325,79225,793

128,963

20,00032,00019,20011,52011,5205,760

100,000

(20,000)(6,207)

6,59214,27314,27220,03328,963

Figure 2.11: Income from tax lease transaction

Comparison Lessors realize more of a time value of money benefit from leasingthan they do from lending. A year-by-year loan/lease incomecomparison is displayed in Figure 2.12.

Timing ofcash flows

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




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Worth of leasealternative

In this transaction, the lease alternative is worth an additional $2,892to the lessor. This represents the amount, on a present value basis, of the tax savings from the accelerated depreciation deductionscompared 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 lowerpayment to the lessee.

INCOME COMPARISON

YearLoan

IncomeLease

Income Difference

123

456

09,7427,973

6,0103,8291,409

28,963

(20,000)(6,207)

6,592

14,27314,27220,03328,963

20,00015,9491,381

(8,263)(10,443)(18,624)

0

Figure 2.12: Loan / lease income comparison

Effect ofinception date

In the above example we used an inception date of December 31.Because of the half-year convention, this date results in the maximumtiming differences of the two alternatives. If the

inception date were January 1, the depreciation value would be lower.Although still beneficial, the effect of depreciation is greatly loweredfor tax transactions completed early in the year. The lessor's pricingreflects this.

Fourthquarter

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




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Corporate Alternative Minimum Tax (AMT)

Limits onMACRS

depreciation

Although corporations are allowed to reduce taxable income withMACRS depreciation, Congress has placed limits on the amount of

these deductions. If these limits are exceeded, an additional tax isimposed. This tax is referred to as the AMT. The AMT attemptsto ensure that all corporations pay a minimum tax. It requirescorporations to compute both the regular tax and the AMT, and thenpay the higher of the two calculations.

How AMT Work s

Examine Figure 2.13 to see how the AMT works.

BASIC AMT CALCULATION

Regular Tax AMT

Income before taxes

– Adjustments

Taxable income

x 35%

Taxes payable

Income before taxes

– Adjustments__

Taxable income

+ Preferences a

AMT income

x 20% a

AMT payable

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

Adjustments The adjustments referred to in the illustration are various InternalRevenue Code (IRC) adjustments firms make to income beforetaxes in order to arrive at taxable income. These adjustments (such asMACRS) decrease or increase the income before taxes. Tax

departments in corporations identify and use the IRC-allowedadjustments to lower the firm’s taxes. More negative adjustmentsresult in lower taxable income, which means the corporation will payfewer taxes to the IRS.

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




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items income, a portion of the adjustment or deduction is added back toregular taxable income. These are preference items. The preferenceitem with the greatest impact on the leasing industry is accelerateddepreciation on personal property. This preference item is the

difference between depreciation used for the regular tax calculation(generally MACRS) and depreciation calculated using the prescribedAMT method.

M ark e t ing Ap proach

Once a lessor understands the complexities of AMT, it can use its

knowledge of the AMT to identify lessees in a potential AMT

position and convince the lessee to lease the equipment to avoid

AMT.

Potentialcustomers

Characteristics of companies in AMT include:

n Companies experiencing low taxable income and high AMTpreferences

n Companies that heavily invest in machinery and equipment

n Companies that purchase equipment that falls at the high end (longADR life) of the MACRS classification

n Young companies that have rapidly growing asset bases and thatcannot benefit substantially from the turn-around of older assets,which would lessen the preference burden

Avoidpreferences

In marketing tax leases to a potential lessee, the goal is to show theclient how to minimize the risk of paying AMT through leasing.Because preferences cause AMT situations, a number one priority isto help the lessee to avoid those preferences that may trigger AMT.

The preference for accelerated depreciation can be avoided by taxleasing because the preference applies only if the lessee owns anddepreciates equipment. Purchasing creates a depreciation preference,whereas tax leasing does not.




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Lessor Perspective

AMT risk As the tax owner of the equipment in a tax lease, lessors are primecandidates 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 minimizeits impact. For example, different nontax lease products can bedeveloped. In some situations, however, lessors will be unable toavoid 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 tomeet the needs of various customers. In this section, we will discusstax and nontax lease products.

T a x L e a s e P r od u c t s

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

Targetindustry

The TRAC lease is a tax lease specifically designed for thecommercial vehicle leasing industry. TRAC stands for TerminalRental Adjustment Clause.

Lesseeassumesresidual risk

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

Qualifying

vehicles

Examples of specialized vehicles that qualify for TRAC leases include

dealer service trucks, dealer haul trucks, contractor haul trucks,equipment trailers, and busses.




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End-of-termadjustment

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

the lease payments are based.

Shifts risk tolessee

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

Full paymenttaxable

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

N on t a x Lease Produ c t s

Lesseeownership

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

Similarity to aloan

Sometimes the substance of the lease transaction resembles a sale.In a conditional sales contract, the seller sells the asset andtransfers possession to the purchaser, but retains title to the asset until

the purchaser has fully paid for it. A conditional sale is a form of financing, much like a loan. A dollar-out lease, in which the lesseemay purchase the equipment for one dollar at the end of the leaseterm, is an example of a conditional sales contract.




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Ownershipoptions

A money-over-money lease is a conditional sales contract. Thesubstance of the lease is that the lessee is, or will become, the ownerof the leased equipment by the end of the lease term. This could occurif the lessee has the option to acquire title to the equipment at the end

of the lease for no additional consideration, or for a fixed-pricepurchase option that is substantially less than fair market value.

Interest ratedifferences

In a money-over-money lease, the lessor's profit in the lease is thedifference between the interest rate at which the lessor borrowed themoney to purchase the equipment and the interest rate it charges thelessee. The lessor is making money over money, or a spread. Forexample, if the lessor borrowed the money from the lender at 10percent and is charging the lessee 13 percent, the spread is 3 percent.

Municipalities can enter into a special lease called a municipal lease.A municipal lease is a nontax lease or a conditional sales contract andhas the characteristics of tax exempt debt.

Tax-exemptinterestearnings

An interest rate is stated in the contract. The municipality becomes theowner of the equipment at lease termination. The key characteristic of 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 municipallessee by charging a lower payment than it would normally need tocharge a taxable organization.

SUMMARY

Leases are classified as either tax leases or nontax leases. In a tax lease, the lessor bears therisks of ownership and is entitled to the tax benefits associated with the equipment. In anontax lease, the lessee is deemed owner of the equipment and is entitled to the taxbenefits. 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. Ina 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 theway 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 taxbenefits, thereby relying less on the periodic payment. Hence, the lessee's payment istypically lower if structured in the fourth quarter.

Tax consequences do not always have a positive effect on lease transactions. Tax limitationssuch as the midquarter convention and AMT can adversely affect the lessor’s yield in alease.

Within each of the two broad categories — tax leases and nontax leases — are several typesof lease products structured to meet the needs of various customers.

You have completed Unit Two: Financial Reporting and Tax Classifications. In the nextunit, you will learn how leases are classified for legal purposes. Before you continue tothe next section, check your understanding of the concepts you have just learned bycompleting the progress check that follows. If you answer any question incorrectly, pleasereturn to the text and read the section again.




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Question 1: Which of the following will probably not lead to a nontax classification of alease agreement?

____ a) Bargain purchase option

____ b) A lessee guaranteed residual value

____ c) Acceptance of residual risk by lessor

Question 2: The purpose of Revenue Procedure 75-21 was to:

____ a) clarify the tax responsibilities in a tax lease.

____ b) establish the true intent of the parties to the lease agreement.

____ c) define asset class life.

____ d) provide guidance for structuring large leveraged leases.

Question 3: In a nontax lease, the lessee is entitled to which of the following?

____ a) Full rental payment deductions

____ b) Half of the normal depreciation allowance

____ c) Interest and depreciation deductions

____ d) Expense deductions for depreciation and rental amounts

Question 4: In a tax lease, the lessor records:

____ a) rental income less depreciation expense.____ b) depreciation expense plus interest income.

____ c) rent expense.

____ d) interest income.




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ANSWER KEY

Question 1: Which of the following will probably lead to a nontax classification of a leaseagreement?

c) Acceptance of residual risk by lessor

Question 2: The purpose of Revenue Procedure 75-21 was to:

d) provide guidance for structuring large leveraged leases.

Question 3: In a nontax lease, the lessee is entitled to which of the following?

c) Interest and depreciation deductions

Question 4: In a tax lease, the lessor records:

a) rental income less depreciation expense.




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Question 5: Which one of the following statements is true?

____ a) The half-year convention discourages investment in assets.

____ b) MACRS represents a negative cash flow to the taxpayer.

____ c) The midquarter convention slows the pace of tax benefits fromdepreciation deductions.

____ d) The midquarter convention primarily affects lessees in tax leases.

Question 6: Asset class life is:

____ a) the depreciable economic life of an asset.

____ b) the current tax depreciation methodology.

____ c) equal to the recovery year in the MACRS table.

Question 7: The impact of depreciation is greatly enhanced for tax transactions completedearly in the year.

____ a) True

____ b) False




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ANSWER KEY

Question 5: Which one of the following statements is true?

c) The midquarter convention slows the pace of tax benefits fromdepreciation deductions.

Question 6: Asset class life is:

a) the depreciable economic life of an asset.

Question 7: The impact of depreciation is greatly enhanced for tax transactions completedearly in the year.

b) False



Unit 3



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UNIT 3: LEGAL CLASSIFICATION

AND LEASE DOCUMENTATION

INTRODUCTION

The financial reporting (or accounting), tax, and legal considerations of leasing are veryimportant to a complete understanding of the leasing product. Financial reporting and taxclassifications were described in Unit Two. In this unit, you will learn that, from a legalviewpoint, lease transactions are classified as either true leases or secured transactions.These distinctions are particularly important in the event that the lessee defaults on thelease 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 viewthe lease.

UNIT OBJECTIVES


n Understand the criteria used by the legal system to distinguish a true leasefrom a secured transaction

n Recognize how lease documentation provisions protect lessors

LEGAL CLASSIFICATIONS

Because true leases are treated differently from sales and loans incommercial law, a lease must be separately classified from a legalviewpoint.



3-2 LEGAL CLASSIFICATION AND LEASE DOCUMENTATION

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Sources ofcriteria

The classification criteria the U.S. legal system uses today are basedon three sources:

n The Uniform Commercial Code (UCC), which is a set of

laws governing a variety of business transactions

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

n Various court cases

Focus onownership

Conceptually, the criteria from these sources are similar to thecriteria used for accounting and tax purposes. Once again, the focus ison ownership of the equipment.

If the lessor is deemed to be the owner of the equipment, and thelessee the user, the lease is a true lease. If, in substance, the lessee isdeemed to be the owner, the lease is referred to as a securedtransaction.

The Uniform Commercial Code (UCC)

Technically, true leases are not covered by the UCC at the presenttime. 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.

Ar t icle 9

Article 9 of the code discusses secured transactions — specificallythe rights of a borrower and the rights of a lender.

Secured

interest

A secured transaction is created when a debtor (lessee) gives a creditor

(lessor) a security interest in certain property. From a legal standpoint,a secured transaction is not a true lease. Therefore, Article 9 is used todistinguish between true leases and secured leases.



LEGAL CLASSIFICATION AND LEASE DOCUMENTATION 3-3

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Ar t icle 2

Impliedwarranties

Article 2 deals with sales and the rights of buyers and sellers. Thearticle has been applied to transactions in which a lessor buys goods

from a supplier. Although the article does not technically apply to thelessor-lessee relationship in a true lease transaction, the courts haveapplied some of its provisions either directly or by analogy. Mostnotable has been the application of the implied warranties provision.This provision requires that the property is saleable andis fit for its usual purpose.

Article 2A-Leases

Proposedarticle

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

S cope o f Covera ge

True leases The article applies to any transaction, regardless of form, that createsa true lease. It does not apply to conditional sales or loans that mayappear documented as a lease. It covers all leasing transactions,

whether business or consumer, daily rental, or multimillion dollarleveraged lease transactions. There are no exemptions or exceptionsfrom coverage of the article.

Def in i t ion o f a L ease

Article 2A provides a definition of a lease:

“Lease” means a transfer to the right to possession and

use of goods for a term in return for consideration; buta sale, including a sale on approval or a sale or return, orretention or creation of a security interest is not a lease.Unless the context clearly indicates otherwise, the termincludes a sublease agreement.




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T h e Fi n a n c e L e a s e

The Article also recognizes that a modern finance lease is differentfrom a traditional rental. It provides a definition of a finance lease.

"Finance lease" means a lease in which (i) the lessor doesnot select, manufacture or supply the goods, (ii) the lessoracquires the goods in connection with the lease, and (iii)either the lessee receives a copy of the contract evidencingthe lessor's purchase of the goods on or before signing thelease contract, or the lessee's approval of the contractevidencing the lessor's purchase of the goods is acondition to effectiveness of the lease contract.

R e m ed i e s a n d D a m a g e s

Computationformula

The Article provides a complex remedies and damages scheme forthose parties who have not specified damages by contract, or whosecontract provisions are unenforceable or otherwise fail. The basicunderlying principle of damage computation is that the lessee'soriginal rent will be compared to fair market rent.

Case Law Perspective

Case lawcriteria

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

n The mere existence of a purchase option by a lessee

n The existence of a “nominal purchase option”

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

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

lessee

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




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n Periodic lease payments that do not reflect “reasonable rentalvalue”

n How the lessor conducts its business

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

n The filing of a financing statement by the lessor

n How the lessor treats the transaction on its books

n What the parties understood the transaction to be

n Whether the lessee was responsible for paying the taxes and

insurance on the equipment and keeping it maintained andrepaired

n Who bears the risk of depreciation in estimated residual value

LEGAL IMPLICATIONS

The legal classification of a lease is important because commerciallaw treats lease transactions and secured transactions differently.In this section, we discuss the two ways lessors protect their interestsin leased equipment: UCC filings and action upon notice of lesseebankruptcy.

UCC Filings

Protectinginterest

By definition, a true lease is not a secured transaction and is notsubject to any filing requirement. However, much legal action hasoccurred over the issue of security interest. A careful lessor willalways make a UCC filing to protect its interests in case the courtsdecide that the transaction was a secured transaction. The filing fee ischeap insurance against an expensive legal battle that could cost thelessor all its remaining value in the leased property.




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Bankruptcy Issues for Lessors

Lesseedefault

One of the most important situations in which a transaction must beclassified as a true lease or a secured transaction must be answered in

the event that the lessee defaults on the lease. The consequences forboth lessor and lessee vary significantly depending on the rulings of the court. A lessor receiving notice of a bankruptcy petition filing byone of its lessees should quickly determine a course of action toprotect its interests and retrieve the equipment. Otherwise, the lessorfaces the possibility of waiting a year or more to regain possession of equipment that has, in the meantime, lost some of its value.

SUMMARY

For legal purposes, transactions that are labeled leases are classified as either true leases orsecured transactions. If the lessor is deemed to be the owner of the equipment, the lease isa true lease. If the lessee is deemed to be the owner, the lease is referred to as a securedtransaction.

The legal classification criteria are based on three sources: the UCC, Article 2A, and courtdecisions. Whether the lease is considered by the courts to be a true lease or a securedtransaction 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 quicklydetermine 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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Question 1: The tax, legal, and accounting definitions of a lease are:

____ a) dependent criteria.

____ b) independent criteria.

____ c) determined by FASB 13.

Question 2: Article 2A of the Uniform Commercial Code:

____ a) applies only to lease transactions deemed to be true leases.

____ b) replaces Article 2 of the Uniform Commercial Code.

____ c) is a federally mandated code.

Question 3: Which factor will most likely cause a transaction to be considered a securedtransaction?

____ a) Net terms

____ b) A lessee option to terminate the lease before full payment has been made

____ c) An obligation by the lessee to pay the initial value of the equipment

____ d) The transfer of the title at the end of the lease for no additionalconsideration




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ANSWER KEY

Question 1: The tax, legal, and accounting definitions of a lease are:

b) independent criteria.

Question 2: Article 2A of the Uniform Commercial Code:

a) applies only to lease transactions deemed to be true leases.

Question 3: Which factor will most likely cause a transaction to be considered a securedtransaction?

d) The transfer of the title at the end of the lease for no additionalconsideration




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LEASE DOCUMENTATION

In the previous section, you learned that the courts treat true leasesand secured transactions differently. In this section, we will discuss

the types of documents generally included in lease transactions andpoint out document provisions that help protect the lessor’s interestsin legal situations.

Factors Affecting Documentation

Variablerequirements

There are many ways to structure a lease transaction, whether it be aleveraged lease, single investor lease, consumer lease, municipallease, or otherwise. The documentation for each different type of

lease transaction can vary greatly. Even the dollar volume of theequipment influences the complexity of the documentation.

In this section you will learn about the documentation usually requiredfor a lease transaction. The document provisions generally apply to

most lease transactions.

Lease Documentation

Checklist The lease documentation could include the following:

n Lease/Credit Application

n Master Lease

n Equipment Schedule

n Fair Market Value Purchase Option Rider

n Fair Rental Value Renewal Option Rider

n Certificate of Acceptance

n Casualty Value Schedule

n Officer's Certificate or Corporate Resolution

n Certificate of Insurance

n Precautionary Form UCC-1




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Protecting the Lessor

Some of the documents we listed above protect the lessee, but mostare drafted to protect the lessor's interest. Below, we outline the

various documents involved in a leveraged lease transaction and showhow the document provisions protect the lessor.

Lea se/Credi t Ap pl ica t ion

Assess creditrisk

The Lease/Credit Application is typically used in equipment leasingtransactions involving smaller ticket items of $150,000 or less. It isa fill-in-the-blank type of document lessors use to gather necessaryinformation about the prospective lessee and the equipment to be

leased. The lessor uses this information to assess the credit-worthiness of the prospective lessee and the worth of the proposedlease transaction.

Master Lease

Commonterms andconditions

A Master Lease is often used in a lease transaction involving largeticket equipment or involving one lease transaction of many to come.The Master Lease sets forth all major terms and conditions that will

be common to all lease transactions that follow.

The variable terms and conditions of each lease transaction (i.e.,description of equipment, lease term, and payment amount and terms)are set forth in each succeeding Equipment Schedule.

The major terms and conditions of a Master Lease that protect thelessor include the following:

n Limitation of liability, disclaimer of warranty

This provision protects a lessor from liability that could resultfrom express or implied warranties recognized by the UCC.

n Obligation to pay rent




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This provision details the lessee's obligation to make the rentalpayments.

n Assignment

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

n Risk of loss and damage

Under this provision, the lessee bears the risk of damage ordestruction of the equipment, as well as the risk of a theft orgovernmental taking of the equipment.

n Insurance

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

n Indemnity

This provision protects the lessor against any claims related to

the purchase, use, and ownership of the equipment.

n Liens and taxes

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

n Personal property, location of equipment




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The basic test of whether the equipment is personal property ora fixture is the intent of the parties. This provision sets theintent of the parties — that the equipment is, and shall remain,personal property. Also, this provision bars the lessee from

relocating the equipment without the lessor's prior writtenconsent.

n Designation of ownership

The wording of this provision confirms that the lessor is theowner 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 liabilityin the event that the lessee’s misuse of the equipment causesinjury to a third party or damages the equipment.

n Surrender of equipment

This provision documents the lessor's status as the owner of theequipment for tax and UCC purposes. It also requires the lesseeto bear the expense of returning the equipment to the lessor. Inaddition, it protects the lessor from excessive wear and tear ordepreciation of the equipment caused by the lessee.

n Suspension of obligations of lessor

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

n Lessee's failure to perform

Under this provision, if the lessee fails to perform an

obligation under the lease, the lessor may carry out theobligation and then charge the lessee for all expenses incurred,plus interest.

n Events of default




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

n Remedies

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

E q u i p m e n t S c h e d u l e

Variable leaseinformation

An Equipment Schedule sets forth all the variable fill-in-the-blank information for a particular lease transaction, including a descriptionof the equipment. The most critical information contained in anEquipment Schedule is the amount of the lease payment, the

commencement date, and the lease term.

F a i r M a r k et V a l u e P u r c h a s e O p t i on R i d e r

End-of-termpurchaseoption

This rider provides lessees with the option to purchase the equipmentat the end of the lease term at the equipment’s fair market value.

F a i r R e n t a l V a l u e R e n e w a l O p t io n R i d e r

Re-leaseoption

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

Cer t i f i ca t e o f Accep t an ce

Representa-tions upondelivery

This document requires, upon delivery of the equipment,(1) confirmation that the lessee received, inspected, and accepted theequipment, (2) re-confirmation of Master Lease representations, and

(3) proof that the lessee has insured the equipment in accordance withthe terms of the lease. It also requires the lessee to confirm thelocation of the equipment. Most important, the document sets forththe acceptance date for the Equipment Schedule. This date has tax andUCC consequences.




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C a s u a l t y V a l u e S c h e d u l e

Computecompensation

for loss

The objective of the Casualty Value Schedule is to establish the value(to the lessor) of the lease and the equipment at various times over the

term of the lease. It is used to compute lessee payments for the loss,destruction, or condemnation of the equipment.

Of f i cer ' s Cer t i f i ca te or Corpora te R esolu t ion

Authorization This resolution ensures that (1) the lease has been accepted by eachcorporation's Board of Directors and (2) the agent signing the leasedocuments is authorized and empowered to do so on behalf of thecorporation.

Cer t i f i ca t e of In su ra nce

Insuranceobligation

The purpose of the Certificate of Insurance is to assure the lessor thatthe lessee has obtained the appropriate insurance coverage.

Precau t iona ry Form UCC-1

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

Remedies Upon Lessee Default

The lessor’s position is strengthened if default actions and the lessor’s

options (remedies) are included in the lease. Let’s examine them moreclosely.




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Defau l t Pr ovi sions

Default provisions are probably the most important clauses in thelease agreement.

No UCCdefinitions

A breach or default of an agreement results when one of the partiesfails to perform one or more of its promises. The UCC does notdefine what events constitute a default. Thus, it is important tocarefully define the actions of the lessee that constitute a default inthe lease agreement. These actions generally include the following:

n False representations

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

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

n Any affirmative act of insolvency such as filing for bankruptcy

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

Notice tolessee

These definitions put the lessee on notice that any failure to adhere tothe 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 beupheld in a court of law. However, including them in the leaseagreement enhances that possibility. It also serves to notify thelessee of the options the lessor may take. By specifying the availableremedies, the lessor again maintains a degree of control and flexibility.

Typical remedies specified in a lease agreement include thefollowing:

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




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n If the lessee fails to perform an obligation such as paying forinsurance or taxes, the lessor may carry out the obligation andthen charge the lessee for all expenses incurred, plus interest.

The lessor may opt for this remedy when the lessee haspermitted a judgment or execution to be rendered against theequipment.

n If the lessee loses or destroys the equipment, the lessor maycollect liquidated damages in the amount of the casualty valueof the equipment.

SUMMARY

The documentation for each type of lease transaction can vary greatly. However, certainprovisions apply to most lease transactions. Most of these provisions serve to protect thelessor in the event the lessee defaults on the terms and conditions of the agreement. Lesseeactions considered to be default actions should be defined in the lease agreement. Includingremedies or actions in the lease that the lessor may take in the event of lessee default helpsstrengthen 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 tothe text and read that section again.




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(This Page Intentionally Blank)




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Question 1: Most lease documents protect the lessee.

____ a) True

____ b) False

Question 2: A Master Lease usually contains:

____ a) the amount of the lease payment, the commencement date, and the leaseterm.

____ b) a Casualty Value Schedule.

____ c) the common terms and conditions that apply to all subsequenttransactions.

____ d) renewal and purchase options.

Question 3: Which of the following definitions applies to remedies in lease

documentation?

____ a) Actions a lender may take if the lessor fails to make its payments

____ b) Actions that constitute a default under the agreement

____ c) Actions the courts may take to define a secured agreement

____ d) Actions that a lessor may take in the event the lessee defaults on theagreement




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ANSWER KEY

Question 1: Most lease documents protect the lessee.

b) False

Question 2: A Master Lease usually contains:

c) the common terms and conditions that apply to all subsequenttransactions.

Question 3: Which of the following definitions applies to remedies in leasedocumentation?

d) Actions that a lessor may take in the event the lessee defaults on theagreement



4-2 CREDIT ANALYSIS AND RISK ASSESSMENT

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RISK ASSESSMENT

Focus islessorconcerns

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

30 variables oflease credit

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

n Lessee credit risk assessment

n

Characteristics of lessees

n Lease environment risk factors

Lessor credit assessment includes the basic analytical functions thatcredit analysts perform in the lease assessment process. The secondand third categories identify the various risk factors credit analystsmust consider. Let’s begin by looking at how credit analysts assess andevaluate a lessee’s credit.

Lessee Credit Risk Assessment

Analyticalfunctions

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

n Confirmation

n Corroboration

n Catastrophe

n Concatenation

n Classification

n Consideration

n Computation

n Compilation



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Conf i rm a t i on

Obtaininginformation

Confirmation is the process of obtaining the information the lessorneeds to perform a quantitative and/or qualitative risk evaluation.

The primary sources of confirmation for the lessor are as follows:

n Audit report from an auditing firm

Starting point Audited financial statements are prepared according togenerally accepted accounting principles (GAAP). Thesestatements provide an excellent starting point in risk assessment. Later in this section, you will learn how lessorsuse this source of information.

n A compilation or disclaimer

Warning ofextended risk

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

n Review or limited review of financial statements

Limitedavailability

These are periodic or special reviews such as those producedwhen a bank or factory requires periodic reviews onreceivables or inventories. Availability is limited.

n Tax returns

Different fromfinancialstatements

Tax returns are an excellent source of information to use forevaluating lessor risk. The lessor must keep in mind that taxreturns are prepared according to tax legislation rather thanGAAP; therefore, differences between financial statements and

tax statements will occur.




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n Other special reports

SEC andindustry-specific

reports

Other reports that can help the lessor evaluate risk includeperiodic reports filed with the Securities and ExchangeCommission (SEC) and special reports required in specializedindustries, such as the airline and broadcast industries.

Corroborat ion

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

n Bank references

Bank documentation would include the following:

Name and location of the bank

Loans outstanding

Loan amounts

Collateralization

Payment history

Length of the credit relationshipHighest amount of debt extended

Contingent debt

Leases with that bank

n Prior leasing commitments with other lessors

Not alwaysreliable

Many banks and lessors avoid disclosing information that maysubject them to litigation. Therefore, a lessor cannot rely on

this source of information. You will find alternativecorroborative sources under the subsection entitled Credit.




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Com pi l a t i on

Result used tomake decision

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

scale.

Attainingconsistencythrough matrixdevelopment

You may view Figure 4.1 as a completed credit matrix. It is importantto realize that each analyst may assign different classification valuesand consideration scores to a risk factorcausing variation in computation from analyst to analyst. To attainconsistency within a credit evaluation team, credit managers candevelop credit matrices based on their existing leases. By analyzingthe good, average, and bad leases in its portfolio to deriveclassification 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 - Creditrating

COMPILATION

Reject 0 - 4

Accept (charge premium rate) 4.1 - 5

Accept 5 .1 - 7

Accept (give preferential rate) 7.1 -10

Figure 4.1: Computation worksheet

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




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Characteristics of Lessees

Now that you are familiar with the steps in the credit risk evaluationprocess, we will look at the 12 C characteristics of the lessee that the

lessor investigates and evaluates. As you learned in the previous sectionlessors select, rank, score, and compute risk factors on a credit matrix.Each of the variables discussed in this section represents a risk factorthat the lessor credit analyst may include in a credit matrix.

C h a r a c t e r

Integrity,honesty,commitment

Character refers to the lessee’s potential integrity, honesty, andcommitment to honor its financial obligations. Previous experience

with the lessee is an excellent indicator, but if the lessor has noprevious experience, other indicators may be used. The lessor mayassess the lessee’s character from a personal interview or throughchecking with other leasing companies, bankers, and creditors withwhom the lessee has done business. Another indicator of character iswhether or not the potential lessee has properly disclosed any off balance sheet financing arrangements — proper disclosure the lowerslessor’s risk.

C a p i t a l

Threedefinitions

Capital has several meanings. We will use three meanings of the termhere.

1. In its broadest sense, capital refers to the total resourcesavailable for a firm's usage including all assets and balancesheet resources. Nonbalance sheet resources such as people,experience, and other factors normally not quantified as resourcesalso have been included.

2. A narrower definition of capital is the definition of capital assets,which is generally regarded as property, plant, and equipment.

3. An even narrower definition regards capital as cash.




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Lessee’scapitalposition

For risk assessment purposes, a creditor usually looks for strong networth and limited financial leverage. A strong capital position meansthe lessee has assets available to satisfy a judgment in the event of default. The following accounting formula conveys this concept:

Assets = Liabilities + Equity

The left-hand side of the equation represents all quantified assetvalues and the right-hand side indicates the source of financing forthose assets.

There are only two methods of funding assets.

n Borrowing money to purchase assets

n Investing equity funds to purchase assets

The lessor can analyze the balance sheet equation to determine boththe degree of the lessee’s net worth and the extent of financialleverage.

The lessor should also determine the degree to which assets may beencumbered (tied up as collateral). It is possible for a company to

have a high net worth but have an excessive amount of assets placed ascollateral with other creditors. This could mean that there is notenough protection for a new lease.

If the asset has a questionable residual value or is rapidly losing value,a wise lessor will obtain additional unencumbered capital protection.With smaller companies, the lessor may request additional collateralfrom the lessee and/or personal guarantees. In the case of personalguarantees, the lessor should also evaluate the lease guarantor’scapital position. In larger lease transactions and in most public

companies, personal guarantees cannot or will not be given; the networth of the lessee stands alone. Later in this unit you will learn aboutratios that can be used to analyze capital.




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C a p a c i t y

Lessee’sability to pay

Capacity refers to the lessee's ability to pay. Typically, credit analystsexamine the lessee’s income statement to determine that the net

income is adequate. Lessors should trend historical net incomefigures 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 itsobligations in the future increases. On the other hand, steady growthof net income or growth at an increasing rate would indicate adecreased risk.

The lessee’s source of income also affects capacity. If the lesseerealizes a sizable portion of net income through a limited number of customers, the lessor may verify the probability of continued sales by

obtaining written or verbal confirmations from the customers.

Liquidityassessment

Recall that a broad interpretation of capacity includes not only thecurrent ability of a lessee to earn, but also the lessee’s ability tomaintain adequate liquidity, cash flow, and to sustain solvency. Creditanalysts typically assess liquidity by examining the current assets andthe current liabilities. If a lessee's cash flow position deteriorates oris threatened, liquidity may become inadequate, which increases thelessor’s risk.

To assess this risk, a lessor should determine whether the lessee’scash budget (forecast) demonstrates adequate cash for at least one-half of the lease term. We will cover this in more detail later in thisunit. Finally, the lessor must determine whether net income will growat a rate sufficient to sustain and strengthen solvency.




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Credi t

Size of capitaland paymenttrends

The lessor should investigate credit experience to determine thelessee’s past trading policies and practices. Dunn & Bradstreet is a

common source; it reports size of capital and payment trends (how biga company is and how fast it pays). Typically, the assumption is thatthe bigger a company is and the faster it pays, the better the risk.Conversely, a smaller company that pays slowly would normally beassessed as less creditworthy.

Some firms choose not to provide Dunn & Bradstreet with thefinancial information requested to determine the rating. In thesecircumstances, Dunn & Bradstreet either estimates the information orcomments in the rating that the company does not choose to be rated.

View this as a warning sign.

Officer creditchecks

Lessors also may obtain credit checks on selected officers, ownersand principals of a lessee seeking credit. This may be particularlyimportant if the lessee is a closely-held company or is a relatively newcompany. The lessor will feel more comfortable about extendingcredit if the principals have superior individual credit records.

Sources ofcredit

information

Trade associations are a frequent source of credit information.These associations tend to be a close-knit club credit information is

informally shared with those who have privileged membership.Additionally, formal rating agencies, such as Moody's and Standardand Poor's, have research arms that formally rate most large and somesmall companies. TRW and National Credit Information Services(NACIS) are two other players in the independent credit verificationbusiness.

Cash Flow

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




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Chron o log ica l Age

History affectsextent of risk

A company with a relatively short history presents increased risk tothe lessor. In the case of start-up companies, the lessor may look to

the past successes and failures of the principals to assess risk. Forestablished firms, the lessor should trend relevant income and otherfinancial data to provide a basis for evaluating forecasted data.

CAPM-Beta Coef f ic ien t

Capital assetand riskevaluation

The capital asset pricing model (CAPM), with its attendant betacoefficient, is a way to measure the risk in capital budgeting. Becauseleasing is basically a capital expenditure consideration, it makes sense

for lessors to understand this conceptual approach to capital asset andrisk evaluation.

Twocomponentsof risk

You should understand that interest rates that lessors receive usuallyvaries according to the risks they bear. Interest may be separated intotwo components; risk-free rate and risk premium. Lessors considerthe return on U.S. government securities to be the risk-free rate. Forthe second interest rate component, the lessor assigns a risk premiumto 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 determinedthat the risk-free rate is 7%. Furthermore, because the lessee isconsidered an average risk, the lessor assigns an additional risk premium of 5%. Thus, the total expected return on the leaseinvestment would be 12% (7% + 5%) to compensate for both types of risk.




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Betacoefficient

This is where the concept of the beta coefficient comes into ourexample. The beta coefficient is the educated assessment of thefinancial risk premium of individual companies compared to theirindustry averages. Merrill Lynch, Standard and Poor's, and many other

financial organizations publish "beta books" in which the industryaverage for risk premium is assigned a value of one. Individualcompanies with a beta coefficient of less than one (lower than theindustry average) appear more stable and those with a beta in excess of one (higher than the industry average) are perceived as less stable.

To complete the example, let’s assume the beta coefficient is one, asillustrated below:

7% + (1)(5%) = 12%

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

Beta books Lessors servicing listed corporations should subscribe to a beta book in order to obtain the beta coefficients of all large public companies.

Lessors who want to calculate a beta coefficient for unlisted lesseesshould refer to the relevant chapters in a graduate-level finance text.

A substantial change in a company’s beta coefficient indicates a

change in the risk level of the company, and the lessor should

adjust the lease terms accordingly.




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C a p a b i l i t y

Managementexpertise

Capability is the lessee's level of management expertise — newmanagement frequently has a lower level of capability than

experienced management. Lessors should assess a managerialstaff to determine that they possess requisite skills, training, andexperience. Numerous studies have indicated that this is one of themost important factors in predicting corporate success.

Com pe t ence

Productivity Competence refers to the productivity of the lessee. The lessor seeksto determine how well the lessee’s management has done with the

capital and labor resources entrusted to it.

Contro l

Feedback andbudgetsystems

Control refers to the feedback systems (such as standard costaccounting systems, budget variance systems, and zero base budgetingsystems) that companies use to correct or confirm past actions. Thelessor should pay attention to the type of cost system (such as a joblot cost accounting or a process costing system) thatis in place as well as the lessee’s budgeting process. The budgeting

process should include a strategic plan, a capital plan, and an operatingplan. The strategic plan shows the company’s planned growth. In thecapital plan (balance sheet), the company decides what assets it mustgather and how these assets are to be financed. The operating plan isthe budget or income statement plan.

The concern for the lessor is the kind of budgetary or feedback toolsthe company has in place. If the lessee does not have a budget orfeedback tools, credit risk is high — lessor beware!




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Lease Environment Risk Factors

In the previous section, you learned about the characteristics of the lessee that the lessor investigates and evaluates to assess risk.

However, these are not the only risks lessors must evaluate. There arealso credit risks inherent in the lease environment itself! These arefactors that are external to the lessee and may affect the lessor’sdecision to extend lease credit. They include:

n Collateral

n Complexity

n Currency

n Category

n Cross-border

n Competition

n Cyclical and Countercyclical

n Copartner

n Concealed Value

n Circumstances

Col l a t e ra l

Value ofequipmentover time

Collateral is important because the lessor must look to the value of the equipment if the lessee defaults. Equipment that maintains valueover time is obviously a better risk than equipment that does notmaintain resale value. For example, commercial airplanes and jetsfrequently are worth as much after being leased seven years as they

were at the inception of the lease. In contrast, computers may lose asignificant amount of their value even between the time they areordered and the time they are delivered to the lessee.

Tool forassessingincreased risk

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




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Figure 4.3: Collateral risk

Structuringlease tominimize risk

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

Othercollateralguarantees

Another way to minimize collateral risk is to obtain a collateralguarantee from a vendor or an insurance company. Increasingly,lessors can get the vendor manufacturer to make partial or fullguarantees of the residual value. It is important to note that, under FASB13, a lease with this type of guarantee can still qualify as an operatinglease from the lessee's viewpoint but not from the viewpoint of thelessor. Similarly, an insurance company guarantee reducesthe risk of exposure but is an additional expense that reduces the lessor’sprofit.

Remarketingagreements

Lessors may also consider remarketing agreements to reducecollateral risk. These are agreements in which the vendor does notguarantee the residual equipment value, but does agree to assist in theremarketing of the equipment.

Complex i t y

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




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Equipmentsophistication

Equipment sophistication has increased. If the lessee finds that theleased equipment is operationally inappropriate, it is unlikely that therevenue 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 properengineering study with specifications and (2) have the lessee sign anequipment indemnification agreement stipulating that the equipmentreceived is as ordered and that the order was based upon adequatestudies and specifications. This does not eliminate the risk, but itcauses the lessee to carefully rethink and review the lease agreement.

Leaseagreementdetails

Another source of complexity is the lease itself. To protect itsinterests, the lessor should specify in the agreement all details of itssecurity interests, require an insurance binder, and include details of

any contingent lease agreements that exist.

Provision fortax lawchanges

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

AMT An additional area of complexity in the field of leasing is that of alternative minimum tax, which we discussed in Unit Two. BecauseAMT has changed the after-tax cost of leasing so dramatically for

lessees, the lessor should discuss it with all prospective lessees.

Bundledservices

Bundling of services is also a source of complexity. Lessees find itmore difficult to determine the true cost of the lease. The lessor mustcalculate carefully the profitability of the various portions of thebundled lease to determine that the overall package provides adequatefinancial reward for the inherent complexity.




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C u r r e n c y

Monetary unitrisks

Currency rates, restrictions, fluctuations, and translations all increaserisk to the lessor. The primary risk in currency is the monetary unit

itself. Traditionally, contracts, including leases, have beendenominated in U.S. dollars. If a lease is denominated in a foreigncurrency that is subsequently translated into a balance sheet andincome statement, a translation gain or loss may also occur. Lessorsmust understand these risks.

Category

Asset-specificrisks

Risk assessment is affected by the type of equipment in several ways.

Certain categories of equipment involve additional risk because theycannot be easily moved such as elevators, air conditioning systems,and even wallpaper. Other types of assetsare subject to a high degree of abuse, such as certain rental cars,construction equipment, and carpeting. If the equipment issubstantially abused, the lessor must make considerable financialoutlays to restore the asset to re-lease or sale condition. Thus, lessorsmust quantify this credit risk and work it into the lease proposal.

Cross-border

Political andeconomicrisks

Cross-border leasing is the leasing of equipment in one geographical jurisdiction for utilization in another. In cross-border leasing, themajor risk is changing economic and political conditions. Forexample, during the 1970s as political and economic situations inMexico were stabilizing, cross-border leasing increased. When theeconomic conditions changed in the early 1980s, many Americanlessors were faced with enormous risks they had not anticipated.

Another cross-border risk is the constant state of flux associated with

property and income taxes. Sudden changes in local tax policies canforce lessors to rethink their cross-border policies or even withdrawfrom the market. Political and religious conditions may also alter thedegree of risk inherent in cross-border leasing. When a cross-borderlease goes bad, it is frequently not possible to recover the asset.




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Compet i t ion

Lessee’sgrowthpotential

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

declining share of a growing, stable, or declining market .

Internationallessorcompetition

The lessor must also consider the foreign competition the lesseefaces. The growing internationalization of the business community hasintroduced many new competitive players. These competitors areusing their respective strengths (such as lower interest rates) to gain astrong foothold. This suggests a dramatic change in internationalcompetition in the future.

Cyc l i ca l a n d Coun t ercyc l i ca l

Lessee’sreaction toeconomicswings

Cyclical and countercyclical risk refers to the type of economicreaction the company has to general economic conditions. Forexample, if interest rates rise dramatically, the housing industrytypically experiences difficulty; if interest rates drop to abnormallylow levels, car sales increase dramatically. Other companies react in acountercyclical nature. For example, when the economic climatedeteriorates, grocery store sales do better than ever (people areforced to do more of their own cooking). Lessors should determinewhat type of cyclical or countercyclical risk to expect.

Copar t ner

Relationshipwith anotherinvestingparty

Copartner refers to reducing risks by sharing them through arelationship with a second investing party. Typically, a genuinepartnership dilutes the profitability of the lease. However, other typesof copartnership arrangements are available that reduce risk withoutdiluting earnings — for example, vendor guarantees and joint ventures.Many cross border leases use joint ventures to avoid partnership

liability and to gain additional expertise. Within certain political jurisdictions, however, joint ventures are regarded as partnerships andwill not reduce the lessor’s risk.




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Concea l ed Va l u e

Book valuevs. fair marketvalue

Concealed value refers to the difference between the book value andthe fair market value of a fixed asset. Because balance sheets are

prepared according to GAAP, fixed assets reflect historical cost lessaccumulated depreciation (book value). However, many pieces of equipment retain a high market value which varies considerably fromthe lower amount shown on the balance sheet. A good example of thisis large aircraft. An aircraft may be fully depreciated on the balancesheet after 10 years, yet the fair market value may be a significantportion of its original cost. For this reason, the credit analysis shouldinclude sufficient fair market values on fixed assets.

Intangible

assets

Intangible assets are another source of valuation risk for lessors.

Many lease applicants may have unreported goodwill, patents,copyrights, and trademarks that add to the value of a company. Lessorsshould attempt to uncover intangible, undervalued, and unreportedhidden assets and consider them in the credit analysis.At the same time, lessors must be wary of lessees who reportintangible assets of questionable value.

C i r c u m s t a n c e s

Subjectiveview Even though a potential lessee's creditworthiness appears suspectbased on the other considerations, circumstances may justify

extending credit. For example, the equipment to be leased or used maybe part of a profitable, self-liquidating project that is not dependentupon other less profitable operations of the business. Anothercircumstance may be a start-up company that is just entering a periodof normal profit after having incurred losses during the developmentstage. Consideration of circumstances is a last subjective view of acompany to determine whether any conditions exist that might justifyextending credit when most other credit indicators suggest creditrefusal.




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SUMMARY

In this section, we discussed the 30 Cs of lease credit analysis. We categorized these assteps credit analysts perform in the analysis process, risk factors involving the lessee, and

risk factors involving the lease environment. Included in these categories are some methodsfor minimizing risks associated with particular risk factors. Examples of these areguaranteed residuals, co-partnership arrangements such as joint ventures, and leaseprovisions such as preventative maintenance clauses.

Please check your understanding of the 30 Cs of lease credit analysis by completingProgress Check 4.1, then continue to the next section, Financial Statement Analysis.If you answer any questions incorrectly, review the appropriate text.




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

Question 2: The end purpose of concatenation, classification, consideration, computation,and compilation is to:

____ a) identify the worst down-side possibility.

____ b) rank credit variables from most important to least important.____ c) use the result to reach a credit decision.

____ d) determine the degree to which a credit standard is met.

Question 3: Whether a potential lessee has disclosed any off balance sheet financingarrangements is an indication of the lessee’s:

____ a) character.

____ b) competence.____ c) credit.

____ d) capability.

Question 4: The purpose of analyzing fixed payment coverage (times interest earned)is to:

____ a) calculate a break-even point.

____ b) determine the lessee’s pattern of income growth.____ c) track historical trends of gross operating margin.

____ d) detect limitations in the lessee’s ability to pay.




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ANSWER KEY

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

Question 2: The end purpose of concatenation, classification, consideration, computation,and compilation is to:

c) use the result to reach a credit decision.

Question 3: Whether a potential lessee has disclosed any off balance sheet financingarrangements is an indication of the lessee’s:

a) character.

Question 4: The purpose of analyzing fixed payment coverage (times interest earned)is to:

d) detect limitations in the lessee’s ability to pay.




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Question 5: The CAPM-Beta coefficient is used to measure:

____ a) nonbalance sheet resources such as people and experience.

____ b) the risk of a company.

____ c) cash flow.

____ d) the productivity of the lessee.

Question 6: The larger the lessee’s net income, the better able the lessee is to fund a new

lease transaction.

____ a) True

____ b) False

Question 7: Guaranteed residuals, remarketing agreements, and excess-use penalties areall ways the lessor can minimize risks associated with:

____ a) complexity.

____ b) collateral.

____ c) credit.

____ d) control.

Question 8: The introduction of a partner into a lease agreement reduces liability:

____ a) in a cross-border arrangement.

____ b) and increases profitability.

____ c) but may also reduce profitability.




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ANSWER KEY

Question 5: The CAPM-Beta coefficient is used to measure:

b) the risk of a company.

Question 6: The larger the lessee’s net income, the better able the lessee is to fund a newlease transaction.

b) False

It is possible for a company to have a positive net income, but a

negative cash flow. An example is a growth company that invests large

amounts in assets.

Question 7: Guaranteed residuals, remarketing agreements, and excess-use penalties areall ways the lessor can minimize risks associated with:

b) collateral.

Question 8: The introduction of a partner into a lease agreement reduces liability:

c) but may also reduce profitability.




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FINANCIAL STATEMENT ANALYSIS

Up to now, our discussion has focused on the methods lease creditanalysts use and the risk factors they assess. Financial statement

analysis traditionally has been a major part of the credit analysisprocess. Financial statements provide important information abouta company.

n The income statement communicates profitability for a givenperiod of time.

n The balance sheet illustrates balances or economic residuals at theend of such a period.

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

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

Income Statement Analysis

Verticalanalysis

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

Horizontalanalysis

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

Horizontal analysis reveals the dynamic nature of the income.




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Balance Sheet Analysis

Economicsnapshot

The balance sheet is an economic snapshot of the company at aparticular time. Like the income statement, the balance sheet may be

analyzed horizontally or vertically. Horizontal analysis providestrending information, whereas vertical analysis results in a comparisonof one classified line item to another.

Cash Flow Analysis

Accrualaccounting vs.cash flow

Earlier in this unit, we mentioned the importance of analyzing cashflow to evaluate the lessee’s ability to pay. To appreciate why cashflow gives a lessor a better view of a potential lessee’s capacity, you

need to understand that income statements and balance sheets areprepared on an accrual basis, according to GAAP. Accrual financialstatements reflect sales as revenue before payment is received. Also,expenses may be recorded before they are paid.

The problem with accrual accounting is that salaries, invoices anddividends are not paid with accrual net income; they are paid with cash.A credit analyst must manipulate the accrual statements to determinehow much cash is flowing into and out of the company. The FASBagrees with the importance of cash flow analysis, which is why it has

issued FASB 95. FASB 95 requires a statement of cash flows in the financial statements. Because cash flow analysisis so important, we will discuss it in detail as a separate topic laterin this unit.

Standard Ratio Analysis

From a credit analyst’s point of view, the main purpose of financialstatement analysis is to determine a company’s current and future

financial health. We have just seen how the income statement reportsa company’s operations over a period of time, how a company’sbalance sheet reports the company’s position at a point in time, andhow the cash flow analysis reports a company’s sources and uses of cash over a given period.




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Relationshipsbetweenfinancialstatementaccounts

Another tool credit analysts use to assess a company’s financial well-being is a financial ratio analysis. Financial ratios are useful becausethey reveal relationships between financial statement accounts. Creditanalysts use ratios for comparative analysis, interrelationship studies,

and input to forecasting models. Figure 4.4 shows how ratios are usedand the effect they have on the decision process.

RATIOS AND THE DECISION PROCESS

How Ratios are Used Effect on the Decision Process

COMPARISONS

1) Currently established ratios are comparedwith the same ratios of prior periods for the

same firm.

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

2) Industry ratios are compared with similar

companies within an industry.

2) Relative standing is established within an

industry. Relative standing could highlightstrengths or weaknesses.

INTERRELATIONSHIPS

1) In-depth analysis finds logical relationshipsamong various items on the balance sheet

and income statement.

1) Pinpointing the causes of weaknesses isfacilitated by the use of ratios casually

related to a problem.

2) Ratios are categorized according tocommon objectives of financialmanagement.

2) Common financial objectives that must bemet to maximize profit, insure growth inshare price, and maintain liquidity are

highlighted, along with serious weaknessesin one category that could ultimately lead to

a weakening of another major category.

MODELS

1) Simulation models developed from

interrelated ratios to show the simultaneouseffects of changes in these ratios.

1) The overall effect of component variables

can be observed from the use of simulationmodels.

2) Forecasting models are developed by usingregression analysis techniques on particularratios.

2) Planning is facilitated by the use offorecasting models. Budgets can beestablished as the result of a particularforecast of certain ratios.

Figure 4.4: Ratios and the decision process




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Categories ofnoncashratios

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

n Profitability and earnings growthn Liquidity and working capital

n Investment utilization and activity

n Financial leverage

n Solvency and risk

n Owner's equity

Ratios within each category give the credit analyst an indication of

whether the company is meeting the goal of the particular category.

Informationused forexamples

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




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ABC CompanyBALANCE SHEET

1993 1992ASSETS

Cash $ 106,000 $ 192,000Accounts receivable 566,000 483,000

Inventories 320,000 250,000Plant and equipment (net) 740,000 716,000

Patents 26,000 26,000Other intangible assets 14,000

12,000

Total assets $ 1,772,000 $ 1,679,000

LIABILITIES AND EQUITYAccounts payable $ 170,000 $ 126,000

Federal income tax payable 32,000 13 ,000Miscellaneous accrued payables and

dividends payable 38,000 45,000

Bonds payable (4%, due 1996) 300,000 300,000Preferred stock ($100 par, 7% cumulative,

non-participating and callable at $110) 200,000 200,000Common stock (no par, 20,000 shares

authorized, issued and outstanding) 400,000 400,000Retained earnings 720,000 683,000Treasury stock - 800 shares of preferred (88,000) (88,000)

Total liabilities and equity $ 1,772,000 $ 1,679,000

Figure 4.5: Balance sheet

ABC CompanyINCOME STATEMENT

1993 1992

Net sales $1,500,000 $ 1,100,000

Cost of goods sold 900,000 710,000

Gross margin on sales $ 600,000 $ 390,000

Operating expenses (including interest) 498,000 355,000

Income before federal income taxes $ 102,000 $ 35,000Income tax expense 37,000 13,000

Net income $ 65,000 $ 22,000

Figure 4.6: Income statement




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P r o fi t a b i li t y a n d E a r n i n g s Gr o w t h R a t i o s

Dualobjectives

If we assume that the goal of management is to maximizeshareholders' value, then the company must (l) maximize profits so

continual dividends will be paid and (2) maintain steady growth inearnings so the investor's stock price will grow (capital gains). Thesetwo objectives are interrelated. A company that pays proportionatelyhigh dividends compared to amounts retained each year from netincome will find it difficult to grow as fast as another company thatretains more earnings.

Profitabilitymodel

Seven ratios have been developed into a model (Figure 4.7) thatdescribes 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.

Figure 4.7: Profitability model

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




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1. NETPROFIT TO NETSALES (NETPROFIT MARGIN)

The formula for computing this ratio is:

Net income (after taxes)Net sales (after returns and allowances) $65,000$1,500,000 4.33%= =

Net income aspercentage ofsales

Net profit margin calculates net income as a percentage of sales.Stable or growing net profit margins are favorable indicators so longas asset turnover has not been overly reduced.

2. NETSALES TO TOTAL ASSETS (ASSET TURNOVER)


Net sales

Total assets (beginning of year)=

$1,500,000

$1,679,000= 89.34%

Sales thatinvestmentsin assets cangenerate

Asset turnover indicates the amount of sales that each dollar investedin assets can generate. Thus, in this example, each dollar of assets isable to generate $.8934 of sales revenue. Increases in asset turnoverare considered favorable so long as profit margins are not undulysacrificed to generate volume increases. Remember, it is net profit

margin times asset turnover that really indicates profitability (returnon investment or assets).

Using as partof profitabilitymodel

Notice that when we calculate asset turnover as part of theprofitability growth model, we use: beginning of the year assets ratherthan an average and total assets rather than net fixed assets, which aremore commonly used for asset turnover computations.

3. RETURN ON ASSETS (RETURN ON INVESTMENT)


Net Profit Margin x Total Asset Turnover or

Net income

Total assets

$65,000

$1,679,000= 3.87%=




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6. RETENTION RATIO


1- DividendsNet income

= 1- $28,000$65,000

56.92%=

Declinesindicate profitcrisis

This ratio indicates the percentage of net income that remains afterdividend payment. Sudden or systematic declines in the retention ratiocould indicate an impending profitability crisis.

7. POTENTIAL GROWTH RATE


ROE Retention ratio = 5.44% 56.92% = 3.10%× ×

Growthfactors

A company’s growth rate cannot exceed the product of its retentionratio times its ROE. To grow faster, either ROE has to be increased ordividend payout reduced. Therefore, if leases are to be paid out of anticipated future earnings derived from increased growth, that growthshould be justified.

Additional profitability and earnings growth ratios help the analystanticipate possible future problems. They include: price/earningsratio, gross margin, and dividend yield. Remember, the figures in theexamples are taken from the financial information for ABC Company(page 4-31).

PRICE EARNINGS RATIO


Market price per share (average may be used)

Net income per share (Previous 4 quarters)

$35

$65,000

20,000

= $10.769 per share=




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Decreasesrelative toS & P 500

Sudden decreases in the price / earnings ratio relative to theprice/earnings ratios of the Standard and Poors 500 could indicatean impending profitability problem.

GROSS MARGIN


Gross profit on sales

Total sales revenue=

$600,000

$1,500,000= 40%

Percentage ofsales as grossprofit

Gross profit margin indicates what percentage of sales is gross profit.Steady or increasing gross profit margins are favorable if assetturnover is not being reduced too fast or general and administrative

expenses are not increasing too rapidly.

DIVIDEND YIELD

The formula for computing this ratio is as follows:

Dividend p er share

Average price per share=

$28,000

20,000

35= 4%

Reductionsindicateproblems

Dividend yields usually remain constant within a narrow range of 2%to 4%. Ratios above 4%, or sudden reductions in a ratio when thegeneral stock market is constant, could indicate upcomingprofitability problems.

L i q u i d i t y a n d W or k i n g C a p i t a l R a t i os

Ability to meet

obligations

In addition to profitability, another vital concern of the financial

analyst is liquidity, or the ability of the firm to meet its maturingobligations (current liabilities). Four ratios that indicate liquidityand the composition of working capital in terms of inventory andaccounts receivable are: current ratio, acid-test ratio, inventory-to-networking capital, and accounts receivable-to-net working capital.




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CURRENT RATIO


Current assetsCurrent liabilities

= $992,000$240,000

= 4.13 times

Comparesassets toliabilities

Current assets are 4.13 times as large as current liabilities. Keep inmind, however, that a significant portion of current assets may not beliquid enough to pay liabilities when due.

ACID-TEST RATIO (QUICK RATIO)


Quick assets (cash, securities, accounts receivable)

Current liabilities=

$672,000

$240,000= 2.8 times

A better indexof liquidity

Quick (readily convertible to cash) assets are 2.8 times currentliabilities, which is a more realistic index of liquidity than current ratio.

INVENTORY-TO-NETWORKING CAPITAL


Inventory (end of period or average)

Net working capital=

$285,000

$992,000 - $240,000= 37.90%

Inventory aspercentage ofworkingcapital

Note that net working capital is current assets minus currentliabilities. This ratio indicates what percentage of working capital iscomprised of inventory, its most nonliquid component. An increasinginventory-to-net working capital ratio indicates movement towards anonliquid position.




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ACCOUNTS RECEIVABLE-TO-NETWORKING CAPITAL


Accounts receivable (end of period or average)Net working capital $525,000$752,000 = 69.81%=

Accountsreceivable aspercentage ofnet workingcapital

A growing accounts receivable to net working capital ratio is favorablebecause it indicates a more liquid working capital than if inventorywere the predominant component.

I nves t m en t U t i l i za t i on (Ac t iv i t y) R a t i o s

Effective useof resources Investment utilization or activity ratios measure how effectively thefirm employs its resources. One method to measure investmentutilization is to review the total operating cycle, which is an analysisof the time required to convert cash into merchandise, then intoaccounts receivable, and ultimately back into cash again. There areseveral common ratios that aid in an analysis of investment utilization:

1. Days’ receivables

2. Days’ inventories

3. Total operating cycle

4. Days’ payables, and accounts payable turnover

5. Net sale to owner’s equity

6. Net sales to working capital




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DAYS' RECEIVABLES (COLLECTION PERIOD)


365Accounts receivable turnover

= 365Credit sales

Average accounts receivable

365

$1,500,000

$566,000 + $483,000

2

= 127.628 days

Growing timeperiod signalsliquidityproblems

If credit sales are not available, total sales may be used, and year-endaccounts receivable may be used in place of average accountsreceivable. This ratio indicates it takes an average of 128 days tocollect ABC Company's receivables. If this time period is growing, ared flag is raised indicating liquidity problems such as bad debts,ineffective collection policy, etc.

DAYS' INVENTORIES (SALES PERIOD)


365

Inventory turnover

Cost of goods sold

Average inventory

365

$900,000

$320,000+ $250,000

2

= 115.583 days




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Growing ratiowarrantsinvestigation

If cost of goods sold is not available, total sales may be used.Ending inventory may be used instead of average inventory. This ratioindicates 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 beinvestigated and understood.

TOTAL OPERATING CYCLE


Days' receivables + days' inventories = 127.628 + 115.583 = 243.2 days

Growthindicates poorresourceutilization

This ratio represents the total time to convert inventory into a sale,then into a receivable, and back into cash. Growth of this conversiontime period may indicate poorer overall utilization of resources.

DAYS' PAYABLES AND ACCOUNTS PAYABLE TURNOVER


365

Payable turnover

Cost of goods sold

Average payable

365

$900,000

$170,000+ $126,000

2

= 60.022 days

Growth inresultindicatesliquidity,profitabilityproblems

This ratio represents the average time taken to pay trade payables. The

time period should be less than both days’ receivables or days’inventories. Growth in the days’ payable may indicate forthcomingliquidity and profitability problems since trade creditors are beingforced to increase their waiting period for payment.




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NETSALES TO OWNERS' EQUITY


Net sales

Owners' equity (average)=

$1,500,000

$1,195,000= 1.26 times

Dependencyof sales onowner’s equity

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

NETSALES TO WORKING CAPITAL


Net sales

Average net working capital=

$1,500,000

$747,000= 2.01 times

Dependencyof sales onworkingcapital

The net sales to average net working capital ratio indicates the degreeto which sales are dependent upon working capital. If this ratioincreases, working capital inefficiencies are occurring or a new

product with slower turnover is being sold.

Fi nan c i a l Leverage Ra t i o s

Lessee’s debtburden

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

n Total liabilities-to-total assets (Debt ratio)

n Current liabilities-to-owner’s equity

n Interest-to-net income before interest

n Total liabilities-to-owner’s equity




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TOTAL LIABILITIES-TO-TOTAL ASSETS (DEBT RATIO)


Total liabilities (or long- term liabilities)Total assets

= $540,000$1,772,000

= 30.47%

Growing ratiomay signalinefficiencies

This ratio describes what percentage of the total capital structure isdebt. If a company's ROE is relatively constant while this ratio isgrowing, inefficiencies may be occurring.

CURRENT LIABILITIES-TO-OWNERS' EQUITY


Current liabilities

Owners' equity=

$240,000

$1,232,000= 19.48%

Growing ratiosignalsliquidity needs

This ratio indicates relative commitment to the company: tradecreditors (current liabilities) versus owners' equity. A growing ratiomay indicate forthcoming liquidity needs.

INTEREST-TO-NET INCOME BEFORE INTEREST


Interest

Interest + Net incomeor

Interest (1 - t)

Interest (1 - t) + Net income=

$120,000

$185,000= 64.86%

Growing ratiocompared toROEincreases

Whereas total liabilities to total assets indicate total leverage, thisratio indicates both total leverage and the cost of the leverage relativeto net income. A growing ratio without corresponding increases in

ROE may indicate a profitability problem and a possible forthcomingcredit shortage.




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TOTAL LIABILITIES-TO-OWNERS' EQUITY


Total liabilities

Owners' equity=

$540,000

$1,232,000= 43.83%

Growingpercentage:Liquidityproblems

This ratio indicates the liabilities relative to the investmentcommitment of the company; all creditors (trade and long-term)versus owners' equity. A growing percentage may indicateforthcoming liquidity problems.

S o lv en c y a n d R i s k R a t io

The ability of a lessee to meet the carrying costs on its existing debtprovides a good idea of its potential ability to make the lease payment.This ratio measures that capability.

TIMES INTEREST EARNED


Net income + taxes + interest

Interest

=$222,000

$120,000

= 1.85 times

Interest could have been paid 1.85 times before income is used up.

O wn ers ' Equ i t y Ra t i os

The amount of equity the owners are retaining in the business isanother important measure of financial stability. The following threeratios are used:

n Net fixed assts to owner’s equity

n Book value per common share

n Return on common equity




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Statement of Cash Flows

CASH FLOWS FROM OPERATING ACTIVITIES

Cash received from customers $ 13,850

Cash paid to suppliers and employees (12,000)

Dividend received from affiliate 20

Interest received 55

Interest paid (net of amount capitalized) (220)

Income taxes paid (325)

Insurance proceeds received 15

Cash paid to settle lawsuit for patent infringement (30)

Net cash provided by operating activities $ 1,365

CASH FLOWS FROM INVESTING ACTIVITIES

Proceeds from sale of facility $ 600

Payment received on note for sale of plant 150

Capital expenditures (1,000)

Payment for purchase of Company S, net of cash acquired (925)

Net cash used in investing activities (1,175)

CASH FLOWS FROM FINANCING ACTIVITIES

Net borrowings under line-of-credit agreement $ 300

Principal payments under capital lease obligation (125)Proceeds from issuance of long-term debt 400

Proceeds from issuance of common stock 500

Dividends paid (200)

Net cash provided by financing activities 875

NET INCREASE IN CASH AND CASH EQUIVALENTS $ 1,065

Cash and cash equivalents at the beginning of the year 600

Cash and cash equivalents at the end of the year $ 1,665

RECONCILIATION OF NET INCOME TO NET CASH

PROVIDED BY OPERATING ACTIVITIES

Net income $ 760

Depreciation and amortization $ 445

Provision for losses on accounts receivable 200

Gain on sale of facility (80)

Undistributed earnings of affiliate (25)

Payment received on installment note receivable for sale of inventory 100

Change in assets and liabilities net of effects from purchase of Company S:

Increase in accounts receivable (215)

Decrease in inventory 205

Increase in prepaid expenses (25)

Decrease in accounts payable and accrued expenses (250)

Increase in interest and income taxes payable 50

Increase in deferred taxes 150

Increase in other liabilities 50

Total adjustments 605

Net cash provided by operating activities $ 1,365

SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES

The Company purchased all of the capital stock of Company S for $950. In conjunction with the acquisition, liabilities were

assumed as follows:

Fair value of assets acquired $ I,580Cash paid for the capital stock (950)

Liabilities assumed $ 630

A capital lease obligation of $850 was incurred when the Company entered into a lease for new equipment. Additional common

stock was issued upon the conversion of $500 of long-term debt.

DISCLOSURE OF ACCOUNTING POLICY

For purposes of the statement of cash flows, the Company considers all highly liquid debt instruments purchased with a

maturity of three months or less to be cash equivalents.

Figure 4.8: Statement of cash flows




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CASH FLOW ANALYSIS WORKSHEET (CONTINUED)

DISCRETIONARY CASH NEEDS

Additional property, plant, and equipment ($ 404)3

Other investments (subsidiaries) ($ 925)

Reduction of permanent debt (bonds, etc.) ( )

Reduction of equity ( )

Total discretionary needs ($ 1,329)

NET CASH NEEDS ($ 885)

NON-OPERATING CASH SOURCES

Short-term debt increase 300

Long-term debt increase 400

Permanent debt increase (bonds)

Sale of equity 500

Sale of fixed assets proceeds 600

Sale leaseback proceeds

Payment on note receivable sale of plant 150

Non-operating cash sources 1,950

NET INCREASE (DECREASE) IN CASH 1,065

Figure 4.9: Cash flow analysis worksheet

Adva n t ages o f Cash F l ow W ork shee t

Separate

grossoperating andworkingcapitalsources

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




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I ncom e S t a t em en t t o Cash F l ow Ra t i o s

There are four cash flow ratios used to identify trends in relationshipsbetween the income statement and cash flow.

1.Net income

Gross operating cash flow=

$760

$1,550= 49.03%

Grossoperatingcash flow as apercentage ofnet income

This ratio demonstrates the proportion of gross operating cash flowderived from net income. If this percentage increases, less cash flowis being generated for each dollar of net income. If such a trendcontinues, liquidity problems might arise.

2.Net income

Net operating cash flow=

$760

$1,365= 55.68%

Impact ofworkingcapitalsources

This ratio is similar to the first ratio, however, the impact of workingcapital sources and uses is factored in. If this ratio is growing orexceeds ratio 1, it may indicate that working capital requirements areconsuming gross operating cash flow. A continuation of this trend mayindicate a forthcoming liquidity problem. However, a decline in thispercentage indicates favorable cash flow generation.

3.Net operating cash flow

Interest and lease rentals=

$1,365

$220 + $0= 6.2045%

Unadjustedcash flow

This ratio is similar to times interest earned except that the cash flowhas not been adjusted for tax expenses or interest. The ratio isimportant because it shows that interest expense was covered 6.2times by net operating cash flow.

4.Disposable net operating cash flow

Interest and lease r entals=

$444

$220= 2.018%




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Feasibility ofnew expense

This cash flow ratio is similar to times interest earned also; however,this key ratio deals with disposable cash that is available to payexisting or future interest expense. Without a ratio greater than one,any proposed interest expense or rental expense would not appear

feasible, due to a lack of disposable cash.

Cash F l ow t o Cash F l ow R a t i o s

There are three cash flow ratios to identify trends in relationshipsbetween different cash flows.

1.Net operating cash generation

Disposable net operating cash flow=

$1,365

$444= 3.074%

Impact of non-discretionarycash needs

This ratio demonstrates the impact of nondiscretionary cash needs.If needs are few, the ratio would be closer to one. High or growingratios indicate greater cash flow commitments, which reduce cashavailable to pay off future loan or lease payments.

2.Gross operating cash flow

Disposable net operating cash flow=

$1,550

$444= 3.491%

Cash flowcommitments

This is the same as ratio 1 except the impact of working capital cashuse or generation has been removed. Increases in this ratio indicategreater cash flow commitments trending towards less cash available topay future loans or leases.

3.Discretionary cash flow

Net operating cash flow=

$885

$1,365= .648%

Discretionaryspending This ratio indicates the percent of net operating cash flow that is beingspent on discretionary requirements. Increases in the percentage or ahigh percentage could indicate excess or runaway growth, which ishampering the creation of disposable cash flow.




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SUMMARY

Credit analysis is the process of examining financial statements to determine the currentand future financial health of a company. There are two basic approaches to analyzing

financial statements: horizontal analysis and vertical analysis. Each method results ina 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 hasits roots in accrual accounting, and cash flow analysis, which focuses a company’s cashinflows and outflows. Cash flow is considered to be the better tool to assesscreditworthiness because cash represents the resource the company will use to pay lease orloan 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 financialtransaction analysis and discover how they apply to cash flow and the other concepts coverdin this unit. Before you continue to the next unit, please check your understanding of thecredit analysis section by completing the Progress Check 4.2. If you answer any of thequestions incorrectly, please return to the text and read the section again.




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(This Page Is Intentionally Blank)




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ANSWER KEY

Question 1: Horizontal decomposition of an income statement reveals the:

d) time relationships of line items.

Question 2: From a credit analyst’s viewpoint, the problem with preparing financialstatements on an accrual basis is that accrual accounting does not show:

a) cash inflow and outflow.

Question 3: In standard ratio analysis, a profitability model:

b) shows the effect of a change in any one factor on each of the otherfactors.

Question 4: In liquidity ratios, inventory is the most nonliquid component of workingcapital.

a) True




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Question 5: Financial leverage ratios help a credit analyst determine the risk associatedwith:

____ a) profitability.

____ b) debt.

____ c) solvency.

____ d) liquidity.

Question 6: Cash flow is considered the best tool to assess creditworthiness because it:

____ a) reveals the lessees ability to pay the lease payments.

____ b) is less cumbersome than using accrual ratios.

____ c) shows the degree to which net operating cash generation is dependentupon actual operations.

____ d) combines discretionary and nondiscretionary cash needs.

Question 7: A high or growing cash flow to cash flow ratio indicates a potential lesseewill have the cash to pay off future leases.

____ a) True

____ b) False



FINANCIAL CONCEPTS AND CALCULATIONS 5-3

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Calculating Present Value

Informationneeded for

present valuecalculation

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

+ Present value of one cash flow

+ Present value of an ordinary annuity (annuity in arrears)

+ Present value of an annuity due (annuity in advance)

+ Present value of an annuity with multiple advance payments

+ Present value of multiple, uneven cash flows

To calculate present value amounts, we must know the followinginformation:

+ The number of future cash flows

+ The amount of each future cash flow

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

+ The discount rate to be used in the present value calculation

Calculatorkeys

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

n The term or number of compounding periods over whichthe cash flow is to be discounted

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

i The interest (discount rate) being used over thecompounding periods



5-4 FINANCIAL CONCEPTS AND CALCULATIONS

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PMT The periodic payment amount.

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

In addition, we show the following keys:

CLX Clears the display

CHS Changes a number from positive to negative or vice-versa

BEG Changes payment mode to advance

END Changes payment mode to arrears

f Indicates a gold key function

g Indicates a blue key function

Presen t Va l ue o f a S i ng l e Cash F l ow

Single cashflow

A single cash flow could represent a purchase option or a balloonpayment, expected to be received at the end of a financing term, or

a large, nonrecurring cash flow, such as a maintenance expense tooccur in the 30th month of a 48-month lease transaction. Let’s look atan 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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KEYSTROKES DISPLAY EXPLANATIONS

f CLX 0.00 Clears all data from registers

f 2 0.00 Rounds answers to two decimal

places

g BEG 0.00 Indicates payment mode

15,000 CHS FV -15,000.00 Enters balloon payment as a

negative amount (outflow)

48 n 48.00 Enters number of discount

periods

13.25 g 12 ÷ 1.10 Enters monthly discount rate

PV 8,854.76 Calculates present value of

balloon payment

The present value of the $15,000 payment due at the end of a 48-month term loan is $8,854.76.

P r e se n t V a l u e o f a n O r d i n a r y A n n u i t y

( A n n u i t y i n A r r e a r s )

End-of-period

paymentstream

Now that you have seen how to calculate present value on a single cash

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

First payment dueat end of first period

0 5 years

Subsequent payments due at theend of each succeedin period




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When you calculate an annuity in arrears, you must start by changingthe payment mode in the calculator to indicate that the cash flows willbe received at the end of each period. Here is how to do this on the12C:


g END 0.00 Changes payment mode to arrears

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

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




640 CHS PMT -640.00 Enters amount of each payment

18 g 12 ÷ 1.50 Enters monthly discount rate

48 n 48.00 Enters number of cash flows

PV 21,787.23 Solves for present value

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




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




2,000 CHS PMT -2,000.00 Enters amount of each payment




The present value of 60 even monthly payments of $2,000, received inarrears, discounted at 14%, is $85,954.03.

P r e se n t V a l u e o f a n A n n u i t y D u e (A n n u i t y i n A d v a n c e)

Payments

received atbeginning ofperiod

An annuity due is similar to an ordinary annuity except that we

assume payments are received at the beginning of each period (thefirst one being due at time “0”). Annuities due are common in all typesof finance transactions, including leasing.

First payment due atinception of the contract

0 5 years

Subsequent payments due at beginningof each subsequent period




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g BEG 0.00 Changes payment mode to

advance

2,000 CHS PMT -2,000.00 Enters amount of each

payment




If the cash price is less than $86,956.83, the customer may prefer topurchase the equipment. If the cash price is greater than the presentvalue amount, the customer may prefer to lease.

P r e se n t V a l u e o f a n A n n u i t y w i t h M u l t i p l e A d v a n c e

P a y m e n t s

Uneven cashflow stream

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

cash flow situation.

Cash flowkeys

For uneven cash flows, you do not have to select a payment modebecause you will enter each cash flow and the number of times itoccurs. In our illustrations, we will use the following keys:

g CFo Initial cash flows

g CFj Subsequent cash flows

g Nj Number of times cash flow occurs

For example:




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750 g CFo 750.00 Enters three advance payments

250 g CFj 250.00 Enters the next cash flow

45 g Nj 45.00 Enters number of times cash flow occurs

14 g 12 ÷ 1.17 Enters monthly discount rate since theseare monthly cash flows

f NPV 9,463.80 Computes present value

The present value of 48 payments of $250 per month with threeadvance payments due at the inception of the lease is $9,463.80,

assuming a discount rate of 14%.

Presen t Va lue o f Mul t ip le , Uneven Ca sh Flows

Other typesof multiple,uneven cashflows

In the previous section, you learned that advance payment transactionsare a form of multiple, uneven cash flow transactions.In this section we will look at another transaction — a step-down

lease -- that creates multiple, uneven cash flows. In a step-downtransaction, payments decrease over the lease term.

Just as in working with multiple advance payments, you must entereach cash flow and the number of times it occurs to solve for thepresent value of multiple, uneven cash flows. Let’s look at an example.

Example What is the present value of a 48-month lease with one advancepayment? The lease is a step-down transaction — the first 36payments 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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INTERNAL RATES OF RETURN (IRR)

In the previous section, we demonstrated how to take a known futurevalue amount and strip out the time value of money (interest) factor.

Internal rates of return (IRR) measures that time value of moneyfactor. Lessors use IRRs to determine whether a given lease issufficiently profitable to justify an investment. In this section we willshow you how to compute IRRs on the HP12C calculator. You willfind many similarities between solving for IRRs and solving forpresent value.

Definition An IRR is the unique discount rate that equates the present value of a series of cash inflows to the present value of the cash outflows. In aleasing 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 rateinherent in the lease. It is analogous to the interest rate that a bank would quote a borrower on a loan.

IRRapplications

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

transactions with multiple, uneven cash flows, including transactionswith multiple advance payments.

IRR – Even Cash Flows

Common IRRs include lease yields, interest costs, interest rates andearnings rates.

Requiredinformation

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




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Recall these keys:

n The number of compounding periods over which the cashflows are being measured

FV The amount of any end of term cash flows (inflows oroutflows)

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

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

i The interest or yield being used over the compoundingperiods

Outflows andinflows

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

Example A lease agreement with a 10-year term requires monthly paymentsin arrears of $199.93, based on an original investment, or equipmentcost, of $10,000. What is the IRR in this lease investment?

Before you begin, remember to clear the register and set the modeto END.


120 n 120.00 Enters number of payments

199.93 PMT 199.93 Enters amount of payments

10,000 CHS PV -10,000.00 Enters original investment

i 1.75 Monthly IRR

12 x 21.00 Annual IRRThe yield in this lease is 21%.

IRR -- Multiple, Uneven Cash Flows

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




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entries step-down transactions are forms of multiple, uneven cash flows. Tocompute the IRR for uneven cash flows, you must enter each cashflow followed by the number of times it occurs. As in our presentvalue calculations, we illustrate entry of the amount of each cash flow

with the g CFj keys, and the number of times each cash flow occurswith the g Nj keys.

CFo Amount of initial cash flow

CFj Subsequent cash flow

Nj Number of times cash flow occurs

Here are some sample keystrokes.


1,000 g CFo 1,000.00 Cash flow at time zero

300 g CFj 300.00 Amount of next cash flow

3 g Nj 3.00 Number of times next cash flow

occurs

400 g CFj 400.00 Amount of second cash flow

2 g Nj 2.00 Number of times second cashflow occurs

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

Example A lease agreement with an inception date of February 1 offerspayments that are in proportion to the lessee’s expected revenuecurve. High payments are to be made in the summer, with no paymentsdue during the winter months. Spring and fall payments are normal.

The lease payments are in advance (due at the beginning of eachperiod) and are based on a principal amount of $220,000. Let’s




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compute the IRR of this transaction, assuming the following paymentschedule repeats for two years.

March $10,000 September $10,000

April $10,000 October $10,000

May $10,000 November $10,000

June $20,000 December -0-

July $20,000 January -0-

August $20,000 February -0-

Here are the keystrokes:


220,000 CHS g CFo -220,000.00 Enters initial cash flow

10,000 g CFj 10,000.00 Enters next cash flow

3 g Nj 3.00 Number of times the cash flowoccurs


3 g Nj 3.00 Number of times cash flow

occurs

10,000 g CFj 10,000.00 Enters next cash flow amount

3 g Nj 3.00 Number of times cash flowoccurs

0 g CFj 0.00 Enters next cash flow amount

3 g Nj 3.00 Number of times cash flowoccurs

10,000 g CFj 10,000.00 Enters next cash flow amount


occurs20,000 g CFj 20,000.00 Enters next cash flow amount


occurs

10,000 g CFj 10,000.00 Enters the final cash flow amount


occurs




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f IRR 0.81 Solves for monthly IRR

12 x 9.68 Converts to annual IRR

The interest rate inherent in this lease is 9.68%. A lessor may viewthis 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 thatinvestment alternatives may be compared. In a present value calculation, the time value of money is removed from a future value amount. In this unit, we discussed five forms of

present value calculations:

+ Present value of one cash flow

+ Present value of an ordinary annuity (annuity in arrears)

+ Present value of an annuity due (annuity in advance)

+ Present value of an annuity with multiple advance payments

+ Present value of multiple, uneven cash flows

To calculate present value amounts, you must know the number of future cash flow(s), theamount(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 isalso called the yield or interest rate. Like present value analysis, IRR analysis is a tool usedto compare investment alternatives. We discussed two forms of IRR calculations:

+ Even cash flows

+ Multiple, uneven cash flows

In IRR calculations, investments are considered cash outflows and repayments as cashinflows. To compute IRRs, you must know the time-zero, or present value cash flows, the




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number and amount(s) of the future cash flows, and the number of periods over which thecash 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 continueto Unit Six: Introduction to the Lease Vs. Buy Analysis. If you answer any questionsincorrectly, 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


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

$____________________




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PROGRESS CHECK 5(Continued)

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

$____________________




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ANSWER KEY

Question 2: What is the present value of 60 monthly lease payments of $2,000, with two

payments in advance, discounted at 15%.

$86,159.05


4,000 g CFo 4,000.00 Enters initial cash flow of two

advance payments


58 g Nj 58.00 Enters number of times cashflow occurs


since these are monthly cashflows

f NPV 86,159.05 Computes present value




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ANSWER KEY

Question 3: A lease contract requires 36 payments of $2,000 followed by 24 payments of

$3,000. Three payments (3 x $2,000) are due in advance, and the leasecontains a purchase option of $20,000. Find the present value of the leasepayments and purchase option using a 16% annual discount rate. You maywant to draw the timeline on a piece of paper to visualize this cash flowseries.

$107,722.87


6,000 g CFo 6,000.00 Enters the initial cash flow ofthree advance payments


33 g Nj 33.00 Enters number of times cashflow occurs


24 g Nj 24.00 Enters number of times cash

flow occurs

0 g CFj 0.00 Enters next cash flow

2 g Nj 2.00 Enters number of times cash

flow occurs

20,000 g CFj 20,000.00 Enters final cash flow


f NPV 107,722.87 Solves for present value




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

$____________________




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ANSWER KEY

Question 4: A lessor invests $800,000 in a new piece of equipment that will generate net

cash returns of $85,000 at the end of each quarter for three years (12quarters). What is the annual IRR of this investment?

15.80%



800,000 CHS PV -800,000.00 Enters original investment

12 n 12.00 Enters number of payments

85,000 PMT 85,000.00 Enters amount of payments

i 3.95 Quarterly IRR

4 x 15.80 Annual IRR



Unit 6



INTRODUCTION TO THE LEASE VS. BUY ANALYSIS 6-3

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+ Discount rate. This is one of the most critical variables in theanalysis, as the ultimate decision to lease or purchase can bealtered by the discount rate used. Later in this unit, we discusschoosing an appropriate discount rate.

LEASE VS. BUY EXAMPLE

Three-stepprocess

There are three main steps in the lease vs. buy analysis process:

1. Gather detailed information for all alternatives

2. Calculate after-tax cash flows for each alternative

3. Calculate the present value of the cash flows

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

Gather Information

Let’s begin by looking at the information used in this example:

General Assumptions:

Equipment cost: $15,000

Company’s tax rate: 35%, and its tax-year end is December31

After-tax cost of capital(opportunity cost):

15.25%

After-tax cost of debt: 8.42% (12.75% times 1-tax rate)Lease/purchase date: January 1

Differential costs: None



6-4 INTRODUCTION TO THE LEASE VS. BUY ANALYSIS

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Lease Assumptions

Payments: $4,015 annually in arrears, for fiveyears

End-of-term option: Equipment will be returned to the lessor

Purchase Assumptions

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

Depreciation: Five-year declining balance taxdepreciation

Salvage value: $1,500 at the end of year five

Calculate After-tax Cash Flows for Each Alternative

Now that we have the information we need, we can calculate the after-tax cash flows for the lease (Figure 6.1). For simplicity, we willassume annual cash flows.

0 1 2 3 4 5

Lease payments $ 0 $4,015 $4,015 $4,015 $4,015 $4,015

Tax savings @ 35% 0 (1,405) (1,405) (1,405) (1,405) (1,405)

Net after-tax cost $ 0 $2,610 $2,610 $2,610 $2,610 $2,610

Figure 6.1: Lease after-tax cash flows

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




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

0 1 2 3 4 5Down payment $3,000 $ 0 $ 0 $ 0 $ 0 $ 0

Loan payments 0 3,391 3,391 3,391 3,391 3,391

Interest tax benefit 0 (536) (452) (359) (253) (134)

Depreciation taxbenefit

0 (1,050) (1,680) (1,008) (605) (302)

Salvage value 0 0 0 0 0 (1,580)

Net after-tax cost $3,000 $1,805 $1,259 $2,024 $2,533 $1,375

Figure 6.2: Loan after-tax cash flows

Cash inflows Notice that the interest tax benefit and the depreciation tax benefitrepresent cash inflows to the company, and are shown in parentheses.

The interest tax benefit was derived by multiplying the interestfrom the loan amortization schedule (Figure 6.3) by the tax rate(Figure 6.4).

Year Interest Principal Balance

1 1,530.00 1,861.00 10,139.00

2 1,292.72 2,098.28 8,040.72

3 1.025.19 2,365.81 5,674.91

4 723.55 2,667.45 3,007.46

5 383.45 3,007.55 0

Figure 6.3: Amortization schedule




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Year Interest Tax Rate Tax Benefit

1 1,530.00 X .35 $535.50

2 1,292.72 X .35 452.45

3 1,025.19 X .35 358.824 723.55 X .35 253.24

5 383.45 X .35 134.21

Figure 6.4: Tax benefits

The tax benefit from depreciation was calculated similarly. In Figure6.5 we show the calculations.

Year Equipment Cost

DecliningBalance

PercentageAnnual

Deduction Tax Rate Tax Benefit

1 $15,000X .2000 = $3,000 X .35 1,050.00

2 $15,000 X .3200 = 4,800 X .35 1,680.00

3 $15,000 X .1920 = 2,880 X .35 1,008.00

4 $15,000 X .1152 = 1,728 X .35 604.80

5 $15,000 X .0576 = 864 X .35 302.40

$13,272

Figure 6.5: Tax benefit from depreciation

Salvage valuecash flow

At this point, the only remaining cash flow we need to identify isthe after-tax cash flow resulting from the disposal of the equipment(salvage value). We show the calculations for this cash flow in Figure6.6.




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Pretax salvage value $1,500

Less remaining tax basis:

Original cost $15,000

Less depreciation taken – 13,272

Tax basis (1,728)

Loss on disposition ($ 228)

X Tax rate .35

Tax benefit from loss deduction $ 80

Salvage value 1,500

After-tax salvage value 1,580

Figure 6.6: After-tax salvage value

Calculate the Present Value of the Cash Flows

Choosingdiscount rate

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

Using thecalculator

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


f REG 0.00 Clears all registers

8.42 i 8.42 Enters the discount rate

2,610 CHS PMT 2,610.00 Enters net after-tax cost

5 n 5.00 Enters number of discountperiods





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Now let’s calculate the present value of the purchase cash flows andcompare the difference (Figure 6.7).




3,000 g CFo 3,000.00 Enters the initial cash flow






f NPV 10,074.95 Solves for present value

Present value at 8.42%

Lease $10,307

Purchase $10,075

Difference ($232)

Figure 6.7: Present value summary

As you can see, the company should purchase the equipment when theafter-tax cost of debt is used as the discount rate.

In the next section, we will discuss how to isolate individual variablesof the analysis and assess the impact of changing any one or more of them.




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Convert topretax futurevalue

We use a two-step process to convert the $232 to its pretax futurevalue of $535.

Step 1 − Calculate future value of the difference at 8.42 percent.




232 CHS PV 232.00 Enters present value difference

5 n 5.00 Enters number of discount periods

FV 347.56 Solves for future value

Step 2 − Convert the after-tax value to a pretax value.

347.56 / (1 - tax rate) = 534.71

Indifferencevalue

The difference between the original salvage value and the pretax futurevalue we calculated above is the indifference value:

$1,500 - $535 = $965

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

FACTORS THAT AFFECT THE LEASE VS. BUY ANALYSIS

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




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Discount Rate

Effect ofdiscount rate

As mentioned in the previous section, the choice of a discount rate isvery important to the lease vs. buy analysis. Generally, when a lower

discount rate (after-tax cost of debt) is selected, the analysis favorspurchasing. When a higher discount rate (after-tax cost of capital) isselected, the analysis favors leasing. Of course, the objective is not tofavor one alternative over the other, but to arrive at an unbiasedconclusion.

Companygoals

Selection of a proper discount rate will depend on each company’ssituation. A large company usually views leasing as debt. Because of its need to maintain constant leverage ratios, the additional cash flowgenerated by the lease is not meaningful to a large company. These

companies should use the after-tax cost of debt as the base discountrate for the analysis. On the other hand, a small, entrepreneurialcompany seeks to maximize cash flow, so that the savings can bereinvested back into the business at a high rate of return. If this is thecase, either the cost of capital or the opportunity cost will be theappropriate discount rate.

Salvage valueand risk

The type of transaction being entered into also affects the choice of the discount rate. If the lessor takes a small residual position (as ina finance lease), there is little asset risk in the transaction. However, if

the lessor assumes a substantial residual risk (as in an operatinglease), the large salvage value in the lease/buy decision increases therisk in the transaction. The greater the risk, the higher the discountrate that should be used.

Consistency Finally, you should remember that it is important to use the samediscount rate to analyze all financing alternatives. Otherwise, they arenot comparable!




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Salvage Value

Factors toconsider

The salvage value has the greatest effect on the result of the lease vs.buy analysis. Therefore, it is important to arrive at a realistic salvage

value, incorporating anticipated use and deinstallation and disposalcosts. Expert opinions may be used, if necessary. A faulty salvagevalue assumption could alter the lease vs. buy decision.

Usingindifferencevalue

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

UNIT SUMMARY

Once a company has decided to acquire equipment, it must determine whether to buy theequipment with cash, finance the equipment with a loan, or enter into a tax lease with alessor for the use of the equipment. For the lessee, a lease vs. buy analysis quantifies afinancing 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 thencalculating the present value at the appropriate discount rate. The choice of a discount ratedepends on the company’s circumstances. If the company wishes to minimize its interestcost, it uses the after-tax cost of debt as the appropriate discount rate. If the companydesires to maximize cash flow, then the appropriate discount rate will be the after-tax costof capital.

The company should choose the financing option with the lowest present-value cost. Usingthe 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 additionalperspective. A lessor may use the break-even discount rate to persuade the potential lesseeto 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, thencontinue to Unit Seven: Lease Structuring. If you answer any questions incorrectly, pleasereview the appropriate sections in the text.




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] PROGRESS CHECK 6


Question 1: A valid lease vs. buy decision depends on ___________________.

Question 2: The reason a lease vs. buy analysis is performed on an after-tax basis is to:

____ a) equate the future cash flows.

____ b) arrive at an appropriate discount rate.

____ c) consider the tax consequences of the alternatives.

____ d) determine the effect of the after-tax cost of debt.

Question 3: Why is present value analysis used in lease vs. buy calculations?

____ a) Leasing and purchasing generate different future cash flows.

____ b) The investment rates for leasing and purchasing usually differ.

____ c) It is important to use the same discount rate for both alternatives.

Question 4: For the lessor, a sensitivity analysis on the discount rate:

____ a) helps determine whether the potential lessee has reached the indifferencepoint.

____ 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 samefor both financing options.

____ a) True

____ b) False




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ANSWER KEY

Question 1: A valid lease vs. buy decision depends on accurate, valid, relevantinformation.

Any one or more of these answers is correct.

Question 2: The reason a lease vs. buy analysis is performed on an after-tax basis is to:

c) consider the tax consequences of the alternatives.

Question 3: Why is present value analysis used in lease vs. buy calculations?

a) Leasing and purchasing generate different future cash flows.

Question 4: For the lessor, a sensitivity analysis on the discount rate:

b) may be used as a marketing tool.

Question 5: When a break-even discount rate is used, the future cash flows are the samefor both financing options.

b) False

The present value of the future cash flows is the same for both

financing options.




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Question 6: The purpose of performing a sensitivity analysis on the salvage value of equipment is to:

____ a) calculate the expected sale value that will equate purchasing with leasing.

____ b) convert the difference between the present values of leasing andpurchasing 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 tendsto favor:

____ a) large corporations.

____ b) purchasing equipment.

____ c) leasing equipment.

____ d) installment loans.




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ANSWER KEY

Question 6: The purpose of performing a sensitivity analysis on the salvage value of

equipment is to:

a) calculate the expected sale value that will equate purchasing withleasing.

Question 7: Generally, selecting the after-tax cost of capital as the discount rate tendsto favor:

c) leasing equipment.



Unit 7



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UNIT 7: LEASE STRUCTURING

INTRODUCTION

In lease structuring, a lessor pulls together the many components of a lease to createa single lease transaction. Structuring includes lease pricing, end-of-term options,documentation issues, indemnification clauses, funding, and residual valuations. In

this unit, we will focus on one of the most important components − pricing.

Pricing is the process of determining the pattern of payments to be made by a lessee.For lessors, the goal of pricing is to satisfy a customer’s financing desires while ensuring

that a profit will be earned. Lessees seek a payment stream that will suit their cash flowpatterns and allow them to successfully use the equipment to earn a profit. The transactionmust be viewed as a win for both sides. Without proper pricing, the leasemay be unacceptable in the marketplace, or the transaction may not meet the lessor’sand lessee’s profit requirements.

In this unit, we will introduce you to lease pricing concepts and work through someexamples. You will see how the present value analysis concepts you learned in UnitFive apply to lease pricing. We will also provide you with methods for evaluatingcompetitors’ leases.

UNIT OBJECTIVES


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

+ Understand the methods lessors use to evaluate competitors’ proposals



7-4 LEASE STRUCTURING

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Residual valueadjustment

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

KEYSTROKES DISPLAY

f REG 0.00

10 g 12 ÷ .83

60 n 60.00

12,000 CHS FV 12,000.00

PV 7,293.46

The present value of the adjusted residual value is $7,293.46.

2. Calculate the net outflow of costs at time zero

Total netoutflowcomponents

We can now add the present value of the net residual to theother components of the net cash outflow at time zero. Let’s look at a time line of the cash flows to see the total net outflow (Figure7.1).

Figure 7.1: Net cash outflow at time zero

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

0 60

(100,000.00)

3,000.00

(2,507.00)

7,293.46

1,000.00

91,213.54

15,000.00

(3,000.00)

12,000.00



LEASE STRUCTURING 7-5

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3. Compute the present value of the unknown lease payment,letting each payment equal one dollar

In this step, we solve for a factor (the investment recovery unit

or IRU) that represents the amount of principal a one-dollarpayment over the lease term would recover and still earn a 10percent yield.

The keystrokes for this calculation are:

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 ofone-dollarpayment

From this calculation, we see that if the payment were only onedollar, then 60 payments in advance would recover principal(investment) of $47.46. Recall that the required payment mustrecover principal of $91,213.54 (step two).

4. Calculate the monthly lease payment: (divide step two bystep three)

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

Step 2 91,213.54

= 1,922

Step 3 47.4576




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INTRODUCTION TO ADVANCED STRUCTURING

In the previous section, we discussed solving for a payment that wouldgive the lessor a given before-tax return on its investment. You learned

that the monthly payment is based on all cash flows in the lease as wellas the targeted yield.

In this section, we will examine some special situations that affectlease pricing. Keep in mind that the pricing is still based upon thestructuring principles you learned about in the previous section. Thesituations we will look at are:

+ Unusual payment streams

+ Early terminations of leases

Structuring Unusual Payment Streams

Conform tolessee’s cashflow

Frequently, a lessor will structure a lease with a varied or unusualpayment pattern to accommodate a lessee's cash flow requirements.Examples of leases with unusual payment streams include skipped ,step-up, and step-down payment streams. In a skipped paymentstream, the lessee skips the payments during the season when revenue

is not being generated. Step-up lease payments start low and areincreased once cash flow is expected to increase. In a step-downlease, the lease begins with higher payments and then “steps down” tolower ones.

Stepsmodified foreffect ofvariedpayments

The same structuring steps we described in the previous sectionare followed in structuring unusual payment stream leases, exceptsome of the steps are slightly modified to include the effect of theunusual payment stream. For example, the assumed one-dollar leasepayments must be altered for the periods with the skipped, increased,

or decreased payments.

To see how unusual payment streams affect structuring, let’s look at the structuring approach for several common uneven paymentstreams. We will assume that the pretax structuring steps apply.




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S k i p p ed P a ym en t s

Skippedpayments =zero

To structure skipped payment leases, let each regular payment equalone dollar and the skipped payments equal zero when finding the

present value of the one-dollar payments.

KEYSTROKES

8.343 i (Discount rate)

5 g CFo (Base one-dollar

payments, first year)

9 g CFj (Base one-dollarpayments, subsequent

years)

3 g Nj (Three skipped payments)

4 g CFj (Base one-dollarpayments, year five)

f NPV 30.954135

.34 f x 10.524406

.9676 x 10.183415

S t ep -up Lease

Increased

payment as apercentage ofbase rental

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

KEYSTROKES

.67 i (Discount rate)

1 g CFj (Base one-dollar

payments)24 g Nj

1.12 g CFj (Stepped-up payments at112% of the one dollar

base)

24 g Nj

f NPV 43.189882




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S t ep -down Lease

Reducedpayments as a

percentage ofbase payment

Structuring a step-down lease is similar to structuring a step-up lease.For example, assume the lessee desires 36 base payments, one in

advance, followed by 12 reduced payments that are 87 percent of thebase payment. In step two, we let each regular payment equal onedollar and the stepped-down payments equal 87 percent of the one-dollar base rental.

KEYSTROKES

.67 i (After-tax IRR)

1 g CFo (One advance payment)

1 g CFj

35 g Nj

.87 g CFj (Stepped-down paymentsat 87% of the one-dollar

base)

12 g Nj

f NPV 40.021926

K n o w n I n i t i a l P a y m e n t s

The structuring methodology changes when the lessee can pay only alimited amount of rent during the early months of a lease.

Price ofremainingpayments

Assume the lessee can pay only $1,800 per month in arrears for thefirst 12 months of a 48-month lease. We must determine the price of the 36 remaining payments that will produce the required yield.

The first adjustment requires including the known cash flows of $1,800 per month as part of step one, where all known cash flows are

identified and present valued.




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KEYSTROKES

.67 i

1,800 g CFj (Known lease payments)

12 g Njf 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

Early Terminations of Leases

Making thelessor“whole”

Leases are sometimes terminated prior to the end of theirnoncancellable terms. For example, the lessee may want to purchasethe equipment or return the equipment to the lessor. Regardless of thereason, the lessor must compute the amount the lessee owes at thetermination date in order to make the lessor “whole” (as defined in thelease agreement or by the lessor).

In computing early terminations, lessors attempt to achieve one of four basic objectives:

+ Maintain the pretax yield in the lease

+ Maintain the after-tax yield in the lease

+ Maintain the accounting yield (avoid book loss)

+ Penalize the lessee




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The basic procedure used to determine lease payoffs is to compute thepresent value of all costs and benefits that were incurred or receivedup to the date of the lease termination. Since all benefits will havebeen received at this point, there will be a net unrecouped present

value investment cost still remaining. The lease payoff will be thepretax equivalent of the future value of this unrecouped netinvestment.

EVALUATING THE COMPETITION

To market leases effectively, lessors should be able to identify thepossible reasons for pricing differences in competing proposals. In

this section, we will discuss the factors that a lessor should look forwhen evaluating a competitor’s proposal and methods used to analyzecompeting proposals.

Reasons for Pricing Differences

Quantitativeandqualitativefactors

There are many different factors that lessors should consider whenevaluating proposals from other lessors. Some of these factors arequantitative, such as monthly payment or internal rate of return. Others

are qualitative, such as insurance requirements or the existence of restrictive covenants. Here, we list five categories of factors that alessor should examine when evaluating the difference between leaseproducts.

F i n a n c i a l

+ 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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O p e r a t i o n a l

+ Accounting classification (capital versus operating lease status)

+ Appraisal techniques used to determine the fair market value at

the end of the lease term

+ Inspection rights and fees

+ Installation, deinstallation, maintenance, repair, and insuranceprovisions

Res t r i c t i ve

+ Restrictive covenants such as limits on debt-to-equity ratios

+ Sublease rights

+ Lessor right of assignment

+ Definition of what constitutes default

T e r m i n a t i o n

+ Purchase option consequences and charges

+ Physical condition of equipment provisions

+ Early-out and payoff amounts

+ Automatic extension policy and terms

L i a b i l it y a n d W a r r a n t y

+ Insurance amount and type

+ Maintenance requirements

+ Tax indemnification provisions

+ Stipulated loss value table




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Analyzing Competing Proposals

There are several methods of analyzing competing proposals. Somemethods are simply a matter of analyzing cash flow. Others use more

financially sophisticated methods such as IRR and NPV (net presentvalue).

Five methods In this section, we will discuss and illustrate five methods of analyzingtwo 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

Paym ent Di f f erences

Ignorespayment mode

A simplistic, yet commonly used, method of analyzing leases is tocompare the monthly payment amounts. This method ignores the factthat although Company A's payment is lower, payments are made inadvance, while Company B's are made in arrears.

COMPANY B $1,212.22

COMPANY A 1,205.58

$ 6.64




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To t a l Cash O ver Term

Terms mustbe equal

Since the term for both proposals is the same, total cash over the termwill again favor Company A. However, terms will not necessarily

always be the same, and unequal terms cannot be compared.

COMPANY B $58,186.56

COMPANY A 57,867.84

$ 318.72

Lease R at e Factor

Payment ÷equipmentcost

The lease rate factor is calculated by dividing the payment by theequipment cost. Because the cost of the equipment is the same forboth proposals, this method again favors Company A.

COMPANY B .024244

COMPANY A .024112

.000132

Lessee 's Im pl ici t Cost

Impact ofpayment mode

A more sophisticated method of comparing proposals is to examinethe lessee's implicit cost. Here, the effect of advance payments versuspayments in arrears is factored into the analysis. This is accomplishedby calculating the IRR inherent in the lessee's cash flows. As shown onthe next page, this IRR calculation favors Company B.




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COMPANY A

KEYSTROKES

48,794.42 CHS g CFo

1,205.58 g CFj

47 g Nj

f IRR .6405

12 x 7.6865

COMPANY B

KEYSTROKES

g 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

N e t Presen t Va l ue (NPV)

Assumediscount rate

The last method we will examine requires the evaluator to assumea discount rate and calculate the net present value of the twoalternatives. While dependent on the discount rate selected. The NPVmethod favors Company B in this example.




V01/11/96 DRAFTP12/06/99

] PROGRESS CHECK 7

Directions: Determine the correct answer to each question. Check your answers with


Question 1: The present value amount that remains after the lessor’s desired yield isremoved from cash flows is the:

____ a) net cash outflow at time zero.

____ b) required monthly payment amount.

____ c) recovery of the lessor’s investment.

____ d) intraperiod present value factor.

Question 2: Structuring to a pretax yield is more accurate than structuring to an after-taxyield.

____ a) True

____ b) False

Question 3: The reason for letting each payment equal one dollar when computing thepresent value of the unknown lease payment is to:

____ a) solve for a factor that can be applied to the net investment at timezero.

____ 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 isremoved from cash flows is the:

c) rate of recovery of the lessor’s investment.

Question 2: Structuring to a pretax yield is more accurate than structuring to an after-taxyield.

b) False

Question 3: The reason for letting each payment equal one dollar when computing thepresent value of the unknown lease payment is to:

a) solve for a factor that can be applied to the net investment at timezero.




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Question 4: Skipped payment, step-ups, and step-downs are example of:

____ a) varied payment streams that meet a lessee’s cash flow needs.

____ b) unusual payment streams that must be estimated rather than calculated.

____ c) known initial payment streams.

____ d) structuring approaches for early lease terminations.

Question 5: The secret to structuring a skipped payment lease is to:

____ a) express the skipped payment as a percentage of the base one-dollarpayment.

____ b) ignore the tax liability on the skipped payments.

____ c) let each regular payment equal one dollar and the skipped payments equalzero when computing present value.

____ d) maintain the after-tax yield in the lease.

Question 6: One of the ways lessors may be made “whole” in an early payoff situation isto maintain the yield upon which the payments were based.

____ a) True

____ b) False




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ANSWER KEY

Question 4: Skipped payment, step-ups, and step-downs are example of:

a) varied payment streams that meet a lessee’s cash flow needs.

Question 5: The secret to structuring a skipped payment lease is to:

c) let each regular payment equal one dollar and the skipped paymentsequal zero when computing present value.

Question 6: One of the ways lessors may be made “whole” in an early payoff situation isto maintain the yield upon which the payments were based.

a) True




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ANSWER KEY

Question 7: In evaluating competing proposals, a lessor should compare:

b) both quantitative factors such as monthly payment and qualitativefactors such as limits on debt-to-equity ratio.

Question 8: Using payment differences as a way to analyze a competing lease:

c) does not take into account the payment mode (advance or arrears).



Unit 8



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UNIT 8: VENDOR LEASE PROGRAMS

INTRODUCTION

In Unit One, you learned that manufacturing companies, distributors, or equipmentmerchandising dealers who use leasing programs to help sell their products are known asvendor lessors. Often, a manufacturer or dealer will establish a wholly owned subsidiary toperform the leasing function, creating a captive leasing company. In this unit, we use theterm “vendor leasing” to refer to any program, including captives, in which a manufacturer,distributor, or dealer uses leasing as a way to sell its product.

Sometimes vendor lessors outsource all or part of their customer financing activity.Financial organizations such as Citibank may assume all aspects of the vendor’s customerfinancing, from program development through billing and collections, or play a partial rolein the program, such as handling billing, collection, and credit checking. Citibank can act asfinance 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 thereasons vendors establish leasing programs and why they use third-party organizations to

develop or support these programs. We will also examine some of the ways third parties,such as Citibank, work with vendor lessors.

UNIT OBJECTIVES


+ Identify the benefits of vendor leasing programs

+ Recognize the various ways third parties participate in vendor leasing programs



8-2 VENDOR LEASE PROGRAMS

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BENEFITS OF VENDOR LEASING PROGRAMS

Third-partybenefits

For financial organizations such as Citibank, assisting vendors withleasing programs offers several benefits. Such programs broadenclient relationships by setting up an additional link to the client’s salesand marketing force, and produce new net revenue and annuityrevenue.

Five reasons To market vendor leasing programs effectively, it is important tounderstand the many benefits vendor leasing programs offer vendors.In this section, we will discuss five reasons vendors establish vendorleasing programs. As you read about these benefits, think about how

they could be used as selling points. The benefits we will discuss are:

+ Market control

+ Market enhancement

+ Ancillary income

+ Tax benefits

+ Financial leverage

Market Control

Criticalperiods

Most vendor leasing programs are established for marketing reasons.Vendor programs give vendors control during critical periods over theuseful life of equipment, including:

+ Control at inception, to prevent loss of a sale during the timethe customer needs to locate funding. On-the-spot financing

can help close a deal.



VENDOR LEASE PROGRAMS 8-3

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+ Control during the noncancellable lease term to provide forupgrades, maintenance, parts, supplies, and any other service orproduct. Monthly contact through billing gives the lessor anadvantage in winning sales of additional services or products.

+ Control over disposition of the equipment, so that at leasetermination, the vendor lessor is able to steer the lessee towardacquiring the lessor's new equipment

+ Control over the resale prices of used equipment repossessed,returned, or traded-in to support lease yields, operating leaseprograms, and avoid price competition problems with newproducts

+ Control over package (blanket) leasing to insure that the

lessor's product is part of the multiple product package

Market Enhancement

In addition to market control, both the size and quality of amanufacturer's sales market can be improved through leasing. Marketenhancement results from:

+ Reduction or elimination of discounts off list price by

directing the customer’s attention from purchase price to thefinancial considerations of a lease

+ Improvement of sales volume through product differentiationobtained by the unique combination of product attributes,financial services, and other bundled services

+ Increased sales volume through the offering of operating leaseand rental programs that meet certain lessee needs not met byother financing alternatives

+ Speed of asset turnover through takeout-rollover programs thatremove a competitor's equipment before the end of theequipment's lease term and replace it with the lessor’sequipment




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+ Expansion of market penetration for new products throughrental programs that allow a customer to try out equipment andlease subsidies that provide low rate financing

+

Improvement of dealer sales through vendor guaranteeprograms that attract third-party lessors who can offerattractive financing for customers

Additional Income Sources

Increased sale of the vendor’s product is not the only source of profitin vendor leasing programs. Here, we look at several additionalsources:

+ The interest spread (difference) between interest income andinterest expense, brokerage fees, and service fees when thelessor continues to service the lease

+ Incremental sales generated from bundled services andproducts in a full-service lease

+ Residual profit to the degree returned equipment can be soldfor more than its remaining book value at the end of a lease

Tax Benefits

In Unit Two, we discussed the various tax benefits of leasing. Recallthat in the U.S., the primary tax benefits for leasing are MACRS andgross profit deferral. The value of MACRS increases the later in thetax year the lease is structured. The value of gross profit tax deferraldepends upon the size of the gross profit, the discount rate applied,and the MACRS classlife of the leased equipment.

A comparison of third-party and two-party leasing tax benefits appearsin Figure 8.1. (All values are expressed as a percentage of retail salesprice, based on an after-tax present value computation.)




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Off balancesheet funding

In addition to enhancing return on equity, financial leveraging mayoffer a vendor lessor certain accounting benefits. In the U.S., a

partially owned subsidiary (≤ 50 percent) is not consolidated foraccounting purposes, so the debt does not appear on the balance sheet

of the parent company.

REASONS VENDORS OUTSOURCE LEASING PROGRAMS

In the previous section, we discussed the many benefits vendor leasingprograms offer manufacturers and equipment dealers. We saw thatvendor leasing programs help vendors sell their products, increaserevenues, and accelerate cash flow. With so many benefits to gain, why

don’t all manufacturers and equipment distributors have customerfinancing programs? In this section, we will examine the reasons andsee how using third-party lessors such as Citibank can help.

Reasons Vendors Lack Customer Financing Programs

Although there are many reasons vendors do not establish financingprograms, most pertain to lack of resources and leasing expertise,concerns about the risks in leasing, and the inability to compete with

large leasing specialists.

Expertise andcapital issues

The lack of in-house leasing expertise is one of the most importantreasons vendors do not have leasing programs. Leasing is a specializedfield. Most companies do not have the time or the resources todevelop the needed expertise or to hire leasing experts. Also, manycompanies do not wish to divert capital away from their primarybusiness to fund and support a leasing portfolio. They also fear thattheir cost of capital may be too high to compete with the lease rates of third-party finance companies.




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Concernsover risks

Even for companies with the resources to set up a leasing program,concerns about the many risks in leasing (residual risk, credit risk,interest rate risk) or an excess tax benefit position may keep them

from doing so.

As we shall see in the following sections, most of these concerns canbe addressed through outsourcing customer financing programs tothird-party participants.

Third-party Participants

Variety of

participantsand services

There are a large number of third-party participants in the vendor

leasing market, including lease brokers, financial institutions such asCitibank, and independent leasing companies. The level of servicesvaries. Some participants function solely as lenders to captives.Others provide special services, such as remarketing, to the vendors.Another class of participants provides funding and a limited range of support services. Finally, some offer full-service leasing and providethe vendors with a wide variety of services, from lease originationthrough equipment disposition. We will discuss these roles in moredetail in the next section.

Joint ventures In addition to the roles just mentioned, the third-party lessor also canserve as a joint venture/equity partner. Under such an arrangement, thethird party invests directly in the leasing subsidiary. More commonly,the vendor and an outside party jointly establish a separate company tolease the vendor’s products to customers. Vendors who want to retaina portion of the financing profit and tax benefits in-house, but do notwant to bear all the risks of a full captive, often choose to enter a jointventure.

WAYS TO MEET VENDOR NEEDS

There are many ways a third party can service vendor lessors.Generally, it is the noncaptive vendor lessors who have the greatestneed for services (although more and more captive lessors areoutsourcing some functions).




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Third-party Services

The services third parties offer vendors can be grouped into sevencategories: sales-aid/training, lease structuring/documentation,

credit review, outplacement/investment syndication, funding,administrative services, and remarketing/asset management. Let’sreview each category.

S a l es -a i d / T ra i n i n g

Education,jointmarketing,

support

Sales-related services provided by a third-party lessor range fromhelping the vendor establish an effective leasing program by educatingthe vendor’s sales force to on-going sales support services, such as

customizing deals. Services can include sales force training, jointcustomer calls, customized lease documentation and marketingmaterials, jointly sponsored advertising, and pricing support.

Lease S t ru c t ur i n g / D ocu m en t a t i on

Third-partylessor’sexpertise

This is an area where third-party lessors offer a great deal of addedvalue. The third-party company works with a vendor to customize atransaction to a particular lessee’s needs. The vendor benefits from

the third-party’s expertise in structuring lease products. The vendorcan also rely on the third-party lessor for help in processing andtracking the lease documentation prior to closing the transaction.

Credi t R ev iew

Customer’scredit-worthiness

Vendors often rely on a third party’s expertise in assessing acustomer’s creditworthiness. The credit review process usuallyinvolves researching the customer’s credit history, analyzing financial

statements, and checking references.




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O u t p l a c e m e n t / I n v e st m e n t S y n d i c a t i on

Lack of capital A lack of capital often causes vendors to seek an equity partneror have a lease broker sell off its equity investment in leases.

Sometimes the investor buys the entire lease (assumes the credit andresidual risks); other times the vendor sells only the rental stream orthe residual.

F u n d i n g

Direct andindirectfunding

There are many ways to fund a vendor leasing program or captive. Themethod chosen depends on the vendor’s desired tax and accounting

consequences. There are two basic types of funding − direct and

indirect. Indirect funding involves loans to the captive or vendor, whothen uses the borrowed funds to lease the equipment directly to thecustomer. Under direct funding methods, the third party is the lessorand provides the financing directly to the vendor’s customer. Thethird-party lessor may buy the asset from the vendor and lease itdirectly to the customer, or purchase existing leases from the vendor.

Accountingissues

Whether the vendor, the third-party lessor, or the customer retains theresidual and tax rights to the asset depends on how the initial sale andlease 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 thecustomer’s lease payments. Alternatively, the vendor can sell itsinterest in the residual only, retaining the lease payment stream andassociated credit risk.




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Adm i n i s t ra t i ve S erv ices

Handlingpaperwork

Vendors may find it more cost-effective to purchase servicesfrom an equipment leasing specialist, whose size and leasing

concentration enable it to achieve certain economies of scale. Theadministrative services a third-party lessor might provide includebooking the transaction; billing and collecting the monthly leasepayments; processing customer service complaints; filing, collectingand remitting sales, use and property taxes; and preparing financialstatements and tax returns.

R em a rk e t i ng / Asset M ana gem en t

Control overasset Vendors often seek outside help in remarketing the asset at the end of the lease term or in the event of a customer default. Also, a vendor maychoose to use the asset tracking systems offered by many leasingcompanies. These systems alert the lessor as to which assets are comingoff lease, report on the status of any off-lease equipment, and processany 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 associatedwith 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 fundingonly, while others provide both funding and a limited range of support services such asbilling, collecting, and credit review. Some third party companies provide special services,such as remarketing, to vendors. Others offer full-service leasing, from lease originationthrough equipment disposition.

Congratulations! You have completed the Basics of Asset Based Financing Course. Pleasecomplete Progress Check 8 to check your understanding of vendor leasing programs. If youanswer any questions incorrectly, please review the appropriate portions of the text.




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] PROGRESS CHECK 8


Question 1: The primary reason manufacturing companies, distributors, or equipmentmerchandising dealers use customer financing programs is to:

____ a) control resale prices of used equipment.

____ b) gain tax benefits.

____ c) reduce risks.

____ d) help sell their products.

Question 2: The reason vendors wish to exercise control at the time of sale is to:

____ a) increase sales by providing the customer with supplies and other services.

____ b) prevent loss of a sale while the customer seeks financing.

____ c) make sure its product is part of a product package.

____ d) influence the resale value of the equipment.

Question 3: One of the ways vendors can increase profits through leasing programs is to

purchase noncompeting equipment at wholesale prices and package it withtheir own equipment.

____ a) True

____ b) False

Question 4: Financial leverage helps increase a lessor’s return on equity because:

____ a) it generates incremental sales from bundled services and products.

____ b) sales volume is increased by reducing reliance on discounts off list price.____ c) it generates income from syndication fees.

____ d) the rate of return from the lease generally exceeds the cost of borrowingto leverage the lease.




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ANSWER KEY

Question 1: The primary reason manufacturing companies, distributors, or equipment

merchandising dealers use customer financing programs is to:

d) help sell their products.


b) prevent loss of a sale while the customer seeks financing.

Question 3: One of the ways vendors can increase profits through leasing programs is topurchase noncompeting equipment at wholesale prices and package it withtheir 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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Question 5: An important reason vendors use third-party lessors is to:

____ a) improve sales.

____ b) avoid the risks inherent in leasing.

____ c) gain tax advantages.

____ d) earn a greater return on equity.

Question 6: Vendors who wish to retain a portion of the financing profit and tax benefitswithout bearing all the risks of leasing should consider:

____ a) a captive subsidiary.

____ b) lease brokering.

____ c) a joint venture.

____ d) an asset tracking system.

Question 7: A vendor often finds it beneficial to outsource its lease administrationactivity to a leasing specialist because:

____ a) the third party’s knowledge of leasing and size enables it to administerleases 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


b) avoid the risks inherent in leasing.


c) a joint venture.


a) the third party’s knowledge of leasing and size enables it toadminister leases more efficiently.



Unit 9



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UNIT 9: VENDOR PROGRAMS

INTRODUCTION

In Units Two through Eight, we discussed leasing, a key ABF product, in detail. In thatcontext, we introduced the concept of vendors using leasing programs to help sell theirproducts and accelerate cash flow from sales. In this unit, we expand our discussion of thattopic to include all vendor finance programs (loans and leases). Specifically, we willexamine the reasons vendors establish programs to finance their customers’ productpurchases, why they use third-party organizations such as Citibank to develop or supportthese programs, and how Citibank uses vendor programs to accelerate ABF activity. We will

also look at several marketing and structuring aspects of vendor programs — vendorselection criteria, program structuring, and risk-sharing mechanisms.

UNIT OBJECTIVES


+ Identify the benefits of vendor financing programs

+ Recognize the various ways third parties participate in vendor financingprograms

+ Identify criteria Citibank uses to select vendors

+ Understand the major types of risk sharing mechanisms in vendor programs



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BENEFITS OF VENDOR FINANCE PROGRAMS

Finance salesof products

In Unit Two, you learned that manufacturing companies, distributors,or equipment merchandising dealers who use financing programs tohelp sell their products are known as vendor lessors. Recall that somemanufacturers or dealers establish a wholly owned subsidiary tofinance 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 asCitibank. In this unit, we use the term vendor financing to refer toany program, including captives, in which a manufacturer, distributor,or dealer finances the sale of its products to end users.

In this section we will look at the benefits of vendor financing fromtwo perspectives — that of Citibank and that of the vendor.Understanding the benefits from both viewpoints will help you marketand structure successful vendor programs. Let’s begin with thebenefits to Citibank.

Citibank Benefits

Access toequipmentusers

Why does Citibank use vendor programs as part of its asset basedfinancing activity? The main reason is that vendor programs help speedthe bank’s access to equipment users. Established vendors have acustomer base in place and a marketing program to acquire newcustomers. Through vendor financing, Citibank establishesrelationships with equipment users that may lead to direct financearrangements in the future.

To help you understand the role Citibank plays in vendor financing, inFigure 9.1, we show the equipment financing flow when Citibank

finances the sale of the product to the end user. Note that Citibank isproviding equipment financing through the vendor for the equipmentuser, not the manufacturer, dealer, or distributor.



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Vendor Benefits

Benefitcategories

To effectively market vendor financing programs, it is important thatyou understand the many benefits vendor financing programs offer

vendors. In this section, we discuss five reasons vendors establishfinancing programs. As you read about these benefits, think about howthey could be used as selling points. The benefits we will discuss are:

+ Market control

+ Market enhancement

+ Ancillary income

+ Tax benefits

+ Financial leverage

Mark e t Con t ro l

Criticalperiods

Most vendor financing programs are established for marketingreasons. Vendor programs give vendors command over the equipmentand control during critical periods over the useful life of theequipment, including control:

+ At inception, to prevent loss of a sale during the time thecustomer needs to locate funding. On-the-spot financing canhelp close a deal.

+ During the funding term to provide for upgrades, maintenance,parts, supplies, and any other service or product. Monthlycontact through billing gives the vendor an advantage in winningsales of additional services or products.

+ Over disposition of the equipment, so that at lease termination,the vendor is able to steer the user toward acquiring thevendor’s new equipment

+ Over the resale prices of used equipment repossessed,returned, or traded-in to support lease yields, operating leaseprograms, and avoid price competition problems with newproducts



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+ Over package (blanket) financing to ensure that the vendor’sproduct is part of the multiple product package

M a r k e t E n h a n c em e n t

Market sizeand quality

In addition to market control, both the size and quality of amanufacturer's sales market can be improved through financing.Market enhancement results from:

+ Reduction or elimination of discounts off list price bydirecting the customer’s attention from the purchase price tothe financial considerations of a lease or loan

+ Improvement of sales volume through product differentiationobtained by the unique combination of product attributes,financial services, and other bundled services

+ Increased sales volume through the offering of operating leaseand rental programs that meet certain equipment user needs notmet by other financing alternatives

+ Speed of asset turnover through takeout-rollover programs thatremove a competitor's equipment before the end of theequipment's lease term and replace it with the vendor’s

equipment

+ Expansion of market penetration for new products throughrental programs that allow a customer to try out equipment andlease and loan subsidies that provide low rate financing

+ Improvement of dealer sales through vendor guaranteeprograms that attract third-party creditors who can offerattractive financing for customers



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Add i t i on a l In com e Sources

Interest,incremental

sales, residualprofits

Increased sale of the vendor’s product is not the only source of profitin vendor financing programs. Here are three additional sources:

+ The interest spread (difference) between interest income andinterest expense, brokerage fees, and service fees when thelessor continues to service the lease

+ Incremental sales generated from bundled services andproducts in a full-service lease

+ Residual profit to the degree returned equipment can be soldfor more than its remaining book value at the end of a lease

T a x B e n e f it s

MACRS andgross profitdeferral

In Unit Three, we discussed the various tax benefits of leasing. Recallthat in the U.S., the primary tax benefits for leasing are MACRS andgross profit deferral. Let’s review two important points from thatdiscussion:

+ 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 MACRSclasslife of the leased equipment.

Keeping these points in mind, look at the comparison of third-partyand two-party leasing tax benefits in Figure 9.2 . (All values areexpressed as a percentage of retail sales price, based on an after-taxpresent value computation.)

Ability to usetax benefits

As you can see, the value of tax benefits in a vendor program can besignificant. If the vendor lessor cannot use the tax benefits, it shouldconsider joint venturing with a partner who can use the benefits.Selling (brokering) tax leases can generate fees that help compensatefor unusable tax benefits.



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THIRD PARTY VENDOR PROGRAMS

In the previous section, we discussed the many benefits vendorfinancing programs offer manufacturers and equipment dealers. We

saw that vendor financing programs help vendors sell their products,increase revenues, and accelerate cash flow. With so many benefits togain, why don’t all manufacturers and equipment distributors havecustomer financing programs? In this section, we will examine thereasons and see how using third-party creditors such as Citibank canhelp overcome the constraints vendors confront.

Reasons Vendors Lack Customer Financing Programs

Although there are many reasons vendors do not establish captivefinancing programs, most pertain to lack of resources and financingexpertise, concerns about the risks in leasing and lending, and theinability to compete with large leasing specialists. Let’s examine eachof these reasons more closely.

Exper t i s e an d Cap i t a l I s sues

Lack of

specializedresources

The lack of in-house financing expertise is one of the most important

reasons vendors do not have financing programs. Leasing, inparticular, is a specialized field. Most companies do not have the timeor the resources to develop the needed expertise or to hire leasingexperts. Also, many companies do not wish to divert capital away fromtheir primary business to fund and support a financing portfolio.Another problem is that internal credit processes may lack integritybecause of ties to marketing, and borrowers may not take a supplier’scredit seriously.



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Joint ventures In addition to the roles just mentioned, the third-party creditoralso can serve as a joint venture/equity partner. Under such anarrangement, the third party invests directly in the financingsubsidiary. More commonly, the vendor and an outside party jointly

establish a separate company to lease the vendor’s products tocustomers. Vendors who want to retain a portion of the financingprofit 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 wayscreditors service vendors are shown in Figure 9.3.

Figure 9.3: Roles of third-party organizations

VENDOR

Captive

Loans (Indirect funding)

Equity (Contract

Direct Financing

All Services

Program development

through billing and collections

JointVenture

Full-Service

Specialized Services

Equity (as a partner)

Specialized Services

Administrative Services

Administrative Services



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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 andcollections, or play a partial role in the program, such as handlingbilling, collection, and credit checking. Citibank can act as finance

program advisor and developer, providing servicing programs andeducation, training, and marketing support, or play the role of equityinvestor or purchaser of vendors’ portfolios of leases or loans.

The services Citibank and other full-service financial organizationsoffer vendors may be grouped into seven categories:

+ Sales-assistance and training

+ Lease and loan structuring and documentation

+ Credit review

+ Outplacement/investment syndication

+ Funding

+ Administrative services

+ Remarketing/asset management

Let’s examine each category.

S a l es -a s s i st a n c e a n d T r a i n i n g

Education,jointmarketing,support

Sales-related services provided by a third-party creditor range fromhelping the vendor establish an effective financing program byeducating the vendor’s sales force to on-going sales support services,such as customizing deals. Services can include sales force training, joint customer calls, customized lease documentation and marketing

materials, jointly sponsored advertising, and pricing support.




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L e a s e a n d L o a n S t r u c t u r i n g a n d D oc u m e n t a t i on

Third-partylessor’s

expertise

This is an area where third-party creditors offer a great deal of addedvalue. The third-party company works with a vendor to develop

financial products and customize individual transactions to the needsof a particular lessee or borrower. The vendor benefits from the third-party’s expertise in structuring lease and loan products. The vendorcan also rely on the third-party creditor for help in preparing,processing, and tracking the documentation prior to closing thetransaction.

Credi t R ev iew

Customer’scredit-worthiness

Vendors often rely on a third party’s expertise in assessing acustomer’s creditworthiness. Third party creditors can develop andmaintain a credit approval process with integrity because it isindependent of the vendor’s marketing function. The credit reviewprocess usually involves researching the customer’s credit history,analyzing financial statements, and checking references.

O u t p l a c e m e n t a n d I n v e st m e n t S y n d i c a t i on

Lack of capital A lack of capital often causes vendors to seek an equity partner orhave a lease broker sell off its equity investment in leases. Sometimesthe investor buys the entire lease (assumes the credit and residualrisks); other times the vendor sells only the rental stream or theresidual.

F u n d i n g

Direct andindirectfunding

There are many ways to fund a vendor financing program or captive

organization. The method chosen depends on the vendor’s desired taxand accounting consequences.




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There are two basic types of funding − direct and indirect. Indirectfunding involves loans to the captive or vendor, who then uses theborrowed 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. Thethird-party lessor may buy the asset from the vendor and lease itdirectly to the customer, or purchase existing leases from the vendor.

Accountingissues

Whether the vendor, the third-party creditor, or the customer retainsthe residual and tax rights to the asset depends on how the initial saleand 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 accountingconsiderations. In a recourse arrangement, the vendor agrees to stand

behind the customer’s lease payments. Alternatively, the vendor cansell its interest in the residual only, retaining the lease payment streamand associated credit risk.

Adm i n i s t ra t i ve S erv ices

Handlingpaperwork

Vendors may find it more cost-effective to purchase services from anequipment leasing specialist, whose size and leasing concentrationenable it to achieve certain economies of scale. The administrative

services a third-party creditor might provide include booking thetransaction; billing and collecting the monthly lease payments;processing customer service complaints; filing, collecting andremitting sales, use and property taxes; and preparing financialstatements and tax returns.




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R e m a r k e ti n g / A s se t a n d R e m e d i a l M a n a g em e n t

Control overasset

Vendors often seek outside help in remarketing the asset at the end of the lease term or in the event of a customer default. Also, a vendor may

choose to use the asset tracking systems offered by many financingcompanies. These systems alert the lessor as to which assets are comingoff lease, report on the status of any off-lease equipment, and processany subsequent sales or re-leases of any returned equipment. Vendorsmay also need assistance in remedial management to know when atransaction is in trouble and how to work out a solution.

It is important to note that each of the services listed in this sectionhas a cost to the provider of the service, whether the provider be thevendor or a third party. The cost of services is an important point in

marketing vendor programs, the topic of the next section.

SUMMARY

There are many reasons vendors create captive financing companies and vendor programs— market control, market enhancement, ancillary income, tax benefits, and financialleverage. Outsourcing some or all of the financing function helps vendors minimize therisks associated with financing, fund their financing programs, and benefit from third-party

expertise. For Citibank, vendor programs accelerate access to equipment users, expandclient relationships, produce new revenues, establish credibility and prestige, speed dealflow, and reduce credit risk.

Third parties meet vendor financing program needs in a variety of ways. Many providefunding 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 equipmentdisposition.

You have completed the first part of Unit Nine, Vendor Programs. Please complete ProgressCheck 9.1 to check your understanding. If you answer any questions incorrectly, pleasereview the appropriate portions of the text before continuing to the next section, “Marketingand Structuring Vendor Programs.”




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Question 1: Access to the vendor’s equipment knowledge and secondary market are waysfor Citibank to:

____ a) justify risk sharing arrangements.

____ b) gain prestige in the equipment market.

____ c) speed financing transactions.

____ d) reduce credit risk.


____ a) control resale prices of used equipment.

____ b) gain tax benefits.

____ c) reduce risks.

____ d) help sell their products.


____ 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 isto purchase noncompeting equipment at wholesale prices and package it withtheir 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 waysfor Citibank to:

d) reduce credit risk.


d) help sell their products.


b) prevent loss of a sale while the customer seeks financing.

Question 4: One of the ways vendors can increase profits through financing programs isto purchase noncompeting equipment at wholesale prices and package it withtheir own equipment.

a) True




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____ a) it generates incremental sales from bundled services and products.

____ b) sales volume is increased by reducing reliance on discounts off list price.

____ c) it generates income from syndication fees.

____ d) the rate of return from the lease generally exceeds the cost of borrowingto leverage the lease.


____ a) improve sales.

____ b) avoid the risks inherent in leasing.

____ c) gain tax advantages.

____ d) earn a greater return on equity.


____ a) a captive subsidiary.____ b) lease brokering.

____ c) a joint venture.

____ d) an asset tracking system.


____ 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.


b) avoid the risks inherent in leasing.


c) a joint venture.

Question 8: A vendor often finds it beneficial to outsource its lease administration

activity to a leasing specialist because:

a) the third party’s knowledge of leasing and size enables it toadminister leases more efficiently.




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MARKETING AND STRUCTURING VENDOR PROGRAMS

So far, we have focused on the benefits of vendor finance programsand the ways third party creditors can help vendors achieve their goals.

With this foundation in mind, we will now discuss marketing andstructuring vendor programs. First, we describe the common types of vendor financing programs and various risk sharing structures; next, wediscuss marketing and structuring successful programs.

Program Types

There are several ways for a financial institution to provide financingto a vendor’s customers. Here, we describe three basic types of

programs — referral, full recourse, and risk sharing.

Re ferra l

Creditor hascontrol andbears risks

In a referral program, the vendor directs or refers its customers to thecreditor for their financing needs, but does not provide support orrecourse. The creditor may be the only institution the vendor refers itscustomers 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 acceptancecriteria.

Ful l R ecou rse (100% Gua ra n tee)

Vendorassumes allcredit risk

Full recourse refers to an arrangement in which the vendor assumes100% of the credit risk by providing a demand guarantee for 100% of the amount of the transaction. In the event of default, the vendor buys

back the contract for the full amount and is responsible for all follow-upactions related to the contract.




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The vendor controls the credit approval process, but the creditorretains veto rights, which are exercised only for non-credit reasons.This type of guarantee is suitable for smaller programs and smallticket programs.

R i s k S h a r i n g

Split credit orcollateralvalue risks

In a risk sharing (partial recourse) program, Citibank and the vendoragree to share credit and/or collateral value risks. For example, Citibank and the vendor may enter a co-lending agreement in which each funds50% of the transaction. Risk sharing is usually necessary until Citibank earns enough of a specific market to make nonrecourse programsfeasible. Vendor support may be reduced as the vendor and creditor

develop greater experience and historical data in markets.

There are several possible risk sharing arrangements. Because this isCitibank’s preferred approach, we discuss risk sharing in detailseparately in the following section.

Forms of Risk Sharing

Balance with

benefits

Citibank requires some form of risk sharing for major programs in Latin

America, so it is important for you to know about the various types. Of course, most vendors do not want to assume any risk; therefore, thechallenge is to design programs that are better than the other financingarrangements available in the market place. Remember, the vendor’sgoal is to sell more products! The marketing benefits that justify a risk sharing arrangement must be clear to the vendor.

The types of risk sharing we will discuss here are:

+ First loss deficiency guarantee

+ Asset value guarantee

+ Co-lending (Pari Passu)




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Before we describe these mechanisms, let’s look at the objectives of risk sharing from a creditor’s view so that you will understand theimportance of these arrangements.

+ Permit risk acceptance criteria under which 80-90% of eligibletransactions will be approved quickly. When risks are shared,more transactions may be approved.

+ Retain sufficient reasonable business risks so that vendors willencourage their customers to finance equipment through theprogram. Vendors who bear all the risks are unlikely to supportthe creditor, whereas shared risk promotes cooperation.

+ Have sufficient business risk to justify target yields. Thevendor must see that the benefits the creditor offers offset thecreditor’s required margins.

Think about how these objectives may be achieved as you read aboutthe three types of risk sharing mechanisms.

Firs t Loss Defi c i en cy Gua ra n tee (FLDG)

Percentage offinancing

In this risk sharing arrangement, the vendor guarantees an amount equalto 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$10million in transactions, the vendor’s liability under the program wouldbe US$2.5 million (.25 X $10 million).

Loss appliedagainstliability

If a borrower defaults on a contract, the vendor repurchases the contractfor its full face value from Citibank. The vendor then repossesses theequipment 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’sFLDG liability.




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Motivation toresolvedefaults

When the vendor repurchases the defaulted contract, it assumes theresponsibilities and risks of repossessing and remarketing theequipment. For this reason, FLDG arrangements motivate the vendor ordealer to resolve default situations. If the vendor restructures the

transaction instead of creating a loss, the amount of the FLDG liabilityis not reduced. If the vendor cannot repossess and resell the equipmentfor 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 forthe first year is $13,000. Assume that two borrowers in Country Bdefault on their contracts for a total of $10,000. The vendor repurchasesthe contracts and sells the equipment for $4,000, realizing a $6,000loss. In this example, the vendor FLDG is reduced to $7,000 (13,000 -6,000 = 7,000).

Figure 9.4: FLDG schedule of loss positions




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A sset Va l ue G u ara n t ee (AVG )

Collateralvalue

guaranteed

In an asset value guarantee (buy back), the vendor guarantees a collateralvalue for each transaction. The AVG agreement contains a schedule of

values over time at which the vendor agrees to repurchase any equipmentthe creditor repossesses. Thus, the vendor acts as an assured andsecondary market.

It is important for you to know that the program loss rate (includingremedial management, loan work-out, and repossession costs andrisks) for an AVG typically is higher than under an FLDG program.

Co-l end i n g (Par i Passu )

Split creditrisk

In co-lending, a vendor assumes 50 percent of the credit risk of eachtransaction on a transaction-by-transaction basis (either directlyextending 50 percent of the funding or providing a demand guarantee for50 percent). Citibank and the vendor separately approve or veto eachtransaction. This type of risk sharing is most suitable for programs withlarger transactions where the vendor has sound transaction screeningpractices and a credit process with integrity.

Com par i son

Each of the program types and risk sharing mechanisms described inthis section affect turn around time, approval ratios, the cost of thedelivery system, and the degree of risk shifting differently. To helpyou visualize these differences, we’ve summarize them in Figure 9.5




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Referral0%

Guarantee

FullRecourse

100%Guarantee

First LossDeficiencyGuarantee

Co-lending50%

Guarantee

Asset ValueGuarantee

Turn-AroundTime

Medium Fast Fast Slow Fast

Control of CreditCriteria

Citibank Vendor Vendor Citibank andvendor,indepen-dently

Citibank

ApprovalRatio

Low. Onlyupper tiercustomers arelikely toqualify.

High. Allcustomerclassesincluded.

High. Smallhigh-risk borrowerscould beincluded.

Low. Smallhigh-risk andmedium-sizeborrowerswould beexcluded.

Medium.Small, high-risk borrowerswould beexcluded.

Cost of DeliverySystem

High Low Low High Low

RiskShifting to

Citibank

Vendor shiftsall program

risks toCitibank

No programrisks shifted

to Citibank

Risk shiftingto Citibank

limited

Risk shiftingto Citibank is

explicit andagainst allrisk categorieswith vendorretaining allrisk types

Risk shiftingto Citibank is

significant.Vendorretains risk type(collateraland resalevalues)

Figure 9.5: Program comparison




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Structuring Vendor Programs

Successcriteria

As you might assume, each of the program types we just discussed —referral, risk sharing, and full recourse — requires a different

structuring approach. The officer’s goal should be to develop a regionalor country-specific vendor financing partnership that will build on thestrengths of each party, keeping in mind how the program structure willmotivate the vendor to support the creditor, especially in defaultsituations. In a successful program, the vendor sells more equipment,Citibank transacts more loans and leases, and defaults are controlled.

To build a successful program, the officer must:

+ Select vendors carefully

+ Effectively market the services

+ Design a program that will meet the vendor’s sales goals andprovide Citibank with the margins it needs

The following discussions will help you understand these points.

Vend or Se lec t ion Cri t er ia

Vendor selection is the first step in building a successful vendorprogram. In this section, we identify the vendor selection criteriaCitibank has developed. The criteria will help you recognize vendorsthat make good candidates for vendor finance programs.

Existingrelationship

The ideal vendor has an existing relationship with Citibank and servesone of the target asset based financing industries. Strong candidatesbelieve that customer financing plays a key role in its sales andmarketing efforts. Other criteria are:

+ Creditworthy (public debt rating of “A” or better)

+ Has multicountry, multiproduct capabilities

+ Holds dominant market position in key markets

+ Market area has few if any captive leasing or finance companies




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+ Good potential financing volume in region or country (forexample, US$100 million)

+ Average cost of equipment is greater than US$75,000

+ Equipment is moveable and has stable collateral values

+ Customers have limited access to external capital, especiallyunsecured capital

Now let’s discuss how to market to selected vendors.

M arke t i ng

Assess need Once you have determined that a vendor meets the selection criteria,you should:

+ Find out what the vendor is doing now

+ Find out what is not working now

+ Find out what the vendor has tried before

As you go through this exercise, think about how the services Citibank offers might solve the vendor’s problem. Recall the seven categories

of services — help with sales and training, transaction structuring anddocumentation, credit review, capital for equity, funding,administrative services, and remarketing/asset management.

Collect basicinformation

Next, gather the basic information required to develop a preliminaryprogram structure. See Figure 9.6 for a list of key questions.




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What is the revenue potential?

What are the key risks?

What data is available on historical loss and delinquency performancefor the vendor’s equipment?

What is the existing break down of the target market? How might thevendor financing program change the target market?

What are the limitations on legal repossession and sales of assets?

What are the tax and accounting objectives of the customers?

How big is the secondary market for the equipment and what are thedistribution channels?

If novel or complicated financing products are to be offered, whatlevel of financial education and marketing is required?

Figure 9.6: Information needed to structure a vendor program

P r og r a m O u t l i n e

Contents Once you have the answers you need, develop a preliminary programoutline. The contents of a program outline should:

+ Identify common interests

+ Provide for a highly consistent regional program with theability to tailor financing for individual markets

+ Describe how local delivery systems (vendor marketing andCitibank financing units) will work together

+ Balance rates with service quality and value-added services,such as marketing support




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+ Provide for balanced, limited risk sharing and initial supportthat allows Citibank a high transaction approval rate and quick turn-around time. The approval ratio and turn-around time areextremely important to vendors and their customers.

+ Address critical issues such as default provisions, thedefinition of loss, who will deal with loss, and who will handlerepossessions

+ Provide for on-going program monitoring and adjusting

+ Contain incentives and flexibility

+ Specify the margin Citibank requires

Remember, vendors want nonrecourse programs. You must build arisk reward package to justify Citibank’s margins to customer!

SUMMARY

In this section, we discussed three basic types of vendor programs — referral, full recourse(100% guarantee), and risk sharing. The most common forms of risk sharing arrangementsare:

+ First loss deficiency guarantee

+ Asset value guarantee

+ Co-lending

The type of program affects the average length of time it takes to process a transaction, thetransaction approval rate, and the cost of the delivery system. It is important for vendors tounderstand 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 programapproval rates are typically low.




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To build a successful vendor program, the officer should evaluate vendors against Citibank’sselection criteria, identify vendors that would benefit from a financing program, andstructure a program that helps the vendor increase sales and provides Citibank with therequired 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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Question 1: In a full recourse arrangement, the creditor’s credit risk is:

____ a) 100 percent.

____ b) 50 percent.

____ c) 0 (zero) percent.

Question 2: Requiring the vendor to share credit and/or collateral risks is not necessarywhen 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 isreduced by:

____ a) the amount of the vendor’s loss when it is unable to repossess and resellequipment.

____ b) the difference between the amount of the original transaction and therestructured transaction.

____ c) the difference between the purchase price of the equipment and the resaleproceeds.

____ d) the percentage specified in the FLDG agreement (for example, 20percent).

Question 4: In an asset value guarantee (buy back), the vendor:

____ a) reimburses the creditor if the collateral resale value is below marketprice.

____ b) purchases defaulted contracts from the creditor.

____ c) agrees to repossess and resell the equipment.

____ d) is a certain, secondary market.




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ANSWER KEY

Question 1: In a full recourse arrangement, the creditor’s credit risk is:

c) 0 (zero) percent.

The vendor assumes all the credit risk.

Question 2: Requiring the vendor to share credit and/or collateral risks is not necessarywhen the vendor’s credit rating is “A” or better.

b) False

The reason we ask vendors to share risks is to create a financing arrangement that will be attractive enough to motivate the vendor’s customers to buy while

permitting Citibank to attain its target margin. The credit rating of the vendor

is not a factor.

Question 3: In a first loss deficiency guarantee, the amount of the vendor’s liability isreduced by:

c) the difference between the purchase price of the equipment and theresale proceeds.

Question 4: In an asset value guarantee (buy back), the vendor:

d) is a certain, secondary market.

In an asset value guarantee, the vendor agrees to buy back collateral that the

creditor repossesses at the price specified in the AVG schedule; thus, the

vendor is a guaranteed secondary market.




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Question 5: Turn-around time in a co-lending arrangement is typically:

____ a) slow.

____ b) fast.

____ c) medium.

Question 6: Select the two risk sharing mechanisms that may best benefit the creditorwhen the secondary market is questionable.

____ a) Full recourse____ b) Asset value guarantee

____ c) Co-lending

____ d) First loss deficiency

Question 7: Select two signs that may indicate that company is a good candidate fora vendor program.

____ a) The vendor’s customers have limited access to capital.

____ b) Equipment resale values are stable.

____ c) The equipment manufacturer’s market share is low and they need to sellmore equipment.

____ d) The vendor’s products are permanent fixtures that are unlikely to“disappear.”

Question 8: A vendor program should be structured to allow a high transaction approvalrate and quick turn-around time.

____ a) True

____ b) False




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ANSWER KEY

Question 5: Turn-around time in a co-lending arrangement is typically:

a) slow.

Both the vendor and the creditor must approve each transaction separately,

which tends to take more time.

Question 6: Select the two risk sharing mechanisms that may best benefit the creditorwhen 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 fora vendor program.

a) The vendor’s customers have limited access to capital.

b) Equipment resale values are stable.

The vendor should hold the dominant position in key markets, and the

collateral should be moveable so that repossession is easier.

Question 8: A vendor program should be structured to allow a high transaction approvalrate and quick turn-around time.

a) True

The vendor will sell more equipment under these conditions.



Unit 10



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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 thisindustry and the factors that affect franchise lending decisions. You will see that a banker’sapproach to franchise financing is somewhat different from the approach to leasing.

UNIT OBJECTIVES


+ Recognize common terminology associated with franchise financing

+ Understand the franchise financing markets

+ Identify the key considerations in franchise credit analysis

+ Understand the legal considerations of franchise finance

WHAT IS A FRANCHISE?

In this section, we explain what a franchise is and define common

terms used in this industry. We also look at the types of franchisestores and ownership options. This overview will prepare you for theconcepts presented in the remainder of the unit.



10-2 FRANCHISE FINANCING

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Franchise Industry Terms

Definitions ofkey terms

A franchise is a license offered by a company that grants the right toothers to sell its products and operate under the same business name.

For example, the Taco Bell™ restaurant system sells franchiselicenses to owner/operators so that they can open Taco Bellrestaurants and sell the same food products as other Taco Bell outlets.The company that sells licenses to operate under its business name iscalled a franchisor. The owner/operator who purchases the license iscalled the franchisee.

Agreements The license is governed by a franchise agreement for which thefranchisor requires an up-front franchise fee, ongoing royalties, andadvertising fees. The franchise agreement spells out the

responsibilities of the franchisor and franchisee, defines remedies foragreement violations, and specifies the renewal options and the periodcovered by the agreement. A key component is the right of thefranchisor to terminate the franchise agreement if the franchisee failsto perform and remedy any default. Later in this unit, we describe howthese provisions affect lenders such as Citibank.

Typically, in addition to the franchise agreement, a franchisee signs anagreement for the right to develop stores in a given territory. This

development agreement specifies the number of stores to be opened

in the territory and the number of years in the development period.

Advantages In addition to the right to sell under a recognized name, a franchiseagreement provides a franchisee a system for doing business and manyother valuable services that give a franchise business strength andvalue. Franchises are popular for this reason.



FRANCHISE FINANCING 10-3

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Franchisorscreening

It is important to note that franchisors receive many applications forfranchise licenses, but grant the right to own and operate a franchise tofew. Franchisors carefully screen applicants for successful business

experience and financial strength. Franchisors also require successfulcompletion of in-store training and textbook courses. What this meansto Citibank is that those who are granted franchises may tend to bebetter risks. Also, the franchisor may serve as an important source of information about the prospect.

Franchise Sales Outlets

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:

Free-standing Store is free-standing and not attached to anyother building

In-line Store is one of many businesses in a givenbuilding, which is usually a strip center withseveral vendors or tenants. Customers access

each business from outdoors.

In-mall This is an outlet that is inside an enclosedshopping area called a mall. Customersaccess the outlet from inside the mall. Thestore may have its own seating or may shareseating with other food outlets in what iscalled a food court .

Kiosk This is a small unit that sells a cookedproduct prepared at a different location. Thecooked product is brought to the kiosk duringthe peak hours; the menu offerings arelimited. Kiosks are prefabricated and requireassembly, making them somewhat portable.




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DELCO This is a term used by Pizza Hut™, and is anacronym for “delivery and carry-out.” Thistype of outlet does not have seating.

Express unit This is another term used by Pizza Hut. Itrefers to restaurants that sell only smallpersonal pizza (for one person) and pizza bythe slice.

Ownership Options

Companies that sell franchises to owner/operators may also own andoperate their own stores and enter partnership agreements to own and

operate stores. Citibank does not finance company-owned stores;the stores must be 100% franchised.

Categories Of course, even though a restaurant is 100% franchised, the franchiseestill has various options for owning the land, building, furniture,fixtures, and equipment. Let’s look at the three categories of ownership:

Fee S im ple

The franchisee owns the land, building, furniture, fixtures, andequipment (LBFF&E).

G r ou n d L e a s e

The franchisee leases the land from a third party and constructs thebuilding. Here, the franchisee owns the building, furniture, fixtures,and equipment (BFF&E).




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La nd an d Bu i l d i ng Lease (Leaseho l d )

The franchisee finds an investor who owns the land and is willing toconstruct the building and lease the property to the franchisee for a

specific period. The franchisee owns only the furniture, fixtures, andequipment (FF&E).

Each of the options described above has product, legal, and creditimplications for Citibank. Later in this unit, we will see how Citibank’sfranchise finance products and credit practices address thefranchisee’s financing needs. First, let’s examine the franchiseindustry markets.

FRANCHISE INDUSTRY MARKETS

So far, you have been introduced to common franchise industry terms,various types of franchise stores, and ownership options available tothe franchisee. Keep this background in mind as we discuss franchiseindustry markets.




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Fast-foodrestaurants

The franchise industry consists mainly of fast-food restaurant systems

such as Burger King™, Kentucky Fried Chicken (KFC) ™,

McDonalds™, Pizza Hut™, and Taco Bell. We often refer to arestaurant system as a concept.

Citibank Bankers Leasing - Franchise Finance (CBL-FF), located inIrvine, California, is a national lender to major fast-food concepts inthe U.S. Included in its loan portfolio are franchisees of the restaurantconcepts listed above, which are considered Tier I business. Citibank defines Tier I business as the top two franchise concepts in total salesin each primary food group. For example, in the U.S., McDonalds andBurger King are the Tier I hamburger concepts. We will have more tosay about Tier I concepts in the next section. Tier II businesses arenational or regional chains with strong market share or concentration

in a given area. Citibank does finance some Tier II restaurant concepts,as well as gas station franchises, but is selective about lending to thesebusinesses. Also, Citibank may consider other types of franchisedbusinesses. (Some retail stores and dry cleaning companies offerfranchises.)

Tier I Franchise Restaurant Systems

Strengths A major reason that Citibank focuses on Tier I concepts is that they

provide many important services and benefits that improve thefranchisees’ chances of success. Among these are:

+ Good initial and ongoing training

+ A proven system for developing uniform and consistentproducts

+ Advertising and marketing expertise

+ Good restaurant site selection criteria and support

+ Supplier arrangements

+ Brand name recognition

Let’s examine three of these services and see how they contribute tothe success of the business.




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Fran ch i sor O pera t i ons and Con t ro l S yst em s

Forcedcompliance

with standards

Tier I franchisees are expected to follow prescribed operating andfood preparation procedures and standards that promote consistent

quality, service, and cleanliness throughout the restaurant system.Franchisors monitor and audit franchises throughout the year andexpect those who fail to meet standards to remedy the problem withina given time, often with the frachisor’s help. From a loan officer’sview, the expected consistency and regular monitoring help maintainthe value of the business.

S i t e S e lec t ion Exper t i se

Site studies One of the many benefits to Tier I franchisees is the site selectionexpertise the franchisor provides. Tier I franchisors develop siteselection studies to identify preferred or ideal sites and make thecriteria available to franchisees. The study and criteria do notguarantee success, but have proven to be a very good tool foridentifying good restaurant sites. As a safeguard, the franchisee is notpermitted to begin construction until the franchisor has approved thesite, the store plan, and the architecture.

Salesprojections

Franchisees use the information gathered during the site study to

project sales and cash flows on the proposed site and review theseprojections with the franchisor to determine how reasonable they are.Later, we will see how Citibank uses these projections in creditanalysis. The point you should remember is that from a lender’sstandpoint, careful site selection and realistic projections tend tolessen the risk of default.




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S u p p l i er A r r a n g e m e n t s

Approvedproducts and

equipment

Tier I franchisors work with franchisees to identify suppliers of equipment and inventory to make the product for a restaurant. A

supplier may be the franchisor, a local company, or a foreign supplier.In any case, franchisors work to ensure that suppliers distributeapproved products and equipment to the franchisee. Like the otherservices we’ve discussed in this section, supplier arrangements helpincrease the franchisee’s chances of success.

As you can see, there are many advantages in lending to Tier Iconcepts. Next, we will look at the status of the fast-food industry inthe U.S. and see how business there has influenced interest in othermarkets such as Latin America.

The U.S. Franchise Industry

Slow growth In the U.S., the fast-food business is a maturing industry that continuesto 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 markethighly competitive.

Foreign Markets

Expandingopportunities

Because growth opportunities are limited in the U.S., companies thatfranchise fast-food restaurants are expanding in Asia, Europe, LatinAmerica, and the Caribbean. In Latin America and the Caribbean alone,fast-food companies will require an average of US$241MM in capitalinvestment from their franchisees per year. This investment represents237 new stores per year that require financing! As you can see, thesignificant expansion planned by these companies presents a huge

opportunity for Citibank, which is positioning itself to take a largeportion of this business.




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Agreementswithfranchisors

One way that Citibank is helping increase its market share is throughcooperative agreements with franchisors. An example is the letter of understanding with the PepsiCo Group, which includes KFC, PizzaHut, and Taco Bell restaurant companies. This agreement states that

the PepsiCo Group and Citibank will work together and shareinformation to increase finance capability in Latin America and theCaribbean (CARIBLA).

Of major benefit to Citibank is the support and assistance PepsiCoprovides to resolve loan default situations that may arise. For example,if a franchisee defaults on a Citibank loan or lease, a member of thePepsiCo group assists Citibank in:

+ Locating another franchisee capable of assuming operation of

the business

+ Reviewing the franchisee’s business to determine if it is aviable operation

+ The sale of the franchisee’s business

CBL-FF is discussing similar arrangements with other franchisors. It is important to remember that Citibank’s relationship with a

franchisor is a key factor in building a successful franchise

portfolio.

FRANCHISE FINANCE PRODUCTS AND PROSPECTS

The preceding discussion of franchise industry markets revealed thatthe franchise market is expanding in Latin America and the Caribbean.Next, we will examine Citibank’s franchise finance products andexplore ways to identify and take advantage of these growing franchisefinance opportunities.




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Franchise Products

Asset typesand tenors

In both Latin America and the U.S., Citibank provides financing forreal estate and furniture, fixtures, and equipment to licensed

franchisees. In this unit, we focus on loans, but you should note thatCitibank will consider leasing equipment to franchisees in LatinAmerican markets as well. Loan tenors offered depend on the asset tobe financed. In the U.S., funds are offered for tenors of five, seven,and ten years, with up to fifteen years amortization on land andbuilding loans.

Most franchise loan products fall into three main categories: securedterm loans, secured nonrevolving lines of credit, and fee simple realestate loans. All loan products are secured by a pledge of collateral.

Let’s examine each category.

S e c u r ed T e r m L o a n s

Old and newobligations

These loans are issued for financing existing and new stores,refinancing and consolidating existing debt, market acquisitions (oneoperator buys existing stores from another franchisee), and financingpersonal obligations such as stock repurchases.

S ecu red N onrevolv ing L in es o f Credi t

Projectfinancing

Financing of new stores is often done with a line of credit thatconverts to term financing upon the completion and opening of thenew store (a form of project financing). Lines are generally availablefor a one- or two-year period. Citibank does not provide workingcapital.

Fee S i m p l e Rea l Es t a t e

Longer terms Longer term financing (up to 10-year tenors with 15-yearamortization) is provided when there is real estate collateral.Typically, a rate review is scheduled about midway through the loanterm.




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You can see that Citibank provides products to meet all a franchisee’scapital and real estate needs, from furniture and fixtures to buildingand land. With this knowledge, you are better prepared to search forfranchise financing opportunities.

Franchise Financing Opportunities

Identifyopportunities

Franchise financing opportunities come in many forms. Look forremodeling projects, expansion projects, and system upgrades. Alsobe alert for the introduction of new products. New products oftenmean the franchisee must acquire new equipment to produce theproduct!

Quantifyopportunity Once you’ve identified an opportunity, find out whether theopportunity is large enough to justify Citibank’s involvement. Howmany outlets are franchisee operated, and how many are companyoperated? What is the dollar size of the financing project? How manyoutlets are affected? What is the timing? What type of operatorneeds the financing (average, good, poor)? Who are the existinglenders?

Assesscollateral

Next, consider the collateral. Who controls the location? What assetsare owned by the operator? (Generally, the more control over the

property Citibank has, the more attractive the deal.) What franchisorsupport is available?

Evaluateagreements

Finally, examine the franchise and lease agreements. What is thelength of the agreements? What are the renewal options? What arethe responsibilities and obligations of each party? What remedies areavailable to the franchisor for noncompliance? What is the operatorturnover history? Are there exclusive rights to a territory? What arethe fees and costs? Are there restrictions on operating other types of businesses?

As you begin to work on franchise deals, we suggest that youperiodically review this process to make sure you have completeinformation for an assessment of the opportunity.




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SUMMARY

A franchise is a license offered by a company (franchisor) that permits an owner/operator(franchisee) to sell the franchisor’s products and operate under the same business name.

The license is governed by a franchise agreement that details the rights and remedies of each party to the agreement. Franchises are attractive because they offer name recognition,leverage with suppliers, business expertise, training, and a system of operations andcontrols.

The franchise industry market consists mainly of fast-food restaurant systems. Suchrestaurant systems are referred to as concepts. Citibank targets Tier I concepts, which arethe top two franchise concepts in total sales in each food product group. The reason for thisfocus is that Tier I concepts provide many important services to their franchisees that tendto 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 estateloans. Once a franchise financing opportunity has been identified, it is important to quantifythe opportunity, assess the collateral, and evaluate the terms in the franchise agreements toadequately judge its value to Citibank.

You have completed the first part of Franchise Financing. Please complete the ProgressCheck and then continue with the section on “Credit Analysis.” If you answer any questionsincorrectly, please review the appropriate text.




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Question 1: A license offered by a company that allows an owner/operator to open andoperate an outlet under the company’s business name is called a(n)__________________________.

Question 2: Match each ownership option with a description of the option. Write theletter of the description next to the name of the option.

Ownership Option Description

______ Leasehold a) The franchisee leases the land and ownsthe building, furniture, fixtures, andequipment.

______ GroundLease

b) The franchisee owns the land, building,furniture, fixtures, and equipment.

______ FeeSimple

c) The franchisee leases the land andbuilding and owns the furniture, fixtures,and equipment.

Question 3: The franchise industry consists solely of fast-food restaurant systems such asKFC, McDonalds, and Pizza Hut.

____ a) True

____ b) False




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ANSWER KEY

Question 1: A license offered by a company that allows an owner/operator to open and

operate an outlet under the company’s business name is called a franchiseagreement.

Question 2: Match each ownership option with a description of the option. Write theletter of the description next to the name of the option.

Ownership Option Description

c Leasehold a) The franchisee leases the land and owns

the building, furniture, fixtures, andequipment.

a GroundLease

b) The franchisee owns the land, building,furniture, fixtures, and equipment.

b FeeSimple

c) The franchisee leases the land andbuilding and owns the furniture, fixtures,and equipment.

Question 3: The franchise industry consists solely of fast-food restaurant systems such asKentucky Fried Chicken (KFC), McDonalds, and Pizza Hut.

b) False

Gas stations, laundry and dry cleaning companies, retail stores, and other

companies offer franchises.




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Question 4: Select two basic characteristics of Tier I markets that influence the value of their franchise outlets:

____ a) Promote consistent standards of quality and service

____ b) Help resolve loan default situations

____ c) Provide good initial and ongoing training

____ d) Guarantee the franchisee’s debts

Question 5: The purpose of a site study is to:

____ a) obtain site approval from the franchisor.

____ b) ensure that product and equipment suppliers are available in the area.

____ c) identify good locations for outlets.

____ d) determine the value of the land collateral.

Question 6: Select the franchise loan product offered for refinancing, consolidatingexisting debt, and purchasing existing stores from another franchisee.

____ a) Secured term loan

____ b) Secured non-revolving line of credit

____ c) Fee simple real estate

Question 7: Select the two best franchise financing opportunities:

____ a) A Taco Bell franchisee plans to expand ten outlets.

____ b) A new restaurant chain begins to offer franchises in your country.

____ c) A Pizza Hut franchisee needs to replace two ovens.

____ d) KFC introduces a new chicken product that requires different cookingequipment.




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ANSWER KEY

Question 4: Select two basic characteristics of Tier 1 markets that influence the value of

their franchise outlets.

a) Promote consistent standards of quality and service

c) Provide good initial and ongoing training

Franchisors do not normally help resolve loan default situations unless they

have a prior agreement with the lender to do so.

Question 5: The purpose of a site study is to:

c) identify good locations for outlets.

Question 6: Select the franchise loan product offered for refinancing, consolidatingexisting debt, and purchasing existing stores from another franchisee.

a) Secured term loan

Question 7: Select the two best franchise financing opportunities.

a) A Taco Bell franchisee plans to expand ten outlets.

d) KFC introduces a new chicken product that requires nonstandardcooking equipment.

The opportunities that involve a number of outlets are most likely to result in

transactions that are large enough to justify Citibank’s effort.




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CREDIT ANALYSIS

So far, we’ve seen that franchise financing, particularly of Tier Iconcepts, can be an attractive market for lenders because of the many

benefits they offer franchisees, and that the value of a transaction isaffected by the size of the deal and the type of collateral that securesthe loan. In this section, we will see how these ideas are applied infranchise credit analysis.

Four aspects As you may have concluded from our earlier discussions, the creditanalysis process for franchise financing is somewhat different than theprocess for other types of asset based financing because of the natureof the industry. In the following sections, we discuss three aspects of franchise credit analysis:

+ Industry risks and offsets

+ Ways out

+ Information requested from the borrower

We begin with the types of industry risks in franchise financing.

Industry Risks and Offsets

Portfolio level There are several credit risks inherent in the franchise industry that areimportant for you to know. We label these risks industry or program

risks because they are usually addressed in the broader context of thefranchise portfolio rather than in individual credit memos. In thissection, we discuss five such risks. This discussion will increase yourunderstanding of the franchise industry and the strategies lenders useto minimize franchise industry risks.

M a r k et S h a r e

Competitionrisk

The franchise fast-food industry is a maturing market wherecompetition is intense. The battle for market share increases the levelof risk within this industry.




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Offsetstrategies

To minimize this risk, lenders such as Citibank may use thesestrategies:

+ Target franchises with strong market share and strong financial

strength (relative to the industry) that maintain strong namerecognition through effective marketing campaigns.

+ Avoid overexposure to any one market segment.

+ Lend only a portion (for example, 80%) of the estimatedcollateral value to maintain an adequate collateral cushion, anduse financial ratio covenants (agreement clauses in the loancontract) to identify financial deterioration early on.

F r a u d u l e n t C on v e ya n c e

Transfer ofsecurityinterests

For tax or other ownership reasons, it is common for fast-foodfranchisees to establish several companies under which they operatetheir restaurants. These business owners may use properties they ownfrom one company to back a loan for one of their other companies.Sometimes, prior to bankruptcy, an owner may transfer ownership of an asset from one company to another to avoid debt or to hindercreditors. This is called fraudulent conveyance. In addition tofraudulent conveyance, the concern to an asset based lender is that

other creditors may legally void transfers of security interests undercertain circumstances, even when there has been no intent to defraud.

Here are some approaches for offsetting this risk:

+ Investigate the borrower’s viability during the due diligenceprocess and document the rationale for doing the deal.

+ Avoid structuring deals with cross-stream (subsidiaryguarantees another subsidiary) and upstream (subsidiaryguarantees parent company) guarantees whenever possible.




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+ Include solvency provisions drafted from the region’sapplicable fraudulent conveyance statutes along with financialprojections as an exhibit to the loan agreement. Obtain writtenacknowledgments of the lender’s security interest (lien) from

major suppliers and from the company’s officers.

Com m odi t y an d L abor Pr i ce Increases

Effect on cashflow

Commodity prices are relatively stable, but unpredictable. Labor costsmay increase because of labor shortages, minimum wage legislation,and requirements for minimum health benefits. Increases in thesecosts could adversely affect the borrower’s cash flow.

Business

solutionsFranchisors and franchisees have some control over these risks.Franchisees can pass on some or all of a cost increase to theircustomers by increasing menu prices. To offset commodity costincreases, franchisors can change their product mix, offering a lower-cost item to offset the more costly commodity. The major franchisorsaddress the cost of labor by automating their food preparationprocesses to limit the amount of workers needed.

Coverageratios

One way lenders mitigate these risks is by requiring the borrowers tomaintain cash flow coverages greater than 1:1 (the point at which thecash flow available to cover debt is exactly same as the debt service

requirement of the business). The coverage ratio is set to provide acushion so that cash flow will still cover costs if they should increase.

N o S ecur i t y In teres t in th e Fran chi se L icen ses

Right to sellas goingconcern

Franchise licenses generally prohibit lenders from taking a securityinterest in the franchise rights. This means a lender such as Citibank can’t sell or take over the operation of stores it has financed.

Here are two ways this type of risk may be mitigated:




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+ Execute a letter of understanding with the franchisor to gain thefranchisor’s assistance in evaluating the location in the event of a default and in locating a new franchisee to buy the store.

+

Secure a first perfected interest in the furniture, fixtures, andequipment of the restaurant, real property/leasehold rights, anda pledge of stock (if possible). This is a legal approach thathelps Citibank keep the restaurant open until a buyer is locatedand bars the franchisor or third party from taking securityinterest or obtaining clear title to the site before Citibank.

Lender L i ab i l i t y U nd er Env i ronm en t a l La w

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 asecured lender an owner, a lender may be responsible for the costs of cleaning the site. The risk is usually in the restaurant site’s previoususe. If the site was contaminated by a previous user and the site wasnot cleaned or was not cleaned properly, the lender could be liable. It is important for your unit to understand the laws in your region

and take steps to mitigate the risks.

U.S. mitigation

strategies

In the U.S., Citibank manages environmental liability risks by not

exercising undue control over the property and by not foreclosing onproperties that could be contaminated. Also, CBL-FF’s practice of lending to multi-unit operators helps spreads the risk over severalproperties. Citibank’s risk is further mitigated by its standard loanprovisions and documentation, which require the borrower toindemnify Citibank of all potential liabilities relating to a hazardouswaste cleanup and allow Citibank to perform environmental audits onany 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 cleanupperiod. In the U.S., this risk is mitigated by the business interruptioninsurance that many of our borrowers carry.




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As you can see, a creditor has a number of risks and mitigants toconsider in the credit analysis process. In the next section, we discuss

another set of considerations − ways out.

Ways Out

Two ways out Earlier in this course, we stated that in asset based financing there is agreater need to analyze “ways out” than in other types of financing.Recall that “ways out” refers to the ways an obligation is satisfied. Inthis section, we look at three ways franchise debt is satisfied. As youread about these, keep in mind that the ways out of a particulartransaction depend on the transaction’s structure, the nature of theassets involved, and the specific markets involved.

Cash F l ow f rom O pera t i ons

Covers debtservice

The first “out” a lender relies on is that cash flow from operations(either historical or projected) covers debt service by a specificmargin. In franchise financing, there is more reliance on cash flowthan collateral. The goal here is to structure transactions that do notrequire the sale of assets or stores to repay debt.

S ale o f S tores

Value as agoing concern

If cash flow fails, debt may be satisfied through the sale of a store,group of stores, or the entire company. Since the franchise creditphilosophy is based on the value of the restaurants as going concerns,the borrower is encouraged to sell the store as a going concern (withthe assistance and approval of the franchisor). This option is possiblebecause of the strong secondary market that exists in most countriesfor the restaurants of certain concepts, particularly Tier I concepts.




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S a l e Leaseback

Proceedsfrom sale to

pay debt

For franchisees who own the real estate under their restaurants, saleleasebacks are an option to satisfy obligations. In a sale leaseback, the

franchisee sells the property and then leases it back. The proceeds of the sale may be used to pay down debt while the franchisee continuesto operate the restaurant.

Credit Analysis Information

Itemsrequestedfrom borrower

Now that we’ve seen the industry (program) risks in franchisefinancing and some of the ways lenders address these risks, we’ll shiftour focus to individual transactions. In this section, we present a list

of items the officer requests from the borrower to assess creditcapacity.

Proposal andcommitmentletter

Before we begin the list, let’s review two types of documents we issue

the potential borrower − the proposal and the commitment letter. Theproposal outlines the terms and conditions under which Citibank iswilling to consider a credit application and recommend approval to aCitibank credit officer. It includes the loan to value ratio (the ratio of the loan amount to the value of the collateral), interest rates, andcovenants. A commitment letter is an acknowledgment of credit

approval and availability, and includes all terms and conditions.

The items described below represent information the officer gathersbefore issuing a proposal and commitment letter. Ideally, the officerobtains and analyzes all the items. Of course, it may not be possible toobtain every item for every transaction! We recommend that you viewthis list as a set of guidelines and ask for direction from CBL-FF whenyou are unable to obtain an item.

B u s i n e ss F in a n c i a l S t a t e m e n t s

Balance sheetand incomestatements

Accountant-prepared financial statements and internally preparedfinancial statements should include the following:




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+ Balance sheets, income statements, changes in financialposition, and sources and uses of funds for

− Each of the last three year-end periods

− The most current year-to-date period and for thecomparable prior year-to-date period

+ On both an annual basis and on a per-month basis, individual andconsolidated store sales history for the last three-year periodand, if available, through the current year-to-date period.

Projec t ions

Individualstore andgroup figures

Recall that franchisees generate projections from informationgathered during the site study. You should request these salesprojections for each individual store and for the group of stores thefranchisee owns. Projections for new stores should be for the first 12months of operations. Request that the franchisee prepare theprojections in the same format as the internally prepared profit andloss statements, as this will simplify the analysis.

O w n e r s h i p S t r u c t u r e

Identifymanagementstructure

Request a list of all affiliated and interrelated companies and theowners of each company. With regard to multiple owners orshareholders, identify the percent of ownership of eachowner/shareholder. Also ask for an organization chart.

P e r so n a l F in a n c i a l S t a t e m e n t s

Owners’financialposition

Request a personal financial statement for each major owner or

shareholder that lists all assets, liabilities, and net worth.




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S t ore In f orm a t i on

Ask for a list of all the stores the franchisee operates, and thefollowing information on each store:

+ Restaurant type (free-standing, mall, in-line, etc.)

+ Owned or leased

+ Opening date

+ Monthly rent payment and lease expiration date

Ex i s t ing L ease an d Loan In f orm a t i on

Current debt For each lease and loan, request the debt amount (original balance andcurrent balance, payment amount and frequency of payment), annualinterest rate, collateral for the loan (type and location), maturity dateof financing, and owner/shareholder personal guarantees.

C a p i t a l I n v e st m e n t s /F in a n c i n g N e e d s

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 openingdate for each store.

D ocum en t a t i on

Before issuing a commitment letter, the officer should obtain andreview copies of the following:

+ Franchise and development agreements

Franchise agreements usually change with time and differamong franchisors; therefore, an officer should always reviewthe agreement carefully to understand terms, conditions, rights,and remedies of both parties.




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+ Applicable deeds of trust when Citibank finances propertiesin which the land and building is owned by the franchisee

+ Applicable leases on the subject store properties when Citibank

finances leasehold properties

+ Applicable articles of incorporation. These are documents filedwith a government body authorizing a business to actas a legal entity. This document describes ownership,shareholders, board of directors, and type of business.

+ Site/demographic studies for proposed sites

As you can see, the type of information the officer gathers forfranchise financing credit analysis is similar to the information

gathered for leasing and vendor credit analysis. In the next section, wewill 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 analysisinformation requested from the borrower. We saw that there are several risks inherent in

the franchise industry:

+ The battle for market share

+ Fraudulent conveyance

+ Commodity and labor price increases

+ Lack of security interest in the franchise license

+ Lender liability under environmental law

Industry considerations are generally addressed at the portfolio level. Another set of

considerations − the ways out of a franchise obligation − include cash flow fromoperations, sale of stores, and the sale/ leaseback.




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To assess creditworthiness, the officer requests several types of credit information frompotential franchise borrowers: financial history and sales projections, the ownershipstructure and personal financial statements, existing lease and loan information, financingneeds, 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 theProgress Check and then continue with the section “Credit Analysis Process.” If you answerany questions incorrectly, please review the appropriate text.




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Question 1: When franchisees transfer the security interests in property of one companyto 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 alender requests from a franchise prospect is:

____ a) usually more trustworthy.

____ b) more detailed.

____ c) very much the same.

____ d) more sales-oriented.




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ANSWER KEY

Question 1: When franchisees transfer the security interests in property of one company

to another company they own, the lender may be at risk for fraudulentconveyance.

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 throughcash flow.

Question 4: Compared to leasing and vendor credit, the type of credit information alender requests from a franchise prospect is:

c) very much the same.




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Credit Analysis Process

The type of information the officer gathers from a prospect wasdiscussed in the previous section. The next step is to analyze the

information. In this section, we focus on several aspects of thefranchise financing credit analysis process. You will see somesimilarities to the process used in equipment leasing, but you will alsosee several differences. What are the reasons for the differences?

Comparison toequipmentfinancing

Like equipment leasing, franchise financing is secured by one or moreassets (the land, building, and the furniture, fixtures, and equipment).The difference between equipment financing and franchise financing isthat franchised stores do not have the same remarketingcharacteristics as equipment; they are less liquid and more difficult to

remarket. For this reason, lenders rely more on the ability of thebusiness to produce cash flow to repay debt rather than on the

value of the collateral. Once installed, the equipment financed isworth very little. Risks are mitigated through the analysis of thebusiness value of the store. The goal is to structure transactions thatdo not require the sale of assets or stores to repay debt. Keep thisconcept in mind as you read about the components of the creditanalysis.

Con sol i da t ed H i s t or i ca l Pro f it an d L oss Sp reads

If the franchisee already owns and operates one or more outlets, wedevelop a consolidated profit and loss spread for analysis. In Figure10.1, we show the recommended format for the spread. Notice thetype of items we spread to calculate earnings before depreciation,interest expense, and income taxes (EBDIT). These items (food andpaper, store labor, etc.) are typical expenses in the fast-food industry.Also note that we look at both post-compensation and pre-compensation figures in computing cash flow. This is because

officers’ salaries are usually discretionary.




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Expense,cash flowcomparison

The consolidated profit and loss spread provides a basis for comparingthe performance of the franchisee to another operator of the sameconcept 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 generatorthe business is compared to others.

This spread is also used to:

+ Determine trends

+ Analyze the consistency of sales and cash flow

+ Calculate debt service capacity

In the next section, we discuss one of these purposes − debt servicecapacity − in detail.




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Debt Serv ice Cap aci t y

Formula Recall that debt service capacity is a measure of a prospect’s ability torepay debt. To calculate debt service capacity, we divide cash flow(cash available to repay principal and interest on current and futuredebts) by debt service (sum of the principal and interest on all loansand capital leases). Here we see this concept expressed as a formula:

Net Income + Non Cash Charges + Interest Expense + Excessive Owners' Compensation

Current Portion of Long Term Debt and Capital Leases + Interest Expense




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Cash flow lesscapitalexpenditures

When computing debt service capacity for franchise financing, it isimportant to consider the franchisee’s ongoing capital expenditures(CAPEX). CAPEX may include painting, parking lot resurfacing,uniforms, and replacement of kitchen cooking utensils. If capital

expenditures are not expensed and included in the profit and lossstatement, we subtract them from the cash flow available to servicedebt.

Ability togenerate cashflow

Once we have calculated the debt service capacity of the prospect, wecan compare it to the debt service coverage ratio on the Risk AssetAcceptance Criteria (RAAC).

The RAAC used in the U.S. is shown in Figure 10.2. Under part II, notethe 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 thisindustry measure a borrower’s ability to repay debt moreconservatively compared to measuring debt coverage in traditionalmiddle market banking.




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I n d i v id u a l S t or e P r of i t a n d L o ss S t a t e m e n t s

Compareindividual

stores

There are two reasons for reviewing each individual store’s saleshistory and financial statements. The first is to identify any bad

locations. If the franchisee plans to open a new store in anunprofitable area, you should question the reasons.

Projectionassessment

A second purpose for reviewing these statements is to analyze changesin annual sales. This trend and history data help us determine whetherthe franchisee’s projections, which we discuss in the next section, arereasonable, conservative, or aggressive.

Prof i t an d Loss Projec t ion s

Line itemcomparison

For a valid analysis, it is important that all items on the historicalprofit and loss statements appear in the profit and loss projectionsupplied by the prospective borrower. This means that you need toreview each line item on the historical statements to make sure thateach has been accounted for on the projection.

Projectioncategories

It is easier to compare figures when we spread projections in the sameformat as the historical consolidated profit and loss statements, butwith data divided into three category columns. The three categories

are:

+ Projections for existing stores only

+ Projections for new stores only

+ Consolidated projections for existing and new stores

Example In Figure 10.3 we show an abbreviated example of projection spreads.Note that the example includes columns for year-end and year-to-datehistorical figures. This is so we can compare projected numbers to

historical profit and loss figures.




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We need to caution you on a few important points. It is important foryou to understand the franchisor’s site selection process to adequatelyassess the projections presented by a franchisee. Also, you shouldalways verify with the franchisor the integrity of the information thefranchisee provides and confirm that store sales, cash flows, and thecost to build the store are reasonable. Prior to funding a loan, youshould obtain verbal or written confirmation from the franchisor thatthe store plan and architecture has been approved.

SUMMARY

So far, we’ve looked at several aspects of the credit analysis process:

+ Consolidated historical profit and loss spreads

+ Debt service capacity

+ Individual store profit and loss statements

+ Profit and loss projections




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The consolidated profit and loss spread is used to compare the performance of a franchiseewho owns more than one outlet to other franchisees. The items compared include food andpaper, labor, and rent expenses. The spread also reveals the business’ success in generatingcash 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. Tocalculate debt service capacity, we divide cash flow by the sum of the principal and intereston all debt. We compare the ratio derived from this calculation to the target debt servicecoverage ratio on the Risk Asset Acceptance Criteria (RAAC). Other considerations, suchas inconsistency of sales and cash flows, the number of stores being financed, and theprospect’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 locationsand to compare trend and sales history to the franchisee’s projections. This comparisonreveals 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 withthis discussion, please complete the Progress Check. If you answer any questionsincorrectly, please review the appropriate text.




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Question 1: A consolidated profit and loss spread is used to compare the franchisee’sperformance with that of other operators.

____ a) True

____ b) False

Question 2: Select two factors that affect the required debt service coverage:

____ a) fluctuations in sales and cash flows.____ b) low liquidity.

____ c) number of stores financed.

____ d) capital expenditures.

Question 3: We use the results of the trend and sales history analysis of individual profitand loss statements to:

____ a) determine whether the consolidated historical statements are valid.

____ b) compare labor, food and paper, and rent expenses.

____ c) calculate debt service capacity.

____ d) help determine whether the projections are reasonable.

Question 4: Understanding the franchisor’s site selection process:

____ a) helps the officer identify questionable locations.

____ b) is necessary to adequately assess new store sales projections.

____ c) prepares the officer to compare rent expenses.____ d) assures the officer that the franchisor has approved the store plan and

architecture.




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ANSWER KEY

Question 1: A consolidated profit and loss spread is used to compare the franchisee’s

performance with that of other operators.

a) True

Question 2: Select two factors that affect the required debt service coverage:

a) fluctuations in sales and cash flows.

c) number of stores financed.

Question 3: We use the results of the trend and sales history analysis of individual profitand loss statements to:

d) help determine whether the projections are reasonable.

Question 4: Understanding the franchisor’s site selection process:

b) is necessary to adequately assess new store sales projections.




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Sen s i t iv i t y An a l ys is

Margin forerror and

break-evenpoint

Recall that a sensitivity analysis is a way to determine what happenswhen the value of certain variables used in a credit assessment

changes. The sensitivity analysis includes determining the break-even point of the business. (Remember, the break-even point is the point atwhich the cash flow available to cover debt is exactly same as the debtservice requirement of the business, thus covering the debt on a one-to-one basis.) In franchise credit analysis, we perform a sensitivityanalysis on the projection spread to determine what happens to aborrower's ability to repay the proposed debt when we assume certaindeviations from the projected figures. Items that we perform asensitivity 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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Bu s i ness an d Co ll a t e ra l Va l u e

Value factors The value of a franchise business is influenced by store type, theassets 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 morethan if the business were sold as an independent pizza restaurant. APizza Hut that is sold to be converted to a hamburger food concept isusually sold for a much lower price.

To place a value on the collateral, we first determine the types of

stores being used as collateral and the type of ownership in thesestores. Lets review the three types of ownership:

+ Land, building, furniture, fixtures and equipment (LBFF&E) areall owned by the operator (called fee simple)

+ Operator has a ground lease, but owns BFF&E

+ Land and building are leased by the operator (also called aleasehold property), and only FF&E are owned by thefranchisee.

In the U.S., to determine total value of a going concern, credit analystsusually separate business value from real estate value. We calculatebusiness value to determine the loan to value, which is the ratio of theloan amount to the value of the collateral. Let’s see how this idea isapplied.




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C a l c u l a t i n g R e a l E st a t e V a l u e

Appraisals Once we have calculated the business value, we can determine thevalue of the real estate (land and building) collateral. We can have a

qualified certified appraiser do an assessment on the property, butappraisals can sometimes be expensive, and the prospective borrowermay not want to incur such an expense. Is there is a way to estimatethe value?

Percentage ofland andbuilding cost

In the U.S., the value of real estate is sometimes estimated by using arental factor. Rents tend to be based on a percentage (the rentalfactor) 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 estateinvestor and market and supply in a specific area.

Example For example, assume the rental factor for a given area is 12% perannum. If the monthly rent for the subject property is estimated atUS$6M, per month, then the annual rent is US$72M. Divide theUS$72M by the 12% rental factor to estimate the fair market value of

the land and building ($72M ÷ .12 = $600M). Looking at it in adifferent way, a property that cost US$600M with a rental factor of 12% will rent for US$72M per year (600M X .12).

Ba l an ce Sh eet An a l ys is

Franchiseattributes

Traditional analysis of a fast-food franchisee's balance sheet typicallyreveals low liquidity and net worth, and sometimes high leverage. Thisis because inventories usually turn quicker than trade payables (foodand paper is sold faster than it is paid for), and large investment infixed assets such as furniture, fixtures, and equipment are rapidlydepreciated, making book value low. Does this mean the franchisebusiness is a poor risk?

The answer lies in remembering that the value of a franchise businessis in its worth as a going concern rather than in its assets. For thisreason, we approach balance sheet analysis for this industry a littledifferently. In the next two sections, we see how two credit indicators,leverage and liquidity, are handled in franchise credit analysis.




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Leverage

Book equity Recall that in standard ratio analysis, we compare total liabilities tothe 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 worthas a going concern, comparing liabilities to actual market value is amore accurate measure of leverage. Therefore, in franchise creditanalysis, we measure leverage by replacing book equity with fairmarket value (FMV), which is the sum of business value and real estatevalue (true value).

The formula for calculating fair market leverage is:

Total Liabilities

(Cash + Inventory + Business FMV), less Total Liabilities

Remember, business FMV is the sum of business value and real estatevalue. Total liabilities excludes stockholder debt that can be paid onlyafter the bank’s loan debt is paid.

Acceptableratios

In the U.S., the combined operations of a franchisee cannot have amarket value leverage exceeding 4:1 (assuming an acceptable debtservice coverage ratio). Furthermore, the bank's overall advance rate

cannot exceed 80% of the collateral business FMV.

L iqu id i t y

Acceptableratio

A standard way to measure liquidity is to compare current assets toliabilities. Because of the cash flow nature of the franchise business,we view liquidity more liberally than in other businesses. We adjustcurrent assets to exclude intercompany and/or stockholder andaffiliate receivables, and adjust current liabilities to exclude current

portion of long term debt (CPLTD) and current portion of capitalizedleases. CBL-FF officers consider a minimum adjusted current ratio of greater than or equal to .50:1 acceptable for this business.




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Reg i ona l R i sk s

As with all lending, the officer must identify various risks andmitigants for the franchise financing transaction. Earlier in this unit,

we identified franchise industry risks. Recall that these includedcommodity price increases, fraudulent conveyance, labor costincreases, and lack of security interest in the franchise licenses.

Weaksecondarymarket

In the Latin American and Caribbean markets, we face an additionalrisk because fast-food is an emerging industry in these regions. Amature secondary market does not exist. Therefore, the officer mustcarefully consider and assess the desirability or attractiveness of themarket to both the franchisor and other potential franchisees.

Culturalacceptance Another risk in Latin America and the Caribbean is that of culturaltastes and differences. Pizzas, fried chicken, and hamburgers may notbe easily accepted in smaller towns or rural areas where people arenot as open to different products, and such products may not beaffordable for routine consumption. Therefore, you should carefullyanalyze financing of a concept’s first entry to the smaller and morerural areas.

C r ed i t R a t i n g s

Ratings fromfranchisors

As you probably know, the credit analysis process includes obtainingcredit ratings from suppliers and creditors. In franchise financing, we

have another source of credit information − the franchisor.

For existing franchisees, the franchisor can provide a characterreference, indicate how good an operator the franchisee is, and tell ushow he or she compares to other franchisees. The franchisor can alsoprovide a rating on the operations and disclose if the franchisee is indefault of the franchise or development agreement. A franchisor canalso rate how punctual a franchisee is with paying franchise fees,monthly royalties, and equipment payments. This is a source of creditinformation you must not overlook!




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RAAC

Applicability In Figure 10.2, we presented the RAAC used in the U.S. for franchisebusiness. If your unit has not developed a RAAC for franchise

business in your country, use the U.S. RAAC as a starting tool forscreening and identifying creditworthy customers. Keep in mind thatthe requirements and quantitative variables in this RAAC need to betested for applicability in each country and modified appropriately.

C ov en a n t R a t i o s

Periodicreview offinancialstatus

Recall that covenant ratios are financial ratios agreed to in a loan orlease contract. Requiring a borrower to maintain certain covenant

ratios is a way to monitor a borrower’s finances so that problems canbe identified and dealt with early on. Depending on the complexity andstrength of the credit, financial information can be requested monthly,quarterly, or annually. Standard covenant ratios for franchise businessare debt service coverage, liquidity, and leverage. Citibank mayinclude covenants for capital expenditures and minimum equityrequirements.

SUMMARY

In our review of the credit analysis process, we saw that lenders to franchise businesses relymore on the ability of the business to produce cash flow to repay debt rather than on thevalue 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 goingconcern.

You have completed the “Credit Analysis” section. Please complete the progress check andthen continue with the section on “Legal Considerations.” If you answer any questions

incorrectly, please review the appropriate text.




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Question 1: Franchise credit philosophy places emphasis on:

____ a) analyzing the ways out of a franchise transaction.

____ b) maintaining an adequate collateral cushion.

____ c) perfecting a security interest in the property financed.

____ d) the value of the business as a going concern.

Question 2: Identify two items usually included in a franchise financing sensitivityanalysis.

____ a) Currency devaluation

____ b) Administrative expenses

____ c) Decline in sales

____ d) Depreciation

Question 3: The purpose of separating business value from real estate value in franchise

credit analysis is to:

____ a) account for differences in fee simple, ground lease, and leaseholdownership.

____ 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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] PROGRESS CHECK 10.4(Continued)

Question 4: When measuring leverage in franchise financing, we replace book equity with__________________.

Question 5: Typically, analysis of a fast-food franchisee’s balance sheet indicates:

____ a) high leverage, high liquidity, and low investment utilization.

____ b) low equity, low leverage, low solvency.

____ c) low net worth, low liquidity, and high leverage.

____ d) low net worth, high equity, low liquidity.

Question 6: Financing a fast-food franchise’s first entry in a rural region may be riskybecause:

____ a) it will be difficult to find experienced labor.

____ b) there may not be enough people in the area to support the restaurant.

____ c) the franchisor has not developed site studies for the region.

____ d) unfamiliar food products may not be accepted.




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ANSWER KEY

Question 4: When measuring leverage in franchise financing, we replace book equity with

fair market value.

Question 5: Typically, analysis of a fast-food franchisee’s balance sheet indicates:

c) low net worth, low liquidity, and high leverage.

Question 6: Financing a fast-food franchise’s first entry in a rural region may be riskybecause:

d) unfamiliar food products may not be accepted.




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LEGAL CONSIDERATIONS

Our discussion of the credit analysis process disclosed a number of items lenders must consider before extending credit. In this section,

we discuss two important categories of legal considerations thatlenders to franchise businesses confront. The first concerns theprotection of the lender’s interests, and the second deals with lender’sinterest in the franchisee’s relationship with other parties as well as itsown relationship with the franchisee.

Security of Lender’s Interests

Collateral to

pay debt

As in any lending or leasing transaction, the structuring and

documentation of a franchise transaction should provide Citibank thegreatest possible protection of its interests in collateral. Even thoughwe’ve emphasized the reliance on cash flow rather than collateral inthis unit, the collateral is still the final source of satisfying a franchisedebt. Here are several guidelines that will help you protect Citibank’sinterest in franchise collateral.

+ Determine the extent to which collateral for the loan isencumbered. Require release of existing liens before fundingthe loan.

+ Understand the applicable laws in your region for securingCitibank’s interest in the equipment, furniture, fixtures, and realestate financed. Take the action necessary to ensure thatCitibank can take the collateral to satisfy its debt as prescribedby law. This could mean filing documents with a regulatorybody or including provisions in the loan agreement.

+ Obtain the greatest possible protection from competing realestate claimants and other secured parties. Again, the actionyou take depends on the laws and practices in your region.

+ Require the borrower to obtain and pay for lender’s titleinsurance or use other means to secure Citibank’s interest inthe real estate property.




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These guidelines illustrate the importance of understanding securityinterest laws in your region and documenting the transaction properly.In addition, you need to consider the legal relationships among theparties involved in a franchise. We discuss these in the following

section.

Legal Relationships Between Franchise Parties

Here we examine three relationships that affect Citibank’s interests in

the franchise − that of the franchisee and franchisor, that of thefranchisee and the landlord (if any), and that of the franchisee andCitibank. Let’s begin with the relationship between the franchisee andthe franchisor.

F r a n c h i s ee a n d F r a n c h i s or

Review offranchiseagreement

Recall that the obligations, responsibilities, and rights of thefranchisor and franchisee are spelled out in the franchise agreement.To help you understand franchise agreements, we’ve provided a sampleagreement (between Pizza Hut and a franchisee) in Appendix ??. It isimportant for you to remember that franchisors often revise andimprove these agreements. Therefore, you and your counsel should

always read the subject agreement and become familiar with therights and remedies of each party.

Key components you should focus on are:

+ Length and expiration dates of the franchise agreementand renewal options. The expiration dates of the franchiseagreement affect the loan tenor Citibank can offer.

+ Events viewed as failure to perform or defaults. Default

situations normally include loan default and filing of insolvency by a franchisee. Examples of failure to performinclude chronically failing to meet the minimum standards forquality, service, and cleanliness, or failure to correct a loandefault.




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+ Provisions for transfers of ownership. The agreement maygrant the franchisor the right to monitor and restrict suchtransfers. The franchisor’s control over the capability of theowners of the business benefits Citibank.

+ Courses of action and remedies available to the franchisorin event of default. Franchisors usually give a franchisee anopportunity to comply with the agreement and often offer tohelp resolve the situation. Because a business is usually worthmore under the franchised name, an operator will often work with the franchisor to sell the business to another franchiseewhen asked to do so. However, a franchisor cannot force afranchisee to sell the business. If a solution cannot be reached,the franchisor can disenfranchise the business.

Effect onlender

When a business is disenfranchised, the franchisee must de-image therestaurant (take down all signs and logos) and stop producing andselling the franchisor’s product. This presents a problem for lendersbecause the value of the business drops. To complicate matters, theagreement often prohibits, for a specified time, the franchisee fromoperating a business that sells a similar product.

F r a n c h i s ee a n d t h e L a n d l o r d ( Ow n e r) of t h e S i t e

Citibankviewpoint

Often, a franchisee will lease the ground and/or building of afranchised store. Since the franchise business is more valuable underthe franchise name, a good relationship between the landlord and thelessee (our borrower) is very important to Citibank. If the lesseebecomes delinquent with the lease payment and faces eviction, it is inCitibank’s interest to avert the eviction. The value of the business candecrease significantly if the business is permanently or temporarilyclosed.

Agreementwith landlord

One way Citibank can protect its interests is to secure an agreementwith the landlord, called a Landlord Consent and Waiver , thatenables the bank and the landlord to work together and resolve leasedefaults. The Landlord Consent and Waiver normally contains five keyprovisions:




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+ The bank will finance and lien (and sometimes mortgage) thefranchisee’s furniture, fixtures, and equipment at the subjectlocation.

+

If the franchisee defaults on the lease payment, the landlordwill notify the bank in writing within a specified number of days.

+ The bank has the right, but not the obligation, to make the leasepayment and bring the lease current.

+ The bank has the right to assume the lease and the right toreassign that lease to another franchisee.

+ The bank has the right to enter the premises and remove its

collateral.

These provisions illustrate the significance of the Landlord Consentand Waiver. You can see why this document is so important toCitibank!

C it i b a n k a n d t h e Fr a n c h i s ee

Defaultremedies

Our discussion of the bank’s relationship with the franchisee will

focus on the bank’s options in the event the franchisee defaults on theloan agreement. We categorize the options according to the type of asset financed.

Furniture, fixtures, and equipment

+ Try to establish a working arrangement

+ Take possession of the collateral

Property

+ Foreclose (sell the property to satisfy the debt)

+ Have the borrower transfer the deed to the property to Citibank




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+ Request the appointment of a receiver to take possession of theproperty

Many of the remedies listed here are considered “last-resort” attempts

to recover debt. Remember, the resale value of franchise collateral isusually low. The preferred solution is to work out a friendlyresolution.

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 tocountry.

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. Withreal estate, Citibank reserves the option to foreclose, request that a receiver takepossession of the property, or require the borrower to transfer the deed to Citibank. Inaddition to its own relationship with the franchisee, Citibank is concerned with therelationship between the franchisee and the franchisor, and between the franchisee and thelandlord. 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 thefranchise agreement carefully and secure a Landlord Consent and Waiver to protectCitibank’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 progresscheck that follows. If you answer any question incorrectly, please return to the text and readthe section again.




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Question 1: Select two ways for a lender to protect its interest in franchise collateral.

____ a) File documents with appropriate regulatory agencies to perfect a securityinterest.

____ b) Immediately repossess the collateral if the franchisee defaults on leasepayments to the landlord.

____ c) Require the release of existing liens on the collateral before funding aloan.

____ d) Restrict the franchisee’s right to transfer ownership of the business.

Question 2: Citibank works to help the franchisee avoid being disenfranchised because:

____ a) the value of the collateral drops when the business is closed permanentlyor temporarily.

____ b) the bank will be barred from entering the premises to collect its collateralif the business is disenfranchised.

____ c) the business will not be worth as much if it is not part of a known

restaurant system.

____ d) the borrower will not have enough cash flow to pay its debt.

Question 3: Select two components of a franchise agreement that greatly concern alender.

____ a) The amount of the franchise fee

____ b) Actions the franchisor may take for noncompliance

____ c) Restrictions on transfer of ownership

____ d) Company indemnification provisions




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ANSWER KEY

Question 1: Select two ways for a lender to protect its interest in franchise collateral.

a) File documents with appropriate regulatory agencies to perfect a securityinterest.

c) Require the release of existing liens on the collateral before funding aloan.

Question 2: Citibank works to help the franchisee avoid being disenfranchised because:

c) the business will not be worth as much if it is not part of a knownrestaurant system.

Question 3: Select two components of a franchise agreement that greatly concern alender.

b) Actions the franchisor may take for noncompliance

c) Restrictions on transfer of ownership




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Question 4: A Landlord Consent and Waiver agreement helps Citibank protect itsinterests in the franchise business by having a measure of control over the:

____ a) franchisee’s right to transfer ownership of the business.

____ b) franchisee’s continued occupancy of the premises.

____ c) landlord’s right to seize the bank’s collateral for lease default.

____ d) landlord’s obligation to pay for environmental cleanup.




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ANSWER KEY

Question 4: A Landlord Consent and Waiver agreement helps Citibank protect its

interests in the franchise business by having a measure of control over the:

b) franchisee’s continued occupancy of the premises.



Unit 11



11-2 RISK MANAGEMENT

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ABF risks Let’s take a moment to review the core ABF risks that we must dealwith in Latin American transactions. This review will prepare you forthe risk management concepts presented in this unit.

Credit The risk in extending credit is the capacity of theborrower or lessee to repay debt now and in thefuture, and its commitment to honor its debts.Central to evaluating credit risk are theapplicant’s cash flow and character.

Collateral The value of the collateral over time is a keyconsideration in ABF because the collateralsecures repayment of the debt. If the borrower orlessee defaults, the creditor ultimately relies on

the value of the collateral to satisfy theobligation.

Documentation The various documents involved in a credittransaction determine how the transaction istreated for legal, tax, and accounting purposes.The risk lies in proper document preparation andexecution. The emphasis is on includingprovisions and remedies that protect thecreditor’s interests.

Country The country’s political, economic, and currencyrestrictions and fluctuations all increase thecreditor’s risk of monetary loss.

Cross Border The risk in financing equipment in onegeographical jurisdiction with equipment use inanother rests in political and economicconditions and in fluctuating property andincome taxes.

ABF life cycle Because we consider each of these risks plus the composition of theportfolio to reach a credit decision, our risk-management practicesmust address each risk throughout the ABF life cycle. To help youunderstand the process, we divide risk management into six phases.



RISK MANAGEMENT 11-3

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+ Credit initiation

+ Risk administration

+ Collateral management

+ Portfolio management

+ Problem recognition

+ Remedial management

In the remainder of this unit, we discuss risk management in terms of these phases. You should keep in mind that these are arbitrarydivisions, and that the risk management practices we describesometimes overlap phases or extend throughout the ABF life cycle.

CREDIT INITIATION

Definition Credit initiation refers to the evaluation, analysis, and approval of individual credit transactions. It includes information gathering,financial analysis, structuring, and other processes leading up to thedecision to extend or deny credit. Both new credits and ongoing risk decisions, such as additions, increases, restructures, new extensions,and line renewals, are part of credit initiation. It is important that you

understand the risk management techniques used in this phase

because what you do here affects what may happen later.

Two types ofprocesses

In this section, we discuss two types of risk management processescommonly 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 forhandling ABF credit approvals, usually by program and target market.However, all standards focus on five key areas of risk management:

+ Target market compliance — addresses target market risks

+ Program RAAC compliance — addresses industry and programrisks

+ Transaction and recourse structure — addresses collateral,country, cross border, and credit risks, with emphasis onprotecting the bank against other creditors

+ Documentation — covers the types of documents required foreach form of transaction and the required filings, with emphasison protecting the bank from a legal standpoint

+ Concentration limits — deals with the risks associated withthe composition of the portfolio

Risk Analysis

Like the standards we’ve just described, credit initiation processes arealso used to manage risks. Let’s review the five key elements of risk analysis practiced during credit initiation to see how each contributesto risk management.

F in a n c i a l S t a t e m e n t A n a l y si s

Credit risks Here, the emphasis is on identifying financial risks. The officerexamines the applicant’s income statements, balance sheets, and otherfinancial data, focusing on:




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+ Historical and forecasted performance

+ Repayment alternatives or ways out

+ Sensitivity of repayment schedule to risk factors (economic,regulatory, competitive, industry cycle)

+ Business practices

Riskmitigation

As the credit analyst identifies the risks, he or she may begin toformulate a plan to manage or mitigate the risks. For example, theanalyst may consider adjusting the repayment schedule toaccommodate the borrower’s business operating cycle. For anongoing transaction involving a temporary overdraft, the analyst mayestablish a plan to monitor the transaction.

Cash F l ow An a l ysi s

Capacity torepay debt

Recall that we use cash flow analysis to determine the applicant’scapacity to repay debt. In the analysis, we look at the applicant’sdisposable income. Because cash flow is a major way out, it is a keyelement of risk management.

M anagem en t Ana l ys i s

Character ofkey personnel

In a management analysis, we assess the customer’s potentialintegrity, honesty, and commitment to honor its financial obligations.The emphasis is on the character of the company’s key individuals,their financial capacity, and their ability to manage change.Understanding these aspects of management helps us limit the risk weare willing to assume.




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Col l a t e ra l Eva l u a t i on

Value overtime

Managing collateral risk is extremely important because the creditormust ultimately look to the value of the equipment if the customer

does not meet the obligation. As you’ve learned, equipment thatmaintains value over time is a better risk than equipment that does notmaintain 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 toreceive from the equipment.

D ocum en t a t i on

Forms andprocedures

In Unit Four, Lease Classification and Legal Documentation, youlearned how the proper preparation and execution of documentationhelps creditors manage legal risks. Documentation risk strategiesinclude using:

+ Standard forms approved by local legal counsel

+ A checklist of required documents for each transaction

+ Proper execution (signatures, registration, stamp duties)

+ Appropriate covenants that mitigate political, commercial, andrepossession risks and provide sufficient time to permitremedial action in the event of difficulty

RISK ADMINISTRATION

In the previous section, we saw how credit initiation standards and risk analysis processes are used to manage risks. In this section, we

discuss another phase of the ABF risk management life cycle — risk administration.




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Managementsystems

Risk administration refers to the ongoing “housekeeping” tasksassociated with managing risks; that is, the credit support, controlsystems, and other practices necessary to manage the outstanding risk assets and to properly monitor business risks. Let’s look at four

important aspects of risk administration:

+ Maintenance of credit files

+ Review procedures

+ Overdraft procedures

+ Tracking past-due obligations

Credit Files

History ofcreditdecision

The credit file should contain all the information necessary toreconstruct the decision to extend credit. It serves as an important risk management tool for two major events:

+ To review the basis on which credit was extended and anylimitations when the borrower seeks additional credit

+ To identify any deficiencies in the process if the borrower

defaults

Review Procedures

Early problemdetection

The timely reviews of credit, collateral, documentation, industry, andsupport structures is a critical part of risk management. Regularreviews help the officer spot potential problems early on, when moreoptions exist to avoid or correct the problem.

Overdraft or Line Excess Procedures

Approvalprocedures

No line excesses or overdrafts should occur without proper creditapproval. To manage this risk, approval procedures must be in placeand followed closely.




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Past-Due Obligation Tracking

Trackingsystem

To manage the risk of past due principal or interest, a system fortracking amortization schedules is appropriate.

As you can see, risk administration practices are important from thebeginning through the end of the ABF life cycle. Similarly, the nexttopic we will discuss, collateral management, is significant throughoutthe entire ABF life cycle.

COLLATERAL MANAGEMENT

Understanding the management of collateral is critical to yourunderstanding of asset based financing. Collateral (equipment) risk management is a broad concept that includes:

+ Collateral analysis

+ Equipment value

+ Residual risk

+

Asset management

+ Structuring

Let’s examine each of these aspects.

Collateral Analysis

Determinevalue overtime

We know that equipment that maintains value over time is a better risk

than equipment that does not maintain resale value. To assess the valueover time, a collateral analysis must be performed. The analysishelps us manage risk by revealing the factors that affect theequipment’s value now and in the future. Once we know these factors,we can structure the transaction to protect the value we expect toreceive from the equipment.




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Rem arke t i ng Cons i dera t i ons

Secondarymarket

We must be able to resell or re-lease the equipment to derive theexpected value. Accordingly, the analyst assesses the chances of

successfully remarketing the equipment by analyzing the following:

+ Diversity of users and market depth, including equipment’sadaptability for other usage

+ Cost to refurbish and remarket; parts and service availability

+ Time to remarket and the cost of carrying

These considerations give the analyst an idea of what the equipment isworth and will be worth in the future. However, equipment worth maybe defined in more than one way. In the next section, we discuss thevarious definitions.

Equipment Value

Factors thataffectdefinition

We know that the creditor must look to the value of the equipment if the customer defaults or if the equipment is resold at the end of alease term. However, in asset based financing, we use several differentdefinitions of value. The definition is affected by:

+ The economic and legal needs of the seller and buyer

+ The cost of doing business

+ The continuation or break in the use of the equipment

Use in riskmanagement

Value definitions should always be included in documentation as a risk management tool. Understanding the differences among the variousdefinitions will help you structure and document appropriately. Here,

we look at five definitions.

+ Fair market value

+ Orderly liquidation value (OLV)

+ 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).

Fai r M ark e t Va l u e (FM V)

Price atnormalconditions

The fair market value is the gross price that a willing and informedbuyer would pay to a willing and informed seller when neither is underpressure to conclude a transaction. The time it takes to sell theequipment is dependent on the industry, but is usually nine months to ayear, assuming a normal market.

O rder l y L i qu i d a t i on Va l ue (OLV)

Net of FMV Orderly liquidation value is defined as the net price that a willingand informed buyer would pay to a willing and informed seller whenneither is under pressure to conclude a transaction. The time it takesto sell the equipment is dependent on the industry and the needs of thebuyer or seller, but is usually three to six months, assuming a normalmarket.

Di s t ress Valu e

Net priceunder duress

Distress value is the net price that would be paid under duress(forced liquidation) for equipment either in a legally distressedsituation or when the asset is in a distressed situation. The equipmentis always sold “as is, where is.” The time it takes to conclude atransaction depends on economic conditions and legal factors. Fromone to two months is common.




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S c r a p V a l u e

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-going concern

The retail, fair market value of equipment sold as part of an on-goingoperation or concern is referred to as value-in-use. This valueassumes equipment to be fully installed and operational.

To put these values in perspective, in Figure 11.1, we present anexample of the relationships among the values and the lessee payments

for the ABC company.

Figure 11.1: Relationship between value definitions and payments

As you may be able to conclude, each of the various definitionsdescribed in this section serves an important purpose in risk management.

Let’s look at an example.




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Example Assume that the vendor of a piece of industrial equipment has agreedto support the value of the collateral through a remarketing agreementthat does not define collateral values. The creditor has assumed, andbased its pricing on, equipment resale at fair market value. One year

before the end of the lease term, the lessee goes bankrupt and stopsmaking payments. The vendor repossesses the equipment and sells itquickly 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 theagreement!




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As you can see, the definitions of value we described in this section have a significanteffect on risk. However, our discussion of equipment value is not complete! Residual value,which you were introduced to earlier in this course, is covered in the next section.

Residual Risk

In Unit Two, Understanding the Leasing Industry, we defined theresidual value of a piece of equipment as the projected market valueremaining at the end of the contract. We excluded from our definitionguaranteed residuals in which purchase at contract end is reasonablyassured.

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 fixedpurchase option. The higher the residual value, the less the lessorneeds to recover from the lease payment. In simplistic terms, if alessor assumes a 10 percent residual, it needs to recover only 90percent of the original equipment cost through the lease payments.Therefore, the higher the residual value, the lower the periodicpayments.

Because residual value plays such an important role in the lessor’sreturn on investment, it is important that we manage residual risks

carefully. Poorly informed or unmanaged residual risk-taking canresult in substantial loss.

Let’s examine four categories of ways to manage residual risk:

+ Risk assessment

+ Pricing

+ Administration

+ Portfolio management




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R i sk Asses sm en t

Three factors To assess residual risk, we look at three primary factors:

+ Equipment characteristics

− Standard, specialized, or customized?

− Susceptible to technological change?

− Long or short life cycle?

− Is use essential?

+ Transaction structure and documentation

− Maintenance provisions asset-specific or general?

− Return provisions costly or cheap for lessee?

− Notification provisions well in advance of term end, nearterm end, or at term end?

− End-of-lease options well defined or loosely defined?

− Controlled by lessee or lessor?

− Long or short term?

+ Remarketing capability

− Secondary market broad and deep or narrow and shallow?

− Third-party sale direct to end user or dealer/speculator?

− Difference in retail/wholesale value small or large?

− Any refurbish and maintenance capabilities?

Residual riskvs. “at risk”

When we consider all these factors, we see that the size of theresidual risk, which is expressed as a percentage of acquisition cost,does not always reflect our true “at risk” position. We may be morevulnerable booking a 5 percent residual on high-tech, short-livedequipment 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 isappropriate must be based on a careful evaluation of each relevantfactor.

Pr i c i ng

Higher return Usually, creditors require a higher return on residual risk than on therelated payment risk. The reason for this is that residual risk has nocontractual payment obligation to support it, and remarketing costsand cost of carry must be covered in addition to the booked residual.Note that pricing residuals to “meet the competition” is rarelyappropriate. Creditors who do so probably have not differentiated

themselves properly, are in the wrong target market, have highoperating costs, or face uninformed competition.

Adm i n i s t ra t i on

Use of specialresources andtools

To manage residual risk, we sometimes use special resources toinspect, appraise, refurbish, and remarket the asset. We view theseresources as administrative risk management tools.

It is also important that we recognize early on any deterioratingmarket conditions and non-compliance with maintenancerequirements. Annual reviews, classification of deteriorating credits(discussed in a later section), and remedial management of residualexposures are some of the other administrative tools we use tomanage deteriorating residual risk.

Por t f ol i o Adm i n i s t ra t i on

Sell offunwantedexposures

The ability to sell off unwanted exposures is important to managingequipment risk. Changing market or tax circumstances, and the need tomanage equipment concentrations and remarketing workloads, areamong the factors that affect a decision to sell certain transactions.We will have more to say about portfolio management later in thisunit.




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Structuring

Costs vs.value over

time

In structuring, we define the most appropriate financing alternativethat addresses the applicant’s financial considerations and provides the

best protection of our collateral. To protect the collateral, we mustgive close attention to the perfection of security interest and thecreditor rights with respect to bankruptcy and repossession. Acreditor’s ability to act quickly to secure its collateral under defaultsituations is very important to success, because the creditor’s default-related costs increase over time, while the collateral (almost withoutexception) decreases in value over time.

Recall that there are several ways for creditors to minimize collateralrisk through transaction structuring. Let’s review five key methods:

+ Require a guaranteed residual

+ Use and enforce strict preventative maintenance clauses,inspection rights, and excess-use penalties to lessen the effectof impaired collateral value caused by excessive wear and tear

+ Obtain a collateral guarantee from a vendor or an insurancecompany

+ Obtain a remarketing agreement. Recall that these are

agreements in which the vendor does not guarantee the residualequipment value, but does agree to assist in the remarketing of the equipment.

+ Use end-of-lease options and return provisions that protect thevalue of the collateral

If you have any questions about these structuring techniques, wesuggest that you read Units Two through Four again.

SUMMARY

In this section, we discussed three categories of risk management — credit initiation, risk administration, and collateral management. In our discussion of credit initiation, we sawhow 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 isconcerned mainly with managing credit risk through tracking, procedural, and controlsystems.

To manage collateral risk, creditors use a broad range of tools. These include conducting acollateral analysis, clearly defining equipment value, using administrative systems andcontrols, pricing, and structuring. Managing the collateral throughout the asset life cycle isa key concept in collateral risk.

You have completed the first part of Unit Eleven, Risk Management . Please completeProgress Check 11.1 to check your understanding of the concepts in this section. If youanswer any questions incorrectly, please review the appropriate portions of the text beforecontinuing to the next section, “Portfolio Management.”




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Question 1: Which risk management method is used to address target market and programcompliance?

____ a) Portfolio review

____ b) Credit initiation standards

____ c) Financial statement analysis

____ d) Trend analysis

Question 2: Overdraft procedures, control systems, and file maintenance are considered:

____ a) Problem recognition strategies

____ b) Portfolio administration tasks

____ c) Asset management tasks

____ d) Risk administration tools

Question 3: Select two key considerations in collateral analysis.

____ a) Distress value

____ b) Characteristics of the equipment

____ c) Remarketing potential

____ d) Industry of use

Question 4: The net price that a willing and informed buyer would pay to a willing andinformed seller when neither is under pressure to conclude the transaction isreferred 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 targetmarket and program compliance?

b) Credit initiation standards

Question 2: Overdraft procedures, control systems, and file maintenance are considered:

d) Risk administration tools

Question 3: Select two key considerations in collateral analysis.

b) Characteristics of the equipment

c) Remarketing potential

The industry of use is considered an equipment characteristic, and

distress value is one of several investment considerations.

Question 4: The net price that a willing and informed buyer would pay to a willing andinformed seller when neither is under pressure to conclude the transaction is

referred to as the:

b) Orderly liquidation value

Value-in-use is the retail, fair market value of equipment sold as part of

an ongoing operation. Fair market value is the gross price that a willing

and informed buyer would pay to a willing and informed seller when

neither is under pressure to conclude the transaction. Residual value is

the projected market value remaining at the end of a contract.




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Question 5: The net price that would be paid during a forced liquidation is called the___________________________.

Question 6: Charging a higher return for residual risk than for the payment risk isappropriate because:

____ a) the size of the residual risk does not always reflect our true “at risk”position.

____ b) we may not be able to sell off unwanted exposures.

____ c) pricing must cover the costs of storing and remarketing the equipment.

____ d) we need a larger safety margin when we are unsure of the equipment value.

Question 7: Performing regular equipment inspections and conducting periodic trendanalyses of equipment markets are ways to:

____ a) monitor maintenance compliance.

____ b) manage assets throughout the asset life cycle.

____ c) identify deficiencies in the equipment valuation process.

____ d) track the cost to refurbish and remarket equipment.

Question 8: Using and enforcing an excess-use penalty is a way to protect the value of collateral through:

____ a) inspection rights.

____ b) defining “value” in the documentation.

____ c) transaction structuring.____ d) asset management.




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ANSWER KEY

Question 5: The net price that would be paid during a forced liquidation is called the

distress value.

Question 6: Charging a higher return for residual risk than for the payment risk isappropriate because:

c) pricing must cover the costs of storing and remarketing theequipment.

a) and d) are true, but are not valid reasons for charging a higher returnthan the payment risk. A valid reason that was not included here is that

residual risk does not have a contractual payment obligation to support

it.

Question 7: Performing regular equipment inspections and conducting periodic trendanalyses of equipment markets are ways to:

b) manage assets throughout the asset life cycle.

Question 8: Using and enforcing an excess-use penalty is a way to protect the value of collateral through:

c) transaction structuring.




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PORTFOLIO MANAGEMENT

Definition A collection of transactions is referred to as a portfolio. In ourdiscussion of residual risk in the previous section, we said that the

ability to sell off unwanted exposures in a portfolio is an importantaspect of risk management. You may have wondered how creditorsidentify unwanted exposures. The main way is to conduct periodicportfolio reviews. In this section, we discuss the two primary types of reviews:

+ Individual transactions

+ Portfolio composition

Understanding the types of reviews will prepare you for conducting orassisting with reviews in your unit.

Individual Transactions

Transaction’seffect onportfolio

The quality of a portfolio depends upon the quality of the individualtransactions in the portfolio. Periodic reviews of individualtransactions help us see how each transaction affects the risk andreturn of the entire portfolio.

The items that the analyst should focus on are:

+ How collectible the principal and interest are in eachtransaction

+ Transaction weaknesses, trends, and risks

+ Adequacy of present safeguards (collateral, covenants,alternative repayment sources)

The results of the review allow the analyst to recommend selling off certain transactions and bolstering others.




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Portfolio Composition

Focus on totalportfolio

Although assessing the weaknesses and strengths of individualtransactions is important in portfolio management, it is equally

important to examine the health of the portfolio as a whole. In aportfolio composition review, we look at the portfolio from severalperspectives to reveal risk categories. The viewpoint categories are:

+ Concentrations

+ Risk and asset liquidity

+ Environmental context

Let’s examine the way each of these categories affects the quality of the portfolio.

Concen t ra t i ons

Common trait A concentration is a group of transactions that share a commoncharacteristic. There are a number of possible concentrations in aportfolio. A few of the most important are:

+ Industry, sub-industry, or type of borrower

+ Currency used to fund transaction

+ Transaction maturity patterns

+ Type of collateral or loan/lease product

+ 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 mixof concentrations, is less risky because adverse results in a singleconcentration have less effect on the portfolio as a whole.




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Risk inoverexposure

Determining the concentrations in a portfolio helps reveal over-exposure. For example, a review may reveal that 40 percent of theportfolio transactions are for a single industry. An unexpecteddownturn in this industry could mean disaster for the creditor! The

creditor may want to sell of some of this exposure and acquiretransactions for other industries to balance the mix.

R i sk Asset L i qu i d i t y

Ability tocollect oncredits

When we talk about liquidity in a portfolio, we are referring to thecreditor’s ability to collect on credits. Liquidity is a function of thecollection options available to the lender. In many markets, liquidity isa major concern for the bank. Factors which have an adverse effect on

asset liquidity include concentrations in:

+ One-way-out loans

+ Non-amortizing loans

+ Foreign currency exposure to foreign-exchange-poor countriesor to borrowers with questionable access to foreign exchange

+ Borrowers or industries dependent upon government support

En v i ronm en t a l Con t ex t

Factors tomonitor

As you know, both external and internal factors can greatly affect aborrower or lessee’s ability to repay debt. Therefore, monitoring theenvironment is an important element of managing portfolio risk.Factors that bear watching are:

+ Industry — Technology, raw material, markets, competition,supply/demand characteristics, government priorities

+ Economic and business climate — Impact of business cycle,balance of payment, management/labor conditions andpractices, capital/money markets, commercial practices andbusiness ethics, legal framework, auditing and accounting,banking system




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+ Political and regulatory conditions — Role of regulation inthe economy and the financial industry, private vs. public sectordominance, political interference, government stability,country sovereign risk management process

+ Market position and strategy — Market share in terms of size, earning, loan losses, tier position with target marketnames, business and vehicles in the market, customer andgovernment attitudes, unit’s overall risk management andmarketing strategy

It should be clear to you that portfolio reviews help creditors spotproblems in their early stages. In the next section, we discuss moreways to recognize current and potential credit problems.

PROBLEM RECOGNITION

Earlydetection

Problem recognition refers to the process of anticipating, detecting,recognizing the significance of, and reporting potential problems asearly as possible. In the previous section, we discussed the use of periodic portfolio reviews to identify potential problems. In thissection, we look at three additional ways risks are managed through aproblem recognition process:

+ Credit monitoring

+ Credit classification

+ A watchlist

In the discussion of these topics, we present a number of specificsignals you may watch for to recognize and evaluate the significanceof credit problems.




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Credit Monitoring

Earlyidentification

The goal of credit monitoring is to identify threats early on and takesteps to reinforce credits while adequate alternatives for action exist.

To effectively manage risk, it is essential for the officer to monitoreach transaction regularly. For other than customer payment default,monthly credit reviews plus semiannual and annual credit/ businessreviews are usually adequate. Your unit may have its own timingstandards.

What should the officer look for during a credit review? Let’s look atthree categories of items that may be cause for concern:

+ Management changes

+ Leverage and financial factors

+ Economics and external factors

M a n a g em e n t C h a n g e s

Changesjustifyconcern

Changes in management or management practices may indicatetrouble ahead. A shift in any of the following may call for closerinquiry.

+ Key executives or directors

+ Ownership

+ The effectiveness of the board of directors

+ The nature of the business, the business objectives, or thebusiness practices

+

Attitudes or skill levels

+ Availability of internal financial information

+ Maintenance practices

+ Employee morale




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Leverage a nd F i nan c i a l Fac t ors

Warning signs Leveraged situations are usually the most vulnerable to financialtrouble. The wise officer watches for rising leverage, diminishing

margins of profitability, and for signs that subsidiaries or otherbusiness segments could be a financial burden.

Econ om i cs an d Ex t e rn a l Fac t ors

Business andeconomiccycles

The business cycle has a continuing effect on a credit obligation, andshould be watched closely. Other external factors also play animportant 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 creditobligations.

Anticipatingrisks

The astute officer will anticipate the risks likely to arise wheneconomic signals change. For example, a recession is typicallymarked by a downswing in consumer spending, with a resultingadjustment in inventories throughout the system of distribution andproduction, and a reduction in the total volume of capital spending.Therefore, when a business economy is in the maturing stage, officersshould keep abreast of their customers’ affairs and reinforce credits

where appropriate.

Signals to watch for include:

+ Inventory build-up

+ Adverse industry or regulatory information

+ Adverse stock market reports and international developments

+

Changing technology

+ Competition from subsidized or capitalized industries




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Diagnosis andaction plan

Critical to the concept of credit monitoring is proper diagnosis tounderstand the nature of the customer’s problem. Is it temporary orpermanent? What are the causes? Does the customer have a viable planto resolve the problem? The next step is to review the creditor’s

options, which may be to help the customer resolve the problem,restructure the transaction, or hold firm to the existing deal (whichcould mean repossessing and remarketing the equipment).

Credit Classification

Definition Once a potential or actual credit problem has been identified, thecreditor 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 sampleclassification system.

Classification systems serve several purposes:

+ Highlight problem credits for attention and remedial action

+ Categorize problem credits according to severity of actual andpotential risk of loss

+

Apply a common language to problem credit identification andmanagement

Timely classification and reporting of favorable or adverse changes inthe status of a transaction is an important risk management tool. In thenext section, we examine a related tool, the watchlist.




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1 - Normal No identified problems

1A - OAEM Other Assets Especially Mentioned :(1) The credit review has revealedevidence of weakness in the borrower’sfinancial condition or creditworthiness,(2) the repayment program is unrealistic,or (3) we lack adequate collateral, creditinformation, or documentation. Earlyattention, including substantivediscussions with borrowers, is required to

correct deficiencies.

II - Substandard The normal repayment of principal andinterest may be, or has been, jeopardizedby adverse trends, weaknesses incollateral, or by financial, managerial,economic, or political developments.Prompt corrective action is required tostrengthen the bank’s position as a lenderto reduce its exposure and to assure that

the borrower takes adequate remedialmeasures.

III - Doubtful Full repayment of credit appearsquestionable, but the amount and timing of the eventual loss has not yet beendetermined. Vigorous action is requiredto avert or minimize losses.

IV - Loss Payment is not collectible.

Figure 11.2: Classification system




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Watchlist

Definition A watchlist is a list of transactions that do not warrant classification,but do require watching. The basis for including a transaction on a

watchlist is usually a current or anticipated change in:

+ Industry patterns or structures

+ Management, composition, or succession

+ National or international political and economic trends thatmay affect the credit

+ Nature of the lender/borrower relationship

+ Borrower performance vs. budget or forecast

+ Nature of joint-venture arrangements or relationships

Watchlistmaintenance

To be an effective risk management tool, the list should be updatedregularly (at least quarterly). Deteriorating transactions may beclassified according to the classification system in use.

Clearly, the problem recognition methods we’ve discussed in thissection can be important risk management tools. Of course, it is not

enough to simply identify a potential problem! Steps must be taken toeliminate or at least reduce the identified risks. This is the topic of thenext section, “Remedial Management.”

REMEDIAL MANAGEMENT

In the previous section, you learned how creditors use creditmonitoring, credit classification, and the watchlist to recognize and

track credit problems. The next step in the risk management process isremedial management.




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Definition Remedial management refers to the actions we take to avert orminimize the credit problems we’ve identified. It means takingopportunities to get concessions or additional collateral, and forcingdecisions at a time when the company still has viability.

Remedial management is results-oriented. The goals are to reduceclassifications and write-offs while increasing recoveries. To help youunderstand how these goals are met, we divide the process into twoparts:

+ Documentation review

+ Action plan

Documentation Review

Purpose One of the first actions that should be taken after a credit has beenclassified is to review its documentation. The purpose of the review isto:

+ Identify possible causes of instability

+ Identify any weaknesses in the documentation that could put thecreditor’s interest in the collateral in jeopardy

+ Review the creditor’s options in the event of default

Action Plan

Alternatestrategies

After the documentation has been reviewed, the creditor must developa strategy to resolve the credit problem. To reach the best decision, itsa good idea to consider and document several alternate strategiesalong with their attendant risks. Appropriate strategies may include:

+ Restructuring the loan/lease to encourage the customer to seek other sources of financing

+ Restructuring the loan/lease to retain some degree of return onthe transaction




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+ Encouraging the customer to sell assets to meet its obligations

+ Requiring additional collateral

Many more strategies are possible. The remedial approach the creditortakes must be based on the individual characteristics of the transactionand 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 portfoliomanagement, we described the two types of portfolio reviews — individual transaction andportfolio composition. Each type of review helps manage portfolio risks from a differentperspective.

In our discussion of problem recognition, we stressed that the goal of problem recognitionis to identify problem credits early on, while more options to resolve the problem exist.We described three risk management tools associated with problem recognition: creditmonitoring, credit classification, and use of a watchlist. A classification system is used tohighlight credits that require immediate or ongoing attention. A watchlist is a related toolused to track potential problem credits.

Remedial management is a results-oriented approach to managing problem credits. Theprocess consists of two parts — the documentation review and the action plan. The ultimategoal of remedial management is to avert or minimize losses.

Congratulations! You have completed the Basics of Asset Based Financing Course. Pleasecomplete Progress Check 11.2 to check your understanding of risk management. If youanswer any questions incorrectly, please review the appropriate portions of the text.




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ANSWER KEY

Question 5: One way that creditors manage risk when an economic downturn is likely is

to:

c) restructure vulnerable transactions.

Credits are not classified unless they become problems. The customer

may need more credit to implement a viable plan to ride out a recession;

denying all requests for more credit may place the customer in greater

jeopardy. Using specialists to remarket equipment is premature because

credit problems are only possible.

Question 6: To tag problem credits that require additional analysis and monitoring,creditors use a classification system.

Question 7: To monitor an anticipated change in a customer’s management, industrycycles, or relationships with partners, creditors may use a watchlist.

Question 8: The main purpose of remedial management is to:

c) reduce the number of classified credits and losses.

Identifying the reasons for the credit problem, identifying documentation

weaknesses, and developing a strategy are all methods for attaining the

primary goal of reducing classified credits and losses.



Appendix



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APPENDIX

GLOSSARY

Accelerated CostRecovery System(ACRS)

The tax depreciation, or cost recovery, method for Internal RevenueService (IRS) purposes which was effective for all depreciableproperty placed into service after December 31, 1980 and beforeJanuary 1, 1987

AcceleratedDepreciation

Any depreciation method that allows for greater deductions or chargesin the earlier years of an asset’s depreciable life, with charges

becoming progressively smaller in each successive period

AccumulatedDepreciation

A financial reporting term for a contra-asset balance sheet accountthat shows the total depreciation charges for an asset since acquisition

Actuarial Interest A constant interest charge (or return) based upon a declining principalbalance

Adjusted (orRemaining) Basis

The undepreciated amount of an asset’s original basis that is used, fortax purposes, to calculate the gain or loss on disposition of an asset

ADR System A tax depreciation system that establishes the minimum, midpoint, andmaximum number of years, by asset category, over which an asset canbe depreciated

AdvancePayments

One or more lease payments required to be paid to the lessor at thebeginning of the lease term

Advance Rent A general term used to describe any rent that precedes the base lease

term and base lease rent



G-2 GLOSSARY

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Alterations Modifications to leased equipment, generally subject to restoration atthe conclusion of the lease

Alternative

Minimum Tax(AMT)

A penalty tax, of sorts, in which a taxpayer must pay the higher of its

regular tax or AMT liability

Annuity A stream of even (equal) cash flows occurring at regular intervals,such as even monthly lease payments

Arrears A payment stream in which each lease payment is due at the end of each period during the lease

Asset Class Life The IRS-designated economic life of an asset, used as the recovery

period for alternative tax depreciation computations

AssetDepreciationRange (ADR)

A tax depreciation system that establishes the minimum, midpoint, andmaximum number of years, by asset category, over which an asset canbe depreciated; the midpoint life has become synonymous with theterm “ADR class life”

Assign To transfer or exchange future rights

At Risk Rules Federal tax laws that prohibit individuals (and some corporations)

from deducting tax losses from equipment leases in excess of theamount they have at risk

BargainPurchase Option

A lease provision allowing the lessee, at its option, to purchase theleased property at the end of the lease term for a price that is so muchlower than the expected fair market value of the property that thelessee is reasonably sure to exercise it

Bargain RenewalOption

A lease provision allowing the lessee, at its option, to extend the leasefor an additional term in exchange for periodic rental payments that

are so much less than fair value rentals for the property that the lesseeis reasonably sure to exercise it

Base Term The minimum time period during which the lessee will have the useand custody of the equipment



GLOSSARY G-3

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Basis The original cost of an asset plus other capitalized acquisition costssuch as installation charges and sales tax; basis reflects the amountupon which depreciation charges are computed

Basis Point One one-hundredth of a percent (.01%)

Broker A company or person who arranges lease transactions between lesseesand lessors for a fee; see “Lease Broker”

Bundled Lease A lease that includes many additional services such as maintenance,insurance, and property taxes that are paid for by the lessor, the costof which is built into the lease payments

Call Option Any option in a lease, such as a purchase or a renewal option, that isexercised at the discretion of the lessee, not the lessor

Capital Lease A lease that has the characteristics of a purchase agreement, and alsomeets certain criteria established by Financial Accounting StandardsBoard Statement No. 13 (FASB 13)

Capitalize To record an expenditure that may benefit future periods as an assetrather than as an expense to be charged off in the period of itsoccurrence

Capitalized Cost The amount of an asset to be shown on the balance sheet, from afinancial reporting perspective; the total capitalized cost (or basis)also is the amount upon which tax benefits are based, and may includeasset 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(see alsoStipulated LossValue Table)

A schedule included in a lease that states the agreed value of equipment at various times during the term of the lease, andestablishes the liability of the lessee to the lessor in the event theleased equipment is lost or rendered unusable during the lease termdue to casualty loss



GLOSSARY G-5

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DebtOptimization

A method of borrowing funds in a leveraged lease where the equityparticipants borrow and repay the obligation in such a manner as tomaximize their return on equity, maintain a constant return whileoffering a lower lease payment, maximize cash flow, etc., or to

maximize a combination of factors

Debt Participant A long-term lender in a leveraged lease transaction

DecliningBalanceDepreciation

A type of accelerated depreciation in which a constant percentage of an asset’s declining remaining basis is depreciated each year

Depreciation A means for a firm to recover the cost of a purchased asset, over time,through periodic deductions or offsets to income

Direct FinancingLease

A lessor capital lease (per FASB 13) that does not give rise tomanufacturer’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 cashflows to their present value in order to state them in current (today’s)dollars

DiscountedLease

A lease in which the lease payments are assigned to a funding sourcein exchange for up-front cash to the lessor

Dry Lease A net lease; a term traditionally used in aircraft and marine leasing todescribe a lease agreement that provides financing only

Early Termination A situation that occurs when the lessee returns leased equipment tothe lessor prior to the end of the lease term as permitted by theoriginal lease contract or subsequent agreement

Economic Life ofLeased Property

The estimated period during which the property is expected to beeconomically usable by one or more users, with normal repairs andmaintenance, for the purpose for which it was intended at theinception of the lease



G-6 GLOSSARY

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EconomicRecovery Tax Act

of 1981 (ERTA ‘81)

The federal tax act that introduced ACRS, among other provisions

End-of-term

OptionsOptions stated in the lease agreement that give the lessee flexibility inits treatment of the leased equipment at the end of the lease term

EquipmentSchedule

A document, incorporated by reference into the lease agreement, thatdescribes in detail the equipment being leased, the lease term,commencement date, and repayment schedule

EquipmentSpecifications

A specific description of a piece of equipment that is to be acquired,including equipment make, model, configuration, and capacityrequirements

Equity Investoror Participant

An entity that provides equity funding in a leveraged lease transactionand, thereby, becomes the owner and ultimate lessor of the leasedequipment

Executory Costs Recurring costs in a lease, such as insurance, maintenance, and taxesfor the leased property, whether paid by the lessor or the lessee

External Rate ofReturn (ERR)

A method of yield calculation; ERR is a modified internal rate of return (IRR) that allows for the incorporation of specific

reinvestment, borrowing, and sinking-fund assumptions

Fair Market Value The value of a piece of equipment if the equipment were to be sold ina transaction determined at arm’s length, between a willing buyer and awilling seller, for equivalent property and under similar terms andconditions

FASB 13 Financial Accounting Standards Board Statement No. 13, ‘Accountingfor Leases’ that specifies the proper classification, accounting, andreporting of leases by lessors and lessees

Finance Lease An expression often used in the industry to refer to a capital lease or anontax lease; also a type of tax-oriented lease



GLOSSARY G-7

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FinancialAccountingStandards Board(FASB)

The rule-making body that establishes financial reporting guidelines

FinancialInstitution Lessor

A type of independent leasing company that is owned by, or a part of, afinancial institution such as a commercial bank, thrift institution,insurance company, industrial loan company, or credit union

FinancingStatement

A notice of a security interest filed under the Uniform CommercialCode (UCC); also known as UCC-1

Floating RentalRate

Rental that is subject to upward or downward adjustments during thelease term

Full Payout Lease A lease in which the lessor recovers, through the lease payments, allcosts incurred in the lease plus an acceptable rate of return withoutany reliance upon the leased equipment’s future residual value

Full-ServiceLease

A lease that includes many additional services such as maintenance,insurance, and property taxes that are paid for by the lessor, the costof which is built into the lease payments

Funding Source An entity, such as a lessor or a bank, that provides any part of the funds

used to pay for the cost of the leased equipment

GuaranteedResidual Value

A situation in which the lessee or an unrelated third party (e.g.,equipment manufacturer, insurance company) guarantees to the lessorthat the leased equipment will be worth a certain fixed amount at theend of the lease term; the guarantor agrees to reimburse the lessor forany deficiency realized if the leased equipment is subsequentlysalvaged at an amount below the guaranteed residual value

Guideline Lease A tax lease that meets or follows the IRS guidelines as established by

Revenue Ruling 75-21, for a leveraged lease



G-8 GLOSSARY

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Half-yearConvention

A tax depreciation convention that assumes all equipment is purchasedor sold at the midpoint of a taxpayer’s tax year; allowsan equipment owner to claim a half-year of depreciation deductions inthe year of acquisition, as well as in the year of disposition, regardless

of the actual date within the year that the equipment was placed inservice or disposed of

Implicit Rate The discount rate that, when applied to the minimum lease payments(excluding executory costs) together with any unguaranteed residual,causes the aggregate present value at the inception of the lease to beequal to the fair market value (reduced by any lessor retainedInvestment Tax Credits) of the leased property

Inception of a

Lease

The date of the lease agreement (or commitment, if earlier)

IncrementalBorrowing Rate

The interest rate that a person would expect to pay for an additionalborrowing at interest rates prevailing at the time

IndemnityClauses

Indemnity provisions in a lease such as general indemnity, the generaltax indemnity, and the special tax indemnity

IndependentLessor

A type of leasing company that is independent of any onemanufacturer and purchases equipment from various unrelated

manufacturers

Initial DirectCosts

Costs incurred by the lessor that are directly associated withnegotiating and consummating a lease (for example, commissions,legal fees, costs of credit investigations, and the cost of preparing andprocessing documents for new leases acquired)

Interest RateImplicit in aLease (as used

in FASB 13)

The discount rate which, when applied to minimum lease payments(excluding executory costs paid by the lessor) and unguaranteedresidual value, causes the aggregate present value at the beginning of

the lease term to be equal to the fair market value of the leasedproperty at the inception of the lease, minus any investment tax creditretained by the lessor and expected to be realized by it



GLOSSARY G-9

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Interim Rent A charge for the use of a piece of equipment from either its in-servicedate or delivery date until the date on which the base term of the leasecommences

Internal Rate ofReturn (IRR)

The unique discount rate that equates the present value of a series of cash inflows (lease payments, purchase option) to the present value of the cash outflows (equipment or investment cost)

Investment TaxCredit (ITC)

A credit that a taxpayer is permitted to claim on the federal tax return(a direct offset to tax liability) as a result of ownership of qualifiedequipment

Lease Acquisition The process whereby a leasing company purchases or acquires a leasefrom a lease originator such as a lease broker or leasing company

Lease Agreement The contractual agreement between the lessor and the lessee that setsforth 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

LeaseOrigination

The process of uncovering (through a sales force), developing, andconsummating lease transactions

Lease Term The fixed, noncancellable term of the lease

Lessee The user of the equipment being leased

Lessee’sIncrementalBorrowing Rate

The interest rate which the lessee would have incurred (at theinception of the lease) to borrow, over a similar term, the fundsnecessary to purchase the leased assets

Lessor The owner of the equipment that is being leased to a lessee or user

Leverage An amount borrowed



G-10 GLOSSARY

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Leveraged Lease A specific form of lease involving at least three parties: a lessor,lessee, and funding source — the lessor borrows a significant portionof the equipment cost on a nonrecourse basis by assigning the futurelease payment stream to the lender in return for up-front funds (the

borrowing); the lessor puts up a minimal amount of its own equityfunds (the difference between the equipment cost and the presentvalue of the assigned lease payments) and is generally entitled to thefull tax benefits of equipment ownership

MACRS ClassLife

The specific tax cost recovery (depreciation) period for a class of assets as defined by MACRS

MaintenanceContract

An agreement in which the lessee contracts with another party tomaintain and repair the leased property during the lease term in

exchange for a payment or stream of payments

Master LeaseAgreement

A lease line of credit that allows a lessee to obtain additional leasedequipment under the same basic lease terms and conditions asoriginally agreed to, without having to renegotiate and execute a newlease contract with the lessor

Match FundedDebt

Debt, incurred by the lessor, to fund a specific piece of leasedequipment, the terms and repayment of which are structured tocorrespond to the repayment of the lease obligation by the lessee

MidquarterConvention

A depreciation convention (replacing half-year convention for certaintaxpayers in certain years) that assumes all equipment is placed inservice halfway through the quarter in which it was actually placed inservice

Minimum LeasePayments

From the lessee perspective, all payments that are required to be madeto the lessor per the lease agreement; minimum lease payments forthe lessor include all payments to be received from the lessee, as wellas the amount of any residual guarantees by unrelated third-partyguarantors



GLOSSARY G-11

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ModifiedAccelerated CostRecovery System(MACRS)

The current tax depreciation system as introduced by the Tax ReformAct of 1986, generally effective for all equipment placed in serviceafter December 31, 1986

Money-over-money Lease

A nontax lease in which the lessee is, or will become, the owner of theleased equipment by the end of the lease term

MultipleInvestmentSinking Fund(MISF)

A method of income allocation used to report earnings on a leveragedlease that assumes a zero earnings rate during periods of disinvestment (a sinking-fund rate equal to 0)

Municipal Lease A conditional sales contract disguised in the form of a lease availableonly 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 forseparately by the lessee and are not included in the lease rental paid tothe lessor

Net PresentValue

The total discounted value of all cash inflows and outflows from aproject or investment

Nonrecourse A type of borrowing in which the borrower (a lessor in the process of funding a lease transaction) is not at-risk for the borrowed funds; thelender expects repayment from the lessee and/or the value of theleased equipment

Nontax Lease A type of lease in which the lessee is, or will become, the owner of the leased equipment, and is entitled to all the risks and benefits(including tax benefits) of equipment ownership

Off BalanceSheet Financing

Any form of financing, such as an operating lease, that, for financialreporting purposes, is not required to be reported on a firm’s balancesheet



G-12 GLOSSARY

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Open-end Lease A lease in which the lessee guarantees the amount of the futureresidual 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 lesseemust pay the amount of any deficiency to the lessor

OperatingBudget

A budget that lists the amount of noncapital goods and services a firmis authorized by management to expend during the operating period

Operating Lease From a financial reporting perspective, a lease that has thecharacteristics of a usage agreement and also meets certain criteriaestablished by the FASB; leases in which the lessor has taken asignificant residual position in the lease pricing and, therefore, mustsalvage the equipment for a certain value at the end of the lease termin order to earn its rate of return

Packager A name used to describe the leasing company, investment banker, orbroker who arranges a leveraged lease

Payments inAdvance

A payment stream in which each lease payment is due at the beginningof each period during the lease

Payments inArrears

A payment stream in which each lease payment is due at the end of each period during the lease

Payoff A situation that occurs when the lessee purchases the leased assetfrom the lessor prior to the end of the lease term

Placed in Service A phrase used to indicate that equipment was delivered and availablefor use, although the equipment may still be subject to finalinstallation and/or assembly

Point One percent, or one percentage point (1.00%); also represents 100basis points

Pooled Funds A funding technique, used by lessors, in which several forms of borrowing are pooled, or grouped, for use in funding leases and arenot specifically tied to the purchase of one piece of leased equipment



GLOSSARY G-13

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Present Value The discounted value of a payment or stream of payments to bereceived in the future, taking into consideration a specific interest ordiscount rate; present value represents a series of future cash flowsexpressed in today’s dollars

Pricing The process of arriving at the periodic rental amount to charge alessee

Private Ruling A ruling by the IRS that was requested by parties to a lease transactionand is applicable to the assumed facts stated in the opinion

PurchaseAgreementAssignment

An agreement where the lessee has entered into a contract to purchasethe equipment to be leased prior to the arranging of the financing;under the agreement, the lessee normally assigns some or all of its

rights under the purchase agreement (always including the right to taketitle to the equipment) to the owner trustee prior to the delivery of theproperty

Purchase Option An option in the lease agreement that allows the lessee to purchase theleased equipment at the end of the lease term for either a fixed amountor at the future fair market value of the leased equipment

Put Option An option in a lease (for example, for equipment purchase or leaserenewal) in which the exercise of the option is at the lessor’s, not thelessee’s, discretion

Recourse A type of borrowing in which the borrower (a lessor funding a lease)is fully at-risk to the lender for repayment of the obligation; therecourse borrower (lessor) is required to make payments to the lenderwhether or not the lessee fulfills its obligation under the leaseagreement

RefundableSecurity Deposit

An amount paid by the lessee to the lessor as security for fulfillment

of all obligations outlined in the lease agreement that is subsequentlyrefunded to the lessee once all obligations have been satisfied



G-14 GLOSSARY

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Remarketing The process of selling or leasing the leased equipment to anotherparty upon termination of the original lease term

Renewal Option An option in the lease agreement that allows the lessee to extend the

lease term for an additional period of time beyond the expiration of the initial lease term in exchange for lease renewal payments

Rent Holiday A period of time in which the lessee is not required to pay rents;typically, the rents are capitalized into the remaining lease payments

Residual Value The value, either actual or expected, of leased equipment at the end, ortermination, of the lease

Retained

TransactionA lease transaction or investment kept for one’s own portfolio; aretained transaction is not sold to another lessor or investor

Return on Assets(ROA)

A common measure of profitability based upon the amount of assetsinvested; ROA is equal to the ratio of either net income to total assetsor net income available to common stockholders to total assets

Return on Equity(ROE)

A measure of profitability related to the amount of invested equity;ROE is equal to the ratio of either net income to owners’ equity or netincome available to common stockholders to common equity

RevenueProcedures

The IRS Revenue Procedures 75-21, 75-28, and 76-30, which setforth requirements for obtaining a favorable federal income tax rulingthat a particular leveraged lease transaction is a true lease

Revenue Ruling A written opinion of the Internal Revenue Service requested by partiesto a lease transaction which is applicable to assumed facts stated in theopinion

Rollover A change in the lease term or lease payment resulting from a change in

equipment, such as in a takeout or upgrade

Rule of 78 An accelerated method of allocating periodic earnings in a lease (or aloan) based upon the sum-of-the-years method



GLOSSARY G-15

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Running Rate The rate of return to the lessor (or cost to the lessee) in a lease, basedsolely upon the initial equipment cost and the periodic leasepayments, without any reliance on residual value, tax benefit, deposits,or fees

Sales-leaseback A transaction that involves the sale of equipment to a leasing companyand a subsequent lease of the same equipment back to the originalowner who continues to use the equipment

Sales-type Lease A capital lease from the lessor’s perspective (per FASB 13) that givesrise 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 matchdebt payments and tax payments in a leveraged lease so as to lessenthe need for a sinking fund

Schedule Listing of equipment to become subject to a lease that describes theequipment, the lease term, the commencement date, and the locationof the equipment

Single InvestorLease

A lease in which the lessor is fully at-risk for all funds (both equity

and pooled funds) used to purchase the leased equipment

Sinking Fund A reserve set aside for the future payment of taxes (generallyapplicable only in leveraged leases) or for the purpose of payment of any liability anticipated to become due at a future date

Sinking FundRate

The earnings allocated to a sinking fund

Skipped-paymentLease

A lease that contains a payment stream requiring the lessee to makepayments only during certain periods of the year

Spread The difference between two values generally used to describe thedifference between the lease interest rate and the interest rate on thedebt



G-16 GLOSSARY

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Step-paymentLease

A lease that contains a payment stream requiring the lessee to makepayments that either increase (step-up) or decrease (step-down) inamount over the term of the lease

Stipulated LossValue Table

A schedule included in the lease agreement, generally used forpurposes of minimum insurance coverage, that sets forth the agreed-upon value of the leased equipment at various points throughout thelease term

Straight-lineDepreciation

A method of depreciation (for financial reporting and tax purposes)where the owner of the equipment claims an equal amount of depreciation in each year of the equipment’s recovery period

Structuring The process of pulling together the many components of a lease to

arrive at a single lease transaction; structuring includes, but is notlimited to, lease pricing, end-of-term options, documentation issues,indemnification clauses, funding, and residual valuations

Subchapter SCorporation

A firm legally organized as a corporation but taxed as a partnership

Takeout A flexible lease option in which the lessor replaces existing leasedequipment with either different equipment or newer equipment of thesame make

Tax Equity andFiscalResponsibilityAct of 1982(TEFRA ‘82)

Tax law enacted in 1982 that, among other things, modified theAccelerated Cost Recovery System (ACRS) and Investment Tax Credit(ITC) rules, as well as introduced the finance lease (which has sincebeen repealed)

Tax Lease A generic term for a lease in which the lessor takes on the risks of ownership (as determined by various IRS pronouncements) and, as theowner, is entitled to the benefits of ownership, including tax benefits

Tax Reform Actof 1984 (TRA ‘84)

U.S. tax law enacted in 1984 that included changes to the generaleffective date for finance leases (renamed transitional finance leases),defined limited use property, set forth the luxury automobile rules, andplaced restrictions on equipment leases to tax-exempt users



GLOSSARY G-17

Tax Reform Actof 1986 (TRA ‘86)

U.S. tax law that effected a major overhaul of the U.S. tax system bylowering tax rates, modifying the Accelerated Cost Recovery System(now MACRS), repealing the Investment Tax Credit (ITC), andrepealing the transitional finance lease

Tax-exempt UserLease

A type of tax lease available to tax-exempt or nonprofit entities inwhich the lessor receives only limited tax benefits

Terminal RentalAdjustmentClause (TRAC)

A lessee-guaranteed residual value for vehicle leases (automobiles,trucks, or trailers), the inclusion of which will not disqualify the taxlease status of a tax-oriented vehicle lease

TerminationValue

A value of leased equipment, representing the lessee’s liability, if theagreement is terminated because the leased equipment becomes

obsolete or surplus

Third-partyLessor

An independent leasing company (or lessor) that writes leasesinvolving three parties: 1) the unrelated manufacturer, 2) theindependent lessor, and 3) the lessee

Ticket Size A term that refers to the cost of equipment being leased; the leasingmarket place is roughly segmented into the small, middle, and largeticket markets

True Lease A tax lease where, for IRS purposes, the lessor qualifies for the taxbenefits of ownership and the lessee is allowed to claim the entireamount of the lease rental as a tax deduction

assets based finance

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