Assets Based Finance

Asset-Based
Finance - Draft
January 1996
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ASSET BASED FINANCE
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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.................... 1-4
Equipment Leasing Today ....................................................................... 1-5
Market Segments ......................................................................... 1-5
Small Ticket Market.......................................................... 1-6
Large Ticket Market.......................................................... 1-6
Middle Market.................................................................... 1-6
Today's Lessors........................................................................... 1-6
Independent Leasing Companies .................................... 1-7
Captive Finance Organizations........................................ 1-8
Lease Brokers or Packagers ........................................... 1-8
Summary.................................................................................................. 1-9
Progress Check 1.1 ............................................................................... 1-11
Reasons Lessees Lease Equipment .................................................... 1-15
Hedge Against Technological Obsolescence............................ 1-15
Financial Reporting .................................................................... 1-16
Off Balance Sheet Financing ................................................................. 1-16
Reported Earnings ......................................................... 1-17
Return on Assets ........................................................... 1-17
Spending Authority ......................................................... 1-17
Cash Management..................................................................... 1-17
Lower Down Payments.................................................. 1-18
Lower Monthly Payments ............................................... 1-18
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Unit 1: Understanding the Leasing Industry (Continued)

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

Trends in the Leasing Industry............................................................... 1-34
Changing Lessor Base .............................................................. 1-34
Lessee Perspective ................................................................... 1-35
Changes in Products ................................................................. 1-35
Profitability .................................................................................. 1-36
Tax and Accounting.................................................................... 1-36
International Markets .................................................................. 1-36
Economic Factors...................................................................... 1-37
Summary................................................................................................ 1-37
Progress Check 1.3 ............................................................................... 1-39
Unit 2: Financial Reporting and Tax Classifications

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

Revenue Procedure 75-21............................................. 2-21
Tax Court Decisions ...................................................... 2-22
Implications of Tax Classifications......................................................... 2-22
Tax Consequences .................................................................... 2-23
Terminology................................................................................ 2-23
Tax Returns................................................................................ 2-24
Lessor - Tax Lease........................................................ 2-24
Lessor - Nontax Lease................................................... 2-24
Lessee - Tax Lease ....................................................... 2-25
Lessee - Nontax Lease.................................................. 2-25
Modified Accelerated Cost Recovery System (MACRS)........... 2-25
Midquarter Convention ............................................................... 2-27
Effect of the Midquarter Convention............................... 2-28
Value of Depreciation ................................................................. 2-29
Corporate Alternative Minimum Tax (AMT) ............................... 2-32
How AMT Works ............................................................ 2-32
Marketing Approach........................................................ 2-33
Lessor Perspective ........................................................ 2-34
Lease Products .......................................................................... 2-34
Tax Lease Products ....................................................... 2-34
Nontax Lease Products.................................................. 2-35
Summary................................................................................................ 2-37
Progress Check 2.2 ............................................................................... 2-38
Unit 3: Legal Classification and Lease Documentation

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

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

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

Cyclical and Countercyclical.......................................... 4-19
Copartner ....................................................................... 4-19
Concealed Value ............................................................ 4-20
Circumstances............................................................... 4-20
Summary................................................................................................ 4-21
Progress Check 4.1 ............................................................................... 4-23
Financial Statement Analysis ................................................................. 4-27
Income Statement Analysis ....................................................... 4-27
Balance Sheet Analysis ............................................................. 4-28
Cash Flow Analysis.................................................................... 4-28
Standard Ratio Analysis ............................................................. 4-28
Profitability and Earnings Growth Ratios ....................... 4-32
Liquidity and Working Capital Ratios ............................. 4-36
Investment Utilization (Activity) Ratios ........................... 4-38
Financial Leverage Ratios.............................................. 4-41
Solvency and Risk Ratio ................................................ 4-43
Owners' Equity Ratios ................................................... 4-43
Cash Flow Analysis................................................................................ 4-45
Statement of Cash Flows .......................................................... 4-45
Advantages of Cash Flow Worksheet ........................... 4-48
Calculating Disposable Cash Flow ................................ 4-49
Nondiscretionary Cash Requirements........................... 4-49
Cash Flow Ratios....................................................................... 4-49
Income Statement to Cash Flow Ratios ........................ 4-50
Cash Flow to Cash Flow Ratios .................................... 4-51
Cash Flow to Balance Sheet Ratios .............................. 4-52
Summary................................................................................................ 4-53
Progress Check 4.2 ............................................................................... 4-55
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viii TABLE OF CONTENTS
Unit 5: Financial Concepts and Calculations (Continued)

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

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

Unit Summary ........................................................................................ 6-14
Progress Check 6 .................................................................................. 6-17
Unit 7: Lease Structuring

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

Introduction............................................................................................... 8-1
Unit Objectives ......................................................................................... 8-1
Benefits of Vendor Leasing Programs..................................................... 8-2
Market Control .............................................................................. 8-2
Market Enhancement ................................................................... 8-3
Additional Income Sources .......................................................... 8-4
Tax Benefits ................................................................................. 8-4
Financial Leverage ....................................................................... 8-5
Reasons Vendors Outsource Leasing Programs ................................... 8-6
Reasons Vendors Lack Customer Financing Programs ............ 8-6
Third-party Participants ................................................................ 8-7
Ways to Meet Vendor Needs ................................................................... 8-7
Third-party Services ..................................................................... 8-8
Sales-aid / Training .......................................................... 8-8
Lease Structuring / Documentation ................................. 8-8
Credit Review ................................................................... 8-8
Outplacement / Investment Syndication .......................... 8-9
Funding............................................................................. 8-9
Administrative Services.................................................. 8-10
Remarketing / Asset Management................................. 8-10
Unit Summary ........................................................................................ 8-10
Progress Check 8 .................................................................................. 8-11
Glossary
Appendix...................................................................................................G-1
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Unit 1
UNIT 1: UNDERSTANDING THE LEASING INDUSTRY
INTRODUCTION
Worldwide, leasing is used more and more to finance equipment and property. In the United
States alone, businesses acquire 33 percent of all equipment through leasing. Companies,
federal and municipal governments, and nonprofit organizations choose leasing to finance
equipment because it offers many benefits. From an equipment provider’s standpoint,
leasing is a venture in which substantial profits may be made.
This unit will introduce you to the leasing industry. You will learn what a lease is, how
leasing evolved, what the leasing industry is like today, and why leasing is so appealing.
UNIT OBJECTIVES
When you complete this unit, you will be able to:
n Define a lease
n Recognize the factors that help divide the leasing market into segments
n Distinguish among the three major types of lessors
n Understand the benefits of leasing
n Define residual value
n Recognize the major trends in today’s leasing industry
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1-2 UNDERSTANDING THE LEASING INDUSTRY
WHAT IS A LEASE?
Definition of a Lease
Agreement A lease is an agreement between the owner of an asset (the lessor)

for use of and the user of the asset (the lessee). In a lease transaction, the lessor
property transfers use, but not ownership, of the property to the lessee for a
certain period. In exchange for use of the property, the lessee makes
payments to the lessor. At the end of the lease period, the lessee may
return the property to the lessor.
Written Lease agreements are generally written contracts that contain the
contracts terms and conditions of the lease transaction. These terms and
conditions include the number of periods the equipment is to be used,
the amount and timing of the lease payments, a description of the
equipment leased, and any end-of-term conditions.
Industry Viewpoint
Transaction From an industry standpoint, a lease is a contract that has been labeled
labelled a lease a lease. However, many transactions that are labeled as leases are not
true usage agreements. They are more like an installment or
conditional sale rather than a pure usage agreement.
Lease treatment The differences between a true usage agreement and an installment or
conditional sale agreement determine how the lease is treated for
accounting, tax, and legal purposes. In Units Two and Three, you will
learn about the ways various regulatory bodies classify leases and how
these classifications affect the way the lease is treated. For now, keep
in mind that a capital lease is really a purchase agreement and an
operating lease is an agreement for use of property owned by
another party.
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UNDERSTANDING THE LEASING INDUSTRY 1-3
HISTORY OF THE LEASING INDUSTRY
The practice of letting property be used in exchange for payment has

existed for thousands of years. To understand the lease process of
today, it helps to understand how leasing evolved.
Early History
First records No one knows the exact date of the first leasing transaction, but we do
know that the earliest records of leasing were written before 2000
B.C. in the ancient Sumerian city of Ur. Sumerian lease documents,
which were produced in damp clay, recorded lease transactions for
agricultural tools, land and water rights, and oxen and other animals.
Early legal systems often included leasing laws. The famous

Babylonian king, Hammurabi, who reigned in about 1700 B.C.,
mentioned leasing in his collection of laws.
Near Babylon, in approximately 400 to 450 B.C., businesses leased

land, oxen, farm equipment, and seed to local farmers. Other ancient
civilizations, including the Greeks, Romans, and Egyptians, also used
leasing to finance equipment, land, and livestock. The ancient
Phoenicians chartered ships and crews. These ship charters resembled
a pure form of an equipment lease.
In medieval times, most leases were for horses and farming

implements. However, unique opportunities sometimes occurred. For
example, many knights of old leased their armor!
Industrial In the early 1800s, the amount and types of leased equipment in the
Revolution United Kingdom (U.K.) increased greatly. The development of the
agricultural, manufacturing, and transportation industries during the
Industrial Revolution brought about new types of equipment, many of
which were suitable for lease financing.
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Railroad The growth and expansion of the railroads also brought about major
expansion advances in the development and use of leasing. Most early railroad
companies were able to supply only the track, and charged tolls for the
use of their lines. Many entrepreneurs began providing the railroad
companies and independent shippers with locomotives and rail cars.
Development of the United States Leasing Industry
Need for While the demand for lease financing was growing in the U.K., the
leasing populace of the United States (U.S.) also was experiencing a need for
lease financing. The first recorded leases of personal property in the
U.S. were written in the 1700s. These early transactions provided for
the leasing of horses, buggies, and wagons by livery men.
The use and development of leasing increased as new types of

equipment were developed and needs for equipment increased. It
was the expansion of the railroad industry in the 1800s, however, that
stimulated real growth in the U.S. leasing industry. Leasing provided
the means to finance locomotives and rail cars when conventional
financing was not available or affordable.
Vendor leasing In the early 1900s, a developing economy and the desire of
begins manufacturers to provide financing for their products increased the
demand for leasing. Manufacturers or vendors thought they would be
able to sell more of their products if they were able to offer an
affordable payment plan. This idea led to the beginning of lease
financing provided by vendors, which is still a significant force in the
equipment leasing industry today.
Third-party Eventually, independent or third-party leasing companies were formed

leasing to provide specific product financing for manufacturers and dealers. In
companies form the early 1950s, many independent leasing companies also began
providing leasing services directly to the lessee for other, unrelated
equipment.
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Banks enter the In 1963, the U.S. Comptroller of the Currency issued a ruling that
leasing industry permitted national banks to own and lease personal property. In 1970,
an amendment to the Bank Holding Company Act further legitimized
the involvement of banks in equipment leasing. This amendment
allowed banks to form holding companies. Under a holding company,
banks could engage in a number of nontraditional financing activities,
such as equipment leasing.
It also is important to note that, especially in recent times, significant

tax and accounting regulations in the U.S. have affected the evolution
of the leasing industry. These are covered in later units.
EQUIPMENT LEASING TODAY
The equipment leasing industry continues to grow. Worldwide, leasing

volume has reached the $350 billion plateau as market penetration
continues to increase. Leasing remains a widely used method of
external finance.
Market Segments
Today, virtually all types of equipment are leased. Leased products

include automobiles, aircraft, computers, furniture, laboratory
equipment, copiers, satellites, and ships.
Factors that The differing types of equipment, the price ranges of the equipment,
determine and the key decision factors that influence lessees help divide the
segment leasing industry into three core segments: the small ticket market, the
large ticket market, and the middle market.
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Small Ticket Market
The small ticket market concentrates on leasing lower-priced

equipment, such as copiers, personal computers, and word processors.
The high end of the transaction range for the small ticket market is
from $25,000 to $100,000. (The cut-off point depends upon
individual firms' interpretations.) The lessee in this market is more
concerned with the convenience of acquisition, maintenance, and
disposal than with cost.
Large Ticket Market
The large ticket market focuses on higher-priced equipment, such

as aircraft, mainframe computers, ships, and telecommunications
equipment. The large ticket market is typically defined as equipment
having a cost of $1,000,000 or more. Because of the transaction size,
the market is very price-sensitive and competition is intense.
Documentation tends to be more involved than in the small ticket
market because of the size and complexity of each individual
transaction.
Middle Market
The middle market fills the wide gap in size and complexity between
the small ticket and large ticket markets. This market is influenced by
a number of factors which sometimes conflict. Both price and
convenience are common issues in the negotiation process.
Today's Lessors
Classification Leasing companies may be classified into three groups:
n Independent leasing companies

n Captive finance organizations
n Lease brokers, or packagers
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There are few accurate statistics to substantiate the proportion of the

leasing industry represented by any individual lessor group, although
the majority of lessors are considered independents.
Independent Leasing Companies
Three parties Independent leasing companies represent a large part of the leasing
industry. These companies are independent of any one manufacturer.
They purchase equipment from various manufacturers, and then
lease the equipment to the end-user or lessee. Independent leasing
companies are often referred to as third-party lessors. The three parties
are the lessor, the unrelated manufacturer, and the lessee. Financial
institutions such as banks, thrift institutions, and insurance
companies that lease property also are considered independent
lessors.
Manufacturer
Equipment
Purchase
Payment
Independent
Lessor
Equipment Lease
Lease Payments
Lessee
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Figure 1.1: Independent leasing company
Captive Finance Organizations
Set up by The second type of lessor is a captive finance organization (lessor).

manufacturer A captive lessor is a leasing company that a manufacturer or
or dealer equipment dealer sets up to finance its own products. The captive
lessor is also referred to as a two-party lessor. One party consists of
the parent company and its captive leasing subsidiary, and the other
party is the lessee (or actual user) of the equipment.
Parent/ Payment
Subsidiary/
Manu-
Lessor
facturer
Equipment Lease
Equipment Lease
Lease Payments
Lessee
Figure 1.2: Captive lessor
Lease Brokers or Packagers
Middle-man The final type of leasing company is the lease broker, or packager.
services The lease broker is essentially a middle-man who provides one or
more various services. The lease broker may do the following:
n Find the interested lessee

n Arrange for the equipment with the manufacturer
n Secure debt financing for the lessor to use in purchasing the
leased equipment
n Find the ultimate lessor in the lease transaction
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The lease broker typically does not own the equipment or retain the
lease transaction for its own account.
Lessee
Lease Ultimate
Equipment
Broker Lessor
Funding
Figure 1.3: Lease broker / packager
SUMMARY
The concept of leasing as an equipment financing tool has survived 4,000 years of history.
The need for equipment leasing continues to grow. The benefits of leasing, such as
affordable payments and off balance sheet financing, have contributed to its popularity.
Today's leasing market includes virtually every type of equipment. In the U.S., market
transactions range from less than $25,000 to more than $1,000,000.
Three major classifications of lessors have evolved to handle the varying needs of the
industry: independent leasing companies, captive finance organizations, and lease brokers
(or packagers). These classifications are based on the leasing company's relationship to the
equipment manufacturer and the types of services they provide.
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In the next section, you will find out about the benefits of leasing and the forces that shape
today’s leasing industry. Before you continue to that section, check your understanding of
the concepts you have just learned by completing the Progress Check that follows. If you
answer any question incorrectly, please return to the text and read the section again.
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þ PROGRESS CHECK 1.1

Directions: Determine the correct answer to each question. Check your answers with
the Answer Key on the next page.
Question 1: A lease is a(n):
____ a) method of borrowing in which the lessor is fully at-risk for any borrowed
funds.
____ b) contract that involves the transfer of ownership of equipment.
____ c) agreement in which the owner of property gives use of the property to
another party for a predetermined period in exchange for compensation.
____ d) arrangement that calls for a lessee to make payments for equipment
directly to the lender.
Question 2: During the last 200 years, the demand for leasing has increased primarily as a
result of:
____ a) the desire of manufacturers to provide financing for their products.

____ b) the development of new types of equipment and the need for affordable
financing.
____ c) the expansion of the railroad industry.
____ d) tax and accounting regulations that favor lease financing.
Question 3: The middle market is more price-sensitive and competitive than the small
ticket and large ticket markets.
____ a) True
____ b) False
Question 4: A captive lessor is a leasing company that:
____ a) a manufacturer or equipment dealer sets up to finance its own products.

____ b) does not own the equipment or retain the lease transaction for its own
account.
____ c) is independent of any one manufacturer.
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ANSWER KEY
Question 1: A lease is a(n):
c) agreement in which the owner of property gives use of the property to

another party for a predetermined period in exchange for compensation.
Question 2: During the last 200 years, the demand for leasing has increased primarily as a
result of:
b) the development of new types of equipment and the need for affordable
financing.
Question 3: The middle market is more price-sensitive and competitive than the small
ticket and large ticket markets.
b) False
Question 4: A captive lessor is a leasing company that:
a) a manufacturer or equipment dealer sets up to finance its own products.
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PROGRESS CHECK 1.1

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

____ b) The formation of third-party leasing companies
____ c) The need for horses, buggies, and wagons by livery men
____ d) The development of the leveraged lease
Question 6: The involvement of banks in equipment leasing was advanced in 1970 through
an amendment to the:
____ a) constitution.
____ b) tax laws.
____ c) third-party leasing agreements.
____ d) Bank Holding Company Act.
Question 7: The classification of a leasing market segment as small ticket, large ticket, or
middle market is based on:
____ a) the types of equipment leased, the price ranges of the equipment, and the
key decision factors that influence lessees.
____ b) the size of the transactions only.
____ c) how the leases are funded.
____ d) the type of lessor involved.
Question 8: A lessor that purchases equipment from various manufacturers, and then
leases the equipment to the end-user or lessee is referred to as a(n):
____ a) lease broker or packager.

____ b) captive or two-party lessor.
____ c) independent or third-party leasing company.
____ d) nonrecourse lessor.
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ANSWER KEY
Question 5: In the 1800s, which of the following had the greatest effect on the growth of
leasing in the United States?
a) The growth and expansion of the railroads
Question 6: The involvement of banks in equipment leasing was advanced in 1970 through
an amendment to the:
d) Bank Holding Company Act.
Question 7: The classification of a leasing market segment as small ticket, large ticket, or
middle market is based on:
a) the types of equipment leased, the price ranges of the equipment, and the
key decision factors that influence lessees.
Question 8: A lessor that purchases equipment from various manufacturers, and then
leases the equipment to the end-user or lessee is referred to as a(n):
c) independent or third-party leasing company.
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REASONS LESSEES LEASE EQUIPMENT
Leasing offers many advantages, benefits, and flexible options to

lessees. Some may lease for only one reason, others for a variety of
reasons. Lessors who understand the motivations of lessees are better
able to offer products that attract lessees.
Most reasons lessees choose to lease fall into the following

categories:
n Hedge against technological obsolescence

n Financial reporting
n Cash management
n Income tax
n Ownership considerations
n Flexibility and convenience
n Economics
Let’s examine each of these categories from the lessee’s viewpoint. In

turn, the lessor will see how these advantages strengthen the sales
process.
Hedge Against Technological Obsolescence
Risk of One of the strongest reasons for acquiring the use of equipment
ownership through leasing is that leasing helps lessees avoid many of the risks of
owning equipment. Much of today’s equipment is based upon rapidly
changing technology. Equipment soon becomes technologically
obsolete. A company’s risk in buying and owning technologically
sensitive equipment is that it may become economically useless much
earlier than expected. Sometimes the equipment becomes useless
before the owner has paid off a loan used to buy the equipment!
Example For example, a computer that is expected to be worth 20 percent of its

original value at the end of five years could easily be worthless in
three years because of new advances in technology.
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Transfer of risk Leasing helps lessees avoid the risk of owning obsolete equipment by
to lessor transferring that risk to a lessor. In other words, lessees let the leasing
company worry about the equipment becoming obsolete.
Lessee Lessor
Risk of Obsolescence
Financial Reporting
Financial reporting, or accounting presentation, comprises an

important part of the decision to lease or buy equipment. Leasing
results in a very different accounting presentation than that of buying a
piece of equipment. Loans from banks and capital raised from
stockholders often depend upon the reported financial health of a
company. For this reason, leasing is of great importance to many
lessees. Here we discuss four aspects of financial reporting.
Off Balance Sheet Financing
No asset or If a lease is a true usage agreement (an operating lease) for financial
liability entry reporting purposes, the lessee’s balance sheet does not show the
equipment as an asset or a liability. The only expense on the lessee’s
income statement for the lease is the lease rental expense. This
reporting practice is called off balance sheet financing.
Improved Off balance sheet financing helps make a firm’s financial statements
financial ratios look better. It improves many of the firm’s financial ratios and
measurements (at least for the first few years). Because there is no
debt or liability for the lease on the balance sheet, the firm appears to
be less in debt and more profitable. Lenders may be more willing to
lend more funds to such a company.
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Reported Earnings
Positive effect In the early years of a lease, an operating lease has a more positive
on income effect on a lessee’s income statement than a capital lease. Initially, the
statement operating lease expense (rental payments) is less than the combined
depreciation and interest expense for the capital lease. Therefore, an
operating lease raises the lessee’s overall reported earnings.
Return on Assets
Increased Because the use of an operating lease lowers the asset base and
return on assets increases reported earnings, a lessee may report a higher return on
assets (ROA). Many managers are sensitive to the level of the
reported ROA, because bonus and profitability goals sometimes are
tied to the ROA that the division or company attains.
Spending Authority
Payments within Managers who do not have the authority to spend funds necessary to
spending purchase equipment find leasing to be a convenient alternative. The
guidelines amount of the monthly lease payment often falls within their spending
authority guidelines.
Cash Management
Affordability Since leasing equipment is often more affordable than purchasing

equipment, many companies choose this option as new and more
advanced (and more expensive) equipment becomes available in the
marketplace. Let’s examine some of the cash management benefits.
Lower Down Payments
Up-front costs Generally, leasing companies require lower down payments than
financial institutions. Also, the leasing company may include other
incidental costs of acquiring the equipment, such as sales tax and
installation charges, as part of the lease payment. If the company buys
equipment, it must pay these costs up front.
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Lower Monthly Payments
Affordable A lease may be more affordable to a company than a conventional loan

payments because the monthly lease payment is lower than the monthly loan
payment.
Improved Cash Forecasting
Future cost Because the amount of the lease payments is fixed, the lessee knows
the future cost of the equipment. This enables the company’s planning
personnel to prepare more accurate cash forecasts and plans.
Capital Budget Constraints
Operating If a department or division has already used its allowance for capital
budget expenditures, the department or division manager may lease the
necessary equipment. Lease payments are paid out of the operating
budget instead of the capital budget. The operating budget contains
the amount of noncapital goods and services a firm is authorized to
spend during the operating period.
Expenditure Similarly, some state and local governments must have either special
approvals capital appropriations made by the decision-making bodies or voter
approval before they can buy equipment. This process may take a long
time. Since lease payments can be paid out of the operating budget,
and approvals for operating expenses generally require much less time
than approvals for capital expenditures, government bodies often
obtain equipment faster through the leasing process.
Cost Constraints
Affordable In certain cases, the only realistic means of acquiring use of

payments equipment is through leasing. For example, a company may need
partial use of a satellite to transmit data to regional offices in other
parts of the world. Unfortunately, the satellite may cost more than the
firm can possibly afford. Through leasing, the company can obtain the
use of a portion of the satellite’s power in exchange for affordable,
periodic rental payments.
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Income Tax
Because leasing provides several income tax benefits to the lessor as

well as the lessee, the lessor must understand them well.
Reciprocity of Tax Benefits
Lower lease When lessors receive tax benefits because they are considered the tax
rates owners of the equipment, they may fully or partially pass these
benefits on to lessees as lower lease rates. This allows the lessees to
indirectly share in the tax benefits. This reciprocity, or exchange of
tax benefits for a lower lease rate, is particularly important for a
lessee that is currently in a nontax paying position. This is because the
lessee cannot directly use the tax benefits of ownership.
Deductible Lease Payments
Income tax When the lessor is deemed the owner of the equipment for tax
benefit purposes, the lessee may fully deduct the lease payments for federal
income tax purposes. Although the lessee does not receive the
depreciation benefits of ownership, the fact that payments are
deductible is a clear tax benefit.
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U.S. Tax Law Penalties
Negative impact Current U.S. tax law may result in penalties for purchasing additional
of additional equipment. A company that purchases new equipment may have to pay
purchases more taxes because of the loss or reduction of certain tax benefits.
For companies facing these situations, it makes more sense to lease
equipment.
Lessor
n Tax benefits
Equipment Lower
Lease Lease
Payments
Lessee
n Deductible lease payment
Ownership Considerations
Leasing can help lessees avoid the risk of owning equipment. Two
major reasons are discussed here.
Stranded Assets
Estimated For financial reporting purposes, owners depreciate equipment over the
economic life equipment’s estimated economic life. If equipment becomes
technologically obsolete before the end of its depreciable life, the
company owns a worthless piece of equipment that is not fully
depreciated on its books. If the company sells the obsolete equipment,
it will be at a loss. This lowers the company’s reported earnings.
If the company retains the worthless equipment until it is fully

depreciated, the equipment is considered a stranded asset. The lessee
can avoid stranded assets by selecting a short-term lease that specifies
reasonable renewal terms for additional periods of use.
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Potential for Ownership
Purchase Another reason for leasing’s growing popularity is the lessee’s ability
options to purchase the equipment at the end of the lease term. Some purchase
options fix the purchase amount; others base the purchase price on the
equipment’s fair market value at the end of the lease term. Fixed
purchase options can be risky. However, having the option to purchase
equipment at fair market value is acceptable to those lessees seeking
flexibility in equipment use and financing.
Flexibility and Convenience
Another benefit of leasing is that it offers many convenience

advantages over other forms of financing. These are summarized below.
n Acquiring the use of an asset through a lease can involve

less red tape and time than bank financing. Also, the leasing
Timing factors
company may be able to obtain speedier delivery
of equipment because of its relationship with the
manufacturer.
One-stop n A lessor can provide product variety and knowledge, the
shopping product itself, financing, and many flexible options, all
under one roof. In addition, a lessor may bundle other
products or services, such as maintenance and insurance,
with the lease to offer a full-service package. A full-service
package may be less expensive than if the lessee separately
purchases the same services.
Reporting n Operating leases require much less bookkeeping than
convenience outright purchases because the entire payment is shown as
rental expense. Also, because most leases have fixed equal
periodic payments, cash flow projections are easier.
n In most companies, the budgeting analysis is not as involved
for leasing a piece of equipment as it is for purchasing
equipment.
n Leasing makes the planned replacement of existing
equipment with new technology easier because company
management must review equipment needs at the end of the
lease term.
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Flexible options n Lessors can structure lease payments and equipment use
options to meet the needs of lessees.
n Within legal limits, the lessee may have more control over
Control
the leasing company of a manufacturer in the event of
warranty disputes.
n The lessee can return the equipment to the lessor upon
Lower risks termination of the lease without further obligation. The
lessor bears the burden and risk of disposing of the
equipment for an adequate price.
Economic Reasons
A crucial selling point for the lessor is that leasing can make good
economic sense for the lessee. The lessor should be familiar with
these aspects.
Diversification of Financing Sources
Financing National economies always experience swings in the availability of

availability financing. Depending solely upon one source of equipment financing
can be dangerous. Using a variety of financing sources makes good
business sense whether credit is in short supply or not. Also, banks
commonly have, by regulatory law, built-in limits on the amount of
funds they may loan to any single customer.
Additional Over the last 30 years, many economic factors have led to shortages in
source of capital through conventional capital financing sources. To sell their
financing products, many manufacturing companies turned to leasing to make
financing available to those customers who otherwise could not afford
the equipment.
Even when bank financing is generally available, some businesses may

not be able to obtain credit. Fortunately, leasing provides an additional
source of financing for companies that cannot borrow needed funds.
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Future Financing Options
Loan When lending to a company, a banker typically builds restrictive loan

restrictions covenants or agreements into the loan agreement. These covenants
restrict a company’s future financing options. Their purpose is to help
lessen any potential default on the loan by the borrower. If the
borrower violates any of the covenants and puts the loan at risk of
default, the lender has the option to demand repayment of the loan.
A company subject to many restrictive covenants has much less

freedom to make financing decisions. Lease agreements, on the other
hand, rarely contain restrictive covenants. Therefore, leasing can offer
greater freedom or flexibility than a loan.
Lower Expenses
Economies Due to their large size, certain leasing companies can save money by
of scale buying equipment in volume and receiving quantity discounts. The
leasing companies may pass on some of these savings to the lessee in
the form of lower lease payments.
Lower cost Leasing can be less expensive than buying equipment. Typically,
potential lessees compare the costs of financial alternatives (such as a
lease versus a loan) after they adjust the alternatives for the effect of
taxes and the time value of money. For a variety of reasons, in such a
comparison, leasing can be the less expensive form of financing. To
effectively determine whether a lease will cost less than an outright
purchase of equipment, one should perform a formal analysis. You will
learn about the lease versus buy analysis in Unit Five.
SUMMARY
In this section, you learned that there are many important reasons lessees choose to lease
equipment. These include the following:
n Guarding against technological obsolescence
n Financial reporting
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n Cash management
n Income tax motivations
n Ownership considerations
n Flexibility and convenience
n Economics
Some of the reasons can be a single source of motivation for a company to lease. In other
cases, it is the combined benefits of leasing that influence a company to lease. Lessors who
understand the motivations of lessees are better able to develop lease products that attract
lessees.
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Directions: Select the correct answer to each question. Check your answers with
Question 1: A major risk of owning equipment is that:
____ a) ownership offers no tax advantages.

____ b) loans used to finance the equipment usually contain restrictive covenants.
____ c) the equipment may become technologically obsolete.
____ d) the equipment may not be fully depreciable on a company’s financial
statements.
Question 2: Operating leases provide off balance sheet financing for the:
____ a) lessor.
____ b) lessee.
____ c) both the lessor and lessee.
Question 3: In the early years of the lease, an operating lease has a more positive effect
on a lessee’s income statement than a capital lease.
____ a) True
____ b) False
Question 4: Leasing is often a more affordable financing option than purchasing because:
____ a) leasing companies require lower up-front costs and monthly payments.
____ b) leasing expenses can be paid from a company’s capital budget.
____ c) it offers the lessee direct tax benefits such as depreciation.
____ d) a lease is not reported as an asset on a firm’s balance sheet.
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ANSWER KEY
Question 1: A major risk of owning equipment is that:
c) the equipment may become technologically obsolete.
Question 2: Operating leases provide off balance sheet financing for the:
b) lessee.
Question 3: In the early years of the lease, an operating lease has a more positive effect
on a lessee’s income statement than a capital lease.
a) True
Question 4: Leasing is often a more affordable financing option than purchasing because:
a) leasing companies require lower up-front costs and monthly payments.
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REASONS LESSORS PROVIDE LEASING SERVICES
In the previous section, we looked at leasing primarily from the

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

profits from each of its lease transactions. Because of the complexities
involved, the lessor must have an in-depth understanding of all aspects
of the lease transaction.
Minimizing A lease requires few, if any, up-front payments and typically

risks requires lower payments throughout the lease term and, therefore,
a lessor’s earnings and profitability may be at risk. To minimize
the risk, a lessor can structure leases that are based on a number
of considerations, including equipment cost, payment stream,
tax benefits, residual value of the equipment, operating cost, and
debt cost.
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Income Tax Benefits
Benefits of When the lessor is considered the tax owner of the leased equipment
ownership according to the Internal Revenue Service criteria, the lessor is
entitled to the many tax benefits of ownership. The primary benefits
are (1) depreciation; (2) gross profit tax deferral (when the lessor also
is the manufacturer of the equipment); and (3) tax-exempt interest for
qualifying municipal leases.
Financial Leverage
Return on One of the more important economic aspects of leasing is financial

equity leverage. A lessor typically borrows most of the funds needed to buy a
piece of equipment and pays for only a fraction of the cost of the
equipment from its own funds, or equity. Because the debt costs less
than the interest rate charged in the lease, the lessor can earn
substantial returns on its equity. Use of significant amounts of
financial leverage is commonplace in leasing.
Lessors can fund their leased equipment in a number of ways. The type
of funding used is one of the ways in which different types of leases
are identified. How a lease is funded determines whether it is a single-
investor lease or a leveraged lease.
Recourse In a single-investor lease, the cash the lessor pays for the equipment
borrowing is made up of the lessor's own equity as well as pooled funds that the
lessor has borrowed from a variety of sources on a recourse basis.
In recourse borrowing, the lessor is fully at-risk for any borrowed
funds. This means that if the lessee defaults on the lease, the lessor
is still responsible for its debt with the lender. The lender does not
know or care who the lessee is, or what the credit position of the
lessee is. The lender has loaned money to the lessor based on the
credit of the lessor (see Figure 1.4).
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Lessor Lessor
n Equity
n Pooled funds
Equipment Payment
Lessee
Figure 1.4: Single-investor lease
Nonrecourse In a leveraged lease, the lessor borrows a significant amount of

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

Lease
Non-
Lessee recourse
Lease Lender
Payment
Figure 1.5: Leveraged lease
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Assigned lease In nonrecourse borrowing, the lender considers the credit-

payments worthiness of the lessee and the value of the leased equipment, not the
credit-worthiness of the lessor. Because the lease payments in a
leveraged lease are assigned to the lender, the lessee generally makes
lease payments directly to the lender. The lending institution seeks
recovery of any losses from the lessee or from the salvage of the
leased equipment (collateral).
Benefits In a leveraged lease, the lessee gets the use of the equipment for a
lower cost. The lessor receives tax benefits and a return on its equity
investment through the value of the equipment at the end of the lease.
Residual Value
Residual value is the actual or expected value of leased equipment at

the end or termination of the lease. The residual value of leased
equipment is an important cash inflow to the lessor and may be a
significant part of the overall return in the lease.
Effect on lease If the lessee returns the leased equipment to the lessor at the end of
rates the lease term, the lessor attempts to re-lease or sell the equipment
for the highest possible amount. To offer competitive lease pricing,
the lessor must factor some of this expected future value into the
lease rates.
For example, if the lessor is confident the equipment will be worth at

least 10 percent of its original value at lease end, the lessor can price
the lease payments to recover 90 percent of the equipment cost. The
lessor hopes to realize the remaining 10 percent once the equipment
is returned and subsequently salvaged or re-leased.
Risk in residual Generally, the amount of the residual used in the lessor’s pricing is
value not the exact amount the lessor expects to receive at the end of the
term. Rather, it is the amount the lessor is willing to be at-risk for in
the lease. The lessor must receive the at-risk residual amount in order
to recover all costs and earn the return it wants. The risk is that the
residual value will be less than the amount assumed when the lease was
priced.
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International Leasing
Expanding Overseas leasing is expected to expand significantly in order to serve

opportunities large multinational companies as well as foreign companies who are
seeking new forms of asset financing. Although equipment leasing
abroad by U.S. companies started only 20 years ago, the amount of
equipment on lease in Western Europe and other parts of the world
has grown significantly. One reason for the growing popularity of
leasing abroad is that many foreign banks offer loans for about three
years. This means equipment buyers must negotiate two or three loans
during the life of a particular piece of equipment.
Types of As in the United States, all types of equipment are being leased
equipment abroad: tankers, railroad cars, computers, machine tools, printing
leased abroad presses, aircraft, restaurant equipment, mining equipment, and drilling
rigs.
Limitations Since foreign tax laws differ from U.S. tax laws, many international
leases do not offer the same benefits of depreciation or the possibility
of residual value gains. Also, restrictive foreign government
regulations concerning percentage of local ownership requirements,
varying tax laws, foreign exchange fluctuations, and export laws affect
the profitability of international leasing.
However, many equipment leasing companies are still interested in the

expanding leasing markets abroad. Many U.S. based multinationals use
leasing to promote foreign sales. In addition, there are numerous tax,
import, and investment tax credit benefits available to the experienced
international lessor. In essence, the same reasons that led to an
expansion of leasing in this country have also stimulated leasing
abroad.
Benefits of Vendor Leasing
Leasing is advantageous to manufacturers in various ways. Here, we

will look at four important considerations: customer convenience,
control of the market, profit potential, and integration opportunities.
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Convenience for Customers
Product Providing lease financing is a successful way for manufacturers to

distinction distinguish their product from their competitors’ products. Providing
the equipment, as well as the financing, may entice a potential
customer to choose a certain manufacturer’s product due to the
convenience offered.
Market Control
Locking out the By locking in the sale with financing so it will not be lost to a
competition competitor as the customer searches for financing, the manufacturer
exerts a considerable amount of market control. Also, the
manufacturer knows when its customer, the lessee, is in need of a new
piece of equipment (i.e., at the termination of the existing lease term).
This allows the manufacturer to market a new piece of equipment to
its current leasing customer long before a competitor
is aware a potential transaction exists.
Profit Potential
Increased sales Vendor lessors may benefit from increased sales because leasing can
make equipment acquisition affordable for customers who cannot
purchase the equipment outright. Along the same lines, customers may
be able and willing to lease more expensive models or additional
accessories now that the cash flow advantages of leasing have put
these extras within their reach.
Full-service Captive lessors can benefit from the combined marketing approach
contracts and profitability of providing bundled services in a full-service
contract. These services typically include maintenance, insurance,
film, reagents, software, and property taxes for the lessee. The captive
lessor may be able to provide these services for less cost than that
which the lessee can separately procure and, as a result, profit from
these additional revenues. Also, the convenience of one-stop shopping
may entice a lessee to choose a captive lessor’s product.
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Integration Opportunities
Types of Integration refers to ways in which a company can expand operations.

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

residuals an important step in vertically integrating a company. Extensive
knowledge of the product permits the lessor to predict residual values
with greater accuracy. This enhanced knowledge of residual values
may enable the vendor leasing company to fine tune the lease payment
amount it charges. Control over residuals also allows the vendor
lessor to sell equipment at the termination of the lease to a somewhat
captive clientele.
Horizontal Integration
Unrelated Some vendor lease companies find leasing so profitable that they
product leasing begin leasing equipment other than that manufactured by the parent
company. This expansion into new, unrelated product leasing is a form
of horizontal integration that is becoming popular among
manufacturer-lessors.
A bank acquiring a leasing company would be a form of horizontal

integration since the leasing service is closely related to the bank’s
loan service.
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Conglomerate Integration
New business Some other companies enter into the leasing business as a totally
opportunities unrelated business opportunity in relation to their normal operations.
New business ventures involved with leasing would represent a form
of conglomerate integration. A utility acquiring a leasing company
would be an example of conglomerate integration.
Now that you understand the opportunities that leasing offers to both
parties, let’s look at some of the trends that are developing in the
leasing industry.
TRENDS IN THE LEASING INDUSTRY
Many important trends are developing in the leasing industry. Some

of these trends are ongoing; others are subtle shifts in prior trends.
Many of the trends result directly from the many recent changes that
have occurred in the world economies.
Changing Lessor Base
Business goals Mergers and acquisitions continue within the leasing industry for
many reasons. The goal of some companies is to increase market share
or enter into a specific market niche. For others, the goal may be to
achieve economies of scale, experience growth without the associated
sales costs, or unload an unprofitable finance subsidiary. The ups and
downs of the economy also lead to an increase in mergers and
acquisitions as companies struggle to adapt to the changes.
Tax laws In the U.S., the changes to the tax laws brought about by the Tax
Reform Act of 1986 continue to affect the way leasing companies do
business. The alternative minimum tax (AMT) has had the greatest
effect. Companies in an AMT position often have difficulty remaining
competitive. For some, the problem is severe enough to cause them to
sell their portfolio and get out of the leasing business.
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Lessee Perspective
Increased The level of lessees’ sophistication about leasing continues to

knowledge increase. More lessees are using leasing to avoid the risk of
obsolescence. At the same time, they are seeking more assurance as
to end-of-term consequences, and selecting lessors more cautiously.
Also, a wide array of inexpensive analytical software is available to
help lessees make their financing decisions.
Lessee Lessees continue to lease for a variety of reasons. Recently, the

motivations impact of tax reform has made tax motivations one of the more
important reasons for leasing. The problems with the U.S. economy,
along with a scarcity of available debt from traditional sources, have
also led to more business for lessors.
Changes in Products
Changing Lessors continue to develop new products to meet the changing needs
needs of lessees. They are creating new structures to meet lessee demands
for off balance sheet accounting. In response to lessees’ concerns
about the end-of-term consequences of leases, lessors are offering
more fixed or capped purchases and renewals. The number of full
service leases continues to grow. Lessors are also responding to
requests for more bundled services.
Leveraged Leveraged leasing continues to attract investors; however, the

leasing competitiveness of this market requires more and more
continues sophistication, expertise, and creativity. This market has experienced
major concerns over aircraft residuals and concentrations, but has
seen an increase in both railcars and satellites.
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Profitability
New emphasis Companies have not been able to maintain the profitability levels
on residuals of the late 1980s. Competition remains high. Fewer, yet larger,
and asset companies strive to increase market share. Companies must rely
management increasingly on residual and end-of-term options for profits. This
reliance increases the need for asset management. In most lease
companies, the role of the remarketer is expanding every day. Even so,
opportunities for residual profits continue to narrow.
Lessors seek Many lessors have shifted part of their business into other financial
other sources of service products such as real estate or insurance to improve
profits profitability. Lessors have also looked to internal sources of
additional profit. These include closely monitoring expenses, using
improved software and systems, and outsourcing some services.
Tax and Accounting
Changes in tax Changes in the U.S. corporate tax structure are highly probable.
laws Congress continues to use tax laws to promote and achieve a variety of
social and economic goals. Key among these goals is a national
healthcare program. The provisions of the program may indirectly
affect the willingness of companies to invest in new equipment. The
likelihood of an increase in the tax burden is quite high.
Accounting An emphasis on accounting for lease economics will continue. Also,

standards lease accounting standards will continue to evolve. The Financial
evolve Accounting Standards Board (FASB) continues to address issues that
indirectly relate to leasing in specific situations such as special-
purpose corporations and financial instruments.
International Markets
Worldwide Worldwide, leasing is increasing as countries develop their

economic infrastructure from an accounting, tax, and economic perspective.
growth From South America to Africa to the Far East, the leasing industry is
growing — sometimes at double-digit rates.
International
Many U.S. lessors are going overseas to tap into these fertile markets.
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agreements At the same time, many foreign leasing companies are active in the
U.S. The spread of economic unions such as the European Economic
Community (EEC) and the union created by the NAFTA agreement
signed by the U.S., Mexico, and Canada have helped expand foreign
leasing opportunities.
Economic Factors
Used equipment Used equipment is increasingly being leased as lessees are less set on
leases having the latest technology. Often, they find that an older model
performs adequately, especially when they consider the cost of
acquiring the latest technology.
Product More lessees are asking for unique lease structures to aid in their cash
requests flow requirements. Lessees are also requesting more bundled leases
and facilities management contracts in order to decrease overhead
costs.
SUMMARY
There are many motivations for lessors to be in the leasing business. The primary objective
of a lessor is to make a reasonable profit from the lease transaction. The reasons lessors
are in the leasing business fall into the following categories:
n Profitability
n Income tax benefits
n Financial leverage
n Residual value
n Vendor leasing issues such as market control, product distinction, and increased
sales through bundled services
n Expansion (integration) opportunities
n International opportunities
Another key concept presented in this unit is that economic changes in the U.S. and abroad
are having a strong effect on leasing trends. Economic ups and downs have led to more
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mergers and acquisitions. Changes in the U.S. economy and tax laws are forcing lessors to
seek other ways to make profits. Lessees are seeking more full service packages and are
leasing more used equipment. Lessors are changing their leasing products to better meet
lessees’ needs and wants. Also, leasing is becoming more global in scope. U.S. lessors are
becoming more active abroad — and foreign leasing companies are doing business in the
U.S.
You have just completed Unit 1: Understanding the Leasing Industry. Please complete
the following Progress Check before you continue to Unit 2: Lease Classifications —
Financial Reporting and Tax Classification. If you answer any question incorrectly, you
should return to the text and read that section again.
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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 and
insurance.
____ b) a lessor provides additional services to the lessee such as equipment,
maintenance, and insurance.
____ c) a third party receives the lessee payments and remits the proper amounts
for services to the maintenance and insurance providers.
____ d) a lessee has more control over the manufacturer in the event of a warranty
dispute.
Question 2: A major difference between a single-investor lease and a leveraged lease is

that in a:
_____ a) leveraged lease, the borrower is not at-risk for the borrowed funds; but in
a single-investor lease, the lessor is fully at-risk for any borrowed funds.
_____ b) single-investor lease, the lender owns the property; while in a leveraged
lease, the lessor owns the property.
_____ c) single-investor lease, the lender is concerned with the credit-worthiness
of the lessee; while in a leveraged lease, the lender is concerned with the
credit-worthiness of the lessor.
_____ d) single-investor lease, the lessor assigns or discounts the lease payments
to the lender in return for up-front cash; while in a leveraged lease, the
lessee usually makes payments directly to the lessor.
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ANSWER KEY
Question 1: A full service lease is one in which:
b) a lessor provides additional services to the lessee such as equipment,

maintenance, and insurance.
Question 2: A major difference between a single-investor lease and a leveraged lease is

that in a:
a) leveraged lease, the borrower is not at-risk for the borrowed funds; but in
a single-investor lease, the lessor is fully at-risk for any borrowed funds.
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PROGRESS CHECK 1.3

(Continued)
Question 3: In financial leverage, a lessor:

_____ a) borrows funds on a nonrecourse basis.
_____ b) assigns or discounts the lease payment series to the lender, in return for
up-front cash.
_____ c) earns substantial returns on its equity because it pays only a fraction of
the cost of equipment with its own funds.
_____ d) is fully at-risk for any borrowed funds.
Question 4: Residual value is the actual or expected value of leased equipment at the end
or termination of the lease.
_____ a) True
_____ b) False
Question 5: Most of the current trends in the leasing industry result from:
_____ a) tax and accounting reforms.

_____ b) economic factors.
_____ c) advances in technology.
_____ d) growing competition among lessors.
Question 6: Today’s lessors are offering more bundled services, off balance sheet
structures, and capped renewals because:
_____ a) the Tax Reform Act of 1986 favors these lease products.
_____ b) these products are more profitable.
_____ c) they wish to achieve economies of scale.
_____ d) knowledgeable lessees request these products.
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ANSWER KEY
Question 3: In financial leverage, a lessor:
c) earns substantial returns on its equity because it pays only a fraction of

the cost of equipment with its own funds.
Question 4: Residual value is the actual or expected value of leased equipment at the end
or termination of the lease
a) True
Question 5: Most of the current trends in the leasing industry result from:
b) economic factors.
Question 6: Today’s lessors are offering more bundled services, off balance sheet
structures, and capped renewals because:
d) knowledgeable lessees request these products.
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Unit 2
UNIT 2: FINANCIAL REPORTING
AND TAX CLASSIFICATIONS
INTRODUCTION
As you learned in Unit One, lease agreements are written contracts that contain the terms
and conditions of the lease transaction. These terms and conditions have certain accounting,
tax, and legal characteristics. The characteristics help the various regulatory bodies
determine how the lease is to be treated for financial reporting, tax, and legal purposes.
Each regulatory body has its own criteria for classifying leases. However, all regulatory
groups consider the substance of the transaction rather than the form to determine
classification. This means that even though a transaction is labeled a lease (its form), the
substance of the agreement (the meaning of the content) may indicate that the transaction is
not a true lease.
In Units Two and Three, you will learn how the characteristics of a lease affect how it is
classified for various purposes and how each classification dictates the way the lease is
treated. Specifically, in Unit Two, you will see how the accounting (financial reporting)
classification affects how the lessor and lessee report the lease on their financial reports.
Then you will learn how tax considerations affect the after-tax cash flows (and,
therefore, the entire pricing structure) of a lessor. In Unit Three, you will see how legal
classifications are determined, why they are important considerations for the lessor (as
well as the lessee), and why provisions of the lease must be carefully documented.
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2-2 FINANCIAL REPORTING AND TAX CLASSIFICATIONS
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 either

operating leases or capital leases. An operating lease is a “true”
usage agreement in which the lessor is considered the owner of the
equipment. A capital lease is really an installment or conditional sale
agreement. In a capital lease, the lessee is considered the owner of the
equipment.
Classification Criteria
FASB The Financial Accounting Standards Board (FASB) sets the criteria for
classifying leases and the rules for reporting leases in a firm’s
financial statements. FASB Statement 13 - Accounting for Leases
(FASB 13) contains the accounting rules for lease transactions. The
main goal of the criteria is to establish who, in substance, owns the
equipment.
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FINANCIAL REPORTING AND TAX CLASSIFICATIONS 2-3
The lessee and the lessor apply the criteria independently. This means
that each party may classify the same lease differently. They make
their decisions at the inception of the lease and cannot change the
classification later.
Four criteria There are four classification criteria that determine whether a lease
transaction resembles a purchase agreement (capital lease) or a usage
agreement (operating lease). If a transaction meets any one of the
four criteria, it is classified as capital.
The criteria are as follows:
Transfer of
1. The lease automatically transfers ownership of the property
ownership to the lessee by the end of the lease term.
If the title will automatically pass to the lessee, then the

transaction is not a usage agreement, but an ownership agreement.
Bargain 2. The lease contains an option that allows the lessee to

purchase purchase the leased property at a bargain price.
option
If the lease contains a purchase option that is so low that the lessee
is likely to exercise it, the lessee is viewed as the owner
of the equipment.
Dollar-out and Most lease companies offer two general categories of products:
fair market dollar-out leases and fair market value (FMV) leases. In a dollar-
value options out lease, the lessee may purchase the equipment for one dollar
at the end of the lease term. This is clearly a bargain purchase
option.
In an FMV lease, the lessee can purchase the equipment at the end
of the lease term for its fair market value. This is clearly not a
bargain purchase option. Sometimes the answer is not as clear. In
these cases, the transaction classifier must decide if the lessee is
likely to become the owner.
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Economic life 3. The lease term is equal to or greater than 75% of the
of equipment estimated economic life of the leased property.
FASB 13 defines economic life as the useful life in the hands

of multiple users, given normal repairs and maintenance. If
the lessee will use the equipment for a major portion of the
equipment’s economic life, the lease should be classified as a
capital lease. The theory is that assets effectively produce income
for a limited time. If the lessee uses the equipment for more than
75 percent of that time, the lessee is, in effect, the owner.
In addition to the asset’s economic life and the lease term, the
classifier must take into account any lease provisions that could
extend the lease term. For example, if all periods in the lease are
covered by bargain renewal options or nonrenewal penalties, the
classifier should classify the lease as a capital lease.
Effective 4. The present value of the minimum lease payments is equal to,
ownership or greater than, 90% of the fair value of the leased property
less any investment tax credit retained by the lessor.
This is the most complex of the four criteria, and is used to

determine effective ownership of the equipment. The present value
of the minimum lease payments is compared to 90 percent of the
equipment’s fair market value. If the result is greater than or equal
to 90% of the fair value, the transaction is a capital lease.
The minimum lease payments are all the required payments

according to the lease agreement. Fair market value is the value of a
piece of equipment if it were to be sold at arm’s length under terms
and conditions similar to those in the lease.
Present value is the discounted value of a future payment stream.

It represents a series of future cash flows expressed in today’s dollars.
A present value calculation (see page 5-__) removes the time value of
money (interest). The remaining value is the portion of the equipment
cost that will be recovered from the lease payments.
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If the calculation indicates that the lessor is recovering more than 90

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

those of the discount rate, may lead lessors and lessees to classify the
same lease differently.
IMPLICATIONS FOR FINANCIAL REPORTING
Now that you know how leases are classified, you are ready to look at
how these classifications affect the way lessors and lessees account
for leases in their financial records.
Lessor and Lessee Accounting
Accounting In addition to setting the criteria for classifying a transaction, FASB 13

regulations provides the rules lessors and lessees use to account for lease
transactions. The goal of the FASB 13 regulations is to have the balance
sheet and income statement reflect the substance of the transaction
(ownership or not).
The accounts in the balance sheet and income statement that lessors and
lessees use for leases is summarized in Figure 2.1. An explanation of
each quadrant follows.
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Figure 2.1: Lessor/lessee lease account summary
Lessor Accounting for a Capital Lease
Lessor as Quadrant 1 shows the accounting for a lessor capital lease where the
financier lessor is not (in substance) the owner of the equipment. Instead, the
lessor is financing the lessee’s acquisition of the equipment. The
accounting is similar to accounting for a loan. On the balance sheet,
the lessor records a net investment in lease receivables, which is
similar to a note receivable account that a bank sets up to record a
loan. The income statement reflects interest income earned on the
outstanding lease receivable, just as a bank earns interest income on
the outstanding principal in a loan.
Lessor Accounting for an Operating Lease
Lessor as Quadrant 2 shows lessor accounting for an operating lease. The lessor
owner accounts for the transaction as if it owns the equipment and is
allowing the lessee to use the equipment. The equipment cost is
recorded as an asset on the balance sheet and depreciated over the
lease term. Rents received from the lessee for use of the equipment
are recorded as income on the income statement.
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Lease term It is important to note that the classification of the lease does not
income affect the total amount of income recognized by the lessor. Over the
life of the lease, the interest income recognized in a capital lease will
equal the difference between rental income and depreciation expense
in an operating lease. The following equation represents income for
the two types of leases over the entire lease term:
Interest Income = Rental Income – Depreciation
Lessee Accounting for a Capital Lease
Lessee as Lessee accounting for a capital lease is shown in Quadrant 3. If the

owner lease is classified as a capital lease, the lessee is considered to be the
owner of the equipment. The accounting for a capital lease is similar
to the accounting for a loan used to purchase the equipment. On the
balance sheet, the lessee records an asset for the equipment and a
liability for the lease payable. The lessee’s income statement shows
depreciation expense on the asset and interest expense on the lease
payable.
Lessee Accounting for an Operating Lease
Lessee as Quadrant 4 shows the lessee’s operating lease accounting. In an

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

affect the total expense recognized by the lessee. Over the life of the
lease, the depreciation expense plus interest expense of a capital lease
will equal the total rent expense of an operating lease. The following
equation represents total expense over the entire lease term:
Rent Expense = Depreciation + Interest Expense
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ABC COMPANY
BALANCE SHEET
(End of first year)
ASSETS
Operating Capital
Lease Lease Difference
Current Assets
Cash in bank $13,684 $13,684
Accounts receivable 12,000 12,000
Inventory 8,000 8,000
Total current assets $33,684 $33,684
Fixed Assets
Deferred tax charge $ 0 $ 1,070 ($1,070)
Property, plant, equipment 96,000 96,000
Capital leased equipment 0 100,000 (100,000)
Less: accum. depreciation (30,000) (50,000) 20,000
Total assets $99,684 $180,754 ($81,070)
LIABILITIES
Current Liabilities
Accounts payable $6,000 $6,000
Lease payable 0 18,350 (18,350)
Total current liabilities $6,000 $24,350 ($18,350)
Long-term Liabilities
Notes payable $30,000 $30,000
Lease payable 0 64,706 ($64,706)
Total liabilities $36,000 $119,056 ($83,056)
STOCKHOLDERS’ EQUITY
Common stock $14,000 $14,000
Retained earnings (prior) $20,000 $20,000
Current portion 29,684 27,698 $1,986
Total equity $63,684 $61,698 $1,986
Total liabilities and equity $99,684 $180,754 ($81,070)
Figure 2.5: Operating / capital lease balance sheet comparison
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Operating Lease Accounting Benefits - Lessee
Financial To help you understand the financial reporting differences for the
reporting lessee, let’s look at a balance sheet and an income statement for the
benefits same lease, accounted for as both a capital lease and an operating
lease. From this example you will see why, from an accounting
perspective, lessees prefer operating leases.
Financial Statement Comparison
A balance sheet comparison of the lease, accounted for as both

operating and capital is shown in Figure 2.5. The balance sheet is
presented as of the end of the first year.
As you examine the income statement comparison for the first year
(Figure 2.6), notice that earnings and net income are higher if this
lease is classified as an operating lease. In the later years of the lease
the operating lease expense will be higher, since the total expense
over the life is the same for both lease types.
ABC COMPANY
INCOME STATEMENT
(End of first year)
ASSETS
Operating Capital
Lease Lease Difference
Revenue
Sales $300,000 $300,000
Cost of goods sold (160,000) 160,000
Gross profit $140,000 $140,000
Operating Expenses
Selling ($4,000) ($4,000)
General and administrative (44,000) (44,000)
Lease expense (24,332) 0 ($24,332)
Depreciation expense (10,000) (30,000) 20,000
Operating income $57,668 $62,000 ($4,332)
Other Income and Expenses
Interest expense ($12,000) $19,388 $7,388
Income before taxes $45,668 42,612 $3,056
Income taxes @ 35% (15,984) (14,914) (1,070)
Net Income $29,684 $27,698 $1,986
Figure 2.6: Operating / capital lease income statement comparison
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SUMMARY
Understanding the accounting for leases for both lessors and lessees is made easier by
remembering that the accounting reflects the substance of the transaction. The substance of
the lease transaction is established by the four criteria of FASB 13. In an operating lease,
the accounting reflects ownership of the equipment in the hands of the lessor. In a capital
lease, the lessee is considered the owner of the equipment.
One of the major reasons lessees lease is off balance sheet financing. The example in this
section showed both the enhancement of earnings that operating leases provide and the
improvement of perceived financial health.
In the next section, you will learn about the tax classification of leases. Before you
continue to the next section, check your understanding of the concepts you have just
learned by completing the Progress Check that follows. If you answer any question
incorrectly, please return to the text and read the section again.
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] PROGRESS CHECK 2.1
Question 1: A lease that transfers substantially all the benefits and risks of ownership to
the lessee should be accounted for as a(n):
____ a) operating lease.

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

____ b) operating lease.
Question 3: In accounting for an operating lease, the lessor shows the rental income and
depreciation expense on its income statement.
____ a) True
____ b) False
Question 4: The lessee prefers operating lease financial statement presentation.
____ a) True
____ b) False
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ANSWER KEY
Question 1: A lease that transfers substantially all the benefits and risks of ownership to
the lessee should be accounted for as a(n):
b) capital lease.
Question 2: If the lessee effectively purchases the asset by the end of the lease term, it
would classify the lease as a(n):
a) capital lease.
Question 3: In accounting for an operating lease, the lessor shows the rental income and
depreciation expense on its income statement.
a) True
Question 4: The lessee prefers operating lease financial statement presentation.
a) True
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PROGRESS CHECK 2.1

(Continued)
Question 5: For the lessee, capital lease accounting is:
____ a) less complex than accounting for an operating lease.

____ b) similar to accounting for a loan.
____ c) the same as for lessor capital lease accounting.
Question 6: A lease that provides off balance sheet financing to a lessee is called a(n):
____ a) operating lease.

____ b) capital lease.
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ANSWER KEY
Question 5: For the lessee, capital lease accounting is:
b) similar to accounting for a loan.
Question 6: A lease that provides off balance sheet financing to a lessee is called a(n):
a) operating lease.
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TAX CLASSIFICATIONS
As discussed earlier, each regulatory body has its own criteria for
classifying leases. In the previous section, you learned that the FASB
classification (operating or capital) determines how the lease is
accounted for on financial statements. In this section, we will discuss
how the U.S. IRS classifies leases and what this means to taxpayers.
Tax and Nontax Leases
Ownership According to U.S. tax law, as interpreted by the Internal Revenue

and tax Service (IRS), leases must be classified from a tax viewpoint as either
benefits tax leases or nontax leases. In a tax lease, the lessor bears the risks
of ownership and is entitled to the tax benefits of ownership (i.e.,
depreciation and tax credits). In a nontax lease, the lessee is,
or will become, the owner of the leased equipment. As owner or
potential owner, the lessee is entitled to the tax benefits of ownership.
A nontax lease is actually an installment sale contract
in the form of a lease.
Congress has never enacted legislation specifically addressing the

classification of a lease. Taxpayers are unable to refer to a particular
code section in the Internal Revenue Code for guidance as to whether
or not the transaction is a true lease (tax lease) for tax purposes or a
nontax lease.
Sources of Classification Criteria
Internal To help taxpayers, the IRS has issued several statements to outline the
Revenue criteria the IRS uses to classify lease transactions. You will see that
Service the criteria used to determine the tax classification of a lease are
statements
similar to, but different from, those used for accounting purposes.
The most important criteria come from Revenue Ruling 55-540 and
Revenue Procedure 75-21. Also providing guidance to taxpayers are
the various tax court rulings that have been rendered over the years.
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Revenue Ruling 55-540
Ruling 55-540 provides the elements of a nontax lease. The more

important items (according to the IRS) are quoted below. If any of
these provisions are included in a lease, the lease must be
considered a nontax lease. As we stated above, in a nontax lease, the
lessee is, or will become, the owner of the leased equipment.
Tax status 1. Portions of the periodic payments (rentals) are made specifically
criteria applicable to an equity interest to be acquired by the lessee.
2. The lessee will acquire title upon the payment of a stated number
of rentals which under the contract he is required to make. This
situation occurs two ways:
a. Paying a stated number of rentals after which title transfers.
b. Title transfers automatically at the end of the lease without a

purchase option or guaranteed residual.
3. The total amount which the lessee is required to pay for a

relatively short period of use constitutes an inordinately large
proportion of the total sum required to be paid to secure the
transfer of title.
4. A bargain purchase option exists in which the option cost is less

than the expected fair market value of the leased asset or is small
in comparison to the total lease payments to be made.
5. Some portion of the periodic payments is specifically designated

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

criteria
- 20 percent minimum investment
- Equipment must have a remaining life beyond the lease

term of the longer of one year or 20 percent of the
originally estimated depreciable life
n Purchases and sale rights
- No bargain purchase options allowed
n No investment by the lessee
n No lessee loans or guarantees
n Profit requirement (complex IRS formula)
n Positive cash flow (complex IRS formula)
Tax Court Decisions
In addition to the IRS statements we’ve just described, tax court

rulings have influenced the tax classification of a lease transaction.
The tax courts have focused on three important variables in reaching
their decisions: risk, intent of the parties, and economic merit.
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Risk of According to the tax courts, the party that bears the risk of ownership
ownership in the transaction should receive the tax benefits of ownership. The
courts often refer to Revenue Ruling 55-540 and Rev. Proc. 75-21 to
help identify and allocate risk. They also examine the transaction for
credit risk and for the risk associated with the unrecovered cost of the
equipment, or the residual risk.
The risk of ownership must be clear. For instance, a tax lease should
not contain a bargain purchase option or specify a lessee guaranteed
residual value. Either of these two events removes the residual risk
from the lessor.
Intent The courts also try to establish the true intent of the parties. Did the
lessee believe it was just using the property in a rental agreement, or
did it perceive the transaction as an installment sale? To establish the
intent of the parties, the courts examine the transaction as well as
previous cases.
Economic Economic merit means that the transaction must have been entered
merit into for other than tax-motivated purposes. The courts look for
positive cash flow and profits from sources other than tax benefits.
IMPLICATIONS OF TAX CLASSIFICATIONS
The tax classification of a lease transaction is important because it

determines which party (the lessor or lessee) is entitled to the tax
benefits of ownership. In this section, we will examine the tax
considerations of tax and nontax leases, describe how tax benefits
affect lease pricing, and discuss a few tax and nontax lease products.
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Tax Consequences
Cash flows Tax consequences represent either positive or negative cash flows to a
company. The sooner companies receive cash, the more it is worth to
them. This concept is referred to as the time value of money.
Understanding this concept is critical to understanding the importance
of tax benefits in the pricing of a lease.
Tax benefits are cash inflows to the lessor. They affect the after-tax
cash flows. For this reason, they influence the entire pricing structure
of a lessor. The lessor can use them to enhance its yield or to lower
the lessee’s payment.
Lease vs. Tax considerations also affect the lessee’s decision to lease or to
purchase purchase equipment. The lessee must weigh the tax benefits of
decision ownership against the benefits of leasing we discussed in Unit One.
Terminology
To understand the tax implications of leasing, you must be familiar

with the following terms.
Asset Class Life (ADR Class Life) — IRS-approved depreciable lives

for all types of property.
Depreciation Basis — The amount of the original cost of the

property that has not been depreciated. Depreciation basis is
represented by the following formula:
Basis = Original Cost – Accumulated Depreciation
Modified Accelerated Cost Recovery System (MACRS) — The

current regular tax depreciation methodology. This is the current form
of tax depreciation corporations use to depreciate their tax assets for
federal income tax purposes.
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Tax Returns
Earlier, you learned that tax ownership of equipment determines

whether a lease is a tax lease or a nontax lease. In a tax lease, the
lessor, as owner of the property, is entitled to the tax benefits. If the
transaction is a nontax lease, the lessee is deemed the property owner,
and is entitled to the tax benefits.
A summary of the tax return implications for lessors and lessees is

presented in Figure 2.7.
Figure 2.7: Lessor/lessee tax implications
Lessor - Tax Lease
Ownership Quadrant 1 shows the benefits of ownership for a lessor in a tax lease:
benefits tax depreciation and any credits available. In addition, the lessor
records as income the rents received from the lessee.
Lessor - Nontax Lease
Taxed on Quadrant 2 shows the tax implications to the lessor in a nontax lease.
interest Since the lessee is deemed to be the owner of the equipment in a
nontax lease, the lessor is taxed on interest income.
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Timing of It is important to note that the tax status of a lease does not affect the
taxable total amount of taxable income recognized; it affects only when that
income income is taxable. Over the life of the lease, the rental income less
depreciation expense recognized in a tax lease will equal the interest
income recognized if the lease is classified as a nontax lease.
Lessee - Tax Lease
Rent expense Quadrant 3 illustrates the tax implications for the lessee if the lease is
a tax lease. The lessee is the user of the equipment and ownership is in
the hands of the lessor in a tax lease. The lessee is entitled to a
deduction on its tax return for the rent expense paid to the lessor.
Lessee - Nontax Lease
Ownership In a nontax lease, the lessee is considered the owner of the equipment,
benefits as detailed in quadrant 4. The lessee receives a deduction for
depreciation and also a deduction for interest expense.
Modified Accelerated Cost Recovery System (MACRS)
Accelerated tax depreciation is one of the tax law provisions that the
U.S. federal government uses to encourage investment in assets.
MACRS is the current form of tax depreciation corporations use to
depreciate their tax assets for federal income tax purposes.
General The three general rules are as follows:

provisions
1. MACRS generally applies to property placed in service after
December 31, 1986.
2. There are six classes of property dealing with personal property,

which is all property other than land and buildings.
3. The MACRS depreciable life is based on the asset class life, which
is the IRS-designated economic life of an asset.
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Half-year MACRS is an accelerated form of tax depreciation because

convention depreciation deductions are calculated using a half-year convention
for the year the equipment is acquired and the year of disposition. The
convention assumes that all property is placed in service in the middle
of the taxpayer's tax year. For a calendar-year taxpayer, all property is
assumed to have been placed in service on July 1. This means that
these taxpayers can take a half-year depreciation deduction even if
they placed the property in service on December 31. For the year of
disposition, taxpayers assume the asset is disposed of in the middle of
the year, regardless of the actual date of disposition.
MACRS depreciation rates are based on the asset class life and the
recovery year. The MACRS table is shown in Figure 2.8. Taxpayers
refer to this table for the applicable percentages for any year to
calculate their depreciation deductions.
Example For this example, assume an original equipment cost of $100,000 and
5-year MACRS property that is in its third year of depreciation. You
calculate the deduction taken on the tax return as follows:
Equipment cost $100,000

MACRS % (third year) x 19.2%
Tax return deduction $ 19,200
MACRS TABLE
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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:
1 33.33% 20.00% 14.29% 10.00% 5.00% 3.750%
2 44.45 32.00 24.49 18.00 9.50 7.219
3 14.81 19.20 17.49 14.40 8.55 6.677
4 7.41 11.52 12.49 11.52 7.70 6.177
5 11.52 8.93 9.22 6.93 5.713
6 5.76 8.92 7.37 6.23 5.285
7 8.93 6.55 5.90 4.888
8 4.46 6.55 5.90 4.522
9 6.56 5.91 4.462
10 6.55 5.90 4.461
11 3.28 5.91 4.462
12 5.90 4.461
13 5.91 4.462
14 5.90 4.461
15 5.91 4.462
16 2.95 4.461
17 4.462
18 4.461
19 4.462
20 4.461
21 2.231
Figure 2.8: Modified Accelerated Cost Recovery System table
Positive cash As a tax benefit, MACRS represents a positive cash flow to the
flow taxpayer because the benefits and cash flows are received more
quickly. Remember that the sooner cash flows are received, the more
they are worth on a present value basis.
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Midquarter Convention
TRA 86 The midquarter convention is a provision in the Tax Reform Act of

1986 (TRA 86). Congress enacted the midquarter convention rule to
prevent taxpayers from over-utilizing the half-year convention benefit.
This rule sets a limit on the amount of equipment a company can place
in service in the fourth quarter of a tax year and still receive the
benefit of the half-year convention.
The 40% The midquarter convention is sometimes referred to as the 40 percent

penalty penalty. Under this penalty, if more than 40 percent of all personal
property placed into service during the tax year is placed into service
in the last three months of the taxable year, the taxpayer must use the
midquarter convention instead of the half-year convention.
The concept of the midquarter convention is illustrated in Figure 2.9.
Figure 2.9: Triggering midquarter penalty
Effect of the Midquarter Convention
Slowed cash The midquarter convention causes the tax benefits from depreciation
inflow deductions to be realized at a slower pace. Again, if the realization of
the tax benefits is slowed, the cash flow benefit is slowed. Because of
the time value of money, the tax benefit is not worth as much as it was
under the half-year convention.
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Because lease companies often complete many transaction in the

fourth quarter, they are prime candidates to be affected by the
midquarter convention. If a lessor is in a midquarter position, the
slowing cash flows realized from tax benefits will lower the yield in
the lease. Looked at another way, if the lessor desires the same yield
in the lease as would be expected under the half-year convention, then
the lessor must increase cash flows from the monthly payments, fees,
or from residual realization.
The slower depreciation rate of the midquarter convention is

highlighted in Figure 2.10.
MIDQUARTER / HALF-YEAR COMPARISON

Midquarter Half-Year
Convention Convention Difference
Year Amount Cumulative Amount Cumulative Amount Cumulative
1 5,000 5,000 20,000 20,000 (15,000) (15,000)
2 38,000 43,000 32,000 52,000 6,000 (9,000)
3 22,800 65,800 19,200 71,200 3,600 (5,400)
4 13,680 79,480 11,520 82,720 2,160 (3,240)
5 10,944 90,424 11,520 94,240 (576) (3,816)
6 9,576 100,000 5,760 100,000 3,816 -0-
Figure 2.10: Midquarter convention effects on depreciation deductions
Value of Depreciation
In this section we quantify the value of the depreciation tax benefit and
show how tax benefits affect lessor pricing. This will help you
understand why depreciation is a source of profit for lessors and why
lease rate factors are generally lower in the fourth quarter.
Assumptions 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 lease In Figure 2.11, we can see the income recognized if the transaction is
income a tax lease. Notice that the total income recognized is the same under
both rental income and MACRS over the 60-month term. Only the
nature and the timing of the income vary.
TAX LEASE INCOME

Tax Rental Total
Year Income MACRS Income
1 0 20,000 (20,000)
2 (2,149.39 x 12) 25,793 32,000 (6,207)
3 “ 25,792 19,200 6,592
4 “ 25,793 11,520 14,273
5 “ 25,792 11,520 14,272
6 “ 25,793 5,760 20,033
128,963 100,000 28,963
Figure 2.11: Income from tax lease transaction
Comparison Lessors realize more of a time value of money benefit from leasing
than they do from lending. A year-by-year loan/lease income
comparison is displayed in Figure 2.12.
Timing of The difference column of Figure 2.12 shows the differences in

cash flows taxable income. The timing of the deductions and taxable income
affects the timing of the resultant cash flows. Therefore, the lessor
realizes a time value of money benefit if the end-user of the
equipment leases the equipment. The amount of this time value of
money benefit is determined by computing the present value of the
difference column times the tax rate. This amount represents the value
of depreciation in this transaction.
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Worth of lease In this transaction, the lease alternative is worth an additional $2,892
alternative to the lessor. This represents the amount, on a present value basis, of
the tax savings from the accelerated depreciation deductions
compared to the principal reductions in the loan. The additional cash
flow, realized purely from timing differences in income recognition,
either increases the lessor's yield or allows the lessor to offer a lower
payment to the lessee.
INCOME COMPARISON
Loan Lease
Year Income Income Difference
1 0 (20,000) 20,000
2 9,742 (6,207) 15,949
3 7,973 6,592 1,381
4 6,010 14,273 (8,263)
5 3,829 14,272 (10,443)
6 1,409 20,033 (18,624)
28,963 28,963 0
Figure 2.12: Loan / lease income comparison
Effect of In the above example we used an inception date of December 31.

inception date Because of the half-year convention, this date results in the maximum
timing differences of the two alternatives. If the
inception date were January 1, the depreciation value would be lower.
Although still beneficial, the effect of depreciation is greatly lowered
for tax transactions completed early in the year. The lessor's pricing
reflects this.
Fourth As you can see, a lease that starts in the fourth quarter is more
quarter sensitive to the value of depreciation. By realizing more of the yield
in the lease from tax benefits, the lessor may rely less on the periodic
payment. Hence, the lessee's payment is typically lower if structured
in the fourth quarter.
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Corporate Alternative Minimum Tax (AMT)
Limits on Although corporations are allowed to reduce taxable income with

MACRS MACRS depreciation, Congress has placed limits on the amount of
depreciation these deductions. If these limits are exceeded, an additional tax is
imposed. This tax is referred to as the AMT. The AMT attempts
to ensure that all corporations pay a minimum tax. It requires
corporations to compute both the regular tax and the AMT, and then
pay the higher of the two calculations.
How AMT Works
Examine Figure 2.13 to see how the AMT works.
BASIC AMT CALCULATION

Regular Tax AMT
Income before taxes Income before taxes

– Adjustments – Adjustments__
Taxable income
x 35% Taxable income
+ Preferences a
Taxes payable
AMT income
x 20% a
AMT payable
Figure 2.13: Calculation of Corporate Alternative Minimum Tax (AMT)
Adjustments The adjustments referred to in the illustration are various Internal

Revenue Code (IRC) adjustments firms make to income before
taxes in order to arrive at taxable income. These adjustments (such as
MACRS) decrease or increase the income before taxes. Tax
departments in corporations identify and use the IRC-allowed
adjustments to lower the firm’s taxes. More negative adjustments
result in lower taxable income, which means the corporation will pay
fewer taxes to the IRS.
Preference Under the AMT, for some adjustments taken to arrive at taxable
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items income, a portion of the adjustment or deduction is added back to

regular taxable income. These are preference items. The preference
item with the greatest impact on the leasing industry is accelerated
depreciation on personal property. This preference item is the
difference between depreciation used for the regular tax calculation
(generally MACRS) and depreciation calculated using the prescribed
AMT method.
Marketing Approach
Once a lessor understands the complexities of AMT, it can use its

knowledge of the AMT to identify lessees in a potential AMT
position and convince the lessee to lease the equipment to avoid
AMT.
Potential Characteristics of companies in AMT include:

customers
n Companies experiencing low taxable income and high AMT
preferences
n Companies that heavily invest in machinery and equipment
n Companies that purchase equipment that falls at the high end (long
ADR life) of the MACRS classification
n Young companies that have rapidly growing asset bases and that
cannot benefit substantially from the turn-around of older assets,
which would lessen the preference burden
Avoid In marketing tax leases to a potential lessee, the goal is to show the
preferences client how to minimize the risk of paying AMT through leasing.
Because preferences cause AMT situations, a number one priority is
to help the lessee to avoid those preferences that may trigger AMT.
The preference for accelerated depreciation can be avoided by tax

leasing because the preference applies only if the lessee owns and
depreciates equipment. Purchasing creates a depreciation preference,
whereas tax leasing does not.
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Lessor Perspective
AMT risk As the tax owner of the equipment in a tax lease, lessors are prime
candidates to be in AMT. Industrywide, about 50 percent of leases are
tax leases and are, therefore, creating preferences for lessors. If
a lessor is in AMT, strategies must be adopted that will minimize
its impact. For example, different nontax lease products can be
developed. In some situations, however, lessors will be unable to
avoid the AMT.
Lease Products
Within each of the two broad categories — tax leases and nontax
leases — are several types of lease products lessors have developed to
meet the needs of various customers. In this section, we will discuss
tax and nontax lease products.
Tax Lease Products
Two tax lease products worthy of mention are the TRAC lease and the
tax-exempt user lease.
Target The TRAC lease is a tax lease specifically designed for the
industry commercial vehicle leasing industry. TRAC stands for Terminal
Rental Adjustment Clause.
Lessee In the TRAC lease, the lessee assures the lessor receipt of a specified
assumes residual, or salvage, value of vehicle. The lease payments in a TRAC
residual risk lease are lower because the lessor relies on the lessee assurances
regarding the residual value of the equipment.
Qualifying Examples of specialized vehicles that qualify for TRAC leases include
vehicles dealer service trucks, dealer haul trucks, contractor haul trucks,
equipment trailers, and busses.
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End-of-term A TRAC is a provision in a lease agreement that requires a rental

adjustment adjustment at the end of the lease term. This adjustment amount is
determined by the comparison of the current fair market value (FMV)
of the equipment versus the lessee-assured residual value upon which
the lease payments are based.
Shifts risk to If the realized actual value is less than the assured value, the lessee
lessee is required to pay the deficit to the lessor as the final rental. If the
actual value is greater than the assured value, the lessor may pay to the
lessee the surplus, which essentially reduces the amount of the lease
payments paid by the lessee. Even though risk is being shifted to the
lessee, the lessee standing behind the residual will not cause tax lease
treatment to be disallowed by the IRS, due to a special provision in the
IRC.
Full payment Lessors enter into a tax-exempt user lease with tax-exempt or
taxable nonprofit organizations such as hospitals or federal government
agencies. The IRS requirements for a tax lease must be met. This lease
is considered a tax lease even though the user does not pay federal
income taxes. The lessor records the full payment as taxable income.
In most circumstances, depreciation is received at a slower rate than
the standard MACRS class life schedule.
Nontax Lease Products
Lessee Recall that when a lease fails to meet the IRS criteria for a tax lease,
ownership the transaction is classified as a nontax lease. In a nontax lease, the
lessor is treated as a provider of financing. Let’s look at a few nontax
lease products.
Similarity to a Sometimes the substance of the lease transaction resembles a sale.

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

options substance of the lease is that the lessee is, or will become, the owner
of the leased equipment by the end of the lease term. This could occur
if the lessee has the option to acquire title to the equipment at the end
of the lease for no additional consideration, or for a fixed-price
purchase option that is substantially less than fair market value.
Interest rate In a money-over-money lease, the lessor's profit in the lease is the
differences difference between the interest rate at which the lessor borrowed the
money to purchase the equipment and the interest rate it charges the
lessee. The lessor is making money over money, or a spread. For
example, if the lessor borrowed the money from the lender at 10
percent and is charging the lessee 13 percent, the spread is 3 percent.
Municipalities can enter into a special lease called a municipal lease.

A municipal lease is a nontax lease or a conditional sales contract and
has the characteristics of tax exempt debt.
Tax-exempt An interest rate is stated in the contract. The municipality becomes the
interest owner of the equipment at lease termination. The key characteristic of
earnings a municipal lease is that the interest earnings to the lessor are tax-
exempt. The lessor can pass part of this tax saving on to the municipal
lessee by charging a lower payment than it would normally need to
charge a taxable organization.
SUMMARY
Leases are classified as either tax leases or nontax leases. In a tax lease, the lessor bears the
risks of ownership and is entitled to the tax benefits associated with the equipment. In a
nontax lease, the lessee is deemed owner of the equipment and is entitled to the tax
benefits. The criteria used to classify leases for tax purposes comes from Revenue Ruling
55-540, Revenue Procedure 75-21, and various tax court rulings.
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The classification of a lease has important tax consequences for both lessors and lessees. In
a tax lease, tax benefits such as accelerated depreciation represent cash inflows to a lessor.
For this reason, tax consequences influence a leasing company’s pricing structure and the
way it does business. A lease that starts in the fourth quarter is more sensitive to the value
of depreciation. The lessor is able to realize more of the yield in the lease from tax
benefits, thereby relying less on the periodic payment. Hence, the lessee's payment is
typically lower if structured in the fourth quarter.
Tax consequences do not always have a positive effect on lease transactions. Tax limitations
such as the midquarter convention and AMT can adversely affect the lessor’s yield in a
lease.
Within each of the two broad categories — tax leases and nontax leases — are several types
of lease products structured to meet the needs of various customers.
You have completed Unit Two: Financial Reporting and Tax Classifications. In the next
unit, you will learn how leases are classified for legal purposes. Before you continue to
the next section, check your understanding of the concepts you have just learned by
completing the progress check that follows. If you answer any question incorrectly, please
return to the text and read the section again.
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Question 1: Which of the following will probably not lead to a nontax classification of a
lease agreement?
____ a) Bargain purchase option

____ b) A lessee guaranteed residual value
____ c) Acceptance of residual risk by lessor
Question 2: The purpose of Revenue Procedure 75-21 was to:
____ a) clarify the tax responsibilities in a tax lease.

____ b) establish the true intent of the parties to the lease agreement.
____ c) define asset class life.
____ d) provide guidance for structuring large leveraged leases.
Question 3: In a nontax lease, the lessee is entitled to which of the following?
____ a) Full rental payment deductions

____ b) Half of the normal depreciation allowance
____ c) Interest and depreciation deductions
____ d) Expense deductions for depreciation and rental amounts
Question 4: In a tax lease, the lessor records:
____ a) rental income less depreciation expense.

____ b) depreciation expense plus interest income.
____ c) rent expense.
____ d) interest income.
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ANSWER KEY
Question 1: Which of the following will probably lead to a nontax classification of a lease
agreement?
c) Acceptance of residual risk by lessor
Question 2: The purpose of Revenue Procedure 75-21 was to:
d) provide guidance for structuring large leveraged leases.
Question 3: In a nontax lease, the lessee is entitled to which of the following?
c) Interest and depreciation deductions
Question 4: In a tax lease, the lessor records:
a) rental income less depreciation expense.
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PROGRESS CHECK 2.2

(Continued)
Question 5: Which one of the following statements is true?
____ a) The half-year convention discourages investment in assets.

____ b) MACRS represents a negative cash flow to the taxpayer.
____ c) The midquarter convention slows the pace of tax benefits from
depreciation deductions.
____ d) The midquarter convention primarily affects lessees in tax leases.
Question 6: Asset class life is:
____ a) the depreciable economic life of an asset.

____ b) the current tax depreciation methodology.
____ c) equal to the recovery year in the MACRS table.
Question 7: The impact of depreciation is greatly enhanced for tax transactions completed
early in the year.
____ a) True
____ b) False
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ANSWER KEY
Question 5: Which one of the following statements is true?
c) The midquarter convention slows the pace of tax benefits from

depreciation deductions.
Question 6: Asset class life is:
a) the depreciable economic life of an asset.
Question 7: The impact of depreciation is greatly enhanced for tax transactions completed
early in the year.
b) False
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Unit 3
UNIT 3: LEGAL CLASSIFICATION
AND LEASE DOCUMENTATION
INTRODUCTION
The financial reporting (or accounting), tax, and legal considerations of leasing are very
important to a complete understanding of the leasing product. Financial reporting and tax
classifications were described in Unit Two. In this unit, you will learn that, from a legal
viewpoint, lease transactions are classified as either true leases or secured transactions.
These distinctions are particularly important in the event that the lessee defaults on the
lease or one of the parties files for bankruptcy. The documentation of a lease is an
important consideration also, as provisions in the lease influence the way courts view
the lease.
UNIT OBJECTIVES
n Understand the criteria used by the legal system to distinguish a true lease
from a secured transaction
n Recognize how lease documentation provisions protect lessors
LEGAL CLASSIFICATIONS
Because true leases are treated differently from sales and loans in
commercial law, a lease must be separately classified from a legal
viewpoint.
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3-2 LEGAL CLASSIFICATION AND LEASE DOCUMENTATION
Sources of The classification criteria the U.S. legal system uses today are based
criteria on three sources:
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 on Conceptually, the criteria from these sources are similar to the
ownership criteria used for accounting and tax purposes. Once again, the focus is
on ownership of the equipment.
If the lessor is deemed to be the owner of the equipment, and the

lessee the user, the lease is a true lease. If, in substance, the lessee is
deemed to be the owner, the lease is referred to as a secured
transaction.
The Uniform Commercial Code (UCC)
Technically, true leases are not covered by the UCC at the present
time. However, provisions from the UCC have been applied regularly
to lease transactions. Secured transactions are covered by Article 9.
Sales transactions are covered by Article 2.
Article 9
Article 9 of the code discusses secured transactions — specifically

the rights of a borrower and the rights of a lender.
Secured A secured transaction is created when a debtor (lessee) gives a creditor

interest (lessor) a security interest in certain property. From a legal standpoint,
a secured transaction is not a true lease. Therefore, Article 9 is used to
distinguish between true leases and secured leases.
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LEGAL CLASSIFICATION AND LEASE DOCUMENTATION 3-3
Article 2
Implied Article 2 deals with sales and the rights of buyers and sellers. The
warranties article has been applied to transactions in which a lessor buys goods
from a supplier. Although the article does not technically apply to the
lessor-lessee relationship in a true lease transaction, the courts have
applied some of its provisions either directly or by analogy. Most
notable has been the application of the implied warranties provision.
This provision requires that the property is saleable and
is fit for its usual purpose.
Article 2A-Leases
Proposed Article 2A is a recent addition to the UCC that specifically covers true
article leases. It has been adopted by 49 states. In this section, we cover some
of the article's more important points.
Scope of Coverage
True leases The article applies to any transaction, regardless of form, that creates
a true lease. It does not apply to conditional sales or loans that may
appear documented as a lease. It covers all leasing transactions,
whether business or consumer, daily rental, or multimillion dollar
leveraged lease transactions. There are no exemptions or exceptions
from coverage of the article.
Definition of a Lease
Article 2A provides a definition of a lease:
“Lease” means a transfer to the right to possession and

use of goods for a term in return for consideration; but
a sale, including a sale on approval or a sale or return, or
retention or creation of a security interest is not a lease.
Unless the context clearly indicates otherwise, the term
includes a sublease agreement.
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The Finance Lease
The Article also recognizes that a modern finance lease is different

from a traditional rental. It provides a definition of a finance lease.
"Finance lease" means a lease in which (i) the lessor does

not select, manufacture or supply the goods, (ii) the lessor
acquires the goods in connection with the lease, and (iii)
either the lessee receives a copy of the contract evidencing
the lessor's purchase of the goods on or before signing the
lease contract, or the lessee's approval of the contract
evidencing the lessor's purchase of the goods is a
condition to effectiveness of the lease contract.
Remedies and Damages
Computation The Article provides a complex remedies and damages scheme for
formula those parties who have not specified damages by contract, or whose
contract provisions are unenforceable or otherwise fail. The basic
underlying principle of damage computation is that the lessee's
original rent will be compared to fair market rent.
Case Law Perspective
Case law Some of the factors courts have considered in deciding whether a
criteria transaction is a true lease or secured transaction are below.
n The mere existence of a purchase option by a lessee
n The existence of a “nominal purchase option”
n The transfer of title at the end of the lease for no additional

consideration
n The creation of an equity in the equipment in favor of the

lessee
n Total lease payments by the lessee “substantially equal to or

greater than the purchase price” of the equipment
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n Periodic lease payments that do not reflect “reasonable rental

value”
n How the lessor conducts its business
n How other lessees have dealt with the lessor, e.g., how many
lessees exercised their purchase option, how many returned the
equipment, etc.
n The filing of a financing statement by the lessor
n How the lessor treats the transaction on its books
n What the parties understood the transaction to be
n Whether the lessee was responsible for paying the taxes and
insurance on the equipment and keeping it maintained and
repaired
n Who bears the risk of depreciation in estimated residual value
LEGAL IMPLICATIONS
The legal classification of a lease is important because commercial

law treats lease transactions and secured transactions differently.
In this section, we discuss the two ways lessors protect their interests
in leased equipment: UCC filings and action upon notice of lessee
bankruptcy.
UCC Filings
Protecting By definition, a true lease is not a secured transaction and is not

interest subject to any filing requirement. However, much legal action has
occurred over the issue of security interest. A careful lessor will
always make a UCC filing to protect its interests in case the courts
decide that the transaction was a secured transaction. The filing fee is
cheap insurance against an expensive legal battle that could cost the
lessor all its remaining value in the leased property.
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Bankruptcy Issues for Lessors
Lessee One of the most important situations in which a transaction must be

default classified as a true lease or a secured transaction must be answered in
the event that the lessee defaults on the lease. The consequences for
both lessor and lessee vary significantly depending on the rulings of
the court. A lessor receiving notice of a bankruptcy petition filing by
one of its lessees should quickly determine a course of action to
protect its interests and retrieve the equipment. Otherwise, the lessor
faces the possibility of waiting a year or more to regain possession of
equipment that has, in the meantime, lost some of its value.
SUMMARY
For legal purposes, transactions that are labeled leases are classified as either true leases or
secured transactions. If the lessor is deemed to be the owner of the equipment, the lease is
a true lease. If the lessee is deemed to be the owner, the lease is referred to as a secured
transaction.
The legal classification criteria are based on three sources: the UCC, Article 2A, and court
decisions. Whether the lease is considered by the courts to be a true lease or a secured
transaction has important consequences in the event a lessee files for bankruptcy. A lessor
receiving notice of a bankruptcy petition filing by one of its lessees should quickly
determine a course of action to protect its interests.
Please complete the following Progress Check before continuing too the final section of
this unit, “Lease Documentation.”
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Question 1: The tax, legal, and accounting definitions of a lease are:
____ a) dependent criteria.

____ b) independent criteria.
____ c) determined by FASB 13.
Question 2: Article 2A of the Uniform Commercial Code:
____ a) applies only to lease transactions deemed to be true leases.

____ b) replaces Article 2 of the Uniform Commercial Code.
____ c) is a federally mandated code.
Question 3: Which factor will most likely cause a transaction to be considered a secured
transaction?
____ a) Net terms

____ b) A lessee option to terminate the lease before full payment has been made
____ c) An obligation by the lessee to pay the initial value of the equipment
____ d) The transfer of the title at the end of the lease for no additional
consideration
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ANSWER KEY
Question 1: The tax, legal, and accounting definitions of a lease are:
b) independent criteria.
Question 2: Article 2A of the Uniform Commercial Code:
a) applies only to lease transactions deemed to be true leases.
Question 3: Which factor will most likely cause a transaction to be considered a secured
transaction?
d) The transfer of the title at the end of the lease for no additional
consideration
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LEASE DOCUMENTATION
In the previous section, you learned that the courts treat true leases
and secured transactions differently. In this section, we will discuss
the types of documents generally included in lease transactions and
point out document provisions that help protect the lessor’s interests
in legal situations.
Factors Affecting Documentation
Variable There are many ways to structure a lease transaction, whether it be a

requirements leveraged lease, single investor lease, consumer lease, municipal
lease, or otherwise. The documentation for each different type of
lease transaction can vary greatly. Even the dollar volume of the
equipment influences the complexity of the documentation.
In this section you will learn about the documentation usually required
for a lease transaction. The document provisions generally apply to
most lease transactions.
Lease Documentation
Checklist 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 most
are drafted to protect the lessor's interest. Below, we outline the
various documents involved in a leveraged lease transaction and show
how the document provisions protect the lessor.
Lease/Credit Application
Assess credit The Lease/Credit Application is typically used in equipment leasing

risk transactions involving smaller ticket items of $150,000 or less. It is
a fill-in-the-blank type of document lessors use to gather necessary
information about the prospective lessee and the equipment to be
leased. The lessor uses this information to assess the credit-
worthiness of the prospective lessee and the worth of the proposed
lease transaction.
Master Lease
Common A Master Lease is often used in a lease transaction involving large

terms and ticket equipment or involving one lease transaction of many to come.
conditions The Master Lease sets forth all major terms and conditions that will
be common to all lease transactions that follow.
The variable terms and conditions of each lease transaction (i.e.,

description of equipment, lease term, and payment amount and terms)
are set forth in each succeeding Equipment Schedule.
The major terms and conditions of a Master Lease that protect the
lessor include the following:
n Limitation of liability, disclaimer of warranty

This provision protects a lessor from liability that could result
from express or implied warranties recognized by the UCC.
n Obligation to pay rent
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This provision details the lessee's obligation to make the rental

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

Under this provision, the lessee bears the risk of damage or
destruction of the equipment, as well as the risk of a theft or
governmental taking of the equipment.
n Insurance
This provides for insurance. The purpose of this provision is
(1) to protect the lessor's investment in the equipment and (2)
to protect the lessor, the lessor's assignee, and the lessee from
liability to a third party for injury to persons or property.
n Indemnity
This provision protects the lessor against any claims related to
the purchase, use, and ownership of the equipment.
n Liens and taxes

This provision sets forth the lessee's obligation to pay all
license and registration fees and all taxes related to the
equipment under a net lease.
n Personal property, location of equipment
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The basic test of whether the equipment is personal property or

a fixture is the intent of the parties. This provision sets the
intent of the parties — that the equipment is, and shall remain,
personal property. Also, this provision bars the lessee from
relocating the equipment without the lessor's prior written
consent.
n Designation of ownership
The wording of this provision confirms that the lessor is the
owner of the equipment for tax and UCC purposes.
n Use
This provision requires the lessee to use the equipment in a
careful and proper manner. It protects the lessor from liability
in the event that the lessee’s misuse of the equipment causes
injury to a third party or damages the equipment.
n Surrender of equipment
This provision documents the lessor's status as the owner of the
equipment for tax and UCC purposes. It also requires the lessee
to bear the expense of returning the equipment to the lessor. In
addition, it protects the lessor from excessive wear and tear or
depreciation of the equipment caused by the lessee.
n Suspension of obligations of lessor

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

Under this provision, if the lessee fails to perform an
obligation under the lease, the lessor may carry out the
obligation and then charge the lessee for all expenses incurred,
plus interest.
n Events of default
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This provision defines the events that constitute a default (a

deviation from the terms of the lease).
n Remedies
This provision defines the actions the lessor may take in the
event the lessee defaults on the lease agreement.
Equipment Schedule
Variable lease An Equipment Schedule sets forth all the variable fill-in-the-blank
information information for a particular lease transaction, including a description
of the equipment. The most critical information contained in an
Equipment Schedule is the amount of the lease payment, the
commencement date, and the lease term.
Fair Market Value Purchase Option Rider
End-of-term This rider provides lessees with the option to purchase the equipment
purchase at the end of the lease term at the equipment’s fair market value.
option
Fair Rental Value Renewal Option Rider
Re-lease The Fair Rental Renewal Option gives lessees the option to re-lease
option the equipment for its then-current fair rental value.
Certificate of Acceptance
Representa- This document requires, upon delivery of the equipment,

tions upon (1) confirmation that the lessee received, inspected, and accepted the
delivery equipment, (2) re-confirmation of Master Lease representations, and
(3) proof that the lessee has insured the equipment in accordance with
the terms of the lease. It also requires the lessee to confirm the
location of the equipment. Most important, the document sets forth
the acceptance date for the Equipment Schedule. This date has tax and
UCC consequences.
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Casualty Value Schedule
Compute The objective of the Casualty Value Schedule is to establish the value
compensation (to the lessor) of the lease and the equipment at various times over the
for loss term of the lease. It is used to compute lessee payments for the loss,
destruction, or condemnation of the equipment.
Officer's Certificate or Corporate Resolution
Authorization This resolution ensures that (1) the lease has been accepted by each
corporation's Board of Directors and (2) the agent signing the lease
documents is authorized and empowered to do so on behalf of the
corporation.
Certificate of Insurance
Insurance The purpose of the Certificate of Insurance is to assure the lessor that
obligation the lessee has obtained the appropriate insurance coverage.
Precautionary Form UCC-1
Priority claim The purpose of a Form UCC-1 is to provide notice to third parties
that the lessor has an interest in the equipment. The form insures that
the lessor will have a priority claim in the equipment regardless of
the bankruptcy court’s classification as either a lease or a secured
transaction.
Remedies Upon Lessee Default
The lessor’s position is strengthened if default actions and the lessor’s

options (remedies) are included in the lease. Let’s examine them more
closely.
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Default Provisions
Default provisions are probably the most important clauses in the

lease agreement.
No UCC A breach or default of an agreement results when one of the parties

definitions fails to perform one or more of its promises. The UCC does not
define what events constitute a default. Thus, it is important to
carefully define the actions of the lessee that constitute a default in
the lease agreement. These actions generally include the following:
n False representations
n Failure to pay rent within the specified days of the due date
n Failure to perform or observe any other term or condition of

the Master Lease and Equipment Schedule
n Any affirmative act of insolvency such as filing for bankruptcy
n Levy, seizure, assignment, or sale of the lessee’s property or

the equipment for, or by, any creditor or governmental agency
Notice to These definitions put the lessee on notice that any failure to adhere to
lessee the terms of the lease may result in the lessor pursuing one or more of
the remedies specified in the lease.
Remedies
Lessor control There is no assurance that the lessor’s options for remedy will be
upheld in a court of law. However, including them in the lease
agreement enhances that possibility. It also serves to notify the
lessee of the options the lessor may take. By specifying the available
remedies, the lessor again maintains a degree of control and flexibility.
Typical remedies specified in a lease agreement include the

following:
n The lessor may take back the equipment and re-lease it, sell it
or keep it.
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n If the lessee fails to perform an obligation such as paying for

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

collect liquidated damages in the amount of the casualty value
of the equipment.
SUMMARY
The documentation for each type of lease transaction can vary greatly. However, certain
provisions apply to most lease transactions. Most of these provisions serve to protect the
lessor in the event the lessee defaults on the terms and conditions of the agreement. Lessee
actions considered to be default actions should be defined in the lease agreement. Including
remedies or actions in the lease that the lessor may take in the event of lessee default helps
strengthen the lessor’s position.
You have just completed Unit Three: Legal Classification and Lease Documentation.
Please complete the following Progress Check before you continue to Unit Four: Credit
Analysis and Risk Assessment. If you answer any question incorrectly, you should return to
the text and read that section again.
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Question 1: Most lease documents protect the lessee.
____ a) True
____ b) False
Question 2: A Master Lease usually contains:
____ a) the amount of the lease payment, the commencement date, and the lease
term.
____ b) a Casualty Value Schedule.
____ c) the common terms and conditions that apply to all subsequent
transactions.
____ d) renewal and purchase options.
Question 3: Which of the following definitions applies to remedies in lease

documentation?
____ a) Actions a lender may take if the lessor fails to make its payments
____ b) Actions that constitute a default under the agreement
____ c) Actions the courts may take to define a secured agreement
____ d) Actions that a lessor may take in the event the lessee defaults on the
agreement
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ANSWER KEY
Question 1: Most lease documents protect the lessee.
b) False
Question 2: A Master Lease usually contains:
c) the common terms and conditions that apply to all subsequent

transactions.
Question 3: Which of the following definitions applies to remedies in lease

documentation?
d) Actions that a lessor may take in the event the lessee defaults on the
agreement
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Unit 4
UNIT 4: CREDIT ANALYSIS AND RISK ASSESSMENT
INTRODUCTION
Like other creditors, lessors use credit analysis to assess the credit-worthiness of
a company. The goal is to avoid, or at least manage, bad debt losses. To evaluate
creditworthiness, lessors have aggressively borrowed financial analysis techniques
used by other creditors, including financial statement analysis and cash flow analysis.
In addition, lessors must assess and evaluate risk factors that are unique to the leasing
industry.
In this unit, we describe the credit analysis process, the factors lessors consider in
their evaluations, and some of the tools they use to assess a potential lessee’s credit-
worthiness. Methods lessors can use to minimize specific leasing risks are discussed
throughout the unit.
UNIT OBJECTIVES
n Recognize the risks inherent in leasing
n Identify ways a lessor can minimize risks
n Understand how financial ratios are used to reveal the financial health
of a potential lessee
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4-2 CREDIT ANALYSIS AND RISK ASSESSMENT
RISK ASSESSMENT
Focus is It is important for lessors to understand the risks inherent in leasing

lessor so they can structure leases to minimize these risks. In this section,
concerns we focus on the lessor’s main concerns: the process of assessing and
evaluating risks and the risk factors.
30 variables of There are 30 variables of lease credit, each of which begins with
lease credit the letter “C.” These variables fall into three categories:
n Lessee credit risk assessment
n Characteristics of lessees
n Lease environment risk factors
Lessor credit assessment includes the basic analytical functions that

credit analysts perform in the lease assessment process. The second
and third categories identify the various risk factors credit analysts
must consider. Let’s begin by looking at how credit analysts assess and
evaluate a lessee’s credit.
Lessee Credit Risk Assessment
Analytical There are eight steps in the credit evaluation and assessment process.
functions The eight Cs of Lessee Credit Risk Assessment are:
n Confirmation n Classification
n Corroboration n Consideration
n Catastrophe n Computation
n Concatenation n Compilation
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CREDIT ANALYSIS AND RISK ASSESSMENT 4-3
Confirmation
Obtaining Confirmation is the process of obtaining the information the lessor

information needs 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 to
generally accepted accounting principles (GAAP). These
statements provide an excellent starting point in risk
assessment. Later in this section, you will learn how lessors
use this source of information.
n A compilation or disclaimer
Warning of If an accounting firm has compiled the financial statements, but
extended risk has not audited them, it is likely to include a disclaimer
statement declaring that they have not audited the statements.
The lessor should view a disclaimer as a warning sign of
extended lessor risk.
n Review or limited review of financial statements

Limited These are periodic or special reviews such as those produced
availability when a bank or factory requires periodic reviews on
receivables or inventories. Availability is limited.
n Tax returns
Different from Tax returns are an excellent source of information to use for
financial evaluating lessor risk. The lessor must keep in mind that tax
statements returns are prepared according to tax legislation rather than
GAAP; therefore, differences between financial statements and
tax statements will occur.
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n Other special reports

SEC and Other reports that can help the lessor evaluate risk include
industry- periodic reports filed with the Securities and Exchange
specific Commission (SEC) and special reports required in specialized
reports
industries, such as the airline and broadcast industries.
Corroboration
Validation In corroboration, the lessor validates the credit information supplied

by the prospective lessee. This means the lessor must obtain bank
references and credit disclosures from the lessee’s creditors.
n Bank references
Bank documentation would include the following:
Name and location of the bank

Loans outstanding
Loan amounts
Collateralization
Payment history
Length of the credit relationship
Highest amount of debt extended
Contingent debt
Leases with that bank
n Prior leasing commitments with other lessors

Not always Many banks and lessors avoid disclosing information that may
reliable subject them to litigation. Therefore, a lessor cannot rely on
this source of information. You will find alternative
corroborative sources under the subsection entitled Credit.
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Catastrophe
Worst-case The lessor should identify the worst down-side possibility and then
exposure evaluate the probability and amount of exposure this catastrophe could
cause. Once the analysis is completed, the lessor should decide how
to protect against down-side risk.
Concatenation
Select credit Concatenation means that the lessor must determine which credit
variables variables are important in the credit decision.
Classification
Rank credit In classification, the lessor ranks the credit variables identified in
variables concatenation and assigns a weighted value to each variable. The
rankings start with the most important variables and end with the least
important ones. The weighted values add up to one.
Consideration
Score credit Consideration is the degree to which a credit standard is met. After
variables ranking the credit variables, the lessor subjectively scores each
variable on a predetermined scale. For example, on a 0 - 10 scale,
an important credit variables is assigned a value of 8 to 10. An
unimportant variable is assigned a value of 0 to 3. Variables of average
importance are assigned values of 4 to 7.
Computation
Compute In computation, the lessor multiplies the classification weighted value

by the consideration score. Figure 4.1 is an example of a computation
worksheet. The lessor adds all the computed products to derive the
lessee credit rating.
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Compilation
Result used to Based on where the credit rating falls on the scale, the credit may
make decision be accepted or rejected. Figure 4.1 shows the compilation process and
scale.
Attaining You may view Figure 4.1 as a completed credit matrix. It is important
consistency to realize that each analyst may assign different classification values
through matrix and consideration scores to a risk factor
development
causing variation in computation from analyst to analyst. To attain
consistency within a credit evaluation team, credit managers can
develop credit matrices based on their existing leases. By analyzing
the good, average, and bad leases in its portfolio to derive
classification values and consideration weightings, a lessor can
develop matrices that help the team achieve uniform evaluations.
COMPUTATION WORKSHEET
a
CONCATENATION CLASSIFICATION CONSIDERATION COMPUTATION
(Weighting) 0 -10
a
Future potential .30 x 7 = 2.10
Independent verification .20 x 6 = 1.20
Past experience .15 x 8 = 1.20
Additional risk factors .15 x 1 = .15
Product and diversification risk .10 x 4 = .40
Mitigating considerations .10 x 3 = .30
1.00 5.35 - Credit
rating
COMPILATION
Reject 0-4
Accept (charge premium rate) 4.1 - 5
Accept 5 .1 - 7
Accept (give preferential rate) 7.1 -10
Figure 4.1: Computation worksheet
You can see that the weighted value of this credit is 5.35. Based on the
compilation table, this credit would probably be accepted.
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Characteristics of Lessees
Now that you are familiar with the steps in the credit risk evaluation
process, we will look at the 12 C characteristics of the lessee that the
lessor investigates and evaluates. As you learned in the previous section,
lessors select, rank, score, and compute risk factors on a credit matrix.
Each of the variables discussed in this section represents a risk factor
that the lessor credit analyst may include in a credit matrix.
Character
Integrity, Character refers to the lessee’s potential integrity, honesty, and

honesty, commitment to honor its financial obligations. Previous experience
commitment with the lessee is an excellent indicator, but if the lessor has no
previous experience, other indicators may be used. The lessor may
assess the lessee’s character from a personal interview or through
checking with other leasing companies, bankers, and creditors with
whom the lessee has done business. Another indicator of character is
whether or not the potential lessee has properly disclosed any off
balance sheet financing arrangements — proper disclosure the lowers
lessor’s risk.
Capital
Three Capital has several meanings. We will use three meanings of the term
definitions here.
1. In its broadest sense, capital refers to the total resources

available for a firm's usage including all assets and balance
sheet resources. Nonbalance sheet resources such as people,
experience, and other factors normally not quantified as resources
also have been included.
2. A narrower definition of capital is the definition of capital assets,

which is generally regarded as property, plant, and equipment.
3. An even narrower definition regards capital as cash.
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Lessee’s For risk assessment purposes, a creditor usually looks for strong net
capital worth and limited financial leverage. A strong capital position means
position the lessee has assets available to satisfy a judgment in the event of
default. The following accounting formula conveys this concept:
Assets = Liabilities + Equity
The left-hand side of the equation represents all quantified asset

values and the right-hand side indicates the source of financing for
those assets.
There are only two methods of funding assets.
n Borrowing money to purchase assets
n Investing equity funds to purchase assets
The lessor can analyze the balance sheet equation to determine both
the degree of the lessee’s net worth and the extent of financial
leverage.
The lessor should also determine the degree to which assets may be
encumbered (tied up as collateral). It is possible for a company to
have a high net worth but have an excessive amount of assets placed as
collateral with other creditors. This could mean that there is not
enough protection for a new lease.
If the asset has a questionable residual value or is rapidly losing value,

a wise lessor will obtain additional unencumbered capital protection.
With smaller companies, the lessor may request additional collateral
from the lessee and/or personal guarantees. In the case of personal
guarantees, the lessor should also evaluate the lease guarantor’s
capital position. In larger lease transactions and in most public
companies, personal guarantees cannot or will not be given; the net
worth of the lessee stands alone. Later in this unit you will learn about
ratios that can be used to analyze capital.
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Capacity
Lessee’s Capacity refers to the lessee's ability to pay. Typically, credit analysts
ability to pay examine the lessee’s income statement to determine that the net
income is adequate. Lessors should trend historical net income
figures to determine the pattern of growth. If net income is growing,
but at a declining rate, the risk that the lessee will not be able to pay its
obligations in the future increases. On the other hand, steady growth
of net income or growth at an increasing rate would indicate a
decreased risk.
The lessee’s source of income also affects capacity. If the lessee

realizes a sizable portion of net income through a limited number of
customers, the lessor may verify the probability of continued sales by
obtaining written or verbal confirmations from the customers.
Liquidity Recall that a broad interpretation of capacity includes not only the
assessment current ability of a lessee to earn, but also the lessee’s ability to
maintain adequate liquidity, cash flow, and to sustain solvency. Credit
analysts typically assess liquidity by examining the current assets and
the current liabilities. If a lessee's cash flow position deteriorates or
is threatened, liquidity may become inadequate, which increases the
lessor’s risk.
To assess this risk, a lessor should determine whether the lessee’s

cash budget (forecast) demonstrates adequate cash for at least one-
half of the lease term. We will cover this in more detail later in this
unit. Finally, the lessor must determine whether net income will grow
at a rate sufficient to sustain and strengthen solvency.
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Credit
Size of capital The lessor should investigate credit experience to determine the
and payment lessee’s past trading policies and practices. Dunn & Bradstreet is a
trends common source; it reports size of capital and payment trends (how big
a company is and how fast it pays). Typically, the assumption is that
the bigger a company is and the faster it pays, the better the risk.
Conversely, a smaller company that pays slowly would normally be
assessed as less creditworthy.
Some firms choose not to provide Dunn & Bradstreet with the
financial information requested to determine the rating. In these
circumstances, Dunn & Bradstreet either estimates the information or
comments in the rating that the company does not choose to be rated.
View this as a warning sign.
Officer credit Lessors also may obtain credit checks on selected officers, owners
checks and principals of a lessee seeking credit. This may be particularly
important if the lessee is a closely-held company or is a relatively new
company. The lessor will feel more comfortable about extending
credit if the principals have superior individual credit records.
Sources of Trade associations are a frequent source of credit information.

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

can pay for the lease without threatening liquidity. Because of the
importance of cash flow to risk assessment, we will discuss cash flow
analysis in a separate section later in this unit.
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Chronological Age
History affects A company with a relatively short history presents increased risk to
extent of risk the lessor. In the case of start-up companies, the lessor may look to
the past successes and failures of the principals to assess risk. For
established firms, the lessor should trend relevant income and other
financial data to provide a basis for evaluating forecasted data.
CAPM-Beta Coefficient
Capital asset The capital asset pricing model (CAPM), with its attendant beta
and risk coefficient, is a way to measure the risk in capital budgeting. Because
evaluation leasing is basically a capital expenditure consideration, it makes sense
for lessors to understand this conceptual approach to capital asset and
risk evaluation.
Two You should understand that interest rates that lessors receive usually
components varies according to the risks they bear. Interest may be separated into
of risk two components; risk-free rate and risk premium. Lessors consider
the return on U.S. government securities to be the risk-free rate. For
the second interest rate component, the lessor assigns a risk premium
to each lessee. Risky lessees dictate higher risk premiums; low-risk
lessees dictate lower risk premiums; and leases, such as those to the
federal government, would have no risk premium.
Example To illustrate this concept, let’s assume that a lessor has determined
that the risk-free rate is 7%. Furthermore, because the lessee is
considered an average risk, the lessor assigns an additional risk
premium of 5%. Thus, the total expected return on the lease
investment would be 12% (7% + 5%) to compensate for both types of
risk.
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Beta This is where the concept of the beta coefficient comes into our
coefficient example. The beta coefficient is the educated assessment of the
financial risk premium of individual companies compared to their
industry averages. Merrill Lynch, Standard and Poor's, and many other
financial organizations publish "beta books" in which the industry
average for risk premium is assigned a value of one. Individual
companies with a beta coefficient of less than one (lower than the
industry average) appear more stable and those with a beta in excess of
one (higher than the industry average) are perceived as less stable.
To complete the example, let’s assume the beta coefficient is one, as

illustrated below:
7% + (1)(5%) = 12%
However, if one of the financial reporting services determines the

beta coefficient in the capital model has increased to 1.8, our formula
is revised to yield a rate of 16% [7% + (1.8)(5%)].
Beta books Lessors servicing listed corporations should subscribe to a beta book
in order to obtain the beta coefficients of all large public companies.
Lessors who want to calculate a beta coefficient for unlisted lessees
should refer to the relevant chapters in a graduate-level finance text.
A substantial change in a company’s beta coefficient indicates a

change in the risk level of the company, and the lessor should
adjust the lease terms accordingly.
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Capability
Management Capability is the lessee's level of management expertise — new

expertise management frequently has a lower level of capability than
experienced management. Lessors should assess a managerial
staff to determine that they possess requisite skills, training, and
experience. Numerous studies have indicated that this is one of the
most important factors in predicting corporate success.
Competence
Productivity Competence refers to the productivity of the lessee. The lessor seeks
to determine how well the lessee’s management has done with the
capital and labor resources entrusted to it.
Control
Feedback and Control refers to the feedback systems (such as standard cost
budget accounting systems, budget variance systems, and zero base budgeting
systems systems) that companies use to correct or confirm past actions. The
lessor should pay attention to the type of cost system (such as a job
lot cost accounting or a process costing system) that
is in place as well as the lessee’s budgeting process. The budgeting
process should include a strategic plan, a capital plan, and an operating
plan. The strategic plan shows the company’s planned growth. In the
capital plan (balance sheet), the company decides what assets it must
gather and how these assets are to be financed. The operating plan is
the budget or income statement plan.
The concern for the lessor is the kind of budgetary or feedback tools
the company has in place. If the lessee does not have a budget or
feedback tools, credit risk is high — lessor beware!
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Course
Compare Course refers to the financial direction of the lessee. It also relates
historical to the financial history of the company. The lessor should first
trends to determine that a proper trend analysis is available for cash flow,
historical
financial ratios, and capacity indicators. The lessor can compare this
plans
analysis to the strategic plan of a company to see if historical trends
have substantiated historical plans.
Next, the lessor should compare the company’s forecasts of future

positioning in the market with historical trends to see if they
correlate. For example, if historical trending indicates a lease
applicant has traditionally experienced a ROA of 11% or 12%, but the
financial forecasts indicate an expected ROA of 20%, the company
must show changes in the strategic plan, the capital plan, and the
operating plan that will create this growth.
Constraints
Success Constraints are those unique business, governmental, and social

factors requirements that impede or promote a potential lessee's success. The
credit analyst must determine the unique characteristics of the
potential lessee that strengthen or weaken its ability to perform on a
lease contract. For example, the best product idea may be doomed to
failure if it is not marketed correctly. Thus, the lessor must take into
account the lessee’s marketing experience as well as the product
potential before extending credit.
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Lease Environment Risk Factors
In the previous section, you learned about the characteristics of

the lessee that the lessor investigates and evaluates to assess risk.
However, these are not the only risks lessors must evaluate. There are
also credit risks inherent in the lease environment itself! These are
factors that are external to the lessee and may affect the lessor’s
decision to extend lease credit. They include:
n Collateral n Competition
n Complexity n Cyclical and Countercyclical
n Currency n Copartner
n Category n Concealed Value
n Cross-border n Circumstances
Collateral
Value of Collateral is important because the lessor must look to the value of
equipment the equipment if the lessee defaults. Equipment that maintains value
over time over time is obviously a better risk than equipment that does not
maintain resale value. For example, commercial airplanes and jets
frequently are worth as much after being leased seven years as they
were at the inception of the lease. In contrast, computers may lose a
significant amount of their value even between the time they are
ordered and the time they are delivered to the lessee.
Tool for Because the question of collateral is so important in many leases, the
assessing lessor should assess its risks carefully. One assessment method used
increased risk compares an actuarial investment recovery curve for the equipment to
the economic obsolescence curve. The shaded area between the curves
in Figure 4.3 represents the area of increased risk to the lessor.
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Figure 4.3: Collateral risk
Structuring Lessors can minimize collateral risk through lease structuring.

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

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

agreements collateral risk. These are agreements in which the vendor does not
guarantee the residual equipment value, but does agree to assist in the
remarketing of the equipment.
Complexity
Complexity refers to risk due to inherent or designed intricacy of

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

agreement interests, the lessor should specify in the agreement all details of its
details security interests, require an insurance binder, and include details of
any contingent lease agreements that exist.
Provision for The lessor should also consider provisions for covering the effect of
tax law tax legislation on its cash flow. One approach may be to specify that
changes the lessor's after-tax cash flow return on investment will remain
constant if a tax law change occurs.
AMT An additional area of complexity in the field of leasing is that of

alternative minimum tax, which we discussed in Unit Two. Because
AMT has changed the after-tax cost of leasing so dramatically for
lessees, the lessor should discuss it with all prospective lessees.
Bundled Bundling of services is also a source of complexity. Lessees find it

services more difficult to determine the true cost of the lease. The lessor must
calculate carefully the profitability of the various portions of the
bundled lease to determine that the overall package provides adequate
financial reward for the inherent complexity.
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Currency
Monetary unit Currency rates, restrictions, fluctuations, and translations all increase
risks risk to the lessor. The primary risk in currency is the monetary unit
itself. Traditionally, contracts, including leases, have been
denominated in U.S. dollars. If a lease is denominated in a foreign
currency that is subsequently translated into a balance sheet and
income statement, a translation gain or loss may also occur. Lessors
must understand these risks.
Category
Asset-specific Risk assessment is affected by the type of equipment in several ways.

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

economic jurisdiction for utilization in another. In cross-border leasing, the
risks major risk is changing economic and political conditions. For
example, during the 1970s as political and economic situations in
Mexico were stabilizing, cross-border leasing increased. When the
economic conditions changed in the early 1980s, many American
lessors were faced with enormous risks they had not anticipated.
Another cross-border risk is the constant state of flux associated with

property and income taxes. Sudden changes in local tax policies can
force lessors to rethink their cross-border policies or even withdraw
from the market. Political and religious conditions may also alter the
degree of risk inherent in cross-border leasing. When a cross-border
lease goes bad, it is frequently not possible to recover the asset.
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Competition
Lessee’s Competition involves the lessee's markets, market shares, and trends.
growth The lessor should determine if the lessee has a growing, stable, or
potential declining share of a growing, stable, or declining market.
International The lessor must also consider the foreign competition the lessee
lessor faces. The growing internationalization of the business community has
competition introduced many new competitive players. These competitors are
using their respective strengths (such as lower interest rates) to gain a
strong foothold. This suggests a dramatic change in international
competition in the future.
Cyclical and Countercyclical
Lessee’s Cyclical and countercyclical risk refers to the type of economic

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

with another relationship with a second investing party. Typically, a genuine
investing partnership dilutes the profitability of the lease. However, other types
party
of copartnership arrangements are available that reduce risk without
diluting earnings — for example, vendor guarantees and joint ventures.
Many cross border leases use joint ventures to avoid partnership
liability and to gain additional expertise. Within certain political
jurisdictions, however, joint ventures are regarded as partnerships and
will not reduce the lessor’s risk.
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Concealed Value
Book value Concealed value refers to the difference between the book value and
vs. fair market the fair market value of a fixed asset. Because balance sheets are
value prepared according to GAAP, fixed assets reflect historical cost less
accumulated depreciation (book value). However, many pieces of
equipment retain a high market value which varies considerably from
the lower amount shown on the balance sheet. A good example of this
is large aircraft. An aircraft may be fully depreciated on the balance
sheet after 10 years, yet the fair market value may be a significant
portion of its original cost. For this reason, the credit analysis should
include sufficient fair market values on fixed assets.
Intangible Intangible assets are another source of valuation risk for lessors.
assets Many lease applicants may have unreported goodwill, patents,
copyrights, and trademarks that add to the value of a company. Lessors
should attempt to uncover intangible, undervalued, and unreported
hidden assets and consider them in the credit analysis.
At the same time, lessors must be wary of lessees who report
intangible assets of questionable value.
Circumstances
Subjective Even though a potential lessee's creditworthiness appears suspect

view based on the other considerations, circumstances may justify
extending credit. For example, the equipment to be leased or used may
be part of a profitable, self-liquidating project that is not dependent
upon other less profitable operations of the business. Another
circumstance may be a start-up company that is just entering a period
of normal profit after having incurred losses during the development
stage. Consideration of circumstances is a last subjective view of a
company to determine whether any conditions exist that might justify
extending credit when most other credit indicators suggest credit
refusal.
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SUMMARY
In this section, we discussed the 30 Cs of lease credit analysis. We categorized these as

steps credit analysts perform in the analysis process, risk factors involving the lessee, and
risk factors involving the lease environment. Included in these categories are some methods
for minimizing risks associated with particular risk factors. Examples of these are
guaranteed residuals, co-partnership arrangements such as joint ventures, and lease
provisions such as preventative maintenance clauses.
Please check your understanding of the 30 Cs of lease credit analysis by completing

Progress Check 4.1, then continue to the next section, Financial Statement Analysis.
If you answer any questions incorrectly, review the appropriate text.
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Question 1: Audit reports, tax returns, and SEC reports are all sources of
___________________ for the lessor credit analyst.
Question 2: The end purpose of concatenation, classification, consideration, computation,

and compilation is to:
____ a) identify the worst down-side possibility.

____ b) rank credit variables from most important to least important.
____ c) use the result to reach a credit decision.
____ d) determine the degree to which a credit standard is met.
Question 3: Whether a potential lessee has disclosed any off balance sheet financing
arrangements is an indication of the lessee’s:
____ a) character.
____ b) competence.
____ c) credit.
____ d) capability.
Question 4: The purpose of analyzing fixed payment coverage (times interest earned)
is to:
____ a) calculate a break-even point.

____ b) determine the lessee’s pattern of income growth.
____ c) track historical trends of gross operating margin.
____ d) detect limitations in the lessee’s ability to pay.
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ANSWER KEY
Question 1: Audit reports, tax returns, and SEC reports are all sources of
confirmation for the lessor credit analyst.
Question 2: The end purpose of concatenation, classification, consideration, computation,

and compilation is to:
c) use the result to reach a credit decision.
Question 3: Whether a potential lessee has disclosed any off balance sheet financing
arrangements is an indication of the lessee’s:
a) character.
Question 4: The purpose of analyzing fixed payment coverage (times interest earned)
is to:
d) detect limitations in the lessee’s ability to pay.
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PROGRESS CHECK 4.1

(Continued)
Question 5: The CAPM-Beta coefficient is used to measure:
____ a) nonbalance sheet resources such as people and experience.

____ b) the risk of a company.
____ c) cash flow.
____ d) the productivity of the lessee.
Question 6: The larger the lessee’s net income, the better able the lessee is to fund a new
lease transaction.
____ a) True
____ b) False
Question 7: Guaranteed residuals, remarketing agreements, and excess-use penalties are

all ways the lessor can minimize risks associated with:
____ a) complexity.
____ b) collateral.
____ c) credit.
____ d) control.
Question 8: The introduction of a partner into a lease agreement reduces liability:
____ a) in a cross-border arrangement.

____ b) and increases profitability.
____ c) but may also reduce profitability.
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ANSWER KEY
Question 5: The CAPM-Beta coefficient is used to measure:
b) the risk of a company.
Question 6: The larger the lessee’s net income, the better able the lessee is to fund a new
lease transaction.
b) False
It is possible for a company to have a positive net income, but a
negative cash flow. An example is a growth company that invests large
amounts in assets.
Question 7: Guaranteed residuals, remarketing agreements, and excess-use penalties are

all ways the lessor can minimize risks associated with:
b) collateral.
Question 8: The introduction of a partner into a lease agreement reduces liability:
c) but may also reduce profitability.
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FINANCIAL STATEMENT ANALYSIS
Up to now, our discussion has focused on the methods lease credit

analysts use and the risk factors they assess. Financial statement
analysis traditionally has been a major part of the credit analysis
process. Financial statements provide important information about
a company.
n The income statement communicates profitability for a given

period of time.
n The balance sheet illustrates balances or economic residuals at the

end of such a period.
n The cash flow statement, which is required by Financial

Accounting Standards Board statement No. 95 (FASB 95),
provides information about the uses and sources of cash.
In this section, we will discuss the use of each financial statement for
lease credit analysis.
Income Statement Analysis
Vertical An income statement may be analyzed in different ways. Its

analysis components may be broken down either vertically or horizontally. In
vertical analysis, the first figure, sales, is equated to 100%.
Each successive income and expense line item is expressed as a
percentage of sales.
Horizontal A horizontal analysis, however, assumes a totally different strategy:

analysis that of trending. Each line item in Year 1 is defined as the base year
and equated to 100%. For each successive year, the line items of the
income statement are expressed as a function of the base year.
Horizontal analysis reveals the dynamic nature of the income.
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Balance Sheet Analysis
Economic The balance sheet is an economic snapshot of the company at a

snapshot particular time. Like the income statement, the balance sheet may be
analyzed horizontally or vertically. Horizontal analysis provides
trending information, whereas vertical analysis results in a comparison
of one classified line item to another.
Cash Flow Analysis
Accrual Earlier in this unit, we mentioned the importance of analyzing cash

accounting vs. flow to evaluate the lessee’s ability to pay. To appreciate why cash
cash flow flow gives a lessor a better view of a potential lessee’s capacity, you
need to understand that income statements and balance sheets are
prepared on an accrual basis, according to GAAP. Accrual financial
statements reflect sales as revenue before payment is received. Also,
expenses may be recorded before they are paid.
The problem with accrual accounting is that salaries, invoices and

dividends are not paid with accrual net income; they are paid with cash.
A credit analyst must manipulate the accrual statements to determine
how much cash is flowing into and out of the company. The FASB
agrees with the importance of cash flow analysis, which is why it has
issued FASB 95. FASB 95 requires a statement of
cash flows in the financial statements. Because cash flow analysis
is so important, we will discuss it in detail as a separate topic later
in this unit.
Standard Ratio Analysis
From a credit analyst’s point of view, the main purpose of financial

statement analysis is to determine a company’s current and future
financial health. We have just seen how the income statement reports
a company’s operations over a period of time, how a company’s
balance sheet reports the company’s position at a point in time, and
how the cash flow analysis reports a company’s sources and uses of
cash over a given period.
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Relationships Another tool credit analysts use to assess a company’s financial well-
between being is a financial ratio analysis. Financial ratios are useful because
financial they reveal relationships between financial statement accounts. Credit
statement
analysts use ratios for comparative analysis, interrelationship studies,
accounts
and input to forecasting models. Figure 4.4 shows how ratios are used
and the effect they have on the decision process.
RATIOS AND THE DECISION PROCESS
How Ratios are Used Effect on the Decision Process
COMPARISONS
1) Currently established ratios are compared 1) Trends are established by looking at a

with the same ratios of prior periods for the series of ratios over time.
same firm.
2) Industry ratios are compared with similar 2) Relative standing is established within an
companies within an industry. industry. Relative standing could highlight
strengths or weaknesses.
INTERRELATIONSHIPS
1) In-depth analysis finds logical relationships 1) Pinpointing the causes of weaknesses is

among various items on the balance sheet facilitated by the use of ratios casually
and income statement. related to a problem.
2) Ratios are categorized according to 2) Common financial objectives that must be

common objectives of financial met to maximize profit, insure growth in
management. share price, and maintain liquidity are
highlighted, along with serious weaknesses
in one category that could ultimately lead to
a weakening of another major category.
MODELS
1) Simulation models developed from 1) The overall effect of component variables

interrelated ratios to show the simultaneous can be observed from the use of simulation
effects of changes in these ratios. models.
2) Forecasting models are developed by using 2) Planning is facilitated by the use of

regression analysis techniques on particular forecasting models. Budgets can be
ratios. established as the result of a particular
forecast of certain ratios.
Figure 4.4: Ratios and the decision process
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Categories of Standard ratios can be grouped into six broad categories, each of
noncash which depicts a particular aspect of the financial condition of the
ratios company:
n Profitability and earnings growth

n Liquidity and working capital
n Investment utilization and activity
n Financial leverage
n Solvency and risk
n Owner's equity
Ratios within each category give the credit analyst an indication of

whether the company is meeting the goal of the particular category.
Information We will use the year-end financial information for ABC Company
used for in Figures 4.5 and 4.6 to illustrate how the ratios in each category
examples are computed and how they are used in the decision process. We
will assume that the average price per share for ABC Company
stock during 1993 is $35 and that dividends in the amount of $28,000
were paid.
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ABC Company
BALANCE SHEET
1993 1992
ASSETS
Cash $ 106,000 $ 192,000
Accounts receivable 566,000 483,000
Inventories 320,000 250,000
Plant and equipment (net) 740,000 716,000
Patents 26,000 26,000
Other intangible assets 14,000
12,000
Total assets $ 1,772,000 $ 1,679,000
LIABILITIES AND EQUITY

Accounts payable $ 170,000 $ 126,000
Federal income tax payable 32,000 13 ,000
Miscellaneous accrued payables and
dividends payable 38,000 45,000
Bonds payable (4%, due 1996) 300,000 300,000
Preferred stock ($100 par, 7% cumulative,
non-participating and callable at $110) 200,000 200,000
Common stock (no par, 20,000 shares
authorized, issued and outstanding) 400,000 400,000
Retained earnings 720,000 683,000
Treasury 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 Company
INCOME 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 $ 35,000

Income tax expense 37,000 13,000
Net income $ 65,000 $ 22,000
Figure 4.6: Income statement
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Profitability and Earnings Growth Ratios
Dual If we assume that the goal of management is to maximize

objectives shareholders' value, then the company must (l) maximize profits so
continual dividends will be paid and (2) maintain steady growth in
earnings so the investor's stock price will grow (capital gains). These
two objectives are interrelated. A company that pays proportionately
high dividends compared to amounts retained each year from net
income will find it difficult to grow as fast as another company that
retains more earnings.
Profitability Seven ratios have been developed into a model (Figure 4.7) that
model describes a company's profitability and also describes the effect of
dividend payout on potential growth rate in earnings.
PROFITABILITY MODEL
1. Net profit to net sales (net profit margin)
x 2. Net sales to total assets (asset turnover)
= 3. Return on investment or assets
x 4. Financial leverage advantage (assets to equity ratio)
= 5. Net income to owners' equity (return on equity)
x 6. Retention ratio (l - dividend to net income ratio)
= 7. Potential growth rate in earnings.
Figure 4.7: Profitability model
Note that each factor in the model can stand alone and still have
significance. However, the model does show the effect of a change in
any one factor on both return on equity (ROE) and potential growth
rate — two objectives that management should be especially
concerned about in the planning process. The following examples of
profitability and earnings growth ratios are based on the information in
Figures 4.5 and 4.6.
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1. NET PROFIT TO NET SALES (NET PROFIT M ARGIN)
The formula for computing this ratio is:
Net income (after taxes) $65,000

= = 4.33%
Net sales (after returns and allowances) $1,500,000
Net income as Net profit margin calculates net income as a percentage of sales.
percentage of Stable or growing net profit margins are favorable indicators so long
sales as asset turnover has not been overly reduced.
2. NET SALES TO T OTAL ASSETS (ASSET T URNOVER)
Net sales $1,500,000

= = 89.34%
Total assets (beginning of year) $1,679,000
Sales that Asset turnover indicates the amount of sales that each dollar invested
investments in assets can generate. Thus, in this example, each dollar of assets is
in assets can able to generate $.8934 of sales revenue. Increases in asset turnover
generate
are considered favorable so long as profit margins are not unduly
sacrificed to generate volume increases. Remember, it is net profit
margin times asset turnover that really indicates profitability (return
on investment or assets).
Using as part Notice that when we calculate asset turnover as part of the
of profitability profitability growth model, we use: beginning of the year assets rather
model than an average and total assets rather than net fixed assets, which are
more commonly used for asset turnover computations.
3. RETURN ON ASSETS (RETURN ON INVESTMENT)
Net Profit Margin x Total Asset Turnover

or
Net income $65,000
= = 3.87%
Total assets $1,679,000
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ROA Return on assets (ROA) demonstrates the after-tax interest equivalent

indicators return on assets invested. Thus, assets are earning 3.87% after-tax.
Steady or growing ROA percentages are important indices of financial
health in a potential lessee.
4. FINANCIAL LEVERAGE ADVANTAGE (ASSETS TO EQUITY RATIO)
Total assets (beginning of year) $1,679,000

= = 1.405
Owners' equity (beginning of year) $1,195,000
Effect of This ratio is not one that indicates profitability directly; rather, it
financial indicates the effect of financial leverage on profit. When a company
leverage earns more than enough on its assets to pay interest on debt, the
balance goes to equity. This ratio, when multiplied times ROA, shows
the effect on equity when leverage is used. Assets are 1.405 times
equity and the ROA, when converted to return on equity (ROE), will be
140.5% higher, as the next ratio demonstrates.
5. NET INCOME TO OWNERS ' EQUITY (RETURN ON EQUITY)
The formula for computing this ratio is as follows:
ROA x Financial leverage advantage = Return on equity

3.87% x 1.405 = 5.44%
or
Net income (after taxes) $65,000
= = 5.44%
Net worth (beginning of year) $1,195,000
Steady or A company's ROE should be steady or growing and be relatively close

growing ROE to other industry competitors. However, increased ROEs that stem
from increased financial leverage, rather than from a growing ROA,
should not be considered a favorable indicator of creditworthiness.
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6. RETENTION RATIO
Dividends $28,000
1- = 1- = 56.92%
Net income $65,000
Declines This ratio indicates the percentage of net income that remains after
indicate profit dividend payment. Sudden or systematic declines in the retention ratio
crisis could indicate an impending profitability crisis.
7. POTENTIAL GROWTH RATE
ROE × Retention ratio = 5.44% × 56.92% = 3.10%
Growth A company’s growth rate cannot exceed the product of its retention
factors ratio times its ROE. To grow faster, either ROE has to be increased or
dividend payout reduced. Therefore, if leases are to be paid out of
anticipated future earnings derived from increased growth, that growth
should be justified.
Additional profitability and earnings growth ratios help the analyst

anticipate possible future problems. They include: price/earnings
ratio, gross margin, and dividend yield. Remember, the figures in the
examples are taken from the financial information for ABC Company
(page 4-31).
PRICE EARNINGS RATIO
Market price per share (average may be used) $35

= = $10.769 per share
Net income per share (Previous 4 quarters)  $65,000 
 
 20,000 
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Decreases Sudden decreases in the price / earnings ratio relative to the

relative to price/earnings ratios of the Standard and Poors 500 could indicate
S & P 500 an impending profitability problem.
GROSS M ARGIN
Gross profit on sales $600,000

= = 40%
Total sales revenue $1,500,000
Percentage of Gross profit margin indicates what percentage of sales is gross profit.
sales as gross Steady or increasing gross profit margins are favorable if asset
profit turnover is not being reduced too fast or general and administrative
expenses are not increasing too rapidly.
DIVIDEND YIELD
The formula for computing this ratio is as follows:
 $28,000 
 
Dividend p er share  20,000 
= = 4%
Average price per share 35
Reductions Dividend yields usually remain constant within a narrow range of 2%

indicate to 4%. Ratios above 4%, or sudden reductions in a ratio when the
problems general stock market is constant, could indicate upcoming
profitability problems.
Liquidity and Working Capital Ratios
Ability to meet In addition to profitability, another vital concern of the financial

obligations analyst is liquidity, or the ability of the firm to meet its maturing
obligations (current liabilities). Four ratios that indicate liquidity
and the composition of working capital in terms of inventory and
accounts receivable are: current ratio, acid-test ratio, inventory-to-net
working capital, and accounts receivable-to-net working capital.
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CURRENT RATIO
Current assets $992,000

= = 4.13 times
Current liabilities $240,000
Compares Current assets are 4.13 times as large as current liabilities. Keep in
assets to mind, however, that a significant portion of current assets may not be
liabilities liquid enough to pay liabilities when due.
ACID-T EST RATIO (QUICK RATIO)
Quick assets (cash, securities, accounts receivable) $672,000

= = 2.8 times
A better index Quick (readily convertible to cash) assets are 2.8 times current
of liquidity liabilities, which is a more realistic index of liquidity than current ratio.
INVENTORY-TO-NET WORKING CAPITAL
Inventory (end of period or average) $285,000

= = 37.90%
Net working capital $992,000 - $240,000
Inventory as Note that net working capital is current assets minus current
percentage of liabilities. This ratio indicates what percentage of working capital is
working comprised of inventory, its most nonliquid component. An increasing
capital
inventory-to-net working capital ratio indicates movement towards a
nonliquid position.
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ACCOUNTS RECEIVABLE-TO-NET WORKING CAPITAL
Accounts receivable (end of period or average) $525,000

= = 69.81%
Net working capital $752,000
Accounts A growing accounts receivable to net working capital ratio is favorable

receivable as because it indicates a more liquid working capital than if inventory
percentage of were the predominant component.
net working
capital
Investment Utilization (Activity) Ratios
Effective use Investment utilization or activity ratios measure how effectively the
of resources firm employs its resources. One method to measure investment
utilization is to review the total operating cycle, which is an analysis
of the time required to convert cash into merchandise, then into
accounts receivable, and ultimately back into cash again. There are
several common ratios that aid in an analysis of investment utilization:
1. Days’ receivables
2. Days’ inventories
3. Total operating cycle
4. Days’ payables, and accounts payable turnover
5. Net sale to owner’s equity
6. Net sales to working capital
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DAYS' RECEIVABLES (COLLECTION PERIOD)
365 365
=
Accounts receivable turnover  Credit sales 
 Average accounts receivable 
365
= 127.628 days
 
 
 $1,500,000 
  $566,000 + $483,000  
  2


Growing time If credit sales are not available, total sales may be used, and year-end
period signals accounts receivable may be used in place of average accounts
liquidity receivable. This ratio indicates it takes an average of 128 days to
problems
collect ABC Company's receivables. If this time period is growing, a
red flag is raised indicating liquidity problems such as bad debts,
ineffective collection policy, etc.
DAYS' INVENTORIES (SALES PERIOD)
365  Cost of goods sold


Inventory turnover  Average in ventory
365
= 115.583 days
 
 
$900,000
 
  $320,000 + $250,000  
  2  
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Growing ratio If cost of goods sold is not available, total sales may be used.
warrants Ending inventory may be used instead of average inventory. This ratio
investigation indicates the time required to convert inventory into a sale.
A growing ratio may indicate sales slowdown, manufacturing
inefficiencies, or a new product mix — all of which should be
investigated and understood.
T OTAL OPERATING CYCLE
Days' receivables + days' inventories = 127.628 + 115.583 = 243.2 days
Growth This ratio represents the total time to convert inventory into a sale,
indicates poor then into a receivable, and back into cash. Growth of this conversion
resource time period may indicate poorer overall utilization of resources.
utilization
DAYS' PAYABLES AND ACCOUNTS PAYABLE T URNOVER
365  Cost of goods sold


Payable turnover  Average payable
365
= 60.022 days
 
 
$900,000
 
  $170,000 + $126,000  
  2  
Growth in This ratio represents the average time taken to pay trade payables. The
result time period should be less than both days’ receivables or days’
indicates inventories. Growth in the days’ payable may indicate forthcoming
liquidity,
liquidity and profitability problems since trade creditors are being
profitability
problems
forced to increase their waiting period for payment.
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NET SALES TO OWNERS ' EQUITY

= = 1.26 times
Owners' equity (average) $1,195,000
Dependency This ratio indicates how dependent sales are on owners' equity
of sales on (assuming constant financial leverage). If this ratio has held constant,
owner’s equity increased sales may require additional equity — without equity
infusions expansion might be limited. Increases in the ratio may
indicate improvement in operational efficiencies.
NET SALES TO WORKING CAPITAL

= = 2.01 times
Average net working capital $747,000
Dependency The net sales to average net working capital ratio indicates the degree
of sales on to which sales are dependent upon working capital. If this ratio
working increases, working capital inefficiencies are occurring or a new
capital
product with slower turnover is being sold.
Financial Leverage Ratios
Lessee’s debt A lessor granting credit should always be concerned with the debt
burden burden a potential lessee is carrying, for if the lessee is too highly
leveraged it may not be able to pay the lease payment. We will present
four financial leverage ratios aid the analyst in determining the risk
associated with debt:
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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T OTAL LIABILITIES -TO-T OTAL ASSETS (DEBT RATIO)
Total liabilities (or long - term liabilities) $540,000

= = 30.47%
Total assets $1,772,000
Growing ratio This ratio describes what percentage of the total capital structure is
may signal debt. If a company's ROE is relatively constant while this ratio is
inefficiencies growing, inefficiencies may be occurring.
CURRENT LIABILITIES -TO-OWNERS ' EQUITY

= = 19.48%
Owners' equity $1,232,000
Growing ratio This ratio indicates relative commitment to the company: trade
signals creditors (current liabilities) versus owners' equity. A growing ratio
liquidity needs may indicate forthcoming liquidity needs.
INTEREST-TO-NET INCOME BEFORE INTEREST
Interest Interest (1 - t) $120,000

or = = 64.86%
Interest + Net income Interest (1 - t) + Net income $185,000
Growing ratio Whereas total liabilities to total assets indicate total leverage, this
compared to ratio indicates both total leverage and the cost of the leverage relative
ROE to net income. A growing ratio without corresponding increases in
increases
ROE may indicate a profitability problem and a possible forthcoming
credit shortage.
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T OTAL LIABILITIES -TO-OWNERS ' EQUITY
Total liabilities $540,000

= = 43.83%
Owners' equity $1,232,000
Growing This ratio indicates the liabilities relative to the investment

percentage: commitment of the company; all creditors (trade and long-term)
Liquidity versus owners' equity. A growing percentage may indicate
problems
forthcoming liquidity problems.
Solvency and Risk Ratio
The ability of a lessee to meet the carrying costs on its existing debt
provides a good idea of its potential ability to make the lease payment.
This ratio measures that capability.
T IMES INTEREST EARNED
Net income + taxes + interest $222,000

= = 1.85 times
Interest $120,000
Interest could have been paid 1.85 times before income is used up.
Owners' Equity Ratios
The amount of equity the owners are retaining in the business is

another important measure of financial stability. The following three
ratios are used:
n Net fixed assts to owner’s equity

n Book value per common share
n Return on common equity
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NET FIXED ASSETS TO OWNERS ' EQUITY
Fixed assets (net of depreciation) $740,000

= = 60.06%
Owner's equity $1,232,000
Reliance of This ratio indicates the reliance of property, plant and equipment on
property, equity. Increases in this percent indicate permanent capital
plant, and requirements as opposed to short- and intermediate-term funding.
equipment on
Too rapid an increase could indicate a forthcoming liquidity problem
equity
as well a cutback on property, plant, and equipment expansion.
BOOK VALUE PER COMMON SHARE
Total book value of common stock $1,012,000

= = $50.60
Shares outstanding $20,000
Owners’ The liquidation value of callable preferred stock, cumulative preferred

equity less dividends in arrears and treasury stock is deducted from the total
liquidation owners' equity in order to obtain the total book value of common
values
stock.
RETURN ON COMMON EQUITY
Net income - preferred dividends currently due $65,000 - $14,000

= = 5.04%
Total book value of common stock $1,012,000
Decreases So long as financial leverage is held constant, increases in ROE are

warrant the ultimate measure of profitability. Decreases in this percent
inquiry indicate problems worthy of further inquiry.
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Evolution Traditionally, credit analysts have used standard financial ratios in

from accrual their analyses. However, traditional ratio analyses evolved from
accounting accrual accounting, and standard ratios present some limitations for
cash accounting. Therefore, many credit analysts use nontraditional
cash flow ratios in addition to standard cash flow ratios. We will
discuss cash flow ratios in the next section.
CASH FLOW ANALYSIS
Tool to assess We mentioned the importance of cash flow analysis previously in this
lessee’s unit. Many credit analysts consider cash flow analysis to be the best
credit- tool to assess a potential lessee's creditworthiness, because available
worthiness
cash represents the resource the lessee will use to pay the lease
payments. In this section, we demonstrate why cash flow analysis is a
useful tool for lessors.
Statement of Cash Flows
Cash flow Figure 4.8 shows the cash flow statement required by FASB 95. In
worksheet Figure 4.9, we present a worksheet for cash flow analysis that is useful
in credit analysis. The numbers in Figure 4.9 represent the same cash
flow information as in Figure 4.8 restated in a form that is appropriate
to credit analysis. Later in this unit, we will explain each element of
the worksheet and show how it helps an analyst make a good lease
credit decision.
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Statement of Cash Flows

CASH FLOWS FROM OPERATING ACTIVITIES
Cash received from customers $ 13,850
Cash paid to suppliers and employees (12,000)
Dividend received from affiliate 20
Interest received 55
Interest paid (net of amount capitalized) (220)
Income taxes paid (325)
Insurance proceeds received 15
Cash paid to settle lawsuit for patent infringement (30)
Net cash provided by operating activities $ 1,365
CASH FLOWS FROM INVESTING ACTIVITIES
Proceeds from sale of facility $ 600
Payment received on note for sale of plant 150
Capital expenditures (1,000)
Payment for purchase of Company S, net of cash acquired (925)
Net cash used in investing activities (1,175)
CASH FLOWS FROM FINANCING ACTIVITIES
Net borrowings under line-of-credit agreement $ 300
Principal payments under capital lease obligation (125)
Proceeds from issuance of long-term debt 400
Proceeds from issuance of common stock 500
Dividends paid (200)
Net cash provided by financing activities 875
NET INCREASE IN CASH AND CASH EQUIVALENTS $ 1,065
Cash and cash equivalents at the beginning of the year 600
Cash and cash equivalents at the end of the year $ 1,665
RECONCILIATION OF NET INCOME TO NET CASH
PROVIDED BY OPERATING ACTIVITIES
Net income $ 760
Depreciation and amortization $ 445
Provision for losses on accounts receivable 200
Gain on sale of facility (80)
Undistributed earnings of affiliate (25)
Payment received on installment note receivable for sale of inventory 100
Change in assets and liabilities net of effects from purchase of Company S:
Increase in accounts receivable (215)
Decrease in inventory 205
Increase in prepaid expenses (25)
Decrease in accounts payable and accrued expenses (250)
Increase in interest and income taxes payable 50
Increase in deferred taxes 150
Increase in other liabilities 50
Total adjustments 605
Net cash provided by operating activities $ 1,365
SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES
The Company purchased all of the capital stock of Company S for $950. In conjunction with the acquisition, liabilities were
assumed as follows:
Fair value of assets acquired $ I,580
Cash paid for the capital stock (950)
Liabilities assumed $ 630
A capital lease obligation of $850 was incurred when the Company entered into a lease for new equipment. Additional common
stock was issued upon the conversion of $500 of long-term debt.
DISCLOSURE OF ACCOUNTING POLICY
For purposes of the statement of cash flows, the Company considers all highly liquid debt instruments purchased with a
maturity of three months or less to be cash equivalents.
Figure 4.8: Statement of cash flows
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CASH FLOW ANALYSIS WORKSHEET
NET OPERATING CASH GENERATION

Gross operating cash generation
Add: Net income $ 760
Depreciation 445
Other noncash amortizations
Increase in deferred tax credits 150
Payment received on installment note 100
Bad debt expense (allowance method) 200
Subsidiary dividends (equity method)
Gross operating sources $ 1,655
Deduct: Gains on the sale of fixed assets ($ 80)

Decrease in deferred tax credits ( )
Subsidiary income (equity method) ( 25)
Miscellaneous ( )
Gross operating uses ($ 105)
Gross operating cash generation $ 1,550
Working capital cash generation (usage)

Add: Increase in accounts payable
Increase in accrued expenses 50
Increase in taxes payable 50
Decrease in inventory 205
Decrease in accounts receivable
Decrease in prepaid expenses
Working capital sources $ 305
Deduct: Decrease in accounts payable ($ 250)
Decrease in accrued expenses ( )
Decrease in taxes payable ( )
Increase in inventory ( )
Increase in accounts receivable ( 215)
Increase in prepaid expenses ( 25)
Working capital uses ($ 490)
Working capital cash generation ($ 185)
NET OPERATING CASH GENERATED $ 1,365
NONDISCRETIONARY CASH REQUIREMENTS

Dividends ($ 200)
Replacement property, plant and equipment ( 445)3
Inflationary property, plant and equipment ( 151)3
Short-term debt repayment ( )
Long-term debt repayment ( )
Principal payments on capital lease ( 125)
Total nondiscretionary requirements ($ 921)
DISPOSABLE NET OPERATING CASH FLOW $ 444
Figure 4.9: Cash flow analysis worksheet
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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
Advantages of Cash Flow Worksheet
Separate The advantage of this worksheet presentation is that operating sources

gross of cash flow are separated into gross operating sources and working
operating and capital sources. This allows the analyst to determine the degree to
working
which net operating cash generation is dependent upon working capital
capital
sources
as opposed to actual operations. In the long run, only operational cash
flow is important since there is a limit to which working capital can
generate cash flow through increasing trade payables, accrued
expenses, and other sources.
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Calculating Disposable Cash Flow
Source of Any future leases or loans would be repaid from disposable cash flow.
cash for Therefore, the computation of disposable cash flow is the whole
future leases purpose of the cash flow analysis worksheet. If a company cannot
demonstrate that it will have enough disposable cash flow, the lessor
probably should not extend credit. In our example, we subtracted total
nondiscretionary requirements of $921 from net operating cash
generation of $1,365 to arrive at disposable net operating cash flow
($444 from Figure 4.9).
Nondiscretionary Cash Requirements
Cash flows as In Figure 4.9, the non-operating cash sources on the cash flow
a function of worksheet disclose the sources of cash that provided for the $885
discretion cash needs, plus the $1,065 increase in cash. Again, the advantage of
the preceding cash flow analysis worksheet is to source cash inflows
and outflows as a function of management discretion and non-
discretion since only disposable cash flow will be available to pay off
future debt or lease obligations.
Cash Flow Ratios
Comparison to Earlier in this unit, you saw how standard ratio analysis relates income
standard ratio statement data to balance sheet data, income statement to income
analysis statement, and balance sheet to balance sheet. In this section, we relate
cash flow data to income statement, balance sheet, and other cash flow
information. We will use the data in Figure 4.9 to illustrate cash flow
ratios.
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Income Statement to Cash Flow Ratios
There are four cash flow ratios used to identify trends in relationships
between the income statement and cash flow.
1.
Net income $760
= = 49.03%
Gross operating cash flow $1,550
Gross This ratio demonstrates the proportion of gross operating cash flow
operating derived from net income. If this percentage increases, less cash flow
cash flow as a is being generated for each dollar of net income. If such a trend
percentage of
continues, liquidity problems might arise.
net income
2.
Net income $760
= = 55.68%
Net operating cash flow $1,365
Impact of This ratio is similar to the first ratio, however, the impact of working
working capital sources and uses is factored in. If this ratio is growing or
capital exceeds ratio 1, it may indicate that working capital requirements are
sources
consuming gross operating cash flow. A continuation of this trend may
indicate a forthcoming liquidity problem. However, a decline in this
percentage indicates favorable cash flow generation.
3.
= = 6.2045%
Interest and lease rentals $220 + $0
Unadjusted This ratio is similar to times interest earned except that the cash flow
cash flow has not been adjusted for tax expenses or interest. The ratio is
important because it shows that interest expense was covered 6.2
times by net operating cash flow.
4.
Disposable net operating cash flow $444
= = 2.018%
Interest and lease r entals $220
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Feasibility of This cash flow ratio is similar to times interest earned also; however,
new expense this key ratio deals with disposable cash that is available to pay
existing or future interest expense. Without a ratio greater than one,
any proposed interest expense or rental expense would not appear
feasible, due to a lack of disposable cash.
Cash Flow to Cash Flow Ratios
There are three cash flow ratios to identify trends in relationships

between different cash flows.
1.
Net operating cash generation $1,365
= = 3.074%
Impact of non- This ratio demonstrates the impact of nondiscretionary cash needs.
discretionary If needs are few, the ratio would be closer to one. High or growing
cash needs ratios indicate greater cash flow commitments, which reduce cash
available to pay off future loan or lease payments.
2.
Gross operating cash flow $1,550
= = 3.491%
Cash flow This is the same as ratio 1 except the impact of working capital cash
commitments use or generation has been removed. Increases in this ratio indicate
greater cash flow commitments trending towards less cash available to
pay future loans or leases.
3.
Discretionary cash flow $885
= = .648%
Discretionary This ratio indicates the percent of net operating cash flow that is being
spending spent on discretionary requirements. Increases in the percentage or a
high percentage could indicate excess or runaway growth, which is
hampering the creation of disposable cash flow.
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Cash Flow to Balance Sheet Ratios
There are three cash flow ratios used to identify trends in

relationships between the balance sheet and cash flow.
For purposes of these ratios, assume the following information:
Assets: $5,000
Equity: $2,300
Net working capital: $500
1.
Net Operating cash flow $1,365
= = 27.3%
Assets $5,000
Profitability This ratio is the same as the standard ROA except it represents the
indicator total cash flow ROA. Decreases in this ratio indicate a decrease in the
company's profitability.
2.
Net workin g capital $500
= = 36.63%
Working The percentage that net working capital is of net operating cash flow
capital should remain steady. Increases could indicate inefficiencies in
management working capital management.
3.
= = 59.35%
Equity $2,300
Net operating This ratio is the same as the standard ROE except this represents the
cash flow as a total cash flow ROE. This percentage should remain relatively
percentage of constant, however, increases in the percentage would be considered
equity
favorable if financial leverage remains constant.
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SUMMARY
Credit analysis is the process of examining financial statements to determine the current
and future financial health of a company. There are two basic approaches to analyzing
financial statements: horizontal analysis and vertical analysis. Each method results in
a different view of the information contained in the statement. For example, the time-
spanning nature of the income statement is most apparent in a horizontal decomposition.
Another tool credit analysts use to assess a company’s financial well-being is ratio analysis.
There are two major types of ratio analysis: standard ratio analysis, which has
its roots in accrual accounting, and cash flow analysis, which focuses a company’s cash
inflows and outflows. Cash flow is considered to be the better tool to assess
creditworthiness because cash represents the resource the company will use to pay lease or
loan payments.
You have completed Unit Four: Credit Analysis and Risk Assessment. In Unit Five:
Financial Concepts and Calculations, you will learn some of the key concepts of financial
transaction analysis and discover how they apply to cash flow and the other concepts coverd
in this unit. Before you continue to the next unit, please check your understanding of the
credit analysis section by completing the Progress Check 4.2. If you answer any of the
questions incorrectly, please return to the text and read the section again.
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Question 1: Horizontal decomposition of an income statement reveals the:
____ a) relationship between profitability and earnings growth.

____ b) relationship of one line item to another.
____ c) relationship of line items to sales.
____ d) time relationships of line items.
Question 2: From a credit analyst’s viewpoint, the problem with preparing financial
statements on an accrual basis is that accrual accounting does not show:
____ a) cash inflow and outflow.

____ b) income and expenses within the time frame they were incurred.
____ c) intangible assets.
Question 3: In standard ratio analysis, a profitability model:
____ a) describes a company’s cash flow.

____ b) shows the effect of a change in any one factor on each of the other
factors.
____ c) describes only the effect of dividend payout on potential growth rate in
earnings.
____ d) uses net fixed assets in the asset turnover computation.
Question 4: In liquidity ratios, inventory is the most nonliquid component of working

capital.
____ a) True
____ b) False
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ANSWER KEY
Question 1: Horizontal decomposition of an income statement reveals the:
d) time relationships of line items.
Question 2: From a credit analyst’s viewpoint, the problem with preparing financial
statements on an accrual basis is that accrual accounting does not show:
a) cash inflow and outflow.
Question 3: In standard ratio analysis, a profitability model:
b) shows the effect of a change in any one factor on each of the other
factors.
Question 4: In liquidity ratios, inventory is the most nonliquid component of working

capital.
a) True
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PROGRESS CHECK 4.2

(Continued)
Question 5: Financial leverage ratios help a credit analyst determine the risk associated
with:
____ a) profitability.
____ b) debt.
____ c) solvency.
____ d) liquidity.
Question 6: Cash flow is considered the best tool to assess creditworthiness because it:
____ a) reveals the lessees ability to pay the lease payments.

____ b) is less cumbersome than using accrual ratios.
____ c) shows the degree to which net operating cash generation is dependent
upon actual operations.
____ d) combines discretionary and nondiscretionary cash needs.
Question 7: A high or growing cash flow to cash flow ratio indicates a potential lessee
will have the cash to pay off future leases.
____ a) True
____ b) False
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ANSWER KEY
Question 5: Financial leverage ratios help a credit analyst determine the risk associated
with:
b) debt.
Question 6: Cash flow is considered the best tool to assess creditworthiness because it:
a) reveal s the lessees ability to pay the lease payments.
Question 7: A high or growing cash flow to cash flow ratio indicates a potential lessee
will have the cash to pay off future leases.
b) False
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Unit 5
UNIT 5: FINANCIAL CONCEPTS AND CALCULATIONS
INTRODUCTION
Leasing involves a series of cash flows, with some occurring today and some in the future.
As you know, a dollar received today is worth more than a dollar received tomorrow
because of the effect of interest. Due to this time value of money, we cannot make a valid
comparison of the face value of cash flows. To compare investment and funding
alternatives, we use present value analysis to convert future cash flows to today’s dollars.
In the leasing industry, present value calculations are used to make lease versus buy
decisions and to structure (price) leases, so it is important that you understand them.
Internal rate of return, or IRR, is another analytical tool used to compare funding
alternatives. IRR is used to compute yields (interest). Whereas present value deals
primarily with principal, IRR concerns the interest in a financial transaction.
In this unit, you will be introduced to present value and IRR computations. We will show
you how to calculate the present value of future cash flows and IRR with the HP12C
financial calculator. Through these examples, you will see how these concepts are applied
in the leasing industry. In Unit Six: Introduction to the Lease versus Buy Analysis and Unit
Seven: Lease Pricing, we present more detailed examples of using present value and IRR
calculations in leasing.
UNIT OBJECTIVES
+ Perform present value calculations
+ Compute IRRs on a stream of cash flows
+ Recognize the applications of present value and internal rate of return to

leasing
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5-2 FINANCIAL CONCEPTS AND CALCULATIONS
PRESENT VALUE
Removing The concept of present value involves taking a known future value
time value of amount and stripping out the time value of money factor (discount
money rate). Removing the effects of interest from a cash flow stream tells
us what those future cash flows are worth today (present value).
Example Assume that someone owes you $10,000 at the end of 36 months and
has signed a note payable to that effect. If someone were to offer to
buy that note payable from you today, for $6,500, would you sell the
note?
To decide, you must weigh the value of $10,000 to be received 36

months in the future against receiving $6,500 today. Since the values
are not comparable, you must convert the $10,000 into today’s dollars
by removing the effects of interest. If your investment yield is 12
percent, you would use this discount rate to strip out the time value of
money from the $10,000 and arrive at its present value. Let’s see how
to calculate the present value on the HP12C calculator.
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FINANCIAL CONCEPTS AND CALCULATIONS 5-3
Calculating Present Value
Information In the remainder of this section, we will discuss five applications of

needed for present value computations:
present value
calculation
+ Present value of one cash flow
+ Present value of an ordinary annuity (annuity in arrears)
+ Present value of an annuity due (annuity in advance)
+ Present value of an annuity with multiple advance payments
+ Present value of multiple, uneven cash flows
To calculate present value amounts, we must know the following

information:
+ 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
Calculator In our examples, we will show how to enter this information with the
keys following keys on the HP12C calculator:
n The term or number of compounding periods over which

the cash flow is to be discounted
FV The amount of the future cash flow (inflow or outflow)
i The interest (discount rate) being used over the

compounding periods
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PMT The periodic payment amount.
PV The present value of a future cash flow or series of

cash flows
In addition, we show the following keys:
CLX Clears the display
CHS Changes a number from positive to negative or vice-versa
BEG Changes payment mode to advance
END Changes payment mode to arrears
f Indicates a gold key function
g Indicates a blue key function
Present Value of a Single Cash Flow
Single cash A single cash flow could represent a purchase option or a balloon
flow payment, expected to be received at the end of a financing term, or
a large, nonrecurring cash flow, such as a maintenance expense to
occur in the 30th month of a 48-month lease transaction. Let’s look at
an example:
Example A $15,000 balloon payment is due at the end of a 48-month term loan.
The discount rate to be used in the analysis is 13.25% per annum
(p.a.). What is the present value of the $15,000 payment?
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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.
Present Value of an Ordinary Annuity

(Annuity in Arrears)
End-of-period Now that you have seen how to calculate present value on a single cash
payment flow, we will show you how to calculate present value on a series of
stream future cash flows. An annuity in arrears refers to a stream of future
cash flows, such as monthly lease payments, due at the end of each
period. The first payment, or cash flow, is received at the end of the
first period, and each subsequent payment occurs at the end of each
succeeding period. The following timeline illustrates this cash flow.
Assume one-year payment periods in a lease with a five-year term.
0 5 years
First payment due Subsequent payments due at the

at end of first period end of each succeeding period
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When you calculate an annuity in arrears, you must start by changing

the payment mode in the calculator to indicate that the cash flows will
be received at the end of each period. Here is how to do this on the
12C:
g END 0.00 Changes payment mode to arrears
Now you can enter the values. Here are two examples. Please note that
the examples in this section demonstrate even cash flows (the same
payment amount each period).
Example A 48-month lease has monthly lease payments, in arrears, of $640

each. What is the present value of the stream of even (equal)
payments when the annual discount rate is 18% (1.5% monthly)?
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 lease

payments of $2,000 due at the end of each period (no advance
payments). A rate of 14% will be used as the appropriate discount rate.
What is the present value?
2,000 CHS PMT -2,000.00 Enters amount of each payment
The present value of 60 even monthly payments of $2,000, received in

arrears, discounted at 14%, is $85,954.03.
Present Value of an Annuity Due (Annuity in Advance)
Payments An annuity due is similar to an ordinary annuity except that we

received at assume payments are received at the beginning of each period (the
beginning of first one being due at time “0”). Annuities due are common in all types
period
of finance transactions, including leasing.
0 5 years
First payment due at Subsequent payments due at beginning

inception of the contract of each subsequent period
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Before you enter the information for an annuity due calculation, you
must change the payment mode to advance to indicate cash flows are
received at the beginning of each period. To do this:
g BEG 0.00 Changes payment mode to advance
Now you can enter the values. Here are two examples.
Example Calculate the present value of 48 monthly lease payments of $250

each, with the first payment due in advance. Use a discount rate of
14% per annum.
g BEG 0.00 Changes payment mode to

advance
250 CHS PMT -250.00 Enters amount of each payment
The present value of a stream of 48 equal monthly lease payments due

at the beginning of each period is $9,255.37.
Example To make a lease versus buy decision, a prospective lessee wishes to

determine the present value of 60 lease payments of $2,000, with one
payment in advance. Use the lessee’s borrowing rate of 14% to
discount the lease payments.
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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 to
purchase the equipment. If the cash price is greater than the present
value amount, the customer may prefer to lease.
Present Value of an Annuity with Multiple Advance

Payments
Uneven cash Some leases require that the lessee make more than one payment in
flow stream advance. More than one payment in advance creates a multiple, uneven
cash flow situation.
Cash flow For uneven cash flows, you do not have to select a payment mode
keys because you will enter each cash flow and the number of times it
occurs. In our illustrations, we will use the following keys:
g CFo Initial cash flows
g CFj Subsequent cash flows
g Nj Number of times cash flow occurs
For example:
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1,000 g CFo 1,000.00 Cash flow at time 0
300 g CFj 300.00 Amount of first cash flow
3 g Nj 3.00 Number of times first cash flow

occurs
400 g CFj 400.00 Amount of second cash flow
2 g Nj 2.00 Number of times second cash flow

occurs
Note that if the cash flow you are working with occurs only once, you
need only press g CFj and then enter the amount of the next cash flow.
Now let’s look at an example.
Example A lease requires 48 payments of $250 per month, with three advance
payments due at the inception of the transaction. What is the present
value of the lease payments discounted at 14%?
Timeline view To gain perspective as to when the cash flows in this transaction take
place, use a timeline:
0 46 48 months
3 advance payments received Final payment in End of

at inception 46th month term
In this example, payment numbers 1, 47 and 48 ($750) are made at the

inception of the lease and the final payment is made at the beginning
of the 46th month.
Keystrokes The keystrokes for entering this uneven cash flow stream are as
follows:
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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 these

are monthly cash flows
f NPV 9,463.80 Computes present value
The present value of 48 payments of $250 per month with three

advance payments due at the inception of the lease is $9,463.80,
assuming a discount rate of 14%.
Present Value of Multiple, Uneven Cash Flows
Other types In the previous section, you learned that advance payment transactions
of multiple, are a form of multiple, uneven cash flow transactions.
uneven cash In this section we will look at another transaction — a step-down
flows
lease -- that creates multiple, uneven cash flows. In a step-down
transaction, payments decrease over the lease term.
Just as in working with multiple advance payments, you must enter

each cash flow and the number of times it occurs to solve for the
present value of multiple, uneven cash flows. Let’s look at an example.
Example What is the present value of a 48-month lease with one advance
payment? The lease is a step-down transaction — the first 36
payments are $12,000 each, and the remaining 12 payments are
$3,000 each. At the end of the term, a purchase option amount of
$7,500 is due. Discount the cash flows at the monthly equivalent of
a 14% annual rate.
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To help visualize the pattern of cash flows for this transaction, study
the timeline shown below.
0 36
$12,000 6
48
35 payments
$3,000
$12,000 12 payments
$7,500
Now let’s see how to solve for present value in this step-down
transaction:
12,000 g CFo 12,000.00 Enters initial advance payment
12,000 g CFj 12,000.00 Enters next cash flow
35 g Nj 35.00 Enters number of times cash flow

occurs
12 g Nj 12.00 Enters number of times cash flow

occurs
7,500 g CFj 7,500.00 Enters final cash flow

since these are monthly cash
flows
Solution The present value of a 48-month step-down lease with a $7,500

purchase option, discounted at 14%, is $381,764.75.
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INTERNAL RATES OF RETURN (IRR)
In the previous section, we demonstrated how to take a known future

value amount and strip out the time value of money (interest) factor.
Internal rates of return (IRR) measures that time value of money
factor. Lessors use IRRs to determine whether a given lease is
sufficiently profitable to justify an investment. In this section we will
show you how to compute IRRs on the HP12C calculator. You will
find many similarities between solving for IRRs and solving for
present value.
Definition An IRR is the unique discount rate that equates the present value of
a series of cash inflows to the present value of the cash outflows. In a
leasing context, the cash inflows usually represent payments and
residual value. The cash outflow consists of equipment (investment)
cost. The IRR is sometimes referred to as the yield or interest rate
inherent in the lease. It is analogous to the interest rate that a bank
would quote a borrower on a loan.
IRR You may apply IRR analysis to a stream of cash flows throughout
applications a period as well as to single amounts due. You can compute IRRs
on transactions that have either even or multiple, uneven cash flow
streams. In this section we focus on IRRs for transactions with
even cash flows (annuities in arrears or advance) and IRRs for
transactions with multiple, uneven cash flows, including transactions
with multiple advance payments.
IRR – Even Cash Flows
Common IRRs include lease yields, interest costs, interest rates and
earnings rates.
Required To calculate IRRs, you must know the time-zero (present value) cash
information flows, the number and amount(s) of the future cash flows and the
number of periods over which the cash flows are being measured. We
will use the same calculator keys we used to calculate present value.
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Recall these keys:
n The number of compounding periods over which the cash

flows are being measured
FV The amount of any end of term cash flows (inflows or
outflows)
PV The amount of any present value, or time zero, cash flows
(inflows or outflows)
PMT The amount of any periodic cash flows (inflows or outflows)
i The interest or yield being used over the compounding
periods
Outflows and When you compute financial yields, think of investments as cash
inflows outflows (negative) and repayments as cash inflows (positive). Now
let’s look at an example.
Example A lease agreement with a 10-year term requires monthly payments

in arrears of $199.93, based on an original investment, or equipment
cost, of $10,000. What is the IRR in this lease investment?
Before you begin, remember to clear the register and set the mode
to END.
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 IRR
The yield in this lease is 21%.
IRR -- Multiple, Uneven Cash Flows
Separate Earlier in this unit you learned that multiple advance payments and
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entries step-down transactions are forms of multiple, uneven cash flows. To

compute the IRR for uneven cash flows, you must enter each cash
flow followed by the number of times it occurs. As in our present
value calculations, we illustrate entry of the amount of each cash flow
with the g CFj keys, and the number of times each cash flow occurs
with the g Nj keys.
CFo Amount of initial cash flow

CFj Subsequent cash flow
Nj 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 cash
flow occurs
Remember that if the cash flows you are working with occur only
once, simply enter the amount of the next cash flow in the g CFj
register. Now let’s look at an example.
Example A lease agreement with an inception date of February 1 offers

payments that are in proportion to the lessee’s expected revenue
curve. High payments are to be made in the summer, with no payments
due during the winter months. Spring and fall payments are normal.
The lease payments are in advance (due at the beginning of each

period) and are based on a principal amount of $220,000. Let’s
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compute the IRR of this transaction, assuming the following payment

schedule repeats for two years.
March $10,000 September $10,000

April $10,000 October $10,000
May $10,000 November $10,000
June $20,000 December -0-
July $20,000 January -0-
August $20,000 February -0-
Here are the keystrokes:
220,000 CHS g CFo -220,000.00 Enters initial cash flow

3 g Nj 3.00 Number of times the cash flow
occurs
3 g Nj 3.00 Number of times cash flow
occurs
10,000 g CFj 10,000.00 Enters next cash flow amount
occurs
0 g CFj 0.00 Enters next cash flow amount
occurs

occurs
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 view
this rate as an indicator of the profitability of the transaction.
UNIT SUMMARY
A present value analysis is used to convert future cash flows to today’s dollars so that
investment alternatives may be compared. In a present value calculation, the time value of
money is removed from a future value amount. In this unit, we discussed five forms of
present value calculations:
+ Present value of one cash flow
+ Present value of an ordinary annuity (annuity in arrears)
+ Present value of an annuity due (annuity in advance)
+ Present value of an annuity with multiple advance payments
+ Present value of multiple, uneven cash flows
To calculate present value amounts, you must know the number of future cash flow(s), the
amount(s) of the future cash flow(s), the number of periods over which the cash flows(s)
will be discounted, and the discount rate to be used in the present value calculation.
The internal rate of return or IRR is a measurement of the time value of money. The IRR is
also called the yield or interest rate. Like present value analysis, IRR analysis is a tool used
to compare investment alternatives. We discussed two forms of IRR calculations:
+ Even cash flows
+ Multiple, uneven cash flows
In IRR calculations, investments are considered cash outflows and repayments as cash
inflows. To compute IRRs, you must know the time-zero, or present value cash flows, the
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number and amount(s) of the future cash flows, and the number of periods over which the
cash flows are being measured.
You have completed Unit Five: Financial Concepts and Calculations. Please check your
understanding of this unit by completing the exercises in Progress Check 5, then continue
to Unit Six: Introduction to the Lease Vs. Buy Analysis. If you answer any questions
incorrectly, please review the appropriate examples in the text.
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] PROGRESS CHECK 5
Question 1: In five years, you have a balloon payment due on your home mortgage in the
amount of $25,000. You have recently received an inheritance and would like
to immediately put adequate funds into a safe investment to assure that you
have the balloon payment amount when it falls due. You have found an
investment that will safely earn 10.5% per year, compounded monthly. What
is the present value equivalent of $25,000 that you must set aside today?
$____________________
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ANSWER KEY
Question 1: In five years, you have a balloon payment due on your home mortgage in the
amount of $25,000. You have recently received an inheritance and would like
to immediately put adequate funds into a safe investment to assure that you
have the balloon payment amount when it falls due. You have found an
investment that will safely earn 10.5% per year, compounded monthly. What
is the present value equivalent of $25,000 (five years hence) that you must
set aside today?
$14,822.69
f 2 0.00 Rounds answers to two decimal places
g BEG 0.00 Indicates payment mode
25,000 CHS FV -25,000.00 Enters balloon payment cost as a negative

amount
60 n 60.00 Enters number of discount periods
10.5 g 12 ÷ 0.88 Enters monthly discount rate
PV 14,822.69 Calculates present value of balloon

payment
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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 cash

flow occurs

since these are monthly cash
flows
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PROGRESS CHECK 5
(Continued)
Question 3: A lease contract requires 36 payments of $2,000 followed by 24 payments of

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

$3,000. Three payments (3 x $2,000) are due in advance, and the lease
contains a purchase option of $20,000. Find the present value of the lease
payments and purchase option using a 16% annual discount rate. You may
want to draw the timeline on a piece of paper to visualize this cash flow
series.
$107,722.87
6,000 g CFo 6,000.00 Enters the initial cash flow of

three advance payments

flow occurs

flow occurs
0 g CFj 0.00 Enters next cash flow

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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PROGRESS CHECK 5
(Continued)
Question 4: A lessor invests $800,000 in a new piece of equipment that will generate net
cash returns of $85,000 at the end of each quarter for three years (12
quarters). What is the annual IRR of this investment?
$____________________
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ANSWER KEY
Question 4: A lessor invests $800,000 in a new piece of equipment that will generate net
cash returns of $85,000 at the end of each quarter for three years (12
quarters). What is the annual IRR of this investment?
15.80%

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
4x 15.80 Annual IRR
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PROGRESS CHECK 5
(Continued)
Question 5: A lease is generating net, after-tax annual cash flows, in arrears, as follows:
Year Amount
1 56,464
2 67,504
3 60,144
4 46,440
Compute the annual IRR of this lease based on an original net investment of
170,956.
$____________________
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ANSWER KEY
Question 5: A lease is generating net, after-tax annual cash flows, in arrears, as follows:
Year Amount
1 56,464
2 67,504
3 60,144
4 46,440
Compute the annual IRR of this lease based on an original net investment of
170,956.
13.59%
170,956 CHS g CFo -170,956.00 Enters initial cash flow

f IRR 13.59 Solves for IRR
The annual IRR of this investment is based on the assumption that

the four net cash flows are received exactly at the end of each of the four
respective periods.
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Unit 6
UNIT 6: INTRODUCTION TO THE
LEASE VS. BUY ANALYSIS
INTRODUCTION
In Unit Five, we discussed using present value analysis to convert the value of future
cash flows to today’s dollars. In this unit, we focus on the application of present value to the
lease vs. buy analysis. Lease vs. buy analysis refers to the comparison of the present value,
after-tax costs of two financing alternatives: present value to remove the time value of
money and after-tax to consider the tax consequences of owning or leasing equipment. For
the lessee, the analysis identifies the most cost-effective means of acquiring equipment.
From a lessor’s perspective, the analysis helps quantify the benefits of the lease product to
the customer.
In this unit, we discuss the information needed to make a lease vs. buy decision, illustrate a
lease vs. buy analysis, and describe the effects of changing the salvage value or using a
different discount rate.
UNIT OBJECTIVES
+ Understand the steps in a lease vs. buy analysis
+ Recognize how the discount rate affects the results of the lease vs. buy
analysis
+ Recognize the purpose of a sensitivity analysis
1
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6-2 INTRODUCTION TO THE LEASE VS. BUY ANALYSIS
INFORMATION NEEDED FOR A LEASE / BUY DECISION
Details of A good lease vs. purchase decision depends on accurate, valid, and
financing relevant information. In this section, we discuss some of the more
alternatives important items of information required to make an informed lease vs.
buy decision. Please note that some items are facts, and others are
assumptions.
+ Applicable corporate tax rate. Because the process is after-

tax, we need to estimate the entity’s tax rate for the period of
financing.
+ Details of the lease quote:
− Lease term
− Payment amount
− End-of-term options
+ Details of the purchase choice:
− Mode of purchase (cash or loan)
− Terms of financing: the number of periods, the interest rate

and the payment amount
+ Salvage value. This is the amount for which the company

expects to sell the purchased equipment at the end of the period
of use.
+ Tax depreciation schedule for the purchase choice
+ Differential costs. These are installation, insurance, taxes, and

operating costs that differ with the mode of acquisition. For
instance, if the cost of maintaining purchased equipment is
$100 per month, but is only $75 per month for leased
equipment, maintenance is a differential cost.
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INTRODUCTION TO THE LEASE VS. BUY ANALYSIS 6-3
+ Discount rate. This is one of the most critical variables in the

analysis, as the ultimate decision to lease or purchase can be
altered by the discount rate used. Later in this unit, we discuss
choosing an appropriate discount rate.
LEASE VS. BUY EXAMPLE
Three-step There are three main steps in the lease vs. buy analysis process:
process
1. Gather detailed information for all alternatives
2. Calculate after-tax cash flows for each alternative
3. Calculate the present value of the cash flows
Example To illustrate the process, we will compare the choice of leasing a

$15,000 piece of equipment with purchasing the equipment. We start
by gathering information.
Gather Information
Let’s begin by looking at the information used in this example:
General Assumptions:
Equipment cost: $15,000

Company’s tax rate: 35%, and its tax-year end is December
31
After-tax cost of capital 15.25%
(opportunity cost):
After-tax cost of debt: 8.42% (12.75% times 1-tax rate)
Lease/purchase date: January 1
Differential costs: None
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Lease Assumptions
Payments: $4,015 annually in arrears, for five

years
End-of-term option: Equipment will be returned to the lessor
Purchase Assumptions
Financing: Five-year loan at 12.75% per annum;

five annual payments in arrears of
$3,391; a down payment of 20%
Depreciation: Five-year declining balance tax
depreciation
Salvage value: $1,500 at the end of year five
Calculate After-tax Cash Flows for Each Alternative
Now that we have the information we need, we can calculate the after-
tax cash flows for the lease (Figure 6.1). For simplicity, we will
assume 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 net
cost 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 installment
loan used to purchase the equipment (Figure 6.2).
0 1 2 3 4 5
Down payment $3,000 $0 $0 $0 $0 $0

Loan payments 0 3,391 3,391 3,391 3,391 3,391
Interest tax benefit 0 (536) (452) (359) (253) (134)
Depreciation tax 0 (1,050) (1,680) (1,008) (605) (302)
benefit
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 benefit
represent cash inflows to the company, and are shown in parentheses.
The interest tax benefit was derived by multiplying the interest

from the loan amortization schedule (Figure 6.3) by the tax rate
(Figure 6.4).
Year Interest Principal 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 .35 358.82
4 723.55 X .35 253.24
5 383.45 X .35 134.21
Figure 6.4: Tax benefits
The tax benefit from depreciation was calculated similarly. In Figure

6.5 we show the calculations.
Declining
Balance Annual
Year Equipment Cost Percentage Deduction Tax Rate Tax Benefit
1 $15,000 X .2000 = $3,000 X .35 1,050.00

2 $15,000 X .3200 = 4,800 X .35 1,680.00
3 $15,000 X .1920 = 2,880 X .35 1,008.00
4 $15,000 X .1152 = 1,728 X .35 604.80
5 $15,000 X .0576 = 864 X .35 302.40
$13,272
Figure 6.5: Tax benefit from depreciation
Salvage value At this point, the only remaining cash flow we need to identify is
cash flow the after-tax cash flow resulting from the disposal of the equipment
(salvage value). We show the calculations for this cash flow in Figure
6.6.
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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
Choosing Once the after-tax cash flows for each alternative have been
discount rate calculated, the present value of the cash flows must be computed.
Recall from Unit Five that we use a discount rate to calculate present
value. In this example, we use a discount rate of 8.42 percent, which is
the after-tax cost of debt. Note that we could use the opportunity cost
of 15.25 percent if the lessee’s goal is to maximize cash flow.
Using the Let’s look at the HP12C keystrokes required to calculate the
calculator present value of the lease cash flows. The cash flow amount is from
Figure 6.1.
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
periods
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Now let’s calculate the present value of the purchase cash flows and
compare the difference (Figure 6.7).

3,000 g CFo 3,000.00 Enters the initial cash flow
Present value at 8.42%

Lease $10,307
Purchase $10,075
Difference ($232)
Figure 6.7: Present value summary
As you can see, the company should purchase the equipment when the
after-tax cost of debt is used as the discount rate.
In the next section, we will discuss how to isolate individual variables

of the analysis and assess the impact of changing any one or more of
them.
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SENSITIVITY ANALYSIS (BREAK-EVEN POINT)
In the previous example, we saw that there are several variables in the
lease vs. buy analysis that influence the result. Two critical variables
are the discount rate and the salvage value. To assess the effect of
changing the discount rate or the salvage value, we use a sensitivity
analysis.
Break-even A sensitivity analysis gives us the break-even (indifference) point of a

investment variable. For example, if a company can reinvest funds at the same rate
rate inherent in the lease, the company is indifferent between leasing and
purchasing. However, if the company can reinvest at a rate greater than
the break-even rate, leasing makes more sense.
Use as a From a lessor point of view, the break-even rate provides a floor above
marketing tool which leasing will be preferred over purchasing. This technique can be
used to market leases. The lessor’s job is to convince a company that
its opportunity cost is greater than the break-even rate.
Now let’s see how to calculate the break-even discount rate.
Discount Rate
IRR of The break-even discount rate is equal to the internal rate of return
differential of the differential cash flows between two financing alternatives. In
cash flows other words, it is the IRR at which the present value is the same for
both alternatives.
To help you understand this concept, we will refer to our example in

the previous section. First, let’s look at the difference in the cash
flows for each period (Figure 6.8).
0 1 2 3 4 5
Lease cash flows $ 0 $2,610 $2,610 $2,610 $2,610 $2,610

Purchase cash flows ($3,000) ($1,805) ($1,259) ($2,024) ($2,533) ($1,375)
Difference (3,000) 805 1,351 586 77 1,235
Figure 6.8: Cash flow differential
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Using the Now let’s calculate the internal rate of return for the differential cash
calculator flows.

3,000 CHS g CFo 3,000.00 Enters the first cash flow
805 g CFj 805.00 Enters the next cash flow
1,351 g CFj 1,351.00 Enters the next cash flow
586 CFj 586.00 Enters the next cash flow
77 CFj 77.00 Enters the next cash flow
1,235 CFj 1,235.00 Enters the next cash flow
f IRR 11.4698 Solves for IRR
Present value The break-even rate is 11.4698. If we solve for present value using
at break-even 11.4698 as the discount rate, the present value will be the same for
IRR both the lease and the loan. Let’s prove this concept.
LEASE

2,610 CHS PMT 2,610.00 Enters net after-tax cost
periods
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PURCHASE

3,000 g CFo 3,000.00 Enters the initial cash flow
As you can see, the present value cost of both alternatives is

$9,533.37 when this discount rate is used. Any discount rate higher
than 11.4698 will favor leasing; any discount rate lower than this value
will favor purchasing.
Salvage Value
Subjective Sensitivity analysis also can be used to find the break-even point of
value salvage value. Because salvage value is judgmental, it makes sense to
solve for the salvage value that will equate leasing to purchasing.
Recall that in our lease vs. buy example we used a $1,500 salvage
value, resulting in a present value difference between leasing and
purchasing of $232 (Figure 6.7). At what salvage value would the
present value be the same for leasing and purchasing? To find out, we
must first convert the $232 difference to a pretax future value number,
as it is an after-tax present value number and the new salvage value is a
pretax future value.
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Convert to We use a two-step process to convert the $232 to its pretax future
pretax future value of $535.
value
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
Indifference The difference between the original salvage value and the pretax future
value value we calculated above is the indifference value:
$1,500 - $535 = $965
Therefore, if the company expects a salvage value greater than $965, it

should purchase. If it expects to receive less than $965, it should
lease.
FACTORS THAT AFFECT THE LEASE VS. BUY ANALYSIS
So far, we’ve discussed the lease vs. buy process and a related process,
the sensitivity analysis. We found that variables such as the discount
rate and the salvage value have a great impact on the result of the lease
vs. buy analysis. In this section, we discuss these variables in greater
detail to emphasize their importance.
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Discount Rate
Effect of As mentioned in the previous section, the choice of a discount rate is

discount rate very important to the lease vs. buy analysis. Generally, when a lower
discount rate (after-tax cost of debt) is selected, the analysis favors
purchasing. When a higher discount rate (after-tax cost of capital) is
selected, the analysis favors leasing. Of course, the objective is not to
favor one alternative over the other, but to arrive at an unbiased
conclusion.
Company Selection of a proper discount rate will depend on each company’s

goals situation. A large company usually views leasing as debt. Because of
its need to maintain constant leverage ratios, the additional cash flow
generated by the lease is not meaningful to a large company. These
companies should use the after-tax cost of debt as the base discount
rate for the analysis. On the other hand, a small, entrepreneurial
company seeks to maximize cash flow, so that the savings can be
reinvested back into the business at a high rate of return. If this is the
case, either the cost of capital or the opportunity cost will be the
appropriate discount rate.
Salvage value The type of transaction being entered into also affects the choice of
and risk the discount rate. If the lessor takes a small residual position (as in
a finance lease), there is little asset risk in the transaction. However, if
the lessor assumes a substantial residual risk (as in an operating
lease), the large salvage value in the lease/buy decision increases the
risk in the transaction. The greater the risk, the higher the discount
rate that should be used.
Consistency Finally, you should remember that it is important to use the same
discount rate to analyze all financing alternatives. Otherwise, they are
not comparable!
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Salvage Value
Factors to The salvage value has the greatest effect on the result of the lease vs.
consider buy analysis. Therefore, it is important to arrive at a realistic salvage
value, incorporating anticipated use and deinstallation and disposal
costs. Expert opinions may be used, if necessary. A faulty salvage
value assumption could alter the lease vs. buy decision.
Using In our discussion of the discount rate, we suggested that the

indifference uncertainty associated with a large salvage value increases the risk
value inherent in a transaction. Therefore, the discount rate used in high
residual risk situations should be higher than the rate normally used.
An alternative would be to adjust the salvage value to its indifference
equivalent and use the base discount rate.
UNIT SUMMARY
Once a company has decided to acquire equipment, it must determine whether to buy the
equipment with cash, finance the equipment with a loan, or enter into a tax lease with a
lessor for the use of the equipment. For the lessee, a lease vs. buy analysis quantifies a
financing decision: it compares a tax lease to one of the other financing alternatives.
Adequate information about each alternative is necessary to make a valid comparison.
The analysis consists of converting all cash flows to after-tax cash flow values and then
calculating the present value at the appropriate discount rate. The choice of a discount rate
depends on the company’s circumstances. If the company wishes to minimize its interest
cost, it uses the after-tax cost of debt as the appropriate discount rate. If the company
desires to maximize cash flow, then the appropriate discount rate will be the after-tax cost
of capital.
The company should choose the financing option with the lowest present-value cost. Using
the after-tax cost of debt as the discount rate will generally favor the purchase alternative;
using the after-tax cost of capital tends to favor the lease alternative.
A sensitivity analysis on either the discount rate or the salvage value should be a part of
every lease vs. buy decision, as it provides both the lessor and the lessee with additional
perspective. A lessor may use the break-even discount rate to persuade the potential lessee
to lease.
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You have completed Unit Six: Introduction to the Lease Vs. Buy Analysis. Please check
your understanding of this unit by completing the exercises in Progress Check 6, then
continue to Unit Seven: Lease Structuring. If you answer any questions incorrectly, please
review the appropriate sections in the text.
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] PROGRESS CHECK 6
Question 1: A valid lease vs. buy decision depends on ___________________.
Question 2: The reason a lease vs. buy analysis is performed on an after-tax basis is to:
____ a) equate the future cash flows.

____ b) arrive at an appropriate discount rate.
____ c) consider the tax consequences of the alternatives.
____ d) determine the effect of the after-tax cost of debt.
Question 3: Why is present value analysis used in lease vs. buy calculations?
____ a) Leasing and purchasing generate different future cash flows.

____ b) The investment rates for leasing and purchasing usually differ.
____ c) It is important to use the same discount rate for both alternatives.
Question 4: For the lessor, a sensitivity analysis on the discount rate:
____ a) helps determine whether the potential lessee has reached the indifference
point.
____ b) may be used as a marketing tool.
____ c) is less important than a sensitivity analysis on the salvage value.
____ d) may be used to lower the lessee’s lease payments.
Question 5: When a break-even discount rate is used, the future cash flows are the same
for both financing options.
____ a) True
____ b) False
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ANSWER KEY
Question 1: A valid lease vs. buy decision depends on accurate, valid, relevant
information.
Any one or more of these answers is correct.
Question 2: The reason a lease vs. buy analysis is performed on an after-tax basis is to:
c) consider the tax consequences of the alternatives.
Question 3: Why is present value analysis used in lease vs. buy calculations?
a) Leasing and purchasing generate different future cash flows.
Question 4: For the lessor, a sensitivity analysis on the discount rate:
b) may be used as a marketing tool.
Question 5: When a break-even discount rate is used, the future cash flows are the same
for both financing options.
b) False
The present value of the future cash flows is the same for both
financing options.
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PROGRESS CHECK 6
(Continued)
Question 6: The purpose of performing a sensitivity analysis on the salvage value of

equipment is to:
____ a) calculate the expected sale value that will equate purchasing with leasing.
____ b) convert the difference between the present values of leasing and
purchasing to a pretax future value.
____ c) arrive at a realistic salvage value.
Question 7: Generally, selecting the after-tax cost of capital as the discount rate tends
to favor:
____ a) large corporations.

____ b) purchasing equipment.
____ c) leasing equipment.
____ d) installment loans.
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ANSWER KEY
Question 6: The purpose of performing a sensitivity analysis on the salvage value of

equipment is to:
a) calculate the expected sale value that will equate purchasing with
leasing.
Question 7: Generally, selecting the after-tax cost of capital as the discount rate tends
to favor:
c) leasing equipment.
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Unit 7
UNIT 7: LEASE STRUCTURING
INTRODUCTION
In lease structuring, a lessor pulls together the many components of a lease to create
a single lease transaction. Structuring includes lease pricing, end-of-term options,
documentation issues, indemnification clauses, funding, and residual valuations. In
this unit, we will focus on one of the most important components − pricing.
Pricing is the process of determining the pattern of payments to be made by a lessee.

For lessors, the goal of pricing is to satisfy a customer’s financing desires while ensuring
that a profit will be earned. Lessees seek a payment stream that will suit their cash flow
patterns and allow them to successfully use the equipment to earn a profit. The transaction
must be viewed as a win for both sides. Without proper pricing, the lease
may be unacceptable in the marketplace, or the transaction may not meet the lessor’s
and lessee’s profit requirements.
In this unit, we will introduce you to lease pricing concepts and work through some
examples. You will see how the present value analysis concepts you learned in Unit
Five apply to lease pricing. We will also provide you with methods for evaluating
competitors’ leases.
UNIT OBJECTIVES
+ Understand the basic steps in the pricing process for a pretax yield
+ Understand the methods lessors use to evaluate competitors’ proposals
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7-2 LEASE STRUCTURING
ELEMENTS OF LEASE PRICING
Return of In pricing, the lessor solves for a monthly payment amount that will
investment recover its investment in the equipment and earn the targeted yield.
and return on The lessor’s targeted profit must be received from the payments and
investment
residual value.
Pricing is based on cash flow. Every cash flow is separated into a

return of investment (recovery of cash outlay) and a return on
investment (profit). This breakout is done on a present value basis. In
the pricing calculations, the lessor uses its desired pretax as the
discount rate to strip out the time value of money (lessor’s profit).
The present value amount remaining represents the recovery of the
lessor’s investment in the lease transaction.
Pricing factors Lessors consider several factors when they price a lease:
+ Number of rental payments

+ Number of lease payments in advance
+ Pretax yield required by the lessor
+ Initial direct costs incurred by the lessor
+ Equipment cost
+ Closing or lease documentation fees
+ Refundable security deposit
+ Residual value
To illustrate some of these factors, we will present examples of

pricing a transaction to determine a payment that will earn a lessor
a given targeted yield on a pretax basis. Structuring to a pretax yield is
an acceptable, though less accurate, method of pricing for lessors who
pay taxes. A more accurate method is to price on an after-tax basis.
This is a more complicated structuring process that will not be
covered in this basic course.
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LEASE STRUCTURING 7-3
PRICING (STRUCTURING) TO A GIVEN PRETAX YIELD
Four-step In this section, we discuss the four basic steps that are necessary to
process structure a lease to a given pretax yield. These steps apply whether the
lease has even (level) payments or uneven payment streams. The four
basic steps are:
1. Compute the present value of all the known cash flows
2. Calculate the net outflow of costs at time zero
3. Compute the present value of the unknown lease payment,

letting each payment equal one dollar
4. Calculate the monthly lease payment by dividing the results of

step two by the results of step three
Example To help you understand these steps, let’s work through an example.
Assumptions:
Equipment cost $100,000

Refundable security deposit 3,000
Residual value 15,000
Initial direct costs 2,507
Closing fee 1,000
60 payments in advance
10 percent pretax gross yield required
1. Compute the present value of all the known cash flows
Net cash The monthly payment we are solving for is affected by all cash
outflow at time flows in the lease. For example, the higher the residual, the lower
zero plus the monthly payment. To solve for the monthly payment that will
target yield
recover the lessor’s investment and earn the targeted yield (10
percent), we must first calculate the present value of all future cash
flows. The payment must recover the net cash outflow at time zero
(the beginning of the lease) and earn at the 10 percent targeted
yield.
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Residual value In this example, the only future cash flow is the residual value,
adjustment adjusted for the return of the security deposit (15,000 - 3,000 =
12,000). Let’s calculate the present value on the HP12C:
KEYSTROKES DISPLAY
f REG 0.00
10 g 12 ÷ .83
60 n 60.00
12,000 CHS FV 12,000.00
PV 7,293.46
The present value of the adjusted residual value is $7,293.46.
2. Calculate the net outflow of costs at time zero
Total net We can now add the present value of the net residual to the
outflow other components of the net cash outflow at time zero. Let’s look
components at a time line of the cash flows to see the total net outflow (Figure
7.1).
0 60
(100,000.00) 15,000.00
3,000.00 (3,000.00)
(2,507.00)
7,293.46 12,000.00
1,000.00
91,213.54
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.
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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-dollar
payment over the lease term would recover and still earn a 10
percent 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 of From this calculation, we see that if the payment were only one
one-dollar dollar, then 60 payments in advance would recover principal
payment (investment) of $47.46. Recall that the required payment must
recover principal of $91,213.54 (step two).
4. Calculate the monthly lease payment: (divide step two by

step three)
Step 2 91,213.54
= 1,922
Step 3 47.4576
As you can see, a monthly payment of $1,922 will recover the lessor’s
investment in the lease and earn a 10 percent pretax yield.
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INTRODUCTION TO ADVANCED STRUCTURING
In the previous section, we discussed solving for a payment that would

give the lessor a given before-tax return on its investment. You learned
that the monthly payment is based on all cash flows in the lease as well
as the targeted yield.
In this section, we will examine some special situations that affect

lease pricing. Keep in mind that the pricing is still based upon the
structuring principles you learned about in the previous section. The
situations we will look at are:
+ Unusual payment streams
+ Early terminations of leases
Structuring Unusual Payment Streams
Conform to Frequently, a lessor will structure a lease with a varied or unusual

lessee’s cash payment pattern to accommodate a lessee's cash flow requirements.
flow Examples of leases with unusual payment streams include skipped,
step-up, and step-down payment streams. In a skipped payment
stream, the lessee skips the payments during the season when revenue
is not being generated. Step-up lease payments start low and are
increased once cash flow is expected to increase. In a step-down
lease, the lease begins with higher payments and then “steps down” to
lower ones.
Steps The same structuring steps we described in the previous section

modified for are followed in structuring unusual payment stream leases, except
effect of some of the steps are slightly modified to include the effect of the
varied
unusual payment stream. For example, the assumed one-dollar lease
payments
payments must be altered for the periods with the skipped, increased,
or decreased payments.
To see how unusual payment streams affect structuring, let’s look

at the structuring approach for several common uneven payment
streams. We will assume that the pretax structuring steps apply.
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Skipped Payments
Skipped To structure skipped payment leases, let each regular payment equal
payments = one dollar and the skipped payments equal zero when finding the
zero present value of the one-dollar payments.
KEYSTROKES
8.343 i (Discount rate)

5 g CFo (Base one-dollar
payments, first year)
9 g CFj (Base one-dollar
payments, subsequent
years)
3 g Nj (Three skipped payments)
payments, year five)
f NPV 30.954135
.34 f x 10.524406
.9676 x 10.183415
Step-up Lease
Increased In a step-up lease, express the stepped-up payment as a percentage of

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

payments)
24 g Nj
1.12 g CFj (Stepped-up payments at
112% of the one dollar
base)
24 g Nj
f NPV 43.189882
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Step-down Lease
Reduced Structuring a step-down lease is similar to structuring a step-up lease.

payments as a For example, assume the lessee desires 36 base payments, one in
percentage of advance, followed by 12 reduced payments that are 87 percent of the
base payment
base payment. In step two, we let each regular payment equal one
dollar 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 payments
at 87% of the one-dollar
base)
12 g Nj
f NPV 40.021926
Known Initial Payments
The structuring methodology changes when the lessee can pay only a
limited amount of rent during the early months of a lease.
Price of Assume the lessee can pay only $1,800 per month in arrears for the
remaining first 12 months of a 48-month lease. We must determine the price of
payments the 36 remaining payments that will produce the required yield.
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 Nj
f NPV 20,688.01
In step two, we let each regular payment equal one dollar and use zero,
in place of the twelve $1,800 payments already considered in step one,
to solve for the present value of the remaining payment stream:
KEYSTROKES
.67 i
0 g CFj (12 payments already
considered)
12 g Nj
1 g CFj
36 g Nj
f NPV 29.437088
Early Terminations of Leases
Making the Leases are sometimes terminated prior to the end of their
lessor noncancellable terms. For example, the lessee may want to purchase
“whole” the equipment or return the equipment to the lessor. Regardless of the
reason, the lessor must compute the amount the lessee owes at the
termination date in order to make the lessor “whole” (as defined in the
lease agreement or by the lessor).
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 the

present value of all costs and benefits that were incurred or received
up to the date of the lease termination. Since all benefits will have
been received at this point, there will be a net unrecouped present
value investment cost still remaining. The lease payoff will be the
pretax equivalent of the future value of this unrecouped net
investment.
EVALUATING THE COMPETITION
To market leases effectively, lessors should be able to identify the

possible reasons for pricing differences in competing proposals. In
this section, we will discuss the factors that a lessor should look for
when evaluating a competitor’s proposal and methods used to analyze
competing proposals.
Reasons for Pricing Differences
Quantitative There are many different factors that lessors should consider when
and evaluating proposals from other lessors. Some of these factors are
qualitative quantitative, such as monthly payment or internal rate of return. Others
factors
are qualitative, such as insurance requirements or the existence of
restrictive covenants. Here, we list five categories of factors that a
lessor should examine when evaluating the difference between lease
products.
Financial
+ Lease term
+ Up-front origination, closing, documentation fees
+ Payment stream (even, skipped payments, step-ups, step-
downs)
+ Contingent payments such as an excessive use penalty
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Operational
+ Accounting classification (capital versus operating lease status)

+ Appraisal techniques used to determine the fair market value at
the end of the lease term
+ Inspection rights and fees
+ Installation, deinstallation, maintenance, repair, and insurance
provisions
Restrictive
+ Restrictive covenants such as limits on debt-to-equity ratios

+ Sublease rights
+ Lessor right of assignment
+ Definition of what constitutes default
Termination
+ Purchase option consequences and charges

+ Physical condition of equipment provisions
+ Early-out and payoff amounts
+ Automatic extension policy and terms
Liability and Warranty
+ 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. Some

methods are simply a matter of analyzing cash flow. Others use more
financially sophisticated methods such as IRR and NPV (net present
value).
Five methods In this section, we will discuss and illustrate five methods of analyzing
two competing proposals: payment differences, total cash over term,
lease rate factor, lessee’s implicit cost, and NPV.
Assumptions:
48 months
50,000 cost
11% pretax yield
COMPANY A COMPANY B
1 in advance In arrears
$300 broker fee No broker fee
Payment $1,205.58 Payment, $1,212.22
$5,000 residual $4,800 residual
Payment Differences
Ignores A simplistic, yet commonly used, method of analyzing leases is to

payment mode compare the monthly payment amounts. This method ignores the fact
that although Company A's payment is lower, payments are made in
advance, while Company B's are made in arrears.
COMPANY B $1,212.22
COMPANY A 1,205.58
$ 6.64
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Total Cash Over Term
Terms must Since the term for both proposals is the same, total cash over the term
be equal will again favor Company A. However, terms will not necessarily
always be the same, and unequal terms cannot be compared.
COMPANY B $58,186.56
COMPANY A 57,867.84
$ 318.72
Lease Rate Factor
Payment ÷ The lease rate factor is calculated by dividing the payment by the
equipment equipment cost. Because the cost of the equipment is the same for
cost both proposals, this method again favors Company A.
COMPANY B .024244
COMPANY A .024112
.000132
Lessee's Implicit Cost
Impact of A more sophisticated method of comparing proposals is to examine

payment mode the lessee's implicit cost. Here, the effect of advance payments versus
payments in arrears is factored into the analysis. This is accomplished
by calculating the IRR inherent in the lessee's cash flows. As shown on
the next page, this IRR calculation favors Company B.
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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
Net Present Value (NPV)
Assume The last method we will examine requires the evaluator to assume
discount rate a discount rate and calculate the net present value of the two
alternatives. While dependent on the discount rate selected. The NPV
method favors Company B in this example.
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Assume a 9.75 percent borrowing rate.
COMPANY A
KEYSTROKES
g BEG
9.75 g 12 ÷
1,205.58 CHS PMT
48 n
PV 48,148
COMPANY B
KEYSTROKES
g END
9.75 g 12 ÷
1,212.22 CHS PMT
48 n
PV 48,023
Differences
COMPANY A 48,148
COMPANY B 48,023
125
Lease Proposal Evaluation Matrix
The following matrix can be a useful tool for evaluating competing

proposals. It is used to weight the importance of each evaluation
method. While the IRR and NPV methods are financially more
accurate, lessors should be aware that, for many lessees, the method
given the greatest weight is monthly payment.
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Value Amount
METHOD OF COMPARISON Co. Co. Co. Co.
A B C D
Monthly payment
Total cash outlay
Lease rate factor
Implicit/interest cost
Net present value
UNIT SUMMARY
The purpose of lease structuring (pricing) is to determine a monthly payment that will
recover the lessor’s investment and earn the desired profit (return on investment). There are
two basic methods of structuring leases: pricing to a pretax yield and structuring to an after-
tax yield. In this unit, we discussed pricing to a pretax yield. Cash flows are separated into
recovery of investment and return on investment. In calculating the present value of the cash
flows, the targeted yield (return on investment) is used as the discount rate.
Lessors often structure leases with varied or unusual payment streams to accommodate
lessees’ cash flow requirements. Skipped payment, step-up, step-down, and known initial
payments are common structures. The same basic approach is used to price such leases.
Some of the steps are modified to account for the effect of the varied payments.
When faced with an early lease termination, a lessor calculates a payoff amount. The lease
payoff is the pretax equivalent of the future value of the unrecouped net investment.
In marketing leases, lessors often evaluate competitors’ proposals. In this unit, we listed
financial, operational, restrictive, termination, and liability factors that may be compared. We
also presented five methods of analyzing competing proposals: payment differences, total
cash over term, lease rate factor, lessee’s implicit cost, and net present value.
You have completed Unit 7: Lease Structuring. Please check your understanding of this unit
by completing the exercises in Progress Check 7, then continue to Unit Eight: Vendor
Programs. If you answer any questions incorrectly, please review the appropriate portions in
the text.
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] PROGRESS CHECK 7
Question 1: The present value amount that remains after the lessor’s desired yield is
removed from cash flows is the:
____ a) net cash outflow at time zero.

____ b) required monthly payment amount.
____ c) recovery of the lessor’s investment.
____ d) intraperiod present value factor.
Question 2: Structuring to a pretax yield is more accurate than structuring to an after-tax

yield.
____ a) True
____ b) False
Question 3: The reason for letting each payment equal one dollar when computing the
present value of the unknown lease payment is to:
____ a) solve for a factor that can be applied to the net investment at time
zero.
____ b) account for the adjusted residual value.
____ c) make it easier to compute the effects of tax benefits.
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ANSWER KEY
Question 1: The present value amount that remains after the lessor’s desired yield is
removed from cash flows is the:
c) rate of recovery of the lessor’s investment.
Question 2: Structuring to a pretax yield is more accurate than structuring to an after-tax

yield.
b) False
Question 3: The reason for letting each payment equal one dollar when computing the
present value of the unknown lease payment is to:
a) solve for a factor that can be applied to the net investment at time
zero.
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PROGRESS CHECK 7
(Continued)
Question 4: Skipped payment, step-ups, and step-downs are example of:
____ a) varied payment streams that meet a lessee’s cash flow needs.
____ b) unusual payment streams that must be estimated rather than calculated.
____ c) known initial payment streams.
____ d) structuring approaches for early lease terminations.
Question 5: The secret to structuring a skipped payment lease is to:
____ a) express the skipped payment as a percentage of the base one-dollar

payment.
____ b) ignore the tax liability on the skipped payments.
____ c) let each regular payment equal one dollar and the skipped payments equal
zero when computing present value.
____ d) maintain the after-tax yield in the lease.
Question 6: One of the ways lessors may be made “whole” in an early payoff situation is
to maintain the yield upon which the payments were based.
____ a) True
____ b) False
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ANSWER KEY
Question 4: Skipped payment, step-ups, and step-downs are example of:
a) varied payment streams that meet a lessee’s cash flow needs.
Question 5: The secret to structuring a skipped payment lease is to:
c) let each regular payment equal one dollar and the skipped payments
equal zero when computing present value.
Question 6: One of the ways lessors may be made “whole” in an early payoff situation is
to maintain the yield upon which the payments were based.
a) True
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PROGRESS CHECK 7
(Continued)
Question 7: In evaluating competing proposals, a lessor should compare:
____ a) only the lease term, payment amount, and up-front fees.
____ b) both quantitative factors such as monthly payment and qualitative factors
such as limits on debt-to-equity ratio.
____ c) financial factors such as the lease term and operational factors such as
accounting classification.
Question 8: Using payment differences as a way to analyze a competing lease:
____ a) is a more complex approach than other analytical methods.

____ b) compares total cash flow over the term of the lease.
____ c) does not take into account the payment mode (advance or arrears).
____ d) requires use of a discount rate.
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ANSWER KEY
Question 7: In evaluating competing proposals, a lessor should compare:
b) both quantitative factors such as monthly payment and qualitative

factors such as limits on debt-to-equity ratio.
Question 8: Using payment differences as a way to analyze a competing lease:
c) does not take into account the payment mode (advance or arrears).
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Unit 8
UNIT 8: VENDOR LEASE PROGRAMS
INTRODUCTION
In Unit One, you learned that manufacturing companies, distributors, or equipment

merchandising dealers who use leasing programs to help sell their products are known as
vendor lessors. Often, a manufacturer or dealer will establish a wholly owned subsidiary to
perform the leasing function, creating a captive leasing company. In this unit, we use the
term “vendor leasing” to refer to any program, including captives, in which a manufacturer,
distributor, or dealer uses leasing as a way to sell its product.
Sometimes vendor lessors outsource all or part of their customer financing activity.
Financial organizations such as Citibank may assume all aspects of the vendor’s customer
financing, from program development through billing and collections, or play a partial role
in the program, such as handling billing, collection, and credit checking. Citibank can act as
finance program advisor and developer, providing servicing programs and education,
training, and marketing support, or play the role of equity investor or purchaser of vendors’
portfolios of leases.
Vendor leasing is rapidly increasing in importance today. In this unit, we will discuss the
reasons vendors establish leasing programs and why they use third-party organizations to
develop or support these programs. We will also examine some of the ways third parties,
such as Citibank, work with vendor lessors.
UNIT OBJECTIVES
+ Identify the benefits of vendor leasing programs
+ Recognize the various ways third parties participate in vendor leasing programs
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8-2 VENDOR LEASE PROGRAMS
BENEFITS OF VENDOR LEASING PROGRAMS
Third-party For financial organizations such as Citibank, assisting vendors with

benefits leasing programs offers several benefits. Such programs broaden
client relationships by setting up an additional link to the client’s sales
and marketing force, and produce new net revenue and annuity
revenue.
Five reasons To market vendor leasing programs effectively, it is important to

understand the many benefits vendor leasing programs offer vendors.
In this section, we will discuss five reasons vendors establish vendor
leasing programs. As you read about these benefits, think about how
they could be used as selling points. The benefits we will discuss are:
+ Market control
+ Market enhancement
+ Ancillary income
+ Tax benefits
+ Financial leverage
Market Control
Critical Most vendor leasing programs are established for marketing reasons.
periods Vendor programs give vendors control during critical periods over the
useful life of equipment, including:
+ Control at inception, to prevent loss of a sale during the time

the customer needs to locate funding. On-the-spot financing
can help close a deal.
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VENDOR LEASE PROGRAMS 8-3
+ Control during the noncancellable lease term to provide for

upgrades, maintenance, parts, supplies, and any other service or
product. Monthly contact through billing gives the lessor an
advantage in winning sales of additional services or products.
+ Control over disposition of the equipment, so that at lease

termination, the vendor lessor is able to steer the lessee toward
acquiring the lessor's new equipment
+ Control over the resale prices of used equipment repossessed,

returned, or traded-in to support lease yields, operating lease
programs, and avoid price competition problems with new
products
+ Control over package (blanket) leasing to insure that the

lessor's product is part of the multiple product package
Market Enhancement
In addition to market control, both the size and quality of a

manufacturer's sales market can be improved through leasing. Market
enhancement results from:
+ Reduction or elimination of discounts off list price by

directing the customer’s attention from purchase price to the
financial considerations of a lease
+ Improvement of sales volume through product differentiation

obtained by the unique combination of product attributes,
financial services, and other bundled services
+ Increased sales volume through the offering of operating lease

and rental programs that meet certain lessee needs not met by
other financing alternatives
+ Speed of asset turnover through takeout-rollover programs that

remove a competitor's equipment before the end of the
equipment's lease term and replace it with the lessor’s
equipment
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+ Expansion of market penetration for new products through

rental programs that allow a customer to try out equipment and
lease subsidies that provide low rate financing
+ Improvement of dealer sales through vendor guarantee

programs that attract third-party lessors who can offer
attractive financing for customers
Additional Income Sources
Increased sale of the vendor’s product is not the only source of profit
in vendor leasing programs. Here, we look at several additional
sources:
+ The interest spread (difference) between interest income and

interest expense, brokerage fees, and service fees when the
lessor continues to service the lease
+ Incremental sales generated from bundled services and

products in a full-service lease
+ Residual profit to the degree returned equipment can be sold

for more than its remaining book value at the end of a lease
Tax Benefits
In Unit Two, we discussed the various tax benefits of leasing. Recall

that in the U.S., the primary tax benefits for leasing are MACRS and
gross profit deferral. The value of MACRS increases the later in the
tax year the lease is structured. The value of gross profit tax deferral
depends upon the size of the gross profit, the discount rate applied,
and the MACRS classlife of the leased equipment.
A comparison of third-party and two-party leasing tax benefits appears

in Figure 8.1. (All values are expressed as a percentage of retail sales
price, based on an after-tax present value computation.)
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Ability to use The value of tax benefits to a vendor program can be significant. If the
tax benefits vendor lessor cannot use the tax benefits, it should consider
joint venturing with a partner who can use the benefits. Selling
(brokering) tax leases can generate fees that help compensate for
unusable tax benefits.
Third-party Two-party
Lessor Lessor
MACRS 4.263% 4.263%
Gross
profit tax 0.000 2.425
deferral
Total 4.263% 6.688%
Assumptions:
(1) 40% gross margin
(2) 12% parent discount rate (Values would be lower
if a typical captive discount rate of 6 to 8% were
used in the present value analysis)
(3) December 15 structuring date
(4) 5-year MACRS classlife
(5) 35% corporate tax rate
Figure 8.1: Third-party versus two-party lessor tax benefits
Financial Leverage
Interest rate Recall that in a leveraged lease, the lessor borrows much of the
and cost of equipment cost and assigns the future lease payment stream to the
debt lender in return for the funds borrowed. The use of financial leverage
increases a company's return on equity because the interest rate
implicit in the lease is greater than the cost of the debt used to
leverage the lease. To receive as much cash as possible, captive
lessors use large amounts of debt to fund their leasing portfolios.
Leveraging also lowers the investment risk since the lessor uses a
minimal amount of its own equity funds.
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Off balance In addition to enhancing return on equity, financial leveraging may

sheet funding offer a vendor lessor certain accounting benefits. In the U.S., a
partially owned subsidiary (≤ 50 percent) is not consolidated for
accounting purposes, so the debt does not appear on the balance sheet
of the parent company.
REASONS VENDORS OUTSOURCE LEASING PROGRAMS
In the previous section, we discussed the many benefits vendor leasing

programs offer manufacturers and equipment dealers. We saw that
vendor leasing programs help vendors sell their products, increase
revenues, and accelerate cash flow. With so many benefits to gain, why
don’t all manufacturers and equipment distributors have customer
financing programs? In this section, we will examine the reasons and
see how using third-party lessors such as Citibank can help.
Reasons Vendors Lack Customer Financing Programs
Although there are many reasons vendors do not establish financing

programs, most pertain to lack of resources and leasing expertise,
concerns about the risks in leasing, and the inability to compete with
large leasing specialists.
Expertise and The lack of in-house leasing expertise is one of the most important
capital issues reasons vendors do not have leasing programs. Leasing is a specialized
field. Most companies do not have the time or the resources to
develop the needed expertise or to hire leasing experts. Also, many
companies do not wish to divert capital away from their primary
business to fund and support a leasing portfolio. They also fear that
their cost of capital may be too high to compete with the lease rates of
third-party finance companies.
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Concerns Even for companies with the resources to set up a leasing program,
over risks concerns about the many risks in leasing (residual risk, credit risk,
interest rate risk) or an excess tax benefit position may keep them
from doing so.
As we shall see in the following sections, most of these concerns can

be addressed through outsourcing customer financing programs to
third-party participants.
Third-party Participants
Variety of There are a large number of third-party participants in the vendor

participants leasing market, including lease brokers, financial institutions such as
and services Citibank, and independent leasing companies. The level of services
varies. Some participants function solely as lenders to captives.
Others provide special services, such as remarketing, to the vendors.
Another class of participants provides funding and a limited range of
support services. Finally, some offer full-service leasing and provide
the vendors with a wide variety of services, from lease origination
through equipment disposition. We will discuss these roles in more
detail in the next section.
Joint ventures In addition to the roles just mentioned, the third-party lessor also can
serve as a joint venture/equity partner. Under such an arrangement, the
third party invests directly in the leasing subsidiary. More commonly,
the vendor and an outside party jointly establish a separate company to
lease the vendor’s products to customers. Vendors who want to retain
a portion of the financing profit and tax benefits in-house, but do not
want to bear all the risks of a full captive, often choose to enter a joint
venture.
WAYS TO MEET VENDOR NEEDS
There are many ways a third party can service vendor lessors.
Generally, it is the noncaptive vendor lessors who have the greatest
need for services (although more and more captive lessors are
outsourcing some functions).
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Third-party Services
The services third parties offer vendors can be grouped into seven
categories: sales-aid/training, lease structuring/documentation,
credit review, outplacement/investment syndication, funding,
administrative services, and remarketing/asset management. Let’s
review each category.
Sales-aid / Training
Education, Sales-related services provided by a third-party lessor range from

joint helping the vendor establish an effective leasing program by educating
marketing, the vendor’s sales force to on-going sales support services, such as
support
customizing deals. Services can include sales force training, joint
customer calls, customized lease documentation and marketing
materials, jointly sponsored advertising, and pricing support.
Lease Structuring / Documentation
Third-party This is an area where third-party lessors offer a great deal of added
lessor’s value. The third-party company works with a vendor to customize a
expertise transaction to a particular lessee’s needs. The vendor benefits from
the third-party’s expertise in structuring lease products. The vendor
can also rely on the third-party lessor for help in processing and
tracking the lease documentation prior to closing the transaction.
Credit Review
Customer’s Vendors often rely on a third party’s expertise in assessing a

credit- customer’s creditworthiness. The credit review process usually
worthiness involves researching the customer’s credit history, analyzing financial
statements, and checking references.
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Outplacement / Investment Syndication
Lack of capital A lack of capital often causes vendors to seek an equity partner
or have a lease broker sell off its equity investment in leases.
Sometimes the investor buys the entire lease (assumes the credit and
residual risks); other times the vendor sells only the rental stream or
the residual.
Funding
Direct and There are many ways to fund a vendor leasing program or captive. The
indirect method chosen depends on the vendor’s desired tax and accounting
funding consequences. There are two basic types of funding − direct and
indirect. Indirect funding involves loans to the captive or vendor, who
then uses the borrowed funds to lease the equipment directly to the
customer. Under direct funding methods, the third party is the lessor
and provides the financing directly to the vendor’s customer. The
third-party lessor may buy the asset from the vendor and lease it
directly to the customer, or purchase existing leases from the vendor.
Accounting Whether the vendor, the third-party lessor, or the customer retains the
issues residual and tax rights to the asset depends on how the initial sale and
lease of the equipment is structured, and on the type of lease (capital
or operating). As you learned in Unit Two, the type of borrowing −
recourse or nonrecourse − has important accounting considerations.
In a recourse arrangement, the vendor agrees to stand behind the
customer’s lease payments. Alternatively, the vendor can sell its
interest in the residual only, retaining the lease payment stream and
associated credit risk.
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Administrative Services
Handling Vendors may find it more cost-effective to purchase services

paperwork from an equipment leasing specialist, whose size and leasing
concentration enable it to achieve certain economies of scale. The
administrative services a third-party lessor might provide include
booking the transaction; billing and collecting the monthly lease
payments; processing customer service complaints; filing, collecting
and remitting sales, use and property taxes; and preparing financial
statements and tax returns.
Remarketing / Asset Management
Control over Vendors often seek outside help in remarketing the asset at the end of
asset the lease term or in the event of a customer default. Also, a vendor may
choose to use the asset tracking systems offered by many leasing
companies. These systems alert the lessor as to which assets are coming
off lease, report on the status of any off-lease equipment, and process
any subsequent sales or re-leases of any returned equipment.
UNIT SUMMARY
There are many reasons vendors create captive leasing companies and vendor programs:
market control, market enhancement, ancillary income, tax benefits, and financial leverage.
Outsourcing some or all of the leasing function helps vendors minimize the risks associated
with leasing, fund their leasing programs, and benefit from third-party expertise.
Third parties meet vendor leasing program needs in a variety of ways. Many provide funding
only, while others provide both funding and a limited range of support services such as
billing, collecting, and credit review. Some third party companies provide special services,
such as remarketing, to vendors. Others offer full-service leasing, from lease origination
through equipment disposition.
Congratulations! You have completed the Basics of Asset Based Financing Course. Please
complete Progress Check 8 to check your understanding of vendor leasing programs. If you
answer any questions incorrectly, please review the appropriate portions of the text.
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] PROGRESS CHECK 8
Question 1: The primary reason manufacturing companies, distributors, or equipment

merchandising dealers use customer financing programs is to:
____ a) control resale prices of used equipment.

____ b) gain tax benefits.
____ c) reduce risks.
____ d) help sell their products.
Question 2: The reason vendors wish to exercise control at the time of sale is to:
____ a) increase sales by providing the customer with supplies and other services.
____ b) prevent loss of a sale while the customer seeks financing.
____ c) make sure its product is part of a product package.
____ d) influence the resale value of the equipment.
Question 3: One of the ways vendors can increase profits through leasing programs is to
purchase noncompeting equipment at wholesale prices and package it with
their own equipment.
____ a) True
____ b) False
Question 4: Financial leverage helps increase a lessor’s return on equity because:
____ a) it generates incremental sales from bundled services and products.

____ b) sales volume is increased by reducing reliance on discounts off list price.
____ c) it generates income from syndication fees.
____ d) the rate of return from the lease generally exceeds the cost of borrowing
to leverage the lease.
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ANSWER KEY

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 to
purchase noncompeting equipment at wholesale prices and package it with
a) True
d) the rate of return from the lease generally exceeds the cost of
borrowing to leverage the lease.
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PROGRESS CHECK 8
(Continued)
Question 5: An important reason vendors use third-party lessors is to:
____ a) improve sales.

____ b) avoid the risks inherent in leasing.
____ c) gain tax advantages.
____ d) earn a greater return on equity.
Question 6: Vendors who wish to retain a portion of the financing profit and tax benefits
without bearing all the risks of leasing should consider:
____ a) a captive subsidiary.

____ b) lease brokering.
____ c) a joint venture.
____ d) an asset tracking system.
Question 7: A vendor often finds it beneficial to outsource its lease administration

activity to a leasing specialist because:
____ a) the third party’s knowledge of leasing and size enables it to administer
leases more efficiently.
____ b) outsourcing helps increase the value of depreciation.
____ c) it retains full tax benefits without the risks.
____ d) leasing specialists know how to remarket equipment.
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ANSWER KEY
b) avoid the risks inherent in leasing.
c) a joint venture.

a) the third party’s knowledge of leasing and size enables it to

administer leases more efficiently.
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Unit 9
UNIT 9: VENDOR PROGRAMS
INTRODUCTION
In Units Two through Eight, we discussed leasing, a key ABF product, in detail. In that
context, we introduced the concept of vendors using leasing programs to help sell their
products and accelerate cash flow from sales. In this unit, we expand our discussion of that
topic to include all vendor finance programs (loans and leases). Specifically, we will
examine the reasons vendors establish programs to finance their customers’ product
purchases, why they use third-party organizations such as Citibank to develop or support
these programs, and how Citibank uses vendor programs to accelerate ABF activity. We will
also look at several marketing and structuring aspects of vendor programs — vendor
selection criteria, program structuring, and risk-sharing mechanisms.
UNIT OBJECTIVES
+ Identify the benefits of vendor financing programs
+ Recognize the various ways third parties participate in vendor financing

programs
+ Identify criteria Citibank uses to select vendors
+ Understand the major types of risk sharing mechanisms in vendor programs
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9-2 VENDOR PROGRAMS
BENEFITS OF VENDOR FINANCE PROGRAMS
Finance sales In Unit Two, you learned that manufacturing companies, distributors,
of products or equipment merchandising dealers who use financing programs to
help sell their products are known as vendor lessors. Recall that some
manufacturers or dealers establish a wholly owned subsidiary to
finance the purchase of their products, creating a captive (two-party)
financing company. In other instances, vendors outsource all or part of
their customer financing activity to a financial organization such as
Citibank. In this unit, we use the term vendor financing to refer to
any program, including captives, in which a manufacturer, distributor,
or dealer finances the sale of its products to end users.
In this section we will look at the benefits of vendor financing from

two perspectives — that of Citibank and that of the vendor.
Understanding the benefits from both viewpoints will help you market
and structure successful vendor programs. Let’s begin with the
benefits to Citibank.
Citibank Benefits
Access to Why does Citibank use vendor programs as part of its asset based
equipment financing activity? The main reason is that vendor programs help speed
users the bank’s access to equipment users. Established vendors have a
customer base in place and a marketing program to acquire new
customers. Through vendor financing, Citibank establishes
relationships with equipment users that may lead to direct finance
arrangements in the future.
To help you understand the role Citibank plays in vendor financing, in

Figure 9.1, we show the equipment financing flow when Citibank
finances the sale of the product to the end user. Note that Citibank is
providing equipment financing through the vendor for the equipment
user, not the manufacturer, dealer, or distributor.
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VENDOR PROGRAMS 9-3
Sale Distributor Sale
Manufacturer or Equipment User
Dealer
Citibank Financing
• Vendor
• Direct
Figure 9.1: Financing equipment purchases
Additional In addition to providing access to equipment customers, participating

advantages in vendor financing programs offers Citibank several other advantages.
+ Broadens client relationships by setting up an additional link to

the client’s sales and marketing force
+ Produces new revenues
+ Establishes credibility and prestige in the equipment market
+ Speeds deal flow by enhancing the sales and marketing force
+ Reduces credit risk through risk sharing arrangements, access

to the vendor’s knowledge of the equipment and the customer
base, and access to larger secondary markets
+ Provides economies of scale to justify equipment and industry

specialization
As you can see, there are many reasons for Citibank to be involved
with vendor finance arrangements. Likewise, vendor programs are
beneficial to manufacturers, dealers, and distributors. Let’s continue
our discussion by looking at the benefits from the vendor’s view.
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9-4 VENDOR PROGRAMS
Vendor Benefits
Benefit To effectively market vendor financing programs, it is important that

categories you understand the many benefits vendor financing programs offer
vendors. In this section, we discuss five reasons vendors establish
financing programs. As you read about these benefits, think about how
they could be used as selling points. The benefits we will discuss are:
+ Market control
+ Market enhancement
+ Ancillary income
+ Tax benefits
+ Financial leverage
Market Control
Critical Most vendor financing programs are established for marketing

periods reasons. Vendor programs give vendors command over the equipment
and control during critical periods over the useful life of the
equipment, including control:
+ At inception, to prevent loss of a sale during the time the

customer needs to locate funding. On-the-spot financing can
help close a deal.
+ During the funding term to provide for upgrades, maintenance,

parts, supplies, and any other service or product. Monthly
contact through billing gives the vendor an advantage in winning
sales of additional services or products.
+ Over disposition of the equipment, so that at lease termination,

the vendor is able to steer the user toward acquiring the
vendor’s new equipment
+ Over the resale prices of used equipment repossessed,

returned, or traded-in to support lease yields, operating lease
programs, and avoid price competition problems with new
products
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VENDOR PROGRAMS 9-5
+ Over package (blanket) financing to ensure that the vendor’s

product is part of the multiple product package
Market Enhancement
Market size In addition to market control, both the size and quality of a
and quality manufacturer's sales market can be improved through financing.
Market enhancement results from:
+ Reduction or elimination of discounts off list price by

directing the customer’s attention from the purchase price to
the financial considerations of a lease or loan
+ Improvement of sales volume through product differentiation

obtained by the unique combination of product attributes,
financial services, and other bundled services
+ Increased sales volume through the offering of operating lease

and rental programs that meet certain equipment user needs not
met by other financing alternatives
+ Speed of asset turnover through takeout-rollover programs that

remove a competitor's equipment before the end of the
equipment's lease term and replace it with the vendor’s
equipment
+ Expansion of market penetration for new products through

rental programs that allow a customer to try out equipment and
lease and loan subsidies that provide low rate financing
+ Improvement of dealer sales through vendor guarantee

programs that attract third-party creditors who can offer
attractive financing for customers
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9-6 VENDOR PROGRAMS
Additional Income Sources
Interest, Increased sale of the vendor’s product is not the only source of profit
incremental in vendor financing programs. Here are three additional sources:
sales, residual
profits
+ The interest spread (difference) between interest income and
interest expense, brokerage fees, and service fees when the
lessor continues to service the lease
+ Incremental sales generated from bundled services and

products in a full-service lease
+ Residual profit to the degree returned equipment can be sold

for more than its remaining book value at the end of a lease
Tax Benefits
MACRS and In Unit Three, we discussed the various tax benefits of leasing. Recall
gross profit that in the U.S., the primary tax benefits for leasing are MACRS and
deferral gross profit deferral. Let’s review two important points from that
discussion:
+ The value of MACRS increases the later in the tax year the
lease is structured.
+ The value of gross profit tax deferral depends upon the size of
the gross profit, the discount rate applied, and the MACRS
classlife of the leased equipment.
Keeping these points in mind, look at the comparison of third-party

and two-party leasing tax benefits in Figure 9.2. (All values are
expressed as a percentage of retail sales price, based on an after-tax
present value computation.)
Ability to use As you can see, the value of tax benefits in a vendor program can be
tax benefits significant. If the vendor lessor cannot use the tax benefits, it should
consider joint venturing with a partner who can use the benefits.
Selling (brokering) tax leases can generate fees that help compensate
for unusable tax benefits.
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VENDOR PROGRAMS 9-7
Third-party Two-party
Lessor Lessor
MACRS 4.263% 4.263%
Gross
profit tax 0.000 2.425
deferral
Total 4.263% 6.688%
Assumptions:
(1) 40% gross margin
(2) 12% parent discount rate (Values would be lower
if a typical captive discount rate of 6 to 8% were
used in the present value analysis)
(3) December 15 structuring date
(4) 5-year MACRS classlife
(5) 35% corporate tax rate
Figure 9.2: Third-party versus two-party lessor tax benefits
Financial Leverage
Interest rate Recall that in a leveraged lease, the lessor borrows much of the
and cost of equipment cost and assigns the future lease payment stream to the
debt lender in return for the funds borrowed. The use of financial leverage
increases a company's return on equity because the interest rate
implicit in the lease is greater than the cost of the debt used to
leverage the lease. To receive as much cash as possible, captive
lessors use large amounts of debt to fund their leasing portfolios.
Leveraging also lowers the investment risk since the lessor uses a
minimal amount of its own equity funds.
Off balance In addition to enhancing return on equity, financial leveraging may

sheet funding offer a vendor lessor certain accounting benefits. In the U.S., a
partially owned subsidiary (less than or equal to 50 percent) is not
consolidated for accounting purposes, so the debt does not appear on
the balance sheet of the parent company.
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9-8 VENDOR PROGRAMS
THIRD PARTY VENDOR PROGRAMS
In the previous section, we discussed the many benefits vendor

financing programs offer manufacturers and equipment dealers. We
saw that vendor financing programs help vendors sell their products,
increase revenues, and accelerate cash flow. With so many benefits to
gain, why don’t all manufacturers and equipment distributors have
customer financing programs? In this section, we will examine the
reasons and see how using third-party creditors such as Citibank can
help overcome the constraints vendors confront.
Reasons Vendors Lack Customer Financing Programs
Although there are many reasons vendors do not establish captive

financing programs, most pertain to lack of resources and financing
expertise, concerns about the risks in leasing and lending, and the
inability to compete with large leasing specialists. Let’s examine each
of these reasons more closely.
Expertise and Capital Issues
Lack of The lack of in-house financing expertise is one of the most important
specialized reasons vendors do not have financing programs. Leasing, in
resources particular, is a specialized field. Most companies do not have the time
or the resources to develop the needed expertise or to hire leasing
experts. Also, many companies do not wish to divert capital away from
their primary business to fund and support a financing portfolio.
Another problem is that internal credit processes may lack integrity
because of ties to marketing, and borrowers may not take a supplier’s
credit seriously.
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VENDOR PROGRAMS 9-9
Risk Issues
Financing Even for companies with the resources to set up a financing program,
risks and tax concerns about the many risks in financing equipment or an excess tax
position benefit position may keep them from doing so. Residual, credit,
interest rate, and country risks are some of the risks captive finance
companies face.
Inability to Compete
Cost of capital Few vendors have the administrative and collection infrastructure
and necessary to conduct a financing program. Vendors also fear that their
administration cost of capital may be too high to compete with the rates of third-
party finance companies.
As we shall see in the following section, most of these concerns can

be addressed through outsourcing customer financing programs to
third-party participants.
Ways Third-parties Meet Vendor Needs
Variety of There are a large number of third-party participants in the vendor

participants financing market, including lease brokers, financial institutions such
and services as Citibank, and independent leasing companies. Third parties service
vendors in a variety of ways, at a variety of levels. It is important for
you to understand the types of services offered so that you can help a
vendor compare the program you are offering to those of competitors.
Some participants function solely as lenders to captives. Others

provide special services, such as remarketing. Another class of
participants provides funding and a limited range of support services,
while others offer full-service financing, from lease/loan origination
through billing, collections, and equipment disposition.
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9-10 VENDOR PROGRAMS
Joint ventures In addition to the roles just mentioned, the third-party creditor
also can serve as a joint venture/equity partner. Under such an
arrangement, the third party invests directly in the financing
subsidiary. More commonly, the vendor and an outside party jointly
establish a separate company to lease the vendor’s products to
customers. Vendors who want to retain a portion of the financing
profit and tax benefits in-house, but do not want to bear all the risks of
a full captive, often choose to enter a joint venture. The various ways
creditors service vendors are shown in Figure 9.3.
Loans (Indirect funding)

Equity (Contract
Captive
purchases)
Specialized Services
Joint Equity (as a partner)

VENDOR
Venture Specialized Services
Direct Financing
Full-
Service All Services
Program development
through billing and collections
Figure 9.3: Roles of third-party organizations
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VENDOR PROGRAMS 9-11
Citibank roles Citibank may assume all aspects of the vendor’s customer financing
(full-service program), from program development through billing and
collections, or play a partial role in the program, such as handling
billing, collection, and credit checking. Citibank can act as finance
program advisor and developer, providing servicing programs and
education, training, and marketing support, or play the role of equity
investor or purchaser of vendors’ portfolios of leases or loans.
The services Citibank and other full-service financial organizations

offer vendors may be grouped into seven categories:
+ Sales-assistance and training
+ Lease and loan structuring and documentation
+ Credit review
+ Outplacement/investment syndication
+ Funding
+ Administrative services
+ Remarketing/asset management
Let’s examine each category.
Sales-assistance and Training
Education, Sales-related services provided by a third-party creditor range from

joint helping the vendor establish an effective financing program by
marketing, educating the vendor’s sales force to on-going sales support services,
support
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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Lease and Loan Structuring and Documentation
Third-party This is an area where third-party creditors offer a great deal of added
lessor’s value. The third-party company works with a vendor to develop
expertise financial products and customize individual transactions to the needs
of a particular lessee or borrower. The vendor benefits from the third-
party’s expertise in structuring lease and loan products. The vendor
can also rely on the third-party creditor for help in preparing,
processing, and tracking the documentation prior to closing the
transaction.
Credit Review
Customer’s Vendors often rely on a third party’s expertise in assessing a

credit- customer’s creditworthiness. Third party creditors can develop and
worthiness maintain a credit approval process with integrity because it is
independent of the vendor’s marketing function. The credit review
process usually involves researching the customer’s credit history,
analyzing financial statements, and checking references.
Outplacement and Investment Syndication
Lack of capital A lack of capital often causes vendors to seek an equity partner or
have a lease broker sell off its equity investment in leases. Sometimes
the investor buys the entire lease (assumes the credit and residual
risks); other times the vendor sells only the rental stream or the
residual.
Funding
Direct and There are many ways to fund a vendor financing program or captive
indirect organization. The method chosen depends on the vendor’s desired tax
funding and accounting consequences.
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There are two basic types of funding − direct and indirect. Indirect
funding involves loans to the captive or vendor, who then uses the
borrowed funds to lease the equipment directly to the customer.
Under direct funding methods, the third party is the lessor or lender
and provides the financing directly to the vendor’s customer. The
third-party lessor may buy the asset from the vendor and lease it
directly to the customer, or purchase existing leases from the vendor.
Accounting Whether the vendor, the third-party creditor, or the customer retains
issues the residual and tax rights to the asset depends on how the initial sale
and lease of the equipment are structured, and on the type of lease
(capital or operating). As you learned in Unit Three, the type of
borrowing — recourse or nonrecourse — has important accounting
considerations. In a recourse arrangement, the vendor agrees to stand
behind the customer’s lease payments. Alternatively, the vendor can
sell its interest in the residual only, retaining the lease payment stream
and associated credit risk.
Handling Vendors may find it more cost-effective to purchase services from an

paperwork equipment leasing specialist, whose size and leasing concentration
enable it to achieve certain economies of scale. The administrative
services a third-party creditor might provide include booking the
transaction; billing and collecting the monthly lease payments;
processing customer service complaints; filing, collecting and
remitting sales, use and property taxes; and preparing financial
statements and tax returns.
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Remarketing / Asset and Remedial Management
Control over Vendors often seek outside help in remarketing the asset at the end of
asset the lease term or in the event of a customer default. Also, a vendor may
choose to use the asset tracking systems offered by many financing
companies. These systems alert the lessor as to which assets are coming
off lease, report on the status of any off-lease equipment, and process
any subsequent sales or re-leases of any returned equipment. Vendors
may also need assistance in remedial management to know when a
transaction is in trouble and how to work out a solution.
It is important to note that each of the services listed in this section

has a cost to the provider of the service, whether the provider be the
vendor or a third party. The cost of services is an important point in
marketing vendor programs, the topic of the next section.
SUMMARY
There are many reasons vendors create captive financing companies and vendor programs
— market control, market enhancement, ancillary income, tax benefits, and financial
leverage. Outsourcing some or all of the financing function helps vendors minimize the
risks associated with financing, fund their financing programs, and benefit from third-party
expertise. For Citibank, vendor programs accelerate access to equipment users, expand
client relationships, produce new revenues, establish credibility and prestige, speed deal
flow, and reduce credit risk.
Third parties meet vendor financing program needs in a variety of ways. Many provide
funding only, while others provide both funding and a limited range of support services.
Some third party companies provide special services, such as remarketing, to vendors.
Others offer full-service financing, from lease/loan origination through equipment
disposition.
You have completed the first part of Unit Nine, Vendor Programs. Please complete Progress
Check 9.1 to check your understanding. If you answer any questions incorrectly, please
review the appropriate portions of the text before continuing to the next section, “Marketing
and Structuring Vendor Programs.”
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Question 1: Access to the vendor’s equipment knowledge and secondary market are ways
for Citibank to:
____ a) justify risk sharing arrangements.

____ b) gain prestige in the equipment market.
____ c) speed financing transactions.
____ d) reduce credit risk.

____ 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 is
to purchase noncompeting equipment at wholesale prices and package it with
____ a) True
____ b) False
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ANSWER KEY
Question 1: Access to the vendor’s equipment knowledge and secondary market are ways
for Citibank to:
d) reduce credit risk.

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 is
to purchase noncompeting equipment at wholesale prices and package it with
a) True
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PROGRESS CHECK 9.1

(Continued)
____ a) it generates incremental sales from bundled services and products.

____ b) sales volume is increased by reducing reliance on discounts off list price.
____ c) it generates income from syndication fees.
____ d) the rate of return from the lease generally exceeds the cost of borrowing
to leverage the lease.
____ 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.

a) the third party’s knowledge of leasing and size enables it to

administer leases more efficiently.
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MARKETING AND STRUCTURING VENDOR PROGRAMS
So far, we have focused on the benefits of vendor finance programs

and the ways third party creditors can help vendors achieve their goals.
With this foundation in mind, we will now discuss marketing and
structuring vendor programs. First, we describe the common types of
vendor financing programs and various risk sharing structures; next, we
discuss marketing and structuring successful programs.
Program Types
There are several ways for a financial institution to provide financing

to a vendor’s customers. Here, we describe three basic types of
programs — referral, full recourse, and risk sharing.
Referral
Creditor has In a referral program, the vendor directs or refers its customers to the
control and creditor for their financing needs, but does not provide support or
bears risks recourse. The creditor may be the only institution the vendor refers its
customers to (exclusive basis) or one of several creditors (non-
exclusive basis). The creditor has complete control over credit
extension and bears all the credit risks. Each transaction received is
judged on its own merits according to the creditor’s risk acceptance
criteria.
Full Recourse (100% Guarantee)
Vendor Full recourse refers to an arrangement in which the vendor assumes

assumes all 100% of the credit risk by providing a demand guarantee for 100% of
credit risk the amount of the transaction. In the event of default, the vendor buys
back the contract for the full amount and is responsible for all follow-up
actions related to the contract.
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The vendor controls the credit approval process, but the creditor
retains veto rights, which are exercised only for non-credit reasons.
This type of guarantee is suitable for smaller programs and small
ticket programs.
Risk Sharing
Split credit or In a risk sharing (partial recourse) program, Citibank and the vendor
collateral agree to share credit and/or collateral value risks. For example, Citibank
value risks and the vendor may enter a co-lending agreement in which each funds
50% of the transaction. Risk sharing is usually necessary until Citibank
earns enough of a specific market to make nonrecourse programs
feasible. Vendor support may be reduced as the vendor and creditor
develop greater experience and historical data in markets.
There are several possible risk sharing arrangements. Because this is

Citibank’s preferred approach, we discuss risk sharing in detail
separately in the following section.
Forms of Risk Sharing
Balance with Citibank requires some form of risk sharing for major programs in Latin
benefits America, so it is important for you to know about the various types. Of
course, most vendors do not want to assume any risk; therefore, the
challenge is to design programs that are better than the other financing
arrangements available in the market place. Remember, the vendor’s
goal is to sell more products! The marketing benefits that justify a risk
sharing arrangement must be clear to the vendor.
The types of risk sharing we will discuss here are:
+ First loss deficiency guarantee
+ Asset value guarantee
+ Co-lending (Pari Passu)
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Before we describe these mechanisms, let’s look at the objectives of

risk sharing from a creditor’s view so that you will understand the
importance of these arrangements.
+ Permit risk acceptance criteria under which 80-90% of eligible

transactions will be approved quickly. When risks are shared,
more transactions may be approved.
+ Retain sufficient reasonable business risks so that vendors will

encourage their customers to finance equipment through the
program. Vendors who bear all the risks are unlikely to support
the creditor, whereas shared risk promotes cooperation.
+ Have sufficient business risk to justify target yields. The

vendor must see that the benefits the creditor offers offset the
creditor’s required margins.
Think about how these objectives may be achieved as you read about
the three types of risk sharing mechanisms.
First Loss Deficiency Guarantee (FLDG)
Percentage of In this risk sharing arrangement, the vendor guarantees an amount equal
financing to a percentage of the amount that the creditor financed. This
percentage, referred to as the FLDG liability, is calculated annually.
Example Assume a 25% first loss deficiency program. If Citibank booked US$10
million in transactions, the vendor’s liability under the program would
be US$2.5 million (.25 X $10 million).
Loss applied If a borrower defaults on a contract, the vendor repurchases the contract
against for its full face value from Citibank. The vendor then repossesses the
liability equipment and attempts to sell it. The sale may create a chargeable
loss, which is the difference between the purchase price of the defaulted
loan and the net sales proceeds. This loss is applied against the vendor’s
FLDG liability.
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Motivation to When the vendor repurchases the defaulted contract, it assumes the
resolve responsibilities and risks of repossessing and remarketing the
defaults equipment. For this reason, FLDG arrangements motivate the vendor or
dealer to resolve default situations. If the vendor restructures the
transaction instead of creating a loss, the amount of the FLDG liability
is not reduced. If the vendor cannot repossess and resell the equipment
for any reason, the amount of the FLDG liability is not reduced.
Example Look at the example in Figure 9.4. Notice that the vendor guarantee for
the first year is $13,000. Assume that two borrowers in Country B
default on their contracts for a total of $10,000. The vendor repurchases
the contracts and sells the equipment for $4,000, realizing a $6,000
loss. In this example, the vendor FLDG is reduced to $7,000 (13,000 -
6,000 = 7,000).
Figure 9.4: FLDG schedule of loss positions
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Asset Value Guarantee (AVG)
Collateral In an asset value guarantee (buy back), the vendor guarantees a collateral
value value for each transaction. The AVG agreement contains a schedule of
guaranteed values over time at which the vendor agrees to repurchase any equipment
the creditor repossesses. Thus, the vendor acts as an assured and
secondary market.
It is important for you to know that the program loss rate (including
remedial management, loan work-out, and repossession costs and
risks) for an AVG typically is higher than under an FLDG program.
Co-lending (Pari Passu)
Split credit In co-lending, a vendor assumes 50 percent of the credit risk of each
risk transaction on a transaction-by-transaction basis (either directly
extending 50 percent of the funding or providing a demand guarantee for
50 percent). Citibank and the vendor separately approve or veto each
transaction. This type of risk sharing is most suitable for programs with
larger transactions where the vendor has sound transaction screening
practices and a credit process with integrity.
Comparison
Each of the program types and risk sharing mechanisms described in

this section affect turn around time, approval ratios, the cost of the
delivery system, and the degree of risk shifting differently. To help
you visualize these differences, we’ve summarize them in Figure 9.5
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Referral Full First Loss Co-lending Asset Value

0% Recourse Deficiency 50% Guarantee
Guarantee 100% Guarantee Guarantee
Guarantee
Turn- Medium Fast Fast Slow Fast
Around
Time
Control of Citibank Vendor Vendor Citibank and Citibank
Credit vendor,
Criteria indepen-
dently
Approval Low. Only High. All High. Small Low. Small Medium.
Ratio upper tier customer high-risk high-risk and Small, high-
customers are classes borrowers medium-size risk
likely to included. could be borrowers borrowers
qualify. included. would be would be
excluded. excluded.
Cost of High Low Low High Low
Delivery
System
Risk Vendor shifts No program Risk shifting Risk shifting Risk shifting
Shifting to all program risks shifted to Citibank to Citibank is to Citibank is
Citibank risks to to Citibank limited explicit and significant.
Citibank against all Vendor
risk retains risk
categories type
with vendor (collateral
retaining all and resale
risk types values)
Figure 9.5: Program comparison
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Structuring Vendor Programs
Success As you might assume, each of the program types we just discussed —
criteria referral, risk sharing, and full recourse — requires a different
structuring approach. The officer’s goal should be to develop a regional
or country-specific vendor financing partnership that will build on the
strengths of each party, keeping in mind how the program structure will
motivate the vendor to support the creditor, especially in default
situations. In a successful program, the vendor sells more equipment,
Citibank transacts more loans and leases, and defaults are controlled.
To build a successful program, the officer must:
+ Select vendors carefully
+ Effectively market the services
+ Design a program that will meet the vendor’s sales goals and
provide Citibank with the margins it needs
The following discussions will help you understand these points.
Vendor Selection Criteria
Vendor selection is the first step in building a successful vendor

program. In this section, we identify the vendor selection criteria
Citibank has developed. The criteria will help you recognize vendors
that make good candidates for vendor finance programs.
Existing The ideal vendor has an existing relationship with Citibank and serves
relationship one of the target asset based financing industries. Strong candidates
believe that customer financing plays a key role in its sales and
marketing efforts. Other criteria are:
+ 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 (for

example, US$100 million)
+ Average cost of equipment is greater than US$75,000
+ Equipment is moveable and has stable collateral values
+ Customers have limited access to external capital, especially

unsecured capital
Now let’s discuss how to market to selected vendors.
Marketing
Assess need Once you have determined that a vendor meets the selection criteria,
you should:
+ Find out what the vendor is doing now
+ Find out what is not working now
+ Find out what the vendor has tried before
As you go through this exercise, think about how the services Citibank
offers might solve the vendor’s problem. Recall the seven categories
of services — help with sales and training, transaction structuring and
documentation, credit review, capital for equity, funding,
administrative services, and remarketing/asset management.
Collect basic Next, gather the basic information required to develop a preliminary
information program structure. See Figure 9.6 for a list of key questions.
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What is the revenue potential?
What are the key risks?
What data is available on historical loss and delinquency performance

for the vendor’s equipment?
What is the existing break down of the target market? How might the
vendor financing program change the target market?
What are the limitations on legal repossession and sales of assets?
What are the tax and accounting objectives of the customers?
How big is the secondary market for the equipment and what are the
distribution channels?
If novel or complicated financing products are to be offered, what

level of financial education and marketing is required?
Figure 9.6: Information needed to structure a vendor program
Program Outline
Contents Once you have the answers you need, develop a preliminary program
outline. The contents of a program outline should:
+ Identify common interests
+ Provide for a highly consistent regional program with the

ability to tailor financing for individual markets
+ Describe how local delivery systems (vendor marketing and

Citibank financing units) will work together
+ Balance rates with service quality and value-added services,

such as marketing support
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+ Provide for balanced, limited risk sharing and initial support

that allows Citibank a high transaction approval rate and quick
turn-around time. The approval ratio and turn-around time are
extremely important to vendors and their customers.
+ Address critical issues such as default provisions, the

definition of loss, who will deal with loss, and who will handle
repossessions
+ Provide for on-going program monitoring and adjusting
+ Contain incentives and flexibility
+ Specify the margin Citibank requires
Remember, vendors want nonrecourse programs. You must build a

risk reward package to justify Citibank’s margins to customer!
SUMMARY
In this section, we discussed three basic types of vendor programs — referral, full recourse
(100% guarantee), and risk sharing. The most common forms of risk sharing arrangements
are:
+ First loss deficiency guarantee
+ Asset value guarantee
+ Co-lending
The type of program affects the average length of time it takes to process a transaction, the
transaction approval rate, and the cost of the delivery system. It is important for vendors to
understand how the type of program affects the goal they wish to achieve. Balanced and
limited risk sharing arrangements allow for higher approval rates, whereas referral program
approval rates are typically low.
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To build a successful vendor program, the officer should evaluate vendors against Citibank’s
selection criteria, identify vendors that would benefit from a financing program, and
structure a program that helps the vendor increase sales and provides Citibank with the
required margin. In structuring a program, the officer should always anticipate the way a
structure might motivate the behavior of the vendor.
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Question 1: In a full recourse arrangement, the creditor’s credit risk is:
____ a) 100 percent.

____ b) 50 percent.
____ c) 0 (zero) percent.
Question 2: Requiring the vendor to share credit and/or collateral risks is not necessary
when the vendor’s credit rating is “A” or better.
____ a) True
____ b) False
Question 3: In a first loss deficiency guarantee, the amount of the vendor’s liability is
reduced by:
____ a) the amount of the vendor’s loss when it is unable to repossess and resell
equipment.
____ b) the difference between the amount of the original transaction and the
restructured transaction.
____ c) the difference between the purchase price of the equipment and the resale
proceeds.
____ d) the percentage specified in the FLDG agreement (for example, 20
percent).
Question 4: In an asset value guarantee (buy back), the vendor:
____ a) reimburses the creditor if the collateral resale value is below market
price.
____ b) purchases defaulted contracts from the creditor.
____ c) agrees to repossess and resell the equipment.
____ d) is a certain, secondary market.
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ANSWER KEY
Question 1: In a full recourse arrangement, the creditor’s credit risk is:
c) 0 (zero) percent.
The vendor assumes all the credit risk.
Question 2: Requiring the vendor to share credit and/or collateral risks is not necessary
when the vendor’s credit rating is “A” or better.
b) False
The reason we ask vendors to share risks is to create a financing arrangement

that will be attractive enough to motivate the vendor’s customers to buy while
permitting Citibank to attain its target margin. The credit rating of the vendor
is not a factor.
Question 3: In a first loss deficiency guarantee, the amount of the vendor’s liability is
reduced by:
c) the difference between the purchase price of the equipment and the
resale proceeds.
Question 4: In an asset value guarantee (buy back), the vendor:
d) is a certain, secondary market.
In an asset value guarantee, the vendor agrees to buy back collateral that the
creditor repossesses at the price specified in the AVG schedule; thus, the
vendor is a guaranteed secondary market.
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PROGRESS CHECK 9.2

(Continued)
Question 5: Turn-around time in a co-lending arrangement is typically:
____ a) slow.
____ b) fast.
____ c) medium.
Question 6: Select the two risk sharing mechanisms that may best benefit the creditor
when the secondary market is questionable.
____ a) Full recourse

____ b) Asset value guarantee
____ c) Co-lending
____ d) First loss deficiency
Question 7: Select two signs that may indicate that company is a good candidate for
a vendor program.
____ a) The vendor’s customers have limited access to capital.

____ b) Equipment resale values are stable.
____ c) The equipment manufacturer’s market share is low and they need to sell
more equipment.
____ d) The vendor’s products are permanent fixtures that are unlikely to
“disappear.”
Question 8: A vendor program should be structured to allow a high transaction approval

rate and quick turn-around time.
____ a) True
____ b) False
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ANSWER KEY
Question 5: Turn-around time in a co-lending arrangement is typically:
a) slow.
Both the vendor and the creditor must approve each transaction separately,
which tends to take more time.
Question 6: Select the two risk sharing mechanisms that may best benefit the creditor
when the secondary market is questionable.
a) Full recourse
b) Asset value guarantee
Question 7: Select two signs that may indicate that company is a good candidate for
a vendor program.
a) The vendor’s customers have limited access to capital.

b) Equipment resale values are stable.
The vendor should hold the dominant position in key markets, and the
collateral should be moveable so that repossession is easier.
Question 8: A vendor program should be structured to allow a high transaction approval

rate and quick turn-around time.
a) True
The vendor will sell more equipment under these conditions.
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Unit 10
UNIT 10: FRANCHISE FINANCING
INTRODUCTION
In Unit Nine, you learned about vendor finance, one of the programs Citibank uses to
advance its asset based financing activity. In this unit, we discuss another such program −
franchise financing. The purpose of this unit is to help you understand the nature of this
industry and the factors that affect franchise lending decisions. You will see that a banker’s
approach to franchise financing is somewhat different from the approach to leasing.
UNIT OBJECTIVES
+ Recognize common terminology associated with franchise financing
+ Understand the franchise financing markets
+ Identify the key considerations in franchise credit analysis
+ Understand the legal considerations of franchise finance
WHAT IS A FRANCHISE?
In this section, we explain what a franchise is and define common

terms used in this industry. We also look at the types of franchise
stores and ownership options. This overview will prepare you for the
concepts presented in the remainder of the unit.
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10-2 FRANCHISE FINANCING
Franchise Industry Terms
Definitions of A franchise is a license offered by a company that grants the right to

key terms others to sell its products and operate under the same business name.
For example, the Taco Bell restaurant system sells franchise
licenses to owner/operators so that they can open Taco Bell
restaurants and sell the same food products as other Taco Bell outlets.
The company that sells licenses to operate under its business name is
called a franchisor. The owner/operator who purchases the license is
called the franchisee.
Agreements The license is governed by a franchise agreement for which the

franchisor requires an up-front franchise fee, ongoing royalties, and
advertising fees. The franchise agreement spells out the
responsibilities of the franchisor and franchisee, defines remedies for
agreement violations, and specifies the renewal options and the period
covered by the agreement. A key component is the right of the
franchisor to terminate the franchise agreement if the franchisee fails
to perform and remedy any default. Later in this unit, we describe how
these provisions affect lenders such as Citibank.
Typically, in addition to the franchise agreement, a franchisee signs an

agreement for the right to develop stores in a given territory. This
development agreement specifies the number of stores to be opened
in the territory and the number of years in the development period.
Advantages In addition to the right to sell under a recognized name, a franchise

agreement provides a franchisee a system for doing business and many
other valuable services that give a franchise business strength and
value. Franchises are popular for this reason.
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FRANCHISE FINANCING 10-3
Franchisor It is important to note that franchisors receive many applications for

screening franchise licenses, but grant the right to own and operate a franchise to
few. Franchisors carefully screen applicants for successful business
experience and financial strength. Franchisors also require successful
completion of in-store training and textbook courses. What this means
to Citibank is that those who are granted franchises may tend to be
better risks. Also, the franchisor may serve as an important source of
information about the prospect.
Franchise Sales Outlets
Outlet types The types of stores a franchisee may open depend on the types the
franchisor offers. It is important for you to understand the types of
outlets because different store types have different collateral values.
The basic types of outlets you are likely to encounter are these:
Free-standing Store is free-standing and not attached to any

other building
In-line Store is one of many businesses in a given

building, which is usually a strip center with
several vendors or tenants. Customers access
each business from outdoors.
In-mall This is an outlet that is inside an enclosed

shopping area called a mall. Customers
access the outlet from inside the mall. The
store may have its own seating or may share
seating with other food outlets in what is
called a food court.
Kiosk This is a small unit that sells a cooked

product prepared at a different location. The
cooked product is brought to the kiosk during
the peak hours; the menu offerings are
limited. Kiosks are prefabricated and require
assembly, making them somewhat portable.
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DELCO This is a term used by Pizza Hut, and is an

acronym for “delivery and carry-out.” This
type of outlet does not have seating.
Express unit This is another term used by Pizza Hut. It

refers to restaurants that sell only small
personal pizza (for one person) and pizza by
the slice.
Ownership Options
Companies that sell franchises to owner/operators may also own and

operate their own stores and enter partnership agreements to own and
operate stores. Citibank does not finance company-owned stores;
the stores must be 100% franchised.
Categories Of course, even though a restaurant is 100% franchised, the franchisee

still has various options for owning the land, building, furniture,
fixtures, and equipment. Let’s look at the three categories of
ownership:
Fee Simple
The franchisee owns the land, building, furniture, fixtures, and

equipment (LBFF&E).
Ground Lease
The franchisee leases the land from a third party and constructs the
building. Here, the franchisee owns the building, furniture, fixtures,
and equipment (BFF&E).
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Land and Building Lease (Leasehold)
The franchisee finds an investor who owns the land and is willing to
construct the building and lease the property to the franchisee for a
specific period. The franchisee owns only the furniture, fixtures, and
equipment (FF&E).
Each of the options described above has product, legal, and credit
implications for Citibank. Later in this unit, we will see how Citibank’s
franchise finance products and credit practices address the
franchisee’s financing needs. First, let’s examine the franchise
industry markets.
FRANCHISE INDUSTRY MARKETS
So far, you have been introduced to common franchise industry terms,

various types of franchise stores, and ownership options available to
the franchisee. Keep this background in mind as we discuss franchise
industry markets.
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Fast-food The franchise industry consists mainly of fast-food restaurant systems

restaurants such as Burger King, Kentucky Fried Chicken (KFC) ,
McDonalds, Pizza Hut, and Taco Bell. We often refer to a
restaurant system as a concept.
Citibank Bankers Leasing - Franchise Finance (CBL-FF), located in

Irvine, California, is a national lender to major fast-food concepts in
the U.S. Included in its loan portfolio are franchisees of the restaurant
concepts listed above, which are considered Tier I business. Citibank
defines Tier I business as the top two franchise concepts in total sales
in each primary food group. For example, in the U.S., McDonalds and
Burger King are the Tier I hamburger concepts. We will have more to
say about Tier I concepts in the next section. Tier II businesses are
national or regional chains with strong market share or concentration
in a given area. Citibank does finance some Tier II restaurant concepts,
as well as gas station franchises, but is selective about lending to these
businesses. Also, Citibank may consider other types of franchised
businesses. (Some retail stores and dry cleaning companies offer
franchises.)
Tier I Franchise Restaurant Systems
Strengths A major reason that Citibank focuses on Tier I concepts is that they
provide many important services and benefits that improve the
franchisees’ chances of success. Among these are:
+ Good initial and ongoing training
+ A proven system for developing uniform and consistent

products
+ Advertising and marketing expertise
+ Good restaurant site selection criteria and support
+ Supplier arrangements
+ Brand name recognition
Let’s examine three of these services and see how they contribute to
the success of the business.
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Franchisor Operations and Control Systems
Forced Tier I franchisees are expected to follow prescribed operating and

compliance food preparation procedures and standards that promote consistent
with standards quality, service, and cleanliness throughout the restaurant system.
Franchisors monitor and audit franchises throughout the year and
expect those who fail to meet standards to remedy the problem within
a given time, often with the frachisor’s help. From a loan officer’s
view, the expected consistency and regular monitoring help maintain
the value of the business.
Site Selection Expertise
Site studies One of the many benefits to Tier I franchisees is the site selection
expertise the franchisor provides. Tier I franchisors develop site
selection studies to identify preferred or ideal sites and make the
criteria available to franchisees. The study and criteria do not
guarantee success, but have proven to be a very good tool for
identifying good restaurant sites. As a safeguard, the franchisee is not
permitted to begin construction until the franchisor has approved the
site, the store plan, and the architecture.
Sales Franchisees use the information gathered during the site study to
projections project sales and cash flows on the proposed site and review these
projections with the franchisor to determine how reasonable they are.
Later, we will see how Citibank uses these projections in credit
analysis. The point you should remember is that from a lender’s
standpoint, careful site selection and realistic projections tend to
lessen the risk of default.
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Supplier Arrangements
Approved Tier I franchisors work with franchisees to identify suppliers of

products and equipment and inventory to make the product for a restaurant. A
equipment supplier may be the franchisor, a local company, or a foreign supplier.
In any case, franchisors work to ensure that suppliers distribute
approved products and equipment to the franchisee. Like the other
services we’ve discussed in this section, supplier arrangements help
increase the franchisee’s chances of success.
As you can see, there are many advantages in lending to Tier I

concepts. Next, we will look at the status of the fast-food industry in
the U.S. and see how business there has influenced interest in other
markets such as Latin America.
The U.S. Franchise Industry
Slow growth In the U.S., the fast-food business is a maturing industry that continues
to grow at a slow pace. In 1992 and 1993, the growth rate was 3%,
with the same rate forecasted for 1994. There is an over supply of
fast-food restaurants competing for market share, making the market
highly competitive.
Foreign Markets
Expanding Because growth opportunities are limited in the U.S., companies that
opportunities franchise fast-food restaurants are expanding in Asia, Europe, Latin
America, and the Caribbean. In Latin America and the Caribbean alone,
fast-food companies will require an average of US$241MM in capital
investment from their franchisees per year. This investment represents
237 new stores per year that require financing! As you can see, the
significant expansion planned by these companies presents a huge
opportunity for Citibank, which is positioning itself to take a large
portion of this business.
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Agreements One way that Citibank is helping increase its market share is through
with cooperative agreements with franchisors. An example is the letter of
franchisors understanding with the PepsiCo Group, which includes KFC, Pizza
Hut, and Taco Bell restaurant companies. This agreement states that
the PepsiCo Group and Citibank will work together and share
information to increase finance capability in Latin America and the
Caribbean (CARIBLA).
Of major benefit to Citibank is the support and assistance PepsiCo

provides to resolve loan default situations that may arise. For example,
if a franchisee defaults on a Citibank loan or lease, a member of the
PepsiCo group assists Citibank in:
+ Locating another franchisee capable of assuming operation of

the business
+ Reviewing the franchisee’s business to determine if it is a

viable operation
+ The sale of the franchisee’s business
CBL-FF is discussing similar arrangements with other franchisors. It

is important to remember that Citibank’s relationship with a
franchisor is a key factor in building a successful franchise
portfolio.
FRANCHISE FINANCE PRODUCTS AND PROSPECTS
The preceding discussion of franchise industry markets revealed that

the franchise market is expanding in Latin America and the Caribbean.
Next, we will examine Citibank’s franchise finance products and
explore ways to identify and take advantage of these growing franchise
finance opportunities.
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Franchise Products
Asset types In both Latin America and the U.S., Citibank provides financing for
and tenors real estate and furniture, fixtures, and equipment to licensed
franchisees. In this unit, we focus on loans, but you should note that
Citibank will consider leasing equipment to franchisees in Latin
American markets as well. Loan tenors offered depend on the asset to
be financed. In the U.S., funds are offered for tenors of five, seven,
and ten years, with up to fifteen years amortization on land and
building loans.
Most franchise loan products fall into three main categories: secured
term loans, secured nonrevolving lines of credit, and fee simple real
estate loans. All loan products are secured by a pledge of collateral.
Let’s examine each category.
Secured Term Loans
Old and new These loans are issued for financing existing and new stores,
obligations refinancing and consolidating existing debt, market acquisitions (one
operator buys existing stores from another franchisee), and financing
personal obligations such as stock repurchases.
Secured Nonrevolving Lines of Credit
Project Financing of new stores is often done with a line of credit that
financing converts to term financing upon the completion and opening of the
new store (a form of project financing). Lines are generally available
for a one- or two-year period. Citibank does not provide working
capital.
Fee Simple Real Estate
Longer terms Longer term financing (up to 10-year tenors with 15-year
amortization) is provided when there is real estate collateral.
Typically, a rate review is scheduled about midway through the loan
term.
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You can see that Citibank provides products to meet all a franchisee’s
capital and real estate needs, from furniture and fixtures to building
and land. With this knowledge, you are better prepared to search for
franchise financing opportunities.
Franchise Financing Opportunities
Identify Franchise financing opportunities come in many forms. Look for

opportunities remodeling projects, expansion projects, and system upgrades. Also
be alert for the introduction of new products. New products often
mean the franchisee must acquire new equipment to produce the
product!
Quantify Once you’ve identified an opportunity, find out whether the

opportunity opportunity is large enough to justify Citibank’s involvement. How
many outlets are franchisee operated, and how many are company
operated? What is the dollar size of the financing project? How many
outlets are affected? What is the timing? What type of operator
needs the financing (average, good, poor)? Who are the existing
lenders?
Assess Next, consider the collateral. Who controls the location? What assets
collateral are owned by the operator? (Generally, the more control over the
property Citibank has, the more attractive the deal.) What franchisor
support is available?
Evaluate Finally, examine the franchise and lease agreements. What is the
agreements length of the agreements? What are the renewal options? What are
the responsibilities and obligations of each party? What remedies are
available to the franchisor for noncompliance? What is the operator
turnover history? Are there exclusive rights to a territory? What are
the fees and costs? Are there restrictions on operating other types of
businesses?
As you begin to work on franchise deals, we suggest that you

periodically review this process to make sure you have complete
information for an assessment of the opportunity.
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SUMMARY
A franchise is a license offered by a company (franchisor) that permits an owner/operator

(franchisee) to sell the franchisor’s products and operate under the same business name.
The license is governed by a franchise agreement that details the rights and remedies of
each party to the agreement. Franchises are attractive because they offer name recognition,
leverage with suppliers, business expertise, training, and a system of operations and
controls.
The franchise industry market consists mainly of fast-food restaurant systems. Such
restaurant systems are referred to as concepts. Citibank targets Tier I concepts, which are
the top two franchise concepts in total sales in each food product group. The reason for this
focus is that Tier I concepts provide many important services to their franchisees that tend
to increase the franchisee’s ability to succeed.
There are several types of fast-food franchise outlets, each with a different collateral value.
Collateral value is also determined by the type of ownership option the franchisee chooses
(fee simple, ground lease, leasehold). Citibank finances land, buildings, furniture, fixtures,
and equipment with secured term loans, secured nonrevolving lines of credit, and real estate
loans. Once a franchise financing opportunity has been identified, it is important to quantify
the opportunity, assess the collateral, and evaluate the terms in the franchise agreements to
adequately judge its value to Citibank.
You have completed the first part of Franchise Financing. Please complete the Progress
Check and then continue with the section on “Credit Analysis.” If you answer any questions
incorrectly, please review the appropriate text.
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Question 1: A license offered by a company that allows an owner/operator to open and

operate an outlet under the company’s business name is called a(n)
__________________________.
Question 2: Match each ownership option with a description of the option. Write the
letter of the description next to the name of the option.
Ownership Option Description
______ Leasehold a) The franchisee leases the land and owns

the building, furniture, fixtures, and
equipment.
______ Ground b) The franchisee owns the land, building,

Lease furniture, fixtures, and equipment.
______ Fee c) The franchisee leases the land and

Simple building and owns the furniture, fixtures,
and equipment.
Question 3: The franchise industry consists solely of fast-food restaurant systems such as
KFC, McDonalds, and Pizza Hut.
____ a) True
____ b) False
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ANSWER KEY
Question 1: A license offered by a company that allows an owner/operator to open and

operate an outlet under the company’s business name is called a franchise
agreement.
Question 2: Match each ownership option with a description of the option. Write the
letter of the description next to the name of the option.
Ownership Option Description
c Leasehold a) The franchisee leases the land and owns

the building, furniture, fixtures, and
equipment.
a Ground b) The franchisee owns the land, building,

Lease furniture, fixtures, and equipment.
b Fee c) The franchisee leases the land and

Simple building and owns the furniture, fixtures,
and equipment.
Question 3: The franchise industry consists solely of fast-food restaurant systems such as
Kentucky Fried Chicken (KFC), McDonalds, and Pizza Hut.
b) False
Gas stations, laundry and dry cleaning companies, retail stores, and other
companies offer franchises.
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PROGRESS CHECK 10.1

(Continued)
Question 4: Select two basic characteristics of Tier I markets that influence the value of
their franchise outlets:
____ a) Promote consistent standards of quality and service

____ b) Help resolve loan default situations
____ c) Provide good initial and ongoing training
____ d) Guarantee the franchisee’s debts
Question 5: The purpose of a site study is to:
____ a) obtain site approval from the franchisor.

____ b) ensure that product and equipment suppliers are available in the area.
____ c) identify good locations for outlets.
____ d) determine the value of the land collateral.
Question 6: Select the franchise loan product offered for refinancing, consolidating
existing debt, and purchasing existing stores from another franchisee.
____ a) Secured term loan

____ b) Secured non-revolving line of credit
____ c) Fee simple real estate
Question 7: Select the two best franchise financing opportunities:
____ a) A Taco Bell franchisee plans to expand ten outlets.

____ b) A new restaurant chain begins to offer franchises in your country.
____ c) A Pizza Hut franchisee needs to replace two ovens.
____ d) KFC introduces a new chicken product that requires different cooking
equipment.
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ANSWER KEY
Question 4: Select two basic characteristics of Tier 1 markets that influence the value of
their franchise outlets.
a) Promote consistent standards of quality and service
c) Provide good initial and ongoing training
Franchisors do not normally help resolve loan default situations unless they
have a prior agreement with the lender to do so.
Question 5: The purpose of a site study is to:
c) identify good locations for outlets.
Question 6: Select the franchise loan product offered for refinancing, consolidating
existing debt, and purchasing existing stores from another franchisee.
a) Secured term loan
Question 7: Select the two best franchise financing opportunities.
a) A Taco Bell franchisee plans to expand ten outlets.
d) KFC introduces a new chicken product that requires nonstandard

cooking equipment.
The opportunities that involve a number of outlets are most likely to result in
transactions that are large enough to justify Citibank’s effort.
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CREDIT ANALYSIS
So far, we’ve seen that franchise financing, particularly of Tier I

concepts, can be an attractive market for lenders because of the many
benefits they offer franchisees, and that the value of a transaction is
affected by the size of the deal and the type of collateral that secures
the loan. In this section, we will see how these ideas are applied in
franchise credit analysis.
Four aspects As you may have concluded from our earlier discussions, the credit
analysis process for franchise financing is somewhat different than the
process for other types of asset based financing because of the nature
of the industry. In the following sections, we discuss three aspects of
franchise credit analysis:
+ Industry risks and offsets
+ Ways out
+ Information requested from the borrower
We begin with the types of industry risks in franchise financing.
Industry Risks and Offsets
Portfolio level There are several credit risks inherent in the franchise industry that are
important for you to know. We label these risks industry or program
risks because they are usually addressed in the broader context of the
franchise portfolio rather than in individual credit memos. In this
section, we discuss five such risks. This discussion will increase your
understanding of the franchise industry and the strategies lenders use
to minimize franchise industry risks.
Market Share
Competition The franchise fast-food industry is a maturing market where

risk competition is intense. The battle for market share increases the level
of risk within this industry.
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Offset To minimize this risk, lenders such as Citibank may use these
strategies strategies:
+ Target franchises with strong market share and strong financial

strength (relative to the industry) that maintain strong name
recognition through effective marketing campaigns.
+ Avoid overexposure to any one market segment.
+ Lend only a portion (for example, 80%) of the estimated

collateral value to maintain an adequate collateral cushion, and
use financial ratio covenants (agreement clauses in the loan
contract) to identify financial deterioration early on.
Fraudulent Conveyance
Transfer of For tax or other ownership reasons, it is common for fast-food

security franchisees to establish several companies under which they operate
interests their restaurants. These business owners may use properties they own
from one company to back a loan for one of their other companies.
Sometimes, prior to bankruptcy, an owner may transfer ownership of
an asset from one company to another to avoid debt or to hinder
creditors. This is called fraudulent conveyance. In addition to
fraudulent conveyance, the concern to an asset based lender is that
other creditors may legally void transfers of security interests under
certain circumstances, even when there has been no intent to defraud.
Here are some approaches for offsetting this risk:
+ Investigate the borrower’s viability during the due diligence

process and document the rationale for doing the deal.
+ Avoid structuring deals with cross-stream (subsidiary

guarantees another subsidiary) and upstream (subsidiary
guarantees parent company) guarantees whenever possible.
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+ Include solvency provisions drafted from the region’s

applicable fraudulent conveyance statutes along with financial
projections as an exhibit to the loan agreement. Obtain written
acknowledgments of the lender’s security interest (lien) from
major suppliers and from the company’s officers.
Commodity and Labor Price Increases
Effect on cash Commodity prices are relatively stable, but unpredictable. Labor costs
flow may increase because of labor shortages, minimum wage legislation,
and requirements for minimum health benefits. Increases in these
costs could adversely affect the borrower’s cash flow.
Business Franchisors and franchisees have some control over these risks.
solutions Franchisees can pass on some or all of a cost increase to their
customers by increasing menu prices. To offset commodity cost
increases, franchisors can change their product mix, offering a lower-
cost item to offset the more costly commodity. The major franchisors
address the cost of labor by automating their food preparation
processes to limit the amount of workers needed.
Coverage One way lenders mitigate these risks is by requiring the borrowers to
ratios maintain cash flow coverages greater than 1:1 (the point at which the
cash flow available to cover debt is exactly same as the debt service
requirement of the business). The coverage ratio is set to provide a
cushion so that cash flow will still cover costs if they should increase.
No Security Interest in the Franchise Licenses
Right to sell Franchise licenses generally prohibit lenders from taking a security
as going interest in the franchise rights. This means a lender such as Citibank
concern can’t sell or take over the operation of stores it has financed.
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 the

franchisor’s assistance in evaluating the location in the event of
a default and in locating a new franchisee to buy the store.
+ Secure a first perfected interest in the furniture, fixtures, and

equipment of the restaurant, real property/leasehold rights, and
a pledge of stock (if possible). This is a legal approach that
helps Citibank keep the restaurant open until a buyer is located
and bars the franchisor or third party from taking security
interest or obtaining clear title to the site before Citibank.
Lender Liability Under Environmental Law
Cleanup costs Many countries have laws to regulate the emission, discharge, and
handling of hazardous waste. If these laws make owners of
contaminated properties liable for cleanup costs and consider a
secured lender an owner, a lender may be responsible for the costs of
cleaning the site. The risk is usually in the restaurant site’s previous
use. If the site was contaminated by a previous user and the site was
not cleaned or was not cleaned properly, the lender could be liable. It
is important for your unit to understand the laws in your region
and take steps to mitigate the risks.
U.S. mitigation In the U.S., Citibank manages environmental liability risks by not
strategies exercising undue control over the property and by not foreclosing on
properties that could be contaminated. Also, CBL-FF’s practice of
lending to multi-unit operators helps spreads the risk over several
properties. Citibank’s risk is further mitigated by its standard loan
provisions and documentation, which require the borrower to
indemnify Citibank of all potential liabilities relating to a hazardous
waste cleanup and allow Citibank to perform environmental audits on
any site at the borrower’s expense.
Of course, even if Citibank isn’t held liable, a real risk is the loss of
revenue caused by the interruption of the business during a cleanup
period. In the U.S., this risk is mitigated by the business interruption
insurance that many of our borrowers carry.
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As you can see, a creditor has a number of risks and mitigants to

consider in the credit analysis process. In the next section, we discuss
another set of considerations − ways out.
Ways Out
Two ways out Earlier in this course, we stated that in asset based financing there is a
greater need to analyze “ways out” than in other types of financing.
Recall that “ways out” refers to the ways an obligation is satisfied. In
this section, we look at three ways franchise debt is satisfied. As you
read about these, keep in mind that the ways out of a particular
transaction depend on the transaction’s structure, the nature of the
assets involved, and the specific markets involved.
Cash Flow from Operations
Covers debt The first “out” a lender relies on is that cash flow from operations
service (either historical or projected) covers debt service by a specific
margin. In franchise financing, there is more reliance on cash flow
than collateral. The goal here is to structure transactions that do not
require the sale of assets or stores to repay debt.
Sale of Stores
Value as a If cash flow fails, debt may be satisfied through the sale of a store,
going concern group of stores, or the entire company. Since the franchise credit
philosophy is based on the value of the restaurants as going concerns,
the borrower is encouraged to sell the store as a going concern (with
the assistance and approval of the franchisor). This option is possible
because of the strong secondary market that exists in most countries
for the restaurants of certain concepts, particularly Tier I concepts.
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Sale Leaseback
Proceeds For franchisees who own the real estate under their restaurants, sale
from sale to leasebacks are an option to satisfy obligations. In a sale leaseback, the
pay debt franchisee sells the property and then leases it back. The proceeds of
the sale may be used to pay down debt while the franchisee continues
to operate the restaurant.
Credit Analysis Information
Items Now that we’ve seen the industry (program) risks in franchise
requested financing and some of the ways lenders address these risks, we’ll shift
from borrower our focus to individual transactions. In this section, we present a list
of items the officer requests from the borrower to assess credit
capacity.
Proposal and Before we begin the list, let’s review two types of documents we issue
commitment the potential borrower − the proposal and the commitment letter. The
letter proposal outlines the terms and conditions under which Citibank is
willing to consider a credit application and recommend approval to a
Citibank credit officer. It includes the loan to value ratio (the ratio of
the loan amount to the value of the collateral), interest rates, and
covenants. A commitment letter is an acknowledgment of credit
approval and availability, and includes all terms and conditions.
The items described below represent information the officer gathers

before issuing a proposal and commitment letter. Ideally, the officer
obtains and analyzes all the items. Of course, it may not be possible to
obtain every item for every transaction! We recommend that you view
this list as a set of guidelines and ask for direction from CBL-FF when
you are unable to obtain an item.
Business Financial Statements
Balance sheet Accountant-prepared financial statements and internally prepared

and income financial statements should include the following:
statements
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+ Balance sheets, income statements, changes in financial

position, and sources and uses of funds for
− Each of the last three year-end periods
− The most current year-to-date period and for the

comparable prior year-to-date period
+ On both an annual basis and on a per-month basis, individual and

consolidated store sales history for the last three-year period
and, if available, through the current year-to-date period.
Projections
Individual Recall that franchisees generate projections from information

store and gathered during the site study. You should request these sales
group figures projections for each individual store and for the group of stores the
franchisee owns. Projections for new stores should be for the first 12
months of operations. Request that the franchisee prepare the
projections in the same format as the internally prepared profit and
loss statements, as this will simplify the analysis.
Ownership Structure
Identify Request a list of all affiliated and interrelated companies and the
management owners of each company. With regard to multiple owners or
structure shareholders, identify the percent of ownership of each
owner/shareholder. Also ask for an organization chart.
Personal Financial Statements
Owners’ Request a personal financial statement for each major owner or

financial shareholder that lists all assets, liabilities, and net worth.
position
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Store Information
Ask for a list of all the stores the franchisee operates, and the
following information on each store:
+ Restaurant type (free-standing, mall, in-line, etc.)
+ Owned or leased
+ Opening date
+ Monthly rent payment and lease expiration date
Existing Lease and Loan Information
Current debt For each lease and loan, request the debt amount (original balance and
current balance, payment amount and frequency of payment), annual
interest rate, collateral for the loan (type and location), maturity date
of financing, and owner/shareholder personal guarantees.
Capital Investments/Financing Needs
Capital needs This includes detail of the capital investment requirement by location
and by use (such as land, building, equipment, furniture and fixtures,
initial inventory, working capital). Also find out the projected opening
date for each store.
Documentation
Before issuing a commitment letter, the officer should obtain and

review copies of the following:
+ Franchise and development agreements
Franchise agreements usually change with time and differ

among franchisors; therefore, an officer should always review
the agreement carefully to understand terms, conditions, rights,
and remedies of both parties.
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+ Applicable deeds of trust when Citibank finances properties

in which the land and building is owned by the franchisee
+ Applicable leases on the subject store properties when Citibank

finances leasehold properties
+ Applicable articles of incorporation. These are documents filed

with a government body authorizing a business to act
as a legal entity. This document describes ownership,
shareholders, board of directors, and type of business.
+ Site/demographic studies for proposed sites
As you can see, the type of information the officer gathers for
franchise financing credit analysis is similar to the information
gathered for leasing and vendor credit analysis. In the next section, we
will see how this information is used in the credit analysis process.
SUMMARY
In this section, we discussed three aspects of credit analysis for franchise financing:
industry risks and offsets, ways out of a franchise obligation, and credit analysis
information requested from the borrower. We saw that there are several risks inherent in
the franchise industry:
+ The battle for market share
+ Fraudulent conveyance
+ Commodity and labor price increases
+ Lack of security interest in the franchise license
+ Lender liability under environmental law
Industry considerations are generally addressed at the portfolio level. Another set of
considerations − the ways out of a franchise obligation − include cash flow from
operations, sale of stores, and the sale/ leaseback.
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To assess creditworthiness, the officer requests several types of credit information from
potential franchise borrowers: financial history and sales projections, the ownership
structure and personal financial statements, existing lease and loan information, financing
needs, and documentation (franchise agreements, deeds of trust, lease agreements, articles
of incorporation, and site studies).
You have completed the first part of the section on “Credit Analysis.” Please complete the
Progress Check and then continue with the section “Credit Analysis Process.” If you answer
any questions incorrectly, please review the appropriate text.
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Question 1: When franchisees transfer the security interests in property of one company
to another company they own, the lender may be at risk for
__________________________.
Question 2: To reduce the risks of commodity and labor price increases, lenders can:
____ a) require the borrower to maintain a cash flow ratio greater than 1:1.
____ b) execute a letter of understanding with suppliers to limit price increases.
____ c) encourage the franchisee to automate food preparation.
____ d) require covenant ratios for capital expenditures and minimum equity.
Question 3: Lenders to franchised businesses prefer that franchisees satisfy debts through
____________________.
Question 4: Compared to leasing and vendor credit, the type of credit information a
lender requests from a franchise prospect is:
____ a) usually more trustworthy.

____ b) more detailed.
____ c) very much the same.
____ d) more sales-oriented.
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ANSWER KEY
Question 1: When franchisees transfer the security interests in property of one company
to another company they own, the lender may be at risk for fraudulent
conveyance.
Question 2: To reduce the risks of commodity and labor price increases, lenders can:
a) require the borrower to maintain a cash flow ratio greater than 1:1.
Lenders usually have no say over supplier prices or food preparation methods,
and capital expenditures and equity do not affect commodity
and labor prices.
Question 3: Lenders to franchised businesses prefer that franchisees satisfy debts through
cash flow.
Question 4: Compared to leasing and vendor credit, the type of credit information a
lender requests from a franchise prospect is:
c) very much the same.
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Credit Analysis Process
The type of information the officer gathers from a prospect was

discussed in the previous section. The next step is to analyze the
information. In this section, we focus on several aspects of the
franchise financing credit analysis process. You will see some
similarities to the process used in equipment leasing, but you will also
see several differences. What are the reasons for the differences?
Comparison to Like equipment leasing, franchise financing is secured by one or more

equipment assets (the land, building, and the furniture, fixtures, and equipment).
financing The difference between equipment financing and franchise financing is
that franchised stores do not have the same remarketing
characteristics as equipment; they are less liquid and more difficult to
remarket. For this reason, lenders rely more on the ability of the
business to produce cash flow to repay debt rather than on the
value of the collateral. Once installed, the equipment financed is
worth very little. Risks are mitigated through the analysis of the
business value of the store. The goal is to structure transactions that
do not require the sale of assets or stores to repay debt. Keep this
concept in mind as you read about the components of the credit
analysis.
Consolidated Historical Profit and Loss Spreads
If the franchisee already owns and operates one or more outlets, we

develop a consolidated profit and loss spread for analysis. In Figure
10.1, we show the recommended format for the spread. Notice the
type of items we spread to calculate earnings before depreciation,
interest expense, and income taxes (EBDIT). These items (food and
paper, store labor, etc.) are typical expenses in the fast-food industry.
Also note that we look at both post-compensation and pre-
compensation figures in computing cash flow. This is because
officers’ salaries are usually discretionary.
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Expense, The consolidated profit and loss spread provides a basis for comparing
cash flow the performance of the franchisee to another operator of the same
comparison concept or to the average operator of the concept in your portfolio.
The spread reveals whether the prospect has high or low food and
paper, labor, and rent expenses, and how good of a cash flow generator
the business is compared to others.
This spread is also used to:
+ Determine trends
+ Analyze the consistency of sales and cash flow
+ Calculate debt service capacity
In the next section, we discuss one of these purposes − debt service

capacity − in detail.
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Debt Service Capacity
Formula Recall that debt service capacity is a measure of a prospect’s ability to

repay debt. To calculate debt service capacity, we divide cash flow
(cash available to repay principal and interest on current and future
debts) by debt service (sum of the principal and interest on all loans
and capital leases). Here we see this concept expressed as a formula:
Net Income + N o n C a s h Charges + Interest Expense + Excessive O w n e r s ' C o m p e n s a tion

Current Portion of L ong Term Debt and Capital Leases + Interest Expense
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Cash flow less When computing debt service capacity for franchise financing, it is
capital important to consider the franchisee’s ongoing capital expenditures
expenditures (CAPEX). CAPEX may include painting, parking lot resurfacing,
uniforms, and replacement of kitchen cooking utensils. If capital
expenditures are not expensed and included in the profit and loss
statement, we subtract them from the cash flow available to service
debt.
Ability to Once we have calculated the debt service capacity of the prospect, we
generate cash can compare it to the debt service coverage ratio on the Risk Asset
flow Acceptance Criteria (RAAC).
The RAAC used in the U.S. is shown in Figure 10.2. Under part II, note
the minimum debt service coverage ratios required for the subject
concepts. Under what conditions should a higher ratio be required?
Generally, the greater the inconsistency of sales and cash flows, the
larger the number of new stores being financed, or the more
leveraged the borrower, the higher the debt service coverage
should be. Because a franchise is a cash flow business, lenders to this
industry measure a borrower’s ability to repay debt more
conservatively compared to measuring debt coverage in traditional
middle market banking.
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Individual Store Profit and Loss Statements
Compare There are two reasons for reviewing each individual store’s sales
individual history and financial statements. The first is to identify any bad
stores locations. If the franchisee plans to open a new store in an
unprofitable area, you should question the reasons.
Projection A second purpose for reviewing these statements is to analyze changes

assessment in annual sales. This trend and history data help us determine whether
the franchisee’s projections, which we discuss in the next section, are
reasonable, conservative, or aggressive.
Profit and Loss Projections
Line item For a valid analysis, it is important that all items on the historical
comparison profit and loss statements appear in the profit and loss projection
supplied by the prospective borrower. This means that you need to
review each line item on the historical statements to make sure that
each has been accounted for on the projection.
Projection It is easier to compare figures when we spread projections in the same

categories format as the historical consolidated profit and loss statements, but
with 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-date
historical figures. This is so we can compare projected numbers to
historical profit and loss figures.
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We need to caution you on a few important points. It is important for

you to understand the franchisor’s site selection process to adequately
assess the projections presented by a franchisee. Also, you should
always verify with the franchisor the integrity of the information the
franchisee provides and confirm that store sales, cash flows, and the
cost to build the store are reasonable. Prior to funding a loan, you
should obtain verbal or written confirmation from the franchisor that
the store plan and architecture has been approved.
SUMMARY
So far, we’ve looked at several aspects of the credit analysis process:
+ Consolidated historical profit and loss spreads
+ Debt service capacity
+ Individual store profit and loss statements
+ Profit and loss projections
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The consolidated profit and loss spread is used to compare the performance of a franchisee
who owns more than one outlet to other franchisees. The items compared include food and
paper, labor, and rent expenses. The spread also reveals the business’ success in generating
cash flow. Other areas of particular interest are trends, sales consistency, and debt service
capacity. Debt service capacity is a measure of the franchisee’s ability to repay debt. To
calculate debt service capacity, we divide cash flow by the sum of the principal and interest
on all debt. We compare the ratio derived from this calculation to the target debt service
coverage ratio on the Risk Asset Acceptance Criteria (RAAC). Other considerations, such
as inconsistency of sales and cash flows, the number of stores being financed, and the
prospect’s leverage, also influence the acceptability of the prospect’s debt service capacity.
We review the sales history and financial statements for each store to identify bad locations
and to compare trend and sales history to the franchisee’s projections. This comparison
reveals how reasonable the projections are. For a valid comparison, all item s on the
historical profit and loss statements must be included in the projections.
You have completed the first part of “Credit Analysis Process.” Before you continue with
this discussion, please complete the Progress Check. If you answer any questions
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Question 1: A consolidated profit and loss spread is used to compare the franchisee’s
performance with that of other operators.
____ a) True
____ b) False
Question 2: Select two factors that affect the required debt service coverage:
____ a) fluctuations in sales and cash flows.

____ b) low liquidity.
____ c) number of stores financed.
____ d) capital expenditures.
Question 3: We use the results of the trend and sales history analysis of individual profit
and loss statements to:
____ a) determine whether the consolidated historical statements are valid.

____ b) compare labor, food and paper, and rent expenses.
____ c) calculate debt service capacity.
____ d) help determine whether the projections are reasonable.
Question 4: Understanding the franchisor’s site selection process:
____ a) helps the officer identify questionable locations.

____ b) is necessary to adequately assess new store sales projections.
____ c) prepares the officer to compare rent expenses.
____ d) assures the officer that the franchisor has approved the store plan and
architecture.
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ANSWER KEY
Question 1: A consolidated profit and loss spread is used to compare the franchisee’s
performance with that of other operators.
a) True
Question 2: Select two factors that affect the required debt service coverage:
a) fluctuations in sales and cash flows.
c) number of stores financed.
Question 3: We use the results of the trend and sales history analysis of individual profit
and loss statements to:
d) help determine whether the projections are reasonable.
Question 4: Understanding the franchisor’s site selection process:
b) is necessary to adequately assess new store sales projections.
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Sensitivity Analysis
Margin for Recall that a sensitivity analysis is a way to determine what happens
error and when the value of certain variables used in a credit assessment
break-even changes. The sensitivity analysis includes determining the break-even
point
point of the business. (Remember, the break-even point is the point at
which the cash flow available to cover debt is exactly same as the debt
service requirement of the business, thus covering the debt on a one-
to-one basis.) In franchise credit analysis, we perform a sensitivity
analysis on the projection spread to determine what happens to a
borrower's ability to repay the proposed debt when we assume certain
deviations from the projected figures. Items that we perform a
sensitivity analysis on include sales growth, margins, interest rates,
and currency devaluation. In Figure 10.4, we show a sample sensitivity
analysis of sales decline and expense increases.
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Business and Collateral Value
Value factors The value of a franchise business is influenced by store type, the
assets owned, and the attractiveness of the business as a going concern
to another potential franchisee or to the franchisor. Usually, a
franchise business commands a higher price when it is sold or
traded as a going concern. This is a key idea in franchise financing.
Example For example, a Pizza Hut business sold as a Pizza Hut sells for more
than if the business were sold as an independent pizza restaurant. A
Pizza Hut that is sold to be converted to a hamburger food concept is
usually sold for a much lower price.
To place a value on the collateral, we first determine the types of

stores being used as collateral and the type of ownership in these
stores. Lets review the three types of ownership:
+ Land, building, furniture, fixtures and equipment (LBFF&E) are

all owned by the operator (called fee simple)
+ Operator has a ground lease, but owns BFF&E
+ Land and building are leased by the operator (also called a

leasehold property), and only FF&E are owned by the
franchisee.
In the U.S., to determine total value of a going concern, credit analysts

usually separate business value from real estate value. We calculate
business value to determine the loan to value, which is the ratio of the
loan amount to the value of the collateral. Let’s see how this idea is
applied.
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Multiple of To determine business value, we assume that the property (land

adjusted and building) is rented. Because this is the case with leasehold
earnings properties, we may calculate business value without adjusting for the
real estate. Normally, we calculate business value as a multiple of
earnings before depreciation, interest expense, and income taxes
(EBDIT). In the U.S., the multiple is usually a factor between 4 and 5.
These are benchmark factors developed from Citibank’s knowledge
and experience, and may vary in other locales.
Example Let’s assume an EBDIT of US$100M. This value multiplied by 5

yields a business value of US$500M. Therefore, the business value of
the store on rented premises is US$500M.
Adjustment for When the franchisee owns the premises (fee simple ownership), we
ownership of must make an adjustment to EBDIT to calculate business value.
real estate (Remember, the calculation for business value assumes that the land
and building are leased and not owned.) To calculate the business
value for a property that is not rented, we must reduce EBDIT by a fair
market rent on the premises before we multiply EBDIT by the
business value factor.
Example For instance, let’s assume the EBDIT from a fee simple restaurant is
US$200M per year. Now, let’s assume that a fair market monthly rent
for this location is US$6,000 per month, or US$72M per year. The
business value is determined as follows:
Business Value = (EBDIT minus Fair Market Rent) X a factor of 5
BV = (US$200M - US$72M) X 5
BV = US$128M X 5
BV = US$640M
Fair market You may be wondering how to estimate fair market rent. One way is to
rent look at the rental charge on the profit and loss statements of similar
stores the franchisee rents rather than owns. Another way is to see
what rents other franchisees in your portfolio are paying for similar
properties.
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Calculating Real Estate Value
Appraisals Once we have calculated the business value, we can determine the
value of the real estate (land and building) collateral. We can have a
qualified certified appraiser do an assessment on the property, but
appraisals can sometimes be expensive, and the prospective borrower
may not want to incur such an expense. Is there is a way to estimate
the value?
Percentage of In the U.S., the value of real estate is sometimes estimated by using a
land and rental factor. Rents tend to be based on a percentage (the rental
building cost factor) of the total cost for land and building to a real estate investor.
This factor is a function of the rate of return required by a real estate
investor and market and supply in a specific area.
Example For example, assume the rental factor for a given area is 12% per
annum. If the monthly rent for the subject property is estimated at
US$6M, per month, then the annual rent is US$72M. Divide the
US$72M by the 12% rental factor to estimate the fair market value of
the land and building ($72M ÷ .12 = $600M). Looking at it in a
different way, a property that cost US$600M with a rental factor of
12% will rent for US$72M per year (600M X .12).
Balance Sheet Analysis
Franchise Traditional analysis of a fast-food franchisee's balance sheet typically

attributes reveals low liquidity and net worth, and sometimes high leverage. This
is because inventories usually turn quicker than trade payables (food
and paper is sold faster than it is paid for), and large investment in
fixed assets such as furniture, fixtures, and equipment are rapidly
depreciated, making book value low. Does this mean the franchise
business is a poor risk?
The answer lies in remembering that the value of a franchise business

is in its worth as a going concern rather than in its assets. For this
reason, we approach balance sheet analysis for this industry a little
differently. In the next two sections, we see how two credit indicators,
leverage and liquidity, are handled in franchise credit analysis.
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Leverage
Book equity Recall that in standard ratio analysis, we compare total liabilities to
the book value of total assets to determine leverage. In franchised
businesses, however, book value is not a good indicator of the value of
the business. Because the value of a franchise business is in its worth
as a going concern, comparing liabilities to actual market value is a
more accurate measure of leverage. Therefore, in franchise credit
analysis, we measure leverage by replacing book equity with fair
market value (FMV), which is the sum of business value and real estate
value (true value).
The formula for calculating fair market leverage is:
Total Liabilities
(Cash + Inventory + Business FMV), less Total Liabilities
Remember, business FMV is the sum of business value and real estate
value. Total liabilities excludes stockholder debt that can be paid only
after the bank’s loan debt is paid.
Acceptable In the U.S., the combined operations of a franchisee cannot have a

ratios market value leverage exceeding 4:1 (assuming an acceptable debt
service coverage ratio). Furthermore, the bank's overall advance rate
cannot exceed 80% of the collateral business FMV.
Liquidity
Acceptable A standard way to measure liquidity is to compare current assets to

ratio liabilities. Because of the cash flow nature of the franchise business,
we view liquidity more liberally than in other businesses. We adjust
current assets to exclude intercompany and/or stockholder and
affiliate receivables, and adjust current liabilities to exclude current
portion of long term debt (CPLTD) and current portion of capitalized
leases. CBL-FF officers consider a minimum adjusted current ratio of
greater than or equal to .50:1 acceptable for this business.
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Regional Risks
As with all lending, the officer must identify various risks and
mitigants for the franchise financing transaction. Earlier in this unit,
we identified franchise industry risks. Recall that these included
commodity price increases, fraudulent conveyance, labor cost
increases, and lack of security interest in the franchise licenses.
Weak In the Latin American and Caribbean markets, we face an additional

secondary risk because fast-food is an emerging industry in these regions. A
market mature secondary market does not exist. Therefore, the officer must
carefully consider and assess the desirability or attractiveness of the
market to both the franchisor and other potential franchisees.
Cultural Another risk in Latin America and the Caribbean is that of cultural
acceptance tastes and differences. Pizzas, fried chicken, and hamburgers may not
be easily accepted in smaller towns or rural areas where people are
not as open to different products, and such products may not be
affordable for routine consumption. Therefore, you should carefully
analyze financing of a concept’s first entry to the smaller and more
rural areas.
Credit Ratings
Ratings from As you probably know, the credit analysis process includes obtaining
franchisors credit ratings from suppliers and creditors. In franchise financing, we
have another source of credit information − the franchisor.
For existing franchisees, the franchisor can provide a character

reference, indicate how good an operator the franchisee is, and tell us
how he or she compares to other franchisees. The franchisor can also
provide a rating on the operations and disclose if the franchisee is in
default of the franchise or development agreement. A franchisor can
also rate how punctual a franchisee is with paying franchise fees,
monthly royalties, and equipment payments. This is a source of credit
information you must not overlook!
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RAAC
Applicability In Figure 10.2, we presented the RAAC used in the U.S. for franchise
business. If your unit has not developed a RAAC for franchise
business in your country, use the U.S. RAAC as a starting tool for
screening and identifying creditworthy customers. Keep in mind that
the requirements and quantitative variables in this RAAC need to be
tested for applicability in each country and modified appropriately.
Covenant Ratios
Periodic Recall that covenant ratios are financial ratios agreed to in a loan or
review of lease contract. Requiring a borrower to maintain certain covenant
financial ratios is a way to monitor a borrower’s finances so that problems can
status
be identified and dealt with early on. Depending on the complexity and
strength of the credit, financial information can be requested monthly,
quarterly, or annually. Standard covenant ratios for franchise business
are debt service coverage, liquidity, and leverage. Citibank may
include covenants for capital expenditures and minimum equity
requirements.
SUMMARY
In our review of the credit analysis process, we saw that lenders to franchise businesses rely
more on the ability of the business to produce cash flow to repay debt rather than on the
value of the collateral, that risks are mitigated through the analysis of the business value of
the store, and that the credit emphasis is on the value of the franchise business as a going
concern.
You have completed the “Credit Analysis” section. Please complete the progress check and
then continue with the section on “Legal Considerations.” If you answer any questions
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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 sensitivity

analysis.
____ a) Currency devaluation

____ b) Administrative expenses
____ c) Decline in sales
____ d) Depreciation
Question 3: The purpose of separating business value from real estate value in franchise
credit analysis is to:
____ a) account for differences in fee simple, ground lease, and leasehold
ownership.
____ b) recognize the value of the business as an ongoing concern.
____ c) remove the fair market rent from the total value.
____ d) estimate the value of land and building collateral.
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ANSWER KEY
Question 1: Franchise credit philosophy places emphasis on:
d) the value of the business as a going concern.
Question 2: Identify two items usually included in a franchise financing sensitivity

analysis.
a) Currency devaluation
c) Decline in sales
Question 3: The purpose of separating business value from real estate value in franchise
credit analysis is to:
b) recognize the value of the business as an ongoing concern.
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(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 risky
because:
____ a) it will be difficult to find experienced labor.

____ b) there may not be enough people in the area to support the restaurant.
____ c) the franchisor has not developed site studies for the region.
____ d) unfamiliar food products may not be accepted.
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ANSWER KEY
Question 4: When measuring leverage in franchise financing, we replace book equity with
fair market value.
Question 5: Typically, analysis of a fast-food franchisee’s balance sheet indicates:
c) low net worth, low liquidity, and high leverage.
Question 6: Financing a fast-food franchise’s first entry in a rural region may be risky
because:
d) unfamiliar food products may not be accepted.
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LEGAL CONSIDERATIONS
Our discussion of the credit analysis process disclosed a number of

items lenders must consider before extending credit. In this section,
we discuss two important categories of legal considerations that
lenders to franchise businesses confront. The first concerns the
protection of the lender’s interests, and the second deals with lender’s
interest in the franchisee’s relationship with other parties as well as its
own relationship with the franchisee.
Security of Lender’s Interests
Collateral to As in any lending or leasing transaction, the structuring and

pay debt documentation of a franchise transaction should provide Citibank the
greatest possible protection of its interests in collateral. Even though
we’ve emphasized the reliance on cash flow rather than collateral in
this unit, the collateral is still the final source of satisfying a franchise
debt. Here are several guidelines that will help you protect Citibank’s
interest in franchise collateral.
+ Determine the extent to which collateral for the loan is

encumbered. Require release of existing liens before funding
the loan.
+ Understand the applicable laws in your region for securing

Citibank’s interest in the equipment, furniture, fixtures, and real
estate financed. Take the action necessary to ensure that
Citibank can take the collateral to satisfy its debt as prescribed
by law. This could mean filing documents with a regulatory
body or including provisions in the loan agreement.
+ Obtain the greatest possible protection from competing real

estate claimants and other secured parties. Again, the action
you take depends on the laws and practices in your region.
+ Require the borrower to obtain and pay for lender’s title

insurance or use other means to secure Citibank’s interest in
the real estate property.
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These guidelines illustrate the importance of understanding security

interest laws in your region and documenting the transaction properly.
In addition, you need to consider the legal relationships among the
parties involved in a franchise. We discuss these in the following
section.
Legal Relationships Between Franchise Parties
Here we examine three relationships that affect Citibank’s interests in

the franchise − that of the franchisee and franchisor, that of the
franchisee and the landlord (if any), and that of the franchisee and
Citibank. Let’s begin with the relationship between the franchisee and
the franchisor.
Franchisee and Franchisor
Review of Recall that the obligations, responsibilities, and rights of the

franchise franchisor and franchisee are spelled out in the franchise agreement.
agreement To help you understand franchise agreements, we’ve provided a sample
agreement (between Pizza Hut and a franchisee) in Appendix ??. It is
important for you to remember that franchisors often revise and
improve these agreements. Therefore, you and your counsel should
always read the subject agreement and become familiar with the
rights and remedies of each party.
Key components you should focus on are:
+ Length and expiration dates of the franchise agreement

and renewal options. The expiration dates of the franchise
agreement affect the loan tenor Citibank can offer.
+ Events viewed as failure to perform or defaults. Default

situations normally include loan default and filing of
insolvency by a franchisee. Examples of failure to perform
include chronically failing to meet the minimum standards for
quality, service, and cleanliness, or failure to correct a loan
default.
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+ Provisions for transfers of ownership. The agreement may

grant the franchisor the right to monitor and restrict such
transfers. The franchisor’s control over the capability of the
owners of the business benefits Citibank.
+ Courses of action and remedies available to the franchisor

in event of default. Franchisors usually give a franchisee an
opportunity to comply with the agreement and often offer to
help resolve the situation. Because a business is usually worth
more under the franchised name, an operator will often work
with the franchisor to sell the business to another franchisee
when asked to do so. However, a franchisor cannot force a
franchisee to sell the business. If a solution cannot be reached,
the franchisor can disenfranchise the business.
Effect on When a business is disenfranchised, the franchisee must de-image the

lender restaurant (take down all signs and logos) and stop producing and
selling the franchisor’s product. This presents a problem for lenders
because the value of the business drops. To complicate matters, the
agreement often prohibits, for a specified time, the franchisee from
operating a business that sells a similar product.
Franchisee and the Landlord (Owner) of the Site
Citibank Often, a franchisee will lease the ground and/or building of a

viewpoint franchised store. Since the franchise business is more valuable under
the franchise name, a good relationship between the landlord and the
lessee (our borrower) is very important to Citibank. If the lessee
becomes delinquent with the lease payment and faces eviction, it is in
Citibank’s interest to avert the eviction. The value of the business can
decrease significantly if the business is permanently or temporarily
closed.
Agreement One way Citibank can protect its interests is to secure an agreement
with landlord with the landlord, called a Landlord Consent and Waiver, that
enables the bank and the landlord to work together and resolve lease
defaults. The Landlord Consent and Waiver normally contains five key
provisions:
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+ The bank will finance and lien (and sometimes mortgage) the
franchisee’s furniture, fixtures, and equipment at the subject
location.
+ If the franchisee defaults on the lease payment, the landlord

will notify the bank in writing within a specified number of
days.
+ The bank has the right, but not the obligation, to make the lease
payment and bring the lease current.
+ The bank has the right to assume the lease and the right to
reassign that lease to another franchisee.
+ The bank has the right to enter the premises and remove its
collateral.
These provisions illustrate the significance of the Landlord Consent

and Waiver. You can see why this document is so important to
Citibank!
Citibank and the Franchisee
Default Our discussion of the bank’s relationship with the franchisee will
remedies focus on the bank’s options in the event the franchisee defaults on the
loan agreement. We categorize the options according to the type of
asset financed.
Furniture, fixtures, and equipment
+ Try to establish a working arrangement
+ Take possession of the collateral
Property
+ Foreclose (sell the property to satisfy the debt)
+ Have the borrower transfer the deed to the property to Citibank
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+ Request the appointment of a receiver to take possession of the

property
Many of the remedies listed here are considered “last-resort” attempts

to recover debt. Remember, the resale value of franchise collateral is
usually low. The preferred solution is to work out a friendly
resolution.
SUMMARY
Lenders to the franchise industry must take steps to protect their interests in the collateral.
The specific legal actions used to insure Citibank’s right to repossess its collateral, gain
protection form competing claimants, and secure its interest in real estate vary according to
country.
In its legal relationship with the franchisee, Citibank retains the right to take possession of
the collateral or render the collateral unusable if the franchisee defaults on the loan. With
real estate, Citibank reserves the option to foreclose, request that a receiver take
possession of the property, or require the borrower to transfer the deed to Citibank. In
addition to its own relationship with the franchisee, Citibank is concerned with the
relationship between the franchisee and the franchisor, and between the franchisee and the
landlord. These relationships are important because the franchisor’s and landlord’s
remedies for default can affect the value of the business. The officer should review the
franchise agreement carefully and secure a Landlord Consent and Waiver to protect
Citibank’s interests.
You have completed Unit 10: Franchise Financing. Before you continue to the next unit,
check your understanding of the concepts you have just learned by completing the progress
check that follows. If you answer any question incorrectly, please return to the text and read
the section again.
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Question 1: Select two ways for a lender to protect its interest in franchise collateral.
____ a) File documents with appropriate regulatory agencies to perfect a security

interest.
____ b) Immediately repossess the collateral if the franchisee defaults on lease
payments to the landlord.
____ c) Require the release of existing liens on the collateral before funding a
loan.
____ d) Restrict the franchisee’s right to transfer ownership of the business.
Question 2: Citibank works to help the franchisee avoid being disenfranchised because:
____ a) the value of the collateral drops when the business is closed permanently
or temporarily.
____ b) the bank will be barred from entering the premises to collect its collateral
if the business is disenfranchised.
____ c) the business will not be worth as much if it is not part of a known
restaurant system.
____ d) the borrower will not have enough cash flow to pay its debt.
Question 3: Select two components of a franchise agreement that greatly concern a

lender.
____ a) The amount of the franchise fee

____ b) Actions the franchisor may take for noncompliance
____ c) Restrictions on transfer of ownership
____ d) Company indemnification provisions
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ANSWER KEY
Question 1: Select two ways for a lender to protect its interest in franchise collateral.
a) File documents with appropriate regulatory agencies to perfect a security

interest.
c) Require the release of existing liens on the collateral before funding a

loan.
Question 2: Citibank works to help the franchisee avoid being disenfranchised because:
c) the business wi ll not be worth as much if it is not part of a known

restaurant system.
Question 3: Select two components of a franchise agreement that greatly concern a

lender.
b) Actions the franchisor may take for noncompliance
c) Restrictions on transfer of ownership
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PROGRESS CHECK 10.5

(Continued)
Question 4: A Landlord Consent and Waiver agreement helps Citibank protect its
interests in the franchise business by having a measure of control over the:
____ a) franchisee’s right to transfer ownership of the business.

____ b) franchisee’s continued occupancy of the premises.
____ c) landlord’s right to seize the bank’s collateral for lease default.
____ d) landlord’s obligation to pay for environmental cleanup.
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ANSWER KEY
Question 4: A Landlord Consent and Waiver agreement helps Citibank protect its
interests in the franchise business by having a measure of control over the:
b) franchisee’s continued occupancy of the premises.
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Unit 11
UNIT 11: RISK MANAGEMENT
INTRODUCTION
In Unit One, you learned that asset based financing is a risk-management rather than a risk-
avoidance business. Throughout this course, you have been introduced to some of the risk-
management mechanisms used in this type of financing. We focused on credit review, cash
flow analysis, transaction structure, and documentation. In this unit, we review these
mechanisms and introduce you to additional ABF risk management mechanisms. The
purpose of this discussion is to broaden your understanding and appreciation of ABF risk
management.
UNIT OBJECTIVES
+ Understand the ABF risk management process
+ Identify methods used to manage ABF risks
+ Define common terms used in risk management
INTRODUCTION
In this course, you’ve learned how creditors balance the various types
of risk to structure sound ABF transactions. Recall that the primary
way we balance risks is to rely on the value of the collateral. Because
asset based financing requires that we consider and weigh several
types of risk, risk management is a critical part of the business.
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11-2 RISK MANAGEMENT
ABF risks Let’s take a moment to review the core ABF risks that we must deal
with in Latin American transactions. This review will prepare you for
the risk management concepts presented in this unit.
Credit The risk in extending credit is the capacity of the

borrower or lessee to repay debt now and in the
future, and its commitment to honor its debts.
Central to evaluating credit risk are the
applicant’s cash flow and character.
Collateral The value of the collateral over time is a key

consideration in ABF because the collateral
secures repayment of the debt. If the borrower or
lessee defaults, the creditor ultimately relies on
the value of the collateral to satisfy the
obligation.
Documentation The various documents involved in a credit

transaction determine how the transaction is
treated for legal, tax, and accounting purposes.
The risk lies in proper document preparation and
execution. The emphasis is on including
provisions and remedies that protect the
creditor’s interests.
Country The country’s political, economic, and currency

restrictions and fluctuations all increase the
creditor’s risk of monetary loss.
Cross Border The risk in financing equipment in one

geographical jurisdiction with equipment use in
another rests in political and economic
conditions and in fluctuating property and
income taxes.
ABF life cycle Because we consider each of these risks plus the composition of the
portfolio to reach a credit decision, our risk-management practices
must address each risk throughout the ABF life cycle. To help you
understand the process, we divide risk management into six phases.
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RISK MANAGEMENT 11-3
+ 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 arbitrary
divisions, and that the risk management practices we describe
sometimes overlap phases or extend throughout the ABF life cycle.
CREDIT INITIATION
Definition Credit initiation refers to the evaluation, analysis, and approval of

individual credit transactions. It includes information gathering,
financial analysis, structuring, and other processes leading up to the
decision to extend or deny credit. Both new credits and ongoing risk
decisions, such as additions, increases, restructures, new extensions,
and line renewals, are part of credit initiation. It is important that you
understand the risk management techniques used in this phase
because what you do here affects what may happen later.
Two types of In this section, we discuss two types of risk management processes
processes commonly associated with credit initiation:
+ Standards
+ Risk Analysis
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Standards
Key areas Credit initiation standards vary according to the business segment,
product, market, and location. Typically, the unit of the bank in which
you work will have its own format standards and instructions for
handling ABF credit approvals, usually by program and target market.
However, all standards focus on five key areas of risk management:
+ Target market compliance — addresses target market risks
+ Program RAAC compliance — addresses industry and program

risks
+ Transaction and recourse structure — addresses collateral,

country, cross border, and credit risks, with emphasis on
protecting the bank against other creditors
+ Documentation — covers the types of documents required for

each form of transaction and the required filings, with emphasis
on protecting the bank from a legal standpoint
+ Concentration limits — deals with the risks associated with

the composition of the portfolio
Risk Analysis
Like the standards we’ve just described, credit initiation processes are
also used to manage risks. Let’s review the five key elements of risk
analysis practiced during credit initiation to see how each contributes
to risk management.
Financial Statement Analysis
Credit risks Here, the emphasis is on identifying financial risks. The officer
examines the applicant’s income statements, balance sheets, and other
financial data, focusing on:
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+ Historical and forecasted performance
+ Repayment alternatives or ways out
+ Sensitivity of repayment schedule to risk factors (economic,

regulatory, competitive, industry cycle)
+ Business practices
Risk As the credit analyst identifies the risks, he or she may begin to
mitigation formulate a plan to manage or mitigate the risks. For example, the
analyst may consider adjusting the repayment schedule to
accommodate the borrower’s business operating cycle. For an
ongoing transaction involving a temporary overdraft, the analyst may
establish a plan to monitor the transaction.
Cash Flow Analysis
Capacity to Recall that we use cash flow analysis to determine the applicant’s
repay debt capacity to repay debt. In the analysis, we look at the applicant’s
disposable income. Because cash flow is a major way out, it is a key
element of risk management.
Management Analysis
Character of In a management analysis, we assess the customer’s potential

key personnel integrity, honesty, and commitment to honor its financial obligations.
The emphasis is on the character of the company’s key individuals,
their financial capacity, and their ability to manage change.
Understanding these aspects of management helps us limit the risk we
are willing to assume.
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Collateral Evaluation
Value over Managing collateral risk is extremely important because the creditor
time must ultimately look to the value of the equipment if the customer
does not meet the obligation. As you’ve learned, equipment that
maintains value over time is a better risk than equipment that does not
maintain resale value. To manage the risks associated with collateral,
we use structures such as vendor guarantees and support, insurance,
and maintenance requirements to protect the value we expect to
receive from the equipment.
Documentation
Forms and In Unit Four, Lease Classification and Legal Documentation, you
procedures learned how the proper preparation and execution of documentation
helps creditors manage legal risks. Documentation risk strategies
include using:
+ 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, and

repossession risks and provide sufficient time to permit
remedial action in the event of difficulty
RISK ADMINISTRATION
In the previous section, we saw how credit initiation standards and risk
analysis processes are used to manage risks. In this section, we
discuss another phase of the ABF risk management life cycle — risk
administration.
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Management Risk administration refers to the ongoing “housekeeping” tasks

systems associated with managing risks; that is, the credit support, control
systems, and other practices necessary to manage the outstanding risk
assets and to properly monitor business risks. Let’s look at four
important aspects of risk administration:
+ Maintenance of credit files
+ Review procedures
+ Overdraft procedures
+ Tracking past-due obligations
Credit Files
History of The credit file should contain all the information necessary to
credit reconstruct the decision to extend credit. It serves as an important risk
decision management tool for two major events:
+ To review the basis on which credit was extended and any

limitations when the borrower seeks additional credit
+ To identify any deficiencies in the process if the borrower

defaults
Review Procedures
Early problem The timely reviews of credit, collateral, documentation, industry, and
detection support structures is a critical part of risk management. Regular
reviews help the officer spot potential problems early on, when more
options exist to avoid or correct the problem.
Overdraft or Line Excess Procedures
Approval No line excesses or overdrafts should occur without proper credit

procedures approval. To manage this risk, approval procedures must be in place
and followed closely.
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Past-Due Obligation Tracking
Tracking To manage the risk of past due principal or interest, a system for
system tracking amortization schedules is appropriate.
As you can see, risk administration practices are important from the
beginning through the end of the ABF life cycle. Similarly, the next
topic we will discuss, collateral management, is significant throughout
the entire ABF life cycle.
COLLATERAL MANAGEMENT
Understanding the management of collateral is critical to your

understanding of asset based financing. Collateral (equipment) risk
management is a broad concept that includes:
+ Collateral analysis
+ Equipment value
+ Residual risk
+ Asset management
+ Structuring
Let’s examine each of these aspects.
Collateral Analysis
Determine We know that equipment that maintains value over time is a better risk
value over than equipment that does not maintain resale value. To assess the value
time over time, a collateral analysis must be performed. The analysis
helps us manage risk by revealing the factors that affect the
equipment’s value now and in the future. Once we know these factors,
we can structure the transaction to protect the value we expect to
receive from the equipment.
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Key factors to The collateral analysis is a complex process involving several

consider considerations. It is important for you to know the items collateral
analysts evaluate so that you can do a better job of gathering
information. Here we discuss three key considerations:
+ Equipment
+ Investment
+ Remarketing
Equipment Considerations
Traits To assess value, the analyst first looks at the characteristics of the
equipment itself.
• Equipment’s manufacturer, model, year, features, options, and

acceptance to the market
• Use (special or general purpose), industry of usage, adaptability

for other use
• Cost and discounts
• Product life cycle, useful economic life, risk of obsolescence
Investment Considerations
Profit The items focused on here help the analyst determine whether the
potential equipment is a good investment.
+ Acquisition price, fair market value, and distress values;

probability of buyout or renewal
+ Upgrade/add-on potential
+ Environmental issues, geographic area of use
+ Necessity and severity of use
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Remarketing Considerations
Secondary We must be able to resell or re-lease the equipment to derive the

market expected value. Accordingly, the analyst assesses the chances of
successfully remarketing the equipment by analyzing the following:
+ Diversity of users and market depth, including equipment’s

adaptability for other usage
+ 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 is

worth and will be worth in the future. However, equipment worth may
be defined in more than one way. In the next section, we discuss the
various definitions.
Equipment Value
Factors that We know that the creditor must look to the value of the equipment if
affect the customer defaults or if the equipment is resold at the end of a
definition lease term. However, in asset based financing, we use several different
definitions of value. The definition is affected by:
+ 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 risk Value definitions should always be included in documentation as a risk

management management tool. Understanding the differences among the various
definitions will help you structure and document appropriately. Here,
we look at five definitions.
+ Fair market value
+ 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).
Fair Market Value (FMV)
Price at The fair market value is the gross price that a willing and informed
normal buyer would pay to a willing and informed seller when neither is under
conditions pressure to conclude a transaction. The time it takes to sell the
equipment is dependent on the industry, but is usually nine months to a
year, assuming a normal market.
Orderly Liquidation Value (OLV)
Net of FMV Orderly liquidation value is defined as the net price that a willing
and informed buyer would pay to a willing and informed seller when
neither is under pressure to conclude a transaction. The time it takes
to sell the equipment is dependent on the industry and the needs of the
buyer or seller, but is usually three to six months, assuming a normal
market.
Distress Value
Net price Distress value is the net price that would be paid under duress
under duress (forced liquidation) for equipment either in a legally distressed
situation or when the asset is in a distressed situation. The equipment
is always sold “as is, where is.” The time it takes to conclude a
transaction depends on economic conditions and legal factors. From
one to two months is common.
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Scrap Value
Junk value Scrap value is the amount that could be realized from the property if
it were sold to a junk dealer.
Value-In-Use
Value as on- The retail, fair market value of equipment sold as part of an on-going
going concern operation or concern is referred to as value-in-use. This value
assumes equipment to be fully installed and operational.
To put these values in perspective, in Figure 11.1, we present an

example of the relationships among the values and the lessee payments
for the ABC company.
Figure 11.1: Relationship between value definitions and payments
As you may be able to conclude, each of the various definitions

described in this section serves an important purpose in risk
management.
Let’s look at an example.
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Example Assume that the vendor of a piece of industrial equipment has agreed
to support the value of the collateral through a remarketing agreement
that does not define collateral values. The creditor has assumed, and
based its pricing on, equipment resale at fair market value. One year
before the end of the lease term, the lessee goes bankrupt and stops
making payments. The vendor repossesses the equipment and sells it
quickly for below fair market value, creating a loss for the creditor.
Consider that the result would probably have been very different if
collateral value requirements had been clearly defined in the
agreement!
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As you can see, the definitions of value we described in this section have a significant
effect on risk. However, our discussion of equipment value is not complete! Residual value,
which you were introduced to earlier in this course, is covered in the next section.
Residual Risk
In Unit Two, Understanding the Leasing Industry, we defined the

residual value of a piece of equipment as the projected market value
remaining at the end of the contract. We excluded from our definition
guaranteed residuals in which purchase at contract end is reasonably
assured.
Use in pricing Recall that lessors take the expected residual value of the equipment
into consideration in the pricing of leases that do not have a fixed
purchase option. The higher the residual value, the less the lessor
needs to recover from the lease payment. In simplistic terms, if a
lessor assumes a 10 percent residual, it needs to recover only 90
percent of the original equipment cost through the lease payments.
Therefore, the higher the residual value, the lower the periodic
payments.
Because residual value plays such an important role in the lessor’s

return on investment, it is important that we manage residual risks
carefully. Poorly informed or unmanaged residual risk-taking can
result in substantial loss.
Let’s examine four categories of ways to manage residual risk:
+ Risk assessment
+ Pricing
+ Administration
+ Portfolio management
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Risk Assessment
Three factors To assess residual risk, we look at three primary factors:
+ Equipment characteristics
− Standard, specialized, or customized?
− Susceptible to technological change?
− Long or short life cycle?
− Is use essential?
+ Transaction structure and documentation
− Maintenance provisions asset-specific or general?
− Return provisions costly or cheap for lessee?
− Notification provisions well in advance of term end, near

term end, or at term end?
− End-of-lease options well defined or loosely defined?
− Controlled by lessee or lessor?
− Long or short term?
+ Remarketing capability
− Secondary market broad and deep or narrow and shallow?
− Third-party sale direct to end user or dealer/speculator?
− Difference in retail/wholesale value small or large?
− Any refurbish and maintenance capabilities?
Residual risk When we consider all these factors, we see that the size of the
vs. “at risk” residual risk, which is expressed as a percentage of acquisition cost,
does not always reflect our true “at risk” position. We may be more
vulnerable booking a 5 percent residual on high-tech, short-lived
equipment than a 40 percent residual on low-tech, long-lived assets!
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In general, the more certain we are of the equipment value, the less of
a safety margin we need. The final decision as to how much risk is
appropriate must be based on a careful evaluation of each relevant
factor.
Pricing
Higher return Usually, creditors require a higher return on residual risk than on the
related payment risk. The reason for this is that residual risk has no
contractual payment obligation to support it, and remarketing costs
and cost of carry must be covered in addition to the booked residual.
Note that pricing residuals to “meet the competition” is rarely
appropriate. Creditors who do so probably have not differentiated
themselves properly, are in the wrong target market, have high
operating costs, or face uninformed competition.
Administration
Use of special To manage residual risk, we sometimes use special resources to

resources and inspect, appraise, refurbish, and remarket the asset. We view these
tools resources as administrative risk management tools.
It is also important that we recognize early on any deteriorating

market conditions and non-compliance with maintenance
requirements. Annual reviews, classification of deteriorating credits
(discussed in a later section), and remedial management of residual
exposures are some of the other administrative tools we use to
manage deteriorating residual risk.
Portfolio Administration
Sell off The ability to sell off unwanted exposures is important to managing
unwanted equipment risk. Changing market or tax circumstances, and the need to
exposures manage equipment concentrations and remarketing workloads, are
among the factors that affect a decision to sell certain transactions.
We will have more to say about portfolio management later in this
unit.
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Asset Management
So far, we have seen how using collateral analysis, equipment value

definitions, and residual risk management techniques help creditors
control collateral risk. The methods we discussed may be considered
part of asset management, which refers to managing the asset
throughout the asset cycle.
Continuous Asset management includes:

asset control
+ Identifying niche markets and becoming industry specialists
+ Conducting a complete analysis of the collateral value
+ Structuring transactions from a collateral perspective (with

guarantees and other provisions that assure the value of the
collateral)
+ Performing regular equipment inspections and evaluations
+ Performing periodic trend analyses of collateral and markets
+ Being alert to new and emerging industries that may affect the
value of current collateral
+ Selling or re-leasing assets at the end of the lease term
+ Managing defaulted assets for maximum value as opposed to

liquidation
As you can see, asset management is really a set of processes that

reflect a continuous cycle of valuating and assuring the collateral
value.
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Structuring
Costs vs. In structuring, we define the most appropriate financing alternative

value over that addresses the applicant’s financial considerations and provides the
time best protection of our collateral. To protect the collateral, we must
give close attention to the perfection of security interest and the
creditor rights with respect to bankruptcy and repossession. A
creditor’s ability to act quickly to secure its collateral under default
situations is very important to success, because the creditor’s default-
related costs increase over time, while the collateral (almost without
exception) decreases in value over time.
Recall that there are several ways for creditors to minimize collateral
risk through transaction structuring. Let’s review five key methods:
+ Require a guaranteed residual
+ Use and enforce strict preventative maintenance clauses,

inspection rights, and excess-use penalties to lessen the effect
of impaired collateral value caused by excessive wear and tear
+ Obtain a collateral guarantee from a vendor or an insurance

company
+ Obtain a remarketing agreement. Recall that these are

agreements in which the vendor does not guarantee the residual
equipment value, but does agree to assist in the remarketing of
the equipment.
+ Use end-of-lease options and return provisions that protect the

value of the collateral
If you have any questions about these structuring techniques, we

suggest that you read Units Two through Four again.
SUMMARY
In this section, we discussed three categories of risk management — credit initiation, risk
administration, and collateral management. In our discussion of credit initiation, we saw
how risk analysis processes and standards are used to manage a variety of risks (target
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market, program, industry, country, and cross border). In contrast, risk administration is
concerned mainly with managing credit risk through tracking, procedural, and control
systems.
To manage collateral risk, creditors use a broad range of tools. These include conducting a
collateral analysis, clearly defining equipment value, using administrative systems and
controls, pricing, and structuring. Managing the collateral throughout the asset life cycle is
a key concept in collateral risk.
You have completed the first part of Unit Eleven, Risk Management. Please complete
Progress Check 11.1 to check your understanding of the concepts in this section. If you
answer any questions incorrectly, please review the appropriate portions of the text before
continuing to the next section, “Portfolio Management.”
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(This Page Intentianally Left Blank)
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Directions: Determine the correct answe r to each question. Check your answers with
Question 1: Which risk management method is used to address target market and program
compliance?
____ a) Portfolio review

____ b) Credit initiation standards
____ c) Financial statement analysis
____ d) Trend analysis
Question 2: Overdraft procedures, control systems, and file maintenance are considered:
____ a) Problem recognition strategies

____ b) Portfolio administration tasks
____ c) Asset management tasks
____ d) Risk administration tools
Question 3: Select two key considerations in collateral analysis.
____ a) Distress value

____ b) Characteristics of the equipment
____ c) Remarketing potential
____ d) Industry of use
Question 4: The net price that a willing and informed buyer would pay to a willing and
informed seller when neither is under pressure to conclude the transaction is
referred to as the:
____ a) Value-in-use
____ b) Orderly liquidation value
____ c) Fair market value
d) ___ Residual value
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ANSWER KEY
Question 1: What is the risk management method commonly used to address target
market and program compliance?
b) Credit initiation standards
Question 2: Overdraft procedures, control systems, and file maintenance are considered:
d) Risk administration tools
Question 3: Select two key considerations in collateral analysis.
b) Characteristics of the equipment

c) Remarketing potential
The industry of use is considered an equipment characteristic, and

distress value is one of several investment considerations.
Question 4: The net price that a willing and informed buyer would pay to a willing and
informed seller when neither is under pressure to conclude the transaction is
referred to as the:
b) Orderly liquidation value
Value-in-use is the retail, fair market value of equipment sold as part of

an ongoing operation. Fair market value is the gross price that a willing
and informed buyer would pay to a willing and informed seller when
neither is under pressure to conclude the transaction. Residual value is
the projected market value remaining at the end of a contract.
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PROGRESS CHECK 11.1

(Continued)
Question 5: The net price that would be paid during a forced liquidation is called the
___________________________.
Question 6: Charging a higher return for residual risk than for the payment risk is
appropriate because:
____ a) the size of the residual risk does not always reflect our true “at risk”
position.
____ b) we may not be able to sell off unwanted exposures.
____ c) pricing must cover the costs of storing and remarketing the equipment.
____ d) we need a larger safety margin when we are unsure of the equipment value.
Question 7: Performing regular equipment inspections and conducting periodic trend

analyses of equipment markets are ways to:
____ a) monitor maintenance compliance.

____ b) manage assets throughout the asset life cycle.
____ c) identify deficiencies in the equipment valuation process.
____ d) track the cost to refurbish and remarket equipment.
Question 8: Using and enforcing an excess-use penalty is a way to protect the value of
collateral through:
____ a) inspection rights.

____ b) defining “value” in the documentation.
____ c) transaction structuring.
____ d) asset management.
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ANSWER KEY
Question 5: The net price that would be paid during a forced liquidation is called the
distress value.
Question 6: Charging a higher return for residual risk than for the payment risk is
appropriate because:
c) pricing must cover the costs of storing and remarketing the

equipment.
a) and d) are true, but are not valid reasons for charging a higher return
than the payment risk. A valid reason that was not included here is that
residual risk does not have a contractual payment obligation to support
it.
Question 7: Performing regular equipment inspections and conducting periodic trend

analyses of equipment markets are ways to:
b) manage assets throughout the asset life cycle.
Question 8: Using and enforcing an excess-use penalty is a way to protect the value of
collateral through:
c) transaction structuring.
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PORTFOLIO MANAGEMENT
Definition A collection of transactions is referred to as a portfolio. In our

discussion of residual risk in the previous section, we said that the
ability to sell off unwanted exposures in a portfolio is an important
aspect of risk management. You may have wondered how creditors
identify unwanted exposures. The main way is to conduct periodic
portfolio reviews. In this section, we discuss the two primary types of
reviews:
+ Individual transactions
+ Portfolio composition
Understanding the types of reviews will prepare you for conducting or

assisting with reviews in your unit.
Individual Transactions
Transaction’s The quality of a portfolio depends upon the quality of the individual
effect on transactions in the portfolio. Periodic reviews of individual
portfolio transactions help us see how each transaction affects the risk and
return of the entire portfolio.
The items that the analyst should focus on are:
+ How collectible the principal and interest are in each

transaction
+ 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 total Although assessing the weaknesses and strengths of individual

portfolio transactions is important in portfolio management, it is equally
important to examine the health of the portfolio as a whole. In a
portfolio composition review, we look at the portfolio from several
perspectives to reveal risk categories. The viewpoint categories are:
+ Concentrations
+ Risk and asset liquidity
+ Environmental context
Let’s examine the way each of these categories affects the quality of
the portfolio.
Concentrations
Common trait A concentration is a group of transactions that share a common

characteristic. There are a number of possible concentrations in a
portfolio. A few of the most important are:
+ Industry, sub-industry, or type of borrower
+ 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 mix
of concentrations, is less risky because adverse results in a single
concentration have less effect on the portfolio as a whole.
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Risk in Determining the concentrations in a portfolio helps reveal over-

overexposure exposure. For example, a review may reveal that 40 percent of the
portfolio transactions are for a single industry. An unexpected
downturn in this industry could mean disaster for the creditor! The
creditor may want to sell of some of this exposure and acquire
transactions for other industries to balance the mix.
Risk Asset Liquidity
Ability to When we talk about liquidity in a portfolio, we are referring to the

collect on creditor’s ability to collect on credits. Liquidity is a function of the
credits collection options available to the lender. In many markets, liquidity is
a major concern for the bank. Factors which have an adverse effect on
asset liquidity include concentrations in:
+ One-way-out loans
+ Non-amortizing loans
+ Foreign currency exposure to foreign-exchange-poor countries

or to borrowers with questionable access to foreign exchange
+ Borrowers or industries dependent upon government support
Environmental Context
Factors to As you know, both external and internal factors can greatly affect a
monitor borrower or lessee’s ability to repay debt. Therefore, monitoring the
environment is an important element of managing portfolio risk.
Factors that bear watching are:
+ 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 and
practices, capital/money markets, commercial practices and
business ethics, legal framework, auditing and accounting,
banking system
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+ Political and regulatory conditions — Role of regulation in

the economy and the financial industry, private vs. public sector
dominance, political interference, government stability,
country sovereign risk management process
+ Market position and strategy — Market share in terms of

size, earning, loan losses, tier position with target market
names, business and vehicles in the market, customer and
government attitudes, unit’s overall risk management and
marketing strategy
It should be clear to you that portfolio reviews help creditors spot

problems in their early stages. In the next section, we discuss more
ways to recognize current and potential credit problems.
PROBLEM RECOGNITION
Early Problem recognition refers to the process of anticipating, detecting,

detection recognizing the significance of, and reporting potential problems as
early as possible. In the previous section, we discussed the use of
periodic portfolio reviews to identify potential problems. In this
section, we look at three additional ways risks are managed through a
problem recognition process:
+ Credit monitoring
+ Credit classification
+ A watchlist
In the discussion of these topics, we present a number of specific

signals you may watch for to recognize and evaluate the significance
of credit problems.
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Credit Monitoring
Early The goal of credit monitoring is to identify threats early on and take
identification steps to reinforce credits while adequate alternatives for action exist.
To effectively manage risk, it is essential for the officer to monitor
each transaction regularly. For other than customer payment default,
monthly credit reviews plus semiannual and annual credit/ business
reviews are usually adequate. Your unit may have its own timing
standards.
What should the officer look for during a credit review? Let’s look at
three categories of items that may be cause for concern:
+ Management changes
+ Leverage and financial factors
+ Economics and external factors
Management Changes
Changes Changes in management or management practices may indicate

justify trouble ahead. A shift in any of the following may call for closer
concern inquiry.
+ Key executives or directors
+ Ownership
+ The effectiveness of the board of directors
+ The nature of the business, the business objectives, or the

business practices
+ Attitudes or skill levels
+ Availability of internal financial information
+ Maintenance practices
+ Employee morale
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Leverage and Financial Factors
Warning signs Leveraged situations are usually the most vulnerable to financial
trouble. The wise officer watches for rising leverage, diminishing
margins of profitability, and for signs that subsidiaries or other
business segments could be a financial burden.
Economics and External Factors
Business and The business cycle has a continuing effect on a credit obligation, and
economic should be watched closely. Other external factors also play an
cycles important role. Energy cost increases can diminish purchasing power,
alter cost factors, and render existing equipment obsolete. Likewise,
economic cycles may affect the ability of a debtor to meet credit
obligations.
Anticipating The astute officer will anticipate the risks likely to arise when
risks economic signals change. For example, a recession is typically
marked by a downswing in consumer spending, with a resulting
adjustment in inventories throughout the system of distribution and
production, and a reduction in the total volume of capital spending.
Therefore, when a business economy is in the maturing stage, officers
should keep abreast of their customers’ affairs and reinforce credits
where appropriate.
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 and Critical to the concept of credit monitoring is proper diagnosis to

action plan understand the nature of the customer’s problem. Is it temporary or
permanent? What are the causes? Does the customer have a viable plan
to resolve the problem? The next step is to review the creditor’s
options, which may be to help the customer resolve the problem,
restructure the transaction, or hold firm to the existing deal (which
could mean repossessing and remarketing the equipment).
Credit Classification
Definition Once a potential or actual credit problem has been identified, the
creditor may use a classification system to track the credit.
Classification is the process of assigning to a transaction a class that
represents the level of loss risk. In Figure 11.2, we show a sample
classification system.
Classification systems serve several purposes:
+ Highlight problem credits for attention and remedial action
+ Categorize problem credits according to severity of actual and

potential risk of loss
+ Apply a common language to problem credit identification and

management
Timely classification and reporting of favorable or adverse changes in

the status of a transaction is an important risk management tool. In the
next section, we examine a related tool, the watchlist.
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1 - Normal No identified problems
1A - OAEM Other Assets Especially Mentioned:

(1) The credit review has revealed
evidence of weakness in the borrower’s
financial condition or creditworthiness,
(2) the repayment program is unrealistic,
or (3) we lack adequate collateral, credit
information, or documentation. Early
attention, including substantive
discussions with borrowers, is required to
correct deficiencies.
II - Substandard The normal repayment of principal and

interest may be, or has been, jeopardized
by adverse trends, weaknesses in
collateral, or by financial, managerial,
economic, or political developments.
Prompt corrective action is required to
strengthen the bank’s position as a lender
to reduce its exposure and to assure that
the borrower takes adequate remedial
measures.
III - Doubtful Full repayment of credit appears

questionable, but the amount and timing of
the eventual loss has not yet been
determined. Vigorous action is required
to avert or minimize losses.
IV - Loss Payment is not collectible.
Figure 11.2: Classification system
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Watchlist
Definition A watchlist is a list of transactions that do not warrant classification,

but do require watching. The basis for including a transaction on a
watchlist is usually a current or anticipated change in:
+ Industry patterns or structures
+ Management, composition, or succession
+ National or international political and economic trends that

may affect the credit
+ Nature of the lender/borrower relationship
+ Borrower performance vs. budget or forecast
+ Nature of joint-venture arrangements or relationships
Watchlist To be an effective risk management tool, the list should be updated

maintenance regularly (at least quarterly). Deteriorating transactions may be
classified according to the classification system in use.
Clearly, the problem recognition methods we’ve discussed in this

section can be important risk management tools. Of course, it is not
enough to simply identify a potential problem! Steps must be taken to
eliminate or at least reduce the identified risks. This is the topic of the
next section, “Remedial Management.”
REMEDIAL MANAGEMENT
In the previous section, you learned how creditors use credit

monitoring, credit classification, and the watchlist to recognize and
track credit problems. The next step in the risk management process is
remedial management.
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Definition Remedial management refers to the actions we take to avert or

minimize the credit problems we’ve identified. It means taking
opportunities to get concessions or additional collateral, and forcing
decisions at a time when the company still has viability.
Remedial management is results-oriented. The goals are to reduce

classifications and write-offs while increasing recoveries. To help you
understand how these goals are met, we divide the process into two
parts:
+ Documentation review
+ Action plan
Documentation Review
Purpose One of the first actions that should be taken after a credit has been
classified is to review its documentation. The purpose of the review is
to:
+ Identify possible causes of instability
+ Identify any weaknesses in the documentation that could put the

creditor’s interest in the collateral in jeopardy
+ Review the creditor’s options in the event of default
Action Plan
Alternate After the documentation has been reviewed, the creditor must develop
strategies a strategy to resolve the credit problem. To reach the best decision, its
a good idea to consider and document several alternate strategies
along with their attendant risks. Appropriate strategies may include:
+ Restructuring the loan/lease to encourage the customer to seek

other sources of financing
+ Restructuring the loan/lease to retain some degree of return on

the transaction
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+ Encouraging the customer to sell assets to meet its obligations
+ Requiring additional collateral
Many more strategies are possible. The remedial approach the creditor
takes must be based on the individual characteristics of the transaction
and the relationship with the customer.
SUMMARY
Portfolio management, problem recognition, and remedial management were the three risk
management categories discussed in the second part of this unit. Under portfolio
management, we described the two types of portfolio reviews — individual transaction and
portfolio composition. Each type of review helps manage portfolio risks from a different
perspective.
In our discussion of problem recognition, we stressed that the goal of problem recognition
is to identify problem credits early on, while more options to resolve the problem exist.
We described three risk management tools associated with problem recognition: credit
monitoring, credit classification, and use of a watchlist. A classification system is used to
highlight credits that require immediate or ongoing attention. A watchlist is a related tool
used to track potential problem credits.
Remedial management is a results-oriented approach to managing problem credits. The

process consists of two parts — the documentation review and the action plan. The ultimate
goal of remedial management is to avert or minimize losses.
Congratulations! You have completed the Basics of Asset Based Financing Course. Please
complete Progress Check 11.2 to check your understanding of risk management. If you
answer any questions incorrectly, please review the appropriate portions of the text.
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Question 1: A portfolio concentration refers to:
____ a) the effect of political and economic regulations on the portfolio.

____ b) the strategy of maintaining a mix of industries and products.
____ c) a transaction that has an adverse effect on rest of the portfolio.
____ d) a group of transactions that have something in common.
Question 2: In a portfolio, liquidity is the creditor’s ability to collect on debts.
____ a) True
____ b) False
Question 3: Diversification in a portfolio tends to be lessen risk because:
____ a) the exposure in any one risk category is limited.

____ b) covenants and other present safeguards are adequate.
____ c) it lessens the adverse effects of environmental factors.
____ d) the creditor has more collection options available.
Question 4: When a customer’s leverage increases, the creditor may monitor the credit
less frequently.
____ a) True
____ b) False
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ANSWER KEY
Question 1: A portfolio concentration refers to:
d) a group of transactions that have something in common.
Question 2: In a portfolio, liquidity is the creditor’s ability to collect on debts.
a) True
Question 3: Diversification in a portfolio tends to be lessen risk because:
a) the exposure in any one risk category is limited.
Diversification is the strategy of maintaining a mix of industries and

products so that adverse results in any one concentration does not
jeopardize the entire portfolio.
Question 4: When a customer’s leverage increases, the creditor may monitor the credit
less frequently.
b) False
Highly leveraged situations are more susceptible to financial problems

and warrant more frequent monitoring.
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PROGRESS CHECK 11.2

(Continued)
Question 5: One way that creditors manage risk when an economic downturn is likely is
to:
____ a) classify the credits.

____ b) deny requests for line renewals or extensions.
____ c) restructure vulnerable transactions.
____ d) use special resources to appraise and remarket the equipment.
Question 6: To tag problem credits that required additional analysis and monitoring,
creditors use a _____________________________.
Question 7: To monitor an anticipated change in a customer’s management, industry

cycles, or relationships with partners, creditors may use a
_____________________.
Question 8: The main purpose of remedial management is to:
____ a) identify weaknesses in the documentation.

____ b) develop a strategy for handling a credit problem.
____ c) reduce the number of classified credits and losses.
____ d) identify the reasons for a credit problem.
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ANSWER KEY
Question 5: One way that creditors manage risk when an economic downturn is likely is
to:
c) restructure vulnerable transactions.
Credits are not classified unless they become problems. The customer
may need more credit to implement a viable plan to ride out a recession;
denying all requests for more credit may place the customer in greater
jeopardy. Using specialists to remarket equipment is premature because
credit problems are only possible.
Question 6: To tag problem credits that require additional analysis and monitoring,
creditors use a classification system.
Question 7: To monitor an anticipated change in a customer’s management, industry

cycles, or relationships with partners, creditors may use a watchlist.
Question 8: The main purpose of remedial management is to:
c) reduce the number of classified credits and losses.
Identifying the reasons for the credit problem, identifying documentation

weaknesses, and developing a strategy are all methods for attaining the
primary goal of reducing classified credits and losses.
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Appendix
APPENDIX
GLOSSARY
Accelerated Cost The tax depreciation, or cost recovery, method for Internal Revenue
Recovery System Service (IRS) purposes which was effective for all depreciable
(ACRS) property placed into service after December 31, 1980 and before
January 1, 1987
Accelerated Any depreciation method that allows for greater deductions or charges
Depreciation in the earlier years of an asset’s depreciable life, with charges
becoming progressively smaller in each successive period
Accumulated A financial reporting term for a contra-asset balance sheet account

Depreciation that shows the total depreciation charges for an asset since acquisition
Actuarial Interest A constant interest charge (or return) based upon a declining principal
balance
Adjusted (or The undepreciated amount of an asset’s original basis that is used, for
Remaining) Basis tax purposes, to calculate the gain or loss on disposition of an asset
ADR System A tax depreciation system that establishes the minimum, midpoint, and
maximum number of years, by asset category, over which an asset can
be depreciated
Advance One or more lease payments required to be paid to the lessor at the
Payments beginning of the lease term
Advance Rent A general term used to describe any rent that precedes the base lease
term and base lease rent
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G-2 GLOSSARY
Alterations Modifications to leased equipment, generally subject to restoration at

the conclusion of the lease
Alternative A penalty tax, of sorts, in which a taxpayer must pay the higher of its
Minimum Tax regular tax or AMT liability
(AMT)
Annuity A stream of even (equal) cash flows occurring at regular intervals,

such as even monthly lease payments
Arrears A payment stream in which each lease payment is due at the end of
each period during the lease
Asset Class Life The IRS-designated economic life of an asset, used as the recovery
period for alternative tax depreciation computations
Asset A tax depreciation system that establishes the minimum, midpoint, and
Depreciation maximum number of years, by asset category, over which an asset can
Range (ADR) be depreciated; the midpoint life has become synonymous with the
term “ADR class life”
Assign To transfer or exchange future rights
At Risk Rules Federal tax laws that prohibit individuals (and some corporations)
from deducting tax losses from equipment leases in excess of the
amount they have at risk
Bargain A lease provision allowing the lessee, at its option, to purchase the
Purchase Option leased property at the end of the lease term for a price that is so much
lower than the expected fair market value of the property that the
lessee is reasonably sure to exercise it
Bargain Renewal A lease provision allowing the lessee, at its option, to extend the lease
Option for an additional term in exchange for periodic rental payments that
are so much less than fair value rentals for the property that the lessee
is reasonably sure to exercise it
Base Term The minimum time period during which the lessee will have the use
and custody of the equipment
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GLOSSARY G-3
Basis The original cost of an asset plus other capitalized acquisition costs
such as installation charges and sales tax; basis reflects the amount
upon which depreciation charges are computed
Basis Point One one-hundredth of a percent (.01%)
Broker A company or person who arranges lease transactions between lessees

and lessors for a fee; see “Lease Broker”
Bundled Lease A lease that includes many additional services such as maintenance,
insurance, and property taxes that are paid for by the lessor, the cost
of which is built into the lease payments
Call Option Any option in a lease, such as a purchase or a renewal option, that is
exercised at the discretion of the lessee, not the lessor
Capital Lease A lease that has the characteristics of a purchase agreement, and also
meets certain criteria established by Financial Accounting Standards
Board Statement No. 13 (FASB 13)
Capitalize To record an expenditure that may benefit future periods as an asset

rather than as an expense to be charged off in the period of its
occurrence
Capitalized Cost The amount of an asset to be shown on the balance sheet, from a
financial reporting perspective; the total capitalized cost (or basis)
also is the amount upon which tax benefits are based, and may include
asset cost plus other amounts such as sales tax
Captive Lessor A leasing company that has been set up by a manufacturer or dealer of
equipment to finance the sale or lease of its own products to end-
users or lessees
Casualty Value A schedule included in a lease that states the agreed value of
(see also equipment at various times during the term of the lease, and
Stipulated Loss establishes the liability of the lessee to the lessor in the event the
Value Table)
leased equipment is lost or rendered unusable during the lease term
due to casualty loss
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G-4 GLOSSARY
Certificate of A document that is signed by the lessee to acknowledge that the

Delivery and equipment to be leased has been delivered and is acceptable
Acceptance
Closed-end A lease that does not contain a purchase or renewal option, thereby
Lease requiring the lessee to return the equipment to the lessor at the end of
the initial lease term
Commitment Fee A fee required by the lessor, at the time a proposal or commitment is
accepted by the lessee, to lock in a specific lease rate or other lease
terms
Commitment A document prepared by the lessor that sets forth its commitment,
Letter including the lease rate and term, to provide lease financing to the
lessee
Compensating The amount of funds that a bank requires a borrower to keep on

Balance deposit during the term of a loan
Conditional Sales An agreement for the purchase of an asset in which the lessee is
Contract treated as the owner of the asset for federal income tax purposes
(thereby being entitled to the tax benefits of ownership, such as
depreciation), but does not become the legal owner of the asset until
all terms and conditions of the agreement have been satisfied
Construction See Purchase Agreement Assignment

Contract
Assignment
Contingent Rentals in which the payment of rents are dependent upon some factor
Rentals other than passage of time
Cost of Capital The weighted-average cost of funds that a firm secures, from both debt
and equity sources, in order to fund its assets
Cost of Debt The costs incurred by a firm to fund the acquisition of assets through
the use of borrowings
Cost of Equity The return on investment required by the equity holders of a firm
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GLOSSARY G-5
Debt A method of borrowing funds in a leveraged lease where the equity

Optimization participants borrow and repay the obligation in such a manner as to
maximize their return on equity, maintain a constant return while
offering a lower lease payment, maximize cash flow, etc., or to
maximize a combination of factors
Debt Participant A long-term lender in a leveraged lease transaction
Declining A type of accelerated depreciation in which a constant percentage of

Balance an asset’s declining remaining basis is depreciated each year
Depreciation
Depreciation A means for a firm to recover the cost of a purchased asset, over time,
through periodic deductions or offsets to income
Direct Financing A lessor capital lease (per FASB 13) that does not give rise to
Lease manufacturer’s or dealer’s profit (or loss) to the lessor
Discount Rate A certain interest rate that is used to bring a series of future cash
flows to their present value in order to state them in current (today’s)
dollars
Discounted A lease in which the lease payments are assigned to a funding source
Lease in exchange for up-front cash to the lessor
Dry Lease A net lease; a term traditionally used in aircraft and marine leasing to
describe a lease agreement that provides financing only
Early Termination A situation that occurs when the lessee returns leased equipment to
the lessor prior to the end of the lease term as permitted by the
original lease contract or subsequent agreement
Economic Life of The estimated period during which the property is expected to be
Leased Property economically usable by one or more users, with normal repairs and
maintenance, for the purpose for which it was intended at the
inception of the lease
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G-6 GLOSSARY
Economic The federal tax act that introduced ACRS, among other provisions
Recovery Tax Act
of 1981 (ERTA ‘81)
End-of-term Options stated in the lease agreement that give the lessee flexibility in
Options its treatment of the leased equipment at the end of the lease term
Equipment A document, incorporated by reference into the lease agreement, that

Schedule describes in detail the equipment being leased, the lease term,
commencement date, and repayment schedule
Equipment A specific description of a piece of equipment that is to be acquired,

Specifications including equipment make, model, configuration, and capacity
requirements
Equity Investor An entity that provides equity funding in a leveraged lease transaction
or Participant and, thereby, becomes the owner and ultimate lessor of the leased
equipment
Executory Costs Recurring costs in a lease, such as insurance, maintenance, and taxes
for the leased property, whether paid by the lessor or the lessee
External Rate of A method of yield calculation; ERR is a modified internal rate of

Return (ERR) return (IRR) that allows for the incorporation of specific
reinvestment, borrowing, and sinking-fund assumptions
Fair Market Value The value of a piece of equipment if the equipment were to be sold in
a transaction determined at arm’s length, between a willing buyer and a
willing seller, for equivalent property and under similar terms and
conditions
FASB 13 Financial Accounting Standards Board Statement No. 13, ‘Accounting

for Leases’ that specifies the proper classification, accounting, and
reporting of leases by lessors and lessees
Finance Lease An expression often used in the industry to refer to a capital lease or a
nontax lease; also a type of tax-oriented lease
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GLOSSARY G-7
Financial The rule-making body that establishes financial reporting guidelines

Accounting
Standards Board
(FASB)
Financial A type of independent leasing company that is owned by, or a part of, a
Institution Lessor financial institution such as a commercial bank, thrift institution,
insurance company, industrial loan company, or credit union
Financing A notice of a security interest filed under the Uniform Commercial

Statement Code (UCC); also known as UCC-1
Floating Rental Rental that is subject to upward or downward adjustments during the
Rate lease term
Full Payout Lease A lease in which the lessor recovers, through the lease payments, all
costs incurred in the lease plus an acceptable rate of return without
any reliance upon the leased equipment’s future residual value
Full-Service A lease that includes many additional services such as maintenance,

Lease insurance, and property taxes that are paid for by the lessor, the cost
of which is built into the lease payments
Funding Source An entity, such as a lessor or a bank, that provides any part of the funds
used to pay for the cost of the leased equipment
Guaranteed A situation in which the lessee or an unrelated third party (e.g.,

Residual Value equipment manufacturer, insurance company) guarantees to the lessor
that the leased equipment will be worth a certain fixed amount at the
end of the lease term; the guarantor agrees to reimburse the lessor for
any deficiency realized if the leased equipment is subsequently
salvaged at an amount below the guaranteed residual value
Guideline Lease A tax lease that meets or follows the IRS guidelines as established by
Revenue Ruling 75-21, for a leveraged lease
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G-8 GLOSSARY
Half-year A tax depreciation convention that assumes all equipment is purchased

Convention or sold at the midpoint of a taxpayer’s tax year; allows
an equipment owner to claim a half-year of depreciation deductions in
the year of acquisition, as well as in the year of disposition, regardless
of the actual date within the year that the equipment was placed in
service or disposed of
Implicit Rate The discount rate that, when applied to the minimum lease payments
(excluding executory costs) together with any unguaranteed residual,
causes the aggregate present value at the inception of the lease to be
equal to the fair market value (reduced by any lessor retained
Investment Tax Credits) of the leased property
Inception of a The date of the lease agreement (or commitment, if earlier)

Lease
Incremental The interest rate that a person would expect to pay for an additional
Borrowing Rate borrowing at interest rates prevailing at the time
Indemnity Indemnity provisions in a lease such as general indemnity, the general

Clauses tax indemnity, and the special tax indemnity
Independent A type of leasing company that is independent of any one

Lessor manufacturer and purchases equipment from various unrelated
manufacturers
Initial Direct Costs incurred by the lessor that are directly associated with
Costs negotiating and consummating a lease (for example, commissions,
legal fees, costs of credit investigations, and the cost of preparing and
processing documents for new leases acquired)
Interest Rate The discount rate which, when applied to minimum lease payments
Implicit in a (excluding executory costs paid by the lessor) and unguaranteed
Lease (as used residual value, causes the aggregate present value at the beginning of
in FASB 13)
the lease term to be equal to the fair market value of the leased
property at the inception of the lease, minus any investment tax credit
retained by the lessor and expected to be realized by it
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GLOSSARY G-9
Interim Rent A charge for the use of a piece of equipment from either its in-service
date or delivery date until the date on which the base term of the lease
commences
Internal Rate of The unique discount rate that equates the present value of a series of
Return (IRR) cash inflows (lease payments, purchase option) to the present value of
the cash outflows (equipment or investment cost)
Investment Tax A credit that a taxpayer is permitted to claim on the federal tax return
Credit (ITC) (a direct offset to tax liability) as a result of ownership of qualified
equipment
Lease Acquisition The process whereby a leasing company purchases or acquires a lease
from a lease originator such as a lease broker or leasing company
Lease Agreement The contractual agreement between the lessor and the lessee that sets
forth all the terms and conditions of the lease
Lease Broker An entity that provides one or more services in the lease transaction,
but that does not retain the lease transaction for its own portfolio
Lease The process of uncovering (through a sales force), developing, and

Origination consummating lease transactions
Lease Term The fixed, noncancellable term of the lease
Lessee The user of the equipment being leased
Lessee’s The interest rate which the lessee would have incurred (at the
Incremental inception of the lease) to borrow, over a similar term, the funds
Borrowing Rate necessary to purchase the leased assets
Lessor The owner of the equipment that is being leased to a lessee or user
Leverage An amount borrowed
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G-10 GLOSSARY
Leveraged Lease A specific form of lease involving at least three parties: a lessor,
lessee, and funding source — the lessor borrows a significant portion
of the equipment cost on a nonrecourse basis by assigning the future
lease payment stream to the lender in return for up-front funds (the
borrowing); the lessor puts up a minimal amount of its own equity
funds (the difference between the equipment cost and the present
value of the assigned lease payments) and is generally entitled to the
full tax benefits of equipment ownership
MACRS Class The specific tax cost recovery (depreciation) period for a class of
Life assets as defined by MACRS
Maintenance An agreement in which the lessee contracts with another party to

Contract maintain and repair the leased property during the lease term in
exchange for a payment or stream of payments
Master Lease A lease line of credit that allows a lessee to obtain additional leased
Agreement equipment under the same basic lease terms and conditions as
originally agreed to, without having to renegotiate and execute a new
lease contract with the lessor
Match Funded Debt, incurred by the lessor, to fund a specific piece of leased
Debt equipment, the terms and repayment of which are structured to
correspond to the repayment of the lease obligation by the lessee
Midquarter A depreciation convention (replacing half-year convention for certain

Convention taxpayers in certain years) that assumes all equipment is placed in
service halfway through the quarter in which it was actually placed in
service
Minimum Lease From the lessee perspective, all payments that are required to be made
Payments to the lessor per the lease agreement; minimum lease payments for
the lessor include all payments to be received from the lessee, as well
as the amount of any residual guarantees by unrelated third-party
guarantors
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GLOSSARY G-11
Modified The current tax depreciation system as introduced by the Tax Reform
Accelerated Cost Act of 1986, generally effective for all equipment placed in service
Recovery System after December 31, 1986
(MACRS)
Money-over- A nontax lease in which the lessee is, or will become, the owner of the
money Lease leased equipment by the end of the lease term
Multiple A method of income allocation used to report earnings on a leveraged

Investment lease that assumes a zero earnings rate during periods of
Sinking Fund disinvestment (a sinking-fund rate equal to 0)
(MISF)
Municipal Lease A conditional sales contract disguised in the form of a lease available
only to municipalities in which the interest earnings are tax-exempt to
the lessor
Net Lease A lease in which all costs in connection with the use of the equipment,
such as maintenance, insurance, and property taxes, are paid for
separately by the lessee and are not included in the lease rental paid to
the lessor
Net Present The total discounted value of all cash inflows and outflows from a
Value project or investment
Nonrecourse A type of borrowing in which the borrower (a lessor in the process of

funding a lease transaction) is not at-risk for the borrowed funds; the
lender expects repayment from the lessee and/or the value of the
leased equipment
Nontax Lease A type of lease in which the lessee is, or will become, the owner of
the leased equipment, and is entitled to all the risks and benefits
(including tax benefits) of equipment ownership
Off Balance Any form of financing, such as an operating lease, that, for financial
Sheet Financing reporting purposes, is not required to be reported on a firm’s balance
sheet
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G-12 GLOSSARY
Open-end Lease A lease in which the lessee guarantees the amount of the future
residual value to be realized by the lessor at the end of the lease;
if the equipment is sold for less than the guaranteed value, the lessee
must pay the amount of any deficiency to the lessor
Operating A budget that lists the amount of noncapital goods and services a firm
Budget is authorized by management to expend during the operating period
Operating Lease From a financial reporting perspective, a lease that has the
characteristics of a usage agreement and also meets certain criteria
established by the FASB; leases in which the lessor has taken a
significant residual position in the lease pricing and, therefore, must
salvage the equipment for a certain value at the end of the lease term
in order to earn its rate of return
Packager A name used to describe the leasing company, investment banker, or

broker who arranges a leveraged lease
Payments in A payment stream in which each lease payment is due at the beginning
Advance of each period during the lease
Payments in A payment stream in which each lease payment is due at the end of
Arrears each period during the lease
Payoff A situation that occurs when the lessee purchases the leased asset
from the lessor prior to the end of the lease term
Placed in Service A phrase used to indicate that equipment was delivered and available
for use, although the equipment may still be subject to final
installation and/or assembly
Point One percent, or one percentage point (1.00%); also represents 100
basis points
Pooled Funds A funding technique, used by lessors, in which several forms of

borrowing are pooled, or grouped, for use in funding leases and are
not specifically tied to the purchase of one piece of leased equipment
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GLOSSARY G-13
Present Value The discounted value of a payment or stream of payments to be

received in the future, taking into consideration a specific interest or
discount rate; present value represents a series of future cash flows
expressed in today’s dollars
Pricing The process of arriving at the periodic rental amount to charge a

lessee
Private Ruling A ruling by the IRS that was requested by parties to a lease transaction
and is applicable to the assumed facts stated in the opinion
Purchase An agreement where the lessee has entered into a contract to purchase
Agreement the equipment to be leased prior to the arranging of the financing;
Assignment under the agreement, the lessee normally assigns some or all of its
rights under the purchase agreement (always including the right to take
title to the equipment) to the owner trustee prior to the delivery of the
property
Purchase Option An option in the lease agreement that allows the lessee to purchase the
leased equipment at the end of the lease term for either a fixed amount
or at the future fair market value of the leased equipment
Put Option An option in a lease (for example, for equipment purchase or lease
renewal) in which the exercise of the option is at the lessor’s, not the
lessee’s, discretion
Recourse A type of borrowing in which the borrower (a lessor funding a lease)

is fully at-risk to the lender for repayment of the obligation; the
recourse borrower (lessor) is required to make payments to the lender
whether or not the lessee fulfills its obligation under the lease
agreement
Refundable An amount paid by the lessee to the lessor as security for fulfillment
Security Deposit of all obligations outlined in the lease agreement that is subsequently
refunded to the lessee once all obligations have been satisfied
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G-14 GLOSSARY
Remarketing The process of selling or leasing the leased equipment to another

party upon termination of the original lease term
Renewal Option An option in the lease agreement that allows the lessee to extend the
lease term for an additional period of time beyond the expiration of
the initial lease term in exchange for lease renewal payments
Rent Holiday A period of time in which the lessee is not required to pay rents;
typically, the rents are capitalized into the remaining lease payments
Residual Value The value, either actual or expected, of leased equipment at the end, or
termination, of the lease
Retained A lease transaction or investment kept for one’s own portfolio; a

Transaction retained transaction is not sold to another lessor or investor
Return on Assets A common measure of profitability based upon the amount of assets
(ROA) invested; ROA is equal to the ratio of either net income to total assets
or net income available to common stockholders to total assets
Return on Equity A measure of profitability related to the amount of invested equity;

(ROE) ROE is equal to the ratio of either net income to owners’ equity or net
income available to common stockholders to common equity
Revenue The IRS Revenue Procedures 75-21, 75-28, and 76-30, which set
Procedures forth requirements for obtaining a favorable federal income tax ruling
that a particular leveraged lease transaction is a true lease
Revenue Ruling A written opinion of the Internal Revenue Service requested by parties
to a lease transaction which is applicable to assumed facts stated in the
opinion
Rollover A change in the lease term or lease payment resulting from a change in
equipment, such as in a takeout or upgrade
Rule of 78 An accelerated method of allocating periodic earnings in a lease (or a

loan) based upon the sum-of-the-years method
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GLOSSARY G-15
Running Rate The rate of return to the lessor (or cost to the lessee) in a lease, based
solely upon the initial equipment cost and the periodic lease
payments, without any reliance on residual value, tax benefit, deposits,
or fees
Sales-leaseback A transaction that involves the sale of equipment to a leasing company

and a subsequent lease of the same equipment back to the original
owner who continues to use the equipment
Sales-type Lease A capital lease from the lessor’s perspective (per FASB 13) that gives
rise to manufacturer’s or dealer’s profit to the lessor
Salvage Value The expected or realized value from selling a piece of equipment
Saw Tooth Rents Rents which vary throughout the term of the lease, usually to match
debt payments and tax payments in a leveraged lease so as to lessen
the need for a sinking fund
Schedule Listing of equipment to become subject to a lease that describes the

equipment, the lease term, the commencement date, and the location
of the equipment
Single Investor A lease in which the lessor is fully at-risk for all funds (both equity
Lease and pooled funds) used to purchase the leased equipment
Sinking Fund A reserve set aside for the future payment of taxes (generally
applicable only in leveraged leases) or for the purpose of payment of
any liability anticipated to become due at a future date
Sinking Fund The earnings allocated to a sinking fund

Rate
Skipped-payment A lease that contains a payment stream requiring the lessee to make
Lease payments only during certain periods of the year
Spread The difference between two values generally used to describe the
difference between the lease interest rate and the interest rate on the
debt
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G-16 GLOSSARY
Step-payment A lease that contains a payment stream requiring the lessee to make
Lease payments that either increase (step-up) or decrease (step-down) in
amount over the term of the lease
Stipulated Loss A schedule included in the lease agreement, generally used for
Value Table purposes of minimum insurance coverage, that sets forth the agreed-
upon value of the leased equipment at various points throughout the
lease term
Straight-line A method of depreciation (for financial reporting and tax purposes)

Depreciation where the owner of the equipment claims an equal amount of
depreciation in each year of the equipment’s recovery period
Structuring The process of pulling together the many components of a lease to

arrive at a single lease transaction; structuring includes, but is not
limited to, lease pricing, end-of-term options, documentation issues,
indemnification clauses, funding, and residual valuations
Subchapter S A firm legally organized as a corporation but taxed as a partnership

Corporation
Takeout A flexible lease option in which the lessor replaces existing leased
equipment with either different equipment or newer equipment of the
same make
Tax Equity and Tax law enacted in 1982 that, among other things, modified the
Fiscal Accelerated Cost Recovery System (ACRS) and Investment Tax Credit
Responsibility (ITC) rules, as well as introduced the finance lease (which has since
Act of 1982
been repealed)
(TEFRA ‘82)
Tax Lease A generic term for a lease in which the lessor takes on the risks of
ownership (as determined by various IRS pronouncements) and, as the
owner, is entitled to the benefits of ownership, including tax benefits
Tax Reform Act U.S. tax law enacted in 1984 that included changes to the general
of 1984 (TRA ‘84) effective date for finance leases (renamed transitional finance leases),
defined limited use property, set forth the luxury automobile rules, and
placed restrictions on equipment leases to tax-exempt users
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GLOSSARY G-17
Tax Reform Act U.S. tax law that effected a major overhaul of the U.S. tax system by
of 1986 (TRA ‘86) lowering tax rates, modifying the Accelerated Cost Recovery System
(now MACRS), repealing the Investment Tax Credit (ITC), and
repealing the transitional finance lease
Tax-exempt User A type of tax lease available to tax-exempt or nonprofit entities in

Lease which the lessor receives only limited tax benefits
Terminal Rental A lessee-guaranteed residual value for vehicle leases (automobiles,

Adjustment trucks, or trailers), the inclusion of which will not disqualify the tax
Clause (TRAC) lease status of a tax-oriented vehicle lease
Termination A value of leased equipment, representing the lessee’s liability, if the

Value agreement is terminated because the leased equipment becomes
obsolete or surplus
Third-party An independent leasing company (or lessor) that writes leases

Lessor involving three parties: 1) the unrelated manufacturer, 2) the
independent lessor, and 3) the lessee
Ticket Size A term that refers to the cost of equipment being leased; the leasing
market place is roughly segmented into the small, middle, and large
ticket markets
True Lease A tax lease where, for IRS purposes, the lessor qualifies for the tax
benefits of ownership and the lessee is allowed to claim the entire
amount of the lease rental as a tax deduction
Two-party Lessor A captive leasing company (or lessor) that writes leases involving two
parties: 1) the consolidated parent and captive leasing subsidiary and
2) the lessee or end-user of the equipment
UCC Financing A document, under the UCC, filed with the county (and sometimes the
Statement Secretary of State) to provide public notice of a security interest in
(UCC-1) personal property
Unguaranteed The portion of residual value for which the lessor is at-risk
Residual Value
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G-18 GLOSSARY
Uniform The Uniform Commercial Code that governs commercial transactions

Commercial Code
(UCC)
Upgrade An option that allows the lessee to add equipment to an existing piece
of leased equipment in order to increase its capacity or improve its
efficiency
Useful Life A period of time during which an asset will have economic value and
be usable
Vendor Leasing Lease financing offered to an equipment end-user in conjunction with

the sale of equipment
Wet Lease A lease in which the lessor provides bundled services, such as the
payment of property taxes, insurance, maintenance costs, fuel, or
provisions, and may even provide persons to operate the leased
equipment
Wrap Lease A lease in which the lessor leases equipment at a rental rate that
amortizes the investment over a longer period than the term of the
initial lease
Yield The rate of return to the lessor in a lease investment
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Unit 1: Understanding the Leasing Industry

Unit 1: Understanding the Leasing Industry (Continued)

Unit 1: Understanding the Leasing Industry (Continued)

Unit 2: Financial Reporting and Tax Classifications

Unit 2: Financial Reporting and Tax Classifications (Continued)

Unit 3: Legal Classification and Lease Documentation

Unit 3: Legal Classification and Lease Documentation (Continued)

Unit 4: Credit Analysis and Risk Assessment

Unit 4: Credit Analysis and Risk Assessment (Continued)

Unit 5: Financial Concepts and Calculations (Continued)

Unit 6: Introduction to the Lease vs. Buy Analysis

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

Unit 7: Lease Structuring

Unit 8: Vendor Lease Programs

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

Agreement A lease is an agreement between the owner of an asset (the lessor)

HISTORY OF THE LEASING INDUSTRY

The practice of letting property be used in exchange for payment has

Early legal systems often included leasing laws. The famous

Near Babylon, in approximately 400 to 450 B.C., businesses leased

In medieval times, most leases were for horses and farming

Development of the United States Leasing Industry

The use and development of leasing increased as new types of

Third-party Eventually, independent or third-party leasing companies were formed

It also is important to note that, especially in recent times, significant

EQUIPMENT LEASING TODAY

The equipment leasing industry continues to grow. Worldwide, leasing

Today, virtually all types of equipment are leased. Leased products

Small Ticket Market

The small ticket market concentrates on leasing lower-priced

Large Ticket Market

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

Classification Leasing companies may be classified into three groups:

n Independent leasing companies

There are few accurate statistics to substantiate the proportion of the

Independent Leasing Companies

Figure 1.1: Independent leasing company

Captive Finance Organizations

Set up by The second type of lessor is a captive finance organization (lessor).

Figure 1.2: Captive lessor

Lease Brokers or Packagers

n Find the interested lessee

Figure 1.3: Lease broker / packager

þ PROGRESS CHECK 1.1

Question 1: A lease is a(n):

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

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

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

Question 1: A lease is a(n):

c) agreement in which the owner of property gives use of the property to

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

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

PROGRESS CHECK 1.1

____ a) The growth and expansion of the railroads

____ a) lease broker or packager.

a) The growth and expansion of the railroads

d) Bank Holding Company Act.

c) independent or third-party leasing company.

REASONS LESSEES LEASE EQUIPMENT

Leasing offers many advantages, benefits, and flexible options to