[citibank] asset based finance citibank(bookos-z1.org)

Asset-BasedFinance - DraftJanuary 1996

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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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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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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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 AdvancePayments ....................................................................... 5-10

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

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

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

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

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

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

Unit 6: Introduction to the Lease vs. Buy Analysis

Introduction............................................................................................... 6-1

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

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

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

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

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

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

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

Discount Rate .............................................................................. 6-9

Salvage Value............................................................................. 6-11

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

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

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

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

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

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

Unit 7: Lease Structuring

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Lessee's Implicit Cost.................................................... 7-13

Net Present Value (NPV)................................................ 7-14

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

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

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

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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

Unit 1

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UNIT 1: UNDERSTANDING THE LEASING INDUSTRY

INTRODUCTION

Worldwide, leasing is used more and more to finance equipment and property. In the UnitedStates alone, businesses acquire 33 percent of all equipment through leasing. Companies,federal and municipal governments, and nonprofit organizations choose leasing to financeequipment because it offers many benefits. From an equipment providers standpoint,leasing is a venture in which substantial profits may be made.

This unit will introduce you to the leasing industry. You will learn what a lease is, howleasing evolved, what the leasing industry is like today, and why leasing is so appealing.

UNIT OBJECTIVES

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

n Define a lease

n Recognize the factors that help divide the leasing market into segments

n Distinguish among the three major types of lessors

n Understand the benefits of leasing

n Define residual value

n Recognize the major trends in todays leasing industry

1-2 UNDERSTANDING THE LEASING INDUSTRY

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WHAT IS A LEASE?

Definition of a Lease

Agreementfor use ofproperty

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

Writtencontracts

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

Industry Viewpoint

Transactionlabelled a lease

From an industry standpoint, a lease is a contract that has been labeleda lease. However, many transactions that are labeled as leases are nottrue usage agreements. They are more like an installment orconditional sale rather than a pure usage agreement.

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

UNDERSTANDING THE LEASING INDUSTRY 1-3

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HISTORY OF THE LEASING INDUSTRY

The practice of letting property be used in exchange for payment hasexisted for thousands of years. To understand the lease process oftoday, it helps to understand how leasing evolved.

Early History

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

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

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

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

IndustrialRevolution

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


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Railroadexpansion

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

Development of the United States Leasing Industry

Need forleasing

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

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

Vendor leasingbegins

In the early 1900s, a developing economy and the desire ofmanufacturers to provide financing for their products increased thedemand for leasing. Manufacturers or vendors thought they would beable to sell more of their products if they were able to offer anaffordable payment plan. This idea led to the beginning of leasefinancing provided by vendors, which is still a significant force in theequipment leasing industry today.

Third-partyleasingcompanies form

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


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Banks enter theleasing industry

In 1963, the U.S. Comptroller of the Currency issued a ruling thatpermitted national banks to own and lease personal property. In 1970,an amendment to the Bank Holding Company Act further legitimizedthe involvement of banks in equipment leasing. This amendmentallowed banks to form holding companies. Under a holding company,banks could engage in a number of nontraditional financing activities,such as equipment leasing.

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

EQUIPMENT LEASING TODAY

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

Market Segments

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

Factors thatdeterminesegment

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


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Small Ticket Market

The small ticket market concentrates on leasing lower-pricedequipment, such as copiers, personal computers, and word processors.The high end of the transaction range for the small ticket market isfrom $25,000 to $100,000. (The cut-off point depends uponindividual firms' interpretations.) The lessee in this market is moreconcerned with the convenience of acquisition, maintenance, anddisposal than with cost.

Large Ticket Market

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

Middle Market

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

Today's Lessors

Classification Leasing companies may be classified into three groups:

n Independent leasing companies

n Captive finance organizations

n Lease brokers, or packagers


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

Independent Leasing Companies

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

ManufacturerEquipmentPurchase

Payment

IndependentLessor

EquipmentLease

LeasePayments

Lessee


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Figure 1.1: Independent leasing company

Captive Finance Organizations

Set up bymanufactureror dealer

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

Payment

Equipment Lease

Parent/Manu-

facturer

Subsidiary/Lessor

EquipmentLease

Lessee

LeasePayments

Figure 1.2: Captive lessor

Lease Brokers or Packagers

Middle-manservices

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

n Find the interested lessee

n Arrange for the equipment with the manufacturer

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

n Find the ultimate lessor in the lease transaction


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

Lessee

Equipment LeaseBroker

UltimateLessor

Funding

Figure 1.3: Lease broker / packager

SUMMARY

The concept of leasing as an equipment financing tool has survived 4,000 years of history.The need for equipment leasing continues to grow. The benefits of leasing, such asaffordable payments and off balance sheet financing, have contributed to its popularity.

Today's leasing market includes virtually every type of equipment. In the U.S., markettransactions range from less than $25,000 to more than $1,000,000.

Three major classifications of lessors have evolved to handle the varying needs of theindustry: independent leasing companies, captive finance organizations, and lease brokers(or packagers). These classifications are based on the leasing company's relationship to theequipment manufacturer and the types of services they provide.


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


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PROGRESS CHECK 1.1Directions: 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 borrowedfunds.

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

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

____ d) arrangement that calls for a lessee to make payments for equipmentdirectly to the lender.

Question 2: During the last 200 years, the demand for leasing has increased primarily as aresult of:

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

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

____ c) the expansion of the railroad industry.

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

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

____ a) True

____ b) False

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

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

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

____ c) is independent of any one manufacturer.


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ANSWER KEY

Question 1: A lease is a(n):

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

Question 2: During the last 200 years, the demand for leasing has increased primarily as aresult of:

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

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

b) False

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

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


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PROGRESS CHECK 1.1(Continued)

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

____ a) constitution.

____ b) tax laws.

____ c) third-party leasing agreements.

____ d) Bank Holding Company Act.

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

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

____ b) the size of the transactions only.

____ c) how the leases are funded.

____ d) the type of lessor involved.

Question 8: A lessor that purchases equipment from various manufacturers, and thenleases 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 ofleasing in the United States?

a) The growth and expansion of the railroads

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

d) Bank Holding Company Act.

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

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

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

c) independent or third-party leasing company.


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REASONS LESSEES LEASE EQUIPMENT

Leasing offers many advantages, benefits, and flexible options tolessees. Some may lease for only one reason, others for a variety ofreasons. Lessors who understand the motivations of lessees are betterable to offer products that attract lessees.

Most reasons lessees choose to lease fall into the followingcategories:

n Hedge against technological obsolescence

n Financial reporting

n Cash management

n Income tax

n Ownership considerations

n Flexibility and convenience

n Economics

Lets examine each of these categories from the lessees viewpoint. Inturn, the lessor will see how these advantages strengthen the salesprocess.

Hedge Against Technological Obsolescence

Risk ofownership

One of the strongest reasons for acquiring the use of equipmentthrough leasing is that leasing helps lessees avoid many of the risks ofowning equipment. Much of todays equipment is based upon rapidlychanging technology. Equipment soon becomes technologicallyobsolete. A companys risk in buying and owning technologicallysensitive equipment is that it may become economically useless muchearlier than expected. Sometimes the equipment becomes uselessbefore the owner has paid off a loan used to buy the equipment!

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


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Transfer of riskto lessor

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

Financial Reporting

Financial reporting, or accounting presentation, comprises animportant part of the decision to lease or buy equipment. Leasingresults in a very different accounting presentation than that of buying apiece of equipment. Loans from banks and capital raised fromstockholders often depend upon the reported financial health of acompany. For this reason, leasing is of great importance to manylessees. Here we discuss four aspects of financial reporting.

Off Balance Sheet Financing

No asset orliability entry

If a lease is a true usage agreement (an operating lease) for financialreporting purposes, the lessees balance sheet does not show theequipment as an asset or a liability. The only expense on the lesseesincome statement for the lease is the lease rental expense. Thisreporting practice is called off balance sheet financing.

Improvedfinancial ratios

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

Lessee Lessor

Risk of Obsolescence


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Reported Earnings

Positive effecton incomestatement

In the early years of a lease, an operating lease has a more positiveeffect on a lessees income statement than a capital lease. Initially, theoperating lease expense (rental payments) is less than the combineddepreciation and interest expense for the capital lease. Therefore, anoperating lease raises the lessees overall reported earnings.

Return on Assets

Increasedreturn on assets

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

Spending Authority

Payments withinspendingguidelines

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

Cash Management

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

Lower Down Payments

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


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Lower Monthly Payments

Affordablepayments

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

Improved Cash Forecasting

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

Capital Budget Constraints

Operatingbudget

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

Expenditureapprovals

Similarly, some state and local governments must have either specialcapital appropriations made by the decision-making bodies or voterapproval before they can buy equipment. This process may take a longtime. Since lease payments can be paid out of the operating budget,and approvals for operating expenses generally require much less timethan approvals for capital expenditures, government bodies oftenobtain equipment faster through the leasing process.

Cost Constraints

Affordablepayments

In certain cases, the only realistic means of acquiring use ofequipment is through leasing. For example, a company may needpartial use of a satellite to transmit data to regional offices in otherparts of the world. Unfortunately, the satellite may cost more than thefirm can possibly afford. Through leasing, the company can obtain theuse of a portion of the satellites power in exchange for affordable,periodic rental payments.


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Income Tax

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

Reciprocity of Tax Benefits

Lower leaserates

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

Deductible Lease Payments

Income taxbenefit

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


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U.S. Tax Law Penalties

Negative impactof additionalpurchases

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

n Tax benefits

n Deductible lease payment

Lessor

EquipmentLease

Lessee

LowerLease

Payments

Ownership Considerations

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

Stranded Assets

Estimatedeconomic life

For financial reporting purposes, owners depreciate equipment over theequipments estimated economic life. If equipment becomestechnologically obsolete before the end of its depreciable life, thecompany owns a worthless piece of equipment that is not fullydepreciated on its books. If the company sells the obsolete equipment,it will be at a loss. This lowers the companys reported earnings.

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


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Potential for Ownership

Purchaseoptions

Another reason for leasings growing popularity is the lessees abilityto purchase the equipment at the end of the lease term. Some purchaseoptions fix the purchase amount; others base the purchase price on theequipments fair market value at the end of the lease term. Fixedpurchase options can be risky. However, having the option to purchaseequipment at fair market value is acceptable to those lessees seekingflexibility in equipment use and financing.

Flexibility and Convenience

Timing factors

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

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

One-stopshopping

n A lessor can provide product variety and knowledge, theproduct itself, financing, and many flexible options, allunder one roof. In addition, a lessor may bundle otherproducts or services, such as maintenance and insurance,with the lease to offer a full-service package. A full-servicepackage may be less expensive than if the lessee separatelypurchases the same services.

Reportingconvenience

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

n In most companies, the budgeting analysis is not as involvedfor leasing a piece of equipment as it is for purchasingequipment.

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


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Flexible options

Control

Lower risks

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

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

n The lessee can return the equipment to the lessor upontermination of the lease without further obligation. Thelessor bears the burden and risk of disposing of theequipment for an adequate price.

Economic Reasons

A crucial selling point for the lessor is that leasing can make goodeconomic sense for the lessee. The lessor should be familiar withthese aspects.

Diversification of Financing Sources

Financingavailability

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

Additionalsource offinancing

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

Even when bank financing is generally available, some businesses maynot be able to obtain credit. Fortunately, leasing provides an additionalsource of financing for companies that cannot borrow needed funds.


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Future Financing Options

Loanrestrictions

When lending to a company, a banker typically builds restrictive loancovenants or agreements into the loan agreement. These covenantsrestrict a companys future financing options. Their purpose is to helplessen any potential default on the loan by the borrower. If theborrower violates any of the covenants and puts the loan at risk ofdefault, the lender has the option to demand repayment of the loan.

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

Lower Expenses

Economiesof scale

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

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

SUMMARY

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

n Guarding against technological obsolescence

n Financial reporting


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n Cash management

n Income tax motivations

n Ownership considerations

n Flexibility and convenience

n Economics

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


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PROGRESS CHECK 1.2Directions: 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 companys financialstatements.

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

____ a) lessor.

____ b) lessee.

____ c) both the lessor and lessee.

Question 3: In the early years of the lease, an operating lease has a more positive effecton a lessees 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 companys capital budget.

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

____ d) a lease is not reported as an asset on a firms balance sheet.


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ANSWER KEY

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

c) the equipment may become technologically obsolete.

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

b) lessee.

Question 3: In the early years of the lease, an operating lease has a more positive effecton a lessees 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 thelessees point of view. Although there are many advantages to thelessee, the lessor benefits as well. In this section we will see thatthere are many reasons for lessors to be in the leasing business.Understanding these reasons is beneficial for all parties to the leasetransaction. Some benefits apply to all lessors, and some are specificto vendor leasing.

General Lessor Benefits

There are several opportunities associated with leasing that make thebusiness attractive to lessors. They include profitability, income taxbenefits, financial leverage, residual value of the leased equipment,and the expanding international leasing market.

Profitability

Reasonableprofits

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

Minimizingrisks

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


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Income Tax Benefits

Benefits ofownership

When the lessor is considered the tax owner of the leased equipmentaccording to the Internal Revenue Service criteria, the lessor isentitled to the many tax benefits of ownership. The primary benefitsare (1) depreciation; (2) gross profit tax deferral (when the lessor alsois the manufacturer of the equipment); and (3) tax-exempt interest forqualifying municipal leases.

Financial Leverage

Return onequity

One of the more important economic aspects of leasing is financialleverage. A lessor typically borrows most of the funds needed to buy apiece of equipment and pays for only a fraction of the cost of theequipment from its own funds, or equity. Because the debt costs lessthan the interest rate charged in the lease, the lessor can earnsubstantial returns on its equity. Use of significant amounts offinancial leverage is commonplace in leasing.

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

Recourseborrowing

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


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Lessor Lessorn Equityn Pooled funds

Equipment Payment

Lessee

Figure 1.4: Single-investor lease

Nonrecourseborrowing

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

EquipmentLease

n Equity

Lessor

LeasePayment

Loan Amount

Non-recourseLender

Lessee

Figure 1.5: Leveraged lease


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Assigned leasepayments

In nonrecourse borrowing, the lender considers the credit-worthiness of the lessee and the value of the leased equipment, not thecredit-worthiness of the lessor. Because the lease payments in aleveraged lease are assigned to the lender, the lessee generally makeslease payments directly to the lender. The lending institution seeksrecovery of any losses from the lessee or from the salvage of theleased equipment (collateral).

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

Residual Value

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

Effect on leaserates

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

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

Risk in residualvalue

Generally, the amount of the residual used in the lessors pricing isnot the exact amount the lessor expects to receive at the end of theterm. Rather, it is the amount the lessor is willing to be at-risk for inthe lease. The lessor must receive the at-risk residual amount in orderto recover all costs and earn the return it wants. The risk is that theresidual value will be less than the amount assumed when the lease waspriced.


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International Leasing

Expandingopportunities

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

Types ofequipmentleased abroad

As in the United States, all types of equipment are being leasedabroad: tankers, railroad cars, computers, machine tools, printingpresses, aircraft, restaurant equipment, mining equipment, and drillingrigs.

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

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

Benefits of Vendor Leasing

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


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Convenience for Customers

Productdistinction

Providing lease financing is a successful way for manufacturers todistinguish their product from their competitors products. Providingthe equipment, as well as the financing, may entice a potentialcustomer to choose a certain manufacturers product due to theconvenience offered.

Market Control

Locking out thecompetition

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

Profit Potential

Increased sales Vendor lessors may benefit from increased sales because leasing canmake equipment acquisition affordable for customers who cannotpurchase the equipment outright. Along the same lines, customers maybe able and willing to lease more expensive models or additionalaccessories now that the cash flow advantages of leasing have putthese extras within their reach.

Full-servicecontracts

Captive lessors can benefit from the combined marketing approachand profitability of providing bundled services in a full-servicecontract. These services typically include maintenance, insurance,film, reagents, software, and property taxes for the lessee. The captivelessor may be able to provide these services for less cost than thatwhich the lessee can separately procure and, as a result, profit fromthese additional revenues. Also, the convenience of one-stop shoppingmay entice a lessee to choose a captive lessors product.


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Integration Opportunities

Types ofintegration

Integration refers to ways in which a company can expand operations.Vertical integration refers to control over the means of providing aproduct, through production and transportation, to the final wholesaleand retail outlets. Horizontal integration refers to expansion into thesales and production of related products (like wax production for anoil company). Conglomerate integration is where a company entersinto a wholly unrelated business venture. Lets see how integrationactivities provide opportunities for vendor leasing.

Vertical Integration

Control overresiduals

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

Horizontal Integration

Unrelatedproduct leasing

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

A bank acquiring a leasing company would be a form of horizontalintegration since the leasing service is closely related to the banksloan service.


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Conglomerate Integration

New businessopportunities

Some other companies enter into the leasing business as a totallyunrelated business opportunity in relation to their normal operations.New business ventures involved with leasing would represent a formof conglomerate integration. A utility acquiring a leasing companywould be an example of conglomerate integration.

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

TRENDS IN THE LEASING INDUSTRY

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

Changing Lessor Base

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

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


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Lessee Perspective

Increasedknowledge

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

Lesseemotivations

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

Changes in Products

Changingneeds

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

Leveragedleasingcontinues

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


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Profitability

New emphasison residualsand assetmanagement

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

Lessors seekother sources ofprofits

Many lessors have shifted part of their business into other financialservice products such as real estate or insurance to improveprofitability. Lessors have also looked to internal sources ofadditional profit. These include closely monitoring expenses, usingimproved software and systems, and outsourcing some services.

Tax and Accounting

Changes in taxlaws

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

Accountingstandardsevolve

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

International Markets

Worldwideeconomicgrowth

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

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


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

Economic Factors

Used equipmentleases

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

Productrequests

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

SUMMARY

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

n Profitability

n Income tax benefits

n Financial leverage

n Residual value

n Vendor leasing issues such as market control, product distinction, and increasedsales through bundled services

n Expansion (integration) opportunities

n International opportunities

Another key concept presented in this unit is that economic changes in the U.S. and abroadare having a strong effect on leasing trends. Economic ups and downs have led to more


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mergers and acquisitions. Changes in the U.S. economy and tax laws are forcing lessors toseek other ways to make profits. Lessees are seeking more full service packages and areleasing more used equipment. Lessors are changing their leasing products to better meetlessees needs and wants. Also, leasing is becoming more global in scope. U.S. lessors arebecoming more active abroad and foreign leasing companies are doing business in theU.S.

You have just completed Unit 1: Understanding the Leasing Industry. Please completethe following Progress Check before you continue to Unit 2: Lease Classifications Financial Reporting and Tax Classification. If you answer any question incorrectly, youshould return to the text and read that section again.


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PROGRESS CHECK 1.3Directions: Select the correct answer to each question. Check your answers with


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

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

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

____ c) a third party receives the lessee payments and remits the proper amountsfor services to the maintenance and insurance providers.

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

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

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

_____ b) single-investor lease, the lender owns the property; while in a leveragedlease, the lessor owns the property.

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

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


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ANSWER KEY

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

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

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

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


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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 forup-front cash.

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

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

Question 4: Residual value is

[citibank] asset based finance citibank(bookos-z1.org)

Documents

equipment leasing

leasing industry introduction

united states leasing

industry viewpoint

lease brokers

market segments

middle market

independent leasing