Basics of Lease Pricing

Transcription

1 Basics of Lease Pricing 2014 ELFA Lease Accountants Conference Kathleen Walseth - U.S. Bank Equipment Finance Scott Thacker- Ivory Consulting Corporation 1

2 Disclaimer US Bankcorp and its affiliates and Ivory Consulting do not provide tax, accounting or legal advice to third parties. Any discussion of U.S. tax matters contained herein (including any attachment) is not intended or written to be used and cannot be used by any taxpayer for the purpose of avoiding U.S. tax-related penalties. If the discussion related to U.S. tax matters is used to promote, market, or recommend any transaction or investment, the discussion was written to support the promotion or marketing of the transaction or matters addressed and each taxpayer should seek advice based on the taxpayer s particular circumstances from an independent tax advisor. 2

3 Topics Elements of Lease Pricing Goals Lessee Perspective Lessor Perspective Taxes Pricing Measures Other Considerations 3

4 The Goal of Lease Pricing The goal of lease pricing is to structure a lease that meets both the lessor s and lessee s objectives Lessor s objective usually expressed as a after-tax return, including secondary costs, but must also consider credit risk, asset risk, and tax risk Lessee Lease vs. Buy An economic decision based upon the NPV of comparative after-tax cash flows Lessee objective usually expressed as PV benefit, average rent, or borrowing cost IRR Objectives for both the lessee and lessor include desired accounting treatment and tax treatment 4

5 Lessee Pricing Perspective 5

6 Which Option would you choose? Option #A 60 Payments of $1,593 Option #B 60 Payments of $1,933 Option # C Buy for $100,000 End of term PO FMV End of term $1 out Put 20% down & finance at incremental borrowing rate 6

7 Lease vs. Buy Analysis Analysis done by the lessee to determine if a tax lease financing is more costeffective than borrowing to buy the equipment. Calculation is a discounted cash flow analysis: LEASE Calculates the PV of the after tax cash flows of the lease Rent to be paid less the tax benefit of deducting the rent Tax deductions are adjusted for impact of NOL and AMT LOAN Calculates the PV of the after tax cash flows of a loan Loan Payments to be paid less the tax benefit of deducting the interest on loan & depreciation of the asset net of the after tax gain on sale of the asset Tax deductions adjusted for impact of NOL and AMT Must assume the asset is either sold under loan or bought under the lease assumptions to be comparable The Lowest PV of the 2 choices = the lowest after tax cost 7

8 Why Do Customers Lease? Manage Assets Obsolescence Uncertain Future Need Manage Accounting Ratios/Credit ratings Covenant restrictions Convenience Multiple takedowns Small ticket Size Servicing Manage Taxes Manage regulatory issues 8

9 Lease VS Buy Advantages of leasing Advantages of buying Lower up-front down-payment costs Payments often are less Less liability on the balance sheet; Equipment available for short-term needs; Access to and use of the latest technology; and For tax purposes, lease payments are considered production expenses. Easier to replace or Owned equipment has asset value and may be used as collateral against other loans; No security deposit requirements ( No use limitations Increased asset value on the balance sheet. 9

10 Lessor Pricing Policy 10

11 Lessor Pricing Policy Every lessor must develop a pricing policy Pricing should be calculated using the same methods that management and shareholders use to measure results Pricing results should be the basis upon which incentive compensation/commissions are paid so that commissions are paid for profits generated Pricing assumptions should be a part of business plans, budgets and forecasts What about the market?????? 11

12 Lessor Pricing Policy Tying In Pricing To Legal Books/Management Profitability Reports Pricing should be calculated on an accounting basis so that, if you achieve the pricing, the priced yield will be the result on both the legal books and management profit reports. This is key for True and Municipal Leases. For non-tax leases, the pricing and accounting models have no differences. Using this approach will eliminate any need for reconciliation and insure that your pricing discipline will create the results you plan for. 12

13 Lessor Pricing Policy Basic Formula The basic pricing formula is: Cost of Funds Profit + + Cost of Doing Business Cost of Credit COC CODB COF + Profit Target - Other Income = Rate to Customer Rate to customer is lower because of other income 13

14 Lessor Pricing Policy Drilling Down Cost of Funds: o Incremental borrowing cost to match fund portfolio, while eliminating interest rate risk Cost of Doing Business (expenses): o Fully-loaded, based on current year budget or forecast o Origination, Servicing and Overhead Unit cost analysis recommended o Ignore Initial Direct Costs IDC accounting deferral Cost of Credit: o Based on risk ratings and expected loss norms o Adjusted for historical portfolio performance Other Income: o Late fees, documentation fees, renewal rents, residual gains, syndication fees o Only if very predictable, high certainty Profit Target: o Pre-tax annual basis points needed to satisfy shareholders return on asset or return on equity requirements, as established by senior management Income Taxes: o Incremental combined income tax rate (Federal, State, Local) excludes one-time gains/losses or temporary items 14

15 Pricing Model Assumptions: Direct Finance Lease with a fair market value (FMV) purchase option Equipment Cost $25,000 Term 5 Years Residual 2,500 Yield 9.50% COF 4.50% Origination Cost $ upfront Servicing Cost $ Overhead Cost $34.72 Cost of Risk 1.50% Late Fees 0.75% Residual Gain % 20.0% Other Revenue 0.05% Tax Rate 40.00% Amortization Costs (b) Other Revenue (c) (a)-(b)+(c) (a) Pre-tax After-tax Year Begin Bal. Payment Principal Interest of Funds Origination Servicing Overhead of Risk Late Fees Resid. Gain Other Rev Earnings Taxes Earnings ROA 1 25, , , , , % 2 21, , , , % 3 17, , , , % 4 12, , , , % 5 7, , , % Total 84, , , , , , , , % Weighted Avg ROA 1.75% ROA Hurdle 1.50% Required Yield 9.09% NPV of A/T Earnings % discount rate (ROE hurdle) NPV of Beg Bal 60,325 NPV ROA 1.59% Required Yield 9.35% 15

16 Tax Benefits 16

17 Tax Benefits True Lease Solution Issue Client is not a full U.S. taxpayer due to NOLs, AMT or other reasons and is seeking to efficiently utilize tax benefits of equipment ownership for purpose of achieving financing rates lower than alternative borrowing rates Solution A direct finance lease (or leveraged lease) is a taxadvantaged, asset-based financing which typically qualifies as an operating lease for lessee accounting and a true lease for tax purposes 17

18 Tax Benefit Impact of Income Taxes For tax purposes, a lease is either a true lease or a loan ( conditional sale ) A true lease results in the lessor being the asset owner for income tax purposes a hard asset taxation model Tax return for a true lease generally includes: Depreciation (computed using MACRS system) Rental income Interest deductions Residual income 18

19 Tax Benefit Lease Tax Deferral Single Investor Lease - Lease versus Loan Taxation Lease taxable income = Rent Depreciation Loan taxable income = (Interest + Principal) Principal Tax deferral benefit due to faster pre-tax depreciation write-off versus loan principal amortization 19

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21 Time Value of Money Best to receive payments as soon as possible and make payments as late as possible Value of lease to lessor or lessee is dependant on their ability to utilize tax benefits, combined with their relative time value of money Rent deferral Tax deferral Longer lease terms and 90/110 rents increase rent deferral. Lessees prefer rent deferral, but such deferred rent may be higher to compensate the lessor. For a lessee with a higher time value of money, this still can be advantageous. Most tax incentives promote investment via tax deferral Depreciation - the more accelerated, or shorter-lived, the greater the tax deferral. Bonus depreciation Cash rent prepayment possible under Section 467 Interest rates Benefit of leasing very sensitive to interest rates Lessors favor higher market rates Greater benefit to lower credit/higher rate borrowers Maximize Net Present Value of After-Tax Cash Flows 21

22 Tax Benefits Yield Measure Three Components of a Lessor s return Lessor s achieve returns and recover their investment from three sources: Rents Residual Tax Benefits After-tax yield Pre-tax equivalent of after-tax yield Pre-tax yield Yield Measure of Tax Benefits? Pre-tax equivalent yield Pre-tax yield 22

23 Pre and After Tax examples Consider a $100,00 deal, 60 monthly pmts in advance, 20% resid, starts Oct 1. 5 year MACRS property. Lessor has 35% Federal tax rate, with a calendar fiscal year Pretax: 6% Nominal IRR After-tax 7.11% pre-tax equivalent MISF yield. Conclusions: Taking taxes into consideration gives a 111 basis point better yield; Giving that tax benefit to the customer results in a 3% lower rent and 12% lower customer rate. Competing against after tax pricing with pretax pricing is an uphill battle. 23

24 Bonus Depreciation What Is 50% Bonus Depreciation? A form of accelerated depreciation equal to 50% of the cost of new property plus normal accelerated depreciation Deduction allowed for both regular tax and AMT What Are The Major Rules? Applies only to qualified property Original use with taxpayer, subject to some exceptions Timely acquisition Timely placed in service 24

25 Tax Update 3Q 2014 American Taxpayer Relief Act of 2012 Bonus Depreciation-50% Bonus depreciation expired end of House passed bill to make permanent-unlikely to become law. (Cost $276 Billion over 10 years) Section 179 deduction reverted back to $25,000 In June, the U.S. House passed H.R. 4457, the American Small Business Tax Relief Act of This legislation would permanently extend Section 179 with a deduction limit of $500,000. Estimated cost $73 Billion over 10 years. The Statutory Pay-As-You-Go Act of 2010 establishes budgetreporting and enforcement procedures for legislation affecting direct spending and revenues 25

26 Tax Exempt Leases Where the lessee is a state or local government agency (municipal) or a not for profit 501(c)(3) entity that utilizes a municipal entity (conduit) to access tax-exempt financing. The gross interest income and cost of funds are both 100% tax-deductible for the lessor The lessor must comply with de minimis standards: tax-exempt assets cannot exceed 2% of a company s total third-party assets. Otherwise, the lessor loses the 100% deduction for cost of funds expense on the entire tax-exempt portfolio. 26

27 Summary Tax Considerations IRS Tax Rate / Effective Tax Rate Transfer Taxes Depreciation Tax Credits Rent Deferral/Prepayment True lease guidelines (Rev. Proc ) Higher income tax rate increases value of tax deferral Net Operating Loss (NOL) position Change in tax rates Sales taxes impact lease/buy decision Shorter life/faster method increases tax deferral (MACRS) Bonus depreciation Tax-exempt use property Like-kind exchange (Sec 1031) Investment tax credits Cash grant Variability of taxable rents (Sec /110 test) Prepaid / deferred rents (Sec 467) Interest Deduction Non-recourse debt/recourse debt (Sec 861) Debt principal amortization (level vs. optimized) Fees Paid Deduction Tax amortization reduces deferral benefits Maximize Net Present Value of After-Tax Cash Flows 27

28 Pricing Metrics IRR, MISF ROA, ROE, RAROC 28

29 Pricing Measures Internal rate of return Unique discount rate that equates present value of cash outflows with present value of cash inflows Most common method to compute yield IRR assumes that all cash flows have the same reinvestment opportunity or cost In case of multiple sign changes in cash flows, more than one IRR can be found Which is correct? Both are correct, which is a shortcoming of the IRR method Example courtesy of Warren & Selbert 29

30 Pricing Measures Multiple investment sinking fund Similar to IRR, but uses two rates of return to calculate yield MISF method avoids problems of multiple solutions and allows a specified rate to be applied to surplus funds Equity investment earns at the yield rate, and surplus cash (before it is depleted by later cash outflows), earns at sinking fund rate SFAS 13 o o Method for recording accounting earnings in a leveraged lease ( investment with separate phases method ) Requires a zero sinking fund rate for accounting earnings Period Cash Flows Sinking Fund Flow Cash Flow After Sinking Fund Return At 10% Investment Balance Sinking Fund Earnings At Sinking Fund 5% Balance Totals Example courtesy of Warren & Selbert 30

31 Pricing Measures: Comparison IRR: almost always pre-tax and unloaded ADVANTAGE: Largely understandable by lessee - most nearly apples to apples comparison for lessee and lessor where rents are major component of lessor return. DISADVANTAGE: Does not reflect lessor s true economics or accounting for leases with high residuals and/or tax benefits. MISF: usually after-tax, may be loaded ADVANTAGE: Includes taxes and may include expense loads. DISADVANTAGE: May not include cost of funding the transaction. HIDDEN ISSUE: Values tax deferrals as cash, which, while economically defensible, does not map to direct finance lease accounting. 31

32 Pricing Measures: Comparison ROE: almost always after-tax, contains Borrowing costs at a corporate level; Portfolio-level expenses; ADVANTAGE: Includes taxes, expenses and corporate borrowing costs. DISADVANTAGE: Tends to be opaque to users. HIDDEN ISSUE: Can be set up to consider tax deferrals as either a reduction in borrowing costs (acceptable to accounting) or cash (often considered more reflective of economic reality). 32

33 Pricing Measures: Comparison Risk-Adjusted Returns (RAROC) Based on a ROE-type calculation, with variable capital allocations, determined by risk factors. Typically has very sophisticated cost allocations. ADVANTAGE: Translates well to Basil requirements, allows for more sophisticated modeling of risk, applies corporate allocation methodology at a transaction level. DISADVANTAGE: Tends to be very opaque to users. 33

34 Risk-Based Returns Risk-Adjusted Return on Capital: RAROC Driven partly by regulatory concerns Required in EU Sufficiency of capital judged by looking to overall risk profile of each transaction Overall risk used to allocate capital More risk means more capital allocated; Caution: top credits show high yields on tiny capital, but shed little cash: the 20% plus lunch phenomenon Always use RAROC in conjunction with other yields 34

35 Pricing Measures: Comparison Other common measures (e.g., spread) are based on one of the above methods. ROA: The premiere accounting yield ADVANTAGE: Since ROA is what the analysts are doing on the back on an envelope, ROA is how the world sees your leasing company. DISADVANTAGE: ROA tends to obscure some valuable economic data (e.g., payment timings) that are captured in other yields. 35

36 Measuring Tax Deferral Benefits MISF: measuring deferrals as cash On tax payment dates, recognizes negative tax cash inflows Treats those negative taxes just like any other cash flow Result: an MISF Yield will be typically 50 to 120 basis points better than an similarly calculated pre-tax yield (IRR) Makes sense for entities who don t have to report, but doesn t work under GAAP 36

37 Measuring Tax Deferral Benefits Book ROE: considering deferrals as reductions in borrowing Each period, calculates cost saving of not having to borrow the deferred tax balance; Allocates those savings to the transactions Result: an after-tax Book ROE Yield will be typically 25 to 60 basis points better than an similarly calculated pre-tax yield book yield. (Note: ROE calculation methodologies vary greatly, so these results are *very* approximate.) 37

38 Other considerations 38

39 Exposure Draft-FASB & IFRS part ways? FASB sticks with the two accounting methods Direct Finance Lease vs Operating lease Classification in line with IAS 17-no bright lines Short term definition only includes renewals with significant incentive to exercise. Capitalization of assets and liability of operating leases reported separately on Balance sheet (not debt) Overall good news with limited impact to US lessees and lessors 39

40 Limited potential Impact on pricing More one year lease with renewal options? How does Asset risk get priced in? More awareness of interim rent and end of term? 40

41 Other Pricing Considerations Art vs. Science Market/Competition Fixed vs. Marginal costs Hold on balance sheet vs. securitize/syndicate Business Strategy - revenue growth vs. profitability 41

42 Q&A 42

43 Appendix 43

44 Pricing Terminology Basis Point One-hundredth of one percent 0.50% = fifty basis points Cost of Credit Credit write-offs less recoveries a.k.a. net credit losses and cost of risk Residual Value The amount a lessor books as a future value at the end of the lease term, and is usually less than the expected future fair market value ROA/ROE (Net) Spread Tax Benefits Yield (gross) Return on Assets and Return on Equity hurdles set by senior management to satisfy shareholders The lessor's yield minus the cost of funds rate Depreciation is the major tax benefit. Other benefits include tax credits and like-kind exchange The rate whereby the NPV of lease payments including any future value (residual) equals the original funded amount a.k.a. implicit rate, internal rate of return 44