The Basics of Pricing Lease Transactions
ELA Lease Accountants Conference
September 18-20, 2006 - San Antonio, TX
Bill Bosco, Leasing 101
David Holmgren, Ivory
Suresh Makam, CitiCapital
Table of Contents
•  Overview of Pricing Methodology
•  Pricing Models
•  True Leases and Tax-Exempt Leases
•  Other Considerations (Art vs. Science)
•  Key Terminology
Pricing Philosophy
•
Every business 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.
Tying In Pricing To Legal Book/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.
Basic Formula
•  The basic pricing formula is:
Profit
Cost of Funds
+ Cost of Doing Business
+ Cost of Credit
+ Profit Target
COF
COC
CODB
- Other Income
= Rate to Customer
Rate to customer is lower because of
other income
Drilling Down…
•
Cost of Funds:
- incremental borrowing cost to match fund the portfolio, while eliminating interest rate risk
•
Cost of Doing Business (expenses):
- fully-loaded
- based on current year budget or forecast
- Origination, Servicing and Overhead
- unit cost analysis recommended
- ignore Initial Direct Costs “IDC” accounting deferral
•
Cost of Credit:
- based on risk ratings and expected loss norms
- adjusted for historical portfolio performance
•
Other Income:
- late fees, documentation fees, renewal rents, residual gains, syndication fees
- only if very predictable, high certainty
•
Profit Target:
- pre-tax annual basis points needed to satisfy shareholders’ return on asset or return on equity
requirements, as established by senior management
•
Income Taxes:
- incremental combined income tax rate (Federal, State, Local)
- excludes one-time gains/losses or temporary items
Sample Lessor’s Management Profitability Report (MPR)
$ thousands
2005 Est.
100,000
40,000
2004
100,000
40,000
2003
90,000
40,000
2002
80,000
30,000
10,000
(5,000)
750
600
50
6,400
11,000
(6,000)
750
600
50
6,400
10,800
(6,300)
450
500
35
5,485
9,600
(5,600)
400
100
25
4,525
1,000
1,250
250
2,500
1,000
1,200
250
2,450
1,000
1,100
250
2,350
850
1,000
250
2,100
2,500
(1,000)
1,500
2,500
(1,000)
1,500
1,800
(900)
900
1,200
(400)
800
Pre-Tax Earnings
Taxes (40%)
After-Tax Earnings
2,400
(960)
1,440
2,450
(980)
1,470
2,235
(894)
1,341
1,625
(650)
975
ROA
ROE (10% equity allocation)
1.44%
14.4%
1.47%
14.7%
1.49%
14.9%
1.22%
12.2%
Net Leases & Loans (avg)
Annual New Business Volume
Lease & Loan Income
Cost of Funds
Late Fees
Residual Gains
Other Revenue
Net Revenue
Origination Costs
Servicing Costs
Overhead Costs
Total Expenses
Write-offs
Recoveries
Net Losses
Pricing Analysis
Average Ticket Size
Average Term
$25,000
5 years
# new contracts booked
# contracts in portfolio
Origination Costs
New Business Volume
Origination Costs
% of NBV
Annual cost per new contract
Servicing Costs
Servicing Costs
Annual cost per contract
2005E
2004
2003
2002
1,600
7,200
1,600
6,600
1,600
6,000
1,200
4,400
$40,000,000
$1,000,000
2.5%
$625.00
$40,000,000
$1,000,000
2.5%
$625.00
$40,000,000
$1,000,000
2.5%
$625.00
$30,000,000
$850,000
2.8%
$708.33
$1,250,000
$173.61
$1,200,000
$181.82
$1,100,000
$183.33
$1,000,000
$227.27
Overhead Costs
Overhead Costs
$250,000
Avg Portfolio
$100,000,000
% of portfolio
0.25%
% of NBV
0.63%
Annual cost per new contract
$156.25
Annual cost per contract
$34.72
$250,000
$100,000,000
0.25%
0.63%
$156.25
$37.88
$250,000
$90,000,000
0.28%
0.63%
$156.25
$41.67
$250,000
$80,000,000
0.31%
0.83%
$208.33
$56.82
Cost of Risk
Net Write-offs
Avg Portfolio
% of portfolio
$1,500,000
$100,000,000
1.50%
$1,500,000
$100,000,000
1.50%
$900,000
$90,000,000
1.00%
$800,000
$80,000,000
1.00%
Late Fees
Late Fees
Avg Portfolio
% of portfolio
$750,000
$100,000,000
0.75%
$750,000
$100,000,000
0.75%
$450,000
$90,000,000
0.50%
$400,000
$80,000,000
0.50%
Residual Upside
Residual Upside
Residuals Maturing
Residual Gain %
$600,000
$3,000,000
20.0%
$600,000
$3,000,000
20.0%
$500,000
$2,500,000
20.0%
$100,000
$500,000
20.0%
Other Revenue
Other Revenue
Avg Portfolio
% of portfolio
$50,000
$100,000,000
0.05%
$50,000
$100,000,000
0.05%
$35,000
$90,000,000
0.04%
$25,000
$80,000,000
0.03%
Pricing Model
Assumptions:
New Business Volume
Origination Costs
% of NBV
Annual cost per new contract
Servicing Costs
Servicing Costs
Annual cost per contract
Overhead Costs
Overhead Costs
Avg Portfolio
% of portfolio
% of NBV
Annual cost per new contract
Annual cost per contract
$250,000
$100,000,000
0.25%
0.63%
$156.25
$34.72
Cost of Risk
Net Write- offs
Avg Portfolio
% of portfolio
$1,500,000
$100,000,000
1.50%
Late Fees
Late Fees
Avg Portfolio
% of portfolio
$750,000
$100,000,000
0.75%
Residual Upside
Residual Upside
Residuals Maturing
Residual Gain %
Other Revenue
AvgPortfolio
% of portfolio
$600,000
$3,000,000
20.0%
$50,000
$100,000,000
0.05%
Capital Lease with a $1.00 purchase option
Equipment Cost
Term
Residual
Yield
COF
Origination Cost
Servicing Cost
Overhead Cost
Cost of Risk
Late Fees
Residual Gain %
Other Revenue
Tax Rate
$25,000
5 Years
0
9.50%
4.50%
$625.00 upfront
$173.61
$34.72
1.50%
0.75%
0.05%
40.00%
Amortization
Year
1
Begin Bal.
25,000.00
Payment
6,510.91
Principal
4,135.91
(a)
Interest
2,375.00
2
3
4
5
20,864.09
16,335.27
11,376.21
5,946.04
6,510.91
6,510.91
6,510.91
6,510.91
4,528.82
4,959.06
5,430.17
5,946.04
Total
79,521.60
32,554.55
25,000.00
Weighted Avg ROA
ROA Hurdle
Required Yield
1.32%
1.50%
9.80%
NPV of A/T Earnings
NPV of Beg Bal
NPV ROA
Required Yield
744
57,717
1.29%
9.85%
Other Revenue
Costs (b)
Other Revenue (c)
of Funds Origination Servicing Overhead
1,982.09
1,551.85
1,080.74
564.87
1,125.00
938.88
735.09
511.93
267.57
625.00
-
173.61
173.61
173.61
173.61
173.61
34.72
34.72
34.72
34.72
34.72
7,554.55
3,578.47
625.00
868.06
173.61
15% discount rate (ROE hurdle)
of Risk Late Fees Resid. Gain Other Rev
375.00
187.50
12.50
312.96
156.48
10.43
245.03
122.51
8.17
170.64
85.32
5.69
89.19
44.60
2.97
1,192.82
2005 E
$40,000,000
$1,000,000
2.5%
$625.00
Origination Costs
596.41
-
39.76
$1,250,000
$173.61
(a)-(b)+(c)
Pre-tax
Earnings
241.67
688.82
494.08
280.84
47.35
Taxes
96.67
275.53
197.63
112.34
18.94
After-tax
Earnings
145.00
413.29
296.45
168.51
28.41
ROA
0.58%
1.98%
1.81%
1.48%
0.48%
1,752.76
701.10
1,051.66
1.32%
Pricing Model
Assumptions:
Capital Lease with a fair market value (FMV) purchase option
Equipment Cost
Term
Residual
Yield
COF
Origination Cost
Servicing Cost
Overhead Cost
Cost of Risk
Late Fees
Residual Gain %
Other Revenue
Tax Rate
$25,000
5 Years
2,500
9.50%
4.50%
$625.00 upfront
$173.61
$34.72
1.50%
0.75%
20.0%
0.05%
40.00%
Amortization
Year
1
2
3
4
5
Begin Bal.
25,000.00
21,277.68
17,201.74
12,738.59
7,851.43
Payment
6,097.32
6,097.32
6,097.32
6,097.32
6,097.32
Total
84,069.44
30,486.60
Principal
3,722.32
4,075.94
4,463.15
4,887.15
5,351.43
22,500.00
Weighted Avg ROA
ROA Hurdle
Required Yield
1.75%
1.50%
9.09%
NPV of A/T Earnings
NPV of Beg Bal
NPV ROA
Required Yield
960
60,325
1.59%
9.35%
Costs (b)
(a)
Interest
2,375.00
2,021.38
1,634.17
1,210.17
745.89
of Funds Origination
1,125.00
625.00
957.50
774.08
573.24
353.31
-
7,986.60
3,783.12
625.00
15% discount rate (ROE hurdle)
Other Revenue (c)
Servicing Overhead
173.61
34.72
173.61
34.72
173.61
34.72
173.61
34.72
173.61
34.72
868.06
173.61
of Risk Late Fees Resid. Gain Other Rev
375.00
187.50
12.50
319.17
159.58
10.64
258.03
129.01
8.60
191.08
95.54
6.37
117.77
58.89
500.00
3.93
1,261.04
630.52
500.00
42.03
(a)-(b)+(c)
Pre-tax
Earnings
241.67
706.61
531.34
339.43
629.28
Taxes
96.67
282.64
212.54
135.77
251.71
After-tax
Earnings
145.00
423.96
318.80
203.66
377.57
ROA
0.58%
1.99%
1.85%
1.60%
4.81%
2,448.32
979.33
1,468.99
1.75%
Pricing Model
Assumptions:
Operating Lease with a fair market value (FMV) purchase option
Equipment Cost
Term
Residual
Yield
COF
Origination Cost
Servicing Cost
Overhead Cost
Cost of Risk
Late Fees
Residual Gain %
Other Revenue
Tax Rate
$25,000
5 Years
$3,750
9.50%
4.50%
$625.00 upfront
$173.61
$34.72
1.50%
0.75%
13.3%
0.05%
40.00%
Amortization
Year
1
2
3
4
5
Begin Bal.
25,000.00
20,750.00
16,500.00
12,250.00
8,000.00
Total
82,500.00
29,452.62
21,250.00
Weighted Avg ROA
ROA Hurdle
Required Yield
2.00%
1.50%
8.67%
NPV of A/T Earnings
NPV of Beg Bal
NPV ROA
Required Yield
854
59,260
1.44%
9.60%
Other Revenue (c)
Costs (b)
(a)
Payment Depreciation Rent Income
5,890.52
4,250.00
5,890.52
5,890.52
4,250.00
5,890.52
5,890.52
4,250.00
5,890.52
5,890.52
4,250.00
5,890.52
5,890.52
4,250.00
5,890.52
29,452.62
of Funds Origination
1,125.00
625.00
933.75
742.50
551.25
360.00
3,712.50
625.00
15% discount rate (ROE hurdle)
Servicing Overhead
173.61
34.72
173.61
34.72
173.61
34.72
173.61
34.72
173.61
34.72
868.06
173.61
of Risk Late Fees Resid. Gain Other Rev
375.00
187.50
12.50
311.25
155.63
10.38
247.50
123.75
8.25
183.75
91.88
6.13
120.00
60.00
498.75
4.00
1,237.50
618.75
498.75
41.25
(a)-(b)+(c)
Pre-tax
Earnings
(492.81)
353.19
574.19
795.19
1,514.94
2,744.70
Taxes
(197.12)
141.28
229.68
318.08
605.98
1,097.88
After-tax
Earnings
ROA
(295.69) -1.18%
211.91
1.02%
344.51
2.09%
477.11
3.89%
908.96 11.36%
1,646.82
2.00%
True (Tax) Leases
•
The Lessor bears the risks and rewards of ownership, and
therefore receives benefits of accelerated depreciation on
the income tax return
•
Unlike Capital and Direct Finance Leases, True Leases do
not have constant spreads and rates of return
•
The challenge is to translate tax benefits into both the
management reports and pricing models, using the same
methodology and measurements.
MISF Yield
•
MISF (Multiple Investment Sinking Fund) Yield is the most
widely practiced measurement method.
•
MISF represents the rate of return of after-tax cash flows
based on the net cash invested, in periods when it is positive.
•
It was derived to amortize accounting earnings on highly
structured Leveraged True Leases, where the net cash
invested can be zero or even negative.
•
It has evolved into a measurement of profitability.
MISF Profile
100%
Net Cash Invested (Net Investment – Deferred Taxes)
Net Investment (GAAP)
Residual
Inception
Expiry
•  MISF yield is the comparison of the net cash flows as compared to the net
cash invested.
•  Net Cash Invested is reduced by:
•  Cash received from rents as well as
•  the “tax refund” received from the IRS due to the depreciation (the
deferred tax balance).
MISF Pitfalls
The MISF approach does not correlate to management reporting:
•
Under GAAP and management reporting, deferred taxes are a
liability, not a contra-asset.
•
GAAP income is based on the gross yield (a.k.a. IRR or
implicit rate), not after-tax cash flows
RORA to the Rescue
RORA (Return on Risk Asset) is a better measurement
than MISF:
•  The denominator (Net Risk Asset) equals the GAAP Net
Investment.
•  Deferred Taxes are accounted for as liabilities, which
reduce actual funding costs.
•  The numerator (net after-tax profit) mirrors actual after-tax
earnings in the management reports.
•  Most True Lease pricing software models include RORA (or
ROA) as a measurement target.
RORA Profile
100%
Net Risk Asset (= Investment – rent + income)
Residual
Deferred Tax Balance
Inception
Expiry
•  Under the RORA calculation the net risk asset is not reduced by the
deferred tax balance as the risk is the unamortized balance of the your
investment.
•  The deferred tax balance is utilized under the RORA calculation as a
reduction of the amount to be funded (reduction in cost of funds).
RORA vs MISF Yield
•
•
•
•
RORA
MISF
•  Aligned with Legal Books/MPR
Yes
No
•  Numerator (Income)
Book Income
Based on after-tax cash
flows
•  Denominator (Asset)
Net Risk Asset
Net Cash Invested
•  Income Pattern
Varies by lease type
(Direct Finance,
Operating, Leverage)
Same, regardless of lease
type
•  Suitable for pricing
Single Investor and
Leveraged Leases
Leveraged Leases
Income used in RORA is book Income, not cash flows as used in the MISF
calculation (the numerator)
The base (denominator) under RORA is the average net risk asset, not the net cash
invested.
For book accounting purposes, although the total income is always the same, the
recognition pattern is very different for Operating (back-ended), Direct Finance
(slightly back-ended) and Leverage (front-ended) Leases.
RORA is very sensitive to the book earnings pattern as it uses the book earnings to
recognize return where as MISF yield uses cash flows and does not change if the
type of lease is different.
Pricing Model
Assumptions:
Operating Lease with a fair market value (FMV) purchase option, with tax depreciation benefits (True Lease)
Same as previous operating lease example:
Amortization
Year
1
2
3
4
5
Begin Bal.
25,000.00
20,750.00
16,500.00
12,250.00
8,000.00
Total
82,500.00
Costs (b)
(a)
Payment Depreciation Rent Income
5,890.52
4,250.00
5,890.52
5,890.52
4,250.00
5,890.52
5,890.52
4,250.00
5,890.52
5,890.52
4,250.00
5,890.52
5,890.52
4,250.00
5,890.52
29,452.62
Yield
Weighted Avg ROA
ROA Hurdle
Required Yield
NPV Required Yield
21,250.00
29,452.62
of Funds Origination
1,125.00
625.00
933.75
742.50
551.25
360.00
3,712.50
625.00
Other Revenue (c)
Servicing Overhead
173.61
34.72
173.61
34.72
173.61
34.72
173.61
34.72
173.61
34.72
of Risk Late Fees
375.00
187.50
311.25
155.63
247.50
123.75
183.75
91.88
120.00
60.00
868.06
173.61
1,237.50
Deferred
Tax
Balance
4,300.00
4,200.00
3,460.00
2,336.00
1,212.00
COF
Savings
193.50
189.00
155.70
105.12
54.54
Revised
Pre-tax
Earnings
(299.31)
542.19
729.89
900.31
1,569.48
618.75
(a)-(b)+(c)
Pre-tax
Resid. Gain Other Rev
Earnings
ROA
12.50
(492.81) -1.18%
10.38
353.19 1.02%
8.25
574.19 2.09%
6.13
795.19 3.89%
498.75
4.00
1,514.94 11.36%
498.75
41.25
9.50%
2.00%
1.50%
8.67%
9.60%
Calculating Tax Benefits (RORA method)
IRS MACRS
Book
Depreciation
Depreciation
IRS
% (50%
Depreciation
bonus)
Year (see above)
1
4,250.00
60.0%
15,000.00
2
4,250.00
16.0%
4,000.00
3
4,250.00
9.6%
2,400.00
4
4,250.00
5.8%
1,440.00
5
4,250.00
5.8%
1,440.00
6
2.9%
720.00
Timing
Difference
(10,750.00)
250.00
1,850.00
2,810.00
2,810.00
Deferred
Taxes
(4,300.00)
100.00
740.00
1,124.00
1,124.00
Revised
Revised After-tax
Taxes
Earnings
(119.72)
(179.59)
216.88
325.31
291.96
437.93
360.12
540.19
627.79
941.69
Revised
ROA
-0.72%
1.57%
2.65%
4.41%
11.77%
2.50%
NPV of A/T Earnings
NPV of Beg Bal
NPV ROA
NPV Required Yield
without
tax-benes
854
59,260
1.44%
9.60%
with
tax-bene's
1,155
59,260
1.95%
8.75%
Timing difference
times tax rate
15% discount rate (ROE hurdle)
Deferred Taxes are
a liability on the
balance sheet, and
therefore a free
source of funds
2,744.70
2.00%
Tax Rate
•
The proper tax rate is critical for True and Tax-Exempt
leases.
•
For True Leases use the tax rate for the legal vehicle the deal
will be booked in. Consult with your Tax Department to
insure there is enough taxable income in the vehicle.
•
For Municipal leases the Federal Tax rate of 35% should be
used, unless you can fully utilize (and measure) state and
local tax savings.
•
For non-tax deals, use the MPR tax rate at the time the deal
is booked.
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: taxexempt assets cannot exceed 2% of a company’s total thirdparty assets.
•
Otherwise, the lessor loses the 100% deduction for cost of
funds expense on the entire tax-exempt portfolio.
Pricing Model
Assumptions:
Municipal Lease (non-bank qualified) similar to Capital Lease with a $1.00 purchase option
Equipment Cost
Term
Residual
Yield
COF
Origination Cost
Servicing Cost
Overhead Cost
Cost of Risk
Late Fees
Residual Gain %
Other Revenue
Tax Rate
$25,000
5 Years
0
9.50%
4.50%
$625.00 upfront
$173.61
$34.72
1.50%
40.00%
Amortization
Year
1
2
3
4
5
Begin Bal.
25,000.00
20,864.09
16,335.27
11,376.21
5,946.04
Payment
6,510.91
6,510.91
6,510.91
6,510.91
6,510.91
Total
79,521.60
32,554.55
Weighted Avg ROA
ROA Hurdle
Required Yield
NPV of A/T Earnings
NPV of Beg Bal
NPV ROA
Required Yield
Principal
4,135.91
4,528.82
4,959.06
5,430.17
5,946.04
25,000.00
Costs (b)
(a)
Interest
2,375.00
1,982.09
1,551.85
1,080.74
564.87
of Funds Origination
1,125.00
625.00
938.88
735.09
511.93
267.57
-
7,554.55
3,578.47
625.00
5.39%
1.50%
5.61% vs. 9.50% taxable
3,093
57,717
5.36%
5.58%
15% discount rate (ROE hurdle)
Other Revenue (c)
Servicing Overhead
173.61
34.72
173.61
34.72
173.61
34.72
173.61
34.72
173.61
34.72
868.06
173.61
of Risk
62.50
52.16
40.84
28.44
14.87
198.80
None
-
(a)-(b)+(c)
Pre-tax
Earnings
354.17
782.71
567.59
332.04
74.10
-
Interest Income is 100%
tax-deductible
2,110.61
After-tax
Taxes Earnings
(808.33) 1,162.50
(479.75) 1,262.46
(393.70)
961.30
(299.48)
631.52
(196.31)
270.41
(2,177.58) 4,288.19
ROA
4.65%
6.05%
5.88%
5.55%
4.55%
5.39%
Initial Direct Costs (IDC)
Be Careful!
•
Initial Direct Costs (IDC) is an accepted accounting practice that can
defer expenses at inception so that the expenses can be amortized
over the life of the transaction to match the income recognition.
•
It should be noted that income can be misleading if the IDC is not
taken into account. The add-back or reversal of expenses will show
a one time increase in income and can temporarily show earnings
that are artificially manufactured.
•
This practice is not allowed for tax purposes.
•
If the amortization period is consistent (i.e. 5 years), after the 5th
year of this practice the accounting benefit is neutralized as long as
business is the same. If business is in the decline mode then this
practice will have a negative effect starting in the sixth year. And
conversely if business is growing a benefit will occur.
Other Considerations
Art vs. Science
•  Market/Competition
•  Fixed vs. Marginal costs
•  Hold on balance sheet vs. securitize/syndicate
•  Business Strategy - revenue growth vs. profitability
Key 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
Return on Assets and Return on Equity
hurdles set by senior management to satisfy shareholders
(Net) Spread
the lessor's yield minus the cost of funds rate
Tax Benefits
a tax advantage created by timing differences between accelerated tax
depreciation (MACRS) and straight-line book depreciation, for True Leases
Yield (gross)
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