How to Calculate the Best Amortization Rate
Choosing the right amortization rate for leased fleet vehicles will have a positive impact on your cash flow; however, some fleet managers choose to stick with the “standard” rate,
which can result in a roller coaster ride.
While sometimes used interchangeably with “depreciation,” amortization is an accounting entry, rather than a fixed fleet cost. Both terms are important figures for fleet managers to know. However, while there are limits to what can be done about depreciation, amortization is a number fleet managers have complete control over.
If it is merely an accounting entry, why is amortization important? Because the rate chosen will determine the rate at which cash flows in and out of the company during the service life of fleet vehicles. Knowing how to choose and calculate the right amortization rate for fleet is a basic tenet of successful fleet management.
Merriam-Webster’s defines amortization as “the gradual reduction or writing off of an asset over time.”
In the fleet industry, amortization is exactly that, and it is accomplished in an open-end terminal rental adjustment clause (TRAC) lease, the most common type of fleet lease, via the major portion of a monthly lease payment.
The concept is relatively simple. Most fleets replace vehicles under some regular criteria, usually an algorithm of time and mileage (e.g., 36 months or 36,000 miles). Fleet leases contain a TRAC, which states that when a vehicle is sold proceeds are applied against a pre-determined remaining net book value (NBV). If those proceeds are greater than the vehicle’s value, the lessee receives the excess; if they are lower than the vehicle’s value, the lessee must pay the difference.
Fleet managers determine this value, in consultation with the lessor, by choosing a rate at which the original capitalized cost of the vehicle is reduced each month, such that when the vehicle is replaced and sold, the value is a fair representation of the market value. In this manner, the lessee will ultimately pay the lessor the entire original cost of the vehicle — no more, no less.
Amortization rates are usually expressed in months or as a percentage of the original value. For example, a very common rate is 50 months or 2-percent-per-month. Thus, if a vehicle costs $15,000, the monthly amortization amount is $300:
Each month, as lease payments are made, $300 is deducted from $15,000, so that after the first month’s payment, the unamortized value would be $14,700 ($15,000 - $300 = $14,700); after month two, it would be reduced to $14,400, etc.
Now, say the vehicle accumulates the replacement policy mileage of 65,000 miles in the 30th month in service. At this point, the unamortized “book” value (assuming that the amortization rate is 2-percent-per-month) would be $6,000:
Ideally, this remaining value would accurately represent a true market value at or around $6,000. The cash flows represented by this transaction would be a series of 30 outflow (lease) payments of $300, offset by the tax benefit of their deductibility, with one final cash flow of the excess (inflow) or shortfall (outflow) of the resale proceeds applied to the unamortized balance (also offset by the tax effect).
Gain or Loss?
As tax time approaches, you hear it often from friends, family members, even in commercials for tax preparers: “I’m getting a refund!” People work hard at getting the largest refund of taxes that have been withheld from their paychecks for the past year. Not considered in this comment, however, is the fact that the government has had use of this money, without cost, for anywhere from one to 12 months — an “interest-free loan,” so to speak.
In much the same manner, some fleet managers (and their lessors, too) will boast that they “gain” hundreds — sometimes thousands — of dollars when vehicles are sold, after the proceeds are applied against that arbitrary book value. Conversely, they’ll lament that they’ve “lost” money if the proceeds are less than the book value.
The fact is that there is no “gain,” nor can there be a “loss,” in the strict sense of these terms. As with any other debt, lessors must recover the amount lent, with an acceptable level of profit.
The open-end TRAC lease is structured such that the lessor will be paid, ultimately, for the full value of the capitalized cost of the vehicle leased, via a combination of payments from the lessee, proceeds from its sale, and the final TRAC adjustment. The lessee will never pay the lessor more or less than that agreed cost.
One example of how the open-end TRAC lease accomplishes this shows the lessee has paid precisely $20,000 for the vehicle — $12,000 via amortization payments, $7,000 via resale proceeds, and $1,000 via the final TRAC payment.
In a second scenario, the overall payment for the vehicle is also $20,000 — $12,000 via amortization payments, $9,000 from the resale proceeds, and a $1,000 credit back to the lessee in the TRAC adjustment.
The key difference, however, is that in the first example, the lessee covered the shortfall that the used-vehicle market did not “pay.” In the second scenario, the market paid more than the remaining value, and the lessee received the difference back. The open-end TRAC lease provides lessees the economic benefit of owning the vehicle, and, if structured carefully, it can, at the same time, offer the accounting and tax treatment of a lease (this may change for some companies with the adoption of new international accounting standards for leases that are currently in process).
Notice how we’ve been careful to note that these payments are to the lessor; that is, the lessee will pay to the lessor the full value, no more or less. But, from an economic standpoint, where there is a TRAC adjustment back to the lessee for resale proceeds in excess of book value, the total cash flows out (for the vehicle cost) can be less than the capitalized cost. But, it will never be more.
The Purpose of Amortization
Thus, we see how amortization works, what it is, and how the flows of funds from and to the lessee happen. But, what is the ultimate purpose of amortization, as it applies to fleet vehicle transactions?
Much in the way that tax depreciation is set up to fairly match the decline of the value of an asset to its decline in the free market, amortization is an accounting process set up to do the same thing. Fleets of all sizes have vehicle use that differs from one another. Some are high mileage, such as those in rural areas where customers can be hundreds of miles apart. Others don’t accumulate mileage as quickly, such as those in urban settings where customers are more densely located. Some travel difficult terrain, others cruise on the interstates. The point is, the amount of original value retained for any vehicle will depend on factors that include condition and mileage — retained value can vary dramatically even for identical vehicles whose usage varies.
So, as a fleet vehicle’s value can vary, the lease transaction should match the value anticipated as closely as possible when the vehicle will be replaced.
Ease of administration, however, will point some fleet managers to use only one or two amortization rates for the entire fleet, as with the 2-percent-per-month, or 50-month rate, mentioned at the outset of this article. While this might work well for some, a plurality, even a majority of the fleet, there are always vehicles whose usage and mileage accumulation require amortization rates better suited to these factors.
In a perfect world, the purpose of amortization is to reduce the original value of a vehicle, such that when it is taken out of service and sold, the resale proceeds exactly match the unamortized book value.
Clearly, we don’t live in a perfect world; the used-vehicle market is much like any other commodity market. Values rise and fall daily, even hourly, and it is nearly impossible to anticipate two, three, four, or more years in advance what the market will be.
But, with a careful analysis of markets and internal history, the best amortization rates can be selected. Why are such rates better than, say, those which result in large payments or credits? Two words: cash flow. Your treasury and financial staff prefer even, predictable cash flow to that which has large peaks and valleys.
These can occur when amortization rates are set purposefully to either over- or under-amortize the original cost. The reason for the former is usually that it “gets the amortization out of the way,” such that the book value when the vehicle is sold is artificially low, and the TRAC adjustment results in a large credit (cash in-flow) back to the company. Under depreciating results in the exact opposite: artificially low lease payments with the balance of the pay down occurring with a large chargeback after resale. The fact is neither is very beneficial.
Let’s create an example of over amortizing a vehicle, with the goal of creating a large credit back after resale.
We’ll look at it using the concepts of present value, which holds that a dollar tomorrow is worth less than the same dollar today (the reverse is also true, that a dollar today is worth more than a dollar tomorrow).
We’ll assume that a vehicle with a capitalized cost of $20,000 accumulates 25,000 miles per year, is replaced after 30 months in service, and that the anticipated value at replacement is $6,000. First, we’ll calculate the anticipated depreciation of the car:
The vehicle has depreciated 70 percent of its original cost.
Now, we can calculate what the amortization rate should be:
Thus, the amortization rate on this vehicle, if set at 2.33 percent per month ($466 per month), will result in a “break even” when the car is sold. Using present value, we can now see what the cost of this break-even scenario would be at the inception of the transaction. Using a 2-percent discount rate, the total of the monthly $466 amortization payments is $13,625.18.
There is no need to present value the final $6,000, since the lessee isn’t making that payment, the used-vehicle market is.
Now, let’s over-amortize the vehicle, paying the value down at a faster rate so that the final adjustment results in a credit back (much in the same way a taxpayer chooses to over-withhold taxes to get a big return when filing taxes). Rather than the 2.33-percent-per-month rate, which results in a break even, we’ll do the calculations using a 3-percent-per-month rate:
A series of 30 monthly payments of $600 would reduce the value down to $2,000. The resale value of $6,000 would then result in a final TRAC adjustment of a $4,000 credit back to the lessee. Now, we can present value this stream, and compare it to the break-even scenario.
The $600 monthly amortization payments, made over 30 months, with a 2-percent discount rate, have a present value of $17,543.15. The final credit of $4,000 back to the lessee would have a present value of $3,806.51, and results in a total net present value in the transaction of $13,736.64 ($17,543.15 - $3,806.51 = $13,736.64).
Thus, over-amortizing the vehicle cost so that there is a large, final payment back to the lessee, is actually more expensive than the break-even scenario by $111.46, using present value in the calculations.
We’ve now seen that over-amortizing a vehicle so that there is a lower unamortized book value when the vehicle is replaced, and resulting in a large credit back after the sale, is slightly more expensive than the break-even rate.
What if the cap cost is under-amortized, reducing the amortization payment stream with a single larger payment in the future? We’ll reduce the break-even rate by the same amount we used to increase it when over-amortizing; this results in a monthly amortization rate of 1.67-percent-per-month.
Let’s see what this does to our transaction; we’ll use the same sequence of calculations as we did in the over amortization example:
Here, the fleet manager has chosen to essentially delay paying down the original value during the time in service (reduced monthly amortization), preferring to pay a large balance after the vehicle is sold.
The present value of this smaller payment stream is $9,765.69, and, the present value of the final $3,980 TRAC payment is $3,806.51, resulting in a total present value of $13,572.20 ($52.98 less than the break even).
So, what do these examples show us? From a financial perspective, the cash flows from under- or over-amortizing a vehicle are pretty much the same, using present value. There is little advantage (or disadvantage) to either when compared to the proper, break-even scenario.
That said, most treasurers would tell you they prefer a steady, predictable flow of funds to one that includes a large, single flow (either in or out of the company) at some point. Predictability, in cash flow, as in other disciplines, such as manufacturing, makes managing the company’s finances much easier, all things being relatively equal.
Choosing Amortization Rates
It is reasonable to assume that there is little likelihood that a fleet manager can peg what a break-even amortization rate should be to the dollar. That said, it is also reasonable to assume that, with the right kind of historical data and close tracking of the used-vehicle market, a smart fleet manager can come pretty darn close to doing so.
A “one-size-fits-all” amortization schedule, unless the use of all the vehicles in a fleet is the same, won’t accomplish the basic goal of matching amortization to market depreciation, and creating the even cash flows that treasury and finance people crave.
Here are the basics of calculating the proper amortization rates for all of the vehicles in your fleet:
• The purpose of amortizing vehicles is to reduce the capitalized cost as closely as possible to what the fleet manager believes the future value of the vehicle will be when it is replaced.
• This should be done so with the assistance and cooperation of the fleet lessor.
• In most fleets, different vehicles will experience different usage, in mileage, topography, territory size, and other factors.
• The more severe the use, the faster vehicles should be amortized.
• Financial management prefers even, predictable cash flows.
• There are no great advantages or disadvantages to over-amortizing (to get a large TRAC credit back) or under-amortizing (to get lower lease payments, and pay the balance owed later) vehicles.
• Any comparison or analysis should be done using present/future values of the cash flows involved.
• While it may seem simpler to try to use as few amortization rates as possible for both the fleet and the lessor, the goal in choosing the right ones should not be simplicity or administrative ease.
• The goal should be a simple one: to match the amortization to the anticipated depreciation the vehicles will experience.
Keep in mind there will be some cases, particularly with vehicles that aren’t used severely (executive vehicles, for example), and/or that have unusually high value retention (executive vehicles), where the actual depreciation curve can be a very long one.
Lessors may not be able to accommodate such lengthy amortization rates (beyond five or six years — for example, for autos), simply because of their own internal fund matching and risk aversion. In such cases, under amortizing may be a necessity. However, for the most part, lessors are valuable resources in helping determine the amortization rates right for fleet. FF