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In the July, 1997 issue of the Lessee Letter, I discussed lease termination values. That article provides a useful platform from which to develop a presentation of stipulated loss values (also known as casualty values).

The reader may recall that, in theory, termination values are designed to protect the lessor's yield in a lease that is cancelled prior to the end of the lease term. Termination values are typically conservatively calculated, since they make the lessor whole without the lessor receiving any proceeds from sale or remarketing of the equipment whatsoever. This is the reason termination values are said to "protect" the residual originally booked - the residual is realized without selling it!

If equipment is destroyed at the hands of the lessee, the lessor's ability to realize a higher than anticipated residual is destroyed along with the equipment. This is the definition of a casualty loss.

From the lessor's point of view, the theoretical difference between a termination and a casualty is a layer of residual value commonly referred to as "upside". Upside is the difference between the residual the lessor booked in a lease and what it believed it could actually get for the equipment upon disposition. These are rarely the same numbers, since lessors book conservative residual values to avoid unpleasant surprises (realized residuals less than booked residuals).

Since casualty losses automatically extinguish the possibility of residual upside, casualty or stipulated loss values should always be greater than termination values. If a lessor provides a schedule of values and indicates it is to be used for either termination of stipulated loss purposes, this should be a red alert that the termination values are inflated (it could mean the casualty values are understated, but this never happens).

Arithmetically, the difference between a termination and a casualty value should be the present value of the residual upside the lessor estimates might be experienced at the end of the lease term. More specifically, suppose a lessor books a 10 percent (of equipment cost) residual in a leasing transaction, but believes the equipment will likely be disposed of for 18 percent at the end of the lease term. The casualty value applicable to month t during a lease of n months would equal the termination value applicable to month t, plus the present value of the extra 8 percentage points of residual upside discounted back to month t (i.e., discounted for n-t months).

Casualty values are an important issue, since they are invoked for unforeseeable events. Casualty values take an additional importance for leased assets that are easily lost or stolen, and when a lessor's form lease is being used. Virtually all lessor form leases with which the author is familiar state that lost equipment will be deemed a casualty occurrence. For rapidly depreciating leased property (desk top computers, printers, fax machines, and the like), the lessee would be wise to have the contractual option to replace lost equipment with like kind equipment.