F402/F560
Corporate Valuation and Strategy
Part 6: Valuing Operating Leases
OFF-BALANCE SHEET LEASES
The issue:
Many companies lease important equipment or buildings. They often
structure these leases so they qualify as “operating” leases, not “capital”
leases. Operating leases do not have to be included on the balance sheet.
Companies use this device to reduce the amount of debt on
their statements, which makes their debt-to-equity ratio look
healthier.
However: The equipment is, in fact, part of the invested capital
employed in the business. And these lease payments are contractual
commitments, just like loan payments.
A list of expected future lease payments is included in the
auditors’ footnotes.
The recommended treatment of operating leases:
The basic intent:
o
Include the leased equipment as part of invested capital.
It’s as if it were PP&E.
o
Include the amount owed on the leased equipment as longterm debt, in an amount equal to what was added to PP&E.
o
Reverse the implied interest expense which is a portion of
the lease payments. It’s as if they were loan payments.
o
Forecast the value of these operating leases as a percent of
sales. It’s as if they were part of PP&E.
Here’s how:
F402/560
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1. Adjust both the operating and financial calculations of invested capital.
Compute the present value of the lease commitments, as disclosed in
the notes to the financial statements. Use cost of debt as the discount
rate.
Add the present value of the leases as an “operating leases”
adjustment to operating invested capital.
Add the present value of the leases as additional “operating leases”
debt to financial invested capital.
2. Adjust NOPAT for the amount of implied interest paid on the leases.
Compute the implied interest expense as a percent of the present
value of the leases. Use cost of debt as the interest rate.
Add the implied interest expense – after tax – to NOPAT.
Alternatively, adjust cash taxes for the tax shield created by
this added interest expense.
3. Adjust weighted average cost of capital.
Include the present value of the operating leases as a debt. Use
interest rate on long-term debt as cost of debt on the leases.
4. Deduct the present value of operating leases as an interest-bearing
liability or commitment in the final equity value calculation.
Note that these changes can have a dramatic effect on ROIC
and FCF!
F402/560
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Operating Leases Example
Value of Leasable Assets = 8,000
Interest rate on debt =
7%
Interest rate on leases =
Own the Assets
Lease the Assets
Year 1
Revenue
Year 2
Year 1
12,000
COGS
(10,760)
Lease payment @ 8%
0
Interest expense @ 7%
(560)
Income before tax
680
Provision for tax
(272)
Net income
408
Year 2
Revenue
12,000
COGS
(10,760)
Lease payment @ 8%
(640)
Interest expense @ 7%
0
Income before tax
600
Provision for tax
(240)
Net income
360
Current oper assets
2,000
Current oper assets
2,000
PP&E
9,000
PP&E
1,000
Total assets
3,000
1,000
Total assets
11,000
Current oper liabilities
1,000
Current oper liabilities
Debt
8,000
Debt
Equity
2,000
Equity
2,000
Total liab & equity
3,000
Total liab & equity
11,000
Net income
408
Net income
Interest after tax
336
Interest after tax
NOPAT
744
NOPAT
Invested capital
ROIC
8%
10,000
Invested capital
7.44%
0
360
0
360
2,000
ROIC
PV of oper leases
Adj inv cap
18.00%
8,000
10,000
NOPAT
360
Implied interest
640
Tax on implied interest
(256)
Adj NOPAT
744
Adjusted ROIC
F402/560
7.44%
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The equations are:
Value of leased equipment = Present Value of noncancelable lease payment obligations,
as disclosed in footnote to audited statements in 10-K report.
= Each future lease payment discounted to present value,
using interest rate on long-term debt as discount rate.
Also:
where last amount listed as “Thereafter” is
discounted as one value for the next number of
periods (e.g., if there are five years of lease payments
plus a total for “thereafter,” then the thereafter total
is discounted six periods).
= Value of assumed debt associated with the leased equipment.
Operating invested capital (after adjustment for operating leases)
= Operating invested capital (unadjusted)
+ PV of operating leases
Financial invested capital (after adjustment for operating leases)
= Financial invested capital (unadjusted)
+ PV of operating leases
NOPAT (after adjustment for operating leases)
= NOPAT (unadjusted)
+ implied interest, after tax, on PV of leases
where implied interest on leases
= PV of leases × interest rate on long-term debt
and implied interest after tax
= Implied interest × 0.6
Therefore:
NOPAT (after adjustment for operating leases)
= NOPAT (unadjusted) + (PV of leases × cost of debt × .6)
F402/560
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