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.

Its as if it were PP&E.

Include the amount owed on the leased equipment as longterm debt, in an amount equal to what was added to PP&E.

Reverse the implied interest expense which is a portion of

the lease payments. Its as if they were loan payments.

Forecast the value of these operating leases as a percent of

sales. Its as if they were part of PP&E.

Heres how:

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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!

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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%

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%

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%

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)

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