Preview

Damodaran on Capital and Operating Leases

Powerful Essays
Open Document
Open Document
5833 Words
Grammar
Grammar
Plagiarism
Plagiarism
Writing
Writing
Score
Score
Damodaran on Capital and Operating Leases
Dealing with Operating Leases in Valuation Aswath Damodaran Stern School of Business 44 West Fourth Street New York, NY 10012 adamodar@stern.nyu.edu

Abstract
Most firm valuation models start with the after-tax operating income as a measure of the operating income on a firm and reduce it by the reinvestment rate to arrive at the free cash flow to the firm. Implicitly, we assume that the operating expenses do not include any financing expenses (such as interest expense on debt). While this assumption, for the most part, is true, there is a significant exception. When a firm leases an asset, the accounting treatment of the expense depends upon whether it is categorized as an operating or a capital lease. Operating lease expenses are treated as part of the operating expenses, but we will argue that they really represent financing expenses. Consequently, the operating income, capital, profitability and cash flow measures for firms with operating leases have to be adjusted when operating lease expenses get categorized as financing expenses. This can have significant effects not just on valuation model inputs, but also on some multiples such as Value/EBITDA ratios that are widely used in valuation.

The operating income is a key input into every firm valuation model, and it is often obtained from an accounting income statement. In using this measure of earnings, we implicitly assume that operating expenses include only those expenses designed to create revenue in the current period, and that they do not include any financing expenses. For the most part, accounting statements separate out financing expenses such as interest expense and show them after operating income. There is one significant exception to this rule, and that is created by the accounting treatment of operating lease expenses, which are categorized as operating expenses to arrive at operating income. We will make the argument in this paper that these expenses are really financing expenses, and that

You May Also Find These Documents Helpful

  • Better Essays

    Congoleum Corp.

    • 1985 Words
    • 8 Pages

    In valuing the target company Congoleum after an LBO by First Boston found the expected free cash flows generated by this firm from 1980 to 1984. These numbers were based on values provided in the case. From there, we employed the Adjusted Present Value method to discount these cash flows because we assumed that Congoleum was varying its Debt to Equity ratio during those years. We discounted these cash flows by the required return on assets that was in turn calculated through use of the Modigliani-Miller unlevering formula (to derive the Asset Beta) and the Capital Asset Pricing Model. The required return on Congoleum debt was calculated by the expected return of the average CCC-company’s debt and the expected return of debt under default. Then, the present value of financial side effects was taken into account by discounting the interest tax shield by the required return on debt. Finally, we calculated the terminal value of cash flows by assuming a constant 4.14% growth rate in perpetuity and a constant D/E ratio for the years after 1984. Thus, these cash flows were initially discounted under WACC-ME. From there, we factored in prior debt and cash that Congoleum had generated to calculate the total equity value of the firm after the LBO had taken place.…

    • 1985 Words
    • 8 Pages
    Better Essays
  • Good Essays

    Lessee Ltd.- Lease Case

    • 954 Words
    • 4 Pages

    No, the junior accountant’s analysis is not correct in classifying the lease as an operating lease in accordance with IFRS. Whether or not a lease is classified as a finance or an operating lease depends on if all of the benefits as well as risks of ownership have been shifted from the lessor to the lessee.…

    • 954 Words
    • 4 Pages
    Good Essays
  • Good Essays

    Oroton

    • 6664 Words
    • 27 Pages

    References: Bennett, B. & Bradbury, M.E. (2003). Capitalizing non-cancellable operating leases. Journal of International Financial Management & Accounting. 14, 101-114.…

    • 6664 Words
    • 27 Pages
    Good Essays
  • Better Essays

    While working on a consulting engagement, a supervisor in the team has given an assignment. The client is a regional trucking company. A new customer has approached the client with an opportunity that would require 120 trailers—20 more than the trucking company currently owns. The client is uncertain how long the relationship with the customer may last, but the deal has the potential for significant growth. The supervisor has asked a research to be conducted on leases and lease structure issues on the Financial Accounting Standards Board (FASB) website, in particular the current practice and thought related to direct financing, sales type, and operating leases. This paper is a memo addressed to the supervisor that summarizes the FASB research results. It recommends an approach that the client can use to evaluate and capitalize on this opportunity.…

    • 1085 Words
    • 5 Pages
    Better Essays
  • Good Essays

    Branson Valuation

    • 1921 Words
    • 8 Pages

    I have been asked to determine the fair market value of Branson Trucking Company as of December 31, 2007 for the purpose of determine your share in the business.…

    • 1921 Words
    • 8 Pages
    Good Essays
  • Satisfactory Essays

    Chapter 21

    • 3724 Words
    • 15 Pages

    The lease does not meet the transfer of ownership test, the bargain purchase test, or the economic life test [(5 years ÷ 8 years) < 75%]. However, it does pass the recovery of investment test. The present value of the minimum lease payments ($31,000 X 4.16986 = $129,266) is greater than 90% of the FV of the asset (90% X $138,000 = $124,200). Therefore, Callaway should classify the lease as a capital lease.…

    • 3724 Words
    • 15 Pages
    Satisfactory Essays
  • Better Essays

    3. The total minimum sublease rentals to be received in the future under noncancelable subleases as of the date of the latest balance sheet presented…

    • 1123 Words
    • 5 Pages
    Better Essays
  • Better Essays

    Lease Memo

    • 1136 Words
    • 5 Pages

    Ingberman, M., Ronen, J., & Sorter, G. H. (1979, Feb). How Lease Capitalization Under FASB Statement No. 13 Will Affect Financial Ratios. Financial Analysts Journal, 35(1), p 28.…

    • 1136 Words
    • 5 Pages
    Better Essays
  • Good Essays

    The trucking company currently owns 100 trailers and a new client have requested 20 more for a total of 120 trailers for its project. The relationship with the new client is uncertain but at the same time it has potential for significant growth of the company. The uncertainty of the relationship may have an effect on the financial position of the client company. The additional trailers may be obtained by the trucking company through either a lease option or by direct financing. If the trucking company is considering leasing the additional trailers to provide to their new client they must first understand leases and lease issues according to the Financial Accounting Standards Board (FASB). FASB Statement No. 13 establishes standards of financial accounting and reporting for leases by lessees and lessors. The leases outlined in FASB Statement No. 13 are operating leases, sales-type leases, and direct financing leases. Sales-type leases and direct financing leases are capital leases and must meet specified criteria; if not, it is an operating lease. Operating leases are accounted for like rental property. Sales-type and direct financing leases, meeting the criteria of a capital lease and two additional criteria dealing with future uncertainties, are accounted for as an investment. A brief description of each lease type below.…

    • 841 Words
    • 4 Pages
    Good Essays
  • Good Essays

    30-9 The lessor shall measure unearned income initially as the difference between the gross investment in the sales-type lease and the sum of the present values of the two components of the gross investment. The discount rate to be used in determining the present values shall be the interest rate implicit in the sales-type lease.…

    • 847 Words
    • 4 Pages
    Good Essays
  • Powerful Essays

    Marriott Case |

    • 2517 Words
    • 11 Pages

    Dan Cohrs is preparing the annual hurdle rates for the three divisions of Marriot Corporation (Lodging, Contracts, and Restaurants) which will have a significant impact on the firm’s financial and operating strategies. Marriott’s has been truthful to its operating strategy to remain a premier growth company, Marriott’s sales and earnings per share have doubled over the last four years. In 1987 Marriot’s sales rose 24%, the return on equity was 22% and profits were $223 million. Lodging consisted of 51% of Marriott’s profits, while contracts services and restaurants amounted to 33% and 16% respectively. However, the sales mix is not proportionate to relative profits, where 41% of sales are generated from lodging, 46% from contract services and 13% from restaurants. One of the main factors in Marriot’s lodging success has been their strategy to syndicate hotels to limited partners with a three percent management fee and 20% of profits before depreciation and debt service. One of Marriot’s key strategic elements is to optimize the use of debt in the capital structure for which it uses an interest coverage target instead of debt to equity ratio to determine the ideal amount of debt to hold.…

    • 2517 Words
    • 11 Pages
    Powerful Essays
  • Satisfactory Essays

    The criteria and characteristics of operating lease is that operating lease usually a shorter-term lease under which the lessor is responsible for insurance, taxes, and upkeep. May be cancelable by the lessee on short notice.…

    • 322 Words
    • 2 Pages
    Satisfactory Essays
  • Good Essays

    With the accounting policies relating to Property, Plant, and Equipment adopted by the company is mentioned as Plant and equipment, leasehold improvements and equipment under finance leases are stated at cost less accumulated depreciation and impairment (if any). But, In this report there are not any impairments.Cost includes expenditure that is directly attributable to the acquisition of the item. In…

    • 1291 Words
    • 4 Pages
    Good Essays
  • Good Essays

    If a lease does not meet the criteria for capitalization then it will be classified as an operating lease by the lessee. A capital lease transfers most of the benefits and risks of ownership to the lessee. This should also be accounted for as an acquisition of assets to the lessee. A lease must meet one of four criteria to be considered a capital lease: at the end of the lease the title must be transferred from the lessor to the lessee, the lessee must be able to obtain the asset for less than fair market value, the lease extends for a period of at least 75 percent of the assets estimated economic life, or the lease payments will be greater than 90 percent of the fair market value of the asset at the beginning of the lease. The lessee will pay the full amount of the asset to the lessor without dependency on the residual value of the asset (Schroeder, Clark, & Cathey, 2005).…

    • 707 Words
    • 3 Pages
    Good Essays
  • Powerful Essays

    11 6 Lessee Ltd Case as of 3

    • 1187 Words
    • 14 Pages

    Board, F. A. (2013, May 2013). Proposed Accounting Standards Update-Leases (Topic 842). Retrieved March 23, 2015, from…

    • 1187 Words
    • 14 Pages
    Powerful Essays