Correct treatment of operating leases?

Just a questions with regards to the treatment of operating leases. In a DCF, do you subtract the PV of operating leases as debt from firm value, or do you subtract it from the P&L as OPEX?


You show the annual payment as Rent Expense on the P&L.

You also have to disclose the obligation in the footnotes.

That’s it.

I wrote a series of articles on leases that may be of some help here:

Do you refer to the pure accounting treatment (US-GAAP/IFRS) or the treatment regarding to financial analysis or company valuation (DCF)?

If you refer to the first one, magician has given you the answer. Regarding the latter in DCF valuation excercises the PV of the operating leases is treated as debt and the WACC or CoE are adjusted accordingly.

Regards, Oscar

Sorry for being unclear, I mean in a DCF.

So you mean that the NPV of the operating leases should be deducted as debt rather than being treated as OPEX each year in the P&L?

Yes, operating leases are considered financing expenses in nature and as such are treated as debt for valuation purposes.

  1. The debt portion is calculated by taking the information from the financial statements (operating lease payments for the next five years need to be disclosed) plus an assumption for the terminal value (e.g. average of five previous years). You then discount these payments back with the pre-tax cost of debt.

  2. The operating expenses and cash flows to the firm are adjusted upward by eliminating the operating lease payments from the operating part of the P&L (i.e. NOPLAT before lease payments).

  3. The WACC (assuming an EV-model) is adjusted by the new capital structure weighting (which now include the PV of the operating lease payments as debt), incl. an adjustment for the beta-factor under the new capital structure (de- and re-leveraging of beta).

Three further remarks:

  1. This also works if you run an Equity Value model. In this case you need to model down to the net income by splitting the operating lease payments into the interest and principal portion. The costs of equity are then adjusted by the new beta factor.

  2. Keep in mind that in case you run a simple multiple valuation you need to do the same adjustments, except for the capital costs. (I always say that multiple valuations are only simple if you do them wrong. A correct and good multiple valuation takes as much work and time as a DCF.)

  3. In order to be totally correct you need to calculate not only one PV for the operating leases but the actual lease value over time and then vary the discount rates with the yearly changing weighting of D/E. But do not bother with this now as this would be really getting to the nerd level of valuation.

Best, Oscar

With a finance lease there is a portion which is finance cost, however with operating leases I thought everything was OPEX? I agree with the adjustment to the WACC. But I am still not sure what you mean. In terms of a DCF, will you subtract the PV of the operating leases in the end or will you subtract the operating leases as costs in the P&L?

In a DCF valuation you treat the operating lease _ as if _ it would be a finance lease. Hence, there is no OPEX from operating lease in the P&L. The operating lease payment is virtually split into an interest and a principal portion.

After calculating the enterprise value based on the cash flows to the firm (which as described above exclude the operating lease payments) you deduct the PV of the lease payments as part of the net debt to get to the equity value.

Ok. In understand Oscar. But let’s say you have a firm that you expect to grow, and hence will require more operating leases in the future. How would you take that into account if you only subtract the PV of today’s outstanding operating leases? Also, not all companies should the split, how big the operating leasing costs were I believe?

The assumption of a future capital structure is an assumption you need to make independent of the current level of debt/ leases.

If you assume that your capital structure will move towards more debt vial leases to finance growth then you need to model it that way (e.g. by forecasting increasing lease payments and taking the PV of theses lease payments in each point in time). As I outlined above you’ll then have differing D/E-Rations in each year to calculate time-specific capital costs.

It’s all a question of what assumptions you make and of how you subsequently model it.