Finance vs Operating Lease - Effect on Equity and RoE

CFA Level II
#1

The curriculum says that the RoE is lower for a finance lease in the early years

I understand that NI is lower for the early years because interest payment is higher. However what is the effect on equity on the denominator ?

#2

It isn’t that the interest payment is higher; it’s that the combination of interest and depreciation expenses are higher than the lease payment (rent, under an operating lease) in the early years, then lower in the later years.

Equity will be lower under a finance lease than under an operating for all times except at the start and at the end.

#3

Thanks for correcting me, I understood the first part correctly, I just made a mistake when typing here.

Thanks also for the answer about Equity, is the reason for the equity being lower for the first year that:

  • there is no depreciation on the first year

I do not understand why it is lower for the end as well though.

#4

At the beginning and at the end, equity under operating leases is the same as equity under finance leases. Because total expenses (interest + depreciation) for finance leases is higher than total expenses (rent) for operating leases in the early years, equity under finance leases is lower. Here’s a simplification that will help you see this: suppose that:

  • Beginning equity = $1,000,000
  • Revenues are $200,000 per year
  • Other expenses are $150,000 per year
  • Lease payments are $10,000/year for 5 years
  • Finance lease expenses are $14,000, $12,000, $10,000, $8,000, and $6,000 per year, respectively
  • No taxes

So, under an operating lease, net income is $200,000 – $150,000 – $10,000 = $40,000 per year. Equity each year is:

  1. $1,000,000 + $40,000 = $1,040,000
  2. $1,040,000 + $40,000 = $1,080,000
  3. $1,120,000
  4. $1,160,000
  5. $1,200,000

Under a finance lease, net income each year is:

  1. $200,000 – $150,000 – $14,000 = $36,000
  2. $200,000 – $150,000 – $12,000 = $38,000
  3. $40,000
  4. $42,000
  5. $44,000

Equity each year is:

  1. $1,000,000 + $36,000 = $1,036,000
  2. $1,036,000 + $38,000 = $1,074,000
  3. $1,114,000
  4. $1,156,000
  5. $1,200,000

Thus, because the expenses on the finance lease are greater in the beginning, equity is lower after the first year, then catches up at the end.

#5

Equity will reverse with Net Income.

#6

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