I encountered an issue at work with regards to the treatment of operating leases in the valuation of a company. To determine the value of equity in the company, my view is that operating leases should be included in the liabilities (indebtedness). The reason is because operating leases is a form of off balance sheet financing and therefore should be accounted for in valuation of a company. Indebtedness is deducted from Enterprise Value to derive the value of equity (assume no surplus assets/liabilities). My colleague disagrees and advises that operating leases are non-interest bearing debt and therefore should not be included in the liabilities (indebtedness). I argue that if operating leases are not accounted for, indebtedness could be undervalued and equity overvalued. Should operating leases be included in liabilities (indebtedness)? Please advise the appropriate treatment of operating leases in deriving the valuation of a company and its equity value. Please back up your reasoning with evidence/literature (if possible). Thanks in advance.
Did you take Level 2?
Passed Level 1. Intend to enrol in Level 2 this August. Would you be able to help pls?
I will give it a crack. Subtract current rent payments from income statement. Add PV of expected future lease payments as liability. Put the asset on the balance sheet. Interest and depreciation will replace rent expense on income statement. This is also level 1 material I believe.
funny…i brought my Level I FSA book to my office for this exact same issue today
Yes, they should be added in with the debt. I remember reading about this in the L2 material… it’s in the Fixed Income book, where they talk about the LT Debt to Capitalization ratio, and the Total Debt to Cap ratio.
The interest is accounted for in the lease price. The PV should be discounted at either the explict stated interest rate in capital leases or the WACC (I think, not sure if WACC should be something else). Your friend should do something productive like make copies or coffee or something if he wants to disregard liabilities, valuation doesn’t seem prudent for him to be engaging in.
Thank you all for your responses. Found the answer in the McKinsey book “Valuation: Measuring and Managing the valuation of companies 4th Edition”. Operating leases are off BS debt / non-equity item and should be deducted from EV to derive the equity value. I photocopy the relevant pages and showed my colleague.
bikru0969 Wrote: ------------------------------------------------------- > Thank you all for your responses. Found the answer > in the McKinsey book “Valuation: Measuring and > Managing the valuation of companies 4th Edition”. > Operating leases are off BS debt / non-equity item > and should be deducted from EV to derive the > equity value. I photocopy the relevant pages and > showed my colleague. Nice job Bikru, in his face!
Hi, I think it depends on how you calculate your EV. I guess there are a few ways to calculate EV. One way is to use free cash flow to the firm (FCFF) and the other is using the relative valuation approach (eg. EV/EBITDA). Assume you calculate EV using FCFF approach. If your EV is calculated after you less off the rental expense, then you should not ‘artificially’ add the PV of the off-balance sheet (PVOBS) to your balance sheet and subsequently take EV - PVOBS = Value of equity. Because the EV, which you calculated, having returned the cash flow to the party of the ‘leased asset’, only rightfully belong to other debt holders and equity holders. Assume you use the multiple approach. You calculate EV = EV/EBITDA multiple x EBITDA. If your EBITDA already less off the rental expense, again, you shouldn’t take EV - PVOBS, reason being the same as described above. Of course, the most correct way, which I very much agree with thommo77, is to adjust the income statement before you calculate the FCFF. That will reinstate the rental expense to net income, and recognizing the PVOBS on the balance sheet. Bottom line is, be careful of what makes up your EV. If you simply take the EV (calculated by another person who didn’t make adjustment to the income statement) minus PVOBS to get the equity value, then it would be wrong. That being said, I thought of the need to adjust the discount rate too, if you are using the FCFF method, and especially if capitalizing the off balance sheet item greatly changes the capital structure. We also need to factor in the change in capital structure during the life of the asset, if you are using sophisticated 2- or 3- stage models. This is my understanding though. Correct me if I am wrong.
They covered the basics in L1 and stepped it up in L2. Here is an example I have in my L2 notes from a Schweser L2 mock exam Question ? $2mil a year payment, 9% int, 5 year SL Dep, Future Sal Value $3 mil. Step 1- PV of Lease = $2mil PMT, 9% I/Y, 5 N, CPT PV = $7.779 mil Step 2- Compute Depreciation (7.7793 - 3.0) / 5 years = $955,860 per year Step 3- Compute Int. Exp (7.7793 X .09) = $700,137 Step 4- Adjust Ratios : Example Int Coverage = Ebit + Lease Pmt - Dep / Old int exp + New Dep (700,137) Operating Income Higher, Int Expense Higher, CFO Higher (only interest portion paid out of CFO + add back Dep), Current Ratio Lower (current portion of lease will be in current Liabilities)