Operating Lease

An agreement to use and operate an asset without ownership

What is an Operating Lease?

An operating lease is an agreement to use and operate an asset without ownership. Common assets that are leased include real estate, automobiles, aircraft or heavy equipment. By renting and not owning, operating leases allow companies to keep from recording an asset on their balance sheets by treating them as operating expenses.

 

Operating Lease Sign

 

Operating Lease vs Capital Lease

For a lease to qualify as a capital lease, it must meet certain criteria as outlined by GAAP:

  • The lease term is greater than or equal to 75% of the asset’s estimated useful life.
  • The present value of the lease payments is greater than or equal to 90% of the total original equipment cost.
  • Ownership of the asset may be transferred to the lessee at the end of the lease.
  • The lease contains a bargain purchase option to buy the equipment below market value.

Under a capital lease, the lessee is considered an owner and can claim depreciation and interest expense for tax purposes. However, the leased asset and lease payments are shown on the balance sheet. Under an operating lease, the lessee enjoys no risk of ownership, but cannot claim tax benefits.

 

Adjusting Debt for Operating Leases

Leasing is an alternative to incurring debt, purchasing assets, and paying interest on the debt outstanding. By shifting operating leases from operating expense to financing expense, the operating income for a firm will always increase when operating expenses are re-categorized.

 

Step 1: Collect input data

Find the operating lease expenses, operating income, reported debt, cost of debt and reported interest expenses. Operating lease expenses can be found in the notes to financial statements.

 

Operating Lease

 

Step 2: Convert operating leases into debt

Find the present value of the operating leases by discounting each year’s expense by the cost of debt. The annuity method can be used to estimate if leases are provided over a timeframe of multiple years (e.g. 6 – 10 years).

 

Operating Lease - Step 2

 

Step 3: Adjust operating income

Start with the reported operating income (EBIT). Then, add the current year’s operating lease expense and subtract the depreciation on the leased asset to arrive at adjusted operating income.

 

Operating Lease - Step 3

 

Impact on Financial Statements

If operating lease expenses represent fixed commitments for the future, they must be treated as financing expenses rather than operating expenses. This will exercise a positive effect on operating income since it is defined to be net of just operating expenses. However, moving operating leases from the operating expense to the financing expense should not affect the net income.

If we treat depreciation on the leased asset as a proxy for the principal portion of the debt being repaid, the adjusted operating income can be computed by adding back the imputed interest expense on the debt value of the operating lease expense:

 

Operating Lease - Financial Statements

 

Impact on Valuation

There are two effects on free cash flow to the firm (FCFF) when we treat operating lease expenses as financing expenses:

  1. FCFF will increase because the imputed interest expense on the capitalized operating leases is added back to the operating income (EBIT).
  2. FCFF will decrease if the present value of operating leases increases (and vice versa) due to the net change in capital expenditures.

Furthermore, the weighted average cost of capital (WACC) will decrease as the debt ratio increases, which has a positive impact on the value of the firm. It is important to note that the increase in firm value derives solely from the value of debt, and not the value of equity. If the debt ratio stays stable, and the operating leases are fairly valued, treating operating leases as debt should have a neutral effect on the value of equity.

 

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