/ INVESTING

# Financing and Operating Leases in Valuation

A lease is a contract where a Lessor (owner) permits a Lesse (user) to utilize an asset for a particular period. Financing and operating leases are essentially a form of financing and need to be considered as such when valuing a company.

This post will discuss the accounting treatment of financing and operating leases and its effects on valuation.

## Cash is King

A business’s intrinsic value is equal to the cash flows you expect the asset to generate over its life and how uncertain you feel about these cash flows.

Cash is king when it comes to pretty much everything – including firm valuation models. Free cash flow to the firm is calculated by taking operating income minus reinvestment. We implicitly assume that operating expenses do not include financing expenses; however, this implicit assumption isn’t always correct.

## Owning vs. Leasing

Firms often have a choice between buying or leasing their assets. There are two types of leases:

• Capital or financial leases
• Operating or service leases

The Financial Accounting Standards Board (FASB) states that firms must treat a lease as a capital lease if:

1. Ownership transfer takes place at the end of the lease
2. The lease is at least 75% of the asset’s life
3. The present value of the lease payments exceeds 90% of the initial asset value
4. There is a “bargain purchase” option where the lessee can purchase the asset at below expected market value

Any lease that does not meet the above is an operating lease.

From a valuation perspective, both lease obligations are debt.

Conceptually, this also makes sense. Let’s think of a capital-heavy business such as airlines. If one airline purchases their planes and another airline leases all of theirs, are they so different? I would argue that they are not. The airline requires planes to operate, and the leases are a contractual commitment that has to be met in both good and bad times. In other words, operating and capital leases are akin to borrowing money.

#### Operating Lease Year Two Entry

Let’s make the year two entries for the operational lease.

 Lease Expense $1,233,333 Lease Liability$966,942 ROU Asset $1,000,275 Cash$1,200,000

#### Financing Lease Year Three Entry

Now let’s make our final journal entries.

 Lease Liability $1,500,000 Cash$1,500,000 Interest Expense $136,364 Lease Liability$136,364 Amortization Expense $1,009,266 ROU Asset$1,009,266

#### Operating Lease Year Three Entry

 Lease Expense $1,233,334 Lease Liability$1,363,636 ROU Asset $1,096,970 Cash$1,500,000

### Financing vs. Operating Lease

Let’s put everything into a table to understand what’s going on from a different perspective. With the changes, we get rid of the off-balance sheet financing and it’s much easier to see what’s going on with our ROU assets and liabilities.

#### Financing Lease Table

Lease PaymentPV of PaymentInterest ExpenseDr. Lease LiabilityAmortizationLease ExpenseTax Deduction
1$1,000,000$909,091$302,780$697,220$1,009,266$1,312,046$1,312,046 2$1,200,000$991,736$233,058$966,942$1,009,266$1,242,324$1,242,324
3$1,500,000$1,126,972$136,364$1,363,636$1,009,266$1,145,630$1,145,630 10%$3,700,000$3,027,799$672,201$3,027,798$3,027,798$3,700,000$3,700,000

#### Operating Lease Table

Lease PaymentPV of PaymentInterest ExpenseDr. Lease LiabilityAmortizationLease ExpenseTax Deduction
1$1,000,000$909,091$302,780$697,220$930,553$1,233,333$1,233,333 2$1,200,000$991,736$233,058$966,942$1,000,275$1,233,333$1,233,333
3$1,500,000$1,126,972$136,364$1,363,636$1,096,970$1,233,333$1,233,333 10%$3,700,000$3,027,799$672,201$3,027,799$3,027,799$3,700,000$3,700,000

### Leases and Valuation

From the above tables, we can see that both operating and financing leases now show up on the balance sheet with only a minor difference in the rate of tax deduction benefits. No longer will the same firm have lower debt and higher returns on capital due to how it’s represented. While this solves a significant problem and saves us a few steps, we still need to go further.

If you analyze the journal entries above, you’ll notice there is no interest expense – it’s incorporated into the operating lease expense and is deducted from operating income. This means for firms with operating leases will understate their operating income profitability.

Operating income should represent operating profitabiliy before financing – earnings before interest and taxes (EBIT), which means we still need to adjust operating income and remove the imputed interest expense.

### Operating and Financing Lease Debt Example

Let’s use Facebook as an example.

First, let’s calculate the calculate debt. Facebook’s 2019 10-K now lists lease liabilities on their balance sheet so we can include this in our interest bearing debt calcuation when determining returns on capital.

Often, you’ll need to go to the supplementary tables to get the breakdown for both operating and financing leases. As we can see below, Facebook has $11,074 million in financing and operating lease debt. The only thing that is left is to adjust operating income. Just like our journal entries, often there is only one line item aggregating interest and amortization. We can calculate the imputed interest cost multiple ways, but the easiest is to determine the annual amortization expense:$ \$10,324 \div 13 = \$794.15 $Then subtract the amortization from the operating lease cost:$ \$1,139 - \$794.15 = \$344.85$

And finally remove the imputed cost from operating income and add it to interest expenses.

### Final Word on Leases & Valuation

To valuation practitioners, leases are another form of financing. With the introduction of ASC 842, operating leases are now brought onto the balance sheet fixing on of the largest sources of off-balance sheet financing; however, unlike financing expenses, operating leases contain both amortization and imputed interest expenses presented as a single operating expense. This affects pre-tax operating measures and needs to be corrected when valuing companies as operating income should only contain operating expenses and not financing costs.

#### Leo Smigel

Based in Pittsburgh, Analyzing Alpha is a blog by Leo Smigel exploring what works in the markets.