Capital Leases and Valuation

Leases add some complication to valuation. Before we get into that let's define the two types of leases.

1) Operating Lease - lease payments treated as an expense and no asset or liability recognized.

2) Capital Lease - Recognize the present value of the lease as an asset and lease liability.

Key accounting differences:

An operating lease is simply recognized as an operating expense. A capital lease is recognized as an asset and liability on the balance sheet. The amount of the asset and liability is the present value of the payments in the lease. The lease is then expensed through depreciation and interest expense. Because interest is not paid on a lease something called "imputed interest" is calculated and treated as an interest expense.

In essence, an operating lease, as compared to a capital lease can do two things. First, it understates EBITDA as compared to a capital lease. Second, it does not create an asset or liability to reflect the payment obligation as a capital lease does.

To better understand capital leases let's calculate one:

- 3-year lease

- $100 annual payment

- Pre-tax cost of debt is 5%

Step 1)

Calculate the present value of the payments.

PV = 272.32

Step 2)

Calculate the imputed interest, liability reduction, and depreciation each year.

Value = present value of payment obligation calculated using the pre-tax cost of debt and reduced by "reduction in liability each year.

Payment = set out in contract

Imputed interest = value of liability * discount rate used to find PV

Reduction in liability = payment - Imputed Interest

Depreciation = Straight line is assumed

The Accompanying Journal Entries in year 1

FCFF excludes both the interest expense and the depreciation expense.

We will factor the capital lease into our equity valuation when we calculate equity value from enterprise value.

We must subtract the PV of lease obligations from enterprise value along with the other standard adjustments to find equity value. Effectively, we have treated the lease like debt.

It can be helpful to adjust for operating leases by converting them into capital leases as we did above. This allows for better comparison between companies, particularly when looking at EV/EBITDA. As long as you understand the difference between the two you can convert one to another and make better comparisons as you see fit.