Dealing with Operating Leases in Valuation
Stern School of Business
44 West Fourth Street
New York, NY 10012
Most firm valuation models start with the after-tax operating income as a measure of the
operating income on a firm and reduce it by the reinvestment rate to arrive at the free
cash flow to the firm. Implicitly, we assume that the operating expenses do not include
any financing expenses (such as interest expense on debt). While this assumption, for the
most part, is true, there is a significant exception. When a firm leases an asset, the
accounting treatment of the expense depends upon whether it is categorized as an
operating or a capital lease. Operating lease expenses are treated as part of the operating
expenses, but we will argue that they really represent financing expenses. Consequently,
the operating income, capital, profitability and cash flow measures for firms with
operating leases have to be adjusted when operating lease expenses get categorized as
financing expenses. This can have significant effects not just on valuation model inputs,
but also on some multiples such as Value/EBITDA ratios that are widely used in
The operating income is a key input into every firm valuation model, and it is
often obtained from an accounting income statement. In using this measure of earnings,
we implicitly assume that operating expenses include only those expenses designed to
create revenue in the current period, and that they do not include any financing expenses.
For the most part, accounting statements separate out financing expenses such as interest
expense and show them after operating income. There is one significant exception to this
rule, and that is created by the accounting treatment of operating lease expenses, which
are categorized as operating expenses to arrive at operating income. We will make the
argument in this paper that these expenses are really financing expenses, and that
ignoring this misclassification can create significant problems in measuring and
comparing profitability. We also suggest two ways in which we can recategorize
operating lease expenses as financing expenses.
The Accounting Treatment of Leases
Firms often have a choice between buying assets and leasing them. When, in fact,
assets are leased, the treatment of the lease expenses can vary depending upon how leases
are categorized and this can have a significant effect on measures of operating income
and book value of capital. In this part of the paper, we will begin by looking at the
accounting treatment of leases and how it affects operating earnings, capital and
Operating versus Financial Leases: Basis for Categorization
An operating or service lease is usually signed for a period much shorter than the
actual life of the asset, and the present value of lease payments are generally much lower
than the actual price of the asset. At the end of the life of the lease, the equipment reverts
back to the lessor, who will either offer to sell it to the lessee or lease it to somebody else.
The lessee usually has the option to cancel the lease and return equipment to the lessor.
Thus, the ownership of the asset in an operating lease clearly resides with the lessor, with
the lessee bearing little or no risk if the asset becomes obsolete. An example of operating
leases would be the store spaces that are leased out by specialty retailing firms like the
A financial or capital lease generally lasts for the life of the asset, with the present
value of lease payments covering the price of the asset. A financial lease generally cannot
be canceled, and the lease can be renewed at the end of its life at a reduced rate or the
asset acquired at a favorable price. In many cases, the lessor is not obligated to pay
insurance and taxes on the asset, leaving these obligations up to the lessee; the lessee
consequently reduces the lease payments, leading to what are called net leases. In
summary, a financial lease imposes substantial risk on the shoulders of the lessee.
While the differences between operating and financial leases are obvious, some
lease arrangements do not fit neatly into one or another of these extremes; rather, they
share some features of both types of leases. These leases are called combination leases.
Accounting For Leases
The effects of leasing an asset on accounting statements will depend on how the
lease is categorized by the Internal Revenue Service (for tax purposes) and by generally
accepted accounting standards (for measurement purposes). Since leasing an asset rather
than buying it substitutes lease payments as a tax deduction for the payments that would
have been claimed as tax deductions by the firm if had owned the asset (depreciation and
interest expenses on debt), the IRS is wary of lease arrangements designed purely to
speed up tax deductions. Some of the issues the IRS considers in deciding whether lease
payments are tax deductible include the following:
• Are the lease payments on the asset spread out over the life of the asset or are they
accelerated over a much shorter period?
• Can the lessee continue to use the asset after the life of the lease at preferential rates
or nominal amounts?
• Can the lessee buy the asset at the end of the life of the lease at a price well below
If lease payments are made over a period much shorter than the asset’s life and the lessee
is allowed either to continue leasing the asset at a nominal amount or to buy the asset at a
price below market, the IRS may view the lease as a loan and prohibit the lessee from
deducting the lease payments in the year(s) in which they are made.
Lease arrangements also allow firms to take assets off the balance sheet and
reduce their leverage, at least in cosmetic terms; in other words, leases are sometimes a
source of off-balance sheet financing. Consequently, the Financial Accounting Standards
Board (FASB) has specified that firms must treat leases as capital leases if any one of the
following four conditions hold:
1. The life of the lease is at least 75% of the asset’s life.
2. The ownership of the asset is transferred to the lessee at the end of the life of
3. There is a “bargain purchase” option, whereby the purchase price is below
expected market value, increasing the likelihood that ownership in the asset will
be transferred to the lessee at the end of the lease.
4. The present value of the lease payments exceeds 90% of the initial value of the
All other leases are treated as operating leases.
Effect on Expenses, Income and Taxes
If, under the above criteria, a lease qualifies as an operating lease, the lease
payments are operating expenses which are tax deductible. Thus, although lease
payments reduce income, they also provide a tax benefit. The after-tax impact of the lease
payment on income can be written as:
After-tax Effect of Lease on Net Income = Lease Payment (1 - t)
where t is the marginal tax rate on income.
Note the similarity in the impact, on after-tax income, of lease payments and
interest payments. Both create a cash outflow while creating a concurrent tax benefit,
which is proportional to the marginal tax rate.
The effect of a capital lease on operating and net income is different than that of
an operating lease because capital leases are treated similarly to assets that are bought by
the firm; that is, the firm is allowed to claim depreciation on the asset and an imputed
interest payment on the lease as tax deductions rather than the lease payment itself. The
imputed interest payment is computed by assuming that the lease payment is a debt
payment and by apportioning it between interest and principal repaid. Thus, a five-year
capital lease with lease payments of $ 1 million a year for a firm with a cost of debt of
10% will have the interest payments and depreciation imputed to it shown in Table 1.
Table 1: Lease Payments, Imputed Interest and Depreciation
Year Lease Payment
Interest Expense Reduction in Lease Liability Lease Liability Depreciation Total Tax Deduction
The lease liability is estimated by taking the present value of $ 1 million a year for five
years at a discount rate of 10% (the pre-tax cost of debt), assuming that the payments are
made at the end of each year.
Present Value of Lease Liabilities
= $ 1 million (PV of Annuity, 10%, 5 years)
= $ 3,790,787
The imputed interest expense each year is computed by calculating the interest on the
remaining lease liability:
In year 1, the lease liability = $ 3,790,787 * .10 = $ 379,079
The balance of the lease payment in that year is considered a reduction in the lease
In year 1, reduction in lease liability = $ 1,000,000 - $379,079 = $ 620,921
The lease liability is also depreciated over the life of the asset, using straight line
depreciation in this example.
If the imputed interest expenses and depreciation, which comprise the tax
deductible flows arising from the lease, are aggregated over the five years, the total tax
deductions amount to $ 5 million, which is also the sum of the lease payments. The only
difference is in timing –– the capital lease leads to greater deductions earlier and less later
Effect on Balance Sheet
The effect of leased assets on the balance sheet will depend on whether the lease
is classified as an operating lease or a capital lease. In an operating lease, the leased asset
is not shown on the balance sheet; in such cases, leases are a source of off-balance sheet
financing. In a capital lease, the leased asset is shown as an asset on the balance sheet,
with a corresponding liability capturing the present value of the expected lease payments.
Given the discretion, many firms prefer the first approach, since it hides the potential
liability to the firm and understates its effective financial leverage.
What prevents firms from constructing lease arrangements to evade these
requirements? The lessor and the lessee have very different incentives, since the
arrangements that would provide the favorable “operating lease” definition to the lessee
are the same ones under which the lessor cannot claim depreciation, interest, or other tax
benefits on the lease. In spite of this conflict of interest, the line between operating and
capital leases remains a thin one, and firms constantly figure out ways to cross the line.
These conditions for classifying operating and capital leases apply in most
countries; France and Japan are major exceptions –– in these countries, all leases are
treated as operating leases.
Effect on Financial Ratios
The effect of leases on the financial ratios of a firm depends on whether the lease
is classified as an operating or a capital lease. Table 2 summarizes types of profitability,
solvency, and leverage ratios and the effects of operating and capital leases on each. (The
effects are misleading, in a way, because they do not consider what would have happened
if the firm had bought the asset rather than lease it.)
Table 2: Effects of Operating and Capitalized Leases
Effect of Operating Lease
Effect of Capitalized Lease
Return on Capital
• Decreases EBIT through lease
• Decreases EBIT through
• Capital does not reflect leases
• Capital increases through
• ROC is higher
present value of
• ROC is lower
Return on Equity
• Net income lowered by after-tax
• Net income lowered by
after-tax interest expense
• BV of Equity Unaffected
• ROE effect depends on whether
• BV of Equity unaffected
lease expense > (imputed interest
• ROE effect depends on
whether lease expense >
(imputed interest +
• EBIT(1-t) decreases
• EBIT(1-t) decreases
• Interest Exp. unaffected
• Interest Exp. increases
• Coverage ratio generally higher
• Coverage Ratio generally
• Debt is unaffected
• Debt increases (to
• Debt Ratio is lower
account for capitalized
• Debt Ratio is higher
Since the level of financial ratios, and subsequent predictions, can vary depending on
whether leases are treated as operating or capital leases, it may make sense to convert
operating leases into capitalized leases when comparing these ratios across firms.
In Summary …
When a lease arrangement qualifies as an operating lease, there are profound
consequences for the reported earnings, book value of debt and capital, and return ratios
of that firm. In general,
• both the operating and net income of the firm will be lowered
• the debt and capital for the firm will be understated
• the return on equity and capital will be much higher
when a lease is treated as an operating lease rather than a capital lease.
The Financial View of Operating Lease
In finance, our view of all leases, operating as well as capital, is colored by
whether the lease payment represents a commitment similar to interest payments on debt.
If the answer is in the affirmative, leasing becomes an alternative to borrowing and
buying the assets, and lease payments becomes financial expenses rather than operating
expenses. This can have significant implications for the measurements of income, debt
and overall profitability. In this section, we will explore two ways of adjusting valuation
inputs for operating leases.
The Capital Adjustment
If operating lease expenses are to be considered financing expenses, it stands to
reason that the present value of commitments to make such payments in the future has to
be treated as debt. Accounting standards in the United States require that operating lease
commitments for the next five years be reported as part of the footnotes to financial
statements, and that any commitments beyond that period be cumulated and reported with
the commitments five years from now.
To convert operating lease commitments into an equivalent debt amount requires
that we discount these commitments back to the present. Again, consistency requires that
we use a pre-tax cost of debt for the discounting, since the commitments are pre-tax and
the lease expenses are being treated as financing expenses. The cost of debt can,
however, vary depending upon whether debt is secured or unsecured. Since the claims of
lessees are similar to the claims of unsecured debt holders, as opposed to secured debt
holders, the firm's cost of unsecured debt should be used in discounting lease