PRACTICAL PROBLEM - OPERATING LEASES financing, valuation, determine, therefore

noel

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.

Rasec

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.

bdavi77962

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.

ryanlb

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.

madaochenggong

Did you take Level 2?