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7/26/2019 Operating Leases
1/20
Corporate Valuation Operating Leases
Advanced Valuation Issues: Operating Leases
Professor David Wessels
The Wharton School of the Universit of Pennslvania ! "##$%
7/26/2019 Operating Leases
2/20
Professor David "
Corporate Va uat on Operat ng Leases
&idden Assets ' Lia(ilities
) Co*panies have three
*a+or hidden assets:
, &ide assets ( using off-
(alance sheet financing
such as operating leases%
, ./pense0 rather than
capitali1e0 intangi(le
invest*ent 23'D4%
, &ide o5nership dilution
through historical
pooling%
7/26/2019 Operating Leases
3/20
Professor David 6
Corporate Va uat on Operat ng Leases
&idden Assets ' Lia(ilities
) Capitalize operating leases
, Many companies have moved financing off-balance sheet using
operating leases, rather than purchase assets outright.
) Capitali1e research ' develop*ent 7 advertising
, Toda0 *an co*panies pri*ar assets are intangi(le% We need to
develop a *ethodolog to value historical invest*ent in products0
(rands0 distri(ution net5or8s0 etc%
) Capitali1e intangi(le assets hidden ( pooling
, Although S9AS ; no5 re
7/26/2019 Operating Leases
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Professor David ;
Corporate Va uat on Operat ng Leases
Understanding Leases 2Snthetic De(t4
Monmouth
Capital
Corporation(lessor)
Fed!
Corporation
(lessee)
use of asset for a
contracted period
periodic pa*ents
25hich cover interest and depreciation4
) Wh Lease>
% 9le/i(ilit has value to the lessee
"% Standardi1ation ( lessor leads to efficient costs
6% Depreciation ta/ shields can (e *ore valua(le to lessor 2avoid A?T4%
) A (usiness *a ac
7/26/2019 Operating Leases
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7/26/2019 Operating Leases
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Professor David B
Corporate Va uat on Operat ng Leases
Lease Tpes
According to 9AS0 a lease that *eets one or *ore of the follo5ing criteria0 *eaning it is
classified as a purchase ( the lessee 2S9AS 64:
24 the lease ter* is greater than $ of the asset=s esti*ated econo*ic lifeE
2"4 the lease contains an option to purchase the asset for less than fair *ar8et valueE
264 o5nership of the asset is transferred to the lessee at the end of the lease ter*E or
2;4 the present value of lease pa*ents e/ceeds F# of the fair *ar8et value of the asset%
Capital lease"
A lease for 5hich the lessee ac
7/26/2019 Operating Leases
7/20
Professor David
Corporate Va uat on Operat ng Leases
Operating Leases vs Capital Leases
) 3eported capitali1ed leases are s*all fraction of the present value of
operating leases% Got onl is toda=s total *uch s*aller0 (ut the gro5th
in capitali1ed leases is *uch s*aller as 5ell%
7/26/2019 Operating Leases
8/20
Professor David H
Corporate Va uat on Operat ng Leases
./plicit Capital: Capitali1ed Leases
) The good ne5s: Capitali1ed leases are alread included on the inco*e
state*ent and (alance sheet0 even though not e/plicitl% Details are
often hidden 5ithin the footnotes 25hich is O4%
Assets Liabilities & Shareholder Equity
Aggregated within PP&E: Aggregated within Long-Term
Aircraft 221 Unsecured debt 1,529
Package handling and ground
support equipment and vehicles 20 !apital lease obligations "22
#ther, principall$ facilities 1%
#ther debt, interest rates of &'(0)
to 9'9(), due through 201 &&
*ross !apitali+ed eases 5&5 -otal .ebt 2,01
ess accumulated amorti+ation /2&( ess current portion %0(
et !apitali+ed eases 29 ong/-erm .ebt 1,09
ource 3ede4 10/ ote ource 3ede4 10/ ote &
FedEx Cororation
6evenues 22,"(
#perating 74penses
alaries and emplo$ee benefits 9,(
Purchased transportation 2,155
6entals and landing fees 1,(0%
.epreciation and amort i+ation 1,%51
3uel 1,%"9
8aintenance and repairs 1,%9(
#ther %,1(2#perating ncome 1,"1
nterest, net /11(
#ther, net /15
ncome :efore ncome -a4es 1,%%(
!n"ome StatementFedEx Cororation
7/26/2019 Operating Leases
9/20
Professor David F
Corporate Va uat on Operat ng Leases
&idden Capital: Operating Leases
) The (ad ne5s: Operating leases
co*(ine depreciation and interest
pa*ents into a single ite* called
rental pa*ents%
) ?ore (ad ne5s: the present value
of operating leases do GOT
appear on the (alance sheet%
) We *ust find a 5a of
recapitali1ing the off-(alance
sheet ite* (ac8 onto the (alance
sheet%
6evenues 22,"(
#perating 74penses
alaries and emplo$ee benefits 9,(Purchased transportation 2,155
6entals and landing fees 1,(0%
.epreciation and amorti+ation 1,%51
3uel 1,%"9
8aintenance and repairs 1,%9(
#ther %,1(2
#perating ncome 1,"1
nterest, net /11(
#ther, net /15
ncome :efore ncome -a4es 1,%%(
!n"ome Statement
FedEx Cororation
7/26/2019 Operating Leases
10/20
Professor David #
Corporate Va uat on Operat ng Leases
Valuation Issues and Operating Leases
) The accounting treat*ent of operating leases 5ill distort
*an critical inputs for the valuation process% @iven its
de(t-li8e characteristics0 *an distortions follo5 directl
fro* the acade*ic literature on de(t%
, Co*petitive (ench*ar8ing and *easuring value creation
, The cost of e
7/26/2019 Operating Leases
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Professor David
Corporate Va uat on Operat ng Leases
ote (' ong/-erm .ebt and !ommitment
Future Caital #erating Future Caital #erating$ear Leases Leases $ear Leases Leases
200" "" 1,%&( 200" &( %1(
2005 125 1,2(5 2005 &( 251
200& 102 1,192 200& 9% 1("
200 11 1,155 200 &( 1%&
200( 11 1,0"5 200( 11% 10"
-hereafter 2%( (,%"2 -hereafter 2"1 555
5%1 1",%( &51 1,5"(
%nited Par"el Seri"e
ote ease !ommitments
FedEx Cororation
) 9ro* the notes0 5e can collect infor*ation on operating leases:
Operating Leases: 9ed./ versus UPS
) 9ed./ uses operating leases heavil% &o5 5ill this affect co*petitive
(ench*ar8ing and value creation>
7/26/2019 Operating Leases
12/20
Professor David "
Corporate Va uat on Operat ng Leases
) Using the accepted *ethodolog of discounting operating lease
pa*ents at the cost of de(t 2B4 to ascertain the value of off-(alance
sheet assets0 9ed./ doesn=t loo8 as asset efficient an *oreJ
Distortion of Capital Turnover
%nited Par"el Ser&i"e
' o( ' o(
Line !tem ) *illions +e&enues ) *illions +e&enues
-otal 6evenues 22,"( 100'0) %1,22 100'0)
:ook PP;7 (,00 %(') 1%,&12 "%'5)
7stimated eases 9,9&9 ""'%) 1,21% %'9)Ad
7/26/2019 Operating Leases
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Professor David 6
Corporate Va uat on Operat ng Leases
Distortion of 3OIC
) 3OIC *easures financial perfor*ance 5ithout regard to a co*pan=s
capital structure% If one fails to ad+ust 3OIC for operating leases0 3OIC
5ill (e sste*aticall distorted ( lease choice%
PV2Lease4-CapitalInvested
PV2Lease44823OIC3OIC3OIC dunad+ +=
After-ta/ lease
interest rate
3OIC 5ith no
operating
leases
3eported
capital
7/26/2019 Operating Leases
14/20
Professor David ;
Corporate Va uat on Operat ng Leases
The Cost of .
7/26/2019 Operating Leases
15/20
Professor David $
Corporate Va uat on Operat ng Leases
Mield to ?aturit and De(t 3atings
) Li*0 ?an0 ' ?ihov 2"##64 co*pare the i*pact of operating leases on de(t
ratings and the ield of ne5 de(t issues to that of (alance sheet de(t% The
argue rating have less sensitivit to leases0 (ut ields do not%
#/0 1egression of 2umerical Debt 1ating #/0 1egression of 3ield 0pread
7/26/2019 Operating Leases
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Professor David B
Corporate Va uat on Operat ng Leases
Valuing Operating Leases
) In the #-0 5e can retrieve (oth
historical as 5ell as future
operating lease co**it*ents%
) There are three *ethods:
24 Su* the future discounted
operating lease flo5s ( the cost
of de(t 2S'P0 Da*odoran4%
2"4 Divide ne/t ear=s flo5 ( the
cost of de(t 2?ood=s4%
264 Divide ne/t ear=s flo5 ( the
su* of the cost of de(t and the
annual depreciation rate%
Future Caital #erating$ear Leases Leases
200" "" 1,%&(
2005 125 1,2(5
200& 102 1,192
200 11 1,155
200( 11 1,0"5
-hereafter 2%( (,%"2
5%1 1",%(
ote ease !ommitments
FedEx Cororation
7/26/2019 Operating Leases
17/20
Professor David
Corporate Va uat on Operat ng Leases
Valuing Operating Leases: An ./a*ple
) To understand ho5 5ell each *ethodolog 5or8s0 let=s (uild a hpothetical
leasing e/a*ple% In our e/a*ple0 5e assu*e the co*pan leases assets for
the first five of their ten-ear lives0 at an interest rate of $%
Assu*e asset
life of #
ears0 lease
for first $
ears
Assets have
(een gro5ing
at #
Cost of de(t
e
7/26/2019 Operating Leases
18/20
Professor David H
Corporate Va uat on Operat ng Leases
Valuing Operating Leases: An ./a*ple
) @iven (oth historical and future rental pa*ents0 ho5 can 5e separate out
interest and principal> i%e% re*ove interest pa*ent0
) &o5 can 5e deter*ine depreciation of the operating assets>
Su* of all asset
lease pa*ents
Onl the oungest
asset 5ill appear in
the final state*ent
7/26/2019 Operating Leases
19/20
Professor David F
Corporate Va uat on Operat ng Leases
Valuation ?ethodolog
) The *ost co**on *ethod0 discounted *ini*u* rental co**it*ents0
sste*aticall underesti*ates the operating leases% A si*ple perpetuit
*ethod 23ental e/pense 7 8d4 sste*aticall overesti*ates lease value%
7/26/2019 Operating Leases
20/20
Professor David "#
Corporate Va uat on Operat ng Leases
Wall Street ?ultipliers
) Toda0 the accepted Wall Street *ultiplier of rental e/pense is H/% This
is consistent 5ith toda=s #-ear corporate (ond rates and an average
asset life of "-ears%