Chapter 27 Leases, Pensions, and Other Obligations Instructors: Please do not post raw PowerPoint files on public website. Thank you! 1

Session Overview Over the past 20 years, clever use of existing accounting rules has allowed companies to keep many assets and their corresponding debts “off balance sheet.” During this session, we will adjust the financial statements to normalize for: 1.Operating leases. A company that chooses to lease its assets will have artificially low operating profits (because rental expenses include an implicit interest expense) and artificially high capital productivity (because the assets do not appear on the lessee’s balance sheet). 2.Securitized receivables. By selling a portion of its receivables, the company will reduce accounts receivable on the balance sheet and increase cash flow from operations on the accountant’s cash flow statement. 3.Pensions. Today, under U.S. GAAP, U.S. companies report the market value of pension shortfalls (and excess pension assets) on the balance sheet. Unfortunately, recent accounting changes have addressed only deficiencies on the balance sheet. The idiosyncrasies of pension accounting still distort operating profitability and can even be manipulated by management to enhance margins artificially. 2

3 Understanding Leases (Synthetic Debt) Monmouth Capital Corporation (lessor) FedEx Corporation (lessee) Use of asset for a contracted period Periodic payments (cover interest costs and asset depreciation) Why lease? Flexibility has value to lessee. Standardization by lessor leads to efficient costs. Depreciation tax shields are more valuable to lessor (to avoid AMT). A business may acquire sole use of an asset through a lease.

4 Lease Types According to the Financial Accounting Standards Board (FASB), a capital lease is a lease that meets one or more of the following four criteria, meaning it is classified as a purchase by the lessee (SFAS 13): 1. The lease term is greater than 75 percent of the asset’s estimated economic life. 2. The lease contains an option to purchase the asset for less than fair market value. 3. Ownership of the asset is transferred to the lessee at the end of the lease term. 4. The present value of lease payments exceeds 90 percent of the fair market value of the asset. Capital lease: A lease for which the lessee acquires the property for only a small portion of its useful life. An operating lease is commonly used to acquire equipment on a short-term basis. Any lease that is not a capital lease is an operating lease. Operating lease:

Operating Leases: The Income Statement Operating leases combine depreciation and interest payments into a single item called rental payments. Since interest expense is part of rental expense, operating income is understated, depressing margins versus those companies who borrow money to purchase assets. Our goal is to eliminate interest expense related to operating leases from operating income. 5 1 The value of operating leases is not typically disclosed. A method for estimating the value of leased assets is presented later. Income statement TodayYear 1Year 2Year 3 Revenues900.01,000.01,150.01,265.0 Expenses(800.0)(920.0)(1,012.0) Rental expense(106.4)(115.4)(118.1) Operating income Interest(7.1)(7.7)(7.9) Earnings before taxes Taxes(21.6)(26.7)(31.7) Net income Supplemental disclosure: Rental expensen/a Value of operating leases −

Operating Leases: The Balance Sheet The value of leased assets via operating leases does not appear on the balance sheet, either as an operating asset or as a debt. Therefore, operating assets and debt are understated. This causes capital turns (revenue to capital) to be distorted upward and debt to EBITDA to be distorted downward versus peers. Our goal is to recapitalize operating leases in both operating assets and debt. 6 Balance sheet TodayYear 1Year 2Year 3 Short-term assets − Long-term assets − Operating assets − Operating liabilities − Debt − Equity − Liabilities and equity −

Valuing Operating Leases Companies seldom disclose the value of their leased assets, but you need to estimate their value to adjust for operating leases. We recommend the following estimation process using rental expense, the cost of secured debt, and an estimated asset life. 7 To compensate the lessor properly, the rental expense includes compensation for the cost of financing the asset (at the cost of secured debt, denoted by k d in the equation) and the periodic depreciation of the asset (for which we assume straight-line depreciation).

Process for Capitalizing Leases The process for adjusting financial statements and valuation for operating leases consists of three steps: 1. Reorganize the financial statements to reflect operating leases appropriately. Capitalize the value of leased assets on the balance sheet, and make a corresponding adjustment to long-term debt. Adjust operating profit upward by removing the implicit interest in rental expense. 2. Build a weighted average cost of capital (WACC) that reflects adjusted debt to enterprise value. To do this, use an adjusted debt-to-value ratio that includes capitalized operating leases. If unlevered industry betas are used to determine the cost of equity, lever them at the adjusted debt-to-value ratio to determine the levered cost of equity. 3.Value the enterprise by discounting free cash flow (based on the newly reorganized financial statements) at the adjusted cost of capital. Subtract traditional debt and the current value of operating leases from enterprise value to determine equity value. 8

Reorganizing the Income Statement To adjust the income statement, remove implicit interest expense from rental expense. Operating taxes must also be adjusted. 9 Leasing Example: NOPLAT Calculation Rental Expense In year 1, $35.5 million (5% × million) of interest expense is removed from operating profit. Operating Taxes Operating taxes are increased by the marginal tax rate (25%) times implicit interest expense. Reconciliation Create a new account titled after-tax lease interest.

Reorganizing the Balance Sheet The value of capitalized operating leases ($710.6 million) is added to book assets to long-term debt. The corresponding adjustments increase both sources and uses of invested capital. 10 Leasing Example: Invested Capital Calculation Operating Financing

Cost of Capital: Capital Structure To determine the cost of capital, start by computing how the company is financed. To adjust capital structure for operating leases, add the value of operating leases ($710.6 million) to unadjusted enterprise value. 11 Leasing Example: Current Capital Structure Capital structure (unadjusted for leases)Capital structure (adjusted for leases) percent $ millionof total$ millionof total Debt value Debt value Market value of equity Market value of equity Enterprise value Value of operating leases Enterprise value1,

Adjusting the Cost of Capital The adjusted cost of capital weights the after-tax cost of debt (4.5 percent) by 10 percent, the cost of equity (12 percent) by 30 percent, and the after-tax cost of operating leases (3.75 percent) by 60 percent. This leads to a lower WACC of 6.3 percent. 12 Leasing Example: Weighted Average Cost of Capital (WACC) Calculation

Free Cash Flow and Valuation Leasing Example: Free Cash Flow and Equity Valuation As long as (1) NOPLAT, (2) invested capital, (3) cost of capital, and (4) total debt are adjusted consistently, equity value will be identical.

14 Are Leases Really Synthetic Debt? If operating leases are forms of synthetic debt, debt ratings should drop as leases rise. Yields on existing bonds should rise with operating leases. Empirical analysis by Lim, Mann, and Mihov supports this supposition. S&P ratingReg 1Reg 2Reg 3New issue yield spreadReg 1Reg 2Reg 3 Intercept Intercept Log (sales) S&P rating−0.274−0.273−0.278 PP&E/total assets Maturity EBIT coverage ratio Proceeds/total assets EBITDA/total liabilities Log (sales)−0.052−0.048−0.033 Total debt/firm value−6.399−6.385−6.401Total debt/firm value OL: PV (minimum lease)−4.186OL: PV (minimum lease)2.066 OL: perpetuity method−2.041OL: perpetuity method0.790 OL: with depreciation−3.269OL: with depreciation1.020 Source: Steve C. Lim, Steven C. Mann, and Vassil T. Mihov, “Market Evaluation of Off-Balance-Sheet Financing: You Can Run but You Can’t Hide,” EFMA 2004 Basel Meetings Paper (December 1, 2003). Regression of S&P Rating and Yield Spread on D/V Ratios

Session Overview Over the past 20 years, clever use of existing accounting rules has allowed companies to keep many assets and their corresponding debts “off balance sheet.” During this session, we will adjust the financial statements to normalize for: 1.Operating leases. A company that chooses to lease its assets will have artificially low operating profits (because rental expenses include an implicit interest expense) and artificially high capital productivity (because the assets do not appear on the lessee’s balance sheet). 2.Securitized receivables. By selling a portion of its receivables, the company will reduce accounts receivable on the balance sheet and increase cash flow from operations on the accountant’s cash flow statement. 3.Pensions. Today, under U.S. GAAP, U.S. companies report the market value of pension shortfalls (and excess pension assets) on the balance sheet. Unfortunately, recent accounting changes have addressed only deficiencies on the balance sheet. The idiosyncrasies of pension accounting still distort operating profitability and can even be manipulated by management to enhance margins artificially. 15

16 Receivables Securitization Another common method of moving assets of the balance sheet is securitization. To securitize an asset, the company either sells the assets outright or transfers the assets to an independent subsidiary called a special purpose entity (SPE). –As long as the company owns less than 50 percent of the SPE and the SPE has more than 3 percent ownership by unaffiliated parties, the original company is not required to consolidate the SPE’s assets on its own balance sheet—nor recognize its obligations. Consider the following example: Crown Holdings, Inc. The Company had no outstanding borrowings under its $758 revolving credit facility at December 31, 2008 and had $234 of securitized receivables.... The Company recorded expenses related to the securitization facilities of $14, $17, and $15, respectively, as interest expense, including commitment fees of 0.25% on the unused portion of the facilities.

Interest or SG&A? In some cases, fees are included in selling, general, and administrative (SG&A) expense, rather than interest expense. In these situations, the fees must be moved from SG&A expense to interest expense for valuation of the company. For example, Hasbro includes securitization fees in its selling expenses: 17 Hasbro Inc. As of December 30, 2008 and December 31, 2007 the utilization of the receivables facility was $250,000. During 2008, 2007, and 2006, the loss on the sale of the receivables totaled $5,302, $7,982, and $2,241, respectively, which is recorded in selling, distribution, and administration expenses in the accompanying consolidated statements of operations.

18 The Dark Side of Securitization Imagine that you run a division that sells $1 billion in products to a large customer. The customer typically pays in 30 to 45 days, and thus has $120 million in receivables outstanding. –Your division is short of cash, and therefore asks the customer to pay in cash. To encourage the transaction, you offer a discount of $5 million. What happens to EBIT, NOPAT, invested capital, and ROIC? –Let’s say instead you decide to trade the receivables for cash with a third party for a $5 million fee. If the fee is classified as interest, what will happen to EBIT, NOPAT, invested capital, and ROIC?

Session Overview Over the past 20 years, clever use of existing accounting rules has allowed companies to keep many assets and their corresponding debts “off balance sheet.” During this session, we will adjust the financial statements to normalize for: 1.Operating leases. A company that chooses to lease its assets will have artificially low operating profits (because rental expenses include an implicit interest expense) and artificially high capital productivity (because the assets do not appear on the lessee’s balance sheet). 2.Securitized receivables. By selling a portion of its receivables, the company will reduce accounts receivable on the balance sheet and increase cash flow from operations on the accountant’s cash flow statement. 3.Pensions. Today, under U.S. GAAP, U.S. companies report the market value of pension shortfalls (and excess pension assets) on the balance sheet. Unfortunately, recent accounting changes have addressed only deficiencies on the balance sheet. The idiosyncrasies of pension accounting still distort operating profitability and can even be manipulated by management to enhance margins artificially. 19

Pension Accounting The process of how to incorporate excess pension assets and unfunded pension liabilities into enterprise value, and how to adjust the income statement to eliminate accounting distortions consists of the following three steps: 1.Identify excess pension assets and unfunded liabilities on the balance sheet. If the company does not separate pension accounts, search the pension footnote for their location. Excess pension assets should be treated as nonoperating, and unfunded pension liabilities should be treated as a debt equivalent. 2.Add excess pension assets to and deduct unfunded pension liabilities from enterprise value. Valuations should be done on an after-tax basis. 3.Remove the accounting pension expense from cost of sales, and replace it with the service cost and amortization of prior service costs reported in the notes. The pension expense, service cost, and amortization of prior service costs are reported in the company’s notes. 20

Step 1: Identify Assets and Liabilities Not every company reports prepaid pension assets and unfunded pension liabilities as a separate line item. Many companies consolidate prepaid pension assets in other long-term assets and unfunded pension liabilities as part of other long-term liabilities, making them difficult to identify. 21 DuPont: Pension Note in Annual Report, Funded Status Overfunded pensions are embedded in other assets; therefore a good portion of other assets should NOT be included in invested capital. The same holds true for unfunded liabilities. They should not be treated as operating liabilities, but rather as debt equivalents.

Step 2: From Enterprise to Equity Value For an ongoing enterprise, excess pension assets can be netted against unfunded liabilities to determine net assets (liabilities) outstanding. –To incorporate pensions for a company with net excess assets, add (1 – Marginal Tax Rate) × Net Pension Assets to enterprise value, as excess pension assets will lead to fewer required contributions in the future. –To value companies with net unfunded liabilities, deduct (1 – Marginal Tax Rate) × Net Pension Liabilities from enterprise value. For enterprises in liquidation, investigate the tax implications of under- or overfunding. For instance, many countries impose large tax penalties to withdraw excess funding from pension plans. 22

Step 3: Adjust Income Statement To determine the portion of pension expense that is compensation to employees (and not gains and losses on pension investments), combine service cost and amortization of prior service cost to arrive at today’s value of promised retirement payments. 23 DuPont: Adjusted Operating Profits Pension Adjustment To remove plan performance from operating expenses, remove pension expense—in DuPont’s case, a $54 million gain in 2007 (subtract gains, add back expenses)—and replace it with the service cost ($383 million) and amortization of prior service cost ($18 million).