Corporate ValuationOperating Leases Advanced Valuation Issues: Operating Leases Professor David Wessels The Wharton School of the University of Pennsylvania © 2005.

Corporate ValuationOperating Leases Professor David Wessels The Wharton School of the University of Pennsylvania 2 Hidden Assets & Liabilities Companies have three major hidden assets: –Hide assets by using off- balance sheet financing such as operating leases. –Expense, rather than capitalize, intangible investment (R&D). –Hide ownership dilution through historical pooling.

Corporate ValuationOperating Leases Professor David Wessels The Wharton School of the University of Pennsylvania 3 Hidden Assets & Liabilities Capitalize operating leases –Many companies have moved financing off-balance sheet using operating leases, rather than purchase assets outright. Capitalize research & development / advertising –Today, many companies primary assets are intangible. We need to develop a methodology to value historical investment in products, brands, distribution networks, etc. Capitalize intangible assets hidden by pooling –Although SFAS 141 now requires companies to use purchase accounting on new acquisitions, intangible assets from old acquisitions won’t appear on the balance sheet. Data Collection Easy Difficult

Corporate ValuationOperating Leases Professor David Wessels The Wharton School of the University of Pennsylvania 4 Understanding Leases (Synthetic Debt) Monmouth Capital Corporation (lessor) FedEx Corporation (lessee) use of asset for a contracted period periodic payments (which cover interest and depreciation) Why Lease? 1. Flexibility has value to the lessee 2. Standardization by lessor leads to efficient costs 3. Depreciation tax shields can be more valuable to lessor (avoid AMT). A business may acquire sole use of an asset through a lease.

Corporate ValuationOperating Leases Professor David Wessels The Wharton School of the University of Pennsylvania 5 The Growth of Operating Leases Rental expenses for have grown steadily over the last fifteen years. As a percentage of sales, the number has remained relatively constant (1.5% of sales). Since interest rates have declined, the present value of leases have outpaced revenue growth.

Corporate ValuationOperating Leases Professor David Wessels The Wharton School of the University of Pennsylvania 6 Lease Types According to FASB, a lease that meets one or more of the following criteria, meaning it is classified as a purchase by the lessee (SFAS 13): (1) the lease term is greater than 75% 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; or (4) the present value of lease payments exceeds 90% 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: The choice is black or white

Corporate ValuationOperating Leases Professor David Wessels The Wharton School of the University of Pennsylvania 7 Operating Leases vs Capital Leases Reported capitalized leases are small fraction of the present value of operating leases. Not only is today’s total much smaller, but the growth in capitalized leases is much smaller as well.

Corporate ValuationOperating Leases Professor David Wessels The Wharton School of the University of Pennsylvania 8 Explicit Capital: Capitalized Leases The good news: Capitalized leases are already included on the income statement and balance sheet, even though not explicitly. Details are often hidden within the footnotes (which is OK).

Corporate ValuationOperating Leases Professor David Wessels The Wharton School of the University of Pennsylvania 9 Hidden Capital: Operating Leases The bad news: Operating leases combine depreciation and interest payments into a single item called rental payments. More bad news: the present value of operating leases do NOT appear on the balance sheet. We must find a way of recapitalizing the off-balance sheet item back onto the balance sheet.

Corporate ValuationOperating Leases Professor David Wessels The Wharton School of the University of Pennsylvania 10 Valuation Issues and Operating Leases The accounting treatment of operating leases will distort many critical inputs for the valuation process. Given its debt-like characteristics, many distortions follow directly from the academic literature on debt. –Competitive benchmarking and measuring value creation –The cost of equity –The yield to maturity on debt & debt ratings –P/E and enterprise value multiples

Corporate ValuationOperating Leases Professor David Wessels The Wharton School of the University of Pennsylvania 11 From the notes, we can collect information on operating leases: Operating Leases: FedEx versus UPS FedEx uses operating leases heavily. How will this affect competitive benchmarking and value creation?

Corporate ValuationOperating Leases Professor David Wessels The Wharton School of the University of Pennsylvania 12 Using the accepted methodology of discounting operating lease payments at the cost of debt (6%) to ascertain the value of off-balance sheet assets, FedEx doesn’t look as asset efficient any more! Distortion of Capital Turnover

Corporate ValuationOperating Leases Professor David Wessels The Wharton School of the University of Pennsylvania 13 Distortion of ROIC ROIC measures financial performance without regard to a company’s capital structure. If one fails to adjust ROIC for operating leases, ROIC will be systematically distorted by lease choice. After-tax lease interest rate ROIC with no operating leases Reported capital

Corporate ValuationOperating Leases Professor David Wessels The Wharton School of the University of Pennsylvania 14 The Cost of Equity Ely (1995) tests whether investors view operating leases as leverage. To do this, Ely test the following theoretical relation: using the following regression: and finds: (40.26) (5.70) (5.72) (2.38)

Corporate ValuationOperating Leases Professor David Wessels The Wharton School of the University of Pennsylvania 15 Yield to Maturity and Debt Ratings Lim, Man, & Mihov (2003) compare the impact of operating leases on debt ratings and the yield of new debt issues to that of balance sheet debt. They argue rating have less sensitivity to leases, but yields do not. OLS Regression of Numerical Debt RatingOLS Regression of Yield Spread

Corporate ValuationOperating Leases Professor David Wessels The Wharton School of the University of Pennsylvania 16 Valuing Operating Leases In the 10-K, we can retrieve both historical as well as future operating lease commitments. There are three methods: (1)Sum the future discounted operating lease flows by the cost of debt (S&P, Damodoran). (2)Divide next year’s flow by the cost of debt (Moody’s). (3)Divide next year’s flow by the sum of the cost of debt and the annual depreciation rate.

Corporate ValuationOperating Leases Professor David Wessels The Wharton School of the University of Pennsylvania 17 Valuing Operating Leases: An Example To understand how well each methodology works, let’s build a hypothetical leasing example. In our example, we assume the company leases assets for the first five of their ten-year lives, at an interest rate of 5%. Assume asset life of 10 years, lease for first 5 years Assets have been growing at 10% Cost of debt equals 5%

Corporate ValuationOperating Leases Professor David Wessels The Wharton School of the University of Pennsylvania 18 Valuing Operating Leases: An Example Given both historical and future rental payments, how can we separate out interest and principal? i.e. remove interest payment, How can we determine depreciation of the operating assets? Sum of all asset lease payments Only the youngest asset will appear in the final statement

Corporate ValuationOperating Leases Professor David Wessels The Wharton School of the University of Pennsylvania 19 Valuation Methodology The most common method, discounted minimum rental commitments, systematically underestimates the operating leases. A simple perpetuity method (Rental expense / k d ) systematically overestimates lease value.

Corporate ValuationOperating Leases Professor David Wessels The Wharton School of the University of Pennsylvania 20 Wall Street Multipliers Today, the accepted Wall Street multiplier of rental expense is 8x. This is consistent with today’s 10-year corporate bond rates and an average asset life of 12-years.