Dealing with Operating Leases and R& D in Valuation

Aswath Damodaran

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, when we do this, that the operating expenses do not include any financing expenses (such as interest) or capital expenditures, which create benefits in future periods. While these assumptions , for the most part, are true, there are two significant exceptions. The first is operating lease expenses that are treated as part of the operating expenses, but really represent financing expenses. The second is research and development, that is again treated as an operating expense, but in reality is a capital expense designed to create future growth. In this paper, we look at ways of adjusting for both these models in valuation.


            The operating income is a key input into every firm valuation model, and it often obtained income statement. In doing so, 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. In fact, for the most part, accounting statements separate out capital expenditures from operating expenses, and do not deduct them from revenues to arrive at operating income. The key exception to this rule seems to be the accounting treatment of research and development expenses, at lease in US accounting statements.  Accounting standards in the United States requires the expensing of R & D when it occurs, even though it is designed to create revenue in future periods. For the most part, again, accounting statements separate out financing expenses such as interest expense and show it after operating income. Here again there is one significant exception to this rule, and that is the accounting treatment of operating lease expenses, which are categorized as operating expenses to arrive at operating expense. We will make the argument in this paper that ignoring these misclassifications can create significant problems in valuation, and suggest ways in which we can incorporate both items in firm value.

Operating 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 can have a significant effect on 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 the corrections we need to make to operating income and capital while doing either discounted cash flow valuation or using multiples.

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 Gap.

            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 is 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:

Š      Are the lease payments on the asset spread out over the life of the asset or are they accelerated over a much shorter period?

Š      Can the lessee continue to use the asset after the life of the lease at preferential rates or nominal amounts?

Š      Can the lessee buy the asset at the end of the life of the lease at a price well below market?

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 the lease.

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 asset.

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, theyalso 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.

            On the other side of the transaction, the lessor counts the lease payment as revenue, which is taxable. In addition, the lessor can generally claim depreciation, interest, and other deductions associated with the lease as expenses. To do so, however, the lease has to fulfill five criteria:

1. The asset can still be used by someone other than the lessee at the end of the life of the lease.

2. The lessee cannot buy the asset at below market value at the end of the life of the lease.

3. The lessor has at least 20% of the asset at risk; in other words, the present value of the lease payments is less than 80% of the asset’s value.

4. The lessor has a positive cash flow from the lease, not counting the tax benefits.

5. The lessee has not lent any money on the asset to the lessor to buy the asset.

The after-tax income generated by the lease can then be written as a function of the lessor’s tax rate, which may be different from the lessee’s 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

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 liability:

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 more deductions earlier and fewer later on.

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 1 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 leased.)

Table 1: Effects of Operating and Capitalized Leases


Effect of Operating Lease

Effect of Capitalized Lease

Return on Capital

Š      Decreases EBIT through lease expense

Š      Capital does not reflect leases

Š      ROC is higher

Š      Decreases EBIT through depreciation

Š      Capital increases through present value of operating lease

Š      ROC is lower

Return on Equity

Š      Net income lowered by after-tax lease expense

Š      BV of Equity Unaffected

Š      ROE effect depends on whether lease expense > (imputed interest + depreciation)

Š      Net income lowered by after-tax interest expense & depreciation

Š      BV of Equity unaffected

Š      ROE effect depends on whether lease expense > (imputed interest + depreciation)

Interest Coverage

Š      EBIT(1-t) decreases

Š      Interest Exp. unaffected

Š      Coverage ratio generally higher

Š      EBIT(1-t) decreases

Š      Interest Exp. increases

Š      Coverage Ratio generally lower

Debt Ratio

Š      Debt is unaffected

Š      Debt Ratio is lower

Š      Debt increases (to account for capitalized leases)

Š      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,

Š      both the operating and net income of the firm will be lowered

Š      the debt and capital for the firm will be understated

Š      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.

The Income Adjustment

            If operating lease expenses represent fixed commitments for the future, then they have to be treated as financing expenses rather than operating expenses. This will have a significant impact on operating income, since it is defined to be net of just operating expenses. Thus, the operating income for a firm will always increase when operating lease expenses are re-categorized as financing expenses. The magnitude of the impact will depend upon whether we use a simple adjustment, where the entire operating lease expense is treated as a financing expense, or if we use the more complex adjustment, where we convert operating leases into capital leases, and then depreciate the asset created by the lease. If we use the latter approach, the operating income will still be affected by the depreciation portion.

            There should be no effect on net income, which is after defined as the income after both operating and financing expenses, if we use the simple adjustment. Moving operating leases from the operating expense to the financing expense column, by itself, should have no effect on the net income. If we decide to treat operating leases as capital leases, and estimate imputed interest and depreciation on it, there can be timing effects on net income, with the net income in earlier years being lower and in later years being higher as a result of the recategorization.

            Should we expend the effort to convert operating leases into capital leases, and then proceed to calculate the imputed interest and depreciation? While we preserve consistency with our treatment of capital leases by doing so, we create a far larger problem for ourselves in terms of cash flow estimation by doing so. It is the entire lease expense that is tax deductible, and not the imputed interest and depreciation amount, and this then becomes an adjustment we would need to make to arrive at after-tax cash flows. It makes far more sense to stick with the simple adjustment for operating leases at this stage of the process.

Illustration 1: The Home Depot - Income Estimation with Operating Income recategorized



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 use to discount these commitments back to the future. 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 commitments.

            As a final detail, the cumulation of all lease commitments after the fifth year into that year's amount does create a discounting problem. One simple approximation that works is to use the average lease commitment over the first four years as an approximate annuity in converting the final cumulated amount into annual amounts. Thus, a firm that has average lease commitments of $ 2 million for the next 4 years, and shows a cumulated commitment of $ 12 million in year 5, can be considered to have annual lease payments of $ 2 million a year for 6 years starting in year 5 for present value purposes.

            The book value of equity should be unaffected by this adjustment, but the book value of capital will then be the sum of the debt, including converted operating leases, and the book value of equity.

The Profitability Adjustment

            The conversion of operating lease expenses into financing expenses increases operating income and capital, and thus affects any profitability measure using one or both of these numbers. The most directly affected estimate is the return on capital, which is the operating income divided by the book value of capital. The modified return on capital, using the simple adjustment where the entire operating lease expense is treated as a financing expense, can be written as:

Will the return on capital be increased or decreased by the conversion of operating leases? It depends upon whether the unadjusted return on capital was greater or lesser than the ratio of after-tax operating lease expenses to the debt value of operating leases (OLDR). Thus,

If         Unadjusted After-tax ROC > OLDR               Return on Capital will decrease

            Unadjusted After-tax ROC < OLDR               Return on Capital will increase

The return on equity should be unaffected if we use the simple conversion method, where the entire operating lease expen

The Free Cash Flow Adjustment


The Valuation Adjustnebt