Discussion Issues and Derivations
- Dealing with Operating Leases in Financial Analysis
Accountants treat operating leases as expenses in income statements. Given that operating leases are fixed commitments which are tax deductible, it is far better to take the present value of operating lease expenses and treat it as the equivalent of debt.
To treat operating lease expenses as debt, we need to do the following:
a. Take the present value of operating lease expenses at the pre-tax cost of debt and use it in computing cost of capital.
b. Consider operating income prior to operating lease expenses. If the present value of operating lease expenses is treated as debt, then the operating lease expenses have to be treated as the equivalent of interest expenses.