Operating Leases: Estimating the Value of Leased Assets (Part III)

In the book Valuation: Measuring and Managing the Value of Companies the issue of operating leases is discussed. 

The beginning section starts out with a discussion about operating leases and its true nature (see earlier post here). How should a business analyst treat operating leases? How should the analyst think about operating leases when performing a financial analysis to make any comparisons with other firms useful (see earlier post here)?

In this post we take a closer look at how to estimate the value of leased assets (emphasis added).

Estimating the Value of Leased Assets

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. To see why, examine the determinants of rental expense. 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 kd in the following equations) and the periodic depreciation of the asset (for which we assume straight-line depreciation). The following equation solves for periodic rental expense:

Skärmavbild 2015-05-05 kl. 21.09.26

To estimate the asset’s value, rearrange equation (27.1) as follows:

Skärmavbild 2015-05-05 kl. 21.09.47

Rental expense is disclosed in the footnotes, and the cost of debt can be estimated using AA-rated yields. (Remember, the operating lease is secured by the underlying asset, so it is less risky than the company’s unsecured debt.) This leaves only the asset life, which is unreported. To estimate asset life, Lim, Mann, and Mihov propose using property, plant, and equipment (PP&E) divided by annual depreciation. In their research, they examined 7,000 firms over 20 years and computed the median asset life at 10.9 years. [6]

[6] 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). 

There are several other approaches for computing asset value. The most common alternative is to compute the present value of required lease payments, which can be found in the company’s footnotes. Although this method is used by rating agencies such as Standard & Poor’s, it systematically undervalues the asset, since it ignores the residual value returned at the end of the lease contract. For example, most would agree that a $1 million asset leased for two years is worth more than the present value of two payments of $100,000 per year.

A second alternative for computing the asset value of operating leases is the perpetuity method. In this method, the rental expense is divided by the cost of debt. But the perpetuity method systematically overvalues leased assets. Why? The method is identical to the depreciation-adjusted perpetuity proposed in equation (27.2) using an infinite asset life. Since the asset life is in fact finite, the perpetuity method understates the denominator and thus overstates the asset value, especially for short-lived assets.

A final possibility is to multiply rental expense by a capitalization rate. Many in the investment banking community multiply rental expenses by 8 times to approximate asset value. Although this method is quite simplistic, the multiplier is based on reasonable assumptions: Using the depreciation-adjusted perpetuity from equation (27.2) with a cost of debt of 6 percent and an asset life of 15 years leads to a multiplier of 8 times. But be careful. As the actual cost of debt or asset life deviates from these values, the 8 times multiplier could lead to incorrect assessments.

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