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Firm Valuation with Operating Leases

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  • Jennergren, L. Peter

    (Dept. of Business Administration, Stockholm School of Economics)

Abstract

Operating leases are quite important in some industries. There are two possible errors that should be avoided when valuing a company with operating leases. In the first place, one should not neglect the implied lease debt. Such neglect distorts the calculation of free cash flow, required rate of return on the equity under partial debt financing, WACC, and residual equity value in the discounted cash flow model. In the second place, lease expense and implied lease debt should not be forecasted as constant, historical fractions of sales revenue in the (non-steady state) explicit forecast period. This paper outlines an approximate procedure for handling operating leases in valuation models, in particular the discounted cash flow model. This procedure avoids the two possible errors that were mentioned and is shown to result in equity values that are very close to the known, exact values in a stylized example problem. Naive valuation (that makes both errors) results in equity values that can be quite far away from those same known, exact values.

Suggested Citation

  • Jennergren, L. Peter, 2011. "Firm Valuation with Operating Leases," SSE/EFI Working Paper Series in Business Administration 2011:3, Stockholm School of Economics, revised 30 May 2011.
    • Handle: RePEc:hhb:hastba:2011_003
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    References listed on IDEAS

    as
    1. Vivien Beattie & Alan Goodacre & Sarah Thomson, 2000. "Recognition versus Disclosure: An Investigation of the Impact on Equity Risk Using UK Operating Lease Disclosures," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 27(9‐10), pages 1185-1224, November.
    2. Richard S Ruback, 2002. "Capital Cash Flows: A Simple Approach to Valuing Risky Cash Flows," Financial Management, Financial Management Association, vol. 31(2), Summer.
    3. Rolf Uwe Fülbier & Jorge Lirio Silva & Marc Henrik Pferdehirt, 2008. "Impact of Lease Capitalization on Financial Ratios of Listed German Companies," Schmalenbach Business Review (sbr), LMU Munich School of Management, vol. 60(2), pages 122-144, April.
    4. Beattie, Vivien & Goodacre, Alan & Thomson, Sarah Jane, 2006. "International lease-accounting reform and economic consequences: The views of U.K. users and preparers," The International Journal of Accounting, Elsevier, vol. 41(1), pages 75-103.
    5. Vivien Beattie & Keith Edwards & Alan Goodacre, 1998. "The impact of constructive operating lease capitalisation on key accounting ratios," Accounting and Business Research, Taylor & Francis Journals, vol. 28(4), pages 233-254.
    6. Vivien Beattie & Alan Goodacre & Sarah Thomson, 2000. "Recognition versus Disclosure: An Investigation of the Impact on Equity Risk Using UK Operating Lease Disclosures," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 27(9&10), pages 1185-1224.
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    Cited by:

    1. Jennergren, L. Peter, 1998. "A Tutorial on the Discounted Cash Flow Model for Valuation of Companies," SSE/EFI Working Paper Series in Business Administration 1, Stockholm School of Economics, revised 13 Dec 2011.
    2. Jennergren L. Peter, 2011. "Approximate Firm Valuation with Operating Leases," Journal of Business Valuation and Economic Loss Analysis, De Gruyter, vol. 6(1), pages 1-22, September.

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