newlease - Leases, Debt and Value Aswath Damodaran Stern...

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Leases, Debt and Value Aswath Damodaran Stern School of Business 44 West Fourth Street New York, NY 10012 adamodar@stern.nyu.edu April 2009
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Abstract When analyzing or the value of a firm, there are three basic questions that we need to address: How much is the firm generating as earnings? How much capital has been invested in its existing investments? How much has the firm borrowed? In answering these questions, we depend upon accounting assessments of earnings, book capital and debt. We assume that the reported operating income is prior to any financing expenses and that all debt utilized by the firm is treated as such on the balance sheet. While this assumption, for the most part, is well founded, there is a significant exception. When a firm leases an asset, the accounting treatment of the expense depends upon whether it is categorized as an operating or a capital lease. Operating lease payments are treated as part of operating expenses, but we will argue that they are really financing expenses. Consequently, the stated operating income, capital, profitability and cash flow measures for firms with operating leases have to be adjusted when operating lease expenses get categorized as financing expenses. This can have far reaching implications for profitability, financial leverage and assessed value at firms.
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Many firms that use long-lived, expensive assets for their operations have a choice of either buying these assets, often borrowing a significant portion of the costs, or leasing them. Since the firm puts the assets to use, generating revenues and operating profits, in either case, it seems logical to consider leasing as a financing choice and leasing costs as financing costs. Unfortunately, both US and international accounting standards choose to ignore this logic and allow a significant portion of lease expenses to be treated as operating expenses. Consequently, the operating income of a firm that has significant operating lease expenses will be misstated, as will the reported book values of debt and capital. If we use these reported numbers in analyzing the firm, we will arrive at skewed estimates of profitability, leverage and value. In this paper, we will begin by examining the accounting and tax treatment of leases and follow up by presenting the argument for why leases should be treated as financing expenses. We will then follow through by examining the consequences of converting leases into debt, for widely used measures of financial leverage and profitability. In the next section, we will explore the effects of converting leases to debt on cash flows, costs of capital and firm value. In the final section, we will examine the factors that firms should consider in deciding on whether to lease or buy assets. The issue is timely, now that recent news stories suggest that both the Financial
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newlease - Leases, Debt and Value Aswath Damodaran Stern...

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