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In accordance with IFRS, almost every leasing contract exceeding one year is recognized as financial leasing. This implies that the contract’s capitalization should occur as assets and liabilities, while the lease payments should be split into amortization and interest expenses.

Under GAAP, we encounter somewhat complex mechanisms. Here, the classification of leasing contracts happens as either financial or operational leasing. A contract is classified as financial leasing only under the following conditions:

• The lease term exceeds 75% of the asset’s economic life.
• The present value of lease payments amounts to 95% of the asset’s initial value.
• The asset’s value is negligible upon lease termination.
• The asset is transferred to the lessee upon contract completion.

In other cases, a leasing contract is classified as operational. Despite the fact that, as a result of the legal amendments introduced in the US in 2019, operational leasing contracts undergo capitalization, their mathematics and implications differ from financial leasing contracts in financial statements.

In the case of operational leasing, the discounting of payment obligations occurs at the organization’s responsible party’s interest rate, and the obtained result is recognized as liabilities and assets, as seen in the table.

Later, the portion of liabilities is subjected to interest expenses, while the asset’s depreciation happens under the “Leasing Expenses” denomination (see Excel file).

The mathematical calculation of operational leasing contracts mandates that the capitalization of leasing assets and liabilities should not correlate during periods, though they both eventually converge to zero by the end.

The process resembles financial leasing, yet it’s not entirely the same. The financial contracts’ interest is included in “Total Interest Expenses,” while asset depreciation follows an annual schedule, with the figure being included in depreciation and reserve.

What’s important here?

We commence NOPAT calculation from EBITA, but, considering accounting principles, EBITA is reduced by operational leasing interest expenses. Thus, to arrive at NOPAT, this expense needs to be added back, as it’s financial rather than operational (see Excel file*).

Furthermore, WACC calculation considers financial structure, hence operational leasing valuations should reflect the equivalent of a loan. Consequently, its impact affects Equity Value as well (see Excel file*).

The Excel file* also provides a check on Cash Flow to Equity Valuation. Sometimes, this method may yield more nuanced results.

Lastly, in the case of short-term contracts, this approach significantly impacts ROIC and warrants a comparison between two different leasing policies. For such comparisons, the following perpetuity formula is suggested:

Lease Expense t = Asset Value (t-1) * (kd +1/Asset Life) =>

Asset Value (t-1) = Lease Expense t / (kd +1/Asset Life)

Where Kd denotes the cost of AA loan. As this applies to the asset’s economic period, additional research is necessary. A comprehensive study (Lim, Mann, Mihov; 7000 companies; 20

Source:
#VALUATION – Measuring and Managing the Value of Companies, 7th Edition
McKinsey & Company,
Tim Koller, Marc Goedhart, David Wessels

Excel Model