On the forecasting of lease expense in firm valuation

The forecasting of operating lease expense in valuation models like the discounted dividends model is more complex than the forecasting of non-lease cash operating expense. The reason is that lease expense depends on past real growth and inflation, due to the long lives of the leased assets, whereas non-lease cash operating expense depends only on this year's nominal sales revenue. Naive forecasting (as if lease expense depends only on current nominal sales revenue) can have a noticeable impact on the calculated value of the equity, if the company is a heavy user of leased equipment and has experienced rapid real growth in recent years. It is shown how lease expense can be forecasted, without capitalizing, in a fashion that does take into account the dependence on past real growth and inflation. Operational leases also affect the cost of capital for discounting, since they represent debt, even if not capitalized. Hence they enter into the financing structure that goes into the cost of capital. An illustrative stylized example is used throughout.