Firm Valuation with Operating Leases
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.
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|Date of creation:||14 Mar 2011|
|Date of revision:||18 May 2011|
|Publication status:||Published as Jennergren, L. Peter, 'Approximate Firm Valuation with Operating Leases' in Journal of Business Valuation and Economic Loss Analysis, 2011.|
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