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Capitalizing Operating Leases

The principal advantages perceived by companies who enter into leases are:

They are able to use the assets in their business without showing the related debt. Companies improve theutilization of their assets via leasing since they can add capacity, as needed, a lot more easily by leasingrather than committing to own the assets.

They show no interest expense or depreciation in the income statement, although both of these are part ofthe lease expense account that does run through the income statement.

They avoid certain risks of ownership such as technological obsolescence, physical deterioration, etc. Ifone of these situations arises, the may terminate the lease, although there may be a penalty involved.

If the lessee is in a lower marginal tax bracket than the lessor, leasing is advantageous to both parties. Thelessor can take advantage of any accelerated depreciation tax shields available to them and some of this

benefit is usually passed on to the lessee in reduced lease payments.

Operating leases are leases that fail all of the following four tests under Financial Accounting Standards(FAS) No.13 and, therefore qualify for off balance sheet treatment:

1. The lease transfers ownership of the asset to the lessee by the end of the lease term.

2. The lease contains an option to purchase the leased property at a bargain price.

3. The lease term is equal to or greater than 75% of the estimated useful life of the leased asset.

4. The PV of the lease and other minimum lease payments equals or exceeds 90 percent of the fair valueof the leased asset.

Most analysts will proforma these operating leases back into the companys financial statements to get a moreproper view of their true debt and related expenses in other words, as if the company bought the asset outright andtook on debt to finance it.

As an example, the following is the leasing footnote from McDonalds Corporations 2000 Annual Report:

At December 31, 2000, the Company was lessee at 6,055 restaurant locations through ground leases (theCompany leases the land and the Company or franchisee owns the building) and at 6,984 restaurant

locations through improved leases (the Company leases land and buildings). Lease terms for mostrestaurants are generally for 20 to 25 years and, in many cases, provide for rent escalations and renewaloptions, with certain leases providing purchase options. For most locations, the Company is obligated forthe related occupancy costs including property taxes, insurance and maintenance. In addition, the Companyis lessee under noncancelable leases covering offices and vehicles. Future minimum payments requiredunder existing operating leases with initial terms of one year or more are:

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($ millions) Restaurant Other Total2001 $748.3 $63.3 $811.62002 735.3 55.1 790.42003 705.8 46.4 752.22004 676.2 38.9 715.12005 623.5 34.8 658.3

Thereafter 6,018.7 221.0 6,239.7Total minimum payments $9,507.8 $459.5 $9,967.3

Rent expense was (in millions): 2000$886.4; 1999$796.3; 1998$723.0. These amountsincluded percent rents in excess of minimum rents (in millions): 2000$133.0; 1999$117.1;1998$116.7.

The process for capitalizing these operating leases involves discounting to PV the future stream of lease paymentsas follows:

1. Years 2000-2005 : cash payments as given.

2. Thereafter : divide the amount given by the 2005 amount to give the approximate number of years left, at

the 2005 level, of lease payments. In this case, 6,240/658 = approx. 10 years (rounding up). Then, put 10years worth of payments of $624MM into your PV computation.

3. Use the companys approximate long-term borrowing rate, matching the long-term nature of its assets

7.00% was used here.

4. The PV of this stream is:Year Payment ($millions)

2000 886.42001 811.6

2002 790.4

2003 752.2

2004 715.1

2005 658.3

2006 624.0

2007 624.0

2008 624.0

2009 624.0

2010 624.0

2011 624.0

2012 624.0

2013 624.0

2014 624.0

2015 624.0

PV at 7.00% 6,625.2

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Now, you need to adjust the published financials. Note capitalizing leases does not change net income itmerely replaces lease expense with interest expense and depreciation:

5. Add $6,625.2MM to the long term asset section of the balance sheet as Assets Under Capitalized Leases,and a like amount to the liabilities section as Capitalized Lease Obligations. This now assumes that thecompany had purchased the assets with borrowed money as of 1/1/2000.

.6. Reverse the existing Lease Expense entry currently on the books. In this case, McDonalds paid $886.4MM

in 2000. (Lease expense may be included in another expense category, such as SG&A, etc.)

7. Calculate the implied interest expense portion of the 2000 payment. Here, its $6,625.2MM x 7.00% =

$463.8MM.

8. Since the total payment was $886.4MM, the difference of $422.6MM should be added to depreciation

expense. Result no change in net income.