**Quick Summary**

1. Extend operating lease commitments beyond year five.

2. Calculate the present value of lease payments by using the cost of debt as the discount rate.

3. Determine the implied interest and depreciation expenses.

**1. Extend Lease Commitments after Year Five**

An operating lease is an agreement that allows a lessee to borrow an asset from a lessor like a rental. The operating lease is reported as a lease expense on the income statement of the lessee, but neither the leased asset nor the associated liability are reported on the lessee’s balance sheet. Therefore, even though operating leases create the same kind of obligations as debt, they are kept entirely off the books of the lessee.

Off-balance-sheet obligations, such as operating leases, should be a concern for an analyst as they can affect the ratios and conclusions of a company valuation. To correct for this, analysts can compute what a company’s financial position would look like if operating leases were capitalized. This adjustment means estimating the obligation as the present value of future lease payments and adding that amount to reported assets and liabilities.

Future operating lease commitments are found in the footnotes to the company’s financials. Under U.S. GAAP, future minimum lease payments are disclosed for the first five years and aggregated for all subsequent years thereafter. (Under IFRS, future payments are disclosed for the first year, in aggregate for years 2-5, and in aggregate for all years thereafter). Analysts have to make a judgement about how to treat the lump-sum commitment reported in the final year. The two most common choices are to set year six and beyond equal to (1) the fifth year commitment or (2) the average of the first five years and use that same amount for subsequent years until the lump-sum in the final year is completely drawn down.

This is best illustrated by example. Airline companies are famous for utilizing operating leases in order to flexibly manage their aircraft fleet size in response to fluctuating demand. Below is the operating lease schedule for Southwest Airlines (LUV), per their Form 10-K for the fiscal year ending 12/31/2014. The subsequent table illustrates the two options addressed above on how to treat the lump-sum (“Thereafter”) commitment in the final year.

**2. Estimating Operating Lease Obligation**

In order to determine what additional amount would be reported as debt on the balance sheet if operating leases were capitalized, analysts can discount future lease payments to the present to find the current value of the lease obligations. A reasonable discount rate can be gauged by comparison to the interest rates of the company’s other debt instruments. (For an introduction on how to calculate a firm’s current pre-tax cost of debt, redirect here). Since lease payments are made at the beginning of each period, the first payment should not be discounted (CF0), the second payment should be discounted by one period (CF1), and so on.

At the time of writing this (1/18/2016), Southwest Airlines had a credit rating of BBB and several outstanding bond issues with varying maturities. The yield to maturity (YTM) on the company’s debt due 3/1/2027 (the closest to a 10-year maturity) was 4.34%. The average bond spread for BBB-rated debt at that same time was 2.53% while the 10-year treasury rate was 2.03%, meaning a BBB-rated firm should have a yield on its debt close to 2.53% + 2.03% = 4.56%. For purposes of this analysis, I’ll split the difference and use 4.45% for the cost of debt. This would imply that if the operating leases were capital leases, the corresponding obligation would be $4,347 or $4,370 under option one or two, respectively (in millions).

**3. Implied Interest and Depreciation Expenses**

Two further adjustments must be made to complete the capitalization of operating leases. This involves estimating the related interest expense on the amount owed and the depreciation expense of the asset. To calculate the pro forma interest expense on operating leases, simply multiply the present value of lease payments by the pre-tax cost of debt. In our two cases, the implied interest costs are $193 [=$4,347 x 4.45%] and $194 [=$4,370 x 4.45%].

To determine the pro forma depreciation expense, we divide the present value of lease payments by the number of years of future lease payments (assuming straight-line depreciation). Under our two scenarios, the lease terms would be 9 and 8 years, respectively. This means the implied depreciation costs are $483 [=$4,347 / 9] and $546 [=$4,370 / 8].

In my personal opinion, the above depreciation approach fails to take into account the lumpiness of future commitments (see chart below). In Southwest Airlines’ case, over half of the future commitments are due by period 4 (of 9) or before, meaning a lease term of 9 or 8 years is likely overstated.

My own custom method for approximating the average lease term is slightly more involved (see table below). I assume that the change in operating lease payments each year represents the termination of prior commitments, which can be used as a proxy for the term length of leases. I then multiply these deltas by the time period (i.e. number of years out) in which they end. The sum of those values are then divided by the highest future annual payment, which typically occurs in year one.

* 44 = 715 – 671

** 88 = 44 * 2

*** 6.66 = 5,016 / 753

**Concluding Thoughts**

The capitalization of operating leases on a pro forma basis creates additional long-term financial debt and a corresponding leased asset. Note that by adding the present value of operating leases to both sides of the balance sheet, a number of ratios are affected. These include financial leverage (=equity/assets), debt-to-equity (=long-term financial debt/equity), and interest coverage (=EBIT/interest expense). The weighted averages used in calculating WACC are also affected, as the value of debt is now larger.

**Suggested Readings**

Aswath Damodaran. *Dealing with Operating Leases in Valuation*.