Capital Leases in Enterprise Value: Why You Should Add Them

In this tutorial, you’ll learn why it’s best to add Capital Leases when moving from Equity Value to Enterprise Value, and why it makes your life much easier when calculating valuation metrics and multiples.
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Table of Contents:
2:09: Operating vs. Capital Leases
4:21: Valuation Multiples and Leases
9:24: Recap and Summary
Some people have disagreed with our treatment of Capital Leases, where we add them when moving from Equity Value to Enterprise Value.
They argue that we should NOT Capital Leases when calculating Enterprise Value because they are operational in nature and do not represent a long-term funding source or different investor group.
You can make a case for this treatment, but from a practical perspective, you pretty much have to add Capital Leases to get consistent valuation multiples.
If you do NOT add them, you’ll have to make further adjustments to metrics such as EBITDA and EBIT when using them in valuation multiples, which may or may not be viable.
Operating vs. Capital Leases
With an operating lease, the company simply rents an asset and records a rental expense under its Operating Expenses on the Income Statement. There is no ownership.
With a capital lease, the company records the asset under PP&E on its Balance Sheet and records the lease as a liability on the L&E side.
It also records Depreciation on the asset and Interest Expense on the Capital Lease on its Income Statement.
The Problem
If you INCLUDE a Balance Sheet item in the numerator of a valuation multiple, you EXCLUDE the corresponding expense in the denominator.
“Exclude” means that you leave it out if it hasn’t yet affected the denominator, or that you add it back if it has.
The opposite applies if you have EXCLUDED a Balance Sheet item in the numerator.
For example, Debt is included in Enterprise Value, so in the EV / EBIT and EV / EBITDA multiples, you exclude the corresponding Interest Expense in the denominator (EBIT or EBITDA).
If you add Capital Leases when calculating Enterprise Value, as we’ve suggested before, you don’t have to do anything special.
By definition, EBITDA already excludes ALL Depreciation and Interest, so it also excludes the Depreciation and Interest from Capital Leases.
This is consistent with adding them to Enterprise Value: You’ve added them in the numerator and excluded the corresponding expenses in the numerator.
But if you do NOT add Capital Leases in the numerator, then you need to adjust EBITDA so that it INCLUDES Depreciation and Interest from Capital Leases.
In other words, you have to SUBTRACT OUT only the portion of Interest and Depreciation associated with Capital Leases from EBITDA.
You end up with some new metric like “EBITDA Adjusted for Capital Leases” (or whatever you want to call it).
Not only is this confusing, but most companies don’t even disclose enough information to do it.
Many firms group together all the expenses for capital leases, and many do not break out Interest and Depreciation from different sources separately.
So, we recommend keeping this concept VERY simple and adding Capital Leases when moving from Equity Value to Enterprise Value.
It has nothing to do with whether or not they’re “financial” or “operational” in nature, but rather a practical consideration: It’s difficult and error-prone to adjust EBITDA (and other metrics) if you do NOT add Capital Leases.
You should use standard metrics that everyone is familiar with and avoid non-standard metrics that require footnotes and explanations.
RESOURCES:
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[@kevinfrancis23]

Yes, aswath damodaran mentioned this in one of his vids, however I understand it a lot better now thanks

[@financialmodeling]

Thanks for watching!

[@chema17bilbao]

I do agree with your arguments... very well and simpified explanation

[@financialmodeling]

Thanks for watching!

[@yihaolu4784]

Good explanation, thx so much

[@financialmodeling]

Thanks for watching!

[@alexandervaltsev6937]

Great video, as always! I have an off-topic question: how do you calculate EBITDA? Do you just take operating income and add D&A or you use some sort of "top-down" or "bottom-up approach"?

[@alexandervaltsev6937]

never mind, saw the approach later in the video

[@bmanq2234]

Great video as always. When we add capital lease to EV we should use present value of capital lease? I am looking at the company and they disclose 2 numbers for capital lease. (1) Total undiscounted cash flows of capital lease liabilities and (2) present value of capital lease liabilities.

[@financialmodeling]

It's best to list the number recorded on their Balance Sheet (often shown within Debt).

[@vincentnguyen6833]

I understand how you said if it is added in the numerator, it must be excluded (added back) in the denominator. In the video you said if "you do not add" Capital leases back you would need to adjust the denominator to include (deduct) the relevant depreciation and interest. The question I had was, does this adjustment to the denominator occur if you "subtract" capital leases from EV, OR "do nothing" (neither add or subtract from EV)? Because when you said if "you do not add" Capital leases, I'm assuming you mean make no changes to equity value when moving to EV (neither add or subtract). But if we are following your rule of only excluding items (add back) in the demoninator which is included (added) in the numerator, wouldn't the reverse have to be including items (deduct) in the denominator and excluded (SUBTRACT) in the numerator - does that mean we subtract Capital leases from Equity value if we were to include the relevant depreciation and interest in the denominator (deduct)? Thanks, hope you understand.

[@financialmodeling]

Enterprise Value by itself does not include capital leases unless you add them first, so it does not make sense to subtract capital leases. So, the first possibility here is out. If you do nothing, then Enterprise Value does not include capital leases. Therefore, you should remove the Depreciation and Interest associated with capital leases from the denominator in metrics such as EBIT and EBITDA so that those metrics only reflect *partial* interest, *partial* Depreciation, etc. This gets very confusing because then the definitions of these metrics start changing, and it's much harder to explain why some interest is included and other interest is not, so the path of least resistance here is to simply add capital leases to Enterprise Value and make sure the full amount of interest and depreciation is added back in EBITDA. You do not adjust Equity Value for capital leases at all because Equity Value only reflects the value of all the company's Assets to common shareholders - it does not represent other investor groups such as the lenders that funded the capital leases.

[@vincentnguyen6833]

Mergers & Inquisitions / Breaking Into Wall Street thanks a lot, that’s makes a lot more sense

[@germanrosales4712]

This adjustment makes EV/EBITDA a consistent multiple, but how could you possibly adjust for EV/EBIT? Since EBIT does consider the depreciation expense on a Capital Lease but not the interest expense, wouldn't it be wrong to add the whole value for Capital Leases to EV?

[@financialmodeling]

You're right; in cases when you're adjusting for capital leases, you pretty much can't use EV/EBIT unless you want to go through a bunch of other, non-standard adjustments (not recommended). So you would have to stick with (EV + Capitalized Leases) / EBITDAR most of the time.

[@ggrrhh909]

Thank you !

[@dominicpascasio6723]

Is cap lease part of the debt in wacc? Thanks

[@financialmodeling]

Yes

[@doomsdayspectrum]

Great lesson. Could you please elaborate a little bit more on the reason why an item included in the numerator has to be excluded in the denominator? Thank you.

[@lokesharora23]

Doomsday Spectrum To explain with a simple example: in EV calculation we take net debt, i.e. gross debt less cash and in denominator, i.e. EBITDA, we exclude all the interest payments on this debt. This simply means that the spectrum that EV is covering, EBITDA is the earnings available to cover it (before that expense i.e. excluding it).

[@financialmodeling]

What Lokesh said above... the denominator represents what's *available* to all the groups in the numerator. So if you're showing debt in the numerator, you need to exclude interest in the denominator because that interest is still available to them for payment. If you're showing preferred stock in the numerator, you need to exclude preferred stock dividends in the denominator because they're still available to the preferred investors as payment.

[@doomsdayspectrum]

Thank you both. That makes a lot of sense. Actually, the confusion simply stems from the fact that "excluding" literally means excluding in the numerator, but "excluding" actually means including in the denominator (adding it back).

[@chonglongchoo]

In another words, "Apple to Apple"

[@lokesharora23]

You're welcome. I agree, this terminology is a little confusing.

[@RichFlair310]

Does ASC 842 change anything in this video, given, under the new rule, both capital and operating leases are now recorded as assets and liabilities?

[@financialmodeling]

Please see the newer coverage of leases and lease accounting on this channel (anything 2020 or beyond). The short answer is you can technically treat Finance Leases (formerly Capital Leases) in different ways, but it's still usually best to add them, especially for IFRS-based companies. U.S. companies are a bit trickier, but Finance Leases also tend to be quite small, so the treatment rarely makes a huge impact either way.

[@vatosiranos]

hey brian, you had at "breaking into wall street" website a section where I could meet some mentors, against payment of a fee, about a career advises. Is this section down or where I can find it. It would be a pleasure to hearing from you asap. best regards

[@financialmodeling]

We do not offer that service anymore (it was done through a 3rd party provider). We do have resume editing/coaching/other services, but those are more comprehensive than a discussion with a mentor.

[@vatosiranos]

ok thx. but can you give me the name of the website of this 3rd party provider. It is not about the use their service. I need to check out the website because of an idea. I would be very pleased if u can send me the name of the website. Best regards

[@financialmodeling]

breakingintowallstreet.evisors.com/

[@vatosiranos]

Mergers & Inquisitions / Breaking Into Wall Street Thx. very much Brian. Do you currently have a problem that you can not solve?

[@kevinfrancis23]

What about operating leases though?

[@financialmodeling]

Please see: kzbin.info/www/bejne/g4OriZSLhLxmmbc