Leases, Pensions, and Other Obligations

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Chapter 27
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• Leases, Pensions, and Other Obligations

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Session Overview

• Over the past 20 years, clever use of existing
  accounting rules has allowed companies to keep
  many assets and their corresponding debts off
  balance sheet. During this session, we will
  adjust the financial statements to normalize for
• Operating leases. A company that chooses to lease
  its assets will have artificially low operating
  profits (because rental expenses include an
  implicit interest expense) and artificially high
  capital productivity (because the assets do not
  appear on the lessees balance sheet).
• Securitized receivables. By selling a portion of
  its receivables, the company will reduce accounts
  receivable on the balance sheet and increase cash
  flow from operations on the accountants cash
  flow statement.
• Pensions. Today, under U.S. GAAP, U.S. companies
  report the market value of pension shortfalls
  (and excess pension assets) on the balance sheet.
  Unfortunately, recent accounting changes have
  addressed only deficiencies on the balance sheet.
  The idiosyncrasies of pension accounting still
  distort operating profitability and can even be
  manipulated by management to enhance margins
  artificially.

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Understanding Leases (Synthetic Debt)

• A business may acquire sole use of an asset
  through a lease.

Use of asset for a contracted period
Monmouth Capital Corporation (lessor)
FedEx Corporation (lessee)
Periodic payments (cover interest costs and asset
depreciation)

• Why lease?
• Flexibility has value to lessee.
• Standardization by lessor leads to efficient
  costs.
• Depreciation tax shields are more valuable to
  lessor (to avoid AMT).

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Lease Types
Capital lease
According to the Financial Accounting Standards
Board (FASB), a capital lease is a lease that
meets one or more of the following four criteria,
meaning it is classified as a purchase by the
lessee (SFAS 13) 1. The lease term is
greater than 75 percent of the assets estimated
economic life. 2. The lease contains an
option to purchase the asset for less than fair
market value. 3. Ownership of the asset is
transferred to the lessee at the end of the lease
term. 4. The present value of lease payments
exceeds 90 percent of the fair market value of
the asset.
Operating lease

• A lease for which the lessee acquires the
  property for only a small portion of its useful
  life. An operating lease is commonly used to
  acquire equipment on a short-term basis. Any
  lease that is not a capital lease is an operating
  lease.

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Operating Leases The Income Statement

• Operating leases combine depreciation and
  interest payments into a single item called
  rental payments.
• Since interest expense is part of rental expense,
  operating income is understated, depressing
  margins versus those companies who borrow money
  to purchase assets.
• Our goal is to eliminate interest expense related
  to operating leases from operating income.

1The value of operating leases is not typically
disclosed. A method for estimating the value of
leased assets is presented later.
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Operating Leases The Balance Sheet

• The value of leased assets via operating leases
  does not appear on the balance sheet, either as
  an operating asset or as a debt.
• Therefore, operating assets and debt are
  understated. This causes capital turns (revenue
  to capital) to be distorted upward and debt to
  EBITDA to be distorted downward versus peers.
• Our goal is to recapitalize operating leases in
  both operating assets and debt.

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Valuing Operating Leases

• Companies seldom disclose the value of their
  leased assets, but you need to estimate their
  value to adjust for operating leases. We
  recommend the following estimation process using
  rental expense, the cost of secured debt, and an
  estimated asset life.

• To compensate the lessor properly, the rental
  expense includes compensation for the cost of
  financing the asset (at the cost of secured debt,
  denoted by kd in the equation) and the periodic
  depreciation of the asset (for which we assume
  straight-line depreciation).

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Process for Capitalizing Leases

• The process for adjusting financial statements
  and valuation for operating leases consists of
  three steps
• 1. Reorganize the financial statements to
  reflect operating leases appropriately.
  Capitalize the value of leased assets on the
  balance sheet, and make a corresponding
  adjustment to long-term debt. Adjust operating
  profit upward by removing the implicit interest
  in rental expense.
• 2. Build a weighted average cost of capital
  (WACC) that reflects adjusted debt to enterprise
  value. To do this, use an adjusted debt-to-value
  ratio that includes capitalized operating leases.
  If unlevered industry betas are used to determine
  the cost of equity, lever them at the adjusted
  debt-to-value ratio to determine the levered cost
  of equity.
• 3. Value the enterprise by discounting free cash
  flow (based on the newly reorganized financial
  statements) at the adjusted cost of capital.
  Subtract traditional debt and the current value
  of operating leases from enterprise value to
  determine equity value.

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Reorganizing the Income Statement

• To adjust the income statement, remove implicit
  interest expense from rental expense. Operating
  taxes must also be adjusted.

Leasing Example NOPLAT Calculation
Rental Expense In year 1, 35.5 million (5
710.6 million) of interest expense is removed
from operating profit.
Operating Taxes Operating taxes are increased by
the marginal tax rate (25) times implicit
interest expense.
Reconciliation Create a new account titled
after-tax lease interest.
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Reorganizing the Balance Sheet

• The value of capitalized operating leases (710.6
  million) is added to book assets to long-term
  debt. The corresponding adjustments increase both
  sources and uses of invested capital.

Leasing Example Invested Capital Calculation
Operating
Financing
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Cost of Capital Capital Structure

• To determine the cost of capital, start by
  computing how the company is financed. To adjust
  capital structure for operating leases, add the
  value of operating leases (710.6 million) to
  unadjusted enterprise value.

Leasing Example Current Capital Structure
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Adjusting the Cost of Capital

• The adjusted cost of capital weights the
  after-tax cost of debt (4.5 percent) by 10
  percent, the cost of equity (12 percent) by 30
  percent, and the after-tax cost of operating
  leases (3.75 percent) by 60 percent. This leads
  to a lower WACC of 6.3 percent.

Leasing Example Weighted Average Cost of Capital
(WACC) Calculation
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Free Cash Flow and Valuation
Leasing Example Free Cash Flow and Equity
Valuation
1. 2.
3.
4.
As long as (1) NOPLAT, (2) invested capital, (3)
cost of capital, and (4) total debt are adjusted
consistently, equity value will be identical.
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Are Leases Really Synthetic Debt?

• If operating leases are forms of synthetic debt,
  debt ratings should drop as leases rise. Yields
  on existing bonds should rise with operating
  leases. Empirical analysis by Lim, Mann, and
  Mihov supports this supposition.

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Session Overview

• Over the past 20 years, clever use of existing
  accounting rules has allowed companies to keep
  many assets and their corresponding debts off
  balance sheet. During this session, we will
  adjust the financial statements to normalize for
• Operating leases. A company that chooses to lease
  its assets will have artificially low operating
  profits (because rental expenses include an
  implicit interest expense) and artificially high
  capital productivity (because the assets do not
  appear on the lessees balance sheet).
• Securitized receivables. By selling a portion of
  its receivables, the company will reduce accounts
  receivable on the balance sheet and increase cash
  flow from operations on the accountants cash
  flow statement.
• Pensions. Today, under U.S. GAAP, U.S. companies
  report the market value of pension shortfalls
  (and excess pension assets) on the balance sheet.
  Unfortunately, recent accounting changes have
  addressed only deficiencies on the balance sheet.
  The idiosyncrasies of pension accounting still
  distort operating profitability and can even be
  manipulated by management to enhance margins
  artificially.

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Receivables Securitization

• Another common method of moving assets of the
  balance sheet is securitization.
• To securitize an asset, the company either sells
  the assets outright or transfers the assets to an
  independent subsidiary called a special purpose
  entity (SPE).
• As long as the company owns less than 50 percent
  of the SPE and the SPE has more than 3 percent
  ownership by unaffiliated parties, the original
  company is not required to consolidate the SPEs
  assets on its own balance sheetnor recognize its
  obligations.
• Consider the following example

Crown Holdings, Inc. The Company had no
outstanding borrowings under its 758
revolving credit facility at December 31, 2008
and had 234 of securitized receivables. . . .
The Company recorded expenses related to the
securitization facilities of 14, 17, and 15,
respectively, as interest expense,
including commitment fees of 0.25 on the unused
portion of the facilities.
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Interest or SGA?

• In some cases, fees are included in selling,
  general, and administrative (SGA) expense,
  rather than interest expense. In these
  situations, the fees must be moved from SGA
  expense to interest expense for valuation of the
  company.
• For example, Hasbro includes securitization fees
  in its selling expenses

Hasbro Inc. As of December 30, 2008 and December
31, 2007 the utilization of the receivables
facility was 250,000. During 2008, 2007, and
2006, the loss on the sale of the receivables
totaled 5,302, 7,982, and 2,241, respectively,
which is recorded in selling, distribution, and
administration expenses in the accompanying
consolidated statements of operations.
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The Dark Side of Securitization

• Imagine that you run a division that sells 1
  billion in products to a large customer. The
  customer typically pays in 30 to 45 days, and
  thus has 120 million in receivables outstanding.
  
• Your division is short of cash, and therefore
  asks the customer to pay in cash. To encourage
  the transaction, you offer a discount of 5
  million. What happens to EBIT, NOPAT, invested
  capital, and ROIC?
• Lets say instead you decide to trade the
  receivables for cash with a third party for a 5
  million fee. If the fee is classified as
  interest, what will happen to EBIT, NOPAT,
  invested capital, and ROIC?

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Session Overview

• Over the past 20 years, clever use of existing
  accounting rules has allowed companies to keep
  many assets and their corresponding debts off
  balance sheet. During this session, we will
  adjust the financial statements to normalize for
• Operating leases. A company that chooses to lease
  its assets will have artificially low operating
  profits (because rental expenses include an
  implicit interest expense) and artificially high
  capital productivity (because the assets do not
  appear on the lessees balance sheet).
• Securitized receivables. By selling a portion of
  its receivables, the company will reduce accounts
  receivable on the balance sheet and increase cash
  flow from operations on the accountants cash
  flow statement.
• Pensions. Today, under U.S. GAAP, U.S. companies
  report the market value of pension shortfalls
  (and excess pension assets) on the balance sheet.
  Unfortunately, recent accounting changes have
  addressed only deficiencies on the balance sheet.
  The idiosyncrasies of pension accounting still
  distort operating profitability and can even be
  manipulated by management to enhance margins
  artificially.

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Pension Accounting

• The process of how to incorporate excess pension
  assets and unfunded pension liabilities into
  enterprise value, and how to adjust the income
  statement to eliminate accounting distortions
  consists of the following three steps
• Identify excess pension assets and unfunded
  liabilities on the balance sheet. If the company
  does not separate pension accounts, search the
  pension footnote for their location. Excess
  pension assets should be treated as nonoperating,
  and unfunded pension liabilities should be
  treated as a debt equivalent.
• Add excess pension assets to and deduct unfunded
  pension liabilities from enterprise value.
  Valuations should be done on an after-tax basis.
• Remove the accounting pension expense from cost
  of sales, and replace it with the service cost
  and amortization of prior service costs reported
  in the notes. The pension expense, service cost,
  and amortization of prior service costs are
  reported in the companys notes.

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Step 1 Identify Assets and Liabilities

• Not every company reports prepaid pension assets
  and unfunded pension liabilities as a separate
  line item. Many companies consolidate prepaid
  pension assets in other long-term assets and
  unfunded pension liabilities as part of other
  long-term liabilities, making them difficult to
  identify.

DuPont Pension Note in Annual Report, Funded
Status
Overfunded pensions are embedded in other assets
therefore a good portion of other assets should
NOT be included in invested capital.
The same holds true for unfunded liabilities.
They should not be treated as operating
liabilities, but rather as debt equivalents.
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Step 2 From Enterprise to Equity Value

• For an ongoing enterprise, excess pension assets
  can be netted against unfunded liabilities to
  determine net assets (liabilities) outstanding.
• To incorporate pensions for a company with net
  excess assets, add (1 Marginal Tax Rate) Net
  Pension Assets to enterprise value, as excess
  pension assets will lead to fewer required
  contributions in the future.
• To value companies with net unfunded liabilities,
  deduct (1 Marginal Tax Rate) Net Pension
  Liabilities from enterprise value.
• For enterprises in liquidation, investigate the
  tax implications of under- or overfunding. For
  instance, many countries impose large tax
  penalties to withdraw excess funding from pension
  plans.

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Step 3 Adjust Income Statement

• To determine the portion of pension expense that
  is compensation to employees (and not gains and
  losses on pension investments), combine service
  cost and amortization of prior service cost to
  arrive at todays value of promised retirement
  payments.

DuPont Adjusted Operating Profits
Pension Adjustment To remove plan performance
from operating expenses, remove pension
expensein DuPonts case, a 54 million gain in
2007 (subtract gains, add back expenses)and
replace it with the service cost (383 million)
and amortization of prior service cost (18
million).