Capital Leases and FCF
Hi all,
Just want to confirm how to properly calculate FCF (unlevered) under capital leases (or finance leases).
I understand the lease expense is now split into interest and depreciation. Following the formula for FCF:
FCF = NOPAT + D&A - changes in NWC - capex
When one thinks about the actual cash outflow of the lease, it's equal to the interest component and principal component (i.e. cash payment - interest component). The interest component is not included in FCF (as we are using NOPAT, which excludes interest), and the principal component is under cash from financing so also is not part of FCF. Therefore, it looks to me as if we have excluded the cash effects of the capital lease.
My question is, do we then also have to add back the depreciation component of the lease expense together with the rest of normal depreciations? My initial feeling is yes, as it seems we have already accounted for the cash flow impact of the lease by excluding both interest and principal payment from FCF (as we are treating as debt), and it seems like if we don't add it back we are kind of missing the tax benefit from the depreciation in a sense...
Thanks!
FCF calc doesn't change in either way you can account for leases. If you keep the leases on the balance sheet as a financing item you technically now should include it in your WACC and in the bridge from EV to Eq value. If you convert the accounting back to how it used to be (leases are expensed) then the impact is already included within your NOPAT and there's nothing further. Theoretically both should give the exact same output but in reality there may be some difference.
Hi, thanks for the reply! So just to confirm, in either case my assumption that we would add back all depreciation (including lease related) is correct?
I would look to the lease notes or cash flow statement in the FS to get the lease cash payment amount
Personally I prefer to always include lease cost in EBITDA vs in EV to equity value buildup. You get a more consistent cost through EBITDA vs accounting for timing of lease renewal in EV, e.g. the balance can be low at the end of a lease term but the next day at renewal suddenly it’s a large balance - it can skew equity value if you’re working down from EV / EBITDA.
I’ve never seen capital leases included in WACC but that’s an interesting concept
Agree with this. Can stand behind both approaches (both theoretically correct) but sticking to pre IFRS is more prudent given accounting nuances.
Agreed on it being preferable to expense the cost, however I am London based and with IFRS16, both finance and operating leases are treated the same so often it's easier just to use the accounts as is and adjust in WACC and bridge rather than redo the statements.
Going back to the point on WACC - the materials I used to learn are very helpful to understand the impact on valuation in general so would recommend for OP (and yourself if interested). Both are written by accounting firms (RSM India and Deloitte).
https://www.google.com/url?sa=t&source=web&rct=j&opi=89978449&url=https…
https://www.google.com/url?sa=t&source=web&rct=j&opi=89978449&url=https…
CPA here - yes you add back depreciation from the capital lease. Cap leases are to be treated as if they are assets you own, so in principal, everything associated with those leases should theoretically be treated as if you purchased said asset
Operating leases are where things might differ. Since it's bucketed under the account "lease expense". Typically this is an adjustment to purchase price from the QofE provider. The idea is that they want all transactions to account for this on an apples-to-apples basis, so they might do a pro-forma adjustment where they say if you were to theoretically purchase instead of lease, what would the hit to capex be and then they would add back the lease expense in EBITDA
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