Valuing a Company with Operating Leases  447
Reorganizing the Financial Statements
To start the valuation of FlightCo, first reorganize the financial statements. 
Exhibit 22.3 presents the income statement, balance sheet, and statement of 
equity for FlightCo.
Using the information from FlightCo’s financial statements, Exhibit 22.4 
presents a calculation of NOPAT and its reconciliation to net income. The pro-
cess starts by adding back the implicit interest embedded in the operating 
lease expense. To estimate implicit interest, multiply the prior year’s operat-
ing lease liability by the interest rate used to value the operating lease. (If the 
company does not disclose the discount rate for operating leases in the notes, 
use the yield to maturity on AA-rated debt.) For FlightCo, embedded interest 
equals the operating lease liability of $27.1 million multiplied by the interest 
rate of 5 percent. Estimate implicit interest using the operating lease liability 
and not the right-of-use asset.
EXHIBIT 22.3  FlightCo: Financial Statements
$ million
Year 0
Year 1
Year 2
Year 3
Income statement
Revenue
75.0
75.0
75.0
Operating expenses
(40.0)
(40.0)
(40.0)
Operating lease expense1
(10.0)
(10.0)
(10.0)
Operating profit, unadjusted
25.0
25.0
25.0
Interest expense, debt2
(0.4)
(0.3)
(0.3)
Earnings before taxes
24.6
24.7
24.7
Income taxes at 20%
(4.9)
(4.9)
(4.9)
Net income
19.7
19.7
19.8
Balance sheet
Inventory
15.0
15.0
15.0
–
Right-of-use assets
27.1
18.5
9.4
–
Total assets
42.1
33.5
24.4
–
Operating leases
27.1
19.5
11.4
–
Debt
7.8
6.6
5.0
–
Equity
7.2
7.4
8.0
–
Liabilities and equity
42.1
33.5
24.4
–
Statement of equity
Equity, start
7.2
7.4
8.0
Net income
19.7
19.7
19.8
Dividends and/or share repurchases
(19.5)
(19.1)
(27.8)
Equity, end
7.4
8.0
–
1 Typically embedded in operating expenses, such as cost of sales.
2 Interest equals 0.39, 0.33, and 0.25 in Year 1 through Year 3. As such, rounding errors affect earnings before taxes and net income.

448  Leases
To calculate NOPAT, subtract operating taxes from adjusted operating 
profit. Operating taxes are estimated by multiplying operating profit by the 
operating tax rate. The resulting NOPAT for year 1 is $21.1 million. The tax 
shield for embedded interest will be incorporated into the cost of capital.
We do not present a reorganized balance sheet for FlightCo, as the simpli-
fied balance sheet already matches invested capital. In general, include the 
right-of-use asset as part of invested capital and the operating lease liability 
as a source of financing.
Estimating Free Cash Flow
Once the financial statements are reorganized, estimate free cash flow. 
Exhibit 22.5 presents the free cash flow statement and its reconciliation to 
cash flow to investors for FlightCo. Free cash flow starts with NOPAT. Since 
FlightCo does not own property or equipment, there is no add-back for de-
preciation.4 From this value, subtract increases in working capital (inventory) 
and long-term assets (in this case, the right-of-use assets). Since both accounts 
are declining over time, they are positive numbers.
Note in Exhibit 22.5 how the summation of operating lease interest and 
the decrease in right-of-use assets equal the operating lease expense from Ex-
hibit 22.3. Essentially, the valuation process eliminates the entire lease expense 
for existing assets from free cash flow. At the completion of the valuation, the 
lease of existing assets will not be valued as part of free cash flow, but rather as 
debt. Consistent with fundamental finance principles, this process separates 
investing flows from the manner in which they are financed.
EXHIBIT 22.4  FlightCo: NOPAT and Reconciliation to Net Income
$ million
Year 1
Year 2
Year 3
EBITA,1 unadjusted
25.0
25.0
25.0
Operating lease interest
1.4
1.0
0.6
EBITA, adjusted for lease interest
26.4
26.0
25.6
Operating taxes at 20%
(5.3)
(5.2)
(5.1)
NOPAT2
21.1
20.8
20.5
Reconciliation to net income
Net income
19.7
19.7
19.8
Interest expense, debt
0.4
0.3
0.3
Operating lease interest
1.4
1.0
0.6
Interest tax shield at 20%
(0.3)
(0.3)
(0.2)
NOPAT
21.1
20.8
20.5
1 Earnings before interest, taxes, and amortization.
2 Net operating profit after taxes.
4 To determine free cash flow, we incorporate the change in the right-of-use asset, which for FlightCo is 
decreasing over time. The positive value generated by the decline mimics the depreciation add-back. 
Essentially, the cash flows from capitalizing a lease are identical to those from purchasing an asset 
financed with debt.