An Alternative Method for Valuing Operating Leases  453 flow equal to the 2024 lease payment. To estimate the number of years, divide the undiscounted lump sum by the 2024 rental payment. For Costco, the an- nuity value equals almost $1.8 billion. Since the annuity values the lump-sum payments beyond 2024 as of 2024, make sure to discount the result back to 2019, as you would any other cash flow. In general, when reorganizing the balance sheet, include the value of oper- ating leases as part of invested capital. Incorporate the corresponding liability as a debt equivalent. For past statements, the asset will equal the liability. In Chapter 11, we adjust Costco’s reorganized financial statements for operating leases. Exhibit 11.5 presents invested capital inclusive of operating leases, and Exhibit 11.9 adjusts EBITA and NOPAT for implicit interest. To calculate implicit interest for 2019, multiply the cost of debt of 3.63 percent by the 2018 capitalized operating lease of $2.5 billion. The resulting adjustment to EBITA equals $91 million. An Alternative Method for Valuing Operating Leases To capitalize operating leases on the balance sheet, the company discounts future lease commitments at the company’s borrowing rate. For short-term leases, this methodology will understate the actual value of the asset, since it ignores the residual value of the asset being returned to the lessor. Consider FlightCo, which rented an aircraft for three years of the plane’s 40-year life. A new aircraft may cost $125 million, but three years of rental expense will be far lower. EXHIBIT 22.10  Costco: Operating Lease Valuation, 2019 $ million Forecast year Rental commitments Discount factor at 3.6%1 Present value of payments 2020 239.0 0.965 230.6 2021 229.0 0.931 213.2 2022 202.0 0.898 181.5 2023 193.0 0.867 167.3 2024 181.0 0.837 151.4 Payments beyond 2024 1,757.1 0.837 1,470.0 Value of operating leases 2,414.0 Value beyond 2024 Rental commitments beyond 2024 2,206.0 / Final year rental payment 181.0 = Number of years 12.19 Annuity value of $181.0 per year for 12.19 years = $1,757.1 1 Yield-to-maturity on 10-year AA-rated debt. Source: Costco 2019 annual report, note 5. 454  Leases While using the present value of lease payments in place of the true asset value will not bias the valuation, it will understate the value of the assets being deployed to run operations. (The error will be largest for short-term leases on long-term assets. In the case of finance leases, the error will be small, since the lease life more closely matches the asset life.) When benchmarking two companies, one that purchases assets and one that rents them, the comparison will not be like-for-like, even under new accounting standards.6 Distortions to ROIC and capital turnover will be largest when leased assets are a significant proportion of invested capital. One way to create a like-for-like comparison for companies with different leasing policies is to estimate each company’s asset value by using a perpetuity. To see how, let’s examine the determinants of rental expense. 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 following equations) and the periodic depreciation of the asset (for which we assume straight-line depreciation). The following equation solves for periodic rental expense: Lease Expense Asset Value Asset Life t t d k = +       −1 1 (22.1) To estimate the asset’s value, rearrange equation 22.1 as follows: Asset Value Lease Expense Asset Life t t d k −= +       1 1 (22.1) Lease expense is disclosed in the notes, and the cost of debt can be esti- mated using AA-rated yields. This leaves only the asset life, which is often un- reported. If this is the case, search the notes for the type of asset being leased, and estimate an asset life appropriate to the asset type. As an alternative, Lim, Mann, and Mihov propose using property, plant, and equipment (PP&E) di- vided by annual depreciation.7 In their research, they examined 7,000 firms over 20 years and computed the median asset life at 10.9 years. 6 In this section, we focus on the distortions to benchmarking caused by different leasing policies. Com- panies choose different leasing policies for many reasons, including flexibility and taxes. 7 S. C. Lim, S. C. Mann, and V. T. Mihov, “Market Evaluation of Off–Balance Sheet Financing: You Can Run but You Can’t Hide” (EFMA 2004 Basel Meetings paper, European Financial Management Associa- tion, December 1, 2003). Closing Thoughts  455 Closing Thoughts Recent changes in lease accounting have brought financial reporting very close to the core principles of this book. Still, a proper valuation requires spe- cial care regarding operating leases. To inform better forecasts, adjust state- ments created prior to the accounting rules changes to incorporate operating leases. If you do not, apples-to-oranges comparisons may obscure crucial trends. For statements reported after the changes, remember to eliminate any interest embedded in operating expenses. Otherwise, you risk double-count- ing embedded interest, biasing your valuation downward. The task requires discipline and attention to detail, but with practice, the adjustments should become routine.